13.5Summary and Conclusions

Previous chapters examined how risk affects a firm’s cost ofwith real options. For this reason, the APVmethod shouldcapital and its capital allocation decisions in the absence ofbe implemented for all major investments,although corpo-taxes. This chapter showed how taxes and financingrations may want to beaware of their WACC and use thatchoices also can have an important effect. Two methods ofmethod to evaluate smaller projects.

accounting for the valuation effect of debt and taxes wereThe discussion up to this point has indicated that the fi-introduced: the weighted average cost of capital (WACC)nancing and the risk of an investment project determine itsmethod and the adjusted present value (APV) method.value. We discussed how different projects generate cashSome analysts prefer the WACC method to the APVap-flows with different levels of risk, but provided little dis-proach since it is the more commonly used approach. How-cussion about why different projects add more or less to aever, the WACC method is appropriate only in limited cir-firm’s debt capacity. At this point, one might conclude thatcumstances. For example, if the debt capacity of a projectfirms should use as much debt as possible since doing sochanges over time, the WACC method is difficult to apply.creates value. However, there are costs associated withIn addition, in contrast to the APVframework, the WACCdebt financing that offset these tax advantages, which is themethod cannot easily be adapted to evaluate investmentssubject of Part IV.

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492Part IIIValuing Real Assets

Key Concepts

Result 13.1:Analysts use two popular methods toResult 13.3:In the absence of taxes and other market

evaluate capital investment projects: thefrictions, the WACC of a firm is

APVmethod and the WACC method.independent of how it is financed.

Both methods use as their starting pointResult 13.4:When debt interest is tax deductible, the

the unlevered cash flows generated by theWACC will decline as the firm’s leverage

project, assuming that the project isratio, D/E,increases.

financed entirely by equity. The APV

Result 13.5:In the absence of default, the present value

method calculates the net present value

of a project’s future unlevered cash flows,

(NPV) of the all-equity financed project

discounted at the WACC, is identicalto the

and adds the value of the tax (and any

present value of cash flows to equityholders

other) benefits of debt. The WACC

discounted at the cost of equity. Hence, in

method accounts for any benefits of debt

the absence of default, the NPVs generated

by adjusting the discount rate.

with both present value calculations selectResult 13.2:Firms can easily use the APVmethodand reject the same projects. When debt

with a variety of valuation methods,default is a significant consideration, projects

including those that make use ofthat increase firm value may not increase

risk-adjusted discount rates, certaintythe values of the shares held by equity holders

equivalents, ratio comparisons, and realand vice versa. However, in these cases, it

options approaches.is more appropriate to analyze the values

of cash flows with the real options approach.

Key Terms

adjusted cost of capital formula482		non-recourse debt (project financing)489
adjusted present value (APV) method	461	recovery rate479
cash flow to equity holders489		unlevered assets (UA)464
debt capacity462		unlevered cost of capital463
debt tax shield (TX)464		valuation by components461
marginal cost of capital486		weighted average cost of capital (WACC) method461

Exercises

Exercises 13.1–13.7 make use of the following data:
In 1985, General Motors (GM) was evaluating the acquisition of Hughes Aircraft Corporation. Recognizingthat the appropriate WACC for discounting the projectedcash flows for Hughes was different from General Motors’WACC, GM assumed that Hughes was of approximatelythe same risk as Lockheed or Northrop, which had low-riskdefense contracts and products that were similar to those ofHughes. Specifically, assume the Hamada model of debt interest tax shields and the inputs in the table at right.	Comparison Firm D/E E GM1.20.40 Lockheed.90.90 Northrop.85.70 D Target for acquisition of Hughes 1 E Hughes’s expected unlevered cash flow next year $300 million
13.1.Analyze the Hughes acquisition by first computing the betas of the comparison firms, Lockheed and Northrop, as if they were all equity financed. Hint: Use equation (13.7) to obtain from . UAE13.2.Compute , the beta of the unlevered assets of UA the Hughes acquisition, by taking the average of the betas of the unlevered assets of Lockheed and Northrop.	Growth rate of cash flows for Hughes 5% per year Marginal corporate tax rate 34% Appropriate discount rate on debt: riskless rate8% Expected return of the tangency portfolio 14%

