Corp Fin 3 Cap Structure 2023

Corporate Finance
Jamie Coen
Imperial College Business School
Autumn 2023
Jamie Coen The Financing Decision 1 / 136

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

What’s next?

Finding an optimal mix of debt and equity

From qualitative to quantitative results
Thus far our discussion of capital structure has been conceptual.

1 Understanding Modigliani & Miller’s capital structure
irrelevance result in perfect capital markets.
2 Understanding how markets are imperfect and the
implications of this for capital structure.
Now we want numbers!

1 How leveraged should my firm be?
2 Why does that firm have a debt-to-equity ratio of 2.3 and
another have a ratio of 0.4?

Plan for these lectures
Cost of capital approach.

1 Logic of the approach.
2 Step-by-step procedure.
3 Limitations of approach.
Other procedures.
1 Enhanced cost of capital approach.
2 Adjusted present value approach.
→ Logic and limitations (not step-by-step).
Key reference: Chapter 8 of Damodaran - Applied Corporate

Finance.

The logic of the financing decision
D
A A
E
E
Holding a firm’s assets fixed, how much should the firm rely on
debt vs equity financing?

The financing decision: what to expect
Intuition:
1 A firm with hardly any equity should have a high WACC, as
its levered beta will be high and it will be very close to a
costly bankruptcy.
→ If it decreased leverage it would reduce these costs.
2 A firm with only equity financing might have high costs too.
→ If it increased leverage a little bit it would enjoy the tax
shield on debt without increasing its probability of failing too
much.
Outcome: optimal choice likely includes debt and equity.

→ How much?

Changing capital structure
D D D
D
A A A A
E E
E E
To increase leverage:
1 Issue new debt.
2 Use the proceeds to buy and retire shares.

Cost of Capital Approach

Cost of capital approach: the basics
We want to know how changing leverage changes the cost of equity

and cost of debt, and hence the weighted average cost of capital.
• For equity, we know this: it’s just levering up beta.
• For debt, we need a new approach.
In all this, we keep operating income fixed.

→ to be discussed later.

Estimating the cost of debt: the issue
In a perfect world:
• Observe a firm’s cost of debt for different amounts of leverage.
• Use these observations directly in computing WACC.
In the real world, we don’t observe a firm’s cost of debt for

different amounts of leverage.
→ just its current leverage.

Estimating the cost of debt: approach
1 For each level of leverage compute $ amount of debt firm

would have.
2 Task is to work out cost of this debt.
1 Guess cost of debt → compute interest coverage ratio (ICR).
EBIT
ICR =
interest expense
2 Map from ICR to credit rating to default spread and
associated cost of debt based on data for other firms.
3 Iterate these two steps until they converge.
3 Repeat this procedure for different amounts of leverage to

map out the cost of debt as a function of leverage.

Cost of debt for Disney
We require Disney’s cost of debt as a function of its leverage, as of

November 2013.
Inputs:
• Disney’s EBIT: $10,032mn. Kept fixed.
• Disney’s initial balance sheet:
• Market value of debt: $15,961mn
• Market value of equity: $121,878mn
• Debt+equity = $137,839mn. Kept fixed.
• Risk-free rate is 2.75%.

No leverage
D/(D+E) 0%
$ Debt 0
EBIT 10032
Interest 0
Interest coverage ∞
Likely rating AAA
Pretax cost of debt 3.15%

Interest coverage ratios, ratings and spreads
ICR Rating (S&P/Moody’s) Default spread (%)

>8.5 Aaa/AAA 0.4
6.5-8.5 Aa2/AA 0.7
5.5-6.5 A1/A+ 0.85
4.25-5.5 A2/A 1
3-4.25 A3/A- 1.3
2.5-3 Baa2/BBB 2
2.25-2.5 Ba1/BB+ 3
2-2.25 Ba2/BB 4
1.75-2 B1/B+ 5.5
1.5-1.75 B2/B 6.5
1.25-1.5 B3/B- 7.25
0.8-1.25 Caa/CCC 8.75
0.65-0.8 Ca2/CC 9.5
0.2-0.65 C2/C 10.5
<0.2 D2/D 12

No leverage
D/(D+E) 0%
$ Debt 0
EBIT 10032
Interest 0
Interest coverage ∞
Likely rating AAA

