Does the mix of debt and equity change what a firm is worth?
In a perfect market (no taxes, no bankruptcy costs, equal information), the value of a firm depends only on its assets' cash flows, not on how they are split between debt and equity (Proposition I). Slicing a pizza differently does not make it bigger. As leverage rises, the cost of equity rises exactly enough to keep WACC constant (Proposition II).
Interest is deductible, so debt creates a tax shield. With permanent debt D:
Example: an unlevered firm worth 1,000 borrows 400 at a 25% tax rate. The tax shield is worth 100 and the firm is worth 1,100.
Proposition II with taxes: cost of equity = unlevered cost of equity + (unlevered cost of equity minus cost of debt) x (D / E) x (1 minus tax rate). With an unlevered cost of 9%, cost of debt 6%, D/E of 0.5 and tax of 25%: 9% + 3% x 0.5 x 0.75 = 10.125%.
If debt only added value, firms would be 100% debt. They are not, because debt brings costs of financial distress:
The optimal capital structure balances the tax shield against expected distress costs. Firms with stable cash flows and tangible assets (utilities, pipelines, real estate) carry more debt. Firms with volatile cash flows and intangible assets (biotech, software) carry little.
Managers know more than investors. Issuing shares signals that management thinks the stock is overvalued, so the price usually falls on the announcement. Firms therefore prefer to finance in this order: internal cash first, then debt, and equity only as a last resort. This explains why very profitable firms often have little debt, which the trade-off theory struggles with.
Credit ratings (many firms target an investment-grade rating of BBB- or better to keep access to cheap funding), financial flexibility for acquisitions, market timing, and the discipline debt places on managers.
Operating leverage comes from fixed operating costs: a small change in sales causes a larger change in EBIT. Financial leverage comes from fixed interest: a change in EBIT causes a larger change in net income. A firm with high operating leverage should carry less financial leverage.
Debt/equity, net debt/EBITDA, debt/total capital and interest coverage. Lenders and rating agencies focus on net debt/EBITDA and coverage.
A firm with assets of 1,000 earns EBIT that depends on the economy. Plan U is all equity, 100 shares at $10. Plan L borrows 500 at 6% and has 50 shares. Tax rate 25%.
| EBIT | EPS, plan U | EPS, plan L |
|---|---|---|
| 30 | 0.225 | 0.000 |
| 60 | 0.450 | 0.450 |
| 120 | 0.900 | 1.350 |
At an EBIT of 60, a 6% return on assets equal to the cost of debt, the plans tie. Above it, leverage raises EPS; below it, leverage cuts EPS. Leverage raises expected EPS and its volatility together, which is why the cost of equity rises with debt (Proposition II).
An unlevered firm is worth 1,000 and its tax rate is 25%. Financial distress would cost 300 of value.
| Debt | PV of tax shield (25% x D) | Probability of distress | Expected distress cost | Net gain from debt |
|---|---|---|---|---|
| 400 | 100 | 10% | 30 | 70 |
| 700 | 175 | 30% | 90 | 85 |
| 900 | 225 | 60% | 180 | 45 |
Value peaks somewhere near 700 of debt. The probabilities are judgments, which is why real firms target a range and a credit rating, not a precise number.
Investment-grade industrial companies typically keep net debt/EBITDA below about 3x; ratings agencies also weigh business risk, so a regulated utility can carry more debt at the same rating than a cyclical manufacturer. Falling below BBB- raises borrowing costs sharply (RS 401).
Announcements of new share issues are followed, on average, by price falls of a few percent; announcements of debt issues by much smaller moves. Buybacks are followed by price rises. These patterns fit the pecking order's idea that managers know more than investors.
Both countries cap how much net interest a company can deduct. Canada's excessive interest and financing expenses limitation (EIFEL) and the US section 163(j) rule each limit net interest deductions to 30% of a tax measure of EBITDA, with exceptions. Highly leveraged firms, such as buyouts, can lose part of the tax shield that Modigliani-Miller with taxes assumes.
Choose debt that the business could service through a severe downturn, keep a rating that preserves access to markets, and use the remaining capacity for flexibility rather than for its own sake.
Compare the capital structure of a utility, a bank, a retailer and a software company: net debt/EBITDA, interest coverage and credit rating. Explain the differences using the trade-off theory.
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