FM213 Principles of Finance

Part 2
Lecture 5

Kim Fe Cramer

LSE Finance
Assistant Professor
This Lecture

1. What projects should you invest in?

• Lecture 1: Capital budgeting and the NPV rule
• Lecture 2: Real options

2. How should you distribute the money you made?

• Lecture 3: Payout Policy

3. How should you raise more money for investments?

• Lecture 4: Does debt policy matter?
• Lecture 5+6: How much debt should a firm borrow?
• Lecture 7: The many different types of debt
• Lecture 8: Initial public offerings

4. Should you agree to a merger?

• Lecture 9: Mergers, corporate governance, and control

5. How can you manage risk?

• Lecture 10: Risk management and hedging

1
What Did We Do?

• Definitions

• The effects of increasing debt

• Firm’s cost of capital

• Exercise

2
This Lecture

1. What projects should you invest in?

• Lecture 1: Capital budgeting and the NPV rule
• Lecture 2: Real options

2. How should you distribute the money you made?

• Lecture 3: Payout Policy

3. How should you raise more money for investments?

• Lecture 4: Does debt policy matter?
• Lecture 5+6: How much debt should a firm borrow?
• Lecture 7: The many different types of debt
• Lecture 8: Initial public offerings

4. Should you agree to a merger?

• Lecture 9: Mergers, corporate governance, and control

5. How can you manage risk?

• Lecture 10: Risk management and hedging

3
Lecture Overview (Chapter 17.1 & 17.2)

• Recap of theory: debt doesn’t matter for firm value!

• Managers and markets: it matters!

• Calculating firm value under debt

• Debt advantage 1: corporate taxes

• Debt advantage 2: personal taxes

• Debt disadvantage 1: direct bankruptcy costs

• Debt disadvantage 2: indirect bankruptcy costs

4
Lecture Overview (Chapter 17.1 & 17.2)

• Recap of theory: debt doesn’t matter for firm value!

• Managers and markets: it matters!

• Calculating firm value under debt

• Debt advantage 1: corporate taxes

• Debt advantage 2: personal taxes

• Debt disadvantage 1: direct bankruptcy costs

• Debt disadvantage 2: indirect bankruptcy costs

5
Modigliani-Miller

Theorem: Debt does not affect firm value

Assumptions

1. Investment decisions don’t change

2. No transaction costs

3. Efficient capital markets

4. Managers maximize shareholders’ wealth

5. No taxes

6. No bankruptcy costs

6
Modigliani-Miller

Theorem: Debt does not affect firm value

Assumptions

1. Investment decisions don’t change

2. No transaction costs

3. Efficient capital markets

4. Managers maximize shareholders’ wealth

5. No taxes

6. No bankruptcy costs

7
Assumptions Are Still Useful

• Even though many of the assumptions are unrealistic, they are

still useful because they tell us where to look

• They will be our guide for the next two lectures

8
Lecture Overview (Chapter 17.1 & 17.2)

• Recap of theory: debt doesn’t matter for firm value!

• Managers and markets: it matters!

• Calculating firm value under debt

• Debt advantage 1: corporate taxes

• Debt advantage 2: personal taxes

• Debt disadvantage 1: direct bankruptcy costs

• Debt disadvantage 2: indirect bankruptcy costs

9
Manager and Markets: Debt Matters

• If capital structure really did not matter, then actual debt ratios
should vary randomly from firm to firm and industry to industry.
But in some industries firms borrow much more heavily!

Median book-value ratios of debt to

debt-plus-equity by industry (2020)
10
Lecture Overview (Chapter 17.1 & 17.2)

• Recap of theory: debt doesn’t matter for firm value!

• Managers and markets: it matters!

• Calculating firm value under debt

• Debt advantage 1: corporate taxes

• Debt advantage 2: personal taxes

• Debt disadvantage 1: direct bankruptcy costs

• Debt disadvantage 2: indirect bankruptcy costs

11
Calculating Firm Value With Adjusted Present Value

• APV makes a series of present value calculations

APV = base-case NPV + PVs of financing side effects

• Positive side effects: taxes

• Negative side effects: bankruptcy costs

• Rule: firms should maximize APV, balancing benefits and costs

12
Lecture Overview (Chapter 17.1 & 17.2)

• Recap of theory: debt doesn’t matter for firm value!

• Managers and markets: it matters!

