2. Chapter Outline
Meaning of capital structure
The capital structure question
Factors that influence capital structure decisions
Business and financial risk:
• Business risk and operating leverage
• Financial risk and financial leverage
Determining the optimal capital structure
• EBIT/EPS analysis
• The effect of capital structure on stock price and the cost of capital
Introduction to the theory of capital structure
• Modigliani and Miller Propositions, Trade-off theory, Signaling theory
• Using debt financing to constrain managers
3. Refers to the mix (or proportion) of a firm’s
permanent long-term source of financing represented
by debt, preferred stock, and common equity that
is used to finance the firm’s assets/investments.
Represent the proportionate relationship between
debt and equity (i.e. debt-equity mix or ratio): where
equity includes paid-up share capital, share premium
and reserves and surplus (retained earnings).
The percentage of each type of investor-supplied
capital, with the total being 100%.
Capital structure (What?)
4. Cont’d
The term capital refers to investor-supplied funds-
debt, preferred stock, common stock, and retained
earnings and excludes current liabilities (except
short-term borrowings though traditionally
excluded) such as accounts payable and accruals
because they come from normal operations, not as
investments by investors.
5. Why should the shareholders in the firm care
about maximizing the value of the entire firm (the
sum of both the debt and the equity)? Instead,
why should the shareholders not prefer the
strategy that maximizes their interests only?
Why should financial managers choose the capital
structure that maximizes the value of the firm?
How should a firm go about choosing its debt-
equity ratio? When it comes to capital structure
decisions, this is essentially the same thing as
maximizing the value of the whole firm?
What is an optimal capital structure or What is the
ratio of debt to equity that maximizes the
shareholders’ interests?
6. Cont’d
suppose the market value of the J.J. Sprint Company is
$1,000. The company currently has no debt, and J.J. Sprint’s
100 shares sell for $10 each. Further, suppose that J.J.
Sprint restructures itself by borrowing $500 and then paying
out the proceeds to shareholders as an extra dividend of
$500/100 = $5 per share.
This restructuring will change the capital structure of the
firm with no direct effect on the firm’s assets. The immediate
effect will be to increase debt and decrease equity.
7. Cont’d
What will be the final impact of the restructuring?
Under Scenario II, value of the firm stays the same,
shareholders will experience a capital loss exactly offsetting
the extra dividend.
In Scenario I, the value of the firm increases to $1,250 and
the shareholders come out ahead by $250, the
restructuring has an NPV of $250 in this scenario.
The NPV in Scenario III is -$250.
Change in the value of the firm is the same as the net effect
on the stockholders.
The value of the firm is maximized when the WACC is
minimized.
The capital structure that maximizes the value of the firm
is the one financial managers should choose for the
shareholders.
8. The objective of a company is to maximize the value
of the company and it is prime objective while
deciding the capital structure.
Capital structure decisions refers to deciding:
the forms of financing (which sources to be
tapped/selected);
their actual requirements (amount to be funded); and
their relative proportions (mix) in total capitalization.
Capital structure decision will decide weight of debt
and equity and ultimately overall cost of capital as
well as the value of the firm. So capital structure is
relevant in maximizing value of the firm and
minimizing overall cost of capital.
9. Factors that influence capital
structure decisions
Four primary factors influence capital structure decisions:
1. Business risk, or the riskiness inherent in the firm’s operations
if it used no debt. The greater the firm’s business risk, the
lower its optimal debt ratio.
2. The firm’s tax position. A major reason for using debt is that
interest is tax deductible, which lowers the effective cost of
debt.
3. Financial flexibility, or the ability to raise capital on reasonable
terms even under adverse market conditions.
4. Managerial conservatism or aggressiveness. Some managers
are more aggressive than others; hence, they are more
willing to use debt in an effort to boost profits.
Those four points largely determine a firm’s target capital
structure, but operating conditions can cause its actual capital
structure to vary from the target.
10. Business Risk
It is the single most important determinant of capital
structure, and
It represents the amount of risk that is inherent in the
firm’s operations even if it uses no debt financing.
11. Cont’d
Business risk depends on a number of factors, the more
important of which are listed here:
Demand variability.
Sales variability - volume and price
Input cost variability
Ability to adjust output prices for changes in input costs.
