Capital Structure in Perfect Markets

Professor Pavle Radicevic

PhD UNSW, Sydney
Capital Structure
• How are projects and firms financed? This choice
determines the capital structure.

• Capital structure is
– mix of types of securities issued by the firm
– mix of claims that investors have on the firm’s cash flows

• Why is it important?
– Capital structure affects the cost of capital, i.e. the discount rate
which we use in valuation
– Hence, optimal capital structure is the one that minimizes the
cost of capital (i.e. maximize the market value of the firm)

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Plan for Capital Structure part

• Sources of long-term finance

• Capital structure in a perfect market
• Effect of taxes and costs of financial distress
• (time permitting) Effect of information asymmetries and
agency costs
• Valuation with leverage

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Sources of Long-term finance

• Internal financing (retained earnings)

– But firms often spend more than they generate internally. The
deficit is financed by new issues of debt & equity
• Types of instruments
– Equity
– Debt

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Equity

• Can be publicly traded or not

• Types:
– Common Stock – claim on the share of profits (after tax and
payments to creditors)
• may have different voting rights
– Preferred Stock – paid after tax and payment to creditors too,
but is normally a fixed claim (similarity to debt)
• No voting rights in normal times
• Dividend is paid before dividend on common stock
– Warrants
• Call options on a firm’s shares
• No voting rights until converted into shares

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Debt

• Can be publicly traded or not

• Fixed claim (not a share of profits!)
• Interest payments occur before payments to preferred and
common stockholders and before taxes, i.e. tax deductible
• No control (voting) rights in normal times
• Control rights in case of default
• Can be convertible into stock

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Debt

• Debt differs by
– Maturity
– Security (for bonds)
• secured (by an asset)
– Mortgage bonds, collateral bonds
• unsecured ordinary
– Debentures – “Backed” by the earning power of the firm, no collateral
• unsecured subordinated
– Subordinated debt (Least protected. Holders of such bonds are paid after
all other creditors)
• Note: any debt is senior to equity

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Financing patterns

• In the US, on average, 60-80% of the investment

expenditures is financed with internal funds! In other
countries reliance on internal funds is generally lower but
still 40-60%.
• New sales of debt strongly prevail over new equity issues.
• Large variations between types of firms and industries (e.g.
for startups equity financing strongly prevails).
• Capital structure: in the US, average debt-to-value ratio is
0.2-0.3 (roughly). Large variations between industries: from
~0.1 in biotech to ~0.7 in for car manufacturers.

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To start thinking about capital structure

• You (entrepreneur) are considering an investment opportunity.

– For an initial investment of $800 this year, the project will
generate cash flows of either $1400 or $900 next year,
depending on whether the economy is strong or weak,
respectively. Both scenarios are equally likely.
• The project cash flows depend on the overall economy and thus
contain market risk. As a result, investors demand a 10% risk
premium over the current risk-free interest rate of 5% to invest
in this project.
• What is the NPV of this investment opportunity?
• If you finance this project using only equity, how much would
investors be willing to pay for this equity?

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Financing a Firm with Equity

• Unlevered Equity
– Equity in a firm with no debt
• Because there is no debt, the cash flows of the
unlevered equity are equal to those of the project.
– PV(equity cash flows)=$1150/1.15=$1000
• Risk of unlevered equity = risk of the project.
• Shareholders earn an appropriate return for the risk
they take, so that the expected return equals to the cost
of capital: 0.5*40%+0.5*(-10%)=15%
• Entrepreneur raises $1000 by selling equity, pays
investment cost of $800 and pockets $200 (NPV) as
profit.

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Financing a Firm with Debt and Equity

• Suppose you decide to borrow $500 initially, in addition

to selling equity.
– Because the project’s cash flow will always be enough to repay the
debt, the debt is risk free and you can borrow at the risk-free
interest rate of 5%.
• Levered Equity
– Equity in a firm with debt outstanding

• What price E should the levered equity sell for?

• Which is the best capital structure choice for
the entrepreneur?