• Calculating firm value under debt

• Debt advantage 1: corporate taxes

• Debt advantage 2: personal taxes

• Debt disadvantage 1: direct bankruptcy costs

• Debt disadvantage 2: indirect bankruptcy costs

13
Modigliani-Miller

Theorem: Debt does not affect firm value

Assumptions

1. Investment decisions don’t change

2. No transaction costs

3. Efficient capital markets

4. Managers maximize shareholders’ wealth

5. No taxes

6. No bankruptcy costs

14
Capital Structure Under Taxes

• Interest payments are tax deductible (= we pay them from our

EBIT before we pay taxes)

• Tax shield calculation

tax shield = rD ∗ tC ∗ D (1)

Example:
• Suppose you have an EBIT of $10, and a tax rate of 40%. If you
have zero debt, your after tax cash flow to equity is
$10*(1-0.4)=$6

• Now assume you take up debt $100 with an interest payment of

5%. Now the cash flow to debt is $5 and the cash flow to equity is
($10-$5)*(1-0.4)=$3. The total cash flow is $8

• The total cash flow to investors is higher if you have debt ($8)
because you benefit from a tax shield
tax shield = 0.05 ∗ 0.4 ∗ $100 = $2 (2) 15
Example

• Your company has no debt and is valued at $4m

• Your annual profit is $900k before interest and taxes

• You pay 35% in corporate taxes

• You have the option to raise capital via perpetual bonds with an
interest rate of 5% and debt of $2m. You think about using this
money to exchange 50% of your equity (buy back shares). Should
you do this?

16
Example

• Remember the adjusted present value

APV (firm value) = base-case NPV + PVs of financing side effects

• Calculate PV of tax shield:

rD ∗ D ∗ tC 0.05 ∗ $2m ∗ 0.35
PV (tax shield) = = = 700, 000
rD 0.05
(3)

• With higher leverage, you have a higher tax benefit, and thus a
higher firm value. Sounds like a no brainer!

17
Weighted Average Cost of Capital Under Taxes

• Since you have to pay less for raising capital due to the tax
shield, you also need to adjust your WACC formula:

D E
After-tax WACC = ( ∗ rD ∗ (1 − tC )) + ( ∗ rE ) (4)
D+E D+E

18
Summary

• We learned that firms can benefit from tax shields and this could
increase their firm value

• There is another important advantage of debt: it is only taxed

once (equity faces double taxation)

19
Lecture Overview (Chapter 17.1 & 17.2)

• Recap of theory: debt doesn’t matter for firm value!

• Managers and markets: it matters!

• Calculating firm value under debt

• Debt advantage 1: corporate taxes

• Debt advantage 2: personal taxes

• Debt disadvantage 1: direct bankruptcy costs

• Debt disadvantage 2: indirect bankruptcy costs

20
Modigliani-Miller

Theorem: Debt does not affect firm value

Assumptions

1. Investment decisions don’t change

2. No transaction costs

3. Efficient capital markets

4. Managers maximize shareholders’ wealth

5. No taxes

6. No bankruptcy costs

21
Personal Taxes

• We denoted corporate tax rate by tC

• Debt holders pay taxes on interest income tP D

• Equity holders pay taxes on equity income tP E

(dividends and capital gains after sale)

• Firms do not pay taxes on interest payouts

22
Personal Taxes

• Would you rather raise debt or equity?

raise debt equity

income before tax $1 $1
corporate tax none tC
income after corporate tax $1 $1-tC
personal taxes $1∗tP D ($1-tC )∗tP E
income after all taxes $1-$1 ∗ tP D ($1-tC )- ($1-tC )∗tP E
= ($1-tP E )∗($1-tC )

• Relative advantage of debt (RAD)

1 − tP D
RAD = (5)
(1 − tP E ) ∗ (1 − tC )
• If RAD>1, issue debt; if RAD < 1 issue equity

23
Example

• Suppose personal capital gain tax is 10.5%, personal interest tax

is 30%, and corporate tax is 35%. Which is more efficient, debt or
equity?
raise debt equity
income before tax $1 $1
corporate tax $0 $0.35
income after corporate tax $1 $0.65
personal taxes $0.3 $0.068
income after all taxes $0.7 $0.582
• Advantage of debt = $0.118

• Relative advantage of debt = 1−0.3

(1−0.105)∗(1−0.35) = 1.2

• Since RAD>1, issue debt

24
So Why Firm’s Don’t Borrow More?

• We learned that firms can benefit from tax shields and this could
increase their firm value

• Additionally, debt only faces taxation once, while equity faces

double taxation

• So why don’t firms borrow more?

