Capital Structure

Dr. Dustin R. Schütte

MSc. Finance 2020-2021 1

What are the key take-aways from session 1?

Time Value of Money: lessons learned

• Concept of costly intertemporal consumption shifts can be directly translated into the
„finance world“ via intertemporal cash flow shifts, at the price of the interest rate

• Compound interest (i.e. paying interest on interest) is fundamental to creating a

continuous relationship between present values and future values to allow for
compounding and discounting

• Net present value calculations are the most common, flexible, and detailed (esp. when
used for proper financial modelling) method to value cash flows. NPVs are additive, hence
method can be applied for any valuation, even for complete firms

• Positive NPVs identify (financial) value creating investments. Negative NPV projects
should be rejected. In reality, firms, however, may invest in negative NPV projects, e.g. for
reputational or regulatory reasons

• Payback method can be used to complement NPVs when break-even timing is key
• Internal rate of return (RR) is the discount factor that sets the NPV to zero and
constitutes the investment’s “compound” return rate. It is a common alternative to quantify
investment returns, i.e. qualify investment opportunities
2
 What are the key buildings blocks along
the way of evaluating a firm?

Discussion of valuation
3 concepts and ingredients

Adding the • FCFF

corporate • The concept of risk
• Risk free rates
context
• Capital Asset Pricing Model
2 Capital Structure • Factor Models (Fama-French)

• Concepts, differentiation,
costs and benefits of equity
and debt
• Agency theory
1 Basics • Asymmetric information
theory Application to
• Time value of money valuation
• Mechanics of discounting context
• Simple interest versus
compound interest
• Net present value calculations
• IRR and payback method

3
CONTENTS SESSION 2 – CAPITAL STRUCTURE

1. Defining and differentiating equity and debt

2. Trade-off between equity and debt: benefits of debt
3. Trade-off between equity and debt: costs of debt
4. Financial distress at play: a numerical example
5. Agency costs at play: a numerical example
6. Costs of capital of firms with equity and debt: the WACC
7. Modigliani & Miller theorem

4
1.
Defining and differentiating
equity and debt

5
What are the two basic sources of funds that a firm
can use for financing?

Equity and debt and the two key sources of financing

Definition: Capital structure refers to the way a firm’s operations, i.e. operating assets are
financed. There are two sources of financing:

1. Equity: Offers a residual claim on the cash flows (i.e., investors can get what is left over
after the interest payments have been made) and comes with a much greater role in the
operation of the business (e.g. management / control)

2. Debt: Raises funds from investors or financial institutions by promising investors a

prioritized, fixed claim (interest payments) on the cash flows generated by the assets,
with a limited or no role in the day-to-day operations of the business

Every business, no matter how large and complex, is ultimately funded with a mix of borrowed
money (debt) and owner’s funds (equity)
− Small firms: debt is more likely to be bank loans and an owner’s savings represent equity
− Large / publicly traded firm: debt may take the form of bonds and equity is usually
common stock

6
What key characteristics differentiate equity from
debt?

Debt first: the equity claim is residual to the debt claim

Debt claim Equity claim

• Static CF: Entitles to contractual set of
fixed cash flows, i.e. interest and principal
payments
• Priority: Debt comes first; periodical cash
flows and liquidation cash flows are paid
out first to debt holders
• Dynamic CF: Entitles to any residual (hence
volatile) cash flows after meeting all other
promised claims
• Priority: Equity comes second; if no money
is left for equity holders after satisfying fixed
claims, then there’s no pay day

• Tax: interest payments are usually tax • Tax: equity flows (e.g. dividend payments)
deductible → creates tax-savings made from after-tax cash flows

• Maturity: debt usually has a fixed maturity • Maturity: equity is perpetual, i.e. equity has
date, at which point the principal is due an infinite lifetime (unless the firm defaults)
• Control: debt investors have a passive role • Control: equity investors control / manage
in the firm the firm’s operations

7
Is it debt or equity? In-class
discussion

Identify the following security

Mr. Tommy Chong, the CEO of Taft C. Industries, comes back from a meeting with the
firms‘ financiers. A new form of financing is offered to the firm with the following
characteristics:
• Fixed monthly payments that are tax deductible
• Infinite lifetime
• Claims on chash flows throughout the operation
• Claims on the liquiditation volume in case of bankruptcy
• All claims are residual to debt holders‘ claims (including unsecured debt)

You are the CFO of the company and are asked to classify the security. In your opinion:
• It is debt
• It is equity
• It is a hybrid security

