Corp Fin 3 Cap Structure Part1

Corporate Finance
Jamie Coen
Imperial College Business School
Autumn 2023
Jamie Coen The Financing Decision 1 / 74

Raising Funds
• Fixed claim • Residual claim

• Tax deductible • Not tax deductible
• High priority in financial distress • Lowest priority in financial distress
• Fixed maturity • Infinite
• No management control • Management control
Debt Hybrid Securities Equity

Bank debt Convertible debt Owner’s equity
Commercial paper Preferred stock Venture capital
Corporate bonds Option-linked bonds Common stock

Quantifying Funding Mix
Various equivalent ways to measure debt vs equity:
debt
Debt ratio =
debt + equity
equity
Capital ratio =
debt + equity
debt
Leverage (or debt-to-equity ratio) =
equity
Firms with relative more debt are more highly leveraged.

The Financing Decision
Maximise the Value of the Firm
The Investment Decision The Financing Decision The Dividend Decision

Which assets should a How should a firm How and when should a firm
firm invest in? finance itself? return cash to shareholders?

Cost of capital → Valuation

→ Value of a firm is obtained by discounting expected cash flows
to the firm at the WACC.
Choice of debt vs equity → cost of capital

→ Debt and equity have different costs, and the WACC is the
weighted sum of these costs.
Financing decision
→ how much of your financing should be debt vs. equity?

The Financing Decision: Outline
1 Capital structure with perfect capital markets.
2 Trade-offs between debt and equity financing.
3 Finding an optimal mix of debt and equity.

Financing Decision: An Easy Question?
D E
WACC = Cost of debt + Cost of equity
D+E D+E
We know the cost of equity exceeds the cost of debt, as debt

payments are always prioritised.
• It follows that we should rely more heavily on debt than equity.
• By this logic, rely only on debt.

Financing Decision: An Easy Question?
D E
D+E D+E
We know the cost of equity exceeds the cost of debt, as debt

payments are always prioritised.
• It follows that we should rely more heavily on debt than equity.
• By this logic, rely only on debt.
What’s the problem?

Financing Decision: A Hard Question
D E
D+E D+E
The costs of debt and equity are a function of a firm’s financing

decisions.
As a firm relies more heavily on debt, it becomes riskier, and so the

costs of both debt and equity go up.
Two competing effects of increasing leverage:

1 Place more weight on (cheaper) debt: ↓ WACC
2 Push up cost of debt and equity: ↑ WACC.
We need a benchmark.

Capital Structure with Perfect Capital Markets

Perfect Capital Markets
1 No taxes.
2 Firms can raise external financing from debt or equity, with no

issuance costs.
3 No costs – direct or indirect – associated with bankruptcy.
4 No agency costs: managers maximise stockholder wealth,

bondholders don’t have to worry about stockholders
expropriating wealth via their decisions.
5 Investors and firms can trade the same set of securities at

competitive market prices equal to the present value of their
cash flows.

Modigliani-Miller Theorem
In a world with perfect capital markets, capital structure is

irrelevant to the total value of a firm.
• As you change the mix of debt vs equity, the costs of each
adjust so that overall financing costs are constant.
→ WACC doesn’t depend on financing decisions.
• A firm’s value depends on the quality of its investments, not
how it structures its financing.
→ firm value doesn’t depend on financing decisions.

Modigliani-Miller & firm value: the logic
A firm’s assets come with cash flows → these are what

determine a firm’s value.
Debt and equity are just ways of dividing these cash flows between
the investors that hold a firm’s securities:
• Debtholders get paid first, shareholders last.
• Debtholders have a fixed claim, shareholders a residual claim.
These financing details – e.g. the order in which we get paid –

don’t change the value of the firm, which depends on its cash
flows.

Consider two firms that have the same cash flow (X ) from
operations.
1 Firm A is an all equity firm.
2 Firm B has both equity and debt.
The interest rate on debt is r .
Assume you are an investor, and you buy

1 a fraction (α) of the equity of Firm A (αEA = αVA ); and
2 the same fraction of both the equity and debt of Firm B
(αEB + αDB = αVB ).

Investor gets cash flow on its investment in Firm A of αX .
Investor gets cash flow on its investment in Firm B of:
α(X − rDB ) + αrDB = αX
Investor receives same cash flow!

• Price of either investment must be the same.
• Value of firms is the same, despite different financing
decisions.

Modigliani-Miller & WACC: the logic
T
X Ct
Value of a firm = C0 +
t=1
(1 + WACC )t
If we’re comparing two firms with identical cash flows, and the
values of the firms are the same, what must the WACC be?

