CAPITAL STRUCTURE

Learning Objectives

• The Cost of Equity

• The Cost of Debt

• The Company Cost of Capital

• The Asset Cost of Capital

• Capital Structure

• The Tax Benefits of Debt

 What is Capital Structure?

Capital Structure is the mix of financial claims to a stream

of cash flows.
– We’ll call such streams “projects” or “firms”, depending on
the application.

Here we will focus mostly on two “generic claims”: Debt

and Equity.

The proportion of debt in the capital structure is called

leverage.
 The Company Cost of Capital

• Investors demand a risk premium to compensate them

for the risk they are taking. The risk, and so the risk
premium, varies by security.

• The company’s overall cost of capital is the weighted-

average cost of all sources of funding. It reflects the risk
of the overall business which is the combined risk of the
firm’s equity and debt.
 The Company Cost of Capital

The Company Cost of Capital is the expected return on a

portfolio of all the company’s existing securities.

For example, if ! is the market value of the company’s

equity, and " is the market value of the company’s debt,
the company cost of capital (aka pre-tax weighted-average
cost of capital) is

# %
&# + &%
#+% #+%

%age of equity financing %age of debt financing

 The Company Cost of Capital
• !" is the equity cost of capital.
– The rate of return that the equity-holders expect to
receive.
– The Capital Asset Pricing Model (CAPM) is a practical way
to estimate it.

• !# is the debt cost of capital.

– The rate of return that the debt-holders expect to receive.
– If there is little risk the firm will default, the YTM is a
reasonable estimate of investors’ expected rate of return.
– If there is significant risk of default, YTM will overstate
investors’ expected return.
 Firm’s Assets
A firm is considering the following project:

Date 0 Date 1
Strong Economy Weak Economy
(%&'( = 0.5) (%&'( = 0.5)
−800 1400 900

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 project?
 NPV of Project
• The cost of capital for this project is:

!" + $%&' (!)*%+* = 5% + 10% = 15%

• The expected cash flow in one year is:

1 1
1400 + 900 = $1150
2 2
• The NPV of the project is:

1150
5(6 = −800 + = −800 + 1000 = $ 200
1.15
 Case 1 : All-equity Financing
Suppose the firm finances this project only by issuing equity (no debt).
How much would investors be willing to pay for all of the firm’s shares?

– The equity in a firm with no debt is called unlevered equity.

– The cash flows of the unlevered equity are equal to those of the
project. The value of the unlevered equity is therefore:

1150
!" #$%&'( )*+ℎ -./0+ = = $ 1000
1.15

– So the firm can raise $1000 by selling equity, pay the investment
cost of $800, and keep the remaining $200, the NPV of the
project, as a profit.
 Case 1 : All-equity Financing
What is the expected return on the unlevered equity? What is the
volatility of the return?
Date 0 Date 1 Return
Strong Weak Strong Weak +[-] /01[-]
Unlevered Equity 1000 1400 900 40% −10% 15% 25%

• The expected return on the unlevered equity is:

1 1
40% + −10% = 15%
2 2

• The volatility of the return on the unlevered equity is:

1 *
1 *
40% − 15% + −10% − 15% = 25%
2 2
 Case 2 : Financing with Debt and Equity
• Suppose instead the firm raises $500 by issuing debt and $500 by
issuing equity.

– The equity in a firm that also has debt outstanding is called

levered equity.
– Note that the promised payments to the bond-holders must be
made before any payments to the equity-holders.
– Because the project’s cash flow will always be enough to repay
the debt, the debt is risk-free and the firm can borrow at the risk-
free interest rate of 5%.
– What are the cash flows of the debt and the levered equity?
 Case 2 : Financing with Debt and Equity
Date 0 Date 1
Strong Weak
Debt 500 525 525
Levered Equity /=? 875 375
Firm 1000 1400 900

• Given the firm’s (500 ∗ 1.05 =) $525 debt obligation, shareholders

will receive only $875 ($1400 – $525 = $875) if the economy is
strong and $375 ($900 – $525 = $375) if the economy is weak.
• What price / should the levered equity sell for?
0.1234150.12641
• Should it be / = = 543?
7571%
 Case 2 : Financing with Debt and Equity
Date 0 Date 1 Return
Strong Weak Strong Weak )[6] 89:[6]
Debt 500 525 525 5% 5% 5% 0%
Levered Equity 500 875 375 75% −25% 25% 50%
Unlevered equity 1000 1400 900 40% −10% 15% 25%

