Capital Structure Decisions

Chapter 15 and 16
Financial Policy and Planning
(MB 29)

Outline
Meaning of Capital Structure
Optimal Capital Structure
How much should a firm borrow? Does

capital structure matter? Does it influence

the value of the firm?
Limits to the use of debt
How companies establish their capital
structure?

Capital Structure
A mix of debt, preferred stock, and common stock with which

the firm plans to finance its investments.

Objective is to have such a mix of debt, preferred stock, and
common equity which will maximize shareholder wealth or
maximize market price per share
WACC depends on the mix of different securities in the capital
structure. A change in the mix of different securities in the
capital structure will cause a change in the WACC. Thus,
there will be a mix of different securities in the capital
structure at which WACC will be the least.
An optimal capital structure means a mix of different securities
which will maximize the stock price share or minimize
WACC.

Leverage and Capital Structure

Leverage means use of fixed cost source of funds.

Generally, it refers to use of debt in the capital structure

of the firm
How much leverage should be there in a firm? Why is
this question important? Two reasons:
a higher debt ratio can enhance the rate of return on equity capital
during good economic times
a higher debt ratio also increases the riskiness of the firms
earnings stream

Capital structure decision involves a trade off between

risk and return to maximize market price per share

Does capital structure matter?

Not really; According to Modigliani and

Miller (1958) article, in a world without

corporate taxes, it mix between debt and
equity does not matter
Value of the firm is independent of capital
structure decisions
Value of a firm equals operating income
divided by overall cost of capital.

 Thus, mix between debt and equity is not

important. Any benefit of low cost debt is
completely offset by an increase in the cost of
equity due to use of borrowing.
Thus, overall cost of capital remains same and
value of the firm does not change if we change
the mix between debt and equity.
Assumption of a world without taxes is quite
unrealistic. M&M revisited their theory in their
1961 article.
They assume a world with corporate taxes

M&M with corporate taxes

If we follow M&M (1958), we should not worry about

mixture of debt and equity in the capital structure.

These decisions should be relegated to the background
because they do not affect the value of the firm. So,
financial managers should not worry about these
decisions.
Still financial managers do show concern for a debt
policy, which is carefully developed. And we find a
pattern among companies in the use of debt in different
industries.
M-Ms argument that the value and the cost of capital of a
firm remains constant with leverage will not hold when
corporate taxes are assumed to exist.

 In their 1963 article, they recognize that the value of the

firm will increase or the cost of capital will decrease with

leverage because interest on debt is a tax deductible
expense.
The value of the levered firm will be greater than the
unlevered firm because the return to bondholders escapes
taxation at the corporate level.
The value of the levered firm will be more than the value
of unlevered firm by the amount of the present value of
the tax shield due to tax savings given by the tax
deductibility of interest expense on debt.
Present value of the tax shield is given by Tc D
Value of a leverered firm = [(1-Tc)EBIT/re] + TcD

Example
Firm L has employed a 6 percent debt of $300,000, while firm U is
unlevered. Both the firms earn a before tax earnings of $120,000. The pure
equity capitalization rate is 10 percent and the corporate tax rate is 34
percent. Find the market value of the firms.
(1 - Tc) EBIT

(1 - 0.34) $120,000

Vu = --------------- = ----------------------------- = $792,000

re

0.10

VL = VU + Tc D
= 792,000 + 0.34 $300,000
= $894,000

M&M Proposition II with

corporate taxes
Re = rA + D/E (1 - Tc) (rA - rD)

Limits to the Use of Debt

According to MM theory with taxes, value of levered

firm equals the value of unlevered plus the value of the

tax shield
Accordingly, the more the debt in the capital structure,
the higher will be the value of a levered firm.
One can always increase firm value by increasing
leverage, implying that firms should issue maximum debt.
This is inconsistent with the real world, where firms
generally employ moderate amount of debt.
The answer lies in bankruptcy costs. Debt provides tax
benefits to the firm.

 However, it also puts pressure on the firm, because

interest and principal payments are obligations. If these

obligations are not met, the firm may risk some sort of
financial distress.
The possibility of bankruptcy has a negative effect on the
value of the firm. However, it is not the risk of
bankruptcy itself that lowers value. Rather it is the cost
associated with bankruptcy that lowers value.
As the proportion of debt in the firms capital structure is
increased, the probability of bankruptcy also increases.
Consequently, the rate of return required by bondholders
increases with leverage.

 The optimal ratio of debt to equity is determined

by taking an increasing amounts of debt until the
marginal gain from leverage is equal to the
marginal expected loss from the bankruptcy costs

How Firms Establish Capital

Structure?
Most corporations have low debt-asset ratios
Changes in Financial Leverage affect Firm Value
There are differences in the Capital Structures of

Different Industries
Most companies have a target debt ratio
Target debt ratio is dependent on taxes, types of
assets, uncertainty of operating income, and pecking
order and financial slack.