THEORY OF CAPITAL STRUCTURE

Determination of an optimal capital structure has frustrated theoreticians for

decades. The early work made numerous assumptions in order to simplify the problem
and assumed that both the cost of debt and the cost of equity were independent of
capital structure and that the relevant figure for consideration was the net income of the
firm. Under these assumptions, the average cost of capital decreased with the use of
leverage and the value of the firm (the value of the debt and equity combined) increased
while the value of the equity remained constant.

!
s
!
a
!
d
Debt"#quity
$odigliani and $iller showed that this could not be the case. Their contention
was that two identical firms, differing only in their capital structure, must have identical
total values. %f they did not, individuals would engage in arbitrage and create the market
forces that would drive the two values to be equal.
Their proof of this proposition was based upon several assumptions (many of
which have subsequently been rela&ed without changing the results)'
(ll investors have complete knowledge of what future returns will be
(ll firms within an industry have the same risk regardless of capital structure
)o ta&es (we will rela& this assumption subsequently)
)o transactions costs
%ndividuals can borrow as easily and at the same rate of interest as the
corporation
(ll earnings are paid out as dividends (thus, earnings are constant and there
is no growth)
The average cost of capital is constant
*ince no ta&es has been assumed, the operating income (#+%T) is equivalent to
the net income which is all paid out as dividends. Thus, the value of the firm is equal to
V
EBIT
k
a
=
*ince the value of the firm is equal to the sum of the value of the debt and equity,
V D E
then
k V k D E
and
k k
E
D E
k
D
D E
a a
a s d
= +
= +
=
+
+
+
( )
( ) ( )
*ubstituting the last equation into the preceding equation and solving for !
s
k k k k
D
E
s a a d
= + ( )
Thus, k
s
must go up as debt is added to the capital structure.

!
s
!
a
!
d
Debt"#quity
To prove their point, they assumed two identical firms, an unlevered firm (all equity) and
a levered firm with ,- million of debt carrying an interest rate of ../, both firms
generating an operating income (#+%T) of ,011,111 annually. They adopted the
assumption that stockholders of both firms would have the same required rate of return
of 21 which, as previously mentioned, was the standard assumption at the time (that
the cost of equity was constant regardless of capital structure).
Unlevered 3irm 4evered 3irm
#+%T , 011,111 , 011,111
5%nterest 1 611,111
%ncome , 011,111 , 711,111
*ince the required rate of return of shareholders is 21 in both cases
Unlevered 3irm 4evered 3irm
8alue of #quity 9
$ ,
.
$ , ,
900 000
10
9 000 000 =
$600, 000
.10
$ 6, 000, 000 =
8alue of Debt 9 , 1 , -,111,111
Total 8alue of 3irm 9 ,0,111,111 ,21,111,111
%f this were true, then someone who owns 21 of the levered firm would have
income of ,71,111 (,711,111 : 21) and could sell it for ,711,111 (,7 million : 21).
;ith this ,711,111 the individual could borrow another ,611,111 at ../ and buy 21
of the unlevered firm for ,011,111 (,0 million : 21). ;hat would this individual<s
income be now=
#+%T , 01,111 (,011,111 : 21)
5%nterest >>,/11 (,611,111 : ../)
%ncome , 7.,/11
Thus, the income would be greater by buying the unlevered firm<s stock and borrowing
money to finance the purchase. (s other individuals see this opportunity, they also will
sell the stock of the levered firm (driving its price down) and buy the stock of the
unlevered firm (using some borrowed money) and thereby driving the value of the
unlevered firm<s stock up. (s the price of the unlevered firm is bid up, the value of the
unlevered firm increases above ,0 million dollars, while the selling of the levered firm<s
stock drives the equity value below ,7 million (which decreases the total firm value,
including the ,- million of debt, below ,21 million) until the two firms< values, in
equilibrium, are equal and no opportunity to arbitrage the difference e&ists.
?onsequently, if the total value of the two firms is equal, then the average cost of capital
must be equal. (nd if the average cost of capital is equal, then it must be true that the
cost of equity rises in such a manner as to e&actly offset the increased use of cheaper
debt financing (and we end up with the previous graph showing this).
(s we previously uncovered when we looked at financial leverage, this is not a
surprising result. (s a firm increases its use of debt, the risk to the stockholder
increases and, as a consequence, the stockholder<s required rate of return will increase.
$odigliani and $iller simply defined how the stockholder<s required rate of return should
increase with increased financial leverage.
The lesson that is intended by this is that value cannot be created by simply
substituting one form of financing for another.
*ubsequent to this analysis, it was pointed out that corporate ta&es have an
impact on the valuation. ;ithout going through the mathematics (which is in your
te&tbook), suffice it to say that the result was that the value of the firm increased with
increased leverage. *pecifically,
V V t D
L U
= + *
The fact that the government is a @partnerA in the business results in a subsidy when
debt financing is used and a deductible e&pense (unlike equity payments). ;hen
corporate ta&es were taken into account, the average cost of capital was found to
decrease with increased leverage'