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Financing a Firm with Debt and Equity

• Modigliani and Miller argued that with perfect capital markets,

the total value of a firm should not depend on its capital
structure.
– They reasoned that the firm’s total cash flows still equal the
cash flows of the project ($1400 or $900), and therefore have
the same present value ($1000).

• Because the cash flows of the debt and equity sum to the
cash flows of the project, by the Law of One Price the
combined values of debt and equity must equal the PV of
the future cash flows!

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Financing a Firm with Debt and Equity

• Thus, levered equity must sell for PV(project cash

flows) – MV(debt)=$1000-$500=$500.

• Note that entrepreneur is indifferent between the two

capital structures:
– Even though equity is less valuable, he can still raise $1000 by
issuing debt and equity and enjoy a profit of $200.

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The Effect of Leverage on Risk and Return

• Since firm can borrow at risk-free rate, it will owe:

$500*1.05=$525 in one year.

• Levered equity receives either $875 or $375, or

0.5*$875+0.5*$375=$625 in expectation.

• Levered equity is riskier: its return is either

+75% or -25%.

• To compensate for risk, levered equity holder receive a

higher expected return of 0.5*75%+0.5*(-25%)=25%.

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Systematic Risk and Risk Premiums

Levered equity in this example has twice the systematic risk of the
unlevered equity, so equity holders receive twice the risk premium.

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Question for self-assessment
Suppose the return on the market portfolio is either X% when
the economy is strong, or Y% when the economy is weak.

Calculate b of levered and unlevered equity. Is there twice as

more systematic risk in the levered equity?

Then do it for an arbitrary amount of debt.

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The Effect of Leverage on Risk and Return

• Leverage increases the risk of the equity of a firm, even

when there is no risk that the firm will default.
– Therefore, it is inappropriate to discount the cash flows of levered
equity at the same discount rate as the unlevered equity.

• Debt can appear to be “cheaper”, but in raises the equity cost of

capital
– Both sources of capital together receive on average:
0.5*5%+0.5*25%=15%, same cost of capital as for the unlevered
firm.

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Firm (market) value:
Assets
Value of cash flows from firm’s
real assets and operations
Value of firm
Liabilities and Stockholder’s Equity
Market value of debt
Market value of equity
Value of firm

• Firm’s cash flows determine the value of the firm, and

therefore the aggregate value of all outstanding debt and
equity.

• Firm value: V = D + E
where D – market value of debt, E – market value of equity

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Pie model of the firm

F D
E D
E

V
default
The Capital Structure decision is about how to best slice up the pie.
As long as D is fixed, maximizing E is equivalent to maximizing the whole
pie (i.e. the total firm value).
If how you slice the pie does not affect the size of the pie, then the capital
structure decision is irrelevant.
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Modigliani-Miller Proposition I

In a perfect capital market a firm’s total market value is equal to

the market value of the total cash flows generated by its
assets and is independent of its capital structure:
A=U=E+D
A – market value of assets (that generate cash flows),
U – market value of unlevered equity,
E – market value of levered equity,
D – market value of debt.

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Perfect capital market assumptions
1. Future cash flows from assets are unaffected by
capital structure
No taxes
No costs of financial distress
The firms' financing and operating decisions are
independent. In particular, no agency costs.
2. Financing decisions do not reveal new information
No asymmetries of information between managers and the
market
3. No transaction and issuance costs
4. Investors and firms can trade the same set of
securities at competitive market prices equal to the
present value of their future cash flows.

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Proof of MM I by arbitrage argument
• Consider firm 1 and firm 2.
• At t=1,2..., both firms get same (random) earnings (EBIT) X >
0.

• But they differ in their capital structure:

– Firm 1 has equity and debt (risk-free and perpetual for simplicity)
– Firm 2 has no debt (unlevered firm)
• Firm 1 pays annual interest rf, which is equal to the risk-free rate.

