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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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12Bankruptcy Costs* Several academic studies have examined the direct costs of bankruptcy:∑===TttMBCBC02$%3.50=VBC)(5−VBCE%4.15=−VBCis even lower

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