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Chapter 13

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493

13.3.	Compute the for the Hughes acquisition at the	machine adds only $300,000 to the firm’s debt
	E
	target debt level.	capacity in years 1, 2, and 3, and only $200,000 in
		years 4 and5.
13.4.	Compute the WACC for the Hughes acquisition.
		Although net income includes the depreciation
13.5.	Compute the value of Hughes with the WACC
		deduction, it does not include the interest
	from exercise 13.4.
		deduction (that is, it assumes that the equipment is
13.6.	Compute the value of Hughes if the WACC of GM
		financed with equity). The equipment can be
	at its existing leverage ratio is used instead of the
		depreciated on a straight-line basis over a five-year
	WACC computed from the comparison firms (see
		life at $100,000 per year. The equipment is
	exercise 13.4).
		expected to be sold for $100,000 in five years.
13.7.	Apply the APVmethod. First, compute the value	Net working capital (NWC) required to support
	of the unlevered assets of the Hughes acquisition.	the new product is estimated to be equal to 10
	Next, compute the present value of the tax shield.	percent of net sales of the new product. The NWC
	Finally, add the two numbers.	will be needed at the start of the year. This means
13.8.	Compute the WACC of Marriott’s restaurant	that if sales were $1 in year 1, the NWC needed to
	division in Example 13.15 by doing the following:	support this one dollar of sales would be
	a.Compute the of Marriott’s restaurant	committed at the beginning of year 1. The
	E
	division using equation (13.6).	company’s discount rate for the unlevered cash
	b.Apply the CAPM’s risk expected return	flows associated with this new product is 18
	equation to obtain the restaurant r,assuming a	percent and the tax rate is 40 percent.
	E
	risk-free rate of 4 percent and a market risk	What is the net present value of this project?
	premium of 8.4 percent.	13.11.Compute the net present value of the mold in
	c.Estimate the WACC, using equation (13.8).	Example 13.4, assuming that the debt capacity of
	d.Compare this WACC to the WACC in Example	the project is zero.
	13.15. If they are not the same, you made a
		13.12.Use the risk-neutral valuation method to directly
	mistake.
		show that the risk-neutral discounted value of the
13.9.	GTAssociates have plans to start a widget	existing debt of Unitron is $636,000 higher if the
	company financed with 60 percent debt and 40	project in Example 13.17 is adopted.
	percent equity. Other widget companies are
		13.13.Applied Micro Devices (AMD) currently spends
	financed with 25 percent debt and 75 percent equity
		$213,333 a year leasing office space in Austin.
	and have equity betas of 1.5. GT’s borrowing costs
		Because lease payments are tax deductible at a 25
	will be 14 percent, the risk-free rate is 8 percent,
		percent corporate tax rate, the firm spends about
	and the expected rate of return on the market is 15
		$160,000 per year [5 $213,333 3 (1 2 .25)] on an
	percent. The tax rate is 50 percent. Compute the
		after-tax basis to lease the building. The firm has
	equity beta and WACC for GTAssociates.
		no debt and has an equity beta of 2. Assuming an
13.10.	The HTTCompany is considering a new product.	expected market return of 14 percent and a risk-
	The new product has a five-year life. Sales and net	free rate of 8 percent, its CAPM-based cost of
	income after taxes for the new product are	capital is 20 percent. Suppose that AMD has the
	estimated in the following table:	opportunity to buy its office space for $1 million.
		The office building is a relatively risk-free
		investment. The firm can finance 100 percent of
	Net Income	the purchase with tax-deductible mortgage
	Net Salesafter Taxes
		payments. The mortgage rate is only slightly
	Year(in $000s)(in $000s)
		higher than the risk-free rate. How does AMD
	1$1,000$ 40	determine whether to buy the building or continue
		to lease it?
	22,00075
		13.14.SL, Inc., is currently an all equity-firm with a beta
	34,000155
		of equity of 1. The risk-free rate is 5 percent and
	46,000310
		the market risk premium is 8 percent. Assume the
	52,00075
		CAPM is true and that there are no taxes. What is
		the company’s weighted average cost of capital? If
		management levers the company at a debt to
	The equipment to produce the new product costs
		equity ratio of 5 to 1, using perpetual riskless debt,
	$500,000. The $500,000 would be borrowed at a
	risk-free interest rate of 14 percent. However, the

