CHAPTER ONE: CAPITAL STRUCTURE AND LEVERAGE

1.1. Meaning of Capital Structure

Capital structure refers to the kinds of securities and the proportionate amounts that make up
capitalization. It is the mix of different sources of long-term financial sources. The term capital
structure refers to the relationship between the various long-term sources of financing such as
equity capital, preference share capital and debt capital. Deciding the suitable capital structure is
the important decision of the financial management because it is closely related to the value of the
firm. Capital structure pattern varies from company to company and the availability of finance.
Normally the following forms of capital structure are popular in practice.
• Equity shares only.
• Equity and preference share only.
• Equity and Debentures (debt) only.
• Equity shares, preference shares and debentures.
1.2. The Capital Structure Question
How should a firm choose its debt–equity ratio? Capital structure is one of the most complex areas
of financial decision making due to its interrelationship with other financial decision variables.
Poor capital structure decisions can result in a high cost of capital, thereby lowering project NPVs
and making them more unacceptable. Effective decisions can lower the cost of capital, resulting
in higher NPVs and more acceptable projects, thereby increasing the value of the firm.
There are really two important questions:
1. Why should the stockholders care about maximizing firm value? Perhaps they should be
interested in strategies that maximize shareholder value.
2. What is the ratio of debt-to-equity that maximizes the shareholder’s value?
As it turns out, changes in capital structure benefit the stockholders if and only if the value of the
firm increases. The value of a firm (V) is defined to be the sum of the market value of the market
value of firm’s debt (D) and the market value of the firm’s equity (E). V = E + D. We call our
approach to the capital structure question the pie model. If the goal of the management of the firm
is to make the firm as valuable as possible, then the firm should pick the debt-equity ratio that
makes the pie as big as possible.
Another important issue that we want to explore in this chapter is what happens to the weighted
average cost of capital (WACC) when we vary the amount of debt financing or the debt-equity

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ratio. The firm’s weighted average cost of capital (WACC) tells us that the firm’s overall cost of
capital is a weighted average of the costs of the various components of the firm’s capital structure.
When we described the WACC, we took the firm’s capital structure as given. A primary reason
for studying the WACC is that the value of the firm is maximized when the WACC is minimized.
1.3. Factors that Influence Capital Structure Decision
The following factors influence capital structure decisions.

• Business risk (the riskiness inherent in the firm’s operations if it used no debt): Excluding
debt, business risk is the basic risk of the company’s operations. The greater the business risk,
the lower the optimal debt ratio. If the operating risk in business is less, the financial risk can
be faced which means that more debt capital can be utilized.
• The firm’s tax position: Debt payments are tax-deductible. For example, if the tax rate of a
company is high, the use of debt as a means of financing a project is attractive. Because this
tax deduction of debt payments saves some income from taxes.
• Financial flexibility (the ability to raise capital on reasonable terms under
adverse conditions): This is essentially the firm’s ability to raise capital in bad times.
Flexibility means the firm's ability to adapt its capital structure to the needs of the changing
conditions. Capital structure should be flexible enough to raise additional funds whenever
required, without much delay and cost. The capital structure of the firm must be designed in
such a way that it is possible to substitute one form of financing for another to economize the
use of funds. Preference shares and debentures offer the highest flexibility in the capital
structure, as they can be redeemed at the discretion of the firm. Companies generally have no
problem raising capital when sales increase and earnings are strong. Given the company’s
strong cash flow in good times, raising capital is not that difficult. The lower the company’s
debt level, the higher the financial flexibility of the company is. In good times, the industry
generates significant volumes of sales and thus cash flow. However, in bad times, that situation
is reversed and the company is in a situation where it needs to borrow money.
• Managerial conservatism or aggressiveness: Management styles range from aggressive to
conservative. The more conservative a management approach is, the less inclined it is to use
debt to increase profits. Aggressive management can try to grow the firm quickly, using
significant amounts of debt to drive the company’s earnings per share (EPS) growth.