8
 How does the equity financing of a firm
evolve over time?

The source of equity is evolving as the firm is growing…

• Owner‘s equity: funds, brought in by the owners of the company to kick off the
business, providing the basis for growth
• Venture Capital / Private Equity:
− As small businesses succeed and grow, they typically run into a funding
constraint, where the funds that they have access to are insufficient to cover their
investment and growth needs
− Venture Capital / PE firms provide equity financing to small and often risky
Firm growth

businesses in exchange for a share of the firm

− Seed money: funds provided to test a concept / develop new product
− Start-up capital: funds provided to grow / expand / market already established products
• Common stock: funds brought in via selling part of the company in the financial
markets
− Company not listed yet: stock price does not yet exist → price is estimated by
the issuing entity (e.g. an investment bank) and is called the offering price →

Session 4
Initial public offering
− Listed company: existing publicly traded company, the price at which additional
equity is issued is usually based on the current market price
9
How does the debt financing of a firm evolve over
time?

… and so is the form of debt

• Bank debt: primary source of borrowed money for all private firms and many publicly traded
firms, with the interest rates on the debt based on the perceived risk of the borrower
− Used for borrowing relatively small amounts of money
− One investor: if company is neither well-known nor widely-followed, bank debt provides a
convenient mechanism to convey information to the lender that will help in both pricing
and evaluating the loan; i.e. borrower can provide internal information about projects and
the firm to the lending bank → how would that look like for a bond issuance?
− No rating required
− Flexibility: banks can offer unanticipated / seasonal financing needs, i.e. “line of credit”
which can be drawn only if financing is needed → no / few interest costs if not needed

• Bonds
− Can be used for large amounts of funds that need to be raised (scalability)
− Usually have more favorable financing terms than equivalent bank debt, largely
because risk is shared by a larger number of financial market investors

10
A closer look between equity and debt: what are
hybrid securities?

Hybrid securities have features of equity and debt at the same time

• Preferred stock – debt-like features:

− (Mostly) Fixed flow: Pays a fixed dollar dividend; BUT: if the firm does not have the cash
to pay the dividend, it is accumulated and paid in a period when there are sufficient
earnings → Cannot cause default
− Limited control: Preferred stockholders do not have a share of control in the firm, and
their voting privileges are strictly restricted to issues that might affect their claims on the
firm’s cash flows or assets

• Preferred stock – equity-like features:

− Tax: Payments to preferred stockholders are not tax deductible
− Priority: Payments come out of after-tax cash → In the case of bankruptcy, preferred
stockholders must wait until the debt holders’ claims have been met before receiving any
portion of the assets of the firm
− Maturity: No maturity date when the face value is due

• Question / problem: When calculating the debt of a firm (e.g. for WACC calculations), do
you categorize preferred stock as equity or debt?
11
A closer look between equity and debt: what are
hybrid securities?

Hybrid securities have features of equity and debt at the same time

• Convertible bond: bond that can be converted into a predetermined number of shares, at
the discretion of the bondholder
− Conversion ratio measures the number of stocks for which each bond may be exchanged
(e.g. 50 shares for 1 bond)
− Market conversion value is the value of the bond if converted at the current market stock
price (e.g. 50 shares * 25 USD per share = 1,250 USD)
− Conversion premium is the difference between current value of the bond and the market
conversion value (e.g. bond is trading at 1,300 USD → 1,300 USD – 1,250 USD = 50 USD)
− Conversion becomes a more attractive option as stock prices increase (i.e. stock options
move “in the money”)

• Convertible bond is valued as the combination of a straight bond and a fixed number of
corresponding equity options

12
 Reality
What are CoCos? Why were they invented?
Check

Contingent convertible as the new “fix” for the financial industry

• Contingent Convertibles (CoCo)

are bonds converting into equity
if a certain condition is met
• For banking, bonds are
contingent on TLAC-ratio (Total
Loss Absorbing Capacity Ratio)
and will convert into equity if
book value of TLAC decreases
and breaches a certain thresholds

• Question / problem: How to

value CoCos? Where is the
biggest problem?

13
Internal vs external funding: what’s the trade-off?

Internal funding is the first funding of choice for most businesses

• Reasons for internal funding:

− External financing is not easy to raise for private firms; if available usually comes at a
high price in terms of (partial) loss of control and funding costs
− PE funding usually involves giving up large amounts of firm control
− VC funding usually involves yielding large amounts of firm ownership
− High costs: Publicly-traded firms may have better access to external financing (SEO, Bonds
issuance) but issuing costs are expensive, especially for equity
→ Question / problem: Why are equity-issuance costs so much higher than debt-
issuance costs?