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494Part IIIValuing Real Assets

what will the WACC become? How would your13.16.Akron, from the last example, is considering an

WACC answer change if the government raises theexchange offer where half of Akron’s outstanding

tax rate from zero to 30 percent?debt ($25 million) is retired. The purchase of this13.15.The Akron Company consists of $50 million indebt would be financed by issuing $25 million in

perpetual riskless debt and $50 million in equity.equity to the debt holders of Akron. Assuming

The current market value of its assets is $100debt policy that is consistent with the Hamada

million and the beta of its equity return is 1.2.model, what will Akron’s new WACC be after the

Assume the risk-free rate is 8 percent, theexchange offer?

expected return of the market portfolio is 13

percent per year, and the CAPM is true. Compute

the expected return of Akron’s equity and its

WACC assuming a 40 percent corporate tax rate.

References and Additional Readings

Benninga, Simon, and Oded Sarig. Corporate Finance: A

Valuation Approach.New York: McGraw-Hill, 1997.Copeland, Tom; Tim Koller; and Jack Murrin. Valuation:

Measuring and Managing the Value of Companies.

New York: John Wiley, 1994.

Cornell, Bradford. Corporate Valuation: Tools for

Effective Appraisal and Decision Making.Burr

Ridge, IL: Business One Irwin, 1993.

Damodoran, Aswath. Investment Valuation.New York:

John Wiley, 1996.

Hamada, Robert. “The Effect of a Firm’s Capital

Structure on the Systematic Risk of Common

Stocks.” Journal of Finance 27(1972), pp.435–452.Kaplan, Steven, and Jeremy Stein. “How Risky Is the

Debt of Highly Leveraged Transactions?” Journal of

Financial Economics27, no. 1 (1990), pp. 215–46.Kuwahara, Hiroto, and Terry Marsh. “The Pricing of

Japanese Equity Warrants.” Management Science38,

no. 11 (1992), pp. 1610–41.

Miles, James, and John Ezzell. “The Weighted Average

Cost of Capital, Perfect Capital Markets, and Project

Life: AClarification.” Journal of Financial and

Quantitative Analysis15, no. 3 (1980), pp. 719–30.

———. “Reformulating Tax Shield Valuation: ANote.”

Journal of Finance40, no. 5 (1985), pp. 1485–92.

Miller, Merton H. “Debt and Taxes.” Journal of Finance

32, no. 2 (1977), pp. 261–75.

Modigliani, Franco, and Merton Miller. “The Cost of

Capital, Corporate Finance and the Theory of

Investment.” American Economic Review48, no. 3

(1958), pp. 261–97.

———. “Corporate Income Taxes and the Cost of

Capital: ACorrection.” American Economic Review

53, no. 3 (1963), pp.433–92.

Myers, Stewart C. “Interactions of Corporate Financing

and Investment Decisions—Implications for Capital

Budgeting.” Journal of Finance29, no. 1 (1974),

pp.1–25.

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Chapter 13	Corporate Taxes and the Impact of Financing on Real Asset Valuation	495
PRACTICALINSIGHTS

Allocating Capital forReal Investment

•Firms create value by implementing real investment

projects that generate returns that are tracked by

combinations of financial instruments with values that

exceed the projects’costs. (Introduction to Chapter 10,

10.2, 11.1)

•The expected return of a project’s tracking portfolio is

the appropriate discount rate to use to value the project.

(Sections 10.2, 11.1, and 11.2)

•When choosing between mutually exclusive investments,

pick the project with the highest NPV, which is rarely

the one with the highest IRR. (Section 10.2)

•EVA^TMis a concept that allocates NPVto the dates at

which future cash flows occur. (Section 10)

•Unlevered cash flows, which can be obtained from

forecasted earnings or cash flow statements, are critical

for valuation (Section 9.1 and Introduction to Chapter

13)

•The NPVrule is useful for evaluating many different

corporate decisions in addition to capital investments.

(Section 10.4)

•The Internal Rate of Return (or IRR) is a useful concept

for projects that can be described as consisting of an

initial negative cash flow, the cost of the project, and a

subsequent series of positive cash flows. In this case,

projects with internal rates of return that exceed the

expected rate of return on an appropriate tracking

portfolio create value for the firm. (Section 10.5)•Projects with future cash flows that alternate between

positive and negative values may have more than one

IRR.For these projects, the IRRgenerally is not a useful

concept. (Section 10.5)

•IRRs are not very useful when choosing between

mutually exclusive projects. (Section 10.5)

•Generally, a project with a negative PVcannot be

valued with the risk-adjusted discount rate method.