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• Size of the firm: Small firms find it very difficult to mobilize long - term debt, as they have
to face higher rate of interest and inconvenient terms; make their capital structure very
inflexible and depend on share capital and retained earnings for their long - term funds; cannot
go to the capital market frequently for the issue of equity shares, as it carries a greater danger
of loss of control over the firm to others; sometimes limit the growth of their business and any
additional fund requirements met through retained earnings only. Large firms have relative
flexibility in capital structure designing; has the facility of obtaining long - term debt at
relatively lower rate of interest and convenient terms; have relatively an easy access to the
capital market.
• Profitability: firms with very high rates of return on investment use relatively little debt, i.e.
their high rates of return enable them to do most of their financing with internally generated
funds.
• Growth rate: other things the same, faster-growing firms must rely more heavily on external
capital.
• Market conditions: in the case of depressed conditions in the share market, the firm should
not issue equity shares but go for debt capital. On the other hand, under boom conditions, it
becomes easy for the firm to mobilise funds by issuing equity shares.
• Control: control considerations can lead to the use of debt or equity because the type of capital
that best protects management varies from situation to situation. In any event, if management
is at all insecure, it will consider the control situation (e.g. risk of dilution, risk of bankruptcy
and loss of job, risk of takeover, etc.).
• Cost of capital: an ideal pattern of capital structure is one that minimises cost of capital
structure and maximises earnings per share (EPS). The overall cost of capital depends on the
proportion in which the capital is mobilised from different sources of finance.
• Legal requirements: the various guidelines issued by the government from time to time
regarding the issue of shares and debentures should be kept in mind while determining the
capital structure of a firm. These legal restrictions are very significant as they give a
framework within which capital structure decisions should be made.

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 1.4. Business and Financial Risk
1.4.1. Leverage

Leverage is used to describe the firm’s ability to use fixed cost assets or funds to magnify the
return to its owners. Generally, increases in leverage result in increases in risk and return, whereas
decreases in leverage result in decreases in risk and return. It can be operating leverage, financial
leverage, or combined leverage or total leverage.

(A) Operating Leverage: Operating leverage is concerned with the relationship between the
firm’s sales revenue and its earnings before interest and taxes (EBIT) or operating profits. It is the
use of fixed operating costs rather than variable costs to magnify the effects of changes in sales on
the firm’s earnings before interest and taxes. The firm is said to have a high degree of operating
leverage if it employees a greater amount of fixed costs and a small amount of variable costs. The
Operating Leverage can be calculated by the following formula:
𝑐𝑜𝑛𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 𝑚𝑎𝑟𝑔𝑖𝑛
Operating leverage = 𝐸𝐵𝐼𝑇

Notes:
1. Contribution = Net Sales – Variable Cost (OR)
Contribution = Fixed Cost + EBIT
2. EBIT = Net Sales – Variable Cost – Fixed Cost (OR)
EBIT (Earnings before Interest and Tax) = Contribution – Fixed Cost
3. Operating Leverage may be Favorable or Unfavorable.
• If Contribution exceed the fixed cost – Favorable
• If Contribution not exceed the fixed cost – Unfavorable
Degree of Operating Leverage (DOL): The degree of operating leverage (DOL) is the numerical
measure of the firm’s operating leverage. This is calculated using the following formula:
% 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝐸𝐵𝐼𝑇
DOL = % 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑠𝑎𝑙𝑒𝑠

𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝐸𝐵𝐼𝑇
Change in EBIT = 𝑏𝑎𝑠𝑒 𝐸𝐵𝐼𝑇
= (EBITt - EBIT t-1) /EBITt-1
𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑠𝑎𝑙𝑒𝑠 t-1
Change in sales = 𝑆𝑎𝑠𝑒 𝑆𝑎𝑙𝑒
= (Salet - Sale t-1) / Sale t-1

A more direct formula for calculating the degree of operating leverage at a base sales level, Q, is

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Example
1. Calculate the Degree of Operating Leverage.
1994 1998
Sales $ 150,000 $ 210,000
EBIT $ 60,000 $ 90,000
2. Calculate the Degree of Operating Leverage.
1994 1998
Sales $ 150,000 $ 210,000
Variable cost $ 60,000 $ 90,000
Fixed cost $ 40,000 $ 30,000
(B) Financial Leverage: Financial leverage is the use of fixed financial costs to magnify the
effects of changes in earnings before interest and taxes on the firm’s earnings per share. It signifies
the existence of fixed interest/fixed dividend bearing securities such as bonds and preferred stock
along with the common equity in the total capital structure of the company. The Financial leverage
can be calculated by using the following formula:
Case – A: If no Preferred Stock Dividend:
𝐸𝐵𝐼𝑇
• Financial leverage = 𝐸𝐵𝑇
Where EBIT = Earnings before Interest and Tax; EBT = Earnings before Tax
Case – B: If preferred stock Dividend is due:
𝐸𝐵𝐼𝑇
• Financial Leverage = 𝑃𝑑
𝐸𝐵𝐼𝑇−𝐼−
1−𝑡
Where EBIT = Earnings before Interest and Tax; I = Fixed Interest on Bonds; Pd =
Fixed Preference Dividend on Preferred Stocks; t = Shareholder’s tax rate.
Financial Leverage may be Favorable or Unfavorable. If Earnings exceeds than the fixed
interest/dividend – Favorable. If Earnings not exceeds than the fixed interest/dividend –
Unfavorable.
Degree of Financial Leverage (DFL): Degree of financial leverage is defined as the percentage
change in the EPS resulting from a percentage change in EBIT. This is calculated using the
following formula
% 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝐸𝑃𝑆
Degree of Financial Leverage (DFL) = % 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝐸𝐵𝐼𝑇

