Session 12.

Capital Structure Decisions Part I

PGP, IIM INDORE
Capital Structure
•Does Debt Policy Matter?

•What is the ratio of debt-to-equity (if any) that maximizes shareholder

value?
Financial Leverage and ROE
•Consider an all-equity firm that is contemplating raising debt (may be some existing
shareholders want to cash out)
•Assume – 0 taxes
Current Proposed
Assets Rs.20,000 Rs.20,000
Debt Rs.0 Rs.8,000
Equity Rs.20,000 Rs.12,000
Debt/Equity ratio 0 2/3
Interest rate n/a 8%
Shares outstanding 400 240
Share price Rs.50 Rs.50
The firm plans to borrow Rs.8,000 and buys back 160 shares at Rs.50
per share.
If EBIT is Rs. 2000, what is the current and new EPS and ROE?
EPS and ROE
Current Proposed
Expected Expected
EBIT Rs.2,000 Rs.2,000
Interest 0 640
Net income Rs.2,000 Rs.1,360
EPS Rs.5.00 Rs.5.67
ROE 10% 11.30%

Current Shares Proposed Shares

Outstanding = 400 Outstanding = 240
shares shares

• Does that mean increase in financial leverage will ALWAYS increase

EPS and ROE?
Different scenarios
Current Proposed
Recession Expected Expansion Recession Expected Expansion
EBIT Rs.1,000 Rs.2,000 Rs.3,000 Rs.1,000 Rs.2,000 Rs.3,000
Interest 0 0 0 640 640 640
Net income Rs.1,000 Rs.2,000 Rs.3,000 Rs.360 Rs.1,360 Rs.2,360
EPS Rs.2.50 Rs.5.00 Rs.7.50 Rs.1.50 Rs.5.67 Rs.9.83
ROE 5% 10% 15% 3.00% 11.30% 19.70%

Current Shares Outstanding = Proposed Shares Outstanding =

400 shares 240 shares

To sum up - Effect of leverage depends on company’s income

(similar example – Kavita Spot removers – Brealey and Myers, Ch. 17)
Borrowing and EPS
•Borrowing increases EPS above a certain level of income (Effect of leverage depends on
company’s income), but does it increase share price or firm value?
• Modigliani Miller theorems
• Trade-off Theory
Effect of Financial Leverage on
Competitive Tax-free Economy
•Modigliani & Miller: Capital structure is irrelevant in determining firm value
• Value is independent of the debt ratio

•Assumptions
• No taxes*, No bankruptcy costs*, Companies and investors can borrow/lend at the same rate, no
information asymmetry, EBIT not affected by the use of debt, Frictionless markets – no transaction
costs, and others

•When firm pays no taxes and capital markets function well, no difference if firm borrows or
individual shareholders borrow
• Investor can create a levered or unlevered position by adjusting the trading in their own account –
Homemade leverage
*Capital structure, therefore, does not affect cash flows.
Recall the earlier example
An all-equity firm, with no debt:

Current Proposed
Assets Rs.20,000 Rs.20,000
Debt Rs.0 Rs.8,000
Equity Rs.20,000 Rs.12,000
Debt/Equity ratio 0 2/3
Interest rate n/a 8%
Shares outstanding 400 240
Share price Rs.50 Rs.50

The company is proposing a new capital structure such Debt is 40% in total capital and equity is
60%.
An investor can create the same leverage, substitute personal leverage for company’s leverage
The investor can buy 10% of company (unlevered) – can buy 40 shares of a Rs.50 stock
Of the total funds required, Rs. 2000, he borrows 40%, that is – he take Rs.800 loan
 Homemade Leverage
Expected
EPS of Unlevered Firm Rs.5.00
Earnings for 40 shares Rs.200
Less interest on Rs.800 (8%) Rs.64
Net Profits Rs.136
ROE (Net Profits / Rs.1,200) 11.30%

Investor can buy 40 shares of a Rs.50 stock, using Rs.800 in

loan.
She gets the same ROE as if she bought into a levered firm.
Investor’s personal debt-equity ratio is: 800/1200 = 2/3
MM Propositions I & II (Without Taxes)

Proposition I (without Corporate Taxes)

◦ Value of a levered firm is equal to the value of an unlevered firm
VL = VU
Proposition II (without Corporate Taxes)
◦ Ka (WACC) is constant, cost of equity (Ke ) increases with the increase in financial leverage.
Capital Structure Decisions

Static Trade-off
Benefit from Tax
Theory: Bankruptcy Pecking Order
Deductibility of
Costs and Costs of Hypothesis
Interest
Financial Distress
MM Propositions I & II (With Taxes)

Proposition I (with Corporate Taxes)

◦ Firm value increases with leverage
VL = VU + Present value of tax shields

• To note: if debt level (dollar value) is constant then, VL = VU + D*t

Tax Effects
Value of firm (V) Value of firm under
MM with corporate
Present value of tax taxes and debt
shield on debt
VL = VU + D*t

Maximum
firm value
V = Actual value of firm
VU = Value of firm with no debt

0 Debt (B)

Optimal amount of debt

The Effect of Financial Leverage
Cost of capital: R
(%)

WACC = Kd × (D/V) ×(1-TC) + Ke × (E/V)

Kd

Debt-to-equity
ratio (B/S)
Implications of Benefits associated with Taxes
•WACC reduces as more debt is used
•As WACC reduces, firm value increases (if all other factors are
held constant) G

B
•Does this mean the optimal capital structure is 99.99% debt?
Capital Structure Decisions

Static Trade-off
MM
Benefit from Tax Theory:
Propositions: Pecking Order
Deductibility of Bankruptcy Costs
Capital Structure Hypothesis
Interest and Costs of
Irrelevance
Financial Distress
Costs of Financial Distress
Financial Distress Costs

Financial distress includes failure to pay interest or principal or both

◦ Occurs when promises to creditors are broken or honored with difficulty.

Direct Costs of Bankruptcy - Legal and administrative costs

Cost of Financial Distress
◦ Costs arising from bankruptcy or distorted business decisions before bankruptcy

Indirect Costs - Impaired ability to conduct business

◦ Example: lost sales, inability to negotiate long-term supply contracts, loss of credibility
Tax Effects and Financial Distress
•Trade-off Theory of Capital Structure
• There is a trade-off between the tax advantage of debt and the costs of financial distress.
Value of the Firm when Costs of Financial
Distress are considered
•Value of firm = value if all-equity financed + PV(tax shield) - PV(costs of financial
distress)
Reference
Brealey, R. A., Myers, S. C., Allen, F., & Mohanty, P. (2015). Principles of corporate finance. Tata
McGraw-Hill Education. Referred to as BM hereafter.
◦ BM: Ch 17 & 18