(Sections 11.1 and 11.2)

•Analysts often examine the return characteristics of

publicly traded firms with real investments that are

similar to the real investments being evaluated to

determine the appropriate tracking portfolio and

discount rate. (Sections 11.2 and 11.4)

•The APTand the CAPM require knowledge of betas

and the expected returns on the relevant tracking

portfolios. Analysts without good estimates for these

inputs sometimes use a dividend discount model to

compute discount rates. (Section 11.4)

•Acommon mistake made by many firms is to use the

firm’s own cost of capital rather than the expected

return of the appropriate tracking portfolio to value the

cash flows of a project. (Sections 11.5 and 13.3)

•Publicly traded firms consist of assets in place and

growth opportunities. Their betas are weighted averages

of the risks associated with these two sources of value.

Growth opportunities generally have much higher betas

than do assets in place. Therefore, the beta of a growth

firm is likely to be substantially higher than the betas of

their assets in place. Analysts should consider this when

using the comparison firm approach to estimate the cost

of capital for a project. (Section 11.5)

•Financial analysts tend to use a single discount rate to

evaluate an investment to simplify their analysis.

However, more accurate valuations can be achieved by

accounting for the fact that cash flowsat different

horizons should be discounted at different rates.

(Section 11.5)

•Asingle discount rate obtained from comparison firms

often is far too large for the cash streams of firms with

some negative low beta cash flows. (Section 11.5)•If a project’s cash flows tend to decline over time

following unusually large cash flow increases, and vice

versa, then expected cash flows generated far in the

future should be discounted at lower rates than the cash

flows occurring in the near future. (Section 11.5)

•It is often easier to evaluate projects by discounting

certainty equivalent cash flows at risk-free rates than by

discounting expected cash flows at risk-adjusted

discount rates. (Section 11.6)

•For projects that generate cash flows over many years,

the estimate of the cash flows in a risk-free scenario

may be the best way to obtain their certainty

equivalents and their present values. (Section 11.7)•Positive NPVinvestment opportunities often arise as a

result of past investments. When evaluating prospective

investments, consider the fact that additional investment

opportunities may be created as a result of this

investment. Option pricing theory may be useful for

evaluating these potential opportunities. (Section 12.1)•Option pricing theory has proved to be especially useful

for evaluating natural resource investments, like copper

mines and oil fields. (Section 12.2)

•Most real investments contain options. Firms have the

option to delay the project’s initiation date, expand the

project, downsize it, and liquidate the project. Option

pricing models are useful for evaluating all of these

options. (Section 12.2)

•More flexible manufacturing processes provide the firm

with more options. These options are more valuable in

more uncertain environments. (Section 12.2)

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496Part IIIValuing Real Assets

•	Information from the option markets and the forward	the expected return on the bond, is generally less than
	and futures markets often provide useful information	the yield on a risky bond. (Section 13.3)
	for evaluating investment projects. (Sections 11.8 and	•The APVand WACC methods assume that the manager
	12.2)	wishes to maximize the combined value of the firm’s
•	When future cash flows are difficult to estimate, the	outstanding debt and equity. For highly levered firms,
	financial ratios of comparable firms, like price/earnings	projects that improve the value of the firm may
	ratios and market/book ratios, may be the best way to	negatively affect the value of the firm’s stock. Analysts
	value an investment project. Price/earnings ratios are	may, therefore, want to evaluate the project cash flows
	often used to evaluate real estate investments and to	that accrue to the firm’s equity holders when such a
	value IPOs. (Section 12.3)	possibility exists. However, this is sometimes difficult to
•	When interest payments are tax deductible, the value of	do with traditional discounting methods. (Section 13.4)
	an investment project depends in part on its debt
	capacity. (Section 13.1)
		Financing the Firm
•	Both the APVand the WACC methods account for the
	debt tax shield when they value a project. Although the	•National and local governments often subsidize debt
	WACC method is currently more popular, the APV	financing, either indirectly through the tax system or
	method is the superior method. (Sections 13.2 and	directly by giving cheap financing to attract investments
	13.3)	that they view favorably. Firms should take advantage
•	The APVmethod can be combined with every approach	of these financing bargains and account for them when
	for valuing real assets. The WACC method can be used	valuing investment projects. (Sections 13.1, 13.2, and
	only when discounting expected cash flows at risk-	13.3)
	adjusted discount rates. (Sections 13.2 and 13.3)	•When debt is tax deductible, the firm’s weighted
•	Acommon mistake is to use the yield on a risky bond	average cost of capital is reduced if the firm uses more
	as the cost of debt capital. The appropriate cost of debt,	debt financing. (Section 13.3)