• Limits to internal funding:

− Internal funding may not suffice for all valuable projects → can result in project delays etc.
− Investors demand the same return on internal equity (i.e. retained earnings) and external
equity (i.e. new stock adjusted for transaction / issuance costs)
→ Question / problem: What is the impact of poor management performance on
equity investors’ thirst towards existing internal funding?
14
 Reality
How did firms historically raise their funds?
Check

Financing Mix: US firms 1975-2012

Black Monday: Lehman Fail, Sep

Oct 19th, 1987 16th, 2008

Question /
problem:
What makes
the two crises
so different?
Why are equity
issuances more
heavily
affected in
2008?

Internal financing External financing: Equity External financing: Debt

15
Source:Applied Corporate Finance; Damodaran
2.
Trade-off between equity
and debt: benefits of debt

16
The trade-off of debt: Why use debt instead of
equity?

The benefits of debt: Disciplining factor for the management

• Added discipline imposed on the management:

− Free Cash Flows = cash flows from operations that can be used by managers for
projects, equity paid outs (dividends or buy backs), or idle cash balances (“buffers”)
− Substantial free cash flows + no or low debt (i.e. no upcoming, recurring interest
payments) → management has strong cash cushion against mistakes → no incentive
to be efficient in either project choice or project management
− Borrowing creates the commitment to make interest and principal payments,
increasing the risk of default on projects with substandard returns
− Stockholders can involve banks in the oversight process

Disciplining argument assumes a conflict of interest between management and

stockholders → Optimal level of debt may be lower for managers than for
stockholders?

17
The trade-off of debt: Why use debt instead of In-class
equity? discussion

The benefits of debt: Disciplining factor for the management

Assume that you buy into the argument that debt adds discipline to
management

Which of the following types of companies will most benefit from adding debt
to induce this discipline?

• Conservatively financed, privately owned businesses

• Conservatively financed, publicly traded companies with a wide and diverse
stock holding
• Conservatively financed, publicly traded companies, with an activist and
primarily institutional holding

Note: By “conservatively financed,” we mean primarily with equity. Explain your

answer.
18
The trade-off of debt: Why use debt instead of
Exercise
equity?

The benefits of debt: The creation of a tax-shield

• Tax benefit:
− In most western countries, interest paid on debt is tax deductible
− Dividends are paid from after-tax cash flows
− Tax benefits increase with rising tax rates

→ Taxes create a “tax shield” via deductible interest rates → Tax shield can be quantified

Example 1: all equity-financed firm Example 2: leveraged firm

• Consider the firm Madden UNL • Consider the firm Madden LEV:
− all-equity-financed • Same as all equity financed firm, but let the
− assets of £1 million firm issue debt to finance a £500,000
− expected annual EBIT of £200,000 repurchase of equity
− Corp tax rate = 35% • Interest rate = 6%

Question / problem: What are the payoffs for equity holders and debt holders before and after the
capital restructuring (assume debt principal is not paid)?
19
The trade-off of debt: Why use debt instead of
Exercise
equity?

A closer look at taxes – Example to quantify the tax shield

Income Madden UNL (Unlevered Madden LEV (Levered

Statement Firm) Firm)
EBIT 200.000 200.000
Interest 0 30.000
EBT (Income) 200.000 170.000
Tax (35%) 70.000 59.500
Net Income for all investors 130.000 110.500 + 30.000 = 140.500

Debt provides a Tax Shield of 0.35*30,000 = 10,500

20
The trade-off of debt: Why use debt instead of
equity?

Generalizing the tax shield

• When a firm generates earnings X:

• First, it pays the interest on its debt i.
• Then it pays taxes on the rest at tax rate TC.
• The total after tax cashflow (value) generated by a firm is:

(1- TC)(X-i) + i

to shareholders to debtholders

• This can be rewritten as:

(1- TC)X + TC *i

all equity firm tax shield

Question / problem: If the tax shield has a positive value, why not using 100% debt
financing to maximize the tax shield?
21
3.
Trade-off between equity
and debt: costs of debt

22
The trade-off of debt: Why NOT use debt instead of
equity? → What are we talking about semantically?

The costs of debt: Legal definitions

• Economic distress:
− The business is not doing well → often difficult to distinguish at what point
exactly economic distress can be determined for a business

• Financial distress:
− Insufficient cash and liquid assets to meet current debt payments
− Violation of debt covenants

• Insolvency:
− Face value of liabilities exceeds market value of assets → firms in financial distress
may or may not be insolvent

