Capital Structure

Debt versus Equity

Advantages of Debt
Interest is tax deductible (lowers the
effective cost of debt)
Debt-holders are limited to a fixed return
so stockholders do not have to share
profits if the business does exceptionally
well
Debt holders do not have voting rights
Disadvantages of Debt
Higher debt ratios lead to greater risk and
higher required interest rates (to
compensate for the additional risk)
What is the optimal debt-equity
ratio?
Need to consider two kinds of risk:
Business risk
Financial risk
Business Risk
Standard measure is beta (controlling for
financial risk)
Factors:
Demand variability
Sales price variability
Input cost variability
Ability to develop new products
Foreign exchange exposure
Operating leverage (fixed vs variable costs)
Financial Risk
The additional risk placed on the common
stockholders as a result of the decision to
finance with debt
Example of Business Risk
Suppose 10 people decide to form a
corporation to manufacture disk drives.
If the firm is capitalized only with common
stock and if each person buys 10% --
each investor shares equally in business
risk
Example of Relationship Between
Financial and Business Risk
If the same firm is now capitalized with
50% debt and 50% equity with five
people investing in debt and five investing
in equity
The 5 who put up the equity will have to
bear all the business risk, so the common
stock will be twice as risky as it would
have been had the firm been all-equity
(unlevered).
Business and Financial Risk
Financial leverage concentrates the firms
business risk on the shareholders because
debt-holders, who receive fixed interest
payments, bear none of the business risk.
Financial Risk
Leverage increases shareholder risk
Leverage also increases the return on
equity (to compensate for the higher risk)
Question?
Is the increase in expected return due to
financial leverage sufficient to compensate
stockholders for the increase in risk?
Modigliani and Miller
YES
Assuming no taxes, the increase in return
to shock-holders resulting from the use of
leverage is exactly offset by the increase
in risk hence no benefit to using financial
leverage (and no cost).
Topics To Be Covered
Leverage in a Tax Free Environment
How Leverage Affects Returns
The Traditional Position

Capital Structure
When a firm issues debt and equity
securities it splits cash flows into two
streams:
Safe stream to bondholders
Risky stream to stockholders
Capital Structure
Modigliani and Miller (1958) show that
financing decisions dont matter in perfect
capital markets
M&M Proposition 1:
Firms cannot change the total value of their
securities by splitting cash flows into two
different streams
Firm value is determined by real assets
Capital structure is irrelevant
M&M (Debt Policy Doesnt Matter)
Modigliani & Miller
When there are no taxes and capital markets
function well, it makes no difference whether
the firm borrows or individual shareholders
borrow. Therefore, the market value of a
company does not depend on its capital
structure.
M&M (Debt Policy Doesnt Matter)
Assumptions
By issuing 1 security rather than 2, company
diminishes investor choice. This does not
reduce value if:
Investors do not need choice, OR
There are sufficient alternative securities
Capital structure does not affect cash flows
e.g...
No taxes
No bankruptcy costs
No effect on management incentives
An Example of the Effects of
Leverage
D and E are market values of debt and
equity of Wapshot Marketing Company.
Wapshot has issued 1000 shares and
these are currently selling at $50 a share.
Wapshot has borrowed $25,000 so
Wapshots stock is levered equity.
E = 1000 x $50 = $50,000
D= $25,000
V = E + D = $75,000
Effects of Leverage
What happens if WPS levers up again by
borrowing an additional $10,000 and at the
same time paying out a special dividend of $10
per share, thereby substituting debt for equity?
This should have no impact on WPS assets or
total cash flows:
V is unchanged
D= $35,000
E= $75,000 - $35,000 = $40,000
Stockholders will suffer a $10,000 capital loss
which is exactly offset by the $10,000 special
dividend.
Effects of Leverage
What if instead of assuming V is
unchanged we allow V it rise to $80,000
as a result of the change in capital
structure?
Then E = $80,000 - $35,000 = $45,000
Any increase or decrease in V as a result
of the change in capital structure accrues
to the shareholders
Effects of Leverage
What if the new borrowing increases the
risk of bankruptcy?
This would suggest that the risk of the old
debt is higher (and the value of the old
debt is lower)
If this is the case, then shareholders would
gain from the increase in leverage at the
expense of the original bondholders.
Modigliani and Miller
Any combination of securities is as good
as any other.
Example:
Two Firms with the same operating income
who differ only in capital structure