• Adding leverage doubles the risk of equity: The safest cash flows go to
the debt holders, so the volatility of the returns increases.
• The expected return on the levered equity is:
1 1
75% + −25% = 25%
2 2
*.,-./,0*.,-1/,
• So the value of levered equity is: ) = = 500.
203,%
Effect of Leverage on the Company Cost of Capital
• What is the effect of capital structure on the company’s cost of capital?

– Cost of capital of the all-equity firm:

! #
$% + $& = 1 ) 15% + 0 ) 5% = 15%
!+# !+#

– Cost of capital of the levered firm:

! # 1 1
$% + $& = ) 25% + ) 5% = 15%
!+# !+# 2 2

• Changing the capital structure (i.e., the proportion of debt and equity)
did not affect the company cost of capital!
 Some General Lessons
1. Adding leverage increases the risk and required return of equity, even
when there is no risk that the firm will default:
– Debt is paid first, and thus has no (or little) risk.
– Equity has “more concentrated” risk.

2. Adding leverage does not change the firm’s cost of capital.

– Even though debt is “cheaper”, the cost of equity goes up by enough
to eliminate any benefit!

3. Adding leverage does not change the total value of the firm
! "#$%&%'%( = ! *%+, + ! ./01,2

Modigliani - Miller (M&M) Theorem (1958)

 Modigliani Miller Proposition

• Modigliani-Miller Proposition I (1958). Under a set of conditions

referred to as perfect capital markets, the total value of a firm is equal
to the market value of the total cash flows generated by its assets and
is not affected by its choice of capital structure.
 Perfect capital markets means….

• No taxes.

• No asymmetric information or differences of opinion.

• No transaction costs.

• No costs of financial distress.

• Individuals and firms can borrow and lend at the same

interest rate.
 Modigliani Miller I

All equity firm Levered firm

! = # = 1000 ! &

! + & = # = 1000

The size of the pie does not depend on how we share it!
 Modigliani Miller II
• MM’s first proposition says that 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.
!=# =$+&
• Hence, the expected return on the company’s assets (asset cost of
capital or unlevered cost of capital) is equal to the company cost of
capital (pre-tax WACC)
$ &
'( = ') = '* + '+ = ',(--
$+& $+&

• Solving for '$ , we get:

&
'* = ') + ' − '+
$ )
Premium due to leverage
 Modigliani Miller II

• Modigliani Miller Proposition II: The cost of capital of levered equity is

equal to the unlevered cost of capital plus a premium that is
proportional to the market value debt-equity ratio.

&
!" = !$ + !$ − !)
'
 Previous Example
Recall from before:
• If the firm is all-equity financed, the expected return on
unlevered equity is 15%.
• If the firm is financed with $500 of debt, the expected
return of the debt is 5%.
• According to MM Proposition II, the expected return on
equity for the levered firm is

500
&' = 15% + 15% − 5% = 25%
500
Modigliani Miller & pre-tax WACC
 Modigliani Miller & WACC
• With no debt, the (pre-tax) WACC is equal to the unlevered equity
cost of capital (15%).
• As the firm borrows at the low cost of capital for debt, its equity
cost of capital rises even if there is no risk of default (i.e. for low
levels of debt). The net effect is that the firm’s WACC is unchanged.
• As leverage increases more and more, the debt becomes more risky
because there is a chance that the firm will default, so the debt cost
of capital rises as well.
• With 100% debt, the debt would be as risky as the asset’s
themselves (similar to unlevered equity).
• Even though both equity cost of capital and the debt cost of capital
increase when leverage is high, because more weight is put on the
lower-cost debt, the (pre-tax) WACC remains constant.
 The Cost of Capital Fallacy

You have been hired by a start-up entrepreneur to advise her

on capital structure decisions. One day she puts forward this
argument to you:

• I have estimated that the cost of equity for my firm is 15%.

• The return on riskless debt is 5%.
• As debt is “cheaper” than equity, I should lever up my firm
to reduce its cost of capital.