10% debt
D/(D+E) 0% 10%
$ Debt 0 13784
EBIT 10032 10032
Interest 0 3.15%×13784=434
Interest coverage ∞ 23.1
Likely rating AAA AAA
Pretax cost of debt 3.15% 3.15%

10% debt
D/(D+E) 0% 10%
$ Debt 0 13784
EBIT 10032 10032
Interest 0 3.15%×13784=434


>8.5 Aaa/AAA 0.4
6.5-8.5 Aa2/AA 0.7
5.5-6.5 A1/A+ 0.85
4.25-5.5 A2/A 1
3-4.25 A3/A- 1.3
2.5-3 Baa2/BBB 2
2.25-2.5 Ba1/BB+ 3
2-2.25 Ba2/BB 4
1.75-2 B1/B+ 5.5
1.5-1.75 B2/B 6.5
1.25-1.5 B3/B- 7.25
0.8-1.25 Caa/CCC 8.75
0.65-0.8 Ca2/CC 9.5
0.2-0.65 C2/C 10.5
<0.2 D2/D 12

10% debt
D/(D+E) 0% 10%
$ Debt 0 13784
EBIT 10032 10032
Interest 0 3.15%×13784=434

Cost of debt by leverage
D/(D+E) Debt ($) Int exp ($) ICR Rating CoDPT Tax rate CoDAT
0% 0 0 Inf AAA 3.15 36.1 2.01
10% 13784 434 23.1 AAA 3.15 36.1 2.01

0% 0 0 Inf AAA 3.15 36.1 2.01
10% 13784 434 23.1 AAA 3.15 36.1 2.01
20% 27568 868 11.55 AAA 3.15 36.1 2.01

30% debt
D/(D+E) 20% 30%

$ Debt 27568 41352
EBIT 10032 10032
Interest 868 3.15%×41352=1303 3.45%×41352=1303
Interest coverage 11.62
Likely rating AAA

30% debt
D/(D+E) 20% 30%

$ Debt 27568 41352
EBIT 10032 10032
Interest 868 3.15%×41352=1303 3.45%×41352=1303
Interest coverage 11.62 7.7
Likely rating AAA


>8.5 Aaa/AAA 0.4
6.5-8.5 Aa2/AA 0.7
5.5-6.5 A1/A+ 0.85
4.25-5.5 A2/A 1
3-4.25 A3/A- 1.3
2.5-3 Baa2/BBB 2
2.25-2.5 Ba1/BB+ 3
2-2.25 Ba2/BB 4
1.75-2 B1/B+ 5.5
1.5-1.75 B2/B 6.5
1.25-1.5 B3/B- 7.25
0.8-1.25 Caa/CCC 8.75
0.65-0.8 Ca2/CC 9.5
0.2-0.65 C2/C 10.5
<0.2 D2/D 12

30% debt
D/(D+E) 20% 30%

$ Debt 27568 41352
EBIT 10032 10032
Interest 868 3.15%×41352=1303 3.45%×41352=1427
Interest coverage 11.62 7.7
Likely rating AAA AA

30% debt
D/(D+E) 20% 30% 30%

$ Debt 27568 41352 41352
EBIT 10032 10032 10032
Interest 868 3.15%×41352=1303 3.45%×41352=1427
Interest coverage 11.62 7.7 7.03
Likely rating AAA AA


>8.5 Aaa/AAA 0.4
6.5-8.5 Aa2/AA 0.7
5.5-6.5 A1/A+ 0.85
4.25-5.5 A2/A 1
3-4.25 A3/A- 1.3
2.5-3 Baa2/BBB 2
2.25-2.5 Ba1/BB+ 3
2-2.25 Ba2/BB 4
1.75-2 B1/B+ 5.5
1.5-1.75 B2/B 6.5
1.25-1.5 B3/B- 7.25
0.8-1.25 Caa/CCC 8.75
0.65-0.8 Ca2/CC 9.5
0.2-0.65 C2/C 10.5
<0.2 D2/D 12

30% debt
D/(D+E) 20% 30% 30%

$ Debt 27568 41352 41352
EBIT 10032 10032 10032
Interest 868 3.15%×41352=1303 3.45%×41352=1427
Interest coverage 11.62 7.7 7.03
Likely rating AAA AA AA
Pretax cost of debt 3.15% 3.45% 3.45%

