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 firm’s
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 don’t 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 Doesn’t 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 Doesn’t 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
Wapshot’s 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: VU=EU

• Firm L is levered: EL= VL-DL

 Modigliani and Miller
• Four Strategies
• Strategy 1
– Buy 1% of Firm U’s Equity
• Dollar investment = .01VU
• Dollar Return= .01 Profits
• Strategy 2
– Buy 1% of Firm L’s Equity and Debt
• Dollar investment= .01DL + .01EL = .01VL
• Dollar Return=
• From owning .01 DL .01 interest
• From owning .01 EL .01 (Profits – interest)
• Total .01 Profits
• Both Strategies give the same payoff
 Modigliani and Miller
• Strategy 3
– Buy 1% of Firm L’s Equity
• Dollar investment = .01EL= .01(VL-DL)
• Dollar Return= .01 (Profits – interest)
• Strategy 4
– Buy 1% of Firm U’s Equity and borrow on your own
account .01DL (home-made leverage)
• Dollar investment= .01(Vu – DL)
• Dollar Return=
• From borrowing .01DL -.01 interest
• From owning .01 EU .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 firm’s
capital structure
• M&M Proposition 1: the value of a firm is
independent of its capital structure.
 Leverage and Returns

expected operating income

Expected return on assets = ra =
market value of all securities

 D   E 
rA =  × rD  +  × rE 
D+E  D+E 
 M&M Proposition II
r
rE

rA

rD
D
Risk free debt Risky debt E
 M&M Proposition 2
• Bonds are almost risk-free at low debt levels
– rD is independent of leverage
– rE increases linearly with debt-equity ratios and the
increase in expected return reflects increased risk
• As firms borrow more, the risk of default rises
– rD starts to increase
– rE increases more slowly (because the holders of risky
debt bear some of the firm’s 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

 D   E 
BA =  × BD  +  × BE 
D+E  D+E 

D
BE = BA + ( BA − BD )
E
 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 company’s securities
 WACC
 WACC is the traditional view of capital
structure, risk and return.

D  E 
WACC = rA =  × rD  +  × rE 
V  V 
 WACC
Expected
Return

.20=rE

Equity
.15=rA
All
assets
.10=rD
Debt

Risk
BD BA BE
 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 firm’s 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
firm’s WACC? D = $2 million
E = 100,000 shares X $30 per share = $3 million
V = D + E = 2 + 3 = $5 million

D  E 
WACC =  × rD  +  × rE 
V  V 
2  3 
=  × .08  +  × .15 
5  5 
= .122 or 12.2%
 The Traditional Position
• The return on equity (rE) is constant
• WACC declines with increasing leverage
because rD<rE
• Given the two assumptions above, a firm
will minimize the cost of capital by issuing
almost 100% debt
• This can’t be correct!
WACC (if rE does not change with
increases in leverage )
r

rE

rA =WACC

rD
D
V
 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”.
WACC (intermediate view)
r
rE

WACC

rD
D
E
 The intermediate position
• Investors don’t 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 firm’s 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 firm’s 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 – rE rises because of the rise in
financial risk
 WACC (M&M view)
r
rE

WACC

rD
D
E
 Capital Structure and Corporate
Taxes
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 company’s 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 Total Cash Flow

Net Cash Flow $600 $540 All Equity = 600

*1/2 Debt = 640

(540 + 100)
 Capital Structure
D x rD x Tc
PV of Tax Shield =
(assume perpetuity)
= D x Tc
rD

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 Includes Bankruptcy Risk
rE

WACC

rD
D
E
 Financial Distress
Maximum value of firm

Costs of
Market Value of The Firm

financial distress

PV of interest
tax shields
Value of levered firm

Value of
unlevered
firm

Optimal amount
of debt
Debt/Total Assets
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).