• Market value of firm i's debt: Di

• Market value of firm i's equity: Ei
• Market value of firm i: Ui = Ei + Di
• Hence, at t:
– firm 1's debtholders receive: rf D1
– firm 1's equityholders receive: X- rf D1
– firm 2's equityholders receive: X

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Step 1: It cannot be that U2>U1

• Suppose U2>U1 and consider an investor holding a

fraction α of firm 2's shares. At t, he would receive αX.
• Instead, he could:
– Sell the shares for αU2
– Buy a fraction αU2/U1 of firm 1's debt and equity:
(αU2/U1)⋅D1+(αU2/U1)⋅E1= (αU2/U1)U1 = αU2
– At t, the investor would receive:
(αU2/U1)⋅rf D1 + (αU2/U1)⋅(X- rf D1) = (αU2/U1)⋅X > αX
• Hence, there is an arbitrage opportunity.
• Intuition: Arbitrageurs can "undo firm 1's leverage" by buying its debt
and equity in proportions such that interest paid and received cancel.

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Step 2: It cannot be that U1>U2

• Suppose U1>U2 and consider an investor holding a

fraction α of firm 1's shares. At t, he would receive α
(X- rfD1).
• Instead, he could:
– Sell the shares for αE1
– Borrow αD1
– Invest the total in a fraction α(U1/U2) of firm 2's shares:
α(U1/U2)⋅U2 = αE1+αD1
– At t, the investor would get α(U1/U2)⋅X and pay interest
αrfD1: α(U1/U2)⋅X - αrfD1 > α(X- rf D1)
• Hence, there is an arbitrage opportunity.
• Intuition: Arbitrageurs can "lever up" firm 2 by borrowing on
individual accounts (homemade leverage).

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Homemade Leverage

• MM demonstrated that if investors would prefer an

alternative capital structure to the one the firm has
chosen, investors can borrow or lend on their own and
achieve the same result (i.e. use homemade leverage).
– To decrease leverage they can buy both bonds and stocks or the
company
– To increase leverage they can borrow, using equity as a collateral

• With perfect capital markets, different choices of capital structure

offer no benefit to investors and do not affect the value of the firm.

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Conclusion
• In a perfect market you should be indifferent between
financing your project/firm by internal funds, issuing
equity, or issuing debt.
– Assume the project requires investment A and delivers V in
present value of future cash flows
– V is the same regardless of the capital structure (MM I)
– If you finance internally you get V-A
– If you raise A by issuing equity, in a perfect market you need
to sell the share such that the value of this share for investors
is A, i.e. sell fraction A/V of your firm, and you will get (1-
A/V)V = V-A
– If you raise A by issuing debt, in a perfect market the present
value of the debt repayments (interest + principal) is A. So
you get again V-A

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Remark!

• MM I holds not only for a split into debt and equity, but for
any combination of any securities (e.g. debt + equity +
preferred equity + warrants)
– If it holds for these “straight” securities then it must also hold for
their combinations.

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Leveraged recapitalization
• Firm has 50 shares and has no debt.
• Shares are traded at p=$4. Hence, firm value is $200
• Management decides to borrow D=$80 at fair market
terms (i.e. so that the market value of the debt is $80)
and spend all of it on repurchasing its stock at price x.
• Questions:
– What will the stock price be after the announcement?
– What will the stock price be after the transaction?
– Do existing shareholders gain from this transaction?

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Leveraged recapitalization: Sequence of events
• Firm announces a recapitalization

• Investors reassess their views and estimate a new equity

value

• New debt is issued and proceeds are used to repurchase

stock at the new equilibrium price.

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Recapitalization
• z – stock price after recapitalization
• It must be that x ≥ z, otherwise nobody will participate in repurchase

• # of shares bought: 80/x. Remaining shares: 50-80/x

• The firm value does not change after the recapitalization (MM1).
Hence: (50-80/x)z + 80 = 200

• z = 120/(50-80/x) – for given x (≥ z), this is the price after repurchase

• If x = p = $4, then:
– z = $4 – if we repurchase at the pre-repurchase market price, post-
repurchase price will be equal to the pre-repurchase price
– # of shares repurchased = 80/4 = 20
– Every shareholder will be indifferent between selling and keeping his
shares
– Equity value falls after recapitalization to 120, but (!) shareholders neither
gain nor lose – regardless of whether you sell or keep your shares, you get
your $4 value.
– After-announcement stock price = $4
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Recapitalization

• What if x > z, say x = $8?