EXECUTIVEPERSPECTIVE

Thomas E. Copeland

The investment decision is the driving force behind thevalue of companies. Nothing is more important. The deci-sion may involve growing the company via a capitalexpenditure, an investment in working capital, or a com-mitment for an acquisition. Or, the decision may implyshrinking the company via a divestment, an equity carve-out, or a spinoff.

Chapters 9 through 13 are a thoroughly modern andfresh exposition of the approach to making investmentdecisions based on the fundamental economic role of oneprice. The reader is introduced to the idea that the value ofa capital project can be estimated by building a trackingportfolio of marketable securities that has similar payoffsto the actual investmennt itself. Hence, the value of theproject is equal to the value of its perfect substitute, atracking portfolio, whose securities have observable mar-ket prices. This idea has been the foundation of securitiespricing on Wall Street for over two decades and is intro-duced here for the first time in a corporate finance text-book. And it’s about time!

Throughout this capital budgeting part of the book,Grinblatt and Titman use simple numerical examples toillustrate fundamental investment theory. Their approachmakes it very easy to understand. And, because the pre-

sentation is so new and fresh, practitioners will find theirmental horizons expanded. For example, Chapter 12 con-tains capital budgeting material on real options. This is themost important breakthrough in thinking about investmentdecisions in decades! The authors convincingly demon-strate how traditional net present value methods are inade-quate when flexibility is important. This same chapter alsocovers ratio approaches to valuation and a competitiveanalysis approach. Any investment banker will be inter-ested in their explanation of how financial leverage mayincrease or decrease price earnings ratios.

Chapter 13 compares the two most widely advocatedcash flow valuation approaches—the adjusted presentvalue method and the traditional approach, which dis-counts enterprise cash flows at the weighted average costof capital. Although mathematically equivalent, the twoapproaches differ in their ease of use—another fact thatwill be useful for today’s practitioners.

Mr. Copeland currently is the Chief Corporate Finance Officer and Headof Monitor Corporate Finance. Previously, Mr. Copeland was a professorof finance at UCLA’s Anderson Graduate School of Management wherehe served as Chairman of the Finance Group and Vice-Chairman of the

graduate school and was a director of corporate financial services at

McKinsey & Company where he co-led the firm’s finance practice.

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PART
IV
	Capital	Structure

F irms raise investment funds in a number of ways. They can borrow from banks and

other financial institutions or they can issue various kinds of debt, preferred stock,

warrants, and common equity. Afirm’s mix of these different sources of capital is

referred to as its capital structure.

Part III pointed out that the capital structure of a corporation can affect capital allo-

cation decisions. In that part of the text, a firm’s capital structure and the financing mix

of its investment projects were taken as given. Part IVexamines how corporate capi-

tal structures are determined.

If a firm’s capital structure includes a great deal of debt, then the firm is said to

be highly leveraged. The term leverageis used because a high debt ratio allows a rel-

atively small percentage change in a firm’s earnings before interest, taxes, depreciation,

and amortization (EBITDA) to translate into a large percentage change in the firm’s

net income.

The extent to which a firm is leveraged is measured in a number of different ways

(see Exhibit IV.1). The first two debt-to-value ratiosmeasure the portion of a firm’s

capitalization financed with debt. The market value of debt is often difficult to calcu-

late since a large percent of corporate debt takes the form of either privately placed

bonds or bank loans which do not generally trade. As a result, the amount of debt in

a firm’s capital structure, the numerators in these expressions, is generally measured at

its book value. The denominator in these expressions represents book debt plus either

the market value (row 1) or the book value (row 2) of the firm’s equity.¹Because the

EXHIBITIV.1Common Leverage Measures

Leverage Measure

What Is Measured

Debt
	Measures long-term ability to meet interest payments
Debt market value of equity

Debt
	Measures historical financing of investments
Total book assets

EBITDA
	Measures ability to meet current interest payments
Interest

¹Debt-to-equity ratios, D/E,also are frequently observed, with Emeasured either as a market value or

a book value.