Ability to develop new products in a timely, cost-effective
manner.
Foreign risk exposure.
The extent to which costs are fixed (operating leverage)
12. Business risk and operating
leverage
Operating leverage is the use of fixed costs rather than
variable costs.
If most costs are fixed, hence do not decline when
demand falls, then the firm has high operating leverage.
More operating leverage leads to more business risk, for
then a small sales decline causes a big ROE decline.
When a high percentage of total costs are fixed, the firm
is said to have a high degree of operating leverage.
13. Financial risk and financial leverage
Financial risk – additional risk place on the common
stockholders as a result of the decision to finance
with debt.
Financial risk is the equity risk that comes from the
financial policy (the capital structure) of the firm.
Financial leverage refers to the extent to which a firm
relies on debt.
The more debt financing a firm uses in its capital
structure, the more financial leverage it employs.
14. Example: Financial Leverage, EPS
and ROE
What happens to EPS and ROE when we issue debt and
buy back shares of stock?
Current and proposed capital structures for the Bigbee
corporation:
16. Example: Financial Leverage,
EPS and ROE
Variability in ROE
Current: ROE ranges from 6.25 % to 18.75 %
Proposed: ROE ranges from 2.5 % to 27.50 %
Variability in EPS
Current: EPS ranges from $ 1.25 to $ 3.75
Proposed: EPS ranges from $ 0.5 to $ 5.5
The variability in both ROE and EPS increases
when financial leverage is increased
17. Determining the Optimal Capital
Structure
Maximize the price of the firm’s stock
Changes in use of debt will cause changes in earnings
per share, and thus, in the stock price
Cost of debt varies with capital structure
Financial leverage increases risk
EPS indifference analysis
the level of sales at which EPS will be the same whether the
firm uses debt or common stock financing
at lower sales, EPS is higher with stock financing
at higher sales, EPS favors debt financing
18. EBIT/EPS analysis or Break-even to
EBIT
EPS versus EBIT The impact of leverage is
evident when the effect of the restructuring on
EPS and ROE is examined.
19. Cont’d
In Figure 1.4, we take a closer look at the effect of the
proposed restructuring. This figure plots EPS, against EBIT,
for the current and proposed capital structures.
The first line, labeled “No debt,” represents the case of no
leverage.
The second line represents the proposed capital structure.
Another observation to make in Figure 1.4 is that the lines
intersect. At that point, EPS is exactly the same for both
capital structures.
To find this point, note that EPS is equal to EBIT/400,000 in
the no-debt case. In the with-debt case, EPS is (EBIT-
$400,000)/200,000. If we set these equal to each other, EBIT
is:
EBIT/400,000=(EBIT-$400,000)/200,000
EBIT=2 X (EBIT-$400,000)
=800,000
20. Cont’d
When EBIT is $800,000, EPS is $2 under either capital
structure.
This is labeled as the break-even point in Figure 1.4; we
could also call it the indifference point.
If we expect EBIT to be greater than the break-even
point, then leverage may be beneficial to our
stockholders
If we expect EBIT to be less than the break-even point,
then leverage is detrimental to our stockholders
21. The effect of capital structure on stock
price and the cost of capital
We know that stock prices are positively related to expected
earnings but negatively related to higher risk.
to the extent that higher debt levels raise expected EPS, leverage
works to increase the stock price.
However, higher debt levels also increase the firm’s risk, which
raises the cost of equity and works to reduce the stock price.
it is difficult to estimate how a given change in the capital structure
will affect the stock price.
WACC tells us that the firm’s overall cost of capital is a weighted
average of the costs of the various components of the firm’s
capital structure.
A primary reason for studying the WACC is that the value of the
firm is maximized when the WACC is minimized.
we seek to find the capital structure that strikes a balance
between risk and return so as to maximize the stock price.
22. Introduction to the theory of capital
structure
Business risk is an important determinant of the optimal
capital structure. Moreover, firms in different industries
have different business risks.
So, we would expect capital structures to vary
considerably across industries, and this is the case.
For example, pharmaceutical companies generally have
very different capital structures than airlines.
In addition, capital structures vary among firms within a
given industry, which is a bit harder to explain.
What factors can explain these differences?
