The document discusses corporate financing and capital structure policies. It covers: 1. The Modigliani-Miller propositions on capital structure irrelevance with and without taxes. With taxes, debt increases firm value up to an optimal level due to interest tax shields. 2. Bankruptcy costs reduce firm value at high debt levels due to financial distress costs. There is an optimal capital structure that balances tax benefits of debt against bankruptcy costs. 3. Criticisms of the static tradeoff theory include that profitable firms use little debt contrary to predictions. The pecking order theory explains this by suggesting firms prefer internal then debt financing over new equity issues.

1. Corporate Financing Decision (MFIN 641)
MBA Vth Term
Kathmandu University School of Management
Rajesh Sharma, PhD

2. Financial Leverage and Capital
Structure Policy

3. 3
Value = + + ··· +
FCF1 FCF2 FCF∞
(1 + WACC)1 (1 + WACC)∞
(1 + WACC)2
Free cash flow
(FCF)
Market interest rates
Firm’s business risk
Market risk aversion
Firm’s
debt/equity
mix
Cost of debt
Cost of equity
Weighted average
cost of capital
(WACC)
Net operating
profit after taxes
Required investments
in operating capital
−
=
Determinants of Intrinsic Value: The Capital Structure Choice

4. Capital Structure Policy
Based on Previous example:
• Financial Leverage magnifies both gain and loss for shareholders.
• Leverage makes stock more volatile and riskier: measured by both ROE and EPS.
• Shareholders are exposed to more risk because the EPS and ROE are much more
sensitive to changes in EBIT.
• Because of the impact that financial leverage has on both the expected return to
stockholders and the riskiness of the stock, capital structure is an important
consideration.
Are all these conclusion correct?

5. Homemade Leverage
• The first three of these conclusions are clearly correct. Does the last conclusion
necessarily follow? Surprisingly, the answer is no.
• Reason: Shareholders can adjust the amount of financial leverage by borrowing
and lending on their own. This use of personal borrowing to alter the degree of
financial leverage is called homemade leverage.
Example in excel

6. Capital Structure Policy
• To understand the firms’ capital structure policy:
– Modigliani and Miller (M&M) devised capital structure irrelevancy theory in the 1950s.
– Four Propositions (with and without DEBT/ with and without TAX)

7. M & M Proposition I (No Taxes)
• We can create a levered or unlevered position by adjusting the trading in our own
account.
• This homemade leverage suggests that capital structure is irrelevant in determining
the value of the firm:
VL = VU
• The size of the pie is same for both firms because the value of the assets is the
same.

8. M & M Proposition II (No Taxes)
• Although changing the capital structure of the firm does not change the firm’s
total value, it does cause important changes in the firm’s debt and equity.
• So, what happens to a firm financed with debt and equity when the debt–equity
ratio is changed.
• Weighted average cost of capital (No Tax):
WACC = RE X (E/V) + RD X (D/V)
• One way of interpreting the WACC is as the required return on the firm’s overall
assets. Therefore,
RA = RE X (E/V) + RD X (D/V)
RA = NOPAT/ Market Value of Equity
• After rearranging, cost of equity turns to be:
RE = RA + (RA - RD) X (D/E)

9. M & M Proposition II (No Taxes)- Example
• Unlevered firm (for all equity Firm):
RE = RA + (RA - RD) X (D/E)
• Levered firm (Restructured by issuing debt of 5000 @ 10%) :
RE = RA + (RA - RD) X (D/E)

10. M & M Proposition II (No Taxes)
• Proposition: firm’s cost of equity capital is a positive linear function of the firm’s
capital structure.
• The cost of debt is lower than the cost of equity is exactly offset by the increase in
the cost of equity from borrowing. In other words, the change in the capital
structure weights (E/V and D/V) is exactly offset by the change in the cost of
equity (RE), so the WACC stays the same.