25
Lecture Overview (Chapter 17.1 & 17.2)

• Recap of theory: debt doesn’t matter for firm value!

• Managers and markets: it matters!

• Calculating firm value under debt

• Debt advantage 1: corporate taxes

• Debt advantage 2: personal taxes

• Debt disadvantage 1: direct bankruptcy costs

• Debt disadvantage 2: indirect bankruptcy costs

26
Modigliani-Miller

Theorem: Debt does not affect firm value

Assumptions

1. Investment decisions don’t change

2. No transaction costs

3. Efficient capital markets

4. Managers maximize shareholders’ wealth

5. No taxes

6. No bankruptcy costs

27
Bankruptcy Costs

• If a firm defaults on debt (missing interest payments or

principal), it is bankrupt

• Direct bankruptcy costs: legal and administrative costs (e.g.

lawyers’ fee, court fee)

• Indirect bankruptcy costs: poor investment/operating

decisions due to possible bankruptcy

We start with direct costs in the following example

28
Example: No Direct Bankruptcy Costs

• Assume you have a firm that can conduct a project with required
investment of $60. The cash flow of this project is with 50%
probability $100 and with 50% probability $60. The cash flow is
realized in one year, and the expected return on asset is rA = 0.15

• Assume that this firm has a leverage that is so high that in the
bad state, the firm defaults (D = $60). The expected return on
debt is rD = 0.066 and βD = 0

• What is the value of firm equity E under no bankruptcy costs?

(also assuming no taxes)

29
Example: No Direct Bankruptcy Costs

Method 1 (= solving two equations with two unknowns)

• First, use the formula we learned in the last lecture
D $60
rE = rA + (rA − rD ) = 0.15 + (0.15 − 0.066) (6)
E E

• We also have another formula for equity

Equity cash flows
E= (7)
(1 + rE )

• What are the equity cash flows?

30
Example: No Direct Bankruptcy Costs

Method 1 (= solving two equations with two unknowns)

today bad state good state expected

total free cash flow 0 60 100 80
bond cash flows -60 60 ? ?
equity cash flows 0 0 ? ?

• In the good state, pay back the full face value (F); if not, pay
back as much as you can ($60). The first line calculates the value
of debt D in one year. The second line says, in expectation, the
debt holder must receive this value.
D ∗ (1 + rD ) = $60 ∗ 1.066 = $64
0.5 ∗ F + 0.5 ∗ $60 = $64 (8)
F = $68

Face value (F) equals dollar amount firm pays to the debt holder
at maturity. Debt value (D) is the current value of this security.
31
Example: No Direct Bankruptcy Costs

Method 1 (= solving two equations with two unknowns)

today bad state good state expected

total free cash flow 0 60 100 80
bond cash flows -60 60 68 64
equity cash flows 0 0 32 16

• In the good state, pay back the full face value (F); if not, pay
back as much as you can ($60). The first line calculates the value
of debt D in one year. The second line says, in expectation, the
debt holder must receive this value.
D ∗ (1 + rD ) = $60 ∗ 1.066 = $64
0.5 ∗ F + 0.5 ∗ $60 = $64 (9)
F = $68

Face value (F) equals dollar amount firm pays to the debt holder
at maturity. Debt value (D) is the current value of this security.
32
Example: No Direct Bankruptcy Costs

Method 1 (= solving two equations with two unknowns)

• First, use the formula we learned in the last lecture
D $60
rE = rA + (rA − rD ) = 0.15 + (0.15 − 0.066) (10)
E E

• We also have another formula for equity

$16
E= (11)
(1 + rE )

• Solving these two equations gives rE = 0.6788 and E = $9.56

33
Example: No Direct Bankruptcy Costs

Method 2 (= firm value)

• The value of the firm is
0.5 ∗ $100 + 0.5 ∗ $60
= $69.56 (12)
1 + 0.15

• Now we can calculate

E = V − D = $69.56 − $60 = $9.56 (13)

34
Example: With Direct Bankruptcy Costs

• Assume now that we introduce direct bankruptcy costs

• If bankruptcy occurs, the firm must pay 7% of the realized cash

flows to lawyers (direct costs)

• What is now the value of firm equity E?