In an attempt to answer that question, academics and
practitioners have developed a number of theories.
23. (M&M) Propositions I and II with no taxes
We have seen that there is nothing special about
corporate borrowing because investors can borrow or lend
on their own.
As a result, whichever capital structure Bigbee chooses,
the stock price will be the same. Bigbee capital structure
is thus irrelevant, at least in the simple world we have
examined.
Our Bigbee example is based on a famous argument
advanced by two Nobel laureates, Franco Modigliani and
Merton Miller, whom we will henceforth call M&M.
What we illustrated for the Bigbee Corporation is a special
case of M&M Proposition I.
M&M Proposition I states that it is completely irrelevant
how a firm chooses to arrange its finances. The
proposition that the value of the firm is independent of
the firm’s capital structure.
24. M&M Proposition I: The Pie Model
It is to imagine two firms that are identical on the left side
of the balance sheet.
Their assets and operations are exactly the same.
The right sides are d/t b/c the two firms finance their
operations differently. In this case, we can view the capital
structure question in terms of a “pie” model.
It gives two possible ways of cutting up the pie between
the equity slice, E, and the debt slice, D: 40%–60% and
60%–40%.
However, the size of the pie is the same for both firms b/c
the value of the assets is the same.
This is precisely what M&M Proposition I state: The size
of the pie doesn’t depend on how it is sliced.
Levered firm value = Unlevered firm value.
VL = VU
25. The Cost of Equity and Financial Leverage: M&M
Proposition II
As a firm increases its use of debt, its cost of equity also
increases; but its WACC remains constant.
Although changing capital structure of the firm does not change
the firms total value, it does cause important changes in the
firms debt-equity ratio.
if we ignore taxes, WACC, is:
WACC = RA = (E/V) X RE + (D/V) X RD …..V=D+E
If we rearrange this to solve for the cost of equity capital, we
see that:
RE = RA + RA − RD X (D/E)…This is MM Proposition II
MM Position II tells us that cost of equity depends on 3 things:
(1)Required rate of return of the firms cost of asset, RA, (2)
Firms cost of debt RD, and (3) Firms debt to equity ratio (D/E).
26. Cont’d
Fig 1.6: The Cost of Equity & the WACC: M&M Propositions I & II with No Taxes
27. Cont’d
Example: The Ricardo Corporation has a WACC (ignoring taxes) of 12%. It can
borrow at 8%. Assuming that Ricardo has a target capital structure of 80% equity
and 20% debt, what is its cost of equity? What is the cost of equity if the target
capital structure is 50% equity? Calculate the WACC using your answers to verify that
it is the same.
According to M&M Proposition II, the cost of equity, RE, is:
RE = RA + RA − RD X (D/E)
In the first case, the debt–equity ratio is 0.2/0.8 = 0.25, so the cost of the equity is:
RE = 12% + 12% − 8% 𝑋 (.25)
= 13%
In the second case, verify that the debt–equity ratio is 1.0, so the cost of equity is
16 percent.
We can now calculate the WACC assuming that the percentage of equity financing is
80%, the cost of equity is 13%, and the tax rate is zero:
WACC = (E/V) X RE + (D/V) X RD
= .80 X 13% + .20 X 8%
= 12%
In the second case, the percentage of equity financing is 50 percent and the cost of
equity is 16 percent. The WACC is:
WACC = (E/V) X RE + (D/V) X RD
= .50 X 16% + .50 X 8%
= 12%
As we have calculated, the WACC is 12 percent in both cases.
28. (M&M) Propositions I and II with taxes
Debt has two distinguishing features that we have not
taken into proper account.
First, interest paid on debt is tax deductible. This is
good for the firm, and it may be an added benefit of
debt financing.
Second, 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.
We can start by considering what happens to M&M
Propositions I and II when we consider the effect of
corporate taxes.
To do this, we will examine two firms: Firm U
(Unlevered) and Firm L (levered). These two firms are
identical on the left side of the balance sheet, so their
29. Cont’d
We 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%.