Notes:
𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝐸𝑃𝑆
% Change in EPS = Base EPS
𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 EBIT
% Change in EBIT = Base EBIT

A more direct formula for calculating the degree of financial leverage at a base level of EBIT is
given by

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 • Note that in the denominator the term 1/(1 - T) converts the after-tax preferred stock
dividend to a before-tax amount for consistency with the other terms in the equation.
Example
Given: EBIT = Birr10,000, I = Birr2,000, PD=Birr2,400, and the tax rate (T= 0.40)

1.4.2. Business Risk and Operating Leverage

Business risk is the possibility of a commercial business making inadequate profits due to
uncertainties. Business risk is related with the uncertainty (variability) in future firm’s Earnings
Before Interest and Taxes (EBIT). In other words, the risk inherent in a firm’s operations
(operating income) is called the business risk of the firm’s equity. Business risk is the risk to the
firm of being unable to cover its operating costs. Thus, business risk focuses ignores financing
effects (capital structure). Business risk depends on a number of factors, the more important of
which are listed below:

• Demand variability: The more stable the demand for a firm’s products, other things held
constant, the lower its business risk.
• Sales price (output price) variability: Firms whose products are sold in highly volatile
markets are exposed to more business risk than similar firms whose output prices are more
stable.
• Input cost variability: Firms whose input costs are highly uncertain are exposed to a high
degree of business risk.
• Ability to adjust output prices for changes in input costs: Some firms are better able than
others to raise their own output prices when input costs rise. The greater the ability to adjust
output prices to reflect cost conditions, the lower the degree of business risk.

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 • Ability to develop new products in a timely, cost-effective manner: Firms in such high-
tech industries as drugs and computers depend on a constant stream of new products. The
faster its products become obsolete, the greater a firm’s business risk
• Foreign risk exposure: Firms that generate a high percentage of their earnings overseas are
subject to earnings declines due to exchange rate fluctuations. Also, if a firm operates in a
politically unstable area, it may be subject to political risks.
• The extent to which costs are fixed (degree of operating leverage): The higher the
proportion of fixed costs within a firm’s overall cost structure, the greater the operating
leverage. Higher operating leverage leads to more business risk, because a small sales decline
causes a larger profit decline. That is, if a high percentage of costs are fixed, hence do not
decline when demand falls, then the firm is exposed to a relatively high degree of business
risk.
1.4.3. Financial Risk and Financial Leverage
Financial risk is the type of danger that can result in the loss of capital to interested parties. The
extra risk that arises from the use of debt financing is called the financial risk of the firm’s equity.
In other words, financial risk is the additional business risk concentrated on common stockholders
when financial leverage is used. The financial risk is completely determined by financial policy.
The greater a firm’s financial leverage, the greater will be its financial risk—the risk of being
unable to meet its two most common fixed financial costs, (1) interest on debt (including financial
leases) and (2) preferred stock dividends.
FIGURE 1 :General Income Statement Format and Types of Leverage

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 1.5. Determining the Optimal Capital Structure

Optimum capital structure may be defined as the capital structure or combination of debt and
equity, that leads to the maximum value of the firm. In other words, optimum capital structure is
the capital structure at which the weighted average cost of capital, WACC, is minimum and thereby
the value of the firm is maximum. It is believed that the value of the firm is maximized when the
cost of capital is minimized.
A firm will borrow because the interest tax shield is valuable. At relatively low debt levels, the
probability of bankruptcy and financial distress is low, and the benefit from debt outweighs the
cost. At very high debt levels, the possibility of financial distress is a chronic, ongoing problem
for the firm, so the benefits from debt financing may be more than offset by the financial distress
costs. Based on our discussion, it would appear that an optimal capital structure exists somewhere
in between these extremes.
The objective of financial management is to maximize wealth and, therefore, one should choose a
capital structure that maximizes wealth for the company’s stakeholders as a whole. Thus, a
financial management has to devise an appropriate capital structure that can provide the highest
earnings per share (EPS) over the company’s expected range of earnings before interest and taxes
(EBIT). For the analysis of capital structure decisions of an entity, the following techniques may
be used:
a) EBIT‐EPS Analysis
b) Analysis of the effect of capital structure on the cost of capital

