CAPITAL STRUCTURE

THE CAPITAL STRUCTURE DECISION

A company’s capital structure is the mix of debt and equity that a
company uses to finance its business. The goal of a company’s capital
structure decision is

to determine the financial leverage or capital structure that

maximizes the value of the company by minimizing the average cost
of capital.

The weighted average cost of capital (WACC) is given by the average

of the marginal costs of financing for each type of financing used. For a
company with both debt and equity in its capital structure for which
interest expense is tax deductible at a rate t, the WACC is

and the outstanding debt, respectively, and the value of the company is
given by
V = D + E. D & E are market values of debt & equity

You will notice that we use the term “marginal” with respect to both
the cost of capital and the tax rate. The cost of capital is a marginal
cost: what it costs the company to raise additional capital. Therefore,
the cost of equity, the cost of debt, and the tax rate that we use
throughout the remainder of these notes are marginal: the cost or tax rate
for additional capital.
We first consider the theoretical relationship between leverage and a
company’s value. We then examine the practical relationship between
leverage and company value in equal depth.

Proposition I without Taxes:

Capital Structure Irrelevance
Economists Franco Modigliani and Merton Miller argued the important
theory that, given certain assumptions, a company’s choice of capital
structure does not affect its value. The assumptions relate to
expectations and markets:

• Perfect Capital Markets.

• No taxes

• No transaction costs

• Efficient markets

• All investors have same expectations about firm’s future

EBIT.

• Single rate for borrowing and lending

• Borrowing/lending is completely risk free.

• Individuals can borrow or lend at the same rate at which

companies borrow or lend.

• Firms follow 100% payout policy.

Consider the capital of a company to be a pie you can split any number
of ways, but the size of the pie remains the same. Likewise, Modigliani
and Miller reason, the amount and risk of the aggregate returns to
debtholders and equity- holders of a company do not change with
changes in capital structure. They use the concept of arbitrage to
demonstrate their point: if the value of an unlevered company—that is, a
company without any debt—is not equal to that of a levered company,
investors could make an arbitrage profit and this profit taking would
force the values to be equivalent.
The importance of the Modigliani and Miller theory is that it
demonstrates that managers cannot create value simply by changing
the company’s capital structure. Consider why this might be true. The
operating earnings of a business are available to the providers of its
capital. In an all-equity company (that is, a company with no debt), all of
the operating earnings are available to the equity- holders and the value
of the company is the present value of these operating earnings. If, on
the other hand, a company is partially financed by debt, these operating
earnings are split between the providers of capital: the equity holders
and the debt holders. Under market equilibrium, the sum of the values of
debt and equity in such a case should equal the value of the all-equity
company. In other words, the value of a company is determined
solely by its cash flows, not by the relative reliance on debt and
equity capital.
This principle does not change the fact of the relative risks of leverage to
debt holders versus equity holders. Adding leverage does increase the
risk faced by the equity holders. In such a case, equity holders are
compensated for this extra risk by receiving a larger proportion of the
operating earnings, with the debt holders receiving a smaller portion, as
they face less risk. Indeed, in equilibrium, the increase in equity
returns is exactly offset by increases in the risk and the associated
increase in the required rate of return on equity, so that there is no
change in the value of the company.

Modigliani and Miller (MM) first illustrated the capital structure

irrelevance proposition under the condition of no taxes:
MM Proposition I:(without taxes)
The market value of a company is not affected by the capital
structure of the company.
In other words, the value of the company-levered (VL) is equal to the
value of company-unlevered (Vu), or VL= VU
To understand this proposition, we can think about two companies with
the same expected, perpetual cash flows and uncertainty and, hence,
the same discount rate applied to value these cash flows. Even if the
companies have different capital structures, these two companies must
have the same present value using discounted cash flow models. If
capital structure changes were to have any effect on a company’s value,
there would exist an arbitrage opportunity to make endless profits.
In a perfect market, investors can substitute their own leverage for a
company’s leverage by borrowing or lending appropriate amounts in
addition to holding shares of the company. Because this process is
costless for investors (remember, we assumed no transaction costs), a
company’s financial leverage should have no impact on its value.
Therefore, a company’s capital structure is irrelevant in perfect
markets if taxes are ignored.

Proposition II without Taxes: Higher Financial

Leverage Raises the Cost of Equity

Modigliani and Miller’s second proposition focuses on the cost of

capital of the company:
MM Proposition II:
The cost of equity is a linear function of the company’s debt to
equity ratio.
Assuming that financial distress has no costs and that debtholders have
prior claim to assets and income relative to equityholders, the cost of
debt is less than the cost of equity. According to this proposition, as the
company increases its use of debt financing, the cost of equity rises.
The net effect of the increased use of a cheaper source of capital (debt)
and the rising cost of equity is that there is no change in the company’s
overall cost of capital. Again, Modigliani and Miller argue that the
relative amount of debt versus equity does not affect the overall value of
the company. This is because despite the low cost of using debt
financing, the more debt in the capital structure, relative to equity, the
riskier the equity capital.

The risk of the equity depends on two factors: the risk of the
company’s operations (business risk) and the degree of
financialleverage (financial risk).

The weighted average cost of capital (WACC), ignoring taxes, is

Example
Leverkin Company currently is all-equity Has an EBIT of $5,000 perpetual

WACC, also = cost of equity, of 10%. Currently EBIT =EBT = $5,000 as there is no interest charge

Applying perpetuity formula value of firm will be

Company issues $15,000 of debt (at 5%) in order to buy back equal equity.