Firm U Firm L
EBIT $1,000 $1,000
Interest 0 80
Taxable income $1,000 $920
Taxes (30%) 300 276
Net income $ 700 $ 644
30. The tax saving attained by a firm from interest expense. 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. In this case, cash flow from
assets is simply equal to EBIT-Taxes. For Firms U and L, we thus have:
We immediately see that capital structure is now having some effect because
the cash flows from U and L are not the same even though the two firms have
identical assets. To see what’s going on, we can compute the cash flow to
stockholders and bondholders:
What we are seeing is that the total cash flow to L is $24 more. This occurs b/c
L’s tax bill (w/c is a cash out flow) is $24 less. The fact that interest is deductible
for tax purposes has generated a tax saving equal to the interest payment ($80)
multiplied by the corporate tax rate (30 percent): $80 X .30 = $24. We call this
tax saving the interest tax shield.
Cash Flow from
Assets
Firm U Firm L
EBIT $1,000 $1,000
-Taxes 300 276
Total $700 $724
Cash Flow Firm U Firm L
To stockholders $700 $644
To bondholders 0 80
Total $700 $724
31. Taxes and M&M Proposition I
Because the debt is perpetual, the same $24 shield will be
generated every year forever. The after-tax cash flow to L
will thus be the same $700 that U earns plus the $24 tax
shield. Because L’s cash flow is always $24 greater, Firm
L is worth more than Firm U, the difference being the value
of this $24 perpetuity.
PV = $24
.08
= .30 X $1000 X .08
.80
= .30 X $1000 = $300
As our example illustrates, the PV of the interest tax shield
can be written as:
PV of the interest tax shield = (TC X D X RD)/RD
= TC X D
32. Cont’d
We have now come up with another famous result, M&M
Proposition I with corporate taxes. We have seen that the
value of Firm L, VL, exceeds the value of Firm U, VU, by the
present value of the interest tax shield, TC X D . M&M
Proposition I with taxes therefore states that:
VL = VU + TC X D
The effect of borrowing in this case is illustrated in Figure
1.7. We have plotted the value of the levered firm, VL,
against the amount of debt, D.
M&M Proposition I with corporate taxes implies that the
relationship is given by a straight line with a slope of TC
and a y -intercept of VU.
we have also drawn a horizontal line representing VU.
As indicated, the distance b/n the two lines is TC X D,
the PV of the tax shield.
34. Cont’d
Suppose that the cost of capital for Firm U is 10 percent. We will
call this the unlevered cost of capital, and we will use the symbol
𝑅𝑈 to represent it. We can think of 𝑅𝑈 as the cost of capital a firm
would have if it had no debt. Firm U’s cash flow is $700 every year
forever, and, because U has no debt, the appropriate discount rate
is 𝑅𝑈 = 10%. The value of the unlevered firm, VU, is simply:
VU =
EBIT X (1−TC)
RU
=
$700
.10
= $7000
The value of the levered firm, VL, is:
VL = VU + TC X D
= $7000 + .30 𝑋 1000
= $7300
35. Cont’d
As Figure 1.7 indicates, the value of the firm goes up by
$.30 for every $1 in debt. whereas, the NPV per dollar of
debt is $.30.
It is difficult to imagine why any corporation would not
borrow to the absolute maximum under these
circumstances.
The result of our analysis in this section is the realization
that, once we include taxes, capital structure definitely
matters.
However, we immediately reach the illogical conclusion
that the optimal capital structure is 100% debt.
36. Taxes, the WACC, and Proposition II
We can also conclude that the best capital structure is 100% debt by
examining the WACC.
WACC = (E/V) X RE + (D/V) X RD X (1 − TC)
To compute this WACC, we need to know the cost of equity.
RE = RU + RU − RD X (D/E) X (1 − TC)
To illustrate, recall that we saw a moment ago that Firm L is worth $7,300
total. Because the debt is worth $1,000, the equity must be worth $7,300-
1,000=$6,300. For Firm L, the cost of equity is thus:
RE = .10 + (.10 − .08) 𝑋 (1000/6300) 𝑋 (1 − .30)
= 10.22%
The weighted average cost of capital is:
𝑊𝐴𝐶𝐶 = ($6300/7300) 𝑋 10.22% + ($1000/7300) 𝑋 8% 𝑋 (1 − .30)
= 9.6%
Without debt, the WACC is over 10 percent; with debt, it is 9.6%. Therefore,
the firm is better off with debt.