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 1.5.1. EBIT‐EPS Analysis

Designing an appropriate capital structure is concerned with choosing a capital structure that can
provide the highest wealth, i.e., the highest value of the firm. This, in turn, is dependent upon EPS.
EBIT‐EPS analysis gives a scientific basis for comparison among various financial plans and
shows ways to maximize EPS. Hence EBIT‐EPS analysis may be defined as ‘a tool of financial
planning that evaluates various alternatives of financing a project under varying levels of EBIT
and suggests the best alternative having highest EPS and determines the most profitable level of
EBIT. It is used to determine when debt financing is advantageous and when equity financing is
advantageous.

The EBIT-EPS analysis holds significant importance and, if executed properly, can prove to be an
effective tool in the hands of a financial manager to get an insight into the planning and designing
of the capital structure of the firm. For a particular level of EBIT, the EPS will be different under
different financing mix depending upon the extent of debt financing. The effect of financial
leverage on the EPS arises due to the existence of fixed financial charges represented by the interest
on the debt and fixed dividend on preference share capital.

Further, the effect of financial leverage on the EPS is directly dependent upon the relationship
between the rate of return on assets and the rate of fixed financial charge. If the rate of return on
assets is greater than the rate of fixed financial charge/ cost of financing, then the increasing use
of debt and preference share capital is likely to result in a favorable increase in the EPS. On the
flip side, if the rate of return on assets is lower than the rate of fixed financial charge/ cost of
financing, then the increasing use of debt and preference share capital is likely to result in an
unfavorable decline in the EPS.

Illustration 1: Suppose A Ltd. Has a share capital of br. 100,000 divided into share of br. 10 each.
It has a major expansion program requiring an investment of another br. 50,000. The
Management is considering the following alternatives for raising this amount:

i. Issue of 5,000 equity shares of br. 10 each;

ii. Issue of 5000, 12% preference shares of br. 10 each;
iii. Issue of 10% debentures of br. 50,000, and
iv. Issue of 2,000 equity shares of br. 10 each, issue of 2000, 12% preference shares of br.
10 each and Issue of 10% debentures of br. 10,000.

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The company’s present Earnings before Interest and Tax (EBIT) are br. 40,000 per annum
subject to tax @ 50%. You are required to calculate the effect of the above financial plan on the
earnings per share presuming EBIT continues to be the same even after expansion.

Required: Calculate EPS at each level of financing the project.

Solution: When EBIT is br. 40,000 Per Annum

Financing alternatives
Issue of Issue of Issue of Issue of equity shares,
equity shares preference debentures preference shares and
shares Issue of debentures
EBIT 40,000 40,000 40,000 40,000
Interest - - 5,000 1,000
Profit before Tax 40,000 40,000 35,000 39,000
Tax 20,000 20,000 17,500 19,500
Profit after Tax 20,000 20,000 17,500 19,500
Preferred Share - 6,000 - 2,400
Dividend
Profit for Common 20,000 14,000 17,500 17,100
Equity
Number of Equity 15 000 10,000 10,000 12,000
Shares
EPS 1.33 1.4 1.75 1.42

In the absence of preferred dividend:

(EBIT − 𝑟𝑑 D)(1 − T)
EPS =
Shares outstanding

In the presence of preferred dividend:

(EBIT − 𝑟𝑑 D)(1 − T) − 𝑃𝑟𝑒𝑓𝑒𝑟𝑟𝑒𝑑 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑

EPS =
Shares outstanding

Therefore, the earnings per share (EPS) is maximized when the firm resorts to debt financing.

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 1.5.2. The effect of capital structure on the cost of capital
It is difficult to predict the effect of changes in capital structure on stock price. Capital structure
that maximizes the stock price also minimizes the WACC. Besides, increases in the Debt/Capital
ratio increases the costs of both debt and equity. Hence, WACC = wd*(rd)*(1-T) + wc(rs); where
wd and wc represent the percentage of debt and equity in the firm’s capital structure that sum to 1.

Bondholders recognize that if a firm has a higher Debt/Capital ratio, this increases the risk of
financial distress which leads to higher interest rates. It can be illustrated while dealing with the
theories of capital structure in the following section.