– 80/8 = 10 shares will be repurchased
– z = $120/(50-10)= $3
– All shareholders strictly prefer to sell their shares, but there
will be pro-rata rationing, as only 1/5 is for repurchase (i.e. if
you have 10 shares you’ll manage to sell only 2)
– If z = $3 < $4, does it mean that shareholders lose?
– No! Because they get $8 for shares that they manage to sell.
– Overall, per share, shareholders get 1/5*$8 + 4/5*$3 = $4 –
the same value as before!
– Hence, the after-announcement stock price = $4
• Conclusion: in MM world, shareholders neither gain nor lose from
leveraged capitalization. In general, in MM world, any zero-NPV
transaction neither hurts nor benefits shareholders.
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Each stage of the leveraged capitalization (if x =$4)
Initial After borrowing After share repurchase

Assets Liabilities Assets Liabilities Assets Liabilities

Cash Debt 80 Cash 0 Debt
Existing Equity 200 80 80
assets Equity 200 Existing
200 Existing assets Equity
assets 200 120
200
200 200 280 280 200 200

Shares outstanding 50 Shares outstanding 50 Shares outstanding 30

Stock price $4 Stock price $4 Stock price $4

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Side note: Read in your own time

• After leveraged recapitalization the stock price does not

change
• What about return on equity (cost of equity)?
• What about earnings per share?

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 Sidenote
• Suppose our firm still has value 200 and each period generates the same
expected EBIT = 20 in perpetuity, which is fully paid out as a dividend
• Assume EBIT = 5 or 35 with prob. =1/2
• Unlevered firm: equity value=200
– Net Income = EBIT = 5 or 35
– EPS: either 5/50 = 0.1 or 35/50 = 0.7
– Expected EPS: 20/50 = 0.4
– Realized return on equity: either 5/200 = 0.025 or 35/200 = 0.175
– Expected return on equity: 20/200 = 0.1
• Levered firm: equity value=120 and debt value=80
– Net Income = EBIT - interest = 1 or 31 (assuming interest rate 5%)
– EPS: either 1/30 = 0.033 < 0.1 or 31/30 = 1.03 > 0.7
– Expected EPS: 16/30 = 0.53 > 0.4
– Realized return on equity: either 1/120 = 0.0083 < 0.025 or 31/120 = 0.258 >
0.175
– Expected return on equity: 16/120 = 0.133 > 0.1
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Capital Structure Fallacy

• Both expected EPS and expected return on equity are higher

with leverage.
– Why? Because the risk of equity is higher!
– The same operating/business risk is absorbed by less equity,
so risk per share increases.

• This is sometimes used (incorrectly) as an argument that leverage

should also increase the firm’s stock price.
– However, the second effect completely offsets the first effect,
so that the share price does not increase as a result of
increasing leverage.

• Thus the argument “let’s increase leverage in order to increase

EPS” is flawed (in perfect markets): shareholders do not gain
from this, because their equity becomes riskier at the same time!
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Cost of Capital: External Financing
Cost of Capital from the point of view of the owner of
the project/firm
• In case of internal financing, the cost of capital is the
opportunity cost of not doing an investment of the
same risk in the market.
• In case of external financing, cost of capital is the return
you must deliver (in expectation) to investors for their
investment. Higher cost of capital translates into higher
“piece” of the project you have to “give” to investors in
exchange for financing.
For example:
– If you finance by selling equity, you would need to sell a
higher share
– If you finance by issuing debt, you will need to promise a
higher repayment (e.g., interest)
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Modigliani-Miller Proposition II: Leverage, Risk and COC

• Leverage and the Equity Cost of Capital

– MM’s first proposition can be used to derive an
explicit relationship between leverage and the equity cost of capital.
• Use the following notation
– E - Market value of equity in a levered firm.
– D - Market value of debt in a levered firm.
– U - Market value of equity in an unlevered firm.
– A - Market value of the firm’s assets.

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Modigliani-Miller Proposition II

– MM Proposition I states that: E  D  U  A

• The total market value of the firm’s securities is equal to the market value of
its assets, whether the firm is unlevered or levered.