497

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498Part IVCapital Structure

market value of equity measures the firm’s discounted futurecash flows, ratios with

market values in the denominator are good measures of the firm’s future ability to meet

its interest payments. Because the book value of equity is determined by how well the

firm has done in the past, the ratio of debt to the book value of equity is not as reli-

able an indicator of the firm’s ability to meet its interest payments. However, it does

indicate how a firm has historically financed its new investments.

An additional measure of leverage is the firm’s interest coverage ratio,which is

the ratio of EBITDAto interest payments. The interest coverage ratio is an indicator

of a firm’s currentability to meet its interest payments.

Exhibit IV.2 provides the financial ratios described in Exhibit IV.1 for a sample of

15 well-known U.S. corporations. It shows that high-tech companies like Hewlett-

Packard tend to rely little on debt financing; its debt-to-value ratio indicates that less

than 20 percent of its total capital consists of debt. The most highly leveraged compa-

nies on this list are Boston Edison, an electric utility; Delta Air Lines; and Safeway, a

supermarket chain. Safeway’s leverage ratio actually declined significantly from the late

1980s, following the company’s purchase by management in a leveraged buyout. Since

a number of supermarkets undertook leveraged buyouts in the 1980s, firms in that

industry are often highly leveraged. Airlines and electric utilities, as groups, also are

relatively highly levered. For the airlines, however, the high level of debt may be tem-

porary, reflecting accumulated losses during the late 1980s and early 1990s. For exam-

ple, the first column’s debt-to-market value ratio of Delta Air Lines was lower in the

past: less than 30 percent in 1990 and less than 25 percent in 1985.

Part IVwill explain why firms like Safeway choose to be highly levered while

firms like Hewlett-Packard use little debt financing. The starting point for this discus-

sion is the Modigliani-Miller Theorem,which states that in the absence of taxes and

other market frictions (for example, transaction costs and bankruptcy costs), the capi-

tal structure choice does not affect firm values. According to this theorem, managers

should place all their effort into making the real investment decisions described in Part

III; how these real investments are actually financed is a matter of indifference.

Of course, the real world is very different from the frictionless markets model set

forth by Modigliani and Miller; in reality, managers can create value for their corpo-

rations by making astute financing decisions. Chapters 14 and 15 discuss how taxes

affect financing choices. The key insight is that when interest payments, but not divi-

dends, are tax deductible, debt is a less expensive form of financing than equity. How-

ever, the corporate tax advantage of debt can be somewhat mitigated by the personal

tax advantages of equity financing. In particular, the returns that accrue to equity hold-

ers are often treated as capital gains, which are more lightly taxed than the interest

income paid to the firm’s debt holders. In addition, because equity holders must pay

personal taxes on dividend income, they may be better off if the firm finances its invest-

ments with retained earnings instead of paying a dividend and financing new invest-

ment with borrowing.

Chapters 16 and 17 describe how contracting and transactions costs can affect the

capital structure choice. In the world of Modigliani and Miller, a firm that goes bank-

rupt has its assets transferred costlessly from equity holders to debt holders. Their model

also assumes that the real investment and operating decisions of the firm can be made

independently of this potential transfer of ownership, which is likely to be the case in

the absence of contracting and transaction costs. In reality, however, legal costs are

associated with this transfer. Perhaps more importantly, managerial incentives in a firm

close to bankruptcy will change in ways that can create substantial costs to the firm.

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Part IV

Capital Structure

499

EXHIBITIV.2Financial Ratios of Selected U.S. Corporations, 1993

	Debt	Debt	EBITDA
Company Name
	Debt Mkt Equity	Total Book Assets	Interest

AT&T	20%	29%	16.36
Boeing	15	13	14.37
Boston Edison	49	42	3.49
John Deere	40	37	2.47
Delta Air Lines	53	32	1.08
Disney	9	20	14.09
General Motors	61	37	2.98
Hewlett-Packard	13	17	21.67
McDonalds	15	31	7.18
3M	6	12	59.70
Philip Morris	27	35	6.72
Safeway Stores	55	53	3.06
Texaco	27	26	4.70
Wal-Mart	14	36	7.54

Source: Standard and Poor’s Compustat Data 1994.