Modigliani-Miller & WACC: the logic
T
X Ct
t=1
(1 + WACC )t
If we’re comparing two firms with identical cash flows, and the
values of the firms are the same, what must the WACC be?
WACC isn’t affected by the financing decision either.

Modigliani-Miller: an alternative logic
Miller:
You understand the M&M theorem if you know why this is a joke:
The pizza delivery man comes to Yogi Berra after the game and
says, “Yogi, how do you want this pizza cut, into quarters or
eighths?”. And Yogi says, “Cut it in eight pieces. I’m feeling
hungry tonight.”
Everyone recognizes that’s a joke because obviously the number

and shape of the pieces don’t affect the size of the pizza. And
similarly, the stocks, bonds, warrants, et cetera, issues don’t affect
the aggregate value of the firm. They just slice up the underlying
earnings in different ways.

Understanding Modigliani-Miller
1 An example.
2 Leverage and the cost of capital.
3 Homemade leverage.

1 An example.

An example
Consider an entrepreneur with the following investment

opportunity: for an initial investment of $800 this year, a project
will next year generate either:
• cash flows of $1400 next year if the economy is strong; or
• cash flows of $900 next year if the economy is weak.
Cashflows depend on economy → investors demand a premium.

• Risk-free interest rate is 5%.
• Risk premium is 10%.

What is NPV?
Cost of equity is 5 + 10 = 15%.
Expected cashflow in 1yr is 1/2 × $1400 + 1/2 × $900 = $1150.

1150
NPV = −800 + = $200
1.15

Option 1: financing the firm with equity
If project is financed with equity alone (=unlevered equity), how

much would investors be willing to pay for the shares?
Equityholders receive all cashflows at date 1. Hence market value

of equity today is:
1150
PV(equity cashflows) = = $1000
1.15
So entrepreneur can raise $1000 by selling equity, and get $200
profit (the NPV) after paying the $800 investment cost.

Option 2: financing the firm with debt & equity
Suppose firm wanted to raise some of the financing as debt, by

borrowing $500.
Debt is always paid first, and the cashflows next period are always
enough to repay the debt.
• Debt is risk-free.
• Firm can borrow at risk-free rate of 5%.
Given firm’s $500 × 1.05 = $525 debt obligation, shareholders will

receive only:
• $1400 - $525 = $875 if economy is strong; and
• $900 - $525 = $375 if economy is weak.

Financing a firm with debt and equity
• What price E should the levered equity sell for?

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

Financing a firm with debt and equity
M&M: with perfect capital markets, the total value of a firm

doesn’t depend on its capital structure.
→ as the firm’s total cash flows still equal the cash flows of the
project.
Therefore value of the firm at date 0 must still be $1000, and so

the value of equity must be $500.
Entrepreneur will raise $1000 as before and get $200 as profit.

→ indifferent between the two capital structures.

Leverage & WACC
WACC with debt and equity: 0.5 × 5% + 0.5 × 25% = 15%.
WACC with equity only: 15%.
As leverage increased, expected returns to equity increased such

that WACC left unchanged.

An example: summing up
The choice between 100% equity funding and 50% debt vs 50%
equity funding did not affect:
1 The value of the firm.
2 The weighted-average cost of capital.
The cost of equity increased as leverage increased such that WACC

was left unchanged.

1 An example.

Modigliani-Miller: Leverage & WACC
As the fraction of the firm financed with debt increases, both the
equity and the debt become riskier and their cost rises.
1 Cost of equity rises as leverage rises (remember levered and
unlevered betas).
2 Cost of debt rises as default risk rises.
Yet, because more weight is put on the lower-cost debt, the

weighted average cost of capital remains constant.

Modigliani-Miller: Leverage & WACC

1 An example.

Homemade Leverage
Suppose investors prefer an alternative capital structure to the

one the firm has chosen.
MM: with perfect capital markets investors can borrow or lend

on their own and achieve the same result.
As long as investors can borrow or lend at the same interest rate as

the firm, homemade leverage is a perfect substitute for the use of
leverage by the firm.
Thus investors don’t care about firm’s capital structure, and so nor
should the firm.

Replicating unlevered equity using homemade leverage
Suppose entrepreneur uses debt, but investor would prefer to hold

unlevered equity.
Investor can replicate payoffs of unlevered equity by buying both
the debt and the equity of the firm.
Combining the cash flows of the two securities produces cash flows
identical to unlevered equity, for a total cost of $1000.
Replicating levered equity using homemade leverage
Suppose entrepreneur uses no leverage.