• Bankruptcy:
− Firms in insolvency can go bankrupt (US: Filing Chapter 7) → Legal process of
winding down a firm, i.e. entering and conducting the liquidation process

23
The trade-off of debt: Why NOT use debt instead of
equity?

The costs of debt: 1. Debt increases bankruptcy costs

Bankruptcy costs = Probability of bankruptcy * (Direct costs + Indirect costs)

• Probability of bankruptcy: decreases in the size of operating cash flows (larger

cash flows reduce likelihood of default) and increases in the op. cash flow
volatility
− (Increased) borrowing leads to increased probability of bankruptcy

• Direct bankruptcy costs:

− Direct cash outflows incurred by the firm at the time of bankruptcy
− Legal and administrative costs of winding down the business (e.g. costs of
business liquidation) → also includes present value effects of cash flow delays
for creditors
− Magnitude of costs depend on business complexity and volume → Costs are
estimated from 1.8% to 5% of firms’ pre-bankruptcy value (see e.g. Senbet and
Wang, 2012)
24
The trade-off of debt: Why NOT use debt instead of Reality
equity? Check

The costs of debt: 1. Debt increases bankruptcy costs

• Lehman collapsed in Sep 2008

• About 140’000 claims were made

against Lehman

• 10 years later, the claims yet remain

unresolved, liquidation process still
ongoing:
− Extremely complicated balance
sheet
− Intricate assets, millions of
pages of contracts / covenants
− Complicated legal situation
(complex financial laws, mix of
jurisdictions)
− Etc.
25
The trade-off of debt: Why NOT use debt instead of
equity?

The costs of debt: 1. Debt increases bankruptcy costs

• Indirect bankruptcy costs

− Costs that arise prior to the actual bankruptcy filing via market
perception that a firm is in financial distress*
o Customers: Increased difficulty to sell products to clients, esp. with long-
term / future goods such as cars (need parts, servicing), airline ticket
(miles programs, conduct of flight) etc.
o Operational suppliers: Stricter terms from suppliers to self-protect from
client default → increased working capital requirements; liquidity drains
o Financial suppliers: Difficulty to raise new capital for projects → higher
capital rationing constraints → rejection of projects (see debt overhang
problem)
− Magnitude of indirect costs are difficult to estimate and largely depend on
the product that the firm is providing

* Hence bankruptcy costs and costs of financial distress difficult to distinguish prior to insolvency; treated semantically equal in this course 26
The trade-off of debt: Why NOT use debt instead of In-class
equity? discussion

Indirect costs largely depend on product characteristics

For the following product characteristics, specify a potential product and

explain the mechanism why the associated indirect costs of bankruptcy could be
high.

• Durable products with a long expected-lifetime

• Products or services for which quality is important but dififcult to determine
in advance
• Products that (independent of lifetime) require continuous servicing and
support from the manufacturer

Explain your answers.

27
The trade-off of debt: Why NOT use debt instead of In-class
equity? discussion

Holistic bankruptcy costs depend on the firm and product characteristics

Rank the following companies on the magnitude of total bankruptcy costs

from most to least, taking into account both direct and indirect costs of
bankruptcy:

• A grocery store
• An airplane manufacturer
• High-technology company

Explain your answers.

28
For bankruptcy costs to materialize, a firm needs to go
bankrupt → What characterizes a “leverageable” firm?

Health-degree of leverage depends on firm’s cash flow characteristics

• Implications of overall bankruptcy costs on capital structure decisions

− More volatile cash flows → lower borrowing rate
− More volatile cash flows but ability to link debt cash flows to operating cash
flows → firm can borrow more
− External entity (e.g. government) provides bail-out opportunity → firm can
borrow more
− Illiquid, immobile, not easily divisible and marketable assets → firm can
borrow less (higher direct bankruptcy costs, due to long bankruptcy process
→ delaying liquidation cash flows)
− Firms heavily depending on customer trust (e.g. products that require long-
term servicing and support) → lower borrowing rate

29
What are the options to reduce financial distress?

Correct remediation of financial distress depends on the firm situation

• Asset sales (“rightsizing the balance sheet”):

− Sell assets to meet obligations → Potential sell and lease back
− Does not work for insolvency / bankruptcy (careful: financial distress
does not equal insolvency)

• Merging with another firm: New firm takes over your obligations

• Issue New Securities. But:

− Debt may not be an option
− Would equity holders be willing to contribute funds?

• Work it out: Private renegotiations with creditors. Types of arrangements:

− Extend debt maturity
− Forgive part of the loan
− Debt for equity swaps
30
The trade-off of debt: Why NOT use debt instead of
equity?

