Teaching the Effects of Risky Debt and Financial Distress Costs Using Consistent Examples

Most finance texts that cover the Modigliani-Miller capital structure propositions use numerical examples to show the effects of debt use on a firm's capital costs. Far fewer texts cover the effects of risky debt or financial distress costs explicitly in their examples. This paper develops consistent numerical examples for instructors to use to illustrate the effects of risky debt and financial distress costs on a firm's capital costs and value. In these examples, risky debt is explicitly risky - the firm's creditors do not receive the full promised interest payment in some states of the world. Also, financial distress costs reduce the firm's cash flows directly, with the result that the amount of debt that maximizes the firm's value need not be the amount that corresponds to its minimum cost of capital.(ProQuest: ... denotes formulae omitted.)INTRODUCTIONCapital structure is an important concept in corporate finance that students should understand thoroughly. Finance textbook authors recognize the importance of capital structure theory and include the topic in their texts along with discussions of the relationship between a firm=s debt, the required rate of return on its equity, and the firm=s value. Since many factors (including taxes, financial distress costs, and agency costs) may influence a firm=s overall cost of capital, its capital structure choice, and its value, it can be quite challenging to make sure that students truly understand the effect of capital structure on firm value and the tradeoffs between the benefits and costs of debt. Fortunately, it is quite possible to illustrate the influence of some factors on capital structure and firm value (notably corporate taxes and financial distress costs) using basic numerical examples. The challenge lies in making sure that the numerical examples are consistent with the concepts they attempt to teach. This paper will develop consistent numerical examples to show the effects of corporate taxes, risky debt, and financial distress costs on a firm=s capital structure choice, its cost of capital, and its value. For pedagogical reasons, the examples will be kept as simple as possible.TEACHING CAPITAL STRUCTUREAppropriately, the teaching of capital structure theory in most textbooks begins with the Miller and Modigliani propositions. Students first learn that given suitable assumptions, in the absence of corporate taxes, a firm=s value is independent of its capital stmcture. Later, students learn that in the presence of corporate taxes (but not personal taxes), the tax deductibility of interest payments can increase the value of firms that use debt. Most texts then go on to posit the possibility of an optimal capital stmcture that maximizes a firm=s value, usually citing financial distress costs and agency costs as limiting factors in a firm=s use of debt.1The most basic concepts of capital stmcture are not particularly difficult for students to understand. The proof of Miller and Modigliani (MM) Proposition I regarding capital stmcture irrelevance may be difficult for some students to follow, since it relies on a no-arbitrage argument with which most students will not be familiar. Even if students are unable to follow the proof of the proposition, they are at least able to remember the capital stmcture irrelevance result. Students also quickly understand why the interest tax deduction is valuable. Other more subtle aspects of capital stmcture, such as the interaction between a firm=s capital stmcture and the rates the firm=s investors require on debt and equity, can be more difficult for students to grasp. For instance, students often have trouble incorporating into their thinking the subtleties of MM Proposition II which states that the required return on a firm=s equity increases linearly with its debt-equity ratio - a result of the firm=s equity becoming more risky as it takes on more debt. Though students intuitively understand that a firm=s use of debt makes its equity more risky, when asked to calculate weighted average costs of capital under different capital stmctures, they often forget to adjust the required rate of return on equity as debt levels change. …