An investor can replicate levered equity by using leverage in their
own portfolio: borrow to buy stock.
Can borrow at risk-free rate with the cash flows of the unlevered
equity serving as collateral.
Combined cash flows equivalent to levered equity.
Implications of Modigliani-Miller
Firms’ financing decisions are irrelevant → whether they rely on

debt or equity doesn’t matter for their cost of financing nor the
value of the firm.
Investment decisions can be made independent of financing

decisions.
Whilst debt is cheaper, relying more on it won’t lower your costs.
Operations like leveraged recapitalisations (borrowing to buy back

stocks) don’t impact value either.

Preview: Capital structure in imperfect markets
M-M results show any role for capital structure must be due to
market frictions/imperfections.
We expect the following:

1 Interest payments are tax-deductible.
2 Bankruptcy is costly.
3 Firms may not have unlimited ability to issue debt.
4 Conflict of interest between bondholders and shareholders.
5 Conflict of interest between managers and shareholders.
Each will have implications for firms’ financing decisions.

The Financing Decision: Next Steps


Capital Structure with Imperfect Capital Markets

Goal of this lecture
Understand:
1 ways in which markets deviate from Modigliani & Miller’s
assumptions → market frictions;
2 why these frictions exist; and
3 implications of these frictions for financing decisions.

Modigliani-Miller: Recap
In perfect capital markets a firm’s financing decision is irrelevant.
Changing the mix of debt and equity:

• Does not change a firm’s WACC.
• Does not change a firm’s value.
A firm’s value is determined by its investment decisions:

• Firms with poor projects cannot hope to recoup lost value
with good financing decisions.
• Firms with good projects will create value regardless of how
they finance themselves.

The Modigliani-Miller Result
MM does exactly what an economic theory should do:

1 Provide intuitive, but non-obvious, results that follow from
clear assumptions.
2 Provide a benchmark with which to study the real world.
But it is dissatisfying for two reasons:

1 Its assumptions are clearly not satisfied:
• Taxes.
• Asymmetric information.
• Costs of bankruptcy.
• Transaction costs.
2 It says financing decisions don’t matter, when most people
(e.g. practitioners) believe they do.

Frictions and Modigliani-Miller
We will consider 5 departures from Modigliani & Miller’s

assumptions of perfect capital markets:
1 Taxes.
2 Bankruptcy costs.
3 Agency costs: managers and shareholders.
4 Agency costs: bondholders and shareholders.
5 Debt limits.


1 Taxes.
2 Bankruptcy costs.
5 Debt limits.

Capital Structure and Taxes
Corporations pay taxes on their profits after interest payments

are deducted.
→ interest expenses reduce the amount of corporate tax firms pay.
This creates an incentive to use debt.
Consider Macy’s, a retail department store that uses leverage.

Macy’s: tax and leverage
With leverage Without leverage

EBIT $2800 $2800
Interest expense -400 0
Income before tax 2400 2800
Taxes (35%) -840 -980
Net income $1560 $1820
Macy’s Income in 2014 ($mn)
Macy’s net income in 2014 was lower than it would have been
without leverage.

Macy’s: tax and leverage
With leverage Without leverage

Interest paid on debt 400 0
Income available to equity 1560 1820
Total available to all investors $1960 $1820
Macy’s: income for investors ($mn)
The total amount available to all investors increased with

leverage.

The tax shield on debt
Where does this additional $140mn come from?

→ equal to the reduction in taxes with leverage: $980mn -
$840mn = $140mn.
Macy’s does not owe taxes on the $400mn of earnings it used to

make interest payments, providing tax savings of 35%×$400mn =
$140mn.
Tax shield on debt (or interest tax shield).

→ gain to investors from the tax deductibility of interest payments.
Tax shield = Corporate tax rate × Interest payments

The tax shield and cash flows
Each year a firm makes interest payments, the cash flows it pays to
investors will be higher than they would be without leverage by the
amount of the tax shield.

The tax shield and cash flows

WACC & the tax shield
E D
WACC = CoE + pre-tax CoD × (1 − τ )
D+E D+E
E D D
= CoE + pre-tax CoD − τ pre-tax CoD
D
|
+ E D +
{z
E } |
D + E {z }
pre-tax WACC reduction due to tax shield
The tax shield reduces a levered firm’s WACC.

The financing decision with a tax shield

WACC & firm value
T
X Ct
t=1
(1 + WACC )t
The tax shield incentivizes firms to increase leverage, and thus

increase the value of the firm.


1 Taxes.
2 Bankruptcy costs.
5 Debt limits.

Bankruptcy Costs
In perfect capital markets there are no bankruptcy costs.
In reality, bankruptcy involves both direct and indirect costs.