!
s
!
a
before5ta&
!
a
after ta&
!
d
before5ta&
!
d
after5ta&
Debt"#quity
This implies that a firm should use as much debt as possible. Bet, we do not see
companies using 211 debt. %t might be pointed out that during the late 20C1s there
was a considerable amount of substitution of debt for equity among firms, particularly in
the case of leveraged buyouts. Dowever, many of those firms subsequently failed (for
e&ample, Unocal) and the typical debt"equity ratio today is similar to earlier levels.
*o why do we not see more debt employed by companies= The answer to this
question has been sought by many and two primary proposals have been put forth.
3irst, bankruptcy costs were invoked as a factor. That is, the more debt a firm uses, the
higher the probability that the firm would default and go into bankruptcy. Therefore, the
present value of bankruptcy costs had to be deducted from the value of the firm. (
second factor was that of @agencyA costs, such as the necessity of reporting regularly to
lenders (audited financial statements, bank @monitoringA fees, trustees for debt
payments, etc.) that accompany the use of debt. +oth of these costs increase in present
value of e&pected costs terms as the proportion of debt increases. (nother way of
viewing these costs is that the risk of receiving full interest and principal payments
increases and thus the required rate of return of lenders increases. (3or e&ample, @EunkA
bonds often yield higher rates of interest than the required rate of return on equity for
companies with very little debt.) ?onsequently, the cost of debt increases and the
average cost of capital will ultimately increase.

!
s
!
a
after5ta&
!
d
after5ta&
Debt"#quity
(s can be observed from the graph, a minimum average cost of capital e&ists,
but e&actly where it should be has yet to be determined within a theoretical framework.
*o what are the insights that we can gain from this theorectical view of capital
structure= 3irst, we should note that, while debt financing is @cheapA in the sense that
required rates of return on equity will always be higher than the interest rate on debt,
there is a @hiddenA cost in that the cost of equity rises as we utiliFe more debt financing.
This is one reason that using the average cost of capital in valuing a proEect or company
is more appropriate, even if we intend to borrow all of the money to finance it. ;hile we
may use cheap debt to finance a proEect, the increased risk to shareholders from
increasing our financial leverage results in an increase in the cost of equity. The
average cost of capital reflects both the cost of debt as well as the cost of equity and
thus will reflect the increased cost of equity associated with the use of more debt
financing.
The second important concept is that ta&5deductible debt financing results in a
ta& subsidy by the government. This subsidy adds value to the firm. 3or e&ample, what
is the @advantageA of being a home owner with a mortgage rather than leasing a home=
%t is the ta&es that you will save. The reason that ?ongress eliminated the deductibility
of credit card interest is that it did not want to encourage, through a ta& subsidy, the
financing of purchases purely for consumption. Gn the other hand, the purchase of a
home (which is still ta&5deductible) is an @investmentA, not to mention the political
consequences of voting to end the subsidy of the (merican Dream of home ownership.