0% 0 0 Inf AAA 3.15 36.1 2.01
10% 13784 434 23.1 AAA 3.15 36.1 2.01
20% 27568 868 11.55 AAA 3.15 36.1 2.01
30% 41352 1427 7.03 AA 3.45 36.1 2.2

0% 0 0 Inf AAA 3.15 36.1 2.01
10% 13784 434 23.1 AAA 3.15 36.1 2.01
20% 27568 868 11.55 AAA 3.15 36.1 2.01
30% 41352 1427 7.03 AA 3.45 36.1 2.2
40% 55136 2068 4.85 A 3.75 36.1 2.4
50% 68919 6892 1.46 B- 10 36.1 6.39
60% 82703 9511 1.05 CCC 11.5 36.1 7.35
70% 96487 11096 0.9 CCC 11.5 32.64 7.75

Adjusting the tax rate
At 70% debt interest exceeds Disney’s EBIT of $10,032.
When interest expenses are lower than EBIT, interest expenses are
fully tax-deductible and earn the 36.1% tax benefit.
When EBIT<interest expense, adjust the tax rate:
Max tax benefit = EBIT × Marginal tax rate

= $10, 032 × 0.361
= $3, 622
Adjusted marginal tax rate = Max tax benefit/Interest expense

= 32.64%

0% 0 0 Inf AAA 3.15 36.1 2.01
10% 13784 434 23.1 AAA 3.15 36.1 2.01
20% 27568 868 11.55 AAA 3.15 36.1 2.01
30% 41352 1427 7.03 AA 3.45 36.1 2.2
40% 55136 2068 4.85 A 3.75 36.1 2.4
50% 68919 6892 1.46 B- 10 36.1 6.39
60% 82703 9511 1.05 CCC 11.5 36.1 7.35
70% 96487 11096 0.9 CCC 11.5 32.64 7.75

0% 0 0 Inf AAA 3.15 36.1 2.01
10% 13784 434 23.1 AAA 3.15 36.1 2.01
20% 27568 868 11.55 AAA 3.15 36.1 2.01
30% 41352 1427 7.03 AA 3.45 36.1 2.2
40% 55136 2068 4.85 A 3.75 36.1 2.4
50% 68919 6892 1.46 B- 10 36.1 6.39
60% 82703 9511 1.05 CCC 11.5 36.1 7.35
70% 96487 11096 0.9 CCC 11.5 32.64 7.75
80% 110271 13508 0.74 CC 12.25 26.81 8.97
90% 124055 16437 0.61 C 13.25 22.03 10.33
We have what we need: an estimate of what Disney’s cost of debt

would be for every different choice of leverage.

Estimating the cost of equity
Estimating the cost of equity is easier:

1 We can estimate a firm’s beta for its given choice of leverage.
2 We can then unlever to get its asset (or unlevered) beta.
→ This is independent of its financing choices.
3 We can then lever back up for different amounts of leverage
to see how its beta – and hence its cost of equity – would
change.
Damodaran does this for Disney.

• He includes tax in the levering/unlevering formula.
• He uses the adjusted tax rate where necessary.

Cost of equity by leverage
Debt ratio D/E ratio Beta Cost of equity

0% 0 0.92 8.07%
10% 11% 0.99 8.45%
20% 25% 1.07 8.92%
30% 43% 1.18 9.53%
40% 67% 1.32 10.34%
50% 100% 1.51 11.48%
60% 150% 1.81 13.18%
70% 233% 2.38 16.44%
80% 400% 3.63 23.66%
90% 900% 7.41 45.43%

From costs of debt and equity to WACC
We now have the cost of equity and the cost of debt as a function
of leverage, and can plug these into the usual WACC formula:
D E
WACC = CoDAT + CoE
D+E D+E

WACC by leverage
Debt ratio Cost of equity CoD (after tax) WACC

0% 8.07% 2.01% 8.07%
10% 8.45% 2.01% 7.81%
20% 8.92% 2.01% 7.54%
30% 9.53% 2.20% 7.33%
40% 10.34% 2.40% 7.16%
50% 11.48% 6.39% 8.94%
60% 13.18% 7.35% 9.68%
70% 16.44% 7.75% 10.35%
80% 23.66% 8.97% 11.90%
90% 45.43% 10.33% 13.84%

WACC by leverage

Cost of capital approach: recap
Taking the asset side of the balance sheet as fixed, assess how the
costs of equity and debt vary with leverage.
For equity, just unlever and lever betas.
For debt, use information on relationship between ICR, credit

ratings and defaults spreads.
Pick the amount of leverage at which the WACC is minimised.