1 Direct costs:
• Legal & admin expenses.
• Delays in paying out.
→ Estimated at 5% of asset values for railroad companies in
the 1970s.
2 Indirect costs:

Bankruptcy Costs
In perfect capital markets there are no bankruptcy costs.
In reality, bankruptcy involves both direct and indirect costs.

1 Direct costs:
• Legal & admin expenses.
• Delays in paying out.
→ Estimated at 5% of asset values for railroad companies in
the 1970s.
2 Indirect costs:
• Customers and staff leaving.
• Stricter terms from prospective creditors.
• Fire sale of assets.

Leverage and Bankruptcy
Bankruptcy occurs when firms fail to repay debts they owe.

→ leverage increases the likelihood of bankruptcy.
Expected costs of bankruptcy are the product of the costs of

bankruptcy and the likelihood of bankruptcy.
Bankruptcy costs → avoid excessive leverage to avoid these

costs.
Note: firms still faced increasing costs of debt as they near default
in Modigliani-Miller.
→ but now defaulting comes with a cost.

Leverage and Bankruptcy
Firms should be less leveraged if the probability or cost of

bankruptcy is high.
Should these type of firms be more or less leveraged than the

typical firm?
1 Firms operating in sectors and/or times where earnings and
cash flows are very stable.
2 Firms where the government is likely to bail them out if they
default.
3 Firms whose assets are hard to sell to other firms/very
bespoke.


1 Taxes.
2 Bankruptcy costs.
5 Debt limits.

Agency costs: managers and shareholders
Managers of a firm may face a conflict of interest vs the

shareholders whose interests they are supposed to represent.
In particular, they may pursue these goals:

1 Empire building.
2 Maximise their own pay.
3 Shirk.
The extent to which they pursue these goals will depend on:
1 Their incentives.
2 Their ability to pursue these goals.

Debt and Discipline
Free cash flows represent cash flows made on operations over

which managers have discretionary spending power, which they can
use to:
1 take on projects;
2 pay to shareholders; and
3 hold as idle cash balances.
Large free cash flows give managers more discretion.

Debt reduces this discretion, as if the firm doesn’t make its
payments it defaults.

Debt and Discipline
The disciplining effects of debt mean firms should be more

leveraged, all else equal.
Is this argument stronger or weaker for the following types of firm?

1 A firm where the manager holds a large proportion of a firm’s
stock?
2 A firm where shareholder oversight of managers’ actions is
very strong?


1 Taxes.
2 Bankruptcy costs.
5 Debt limits.

Agency costs: bondholders & shareholders
Equity investors who receive a residual claim on cash flows tend to

favour actions that increase the value of their holdings, even if
this increases the risk that bondholders don’t get their
money back.
Bondholders just want to ensure they get their money back.
This conflict between debt and equity permeates many decisions a

firm makes, but is particularly stark for firms in financial distress.

Agency costs: bondholders vs shareholders
Consider Baxter, Inc., which is facing financial distress.

• Loan of $1mn due at the end of the year.
• Without a change in its strategy, the market value of its
assets will be only $900k at that time → Baxter will default.
There is a new strategy which requires no initial investment and

has 50% chance of success.
• If it succeeds, it will increase value of firms’ assets to $1.3mn.
• If it fails, it will decrease it to $300k.

Excessive Risk-Taking
Strategy is negative NPV: expected value under new strategy is

$800k<$900k.
But shareholders like the project:

• If they do nothing, they get 0 payoff with certainty.
• If it succeeds, they might get a positive payoff, and still can’t
get a negative payoff in the case of failure.
Shareholders exploit the fact that the downside of the
project will harm bondholders, not them.

Insufficient Investment: Debt Overhang
Instead suppose Baxter is considering an investment opportunity

that requires an initial investment of $100k and will generate a
risk-free return of 50%.
→ if risk-free rate is 5%, clearly a positive-NPV project.
Could Baxter raise $100 in new equity to make the investment?

• Given debt has priority, $100k of the return will go to
bondholders.
• Equityholders would put in $100k, but get back only $50k.
Debt overhang: equityholders don’t invest in a project because

benefits accrue to bondholders, not them.

Shareholders vs bondholders: the bottom line for financing
Conflicts of interest between equity and debt are pervasive.
Bondholders take actions to protect themselves:

1 Covenants.
→ Restrictions on what firms can do, or requirements that
they maintain certain financial ratios, as part of lending
agreement.
2 Higher interests rates.
The more firms borrow, the more these costs will increase.
Upshot: avoid debt to reduce these costs.


