CF Session 10 - Capital Structure

Avijit Bansal
Indian Institute of Management Calcutta

January 25, 2023

1
Story so far

We have discussed
How to value a company using FCF method

How to estimate the risk-adjusted returns/WACC/hurdle rate for a company

How WACC depends on debt and equity

But how do companies decide on the level of debt?

2
What are the implications of taking debt?

Advantages Disadvantages

Interest expenses are tax deductible May create financial distress (bankruptcy)

Tax savings increases the value of the firm Lenders impose covenants

With debt, managers may become more disciplined Lower flexibility to make new investments

Managers have to consider both the advantages and disadvantages of debt

Take a decision to settle on the capital structure which maximizes the value of
the equity investors

3
Modigliani-Miller (M-M) propositions
Efficient and frictionless world: Capital structure is irrelevant

In an efficient and frictionless world, M-M proved that capital structure is

irrelevant

Value of a firm remins unaffected by the choice of debt versus equity

What were the assumptions of M-M

No taxes (Most important assumption)

No transaction cost, agency cost or bankruptcy cost

Borrowing cost for individuals and firms is same

No arbitrage opportunity in the market

No information asymmetry

4
M-M: Proposition 1
Assume two firms with identical assets but different capital structure

Assume buying p% of unlevered firm’s equity (VU ) and p% of levered firm’s

equity (VL ) and debt (DL ) (providing both debt and equity)

Firm Holding Payoff

1 Unlevered Firm p × VU p × EBIT

2 Levered Firm p × EL Equity = p × (EBIT − Interest)

p × DL Debt = p × Interest

Net = p × EBIT

Leverage only creates a partition in cash flows without impacting firm value

One can also borrow p × DL and invest in p × VU and get the same payoff.
This is also called home-made leverage

5
Home-made leverage

VU VL Home-made leverage in VU
Assets 2000 2000 Investment (10% stake) 200
Equity 2000 1000 Own investment 100
Debt 0 1000 Loan 100
rD 10% rD 10%
Taxes 0% 0% Taxes 0%
EBIT 400 400 EBIT 40
Less: Interest 0 100 Interest paid 10
PAT 400 300 Profit net of interest 30
ROE 20% 30% ROE 30%

Investing in a levered firm or creating home-made leverage are equivalent

Taking on leverage enhances the ROE. Why?

Equity investors bear higher risk when a company takes on leverage

6
M-M: Proposition 2

Leverage has no impact on operating income, firm value, and risk of assets (RA )

Leverage does not change the overall risk of a firm, only reallocates it across
equity and debt holders

E D
RA = RE × + RD ×
V V
D
RE = RA + (RA − RD ) ×
E

Expected return of equity investors of a levered firm increases in proportion to

debt-to-equity ratio, expressed in market value term

7
M-M and beta

βA will be the same as the equity beta for a firm fully funded with equity
As a result,
E D
βA = βE × + βD ×
V V
Or,
D
βE = βA + (βA − βD ) ×
E

8
Summary and implications of M-M propositions

Financial leverage has no impact on the cashflow or the risk of the firm. As a
result, the market value of a firm remains unimpacted

Debt increases the risk for the shareholders and they get compensated for that
by higher expected returns on their equity investment (redistribution of risk)

Since capital structure is irrelevant, security type within debt and equity are
also irrelevant

9
Introducing taxes
Assume a perpetual firm with constant debt
Table: Tax savings using debt

Table: Firm details

All equity 50% leverage
RA 20% EBIT 400 400
RD 10% Interest 0 100
Tax rate 25% PBT 400 300
EBIT 400 Tax 100 75
PAT 300 225

Table: Tax shelter and firm value

VU 1500 300 at 20%

Tax shelter 25 Interest × tax
Discounting rate 10% Cost of debt
PV (ITS) 250 ITS at cost of debt
VL 1750 VL = VU + PV (ITS)

We have assumed constant debt hence tax saving is discounted at RD

D
If firm maintains constant ratio, the tax saving will be discounted at RA
V 10
Implications of taxes

Higher the debt taken by firms, higher is the value of tax shield

Why do firms not have extremely high level of debt?

11
Impact of personal taxes

Let Tp be the personal tax rate (tax paid on interest income)

Let TpE be the effective personal tax on equity income

Let Tc be the corporate tax rate

$1 paid as interest $1 paid as equity income

Corporate tax None Tc
Income after corporate tax 1 1 − Tc
Personal Tax Tp TpE (1 − Tc )
Income after all taxes 1 − Tp (1 − TpE )(1 − Tc )

1 − Tp
Relative tax advantage =
(1 − TpE )(1 − Tc )

12
Taxes in India

Corporate tax rate 25%

Peak personal tax rate 33.9%
LTCG 10%

1 − Tp
Relative tax advantage =
(1 − TpE )(1 − Tc )

1 − 0.339 0.66
Relative tax advantage = =
(1 − 0.1)(1 − 0.25) 0.675

When this ratio is close to 1, the debt policy is irrelevant

13
Overall implications of debt

VL = VU + PV (ITS) − PV (Distress cost)

Distress costs include cost of bankruptcy (asset devaluation), loss of key

employees, customers

Bankruptcy costs can vary significantly based on the level of tangible assets of a
firm

If bankruptcy costs do not completely eat away the asset value and the business
assets are productive, then, why is a distressed firm unable to raise finance
successfully by financiers who want to take high risk?