Firm U is unlevered: V
U
=E
U

Firm L is levered: E
L
= V
L
-D
L
Modigliani and Miller
Four Strategies
Strategy 1
Buy 1% of Firm Us Equity
Dollar investment = .01V
U
Dollar Return= .01 Profits
Strategy 2
Buy 1% of Firm Ls Equity and Debt
Dollar investment= .01D
L
+ .01E
L
= .01V
L
Dollar Return=
From owning .01 D
L
.01 interest
From owning .01 E
L
.01 (Profits interest)
Total .01 Profits
Both Strategies give the same payoff
Modigliani and Miller
Strategy 3
Buy 1% of Firm Ls Equity
Dollar investment = .01E
L
= .01(V
L
-D
L
)

Dollar Return= .01 (Profits interest)
Strategy 4
Buy 1% of Firm Us Equity and borrow on your own
account .01D
L
(home-made leverage)

Dollar investment= .01(Vu D
L)
Dollar Return=
From borrowing .01D
L
-.01 interest
From owning .01 E
U
.01 (Profits)
Total .01 (Profits interest)
Both Strategies give the same payoff

Modigliani and Miller
It does not matter what risk preferences
are for investors.
Just need that investors have the ability to
borrow and lend for their own account
(and at the same rate as firms) so that
they can undo any changes in firms
capital structure
M&M Proposition 1: the value of a firm is
independent of its capital structure.
Leverage and Returns
securities all of ue market val
income operating expected
r assets on return Expected
a
= =
|
.
|

\
|

+
+
|
.
|

\
|

+
=
E D A
r
E D
E
r
E D
D
r
r
D
E
r
D
r
E
M&M Proposition II
r
A
Risk free debt Risky debt
M&M Proposition 2
Bonds are almost risk-free at low debt levels
r
D
is independent of leverage
r
E
increases linearly with debt-equity ratios and the
increase in expected return reflects increased risk
As firms borrow more, the risk of default rises
r
D
starts to increase
r
E
increases more slowly (because the holders of
risky debt bear some of the firms business risk)
The Return on Equity
The increase in expected equity return
reflects increased risk
The increase in leverage increases the
amplitude of variation in cash flows
available to share-holders (the same
change in operating income is now
distributed among fewer shares)
We can understand the increase in risk in
terms of Betas
Leverage and Returns
|
.
|

\
|

+
+
|
.
|

\
|

+
=
E D A
B
E D
E
B
E D
D
B
( )
D A A E
B B
E
D
B B + =
The Traditional Position
What did financial experts think before
M&M?
They used the concept of WACC
(weighted average cost of capital)
WACC is the expected return on the portfolio
of all the companys securities
WACC
|
.
|

\
|
+
|
.
|

\
|
= =
E D A
r
V
E
r
V
D
r WACC
WACC is the traditional view of capital
structure, risk and return.
WACC
.10=r
D
.20=r
E
.15=r
A
B
E
B
A
B
D
Risk
Expected
Return
Equity
All
assets
Debt
WACC
Example - A firm has $2 mil of debt and
100,000 of outstanding shares at $30
each. If they can borrow at 8% and the
stockholders require 15% return what is
the firms WACC?
D = $2 million
E = 100,000 shares X $30 per share = $3 million
V = D + E = 2 + 3 = $5 million
WACC
Example - A firm has $2 mil of debt and 100,000 of
outstanding shares at $30 each. If they can borrow at
8% and the stockholders require 15% return what is the
firms WACC?
D = $2 million
E = 100,000 shares X $30 per share = $3 million
V = D + E = 2 + 3 = $5 million
12.2% or 122 .
15 .
5
3
08 .
5
2
=
|
.
|

\
|
+
|
.
|

\
|
=
|
.
|

\
|
+
|
.
|

\
|
=
E D
r
V
E
r
V
D
WACC
The Traditional Position
The return on equity (r
E
) is constant
WACC declines with increasing leverage
because r
D
<r
E
Given the two assumptions above, a firm
will minimize the cost of capital by issuing
almost 100% debt
This cant be correct!
r
D
V
r
D
r
E
r
A
=WACC
WACC (if r
E
does not change with
increases in leverage

)
An intermediate position
A moderate degree of financial leverage may
increase the return on equity (but less than
predicted by M&M proposition 2)
A high degree of financial leverage increases
the return on equity (but by more than predicted
by M&M proposition 2)
WACC then declines at first, then rises with
increasing leverage (U-shape)
Its minimum point is the point of optimal capital
structure.
r
D
E
r
D
r
E
WACC
WACC (intermediate view)
The intermediate position
Investors dont notice risk of moderate
borrowing
They wake up with debt is excessive
The problem with this view is that it confuses
default risk with financial risk.
Default risk may not be serious for moderate amounts
of leverage
Financial risk (in terms of increased volatility of return
and higher beta) will increase with leverage even with
no risk of default