1.6. Introduction to the Theory of Capital Structure

1.6.1. Modigliani and Miller (MM) Theory
1.6.1.1.M&M Propositions I and II with no Corporate Taxes

The Modigliani and Miller with no corporate taxes approach, devised in the 1950s, advocates that
capital structure decision is irrelevant for firm’s value. This suggests that the valuation of a firm is
irrelevant to a company’s capital structure. Whether a firm is high on leverage or has a lower debt
component has no bearing on its market value. Instead, the market value of a firm is solely
dependent on the operating profits of the company. And also, this MM approach maintains that
the average cost of capital does not change with change in the debt weighted equity mix or capital
structures of the firm.

A. M&M Propositions I with no Corporate Taxes: The value of the firm levered is equal
to the value of the firm unlevered.

One way to illustrate M&M Proposition I is to imagine two firms that are identical on the left side
of the balance sheet; their assets and operations are exactly the same. The right sides are different
because the two firms finance their operations differently. In this case, we can view the capital
structure question in terms of a “pie” model which gives two possible ways of cutting up the pie
between the equity slice, E, and the debt slice, D: 40%–60% and 60%–40%. However, the size of
the pie in Figure 1 is the same for both firms because the value of the assets is the same. This is
precisely what M&M Proposition I state that the size of the pie doesn’t depend on how it is sliced.

FIGURE 2. The Cost of Equity and the WACC: M&M Propositions I and II with No Taxes

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Generally, proposition I say that the capital structure is irrelevant to the value of a firm. The value
of two identical firms would remain the same, and value would not affect the choice of finance
adopted to finance the assets. The value of a firm is dependent on the expected future earnings. In
other words, leveraging the company does not increase the company’s market value.

B. M&M Propositions II with no Corporate Taxes: A firm’s weighted average cost of

capital (WACC) is the same no matter what mixture of debt and equity is used.

We now examine what happens to a firm financed with debt and equity when the debt-equity ratio
is changed. If we ignore taxes, the weighted average cost of capital, WACC, is:

WACC = (E/V) x RE + (D/V) x RD

where V = E + D; V, value of the firm; E value of equity; D, value of debt; RE, cost of equity and
RD, cost of equity. We also saw that one way of interpreting the WACC is as the required return
on the firm’s overall assets (RA). To remind us of this, we will use the symbol RA to stand for the
WACC and write:

RA = (E/V) x RE + (D/V) x RD

If we rearrange this to solve for the cost of equity capital, we see that:

RE= RA+ (RA – RD) x (D/E)

This is the famous M&M Proposition II, which tells us that the cost of equity depends on three
things: The required rate of return on the firm’s assets, RA; the firm’s cost of debt, RD and the firm’s
debt- equity ratio, D/E.

Figure 2 summarizes our discussion thus far by plotting the cost of equity capital, RE, against the
debt-equity ratio. As shown, M&M Proposition II indicates that the cost of equity, RE, is given by
a straight line with a slope of (RA – RD). The y-intercept corresponds to a firm with a debt-equity
ratio of zero, so RA= RD in that case. Figure 2 shows that as the firm raises its debt-equity ratio, the

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increase in leverage raises the risk of the equity and therefore the required return or cost of equity
(RE).

FIGURE 3: The Cost of Equity and the WACC: M&M Propositions I and II with No Taxes

Notice in Figure 2 that the WACC doesn’t depend on the debt-equity ratio; it’s the same no matter
what the debt-equity ratio is. The firm’s overall cost of capital is unaffected by its capital structure.
As illustrated, the fact that the cost of debt is lower than the cost of equity is exactly offset by the
increase in the cost of equity from borrowing. In other words, the change in the capital structure
weights (E/V and D/V) is exactly offset by the change in the cost of equity (RE), so the WACC
stays the same.

Illustration 2: The Ricardo Corporation has a weighted average cost of capital (ignoring taxes) of
12 percent. It can borrow at 8 percent. Assuming that Ricardo has a target capital structure of 80
percent equity and 20 percent debt, what is its cost of equity? What is the cost of equity if the target
capital structure is 50 percent equity? Calculate the WACC using your answers to verify that it is
the same.
According to M&M Proposition II, the cost of equity, RE, is:

RE = RA + (RA - RD) x (D/E)

In the first case, the debt-equity ratio is .2/.8 = .25, so the cost of the equity is:

RE = 0.12 + (0.12 - 0.08) x 0.25 = 0.13, or 13%

In the second case, verify that the debt-equity ratio is 1.0, so the cost of equity is 16 percent.
RE = 0.12 + (0.12 - 0.08) x 1 = 0.16, or 16%

We can now calculate the WACC assuming that the percentage of equity financing is 80
percent, the cost of equity is 13 percent, and the tax rate is zero:
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 WACC = (E/V) x RE + (D/V) x RD
= .80 x .13 +.20 x .08 = .12, or 12%

In the second case, the percentage of equity financing is 50 percent and the cost of equity is 16
percent. The WACC is:
WACC = (E/V) x RE + {D/V) x RD
= .50 x .16 + .50 x .08 = .12, or 12%

As we have calculated, the WACC is 12 percent in both cases.