Because of these potential costs, firms tend to limit their use of debt financing despite

its tax advantages.

Our goal in Part IVis to provide guidelines for managers in situations where all

parties have a shared objective to maximize the wealth of shareholders. However, the

maximization of shareholder wealth may not be the objective of all managers because

of the transaction and contracting costs alluded to above. Part Vexamines how finan-

cial decisions are made when managers have differing objectives from those of share-

holders, which will complete the analysis of capital structure.

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Markets and Corporate		Financing Choices	Companies, 2002
Strategy, Second Edition

CHAPTER

How Taxes Affect

14

Financing Choices

Learning Objectives

After reading this chapter, you should be able to:

1.Understand that in the absence of taxes, transaction costs, and other market

frictions, capital structure can affect firm values onlywhen the debt-equity choice

affects cash flows (the Modigliani-Miller Theorem).

2.Explain how corporate taxes provide incentives for firms to use debt financing as

well as how they affect the decision to buy or lease capital assets.

3.Understand why personal taxes provide an incentive for firms to use equity

financing.

4.Explain how nondebt tax shields, such as depreciation deductions and R&D

expenses, affect the capital structure choice.

5.Use the yields on municipal bonds to quantify the total tax gain associated with a

leverage change.

6.Understand how inflation affects the capital structure choice.

After World War II, the U.S. airline industry expanded, and some airlines issued

additional equity to fund their expansions. Jack Frye, then CEO of TWA, thought

that TWAalso should issue equity to fund its expansion. However, Howard Hughes,

TWA’s largest shareholder, disagreed. Partly because of this disagreement, Frye was

replaced as CEO.

In a Civil Aeronautics Board hearing in 1959 concerning Howard Hughes’s

control of TWA, Hughes explained his position at the earlier time: “My position was

[that] ... debt financing was very attractive. Interest rates were low, and interest

could be paid out of basic earnings before taxation. Equity financing, to leave a

satisfied stockholder, probably should have returned something between 7 and 10

percent, and that would have been required to be paid out of earnings after

taxation.”¹

¹Robert W. Rummel, Howard Hughes and TWA(Washington, DC: Smithsonian Institution Press,

1991), p. 128.

500

Grinblatt1015Titman: Financial	IV. Capital Structure	14. How Taxes Affect	© The McGraw1015Hill
Markets and Corporate		Financing Choices	Companies, 2002
Strategy, Second Edition

Chapter 14

How Taxes Affect Financing Choices

501

Chapter 13 discussed how taxes and a firm’s financial structure can interact to affect

its real investment decisions. This chapter and the one that follows it take one step

backward and examine how taxes affect the proportions of debt and equity used to

finance a firm. To understand how taxes affect a firm’s financing choices, one must

first understand what financing choices would be like without taxes. Hence, the spring-

board for discussion of this topic is the no-tax capital structure irrelevance theorem

offered by Franco Modigliani and Merton Miller.

The Modigliani-MillerTheorem,which was largely responsible for both authors

winning Nobel Prizes in economics, states that if the capital structure decision has no

effect on the total cash flows that a firm can distribute to its debt and equity holders,

the decision also will have no effect—in the absence of transaction costs—on the total

value of the firm’s debt and equity. This means that a manager who is contemplating

whether it is cheaper to finance the firm primarily with junk bonds (that is, very high-

yield, high-risk debt) or with equity and perhaps a small amount of high-quality debt

should stop worrying: Neither financing decision is superior to the other!

The premise of the Modigliani-Miller Theorem, that capital structure has no effect

on cash flows, is not true in the real world. Because the interest on debt is tax

deductible, the after-tax cash flows of firms increase when they include more debt in

their capital structures, leading firms to favor debt over equity financing. However,

the capital structure choice becomes more complicated when one considers personal

as well as corporate taxes. Personal taxes tend to favor the use of equity in a firm’s

capital structure since a large portion of the returns on stock are taxed at the capital

gains rate, which is generally more favorable than the ordinary tax rate that applies to

interest income.