The costs of debt: 2. Debt creates agency costs

Equity investor: Debt investor:

− Receives residual claim − Receives fixed claim
− → Reasonable to favour more risky
Conflict! − → Reasonable to make sure that firm
investments because of unlimited upside survives to pay fixed claim

Mechanisms how conflict can materialize ( = “Risk Shifting” from Equity to Debt holders)

Subsequent financing Riskier projects Equity “cash out”

− Equity holders may want to
finance new project by increasing
debt, e.g. introducing more senior
debt or collateralization
− Makes existing debt more risky at
cost of current debt holders
− Equity holders may choose
riskier projects than initially
priced by debt holders
− Price of current debt will
decrease to reflect new / higher
firm risk
− If large cash reserves are used to
pay equity investors (e.g.
dividends), default risk for debt
holders increase
− Also: in stress situations, equity
holders prone to “cash out”

Real costs imposed as a result

• Expectations of conflict realizations can be built into bond prices, increasing interest rates
• Debt holders try to protect via restrictive covenants → equity holders need to monitor covenants + may become
restricted for future financing / project choices via covenants

31
 The trade-off of debt: Why NOT use debt instead of
equity?

The costs of debt: 2. Debt creates agency costs → For which firms?

• Firms with investments that cannot be easily monitored or

Capital structure
observed, i.e. high asymmetric information → higher agency
conclusion:
costs
− Real estate → can “visit” the apartment / house, understand Higher agency costs →
quality etc. tendency for lower debt
− Consulting business → how to do due-diligence in people ratios, applicable for:
business? • Firms with increased
− Tech business → intangible assets, e.g. debt holders would need (high intensity or long
to fully understand the technology, programming code, etc. period) need for
− Banking → why did Lehman crash “suddenly” if everyone management
understood the B/S risks? monitoring
• Firms with low
investments in
• Firms with projects that are long term, follow unpredictable
observable real assets
paths, and may take years to pay off → higher agency costs (manufacturing
− Pharmaceutical companies → year-long research companies, railroad
projects, often unsecure outcome (e.g. AIDS / cancer / companies etc.)
general vaccine research)
32
 What are the asymmetric risk profiles of equity and
debt investors?
Occasionally, equity investors have an incentive to increase risk
All-equity financed firm
Pay off
Income
• All available income is paid off to
equity holders
• Income and pay off have linear
relationship, since no other
claimholders need to be serviced
Levered firm
2 1. Debt holders claims are
Debt holders
serviced first
Pay off to
1 2. They receive all available
income until all pending debt
obligations have been met
Income
3. Equity holders have a residual
claim and are paid off only
when all pending debt
Equity holders obligations are met
Pay off to
4 4. From then on, equity holders
have an unlimited upside
3 potential
Income
• In situations of financial distress (1,3) where not all debt obligations
can be serviced, equity holders have no down-side risk but unlimited
up-side potential, while debt holders have limited up-side and down-
side potential → Financial distress can motivate equity holders to
make overly risky investment decisions
33
The trade-off of debt: Why NOT use debt instead of
equity?

The costs of debt: 3. Levering up to capacity → loss of financial flexibility

• Firms like financial flexibility

− As great projects can arise very spontaneously, so do financing needs → ad-hoc
financing best met with debt (Question / problem: Why?)
− Financial flexibility allows management with more room to breathe and make
stronger steps forward without super tight monitoring by debt holders

• Borrowing to capacity eliminates financial flexibility

− Debt holders may not want to finance due to increased default risk
− Equity holders may not want to increase debt due to shift in risk → see Example
below

34
The trade-off of debt: Why use or not use debt
instead of equity? Putting it together

Summary of the debt decision

Advantages of debt Disadvantages of debt

Tax benefit: higher taxes → higher Bankruptcy costs: Higher business risk
benefits and bankruptcy costs → higher costs
Added discipline: If increased separation Agency cost: If increased separation
between managers and equity holders between debt holders and equity
→ larger benefit holders → higher costs
Loss of future financing flexibility: If
increased uncertainty about future
financing needs → increased costs

35
4.
Financial distress at play:
numerical examples

36
Financial Distress and Restructuring

Setting the scene: investment opportunity and debt financing

Following Setting:
• The firm Stratton O. Inc has an investment opportunity that maps out into
three equally likely payoff scenarios next year:
− Good state: Payoff = $100m
− Medium state: Payoff = $30m
− Bad state: Payoff = $5m

• The firm is financed via equity and debt. Debt holders demand a payback of
$35m next year (i.e. debt is maturing with a face value of $35m)
• Stratton O. Inc has a 1-year discount rate of 10% (Simplification: Discount
rate is applicable to all CF)

Please calculate:
• What are the expected payoffs to equity and debt holders in one year?
• What is the expected value of equity and debt today?
37
Is the firm in financial distress? How does that show?