M&M I and II without tax proposed that the value of a firm is independent of its cost of capital
and its capital structure. This is based on some strong assumptions:

• There are no brokerage costs.

• There are no corporate taxes.
• There are no bankruptcy costs.
• Investors can borrow at the same rate as corporations.
• All investors have the same information as management about
the firm’s future investment opportunities. The investors act rationally.
• EBIT is not affected by the use of debt.
• The business consists of the same level of business risk.
• There is a perfect capital market.
• The dividend payout ratio is 100% and there are no retained earnings.
1.6.1.2.M&M Propositions I and II with Corporate Taxes

In 1963, MM relaxed the assumption that there are no corporate taxes. The Tax Code allows
corporations to deduct interest payments as an expense (all interest paid is tax deductible), but
dividend payments to stockholders are not deductible. In other words, the actual cost of debt is less
than the nominal cost of debt due to tax benefits. The differential treatment encourages
corporations to use debt in their capital structures. The tax deductibility of the interest payments
shields the firm’s pre-tax income. In this scenario, the financial leverage boosts the value of a firm
and reduces WACC.

A. M&M Propositions I with Corporate Taxes

Proposition I (with Corporate Taxes) states that the firm value increases with leverage. The value
of a levered firm is value of an identical unlevered firm plus value of any “side effects.” VL = VU

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+ Value of side effects = VU + PV of tax shield Present value of the tax shield is equal to the
corporate tax rate, T, multiplied by the amount of debt, D: VL = VU + TC D.

Where VL, value of levered firm, VU, unlevered firm, TC D, tax benefit.

Illustration 3: We can start by considering what happens to M&M Propositions I and II when we
look at the effect of corporate taxes. To do this, we examine two firms, Firm U (unlevered) and
Firm L (levered). These two firms are identical on the left side of the balance sheet, so their assets
and operations are the same.

We assume EBIT is expected to be $1,000 every year forever for both firms. The difference
between them is that Firm L has issued $1,000 worth of perpetual bonds on which it pays 8%
interest every year. The interest bill is thus .08 x $1,000 = $80 every year forever. Also, we assume
the corporate tax rate is 30%.

For our two firms, U and L, we can now calculate the following:
Firm U Firm L
EBIT $ 1,000 $1,000
Interest - 80
Taxable income $ 1,000 $ 920
Taxes (30%) 300 276
Net income (EAT) $ 700 $ 644

The Interest Tax Shield

To simplify things, we assume depreciation is equal to zero. We also assume capital spending
is zero and there are no additions to NWC. In this case, the cash flow from assets is simply
equal to EBIT — Taxes.

For firms U and L, we thus have:

Cash Flow from Assets Firm U Firm L

EBIT $1,000 $1,000
-Taxes 300 276
Total $ 700 $ 724
We immediately see that capital structure is now having some effect since the cash flows from U
and L are no longer identical, even though the two firms have identical assets. Allowing companies
to deduct interest payments when computing taxable income lowers the amount of corporate taxes.
This in turn increases firm cash flows and makes more cash available to investors.

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 To see what’s going on, we can compute the cash flow to shareholders and bondholders.

Cash Flow Firm U Firm L

To shareholders $700 $ 644
To bondholders 0 80
Total $ 700 $ 724
What we are seeing is that the total cash flow to L is $24 more. This occurs because L’s tax bill
(which is a cash outflow) is $24 less. The fact that interest is deductible for tax purposes has
generated a tax saving equal to the interest payment ($80) multiplied by the corporate tax rate
(30%): $80 x .30 = $24. We call this tax saving the interest tax shield, tax savings resulting from
deductibility of interest payments.