– Realized return on a portfolio equals the weighted average of the

realized returns of the securities, so:

E D
RE  RD  RU
E  D E  D

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Modigliani-Miller Proposition II

– Solving for RE:

D
RE  RU  ( RU  RD )
Risk without
E
leverage Additional risk
due to leverage

– The levered equity return equals the unlevered return, plus a

premium due to leverage.
• The amount of the premium depends on the amount of leverage, measured
by the firm’s market value debt-equity ratio, D/E.

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Modigliani-Miller Proposition II

– Because the previous equation holds for realized returns, it holds

for expected returns as well.
– MM Proposition II (in perfect markets):
• The cost of capital of levered equity is equal to the cost of capital of unlevered equity plus a
premium that is proportional to the market value debt-equity ratio.
• Cost of Capital of Levered Equity

D
rE  rU  (rU  rD )
E

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Capital Budgeting and WACC

• If a firm is unlevered, all of the free cash

flows generated by its assets are paid out to
its equity holders.
– The market value, risk, and cost of capital for the firm’s assets and
its equity coincide and, therefore:

• Cost of capital for a project should equal the

return that is available on other investments of
similar risk.
rU  rA

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 Capital Budgeting and WACC
• If a firm is levered, project rA is equal to the
firm’s weighted average cost of capital.
– Weighted Average Cost of Capital (No Taxes)
 Fraction of Firm Value   Equity   Fraction of Firm Value   Debt 
rwacc          
 Financed by Equity   Cost of Capital   Financed by Debt   Cost of Capital 
E D
 rE  rD
E  D E  D

rwacc  rU  rA

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Capital Budgeting and WACC

With perfect capital markets, a

firm’s WACC is independent of
its capital structure and is
equal to its equity cost of
capital if it is unlevered, which
matches the cost of capital of
its assets.

As the fraction of the firm financed with debt increases, both the
equity and the debt become riskier and their cost of capital
rises. Yet, because more weight is put on the lower-cost debt,
the weighted average cost of capital remains constant.
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Levered and Unlevered Betas

• The effect of leverage on the risk of a firm’s securities can also

be expressed in terms of beta.
• Beta of the portfolio is the weighted average of betas of the
securities within it, so: E D
bU  bE  bD
E  D E  D

• Unlevered Beta
– A measure of the risk of a firm as if it did not
have leverage, which is equivalent to the beta of the firm’s
assets.
• If you are trying to estimate the unlevered beta for an investment
project, you should base your estimate on the unlevered betas of
firms with comparable investments.

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(in perfect markets)

• If debt is risk-free: bD = 0
D
b E  bU  ( bU  b D )
E
• Leverage amplifies the market risk of a firm’s assets, βU,
raising the market risk of its equity.

D D
b E  bU  bU  (1  ) bU
E E

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Cash and Net Debt

• Holding cash has the opposite effect of leverage on risk

and return and can be viewed as equivalent to negative
debt

Net Debt = Debt – Excess Cash and Risk-Free Securities

• Enterprise value = Equity + Debt – Excess Cash and

Risk-Free Securities.

• Net debt is used in computing WACC and unlevered

beta.

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Equity Issuances and Dilution in perfect markets

• Dilution - an increase in the total of shares that will divide a fixed

amount of earnings.
• It is sometimes (incorrectly) argued that issuing equity will dilute
existing shareholders’ ownership, so debt financing should be
used instead.
• As long as the firm sells the new shares of equity at a fair price,
there will be no gain or loss to shareholders associated with the
equity issue itself (higher number of shares will get a higher total
value as assets increase by the amount raised).
• Any gain or loss associated with the transaction will result from
the NPV of the investments the firm makes with the funds
raised.

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Key things to remember (Perfect markets)
• Capital structure is irrelevant for firm value.
• In particular, cost of capital (WACC) does not depend on
capital structure.
• Required return on equity (cost of equity) and EPS increase
with leverage, because equity becomes riskier.
• Shareholders neither gain nor lose from changes in leverage.

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