14
Agency conflicts (over-investing): Distressed firm
A company is financed by debt of 1000 and equity of 200

Consider a distressed firm with a loan of 1000

Assets Liabilities
Assets 900 900 Debt

Consider a new project which requires investment of 900

Table: New investment payoffs Table: Impact on the value of debt/ equity

New Project Outcome Probability Outcome Debt Equity

Success 3600 20% Success 1000 2600
Failure 100 80% Failure 100 0
Expected 800
NPV -100 Expected Value 280 520

15
Agency conflicts (under-investing): Distressed firm

A company is financed by debt of 1000 and equity of 200

Consider a distressed firm with a loan of 1000

Assets Liabilities
Assets 900 900 Debt

Consider a new project which requires an investment of 1000

This would require equity holders to put invest an additional 100

Table: New investment payoffs Table: Impact on the value of debt/ equity

New Project Outcome Probability Outcome Debt Equity

Success 1050 100% 1000 50
NPV 50 Expected Value 1000 50

16
Agency costs of debt

Converting the cash into a risky asset takes away value from the bondholders
and tilts the value in favour of the shareholders

Equity holders may be inclined to invest in a negative NPV project at the

expense of the shareholders if they think they are recoup their losses. They will
not be interested in investing in a safe project with NPV of 50

Cash and run - dividend

Playing for time (appears to be more prospective than the firm truly is)

17
Agency benefits of debt

While leverage creates agency incentives for managers, it also helps to reduce some of
them such as:
Controlling wasteful investments

Restrictive debt covenants

Hence there is a trade-off:

VL = VU + PV (ITS) − PV (Distress Cost) − PV (Agency cost) + PV (Agency benefits)

18
Theories and evidence: Trade-off theory

Given the costs of financial distress and bankruptcy, the capital structure decision
involves trade-off between PV of ITS and the costs of distress. The theory implies
that:
Profitable firms with substantial tangible assets would use more of debt

Less profitable and risky business firms would use more of equity

Explains the inter-industry differences in capital structure

But can’t explain why so many successful firms use too little debt

Or why debt ratios wary not significantly across countries with different tax
rates

19
Information asymmetry
Managers know more than shareholders

Given that the outside shareholders cannot reliably observe the fundamental
information related to the firm, they have reason to suspect that managers
issue equity, when it is overpriced.

Hence, the equity issue announcement is often associated with a decline in the
market price.

Announcement of increase in regular dividends is met with a positive reaction

as the investors think that managers are confident about future earnings

Buyback is usually followed by an increase in the share price

20
Pecking order

Managers know more about the firm than shareholders which leads to
information asymmetry

Managerial actions can significantly impact the prices (issuances, buyback,

dividend increases)
To reduce impact of information asymmetry, managers have a following hierarchy of
financing sources
Retained earnings

Debt

Equity

This preference is formally called the Pecking order hypothesis.

21
Implications of pecking order theory

Firms prefer internal finance

Maintain sticky dividend policies. Excess cash is preserved

External financing mostly with debt

Highly profitable firms would run down debt, and less profitable ones borrow
more

Pecking theory explains why profitable firms borrow less and the inverse Intra-industry
relation between profitability and leverage.

Pecking order theory states that firms value financial flexibility and financial
slack more

Pecking Order assumes that the tax advantage of debt is secondary

22
Financial flexibility

Firms lose financial flexibility with higher leverage

The presence of many zero-debt firms can be related to the value of financial
flexibility attached by these firms. Such firms include ABB, Siemens, GSK, ICI,
3M, Infosys, TCS, Google, and Apple.

These firms are cash rich and mostly in high-growth industries. This allows
them to retain more of the cashflows. Their investment decisions need not be
linked to the availability of finance from the market.

Flexibility allows firms to pursue investments irrespective of market conditions

Higher leverage allows PV(ITS) but also reduces options for future funding

23
Financial Slack

Slack refers to having excess cash, readily saleable investments, having the
capacity to borrow additional capital but not doing so

Such firms realize that the value of a firm primarily comes from undertaking
sound capital investment and operational decisions

A bad project won’t become worthwhile if the source of financing is changed

The value of financial slack became apparent during the Covid crisis. The firms
with financial slack were able to deal with the covid shock better than those
with high leverage.

Note: Too much financial slack can also create perverse incentives. For
example, top management attending leadership seminars in exotic locations
such as Miami and the Bahamas.

Glamorous corporate lifestyle of senior management funded by money which can

be returned to shareholders or used to retire debt

24
References I

25