Tax benefit = debt x cost of debt x tax rate

Tax benefit = 1000 x (.08) x (.30) = $24

The present value of tax shield = Tc x (rdebt x D)/rdeb = Tc D

The present value of tax shield = 0.3x (.08x 1000)/.08 = 0.3*1000=$3,00
PV of 24 perpetuity = 24 / .08 = $300
Illustration 4: Suppose that the cost of capital for Firm U is 10 percent. We will call this the
unlevered cost of capital, and we will use the symbol Ru to represent it. We can think of Ru as the
cost of “capital a firm would have if it had no debt. Firm U’s cash flow is $790 every year forever,
and, because U has no debt, the appropriate discount rate (WACC) is Ru = 10%. Assume also that
corporate tax rate is 21%. The debt is worth $1,000. The value of the unlevered firm, Vu, is:
EBIT𝑥 (1 − Tc)
Vu =
Ru
$790
Vu = = $𝟕𝟗𝟎𝟎
.10
The value of the levered firm, VL, is:
V L = Vu + TcxD
= $7,900 + .21 x 1,000= $8,110

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FIGURE 4: M&M Proposition I with Taxes

In Figure 3, we have also drawn a horizontal line representing Vu. As indicated, the distance
between the two lines is TC x D, the present value of the tax shield. We have plotted the value of
the levered firm, Vu, against the amount of debt, D. M&M Proposition I with corporate taxes
implies that the relationship is given by a straight line with a slope of TC and a y-intercept of Vu.
As the figure indicates, the value of the firm goes up by $.21 for every $1 in debt. In other words,
the NPV per dollar of debt is $.21.

B. M&M Propositions II with Corporate Taxes

This approach with corporate taxes acknowledges tax savings and thus infers that a change in the
debt-equity ratio affects the WACC (Weighted Average Cost of Capital). This means that the
higher the debt, the lower the WACC.

We know that once we consider the effect of taxes, the WACC is:

WACC = (E/V) x RE + (D/V) x RD x (1 - TC)

To calculate this WACC, we need to know the cost of equity. M&M Proposition II with corporate
taxes states that the cost of equity is:
RE= RU+(RU- RD) x RD x (D/E) x (1 - TC)
To illustrate, recall that we saw a moment ago in the illustration 4 above that Firm L is worth
$8,110 total. Because the debt is worth $1,000, the equity must be worth $8,110 - 1,000 = $7,110.
And, the cost of debt is 8% and the tax rate is 21%. For Firm L, the cost of equity is:
RE = .10 + (.10 - .08) x ($1,000/7,110) x (1 - .21)= .1022, or 10.22%

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The weighted average cost of capital is:
WACC = ($7,110/$8,110) x .1022 + ($1,000/$8,110) x .08 x (1 - .21)
= .0974, or 9.74%
Without debt, the WACC is over 10 percent; with debt, it is 9.74 percent. Therefore, the firm is
better off with debt.
FIGURE 5 M&M Proposition II with Taxes

Figure 4 summarizes our discussion concerning the relationship between the cost of equity, the
after-tax cost of debt, and the weighted average cost of capital. For reference, we have included
RU, the unlevered cost of capital. In Figure 4, we have the debt-equity ratio on the horizontal axis.
Notice how the WACC declines as the debt-equity ratio grows. This illustrates again that the more
debt the firm uses, the lower is its WACC.

Illustration 5: The Cost of Equity and the Value of the Firm

This is a comprehensive example that illustrates most of the points we have discussed thus far.
You are given the following information for the Format Co.:
EBIT =$126.58
Tax rate, TC = 0.21
Amount of Debt = $500
Cost of capital of unlevered firm, Ru = 0.20

The cost of debt capital is 10 percent. What is the value of Format’s equity? What is the cost
of equity capital for Format? What is the WACC?
This one’s easier than it looks. Remember that all the cash flows are perpetuities. The value of
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 the firm if it has no debt, Vu is:
Vu = (EBIT – Taxes) /Ru = EBIT x (1 - Tc))/Ru
= $100
0.20
= $500
From M&M Proposition I with taxes, we know that the value of the firm with debt is:

VL = Vu + Tc x D
= $500 + 0.21 x $500 = $605
Because the firm is worth $605 total and the debt is worth $500, the equity is worth $105:

E = VL-D = $605-500 = $105

Based on M&M Proposition II with taxes, the cost of equity is:

RE = Ru + (Ru - RD) x (D/E) x (1 — Tc)
= .20 + (.20 - .10) x ($500/$105) x (1 - .21)
= .5762, or 57.62%

Finally, the WACC is:

WACC = ($105/$605) x .5762 + ($500/$605) x .10 x (1 - .21)

= .1653, or 16.53%

Notice that this is lower than the cost of capital for the firm with no debt (RU = 20%), so debt
financing is advantageous.