→ This is the capital structure that maximises firm value.

Cost of capital approach: evaluation
Quantifies our intuitions:

1 Costs of leverage sharply increase as risk of bankruptcy
increases.
2 U-shape → optimal mix involves both debt and equity.
Quantitative results like this are a useful input into decisions.

1 No: ‘change debt ratio to 40% immediately’.
2 Yes: cost of financing sharply increases after 40%.
→ avoid ending up here!

Cost of capital approach: evaluation
Approach is driven by the data:

1 Lets the data tell us how much debtholders dislike leverage.
2 Captures any market friction that shows up in the cost of debt.
But:
1 ICR lookup table is for a set of firms, not your own.
→ If, for example, the disadvantages of debt are particularly
strong for your firm, this won’t show up!
2 Approach holds operating income fixed.
→ but changing leverage is likely to affect operating income!
3 Algorithm to find cost of debt doesn’t always work...

Alternative approaches
Enhanced cost of capital approach.

→ adjust approach to allow operating income to change with
leverage.
Adjusted present value approach.

→ different approach.

Enhanced Cost of Capital Approach

Enhanced cost of capital approach
Idea: take the cost of capital approach, and amend its key
weakness – that it keeps operating costs fixed when we might
expect them to vary.
This requires 2 things:

1 A new criterion for choosing optimal leverage.
→ If both WACC and operating income decrease, is this good
or bad?
2 A mapping between leverage and operating income.

Idea: take the cost of capital approach, and amend its key

or bad?

WACC and enterprise value
A firm’s enterprise value measures the value of its operating
assets:
expected cash flow to firm (next year)

enterprise value (EV) =
WACC − g
where g is the growth rate in cash flow to the firm.
→ Formula and terms to be discussed more in coming weeks.
Approach:
1 Compute EV, cash flow to firm, and WACC based on current
firm data, then use this to infer growth rate g.
2 Then plug in different levels of WACC to get how enterprise
value changes with leverage choice.

Damodaran estimates:
• WACC 7.81%.
• EV $133,908.
• Free cash flow to the firm $3657.
→ Operating income, with adjustments to be detailed later in
course.
FCFF0 (1 + g)
EV =
WACC − g
WACC × EV − FCFF0
→g =
EV + FCFF0
= 4.94%

FCFF0 (1 + g)
EV =
WACC − g
Now we know FCFF0 and g, and can see how EV changes when
we plug in different values of WACC.
At optimum, cost of capital was 7.16%, which gives an EV of

$172935mn.
→ as we can see, reducing WACC increases a firm’s value.

Back to the enhanced approach
FCFF0 (1 + g)
EV =
WACC − g
In enhanced approach increasing leverage can reduce WACC and
the free cash flows to the firm.
→ We change our goal to maximising enterprise value directly.

The idea: take the cost of capital approach, and amend its key

or bad?

Leverage and operating income
Much like we map from changes in credit rating to changes in the
cost of debt, we can map from changes in credit rating to
declines in operating income.
→ e.g. if rating falls from A to C then operating income falls by
25%.
Damodaran Chapter 8 gives details on this, which aren’t part of

this course. But note:
• Involves all the same drawbacks of approach for cost of debt.
• Change in operating income is an input into:
1 Enterprise value.
2 Computation of ICR when computing cost of debt.
Damodaran finds Disney’s optimal capital structure is the same as

in the basic approach: 40%.

Adjusted Present Value Approach

APV approach: summary
1 Assume:
• Primary benefit of borrowing is a tax benefit.
• Primary cost is added risk of bankruptcy.
2 Estimate the value of the firm with no leverage.
3 Estimate present value of interest tax savings generated by
borrowing a given amount of money.
4 Evaluate the impact of borrowing on probability a firm goes
bankrupt and the expected cost of bankruptcy.

Present value of tax benefits from debt
View tax savings as a perpetuity, and discount at the cost of debt

to reflect the riskiness of these cashflows:
τ × CoD × D τ × CoD × D
PV(tax benefits) = + + ...
1 + CoD (1 + CoD)2
τ ×CoD×D
1+CoD
= 1
1 − 1+CoD
=τ ×D

Present value of expected bankruptcy cost
PV(expected bankruptcy cost) = P(bankruptcy)

×PV of bankruptcy cost
Each of these terms needs estimating:

1 P(bankruptcy) from statistical analyses, or by reference to
credit rating.
2 PV of bankruptcy cost based on (speculative) studies.
Damodaran Chapter 8 gives details on estimation, which aren’t

part of course. But:
1 The cost estimates are very uncertain.
2 Hard to account for specific firm attributes.