Status Quo: Firm is in financial distress

Valuation today (@10% discount rate):

− Equity: ( 1/3 × 65 + 1/3 × 0 + 1/3 × 0 ) / 1.10 = $19.7m.
− Debt: ( 1/3 × 35 + 1/3 × 30 + 1/3 × 5 ) / 1.10 = $21.2m.

State Proba. Assets Creditors Shareholders

Good 1/3 100 35 65
Medium 1/3 30 30 0
Bad 1/3 5 5 0
Value 21.2 19.7

Firm is in financial distress as in two scenarios, debt holders will not be

paid in full amount → present value of debt is smaller than $31.81m
38
Will equity investors be willing to raise cash for a
new investment project?

Stratton O. is confronted with promising investment opportunity

Changes to the status quo:

• Within the current situation of financial distress, Stratton O. Inc is
confronted with a very promising, dead-safe project called Aerotyne Int’l.:
− Investment costs today: $15m
− Project payoff in one year: $22m

• Project NPV = –$15m + $22m / 1.10 = $5m → Should invest!

• However, currently no internal funds are available, hence need to gather

external funds → Will the current shareholders inject new capital?

Please calculate:
− What are the payoffs in one year for creditors and shareholders?
− What is the value in t=0 for equity holders (net of the 15m they invest)?
39
Will equity investors be willing to raise cash for a
new investment project?

Shareholders are not willing to inject equity due to debt overhang

State Proba. Assets Creditors Shareholders

Good 1/3 122 35 87
Medium 1/3 52 35 17
Bad 1/3 27 27 0
Value (net of $15m) 29.4 16.5
Value under status quo 21.2 19.7

− Post-investment, equity is worth:

( 1/3 × 87 + 1/3 × 17 + 1/3 × 0 ) / 1.10 = $31.5m

➔ Equity value increased by $31.5m – $19.7m = $11.8m

− Shareholders invested $15m ➔ They lose $15m – $11.8 = $3.2m

Shareholders will not inject equity 40

What are the consequences of financial distress for
investments into positive NPV projects?

Debt Overhang: too much debt impedes investment and growth

Equity investors will not accept to inject new capital due to

asymmetric benefit profile from investment

Cost/Benefit Equity holders Debt holders

Benefits Partial benefits Partial benefits
Costs Full inv costs No inv costs

➔ Existing risky debt acts as a “tax on investment” distorting

investment profitability for equity holders

Key takeaway:
Near financial distress, shareholders may be reluctant to fund good
investments because much of the gains go to creditors. Situation is
characterized as debt overhang problem
41
Will new, junior debt investors be willing to raise
cash for a new investment project?

Will new Junior Debt work?

• Stratton O. Inc has found new debt holders that might be willing to
invest. The current debt holders accept no subordination. Hence, the
CEO (Mr. M Hanna) negotiates new loan to be subordinated to old
creditors.

Please calculate:
• Assume new creditors break even to finance the 15M (value of debt
for new creditors is 15M in t=0). What is the required face value of
debt for new creditors in t=1? (Excel required)
• Calculate payoffs in t=1 for old creditors, new creditors and
shareholders.
• Calculate the value in t=0 for old creditors, new creditors and
shareholders.
• Will shareholders and creditors accept? 42
 Would equity investors accept the injection of new,
junior debt?

Debt overhang aggravates: Shareholders will not accept

• To raise $15m (trial-and-error method) ➔ Face value is = $32.5m

Old New
State Proba. Assets Shareholders
Creditors Creditors
Good 1/3 122 35 32.5 54.5
Medium 1/3 52 35 17.0 0.0
Bad 1/3 27 27 0.0 0.0
Value 29.4 15.0 16.5
Value under status quo 21.2 19.7
• New creditors must break even:
− They may be paying the investment cost ($15m)
− but only because they get a fair return (NPV = 0)

• Someone else is de facto bearing the cost: current shareholders. New

creditors extract value from them to break even. They will refuse again
43
Will new, senior debt investors be willing to raise
cash for a new investment project?

Will new Senior Debt work?

• Assume new creditors break even to finance the 15m (value of debt
for new creditors is 15M in t=0). What is the face value of debt for
new creditors in t=1?
• Calculate payoffs in t=1 for old creditors, new creditors and
shareholders.
• Calculate the value in t=0 for old creditors, new creditors and
shareholders.
• Will shareholders and creditors accept?