Under MM Proposition no.I, VL = VU= $50,000 So equity $50,000-$15000 = $35,000

Under MM Proposition II
This shows that (in the absence of taxes) the firm’s value remains
$50,000 with or without leverage (borrowing).

TAXES, THE COST OF CAPITAL, AND THE

VALUE OF THE COMPANY
Taxes are the first practical consideration in modifying the results of the
MM propositions. Because interest is deductible from income for tax
purposes in most countries, the use of debt provides a tax shield
that translates into savings that enhance the value of the firm

From the above formula (with taxes) you will see that
Value (VL)of levered company when taxes are applicable is higher by the PV of
tax shield (tD).

Example
Leverkin Company, currently all-equity Has an EBIT of $5,000 perpetual

WACC, also = cost of equity of 10%.

Corporate taxe rate = 25%.

Currently EBIT =EBT = $5,000 as there is no interest charge.

For unlevered firm I = 0 or EBIT = EBT

Applying perpetuity formula (from time value of money)

The company issues $15,000 of debt at 5% per year and buys back equal equity.

As per MM Proposition –I (with taxes)

VL = Vu + tD = 37,500 + 0.25 ($15,000) = $41,250 = Total value of levered firm

Value of Equity = Total Value of Firm – Value of Debt

= $41,250 - $15,000 = $26,250

Alternate calculation: Annual Interest = $15,000 x 0.05 = $750

Value of tax benefit (perpetuity) = (0.25 x 750)/0.05
= (0.25) [(750)/0.05]
= (0.25) [ 15,000 ] = tD = $3,750
VL = Vu + tD = 37,500 + 3,750 = $ 41,250
As per Proposition –II (with taxes)

This is the value of the company as given by MM Proposition I.

As a further check, the WACC for the levered Leverkin is:

SUMMARY OF MM PROPOSTION I & II
Costs of Financial Distress
The downside of operating and financial leverage is that negative or lower
earnings are magnified downward during economic slowdowns. Lower or
negative earnings put companies under stress, and this financial distress adds
costs. Companies under stress may lose customers, creditors, suppliers, and
valuable employees to more secure competitors.

The probability of bankruptcy increases as the degree of leverage increases.

The fixed cost of debt interact with the instability of the business environment.
Other factors that affect the likelihood of bankruptcy includes the company’s
corporate governance structure and the management of the company

Agency Costs
Agency costs are the costs associated with the fact that all public companies and
the larger private companies are managed by non-owners. Agency costs result
from the inherent conflicts of interest between managers and equity owners. The
smaller the stake that managers have in the company, the less is their share in
bearing the cost of excessive perquisite consumption or not giving their best efforts
in running the company. This conflict has been called the agency costs of equity.
Given that outside shareholders are aware of this conflict, they will take actions to
minimize the loss, such as requiring audited financial statements. The net agency
costs of equity therefore have three components:

1. Monitoring costs. These are the costs borne by owners to monitor the
management of the company and include the expenses of internal audit
department, the annual report, board of director expenses, and the cost of the
annual meeting.
2. Bonding costs. These are the costs borne by management to assure
owners that they are working in the owners’ best interest. These include the
implicit cost of non-compete employment contracts.
3. Residual loss. This consists of the costs that are incurred even when there
is sufficient monitoring and bonding, because monitoring and bonding
mechanisms are not perfect.
The Optimal Capital Structure According to the
Static Trade-Off Theory
Companies make decisions about financial leverage that weigh the value-
enhancing effects of leverage from the tax deductibility of interest against the
value-reducing impact of the costs of financial distress or bankruptcy agency costs.
Putting together all the pieces of the theory of Modigliani and Miller, along with
the taxes, costs of financial distress, agency costs, we see that as financial
leverage is increased, there comes a point beyond which
further increases in value from value-enhancing effects are
offset completely by value-reducing effects. This point is known
as the optimal capital structure. In other words, the optimal capital structure is
that capital structure at which the value of the company is maximized.

Considering only the tax shield provided by debt and the costs of financial
distress, the expression for the value of a leveraged company becomes

VL =VU + tD –PV (of costs of financial distress)

The above equation represents the static trade-off theory of capital structure.
It results in an optimal capital structure such that debt composes less than 100 % of
a company’s capital structure. We diagram this optimum in Figure 10.
The static trade-off theory of capital structure is based on balancing the expected
costs from financial distress against the tax benefits of debt service payments, as
shown in Panel A of Figure 10, Unlike the Modigliani and Miller proposition of no
optimal capital structure, or a structure with almost all debt when the tax shield is
considered, static trade-off theory puts forth an optimal capital structure with an
optimal proportion of debt. Optimal debt usage is found at the point where any
additional debt would cause the costs of financial distress to increase by a
greater amount than the benefit of the additional tax shield.
We cannot say precisely at which level of debt financing a company
reaches its optimal capital structure. The optimal capital structure depends
on the company’s business risk, combined with its tax situation,
corporate governance, and financial accounting information transparency,
among other factors. However, what we can say, based on this theory, is that a
company should consider a number of factors, including its business
risk and the possible costs of financial distress, in determining its
capital structure.

VL =VU + Td –PV (of costs of financial distress)