38. Trade-off theory (Static Trade-off
Hypothesis)
It says that firms borrow 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.
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.
It is illustrated in Figure 1.9, which plots the value of the firm, VL,
against the amount of debt, D. In Figure 1.9, we have drawn lines
corresponding to three different stories.
The first represents M&M Proposition I with no taxes. This is the
horizontal line extending from VU, and it indicates that the value of
the firm is unaffected by its capital structure.
The second case, M&M Proposition I with corporate taxes, is
represented by the upward-sloping straight line. These two cases
are exactly the same as the ones we previously illustrated Figure.
The third case in Figure 1.9 illustrates our current discussion: The
value of the firm rises to a maximum and then declines beyond that
point.
40. Cont’d
The maximum value of the firm, VL*, is reached at D*, so
this point represents the optimal amount of borrowing. Put
another way, the firm’s optimal capital structure is
composed of D*/VL* in debt and (1 - D*/VL*) in equity.
The final thing to notice in Figure 1.9 is that the difference b/n
the value of the firm in our static theory and the M&M value of
the firm with taxes is the loss in value from the possibility of
financial distress. Also, the difference b/n the static theory value
of the firm and the M&M value with no taxes is the gain from
leverage, net of distress costs.
41. Optimal Capital Structure and The
Cost of Capital
Figure 1.10 illustrates the static theory of capital structure in
terms of the WACC and the costs of debt and equity.
Figure 1.10 is much the same as Figure 1.8 except that we have
added a new line for the WACC. This line, which corresponds
to the static theory, declines at first.
This occurs b/c the after-tax cost of debt is cheaper than
equity, so, at least initially, the overall cost of capital declines.
At some point, the cost of debt begins to rise, and the fact
that debt is cheaper than equity is more than offset by the
financial distress costs.
From this point, further increases in debt actually increase the
WACC. As illustrated, the minimum WACC* occurs at the point
D*/E*, just as we described before.
43. Signaling theory
MM assumed that everyone investors and managers alike has the
same information about a firm’s prospects. This is called symmetric
information.
However, in fact, managers often have better information than outside
investors. This is called asymmetric information, and it has an
important effect on the optimal capital structure.
To see why, consider two situations, one where the company’s
managers know that its prospects are extremely favorable (Firm F)
and one where the managers know that the future looks unfavorable
(Firm U).
a firm with very favorable prospects to avoid selling stock and
instead raise any required new capital by using new debt even if
this moved its debt ratio beyond the target level.
a firm with unfavorable prospects would want to finance with
stock, which would mean bringing in new investors to share the
losses.
In a nutshell, the announcement of a stock offering is generally
taken as a signal that the firm’s prospects as seen by its
management are not bright.
44. Cont’d
Signal An action taken by a firm’s management that provides clues to
investors about how management views the firm’s prospects.
This, in turn, suggests that when a firm announces a new stock
offering, more often than not, the price of its stock will decline.
What are the implications of all this for capital structure decisions?
Issuing stock emits a negative signal and thus tends to depress the
stock price; so even if the company’s prospects are bright,
a firm should, in normal times, maintain a reserve borrowing
capacity that can be used in the event that some especially good
investment opportunity comes along.
Reserve Borrowing Capacity The ability to borrow money at a
reasonable cost when good investment opportunities arise.
Firms often use less debt than specified by the MM optimal capital
structure in “normal” times to ensure that they can obtain debt capital
later if necessary.
This means that firms should, in normal times, use more equity and
less debt than is suggested by the tax benefit/bankruptcy cost trade-
off model.
45. Using debt financing to
constrain managers
Managers with more limited free cash flow are less able to
make wasteful expenditures.
Firms can reduce excess cash flow in a variety of ways.
One way is to funnel some of it back to shareholders through
higher dividends or stock repurchases.
Another choose is to tilt the target capital structure toward more
debt in the hope that higher debt service requirements will force
managers to become more disciplined.
leveraged buyout (LBO) is a good way to reduce excess cash
flow. In an LBO, debt is used to finance the purchase of a high
percentage of the company’s shares.
Indeed, the projected savings from reducing frivolous waste
has motivated quite a few leveraged buyouts.
high debt payments after the LBO force managers to
conserve cash by eliminating unnecessary expenditures.
