Capital Structure Theory

Prof. Jayanth R. Varma

Indian Institute of Management, Ahmedabad

©Prof. Jayanth R. Varma Indian Institute of Management, Ahmedabad 1/15

WACC and Capital Structure

Weighted Average Cost of Capital requires weights of Debt and

Equity.
How do companies choose a target capital structure?
What is the optimum capital structure?
Is debt is cheaper than equity?
• The more debt the better?

©Prof. Jayanth R. Varma Indian Institute of Management, Ahmedabad 2/15

Milkman model

Small amount of debt in capital structure (water in milk) is not

noticed and therefore does not impact cost of equity.
That cannot be true in an efficient capital market?

©Prof. Jayanth R. Varma Indian Institute of Management, Ahmedabad 3/15

What happens in perfect capital markets

Modigliani and Miller (MM) analysed capital structure under perfect

capital markets.
Initially assume that there are no taxes. We will bring taxes later.
Consider two firms (unlevered and levered) with identical business and
therefore the same EBIT of 20000
Shareholders of the unlevered firm demand a return of 𝑟𝐴 = 20%
The levered firm borrows at an interest rate of 𝑟𝐷 = 10%
Both firms payout 100% and so there is no growth (all cash flows are
simple perpetuities).

©Prof. Jayanth R. Varma Indian Institute of Management, Ahmedabad 4/15

Cash flows without taxes

Unlevered Levered
EBIT 20000 20000
Debt 0 50000
Interest 0 5000
PBT 20000 15000
Tax 0 0
PAT 20000 15000
Dividend 20000 15000
Dividend+Interest 20000 20000

What happens if an investor owns 1% of the debt and 1% of the

equity of the company?

©Prof. Jayanth R. Varma Indian Institute of Management, Ahmedabad 5/15

Home made leverage

Previous example, the investor undid the leverage created by the firm
and unlevered her portfolio by buying some of the debt issued by the
firm.
The opposite is also possible — this is the idea of home made
leverage.
• If the firm borrows too little, the investor can borrow and invest more
in stocks.
• This is similar to the CAPM framework where the investor can move up
and down the Capital Market Line (CML) depending on the degree of
risk tolerance.
As long as this is possible, the investor does not care about the firm’s
leverage policy.

©Prof. Jayanth R. Varma Indian Institute of Management, Ahmedabad 6/15

Capital structure & market imperfections

MM analysis tells us that capital structure is irrelevant in the absence

of taxes and other market imperfections.
Capital structure choices are driven by market imperfections.

©Prof. Jayanth R. Varma Indian Institute of Management, Ahmedabad 7/15

MM with Taxes

Suppose that the corporate tax rate is 30%

Interest is tax deductible

Unlevered Levered
EBIT 20000 20000
Debt 0 50000
Interest 0 5000
PBT 20000 15000
Tax 6000 4500
PAT 14000 10500
Dividend 14000 10500
Dividend+Interest 14000 15500

Extra cash flow (Dividend + Interest) of 1500 is the interest tax

shield (ITS).

©Prof. Jayanth R. Varma Indian Institute of Management, Ahmedabad 8/15

Present value of ITS

What is the present value of this interest tax shield of 1500?

What discount rate?
• 𝑟𝐷 = 10%
• 𝑟𝐴 = 20%

Amount
VU 70000
ITS 1500
PV ITS @ rD 15000
PV ITS @ rA 7500
VL MM 85000
VL Modern 77500

©Prof. Jayanth R. Varma Indian Institute of Management, Ahmedabad 9/15

Unlimited Leverage?

The simple logic of tax shields would lead to 100% debt being the
optimal capital structure.
Are there other capital market imperfections that prevent very high
levels of debt?

©Prof. Jayanth R. Varma Indian Institute of Management, Ahmedabad 10/15

Bankruptcy and its Costs

High leverage increases the probability of bankruptcy which is costly.

Components of bankruptcy costs include:
1. Lawyers, accountants fees and other direct expenses
2. Destruction of intangible assets (brands, unpatented technology,
incomplete R&D etc.)
3. Customer attrition
4. Destruction of PVGO due to financial distress and loss of financial
flexibility
Bankruptcy costs can be extended to the notion of distress costs and
loss of financial flexibility.

©Prof. Jayanth R. Varma Indian Institute of Management, Ahmedabad 11/15

Bankruptcy Costs and Optimal Capital Structure

Bankruptcy costs rise with increasing leverage

PV of interest tax shield declines in value because of increasing
likelihood that the tax shield will not be earned because the interest is
not paid or that the profits are inadequate to absorb the tax shield.

©Prof. Jayanth R. Varma Indian Institute of Management, Ahmedabad 12/15

Tradeoff Theory
0.8

0.6
VL−VU

0.4

0.2

0.0
0.0 0.2 0.4 0.6 0.8
Leverage

Full.ITS Partial.ITS Partial.ITS.and.Bankruptcy Bankruptcy.Costs

©Prof. Jayanth R. Varma Indian Institute of Management, Ahmedabad 13/15

Leverage and Nature of Industry

Leverage tends to be low when assets are intangible and growth

opportunities are large.
Conversely, high leverage is observed in mature business with assets
that are tangible and fungible.
Optimal capital structure is a function of
• The industry
• The company’s business strategy
• The risk appetite of its managers
Capital structure varies widely from firm to firm even in the same
industry.

©Prof. Jayanth R. Varma Indian Institute of Management, Ahmedabad 14/15

Other Imperfections

Capital structure is driven by various other imperfections also in

addition to taxes (both corporate and personal) and bankruptcy and
distress costs:
• Information asymmetry
• Agency costs
Pecking order theory
• Retained earnings
• Debt
• External equity capital

©Prof. Jayanth R. Varma Indian Institute of Management, Ahmedabad 15/15