1 Taxes.
2 Bankruptcy costs.
5 Debt limits.

Debt limits
One of the consequences of the conflict between shareholders and

bondholders is the introduction of restrictive covenants.
These covenants may limit a firm’s flexibility when making

investment, financing or dividend decisions.
More broadly, debt limits a firm’s flexibility. As a result, firms may

want to limit their borrowing today to retain flexibility to
borrow tomorrow.

We considered 5 deviations from Modigliani & Miller’s assumptions

of perfect capital markets:
1 Taxes.
2 Bankruptcy costs.
5 Debt limits.
Do they lead firms to want more or less leverage?

We considered 5 deviations from Modigliani & Miller’s assumptions

of perfect capital markets:
1 Taxes. ↑ leverage
2 Bankruptcy costs. ↓ leverage
3 Agency costs: managers and shareholders. ↑ leverage
4 Agency costs: bondholders and shareholders. ↓ leverage
5 Debt limits. ↓ leverage
Do they lead firms to want more or less leverage?

Trade-offs in debt and equity
Taken together, these frictions suggest there is a trade-off

between debt and equity.
→ for example, higher leverage has tax benefits but increases
expected bankruptcy costs.
This trade-off suggests for many firms there is an optimal

capital structure, and it likely involves a mix of debt and equity.
→ as the costs and benefits of debt and equity vary, the optimal
mix changes.
Contrary to Modigliani-Miller’s baseline result that capital

structure is irrelevant.

2019 Q1

2019 Q4

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Corporate Finance

Imperial College Business School

Jamie Coen The Financing Decision 1 / 74

• Fixed claim • Residual claim

Debt Hybrid Securities Equity

Jamie Coen The Financing Decision 2 / 74

Various equivalent ways to measure debt vs equity:

Firms with relative more debt are more highly leveraged.

Jamie Coen The Financing Decision 3 / 74

Maximise the Value of the Firm

The Investment Decision The Financing Decision The Dividend Decision

Jamie Coen The Financing Decision 4 / 74

Cost of capital → Valuation

Choice of debt vs equity → cost of capital

Jamie Coen The Financing Decision 5 / 74

1 Capital structure with perfect capital markets.

2 Trade-offs between debt and equity financing.

3 Finding an optimal mix of debt and equity.

Jamie Coen The Financing Decision 6 / 74

We know the cost of equity exceeds the cost of debt, as debt

Jamie Coen The Financing Decision 7 / 74

We know the cost of equity exceeds the cost of debt, as debt

What’s the problem?

Jamie Coen The Financing Decision 7 / 74

The costs of debt and equity are a function of a firm’s financing

As a firm relies more heavily on debt, it becomes riskier, and so the

Two competing effects of increasing leverage:

Jamie Coen The Financing Decision 8 / 74

Jamie Coen The Financing Decision 9 / 74

2 Firms can raise external financing from debt or equity, with no

3 No costs – direct or indirect – associated with bankruptcy.

4 No agency costs: managers maximise stockholder wealth,

5 Investors and firms can trade the same set of securities at

Jamie Coen The Financing Decision 10 / 74

In a world with perfect capital markets, capital structure is

Jamie Coen The Financing Decision 11 / 74

A firm’s assets come with cash flows → these are what

These financing details – e.g. the order in which we get paid –

Jamie Coen The Financing Decision 12 / 74

The interest rate on debt is r .

Assume you are an investor, and you buy

Jamie Coen The Financing Decision 13 / 74

Investor gets cash flow on its investment in Firm A of αX .

Investor gets cash flow on its investment in Firm B of:

α(X − rDB ) + αrDB = αX

Investor receives same cash flow!

Jamie Coen The Financing Decision 14 / 74

Jamie Coen The Financing Decision 15 / 74

WACC isn’t affected by the financing decision either.

Jamie Coen The Financing Decision 15 / 74

Everyone recognizes that’s a joke because obviously the number

Jamie Coen The Financing Decision 16 / 74

2 Leverage and the cost of capital.

Jamie Coen The Financing Decision 17 / 74

2 Leverage and the cost of capital.

Jamie Coen The Financing Decision 18 / 74

Consider an entrepreneur with the following investment

Cashflows depend on economy → investors demand a premium.

Jamie Coen The Financing Decision 19 / 74

Cost of equity is 5 + 10 = 15%.

Expected cashflow in 1yr is 1/2 × $1400 + 1/2 × $900 = $1150.

Jamie Coen The Financing Decision 20 / 74

If project is financed with equity alone (=unlevered equity), how