11. M & M Proposition I and II (With Tax)
• Debt has two distinguishing features that we have not taken into proper account.
– 1) Interest paid on debt is tax deductible. This is good for the firm, and it may be an added benefit
of debt financing.
– 2) Failure to meet debt obligations can result in bankruptcy. This is not good for the firm, and it
may be an added cost of debt financing.
• When explicitly considering either of these two features of debt, we will get a
different answer about the effect of capital structure.
• First part, considers the effect of corporate taxes and second part covers the
effect of bankruptcy.

12. M & M Proposition I (With Taxes)- Example
• For our two firms, U and L: lets assume that EBIT is expected to be $1,000 every
year forever for both firms. The difference between the firms is that Firm L has
issued $1,000 worth of perpetual bonds on which it pays 8 percent interest each year.
The interest bill is thus .08 X 1,000 = $80 every year forever. Also, we assume that
the corporate tax rate is 30 percent.
• To simplify things, we will assume that depreciation is zero. We will also assume that
capital spending is zero and that there are no changes in NWC. Hence, we can
compute the cash flow to stockholders and bondholders:
Firm L > Firm U by $24.
• Interest tax shield = Interest X Tax rate = $80 X 30%= $24
– Note- Increase in firm value?? >> Take PV of tax shield (PV = $24/ 0.08= $300) – NEXT SLIDE

13. M & M Proposition I (With Taxes)
• Present Value of Tax: If the interests paid for perpetuity
PV = Interest / Cost of debt
= Debt X Interest rate X Tax rate/ Interest rate
= 1000 X 0.08 X 0.30 / 0.08
= 1000X 0.30= 300
• Hence, the present value of tax shield = (D X RD X TC )/ RD
= D X TC
• Value of Firm L > Firm U by the present value of the interest tax shield.
VL = VU + D X TC

14. M & M Proposition I (With Taxes)
• Suppose that the cost of capital for Firm Unlevered is 10 percent. Firm U’s cash flow is $700 every year
forever, and, because U has no debt, the appropriate discount rate is RU of the unlevered firm.
• VU, is simply: EBIT (1-T)/ RU = 1000 (1- 0.3) / 0.1 = 7000 (assuming 30% tax rate)
• Similarly, is the firm issues $1,000 worth of perpetual bonds at 8 percent : VL = VU + D X TC = 7000
+ 0.3 X 1000 = 7300 (assuming 30% tax rate)

15. M & M Proposition II (With Taxes)
• Once tax is considered: Capital Structure definitely matters.
• Let’s Check:
– M&M Proposition II with corporate taxes states that the cost of equity is
RE = RU + (RU - RD) X (D/E) (1- Tax Rate)
(Note: RU and RA are same for unlevered firm, therefore RA changed to RU )
• Example: Firm L is worth $7,300 total. Because the debt is worth $1,000, the equity must
be worth $7,300 2 1,000 5 $6,300. For Firm L:
RE = RU + (RU - RD) X (D/E) (1- Tax Rate)
= 0.10 +( 0.10 -0.08) X (1000/6300) (1- 0.30)= 10.22%
WACC = RE X (E/V) + RD X (D/V) (1- Tax Rate)
= 10.22% X (6300/7300) + 8% X (1000/73000) (1-0.30)= 9.6 %
The firm is better off with debt.

16. M & M Proposition II (With Taxes)
Is the capital on optimum level with 100 percent debt?

17. Bankruptcy Cost
• As the debt–equity ratio rises, so too does the probability that the firm will be
unable to pay its bondholders what was promised to them ( especially in economic
downturn / cash crunch). When this happens, ownership of the firm’s assets is
ultimately transferred from the stockholders to the bondholders.
• In principle, a firm becomes bankrupt when the value of its assets equals the value
of its debt. When this occurs, the value of equity is zero, and the stockholders
turn over control of the firm to the bondholders. When this takes place, the
bondholders hold assets whose value is exactly equal to what is owed on the debt.
In a perfect world, there are no costs associated with this transfer of ownership,
and the bondholders don’t lose anything.
• This idealized view of bankruptcy is not, of course, what happens in the real
world. Ironically, it is expensive to go bankrupt