APV approach: details
With estimates for tax benefits and bankruptcy costs, we:
1 Compute value of unlevered firm:
Value of unlevered firm = Current firm value

− current PV of tax benefits
+ current expected bankruptcy costs


2 Then for each level of debt we compute the PV of tax benefits

and expected bankruptcy costs, and get:


2 Then for each level of debt we compute the PV of tax benefits

and expected bankruptcy costs, and get:
Firm value = Value of unlevered firm
+ PV of tax benefits
− expected bankruptcy costs
3 We then pick the level of debt that maximises firm value.

→ Damodaran finds it’s still 40% for Disney.
Cost of capital vs adjusted present value
APV approach gives more flexibility in considering bankruptcy

costs.
→ you choose what they are for your firm.
→ if you understate bankruptcy costs, will you be under- or
over-leveraged?
APV considers tax benefit from a $ debt value, whilst CoC

approach considers a fixed debt-to-capital ratio.
→ which one is better depends on what your firm targets.

Bottom line
Quantitative estimates of optimal leverage are useful input into

decisions.
• A specific target to aim for.
• Shed light on capital structures that lead to high financing
costs.
• But recognise that numbers are uncertain and subject to
change.
Both APV and CoC approach have merits.

→ Consider using together, alongside peer comparisons.

Financing Decision: Summing Up

Summing Up
Perfect capital markets

1 Modigliani & Miller’s assumptions, logic and result.
1 Cash flows on investments determine firm value.
2 Financing decision just slices pizza up differently.
3 CoE and CoD adjust with leverage such that WACC is
constant.
3 Usefulness and insight of the model.

Summing up
Imperfect capital markets

1 Market frictions: their sources and their implications for
financing decisions.
2 How these frictions will vary across firms.
3 Market frictions as the logic of the financing decision.

Summing up
Finding an optimal mix

1 Cost of capital approach:
1 Logic.
2 Step-by-step approach.
3 Evaluation.
2 Enhanced cost of capital approach and adjusted present value
approach.
1 Logic.
2 Evaluation.
3 Strengths and weaknesses of each approach.

Review questions
Discuss the trade-offs of leverage for start-ups as opposed to

established firms.
1 Taxes.
2 Bankruptcy costs.
5 Debt limits.
2019 Question 11.

Corp Fin 3 Cap Structure 2023

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Corporate Finance

Imperial College Business School

Jamie Coen The Financing Decision 1 / 136

• Fixed claim • Residual claim

Debt Hybrid Securities Equity

Jamie Coen The Financing Decision 2 / 136

Various equivalent ways to measure debt vs equity:

Firms with relative more debt are more highly leveraged.

Jamie Coen The Financing Decision 3 / 136

Maximise the Value of the Firm

The Investment Decision The Financing Decision The Dividend Decision

Jamie Coen The Financing Decision 4 / 136

Cost of capital → Valuation

Choice of debt vs equity → cost of capital

Jamie Coen The Financing Decision 5 / 136

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 / 136

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

Jamie Coen The Financing Decision 7 / 136

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

What’s the problem?

Jamie Coen The Financing Decision 7 / 136

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 / 136

Jamie Coen The Financing Decision 9 / 136

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 / 136

In a world with perfect capital markets, capital structure is

Jamie Coen The Financing Decision 11 / 136

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 / 136

The interest rate on debt is r .

Assume you are an investor, and you buy

Jamie Coen The Financing Decision 13 / 136

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 / 136

Jamie Coen The Financing Decision 15 / 136

WACC isn’t affected by the financing decision either.

Jamie Coen The Financing Decision 15 / 136

Everyone recognizes that’s a joke because obviously the number

Jamie Coen The Financing Decision 16 / 136

2 Leverage and the cost of capital.

Jamie Coen The Financing Decision 17 / 136

2 Leverage and the cost of capital.

Jamie Coen The Financing Decision 18 / 136

Consider an entrepreneur with the following investment

Cashflows depend on economy → investors demand a premium.

Jamie Coen The Financing Decision 19 / 136

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 / 136

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