Modigliani and Miller Revisited
M&M proposition 1: A firms total value is
independent of its capital structure
Assumptions needed for Prop 1 to hold:
1. Capital markets are perfect and complete
2. Before-tax operating profits are not affected by
capital structure
3. Corporate and personal taxes are not affected by
capital structure
4. The firms choice of capital structure does not
convey important information to the market
Modigliani and Miller Revisited
M&M Proposition 2: The return on equity
will rise as the debt-equity ratio rises in
order to compensate equity holders for the
additional (financial) risk.
Note: Proposition 2 does not rely on
default risk r
E
rises because of the rise in
financial risk
r
D
E
r
D
r
E
WACC
WACC (M&M view)
Financial Risk - Risk to shareholders resulting
from the use of debt.
Financial Leverage - Increase in the variability of
shareholder returns that comes from the use of
debt.
Interest Tax Shield- Tax savings resulting from
deductibility of interest payments.

Capital Structure and Corporate
Taxes
Example - You own all the equity in a company.
The company has no debt. The companys
annual cash flow is $1,000, before interest and
taxes. The corporate tax rate is 40%. You have
the option to exchange 1/2 of your equity
position for 10% bonds with a face value of
$1,000.

Should you do this and why?
Capital Structure and Corporate
Taxes
All Equity 1/2 Debt
EBIT 1,000 1,000
Interest Pmt 0 100
Pretax Income 1,000 900
Taxes @ 40% 400 360
Net Cash Flow $600 $540
Capital Structure and Corporate
Taxes
Total Cash Flow
All Equity = 600

*1/2 Debt = 640
(540 + 100)
Capital Structure
PV of Tax Shield =
(assume perpetuity)
D x r
D
x Tc
r
D
= D x Tc
Example:
Tax benefit = 1000 x (.10) x (.40) = $40
PV of 40 perpetuity = 40 / .10 = $400

PV Tax Shield = D x Tc = 1000 x .4 = $400
Capital Structure
Firm Value =
Value of All Equity Firm + PV Tax Shield
Example
All Equity Value = 600 / .10 = 6,000
PV Tax Shield = 400

Firm Value with 1/2 Debt = $6,400
U.S. Tax Code
Allows corporations to deduct interest
payments on debt as an expense
Dividend payments to stockholders are not
deductible
Differential treatment results in a net
benefit to financial leverage (debt)
U.S. Tax Code
Personal taxes bias the other way (toward equity)
Income from bonds generally comes as interest and
is taxed at the personal income tax rate
Income from equity comes partly from dividends and
partly from capital gains
Capital gains are often taxed at a lower rate and the
tax is deferred until the stock is sold and the gain
realized.
If the owner of the stock dies no capital gain tax is
paid
On balance, common stock returns are taxed at
lower rates than debt returns
U.S. Tax Rates
Top bracket (over $250,000 for a married
couple)
Personal rates: 35%
Capital gains: 18% (holding period of 18mos)
If stock is held for less than 1 year capital gain is
taxed at the personal rate
If stock is held for over 1 year but less than 18mos
the capital gains tax is between 18-35%

Capital Structure and Financial
Distress
Costs of Financial Distress - Costs arising from
bankruptcy or distorted business decisions before
bankruptcy.

Market Value = Value if all Equity Financed
+ PV Tax Shield
- PV Costs of Financial Distress
Weighted Average Cost of Capital
without taxes (traditional view)
r
D
E
r
D
r
E
Includes Bankruptcy Risk
WACC
Financial Distress
Debt/Total Assets
M
a
r
k
e
t

V
a
l
u
e

o
f

T
h
e

F
i
r
m

Value of
unlevered
firm
PV of interest
tax shields
Costs of
financial distress
Value of levered firm
Optimal amount
of debt
Maximum value of firm
M&M with taxes and bankruptcy
WACC now is more hump-shaped (similar
to the traditional view though for different
reasons).
The minimum WACC occurs where the
stock price is maximized.
Thus, the same capital structure that
maximizes stock price also minimizes the
WACC.
Financial Choices
Trade-off Theory - Theory that capital structure is
based on a trade-off between tax savings and
distress costs of debt.

Pecking Order Theory - Theory stating that firms
prefer to issue debt rather than equity if internal
finance is insufficient.
Pecking Order Theory
The announcement of a stock issue drives down the stock
price because investors believe managers are more likely to
issue when shares are overpriced.

Therefore firms prefer internal finance since funds can be
raised without sending adverse signals.

If external finance is required, firms issue debt first and equity
as a last resort.

The most profitable firms borrow less not because they have
lower target debt ratios but because they don't need external
finance.

Pecking Order Theory
Some Implications:
Internal equity may be better than external
equity.
Financial slack is valuable.
If external capital is required, debt is better.
(There is less room for difference in opinions
about what debt is worth).