Optimal Capital Structure: The Trade-Off

Theory ^
"We can now combine our knowledge of the benefits of leverage from the interest tax shield
(discussed in Chapter 15) with the costs of financial distress to determine the amount of
debt that a firm should issue to maximize its value. The analysis presented in this section is
called the trade-off theory because it weighs the benefits of debt that result from shieldii
cash flows from taxes against the costs of financial distress associated with leverage.
According to this theory, the total value of a levered firm equals the value of the firm with-
out leverage plus the present value of the tax savings from debt, less the present value of financial
distress costs:

VL = Vu + PV(lnterest Tax Shield) - PV[Fmss.dal Distress Costs) (16.1)

Equation 16.1 shows that leverage has costs as well as benefits. Firms have an incentive to
increase leverage to exploit the tax benefits of debt. But with too much debt, they are more
likely to risk default and incur financial distress costs.

The Present Value of Financial Distress Costs

Aside from simple examples, calculating the precise present value of financial distress costs
is quite complicated. Three key factors determine the present value of financial distress
costs: (1) the probability of financial distress, (2) the magnitude of the costs if the firm is in
distress, and (3) the appropriate discount rate for the distress costs. In Example 16.2, when
Armin is levered, the present value of its financial distress costs depends on the probability
that the new product will fail (50%), the magnitude of the costs if it does fail ($20 mil-
lion), and the discount rate (5%).
What determines each of these factors? The probability of financial distress depends
on the likelihood that a firm will be unable to meet its debt commitments and therefore
default. This probability increases with the amount of a firm's liabilities (relative to its
assets). It also increases with the volatility of a firm's cash flows and asset values. Thus, firms
with steady, reliable cash flows, such as utility companies, are able to use high levels of debt
and still have a very low probability of default. Firms whose value and cash flows are very
volatile (for example, semiconductor firms) must have much lower levels of debt to avoid
a significant risk of default.
The magnitude of the financial distress costs will depend on the relative importance
of the costs discussed in Section 16.2, and is also likely to vary by industry. For example,
firms, such as technology firms, whose value comes largely from human capital, are
to incur high costs when they risk financial distress, due to the potential for loss ofcustom-
ers and the need to hire and retain key personnel, as well as a lack of tangible assets that can
be easily liquidated. In contrast, firms whose main assets are physical capital, such as
estate Brms, are likely to have lower costs of financial distress, because a greater portion
their value derives from assets that can be sold relatively easily.

Berk and DeMarzo

Corporate Finance (2017), pp. 562-564
 16.4 Optimal Capital Structure: The Trade-OfFTheory 563

Finally, the discount rate for the distress costs will depend on the firm's market risk.
Note that because distress costs are high when the firm does poorly, the beta of distress
costs will have an opposite sign to that of the firm. Also, the higher the firm's beta, the
more likely it will be in distress in an economic downturn, and thus the more negative the
beta of its distress costs will be. Because a more negative beta leads to a lower cost of capital
(below the risk-free rate), other things equal the present value of distress costs will be higher
for high beta firms.

Optimal Leverage
Figure 16.1 shows how the value of a levered firm, VL, varies with the level of permanent
debt, D, according to Eq. 16.1. With no debt, the value of the firm is Vu. For low levels
of debt, the risk of default remains low and the main effect of an increase in leverage is an
increase in the interest tax shield, which has present value r*D, where T* is the efFecdve
tax advantage of debt calculated in Chapter 15. If there were no costs of financial distress,
the value would continue to increase at this rate until the interest on the debt exceeds the
firm s earnings before interest and taxes and the tax shield is exhausted.
The costs of financial distress reduce the value of the levered firm, V . The amount of the
reduction increases with the probability of default, which in turn increases with the level of
the debt D. The trade-ofF theory states that firms should increase their leverage until it reaches
the level D* for which VL is maxunized. At .this point, the tax savings that result from uicreas-
ing leverage are just ofFset by the increased probability of incurring the costs of financial distress.

Loss ofTax Shield Due to Excess Interest

jptimal Leverage with
and Financial
Bistress Costs Loss of WfFinancial Distress Costs) VL with No
Distress Costs
g the level of debt, D,
Increases, the tax benefits
gf debt increase by T*-D
Ijtil the interest expense
Ijxceeds the firm's EBIT (see
VL with Low
ggure 15.8). The probability
Distress Costs
Bf default, and hence the
Resent value of financial
Ijstress costs, also increase VL with High^
Ijfth D. The optimal level of i Distress Costs
U-bt, D*, occurs when these
Elects balance out and VL
Bimaximized. D* will be lower
firms with higher costs of Dhigh
tjnandal distress.
Value of Debt, D

For intuition, consider a law firm specializing in bankruptcy. Because profits will be higher in down-
turns, the law firm will have negative beta. Formally, the beta of distress costs is similar to the beta of a
put option on the firm, which we calculate in Chapter 21 (see Figure 21.8). See also H. Almeida and
T. Philippon, "The Risk-Adjusted Cost of Financial Distress," Journal of Finance 62 (2007): 2557-2586.
564 Chapter 16 Financial Distress, Managerial Incentives, and Information

Figure 16.1 also illustrates the optimal debt choices for two types affirms. The optimafl
debt choice for a firm with low costs of financial distress is indicated by D/y and diB
optimal debt choice for a firm with high costs of financial distress is indicated by D^ |!
Not surprisingly, with higher costs of financial distress, it is optimal for the firm to choo3i
lower leverage. |[
The trade-ofF theory helps to resoh^e two puzzles regarding leverage that arose in Chaol
ter 15. First, the presence of financial distress costs can explain why firms choose del)J
levels that are too low to fully exploit the interest tax shield. Second, diflferences in (hi
magnitude of financial distress costs and the volatility of cash flows can explain the diflfcri
ences in the use of leverage across industries. That said, bankruptcy costs alone may not bj
sufficient to explain alLof the variation observed. Fortunately, the trade-ofF theory can bt
easily extended to include other effects of leverage—which may be even more important
than financial distress costs—that we discuss next.

IBiiSMBBBIUU Choosing an Optimal Debt Level ' "9

Problem 3
Greenkafladusuies is considering adding leverage to its capital structure. Greenleafs managa^
believe they can add as much as $35 million in debt and exploit the benefits of the tax shield (fd||
which they estimate T* = 15%). However, they also recognize that higher debt increases the ristJ
of financial distress. Based on simulations of the firm's future cash flows, the CFO has made th3i
following estimates (in millions of dollars): 4
99s

Debt 0 10 20 25 30 35 ^1
PV(In.teiest tax shield) 0.00 1.50 3.00 3.75 4.50 5.25 9

Py(Financial distress costs) 0.00 0.00 0.38 1.62 4.00 6.38^!

What is the optimal debt choice for Greenleaf? ,1

Solution iii
From Eq. 16.1, the net benefit of debt is determined by subtracting .Pl/^Financial distress cost||
from -Pl^Interest tax shield). The net benefit for each level of debt is ||

Debt 0 10 20 25 30 35 -•
"31
Net benefit 0.00 1.50 2.62 2.13 0.50 -1.13||
11
The level of debt that leads to the highest net benefit is $20 million. Greenleafwill gain $3
lion due to tax shields, and lose $0.38 million due to the present value of distress costs, for a
gain of $2.62 million. ||
"'•