35
Example: With Direct Bankruptcy Costs

Method 1 (= solving two equations with two unknowns)

• First, use the formula we learned in the last lecture
D $60
rE = rA + (rA − rD ) = 0.15 + (0.15 − 0.066) (14)
E E

• We also have another formula for equity

Equity cash flows
E= (15)
(1 + rE )

• What are the equity cash flows?

36
Example: With Direct Bankruptcy Costs

Method 1 (= solving two equations with two unknowns)

today bad state good state expected

total free cash flow 0 56 (=60*0.93) 100 78
bond cash flows -60 56 (=60*0.93) 72 64
equity cash flows 0 0 28 14

• In the good state, pay back the full face value (F); if not, pay
back as much as you can ($56). The first line calculates the value
of debt D in one year. The second line says, in expectation, the
debt holder must receive this value.
D ∗ (1 + rD ) = $60 ∗ 1.066 = $64
0.5 ∗ F + 0.5 ∗ $56 = $64 (16)
F = $72

37
Example: With Direct Bankruptcy Costs

Method 1 (= solving two equations with two unknowns)

• First, use the formula we learned in the last lecture
D $60
rE = rA + (rA − rD ) = 0.15 + (0.15 − 0.066) (17)
E E

• We also have another formula for equity

$14
E= (18)
(1 + rE )

• Solving these two equations gives rE = 0.7969 and E = $7.79

38
Example: With Direct Bankruptcy Costs

Method 2 (= firm value)

• Incorporating bankruptcy costs, the firm value is:
0.5 ∗ $100 + 0.5 ∗ $56
= $67.82 (19)
1 + 0.15

• Now we can calculate

E = V − D = $67.82 − $60 = $7.82 (20)

• Small differences in method 1 and 2 due to rounding

39
Takeaway 1

• Direct bankruptcy costs are paid by equity holders

• Value of debt remains the same ($60)

• Value of equity decreases ($9.56 to $7.82)

• Firm value decreases ($69.56 to $67.82)

• Riskiness of equity increases, resulting in deeper risk-adjusted

discounting (=rE increases)

• Rationale: with direct bankruptcy costs, the firm is less valuable

in default; this means that the face value increases (otherwise the
debt holders don’t lend). As the face value increases, equity
decreases

40
Takeaway 2

• Direct bankruptcy costs are small

• In this example, the bankruptcy costs reduce the firm value only
by 2.5%

• Bankruptcy is not certain

• Bankruptcy occurs in the future and is thus discounted

• Conclusion: direct bankruptcy costs seem second order

compared to tax shield benefit

41
Lecture Overview (Chapter 17.1 & 17.2)

• Recap of theory: debt doesn’t matter for firm value!

• Managers and markets: it matters!

• Calculating firm value under debt

• Debt advantage 1: corporate taxes

• Debt advantage 2: personal taxes

• Debt disadvantage 1: direct bankruptcy costs

• Debt disadvantage 2: indirect bankruptcy costs

42
Indirect Bankruptcy Costs

• Since firms are not highly levered, our quest for the disadvantage
of debt continues

• What about indirect bankruptcy costs?

• One important indirect bankruptcy cost is that firms don’t choose

the best projects anymore due to conflicts between the different
parties ("stakeholders")

43
Modigliani-Miller

Theorem: Debt does not affect firm value

Assumptions

1. Investment decisions don’t change

2. No transaction costs

3. Efficient capital markets

4. Managers maximize shareholders’ wealth

5. No taxes

6. No bankruptcy costs

44
Conflicts Between Stakeholders

• Everyone maximizes their own payoffs

• They don’t necessarily maximize firm value

• Debt holders prefer safe projects

- They have priority to cash flow

- They only care about the first $x

• Equity holders prefer risky projects

- They claim the residual

- They hope for the upside

45
Example

• A firm currently has $100 and owes its debt holders $120 next
year

• The firm has three potential projects, which produce cash flows
next year when the debt is due

• Discount rate for all projects is 30%

46
Example
Maximize firm value
Project Invest Bad Good Exp CF NPV Rank
A -100 110 (50%) 160 (50%) 135 3.8 1
B -100 50 (80%) 240 (20%) 88 -32.3 3
C -100 120 (80%) 130 (20%) 122 -6.2 2