44
Financial Distress and Restructuring

New Senior Debt?

− To raise $15m ➔ Face = $16.5m.

Old New
State Proba. Assets Shareholders
Creditors Creditors
Good 1/3 122 35.0 16.5 70.5
Medium 1/3 52 35.0 16.5 0.5
Bad 1/3 27 10.5 16.5 0.0
Value 24.4 15.0 21.5
Value under status quo 21.2 19.7

Old creditors share the risk with shareholders.

45
Financial Distress and Restructuring

New Financing: Bottom Line

• More senior new claims are more likely to work:

− Equity won’t work
− Junior debt won’t work
− Senior debt might work:
o Seniority, secured or short-term debt (de facto senior).
o But may violate covenants.
o Renegotiations will be necessary (usual in financial distress)

• Injection is more difficult if existing debt is:

− More senior, secured, short term
− Protected by covenants against new (senior) debt issues
− Warning: Many firms in distress increase short-term debt, delay actual
distress but eventually hit the wall with very high leverage

46
5.
Agency costs at play:
numerical examples

47
Risky projects: Numeric example of agency costs
induced by leverage

Debt overhang can lead shareholder to choose riskier projects

Belfort Ltd has two investment options. All values are in t=0, no discounting is required

• Project A
− Good state: Pays 110 with Prob=0.5
− Bad state: Pays 96 with Prob=0.5

• Project B
− Good state: Pays 114 with Prob=0.5
− Bad state: Pays 84 with Prob=0.5

• The CEO, Mr. Azoff, considers two financing options, i.e. liability structures:
− Case 1: Firm has $20 of equity and debt holders are owed $80
− Case 2: Firm has $5 of equity and debt holders are owed $95

Exercise:
• What is the expected value of both projects and the expected payoffs for equity and
debt holders for each project in each case?
• Which project would they choose in each case and why?

48
Risky projects: Numeric example of agency costs
induced by leverage

Case 1: Equity = 20; Debt = 80

Expected value of projects:

• Project A = 0.5*(110+96) = 103

• Project B = 0.5*(114+84) = 99
• → independent of financing: Project B = inferior project (less value and more risk)

Case 1: Eq = 20 // D = 80

Debt-holders: will be paid off in full, irrespective of project selection → they are
indifferent between both projects

Equity holders: expected shareholder wealth from the two projects is:
− Project A pay-off to EqH = 1/2*(110-80)+1/2*(96-80)- 20 = 3
− Project B pay-off to EqH = 1/2*(114-80)+1/2*(84-80)- 20 = -1

Equity-holders will choose project A.

49
Risky projects: Numeric example of agency costs
induced by leverage

Case 2: Equity = 5; Debt = 95

Case 2: Eq = 5 // D = 95

Debt holders: expected debt holder pay off from the two projects is:
− Project A pay-off to DH = 1/2*(min(110;95))+1/2*(min(96;95)) = 95
− Project B pay-off to DH = 1/2*(min(114;95))+1/2*(min(84;95)) < 95

→ Debt holders prefer Project A since it pays off full owed debt of 95

Equity holders: expected shareholder wealth from the two projects is:
− Project A pay-off to EqH = 1/2*(max(0;110-95))+1/2*(max(0;96-95)) - 5 = 3
− Project B pay-off to EqH = 1/2*(max(0;114-95))+1/2*(max(0;84-95)) - 5 = 4.5

→ Equity holders select project B.

• Equity holders have an asymmetric pay-off profile: they experience losses only as far as
the value of their investment, but their potential profits are uncapped
• Strong incentive to take huge risks, even if doing so has a negative NPV for the firm
• This behavior is also known as risk-shifting, as equity holders start to shift parts of
the down-side risk of the investment to debt holders
50
Equity payouts: Numeric example of agency costs
induced by leverage via “cash-out mechanism”

Debt overhang and under-investment: cashing out

• Suppose 1979-Marcus-Avenue INC, a NY-based industrial company,

has equipment it can sell for $25m at the beginning of the year.
• However, it will need this equipment to continue normal operations
during the year; without it, it will have to shut down some
operations and the firm will be worth only $800m. With the
equipment at year-end, the firm value would be $900m.

• As a shareholder of 1979 Marcus Avenue INC, would you sell? Under

which circumstances would you sell and when would you be
indifferent?