1.6.2. Trade-off Theory

MM theory ignores bankruptcy (financial distress) costs, which increase as more leverage is used.
The trade-off theory of capital structure, developed in the early 1970s, says that corporate leverage
is determined by balancing the tax-saving benefits of debt against dead-weight costs of bankruptcy.
According to the tradeoff theory, firms with initially little or no debt should consider adding debt
to their capital structure because of the tax deductibility of the interest payments. Debt has two
distinguishing features that we have to take into proper account. First, as we have mentioned in a
number of places, interest paid on debt is tax deductible, which increases the value of the firm.
Second, failure to meet debt obligations can result in bankruptcy (cost of financial distress) which
initially offset the tax advantage of debt to some degree. Yet, such costs gradually increase as debt
levels rises until they begin to completely offset the tax advantage of debt. Beyond that point,
issuing more debt decreases the value of the firm. The fact that interest of debt is a deductible
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expense makes debt less expensive than common or preferred stock since debt provides tax shelter
benefits. As a result, using debt causes more of the firm’s operating income (EBIT) to flow through
to investors. Therefore, the more debt a company uses, the higher its value and stock price. Thus,
VL = VU + PV tax shied – Financial distress costs. At low leverage levels, tax benefits outweigh
bankruptcy costs, and at high levels, bankruptcy costs outweigh tax benefits.

The trade-off theory advocates that a company can capitalize on its requirements with debts as
long as the cost of distress, i.e., the cost of bankruptcy, exceeds the value of the tax benefits. Thus,
until a given threshold value, the increased debts will add value to a company.

FIGURE 6: The Static Theory of Capital Structure: The Optimal Capital Structure and the Value of the
Firm

According to the static theory, the gain from the tax shield on debt is offset by financial
distress costs. An optimal capital structure exists that just balances the additional gain
from leverage against the added financial distress cost.

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FIGURE 7: The Static Theory of Capital Structure: The Optimal Capital Structure and the Cost of
Capital

According to the static theory, the WACC falls initially because of the tax advantage of debt.
Beyond the point D*/E*, it begins to rise because of financial distress costs.

1.6.3. Signaling Theory

MM assumed that investors and managers have the same information. But managers often have
better information. Managers use issues of debt and equity to signal information about a firm’s
future prospects to less informed owners and investors. Issuing debt would be interpreted as a
positive signal about the company’s future. In contrast, the decision to issue equity would generally
be interpreted by shareholders and investors as a negative signal. Since managers know the firm’s
future prospects better than investors, managers would not issue additional equity if they thought
the current stock price was less than the true value of the stock (given their inside information).
Hence, investors often perceive an additional issuance of stock as a negative signal, and the stock
price falls.
One would expect a firm with very positive prospects to try to avoid selling stock and, rather, to
raise any required new capital by other means, including using debt beyond the normal target
capital structure. A firm with negative prospects would want to sell stock, which would mean
bringing in new investors to share the losses.

Asymmetric information can impact the firm’s capital structure as follows:

• Suppose management has identified an extremely lucrative investment opportunity and
needs to raise capital. Based on this opportunity, management believes its stock is
undervalued since the investors have no information about the investment. In this case,
management will raise the funds using debt since they believe/know the stock is

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 undervalued (underpriced) given this information. In this case, the use of debt is viewed
as a positive signal to investors regarding the firm’s prospects.
• On the other hand, if the outlook for the firm is poor, management will issue equity instead
since they believe/know that the price of the firm’s stock is overvalued (overpriced).
Issuing equity is therefore generally thought of as a “negative” signal.
1.7. Using Debt Financing to Constrain Managers

Agency problems may arise if managers and shareholders have different objectives.
Such conflicts are particularly likely when the firm's managers have too much cash at their
disposal. Managers often use excess cash to finance pet projects or for perquisites such as nicer
offices which may do little to maximize stock prices. That means managers can use corporate
funds for non-value maximizing purposes. Managers with limited "excess cash flow" are less able
to make wasteful expenditures. Firms can reduce excess cash flow in a variety of ways. One way
is to funnel some of it back to shareholders through higher dividends or stock repurchases. Another
alternative is to shift the capital structure toward more debt in the hope that higher debt service
requirements will force managers to be more disciplined. If debt is not serviced as required, the
firm will be forced into bankruptcy, in which case its managers would likely lose their jobs. Thus,
managers are less likely to waste free cashflows on perquisites or non-value adding acquisitions.

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