18. Bankruptcy Cost
• Differentiate: bankruptcy risk versus bankruptcy cost.
• The possibility of bankruptcy has a negative effect on the value of the firm.
• However, it is not the risk of bankruptcy itself that lowers value.
• Rather, it is the costs associated with bankruptcy (associated with the process).
• It is the stockholders who bear these costs.
• Direct Costs
– Legal and administrative costs
• Indirect Costs
– Impaired ability to conduct business (e.g., lost sales)

19. Optimal Capital Structure
• A firm will borrow because the interest tax shield is valuable.
• At relatively low debt levels, the probability of bankruptcy and financial distress is low,
and the benefit from debt outweighs the cost.
• At very high debt levels, the possibility of financial distress is a chronic, ongoing problem
for the firm, so the benefit from debt financing may be more than offset by the financial
distress costs.
• It appear that an optimal capital structure exists somewhere in between these extremes.
THE STATIC THEORY OF CAPITAL STRUCTURE (Tradeoff Theory)
• Firm borrows up to the point where the tax benefit from an extra dollar in debt is exactly
equal to the cost that comes from the increased probability of financial distress.
• We call this the static theory because it assumes that the firm is fixed in terms of its assets
and operations and it considers only possible changes in the debt–equity ratio.

20. The Static Theory of Capital Structure: Optimal
Capital Structure and Firm Value

21. The Static Theory of Capital Structure: Optimal
Capital Structure and Cost of Capital

22. Optimal Capital Structure: Summary
Case I
• With no taxes or bankruptcy costs, the value of the firm and its weighted
average cost of capital are not affected by capital structures.
Case II
• With corporate taxes and no bankruptcy costs, the value of the firm increases
and the weighted average cost of capital decreases as the amount of debt goes up.
Case III
• With corporate taxes and bankruptcy costs, the value of the firm, VL, reaches
a maximum at D*, the point representing the optimal amount of borrowing. At
the same time, the weighted average cost of capital, WACC, is minimized at
D*/E*.

23. The Static Theory: Criticism
• Even though the static theory has dominated thinking about capital structure for a
long time, it has some shortcomings.
• Empirical result: Many large, financially sophisticated, and highly profitable firms
use little debt. This is the opposite of what is expect.
• Under the static theory, these are the firms that should use the most debt because
there is little risk of bankruptcy and the value of the tax shield is substantial. Why
do they use so little debt?
• The pecking-order theory provides an alternative explanation:
– A key element in the pecking-order theory is that firms prefer to use internal financing whenever
possible.
– A simple reason is that selling securities to raise cash can be expensive, so it makes sense to avoid
doing so if possible. If a firm is very profitable, it might never need external financing; so it would
end up with little or no debt.

24. The Pecking- Order Theory
• Theory stating that firms prefer to issue debt rather than equity if internal
financing is insufficient.
– Rule 1
Use internal financing first
(Cash available for retained earning/ don’t want to incur cost for new issue)
– Rule 2
Issue debt next, new equity last
(Firm with possible new venture expect a positive cash flow which suggest a higher firm value/
however current market without such information trade on discount (undervalued). The firm don’t
want to sell cheaply and therefore issue debt).
 The pecking-order theory is at odds with the tradeoff theory:
 There is no target D/E ratio
 Profitable firms use less debt
 Companies like financial slack

25. The Pecking- Order Theory
 This pecking order is important because it signals to the public how the company is
performing.
 If a company finances itself internally, that means it is strong.
 If a company finances itself through debt, it is a signal that management is
confident the company can meet its monthly obligations.
 If a company finances itself through issuing new stock, it is normally a negative
signal, as the company thinks its stock is overvalued and it seeks to make money
prior to its share price falling

26. Next Class : Dividends and Payout Policy