What do you answer?

 The EPS Fallacy

“Debt is desirable when it increases earnings per share

(EPS)”

EPS can go up (or down) when a company increases its

leverage. (True)

Companies should choose their financial policy to maximize

their EPS. (False)
 The EPS Fallacy - Example
• LVI is currently an all-equity firm.
• It expects to generate earnings before interest and taxes
(EBIT) of $10 million over the next year.
• It has 10 million shares outstanding, and its stock is trading for
a price of $7.50 per share.
• LVI is considering changing its capital structure by borrowing
$15 million at an interest rate of 8% and using the proceeds to
repurchase (i.e., buy back) 2 million shares at the current
market price ($7.50).
 From EBIT to EPS

Suppose initially that LVI is fully financed with equity (no

debt). Since there is no interest and no taxes, LVI’s earnings
would equal its EBIT and LVI’s earnings per share without
leverage would be:
 The EPS Fallacy - Example
• If LVI recapitalizes, the new debt will obligate LVI to make
interest payments each year of
$15 million × 8% = $1.2 million
• As a result, LVI will have expected earnings after interest of
$10 million – $1.2 million = $8.8 million.
• Earnings per share rises to
$8.8 million ÷ $8 million shares = $1.10

• LVI’s expected earnings per share increases with leverage.

 The EPS Fallacy - Example
Are shareholders better off?

NO! Although LVI’s expected EPS rises with leverage, the

risk of its EPS also increases.

While EPS increases on average, this increase is necessary

to compensate shareholders for the additional risk they are
taking, so LVI’s share price does not increase as a result of
the transaction.
The EPS Fallacy - Example
 Takeaways

• The Modigliani-Miller Theorem: In a world without

frictions, the value of a firm is independent of its capital
structure (i.e., its mix of debt and equity).

• In such a world, firm value is created only by the asset

side of the balance sheet.

• Firms can change EPS by changing capital structure, even

when capital structure is irrelevant for value. Thus EPS is
not a useful performance metric.
CAPITAL STRUCTURE: DEBT AND
TAXES
 Financial Policy “Irrelevance”
• In general, M&M implies that corporate financial policy is
irrelevant to firm value.
– Capital structure does not affect the amount of capital the
firm can raise.

• Critical Assumption: Perfect Capital Markets.

• Key Insight: To create value through financial policy, one needs to

identify a “market imperfection” that can affect cash flows.
 Leverage and Taxes
• In a less than perfect world, capital structure matters
because it affects a firm’s tax bill.

For a corporation (typically):

– Interest payments are considered a business expense,
and are tax exempt for the firm.
– Can leverage be used to reduce the taxes that the firm
must pay, and thereby increase its value?
 Gain from Leverage
• Two identical firms: ! and ", except that
– Firm ! has no debt, while " has borrowed $2000 at 10%.
– Firm "'s debt is perpetual.
• The income statements of the firms, which continue in
perpetuity:
Firm U Firm L
EBIT $1000 $1000
Interest Paid to Debt $0 $200
Holders
Taxable Income $1000 $800
Tax at 30% $300 $240

Net Income to Equity $700 $560

 Gain from Leverage
• With vs. Without Leverage
– Net Income of levered firm is lower than that of unlevered firm.
– But, the total amount available to all investors is higher in the
levered firm.
Income available to equity holders $700 $560
Income available to debt holders $0 $200
Total available to all investors $700 $760

– The levered firm is able to pay out $60 million more than the
unlevered firm to its investors. Where does this gain come
from?
– Interest payments in levered firms shield some income from
taxation!
 MM with taxes: Core intuition

Define the “size of the pie” = Value of before-tax cash flows.

MM say: The size of the pie is unaffected by capital structure.

But, with taxation, the government gets a slice too. The firm’s
choice of capital structure affects the size of that slice.

