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1FIN 413Corporate FinanceCapital Structure, Taxes, and BankruptcyEvgeny LyandresFall 2003

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2Relaxing the M-M AssumptionsInterest payments to bondholders are deductible for tax purposes while payments to equity-holders are not.DTEV (levered firm) = V(unlevered firm) + PV(tax shields)

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4Consider the following income statementsIncome Statements Firm U Firm LEBIT $1000 $1000Interest payments at 8% $0 $80Pretax income$1000 $920Taxes $340 $312.8Net shareholders income $660 $607.2Total net income $660 $687.2Interest tax shield $0 $27.2

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5• The tax bill of L is $TCrDDless than that of U• This is the tax shield provided by the debt of L• The value of this tax shield isPV tax shield =Return on Debt• We thus have:VL= VU+ TCDorV(levered firm) = V(unlevered firm) + PV(tax shields)Tax rate * Return on Debt * Amount borrowed

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6• According to this analysis, all firms should be 100% debt-financed• Two reasons can explain the difference between empirical evidence and this argument- personal taxes- bankruptcy costs

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7Taxes and Bankruptcy CostsV (levered firm) =The optimal capital structure balances the gains from lower taxes with the increased expected costs of bankruptcy.DTEBankruptcyCosts

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8U.S. bankruptcy code• Chapter 7 bankruptcy- Absolute priority• Chapter 11 bankruptcy- Debtholders and equityholders get new claims instead of the old ones- Reorganization plan

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9Costs of bankruptcy• Direct costs- Management time- Legal expenses and advisors’ fees- Court costs• Indirect costs- Conflicts of interests between equityholders and debtholders (agency problems)

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10Trade-off between tax shield and cost of financial distressValue of the firm =Value of all equity financed+ PV tax shield- PV costs of financial distressOptimalDebt RatioValue if all equity financedPV of costs of financial distressPV Tax ShieldsDebt RatioMarket Value

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11Bankruptcy Costs• Jerry Warner examined bankruptcies of 11 railroads to estimate the costs of bankruptcy• The bankruptcy proceedings typical lasted many years. The average was 13 years, and the longest was 23 years• On average, these firms spent approximately $2M on the bankruptcy proceedings

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