Capital Structure

Generally speaking, the optimal capital structure is considered to be that which minimizes the
value of the weighted average cost of capital, WACC, and, consequently, maximizes the value of
the firm, D+E1. We will see that if it is assumed that the debt’s market value is the same as its
book value, then the capital structure that minimizes the WACC also maximizes the share price.
However, without this assumption, the minimum value of the WACC may not be the same as the
maximum share price. We will see that for an optimal structure to exist, it is necessary to assume
that the firm’s total value (debt + equity + present value of taxes) decreases with leverage. This
may happen for two reasons: because the expected FCF decreases with debt level, or because the
assets’ risk (the FCF’s risk and the likelihood of bankruptcy) increases with leverage2 (or
because of a combination of both).

Book value of debt ratio 0% 10 % 20% 30% 40% 50%

(Leverage)
 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.

Ks

Ka

Kd
 Debt/Equity

Modigliani and Miller 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. If
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 relaxed without changing the results):

 All investors have complete knowledge of what future returns will be

 All firms within an industry have the same risk regardless of capital structure
 No taxes (we will relax this assumption subsequently)
 No transactions costs
 Individuals can borrow as easily and at the same rate of interest as the corporation
 All earnings are paid out as dividends (thus, earnings are constant and there is no
growth)
 The average cost of capital is constant

Since no taxes has been assumed, the operating income (EBIT) is equivalent to the net income
which is all paid out as dividends. Thus, the value of the firm is equal to
 EBIT
V
ka

Since the value of the firm is equal to the sum of the value of the debt and equity,

V  D E
then
k aV  k a ( D  E )
and
E D
ka  k s ( )  kd ( )
D E D E

Substituting the last equation into the preceding equation and solving for Ks

D
k s  ka  ( ka  kd )
E

Thus, ks must go up as debt is added to the capital structure.

%
 Ks

Ka

Kd

Debt/Equity

To prove their point, they assumed two identical firms, an unlevered firm (all equity) and a
levered firm with $4 million of debt carrying an interest rate of 7.5%, both firms generating an
operating income (EBIT) of $900,000 annually. They adopted the assumption that stockholders
of both firms would have the same required rate of return of 10% which, as previously
mentioned, was the standard assumption at the time (that the cost of equity was constant
regardless of capital structure).

Unlevered Firm Levered Firm

EBIT $ 900,000 $ 900,000

-Interest 0 300,000

Income $ 900,000 $ 600,000

 Since the required rate of return of shareholders is 10% in both cases

Unlevered Firm Levered

Firm

$900, 000
 $9 , 000, 000
Value of Equity = .10

$600, 000
 $ 6,000,000
.10

Value of Debt = $ 0 $
4,000,000

Total Value of Firm = $9,000,000

$10,000,000

If this were true, then someone who owns 10% of the levered firm would have income of
$60,000 ($600,000 * 10%) and could sell it for $600,000 ($6 million * 10%). With this
$600,000 the individual could borrow another $300,000 at 7.5% and buy 10% of the unlevered
firm for $900,000 ($9 million * 10%). What would this individual’s income be now?

\ EBIT $ 90,000 ($900,000 * 10%)

-Interest 22,500 ($300,000 * 7.5%)

Income $ 67,500

Thus, the income would be greater by buying the unlevered firm’s stock and borrowing money to
finance the purchase. As 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. As the price of
the unlevered firm is bid up, the value of the unlevered firm increases above $9 million dollars,
while the selling of the levered firm’s stock drives the equity value below $6 million (which
decreases the total firm value, including the $4 million of debt, below $10 million) until the two
firms’ values, in equilibrium, are equal and no opportunity to arbitrage the difference exists.
Consequently, if the total value of the two firms is equal, then the average cost of capital must be
equal. And 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 exactly offset the increased use of cheaper debt financing (and we end up
with the previous graph showing this).

As we previously uncovered when we looked at financial leverage, this is not a surprising

result. As 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. Modigliani and Miller
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.

Subsequent to this analysis, it was pointed out that corporate taxes have an impact on the
valuation. Without going through the mathematics (which is in your textbook), suffice it to say
that the result was that the value of the firm increased with increased leverage. Specifically,

VL  VU  t * D

The fact that the government is a “partner” in the business results in a subsidy when debt
financing is used and a deductible expense (unlike equity payments). When corporate taxes were
taken into account, the average cost of capital was found to decrease with increased leverage:
 %

Ks

Ka before-tax

Ka
after tax

Kd before-tax

Kd after-tax

Debt/Equity

This implies that a firm should use as much debt as possible. Yet, we do not see companies
using 100% debt. It might be pointed out that during the late 1980s there was a considerable
amount of substitution of debt for equity among firms, particularly in the case of leveraged
buyouts. However, many of those firms subsequently failed (for example, Unocal) and the
typical debt/equity ratio today is similar to earlier levels.

So 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. First, 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. A second factor was that of “agency” costs, such as the
necessity of reporting regularly to lenders (audited financial statements, bank “monitoring” fees,
trustees for debt payments, etc.) that accompany the use of debt. Both of these costs increase in
present value of expected costs terms as the proportion of debt increases. Another 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. (For example, “junk” bonds often yield
higher rates of interest than the required rate of return on equity for companies with very little
debt.) Consequently, the cost of debt increases and the average cost of capital will ultimately
increase.

Ks
 Ka after-tax

Kd after-tax

Debt/Equity

As can be observed from the graph, a minimum average cost of capital exists, but exactly where
it should be has yet to be determined within a theoretical framework.

So what are the insights that we can gain from this theorectical view of capital structure? First,
we should note that, while debt financing is “cheap” in the sense that required rates of return on
equity will always be higher than the interest rate on debt, there is a “hidden” cost in that the cost
of equity rises as we utilize more debt financing. This is one reason that using the average cost
of capital in valuing a project or company is more appropriate, even if we intend to borrow all of
the money to finance it. While we may use cheap debt to finance a project, 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 tax-deductible debt financing results in a tax
subsidy by the government. This subsidy adds value to the firm. For example, what is the
“advantage” of being a home owner with a mortgage rather than leasing a home? It is the taxes
that you will save. The reason that Congress eliminated the deductibility of credit card interest is
that it did not want to encourage, through a tax subsidy, the financing of purchases purely for
consumption. On the other hand, the purchase of a home (which is still tax-deductible) is an
“investment”, not to mention the political consequences of voting to end the subsidy of the
American Dream of home ownership.