Maximize equity value

Project Invest Bad Good Exp CF Rank
A -100 0 (50%) 40 (50%) 20 2
B -100 0 (80%) 120 (20%) 24 1
C -100 0 (80%) 10 (20%) 2 3

Maximize debt value

Project Invest Bad Good Exp CF Rank
A -100 110 (50%) 120 (50%) 115 2
B -100 50 (80%) 120 (20%) 64 3
C -100 120 (80%) 120 (20%) 120 1

Due to conflicts of interest, neither equity holders nor debt holders

have an incentive to pick the best (= highest NPV) project 47
Two Specific Types of Conflicts

1. Risk shifting: under debt, equity holders have the incentive to

take excessive and inefficient risks

2. Debt overhang: under debt, equity holders have the incentivie

to refuse positive NPV projects

48
Risk Shifting: Example

• Assume your company has $50 (face value) of debt maturing next
year; the market value of your assets is only $30, and you have
the following cash flow
Party Good Bad
Total CF 60 (50%) 0 (50%)
CF to debt holder 50 0
CF to equity holder 10 0

The company is in financial distress: the market value of assets is

lower than the face value of debt.

• Market value balance sheet

Debt 25
Assets 30 Equity 5
Total assets 30 Total liabilities 30

49
Risk Shifting: Example

• Assume that you can use the assets to produce the following cash
flow, which has a lower NPV
Party Good Bad
Total CF 100 (25%) 0 (75%)
CF to debt holder 50 0
CF to equity holder 50 0

• Market value balance sheet

Debt 12.5
Assets 25 Equity 12.5
Total assets 25 Total liabilities 25

Equity value increases, while debt value and firm value decrease!
The project is overly risky

50
Debt Overhang: Example

• Assume that you can also spend $9 to find a better manager, who
can produce CF $60 for sure.
Party Good Bad
Total CF 51 (50%) 51 (50%)
CF to debt holder 50 50
CF to equity holder 1 1

• Market value balance sheet

Debt 50
Assets 51 Equity 1
Total assets 51 Total liabilities 51

Equity value decreases, while debt value and firm value increase!
Equity holders don’t want to do a positive NPV change

51
Takeaway

• The negative effects of indirect costs can be big; indirect

costs are the real cost of bankruptcy

• They happen not only as bankruptcy occurs, but already in

anticipation of bankruptcy
• Other indirect costs:

- Poorer prices for products (no guarantees)

- Poorer prices from suppliers (no trade credit)

- Employees may start to leave

52
What Did We Do?

1. What projects should you invest in?

• Lecture 1: Capital budgeting and the NPV rule
• Lecture 2: Real options

2. How should you distribute the money you made?

• Lecture 3: Payout Policy

3. How should you raise more money for investments?

• Lecture 4: Does debt policy matter?
• Lecture 5+6: How much debt should a firm borrow?
• Lecture 7: The many different types of debt
• Lecture 8: Initial public offerings

4. Should you agree to a merger?

• Lecture 9: Mergers, corporate governance, and control

5. How can you manage risk?

• Lecture 10: Risk management and hedging

53
Lecture Overview (Chapter 17.1 & 17.2)

• Recap of theory: debt doesn’t matter for firm value!

• Managers and markets: it matters!

• Calculating firm value under debt

• Debt advantage 1: corporate taxes

• Debt advantage 2: personal taxes

• Debt disadvantage 1: direct bankruptcy costs

• Debt disadvantage 2: indirect bankruptcy

54
Next Lecture

1. What projects should you invest in?

• Lecture 1: Capital budgeting and the NPV rule
• Lecture 2: Real options

2. How should you distribute the money you made?

• Lecture 3: Payout Policy

3. How should you raise more money for investments?

• Lecture 4: Does debt policy matter?
• Lecture 5+6: How much debt should a firm borrow?
• Lecture 7: The many different types of debt
• Lecture 8: Initial public offerings

4. Should you agree to a merger?

• Lecture 9: Mergers, corporate governance, and control

5. How can you manage risk?

• Lecture 10: Risk management and hedging

55
End

Questions?
• Ask during lectures

• Ask during classes

• Class teacher office hours see Moodle (approach first)

• Kim’s office hours Friday after lecture (5-6pm, MAR 7.35)

• Moodle forum

• Email only for sensitive/personal questions

56