Interest payments being tax deductible, the value of the

government’s slice can be reduced by using debt rather than
equity.
 “Pie” Theory

Equity Debt

Taxes
 Valuing the Interest Tax Shield

• When a firm uses debt, the interest tax shield provides a

corporate tax benefit each year
æ Cash Flows to Investors ö æ Cash Flows to Investors ö
ç ÷ = ç ÷ + (Interest Tax Shield)
è with Leverage ø è without Leverage ø

39
 Modigliani Miller Proposition I with Taxes

• Modigliani-Miller Proposition I with Taxes. The total value of

the levered firm exceeds the value of the firm without
leverage due to the present value of the tax savings from
debt.
!" = !$ + &!(()*+,+-* ./0 1ℎ3+45)
 The Interest Tax Shield
Which rate should we use to discount the tax shields?

What is the risk of the tax shields?

Is it possible for the tax shields to fluctuate?

– Risky debt: you don’t get tax shields if you default.
– Changing interest payments: If debt keeps changing in the
future, interest payments will fluctuate, and so will interest
tax shields.
 Discounting the Tax Shields

For any financial policy that implies a predetermined

interest payment schedule (i.e., we know with certainty the
interest we will need to pay), we use the cost of debt to
discount the tax shields:

!"# = !%

Intuition:
– The only risk associated with tax shields is default risk.
– &' adjusts for default risk.
 The Interest Tax Shield with Perpetual Debt
Debt gives firm an interest tax shield which reduces taxes each year
by:
Tax reduction = tax Rate × Interest Payments

This reduction in taxes increases the value of the firm to investors:

PV(future tax shields) = tax rate × PV(future interest payments)

In the special case in which debt is perpetually rolled over, no-

arbitrage implies that the market value of debt must be equal to the
PV of the future interest payments:
D = PV(future interest payments)
So, V(Levered Firm) = V(Unlevered Firm) + tax rate × D
 Tax shields and stock prices
Consider a company that is currently all-equity financed. The
company announces the issuance of £60 million of perpetual
debt, at a 7% coupon, and uses the proceeds to repurchase
shares.

We’ve shown that the value of the firm increases if the firm
issues £60M in debt to repurchase shares, but will the share
price go up as well?

Assume that the share price before the debt issue was £12 a
share (10M shares outstanding) and that the corporate tax rate is
40%.
 Prices change upon announcement

(Semi-strong) Efficient Market Hypothesis: Stock price must

change before the actual debt issue, at the moment the
firm announces it will repurchase shares.

Why?

If not, you can make money for nothing: Buy one share
today, hold it until the debt issue/share repurchase is
completed, and then sell at a higher price.
 Tax Shields and Stock Prices: Example
Balance Sheets in Market Values
Unlevered firm before the debt Unlevered firm after the debt
announcement announcement
Assets Debt Assets Debt
PV of unlevered 120 PV of unlevered
0 120 0
cash flows cash flows
Equity Equity
PV of tax 24
120 144
shields

This is an “intangible” asset

The PV of tax shields is (tax rate x D) = 0.4 $ 60 = 24.

Share price goes up to £14.4; existing shareholders will not sell
()
for less. Firm ends up repurchasing = 4.17 million shares.
*+.+
 Tax Shields and Stock Prices: Example (cont.)
Levered firm (after the debt issue)

Assets Debt
PV of unlevered
120 60
cash flows
Equity
PV of tax 24
shields 84

"#
Share price = $."&
= £14.4
The stock price goes up with the debt issue announcement, and gains
accrue to all existing shareholders before the issue.
 Weighted Average Cost of Capital with Taxes
The After-Tax Cost of Debt
• Each $1 of interest paid gives the firm a $0.40 tax benefit.
• Net after-tax cost of paying $1 in interest is only $0.60!
• Effective after-tax interest rate on debt = rD(1 – tax rate)
Unchanged by
Pre-tax WACC: leverage ratio
; =
1233456789: = >? + >@ = >A
;+= ;+=
Decreasing
with leverage
WACC with Taxes: tax rate

; = =
12339B865789: = > + > 1 − DE = 1233456789: − D >
;+= ? ;+= @ =+; E @
Weighted Average Cost of Capital with Taxes
 Comments

Raising debt does not create value, i.e., you can’t create
value by borrowing and sitting on the excess cash.

Debt only creates value via tax shields relative to raising the
same amount in equity.

Hence, value is created by the tax shield when you:

– Finance an investment with debt rather than equity.
– Undertake a recapitalization, i.e., a financial transaction in
which some equity is retired and replaced with debt.