51
Equity payouts: Numeric example of agency costs
induced by leverage via “cash-out mechanism”

Debt overhang and under-investment: cashing out

• Circumstance 1:
− The firm is going into default within the next year. In this case its liquidated. If
creditors have a payoff of $900 or more next year, equity holders will not receive
any funds from the liquidation
− Selling off equipment now for $25 reduces the value of the firm by $100 but given
above circumstances, this cost would be borne by the debt holders.
− So, equity holders gain if it sells the equipment and uses the $25 to pay an
immediate cash dividend
• Circumstance 2:
− Firm is expected to go into default (see above) and creditors can claim $850
− Not selling the asset now, would leave equity investors with $900 – $850 = $50
from the liquidation volume, hence equipment should not be sold

• Cashing out: when a firm faces financial distress, shareholders have an incentive to
withdraw cash from the firm if possible
− Careful! If default is predictable, this behaviour can be illegal. Hence there are laws
to prevent delayed filings of insolvency
52
6.
Costs of capital of firms with
equity and debt: the WACC

53
What determines the financing costs of a company?

Realistically, financing costs are determined by risk and taxes

Assets Liabilities

Assets determine the

Equity investors
business risk of the
demand return for
firm; responsible for Operating
Equity risk of not receiving
cash flow generation Assets
residual cash flows
→ risky projects = risky
from assets
cash flows

Asset risk = Equity risk

1 For a fully equity-financed firm, the required return on equity is determined by the risk of the
assets. In this instance, the required rate of return for equity is also called the unlevered cost of
capital (since the firm has no debt, i.e. no leverage, i.e. unlevered).

54
What determines the financing costs of a company?

Realistically, financing costs are determined by risk and taxes

2 Adding debt while leaving the assets unchanged does not change the asset risk.
Assets Liabilities

Equity Equity investors demand return for risk (rE) of not

receiving residual cash flows from assets
Operating
Assets Debt investors demand reward for risk (rD) that
Debt
assets may not cover their debt claims

3 In imperfect capital markets (i.e. a normal market environment), adding debt to the firm‘s
financing mix (i.e. inducing leverage) changes the overall cost of capital of the firm as formulated
by the Weighted Average Cost of Capital (WACC)

• MVE/D = Equity /
𝑀𝑉𝐸 𝑀𝑉𝐷 Debt market value
WACC = 𝑟 + 𝑟 (1 − 𝑡) • rE = Cost of equity
𝑀𝑉𝐸 +𝑀𝑉𝐷 𝐸 𝑀𝑉𝐸 +𝑀𝑉𝐷 𝑑 • rD = Cost of debt
• t = Tax rate

55
7.
Modigliani & Miller
theorem

56
Is there an optimal financing mix?

Introducing: Modigliani & Miller

• So far: • Now:
− Two sources of funding: equity & debt − Can we trade-off the
− Debt decision has advantages & advantages & disadvantages
disadvantages to create a mix that optimizes
firm value?

• Answered by two Nobel Prize-winning (each) economists:

− Franco Modigliani, Italian-American economist and the recipient of the 1985 Nobel
Memorial Prize in Economics. He was a professor at University of Illinois at Urbana–
Champaign, Carnegie Mellon University, and MIT Sloan School of Management
− Merton Howard Miller, American economist, and the co-author of the Modigliani–
Miller theorem (1958). He shared the Nobel Memorial Prize in Economic Sciences in
1990, along with Harry Markowitz and William F. Sharpe. Miller spent most of his
academic career at the University of Chicago's Booth School of Business.
(Not to be confused with Robert Cox Merton, Nobel Prize winner for derivative
pricing)
57
Is there an optimal financing mix?

MM Proposition I: The irrelevance of debt in a tax-free world

• The economic “environment” of Modigliani-Miller, i.e. the model assumptions

− No taxes
− Firms can raise external financing from debt / equity without issuance costs
− No costs from bankruptcy
− No agency costs: managers always act to maximize stockholder wealth + bond holders do not
have to worry about equity holders expropriating wealth with investment, financing or dividend
decisions (i.e. no risk shifting)
• Looking at the debt trade-off in this world:
Advantages of debt Disadvantages of debt
Tax benefit: zero Bankruptcy costs: zero
Added discipline: zero, no conflict of Agency cost: zero, because debt holders are fully protected
interest, hence no agency costs from wealth transfer
Loss of future financing flexibility: Not costly, because firms
can raise external financing without costs

MM proposition I: In this “world” of perfect capital markets (see assumptions above): debt
1 creates no benefits and has no costs → the capital structure decision becomes irrelevant and
has no impact on firm value
58
 Is there an optimal financing mix?

Proof of MM Proposition I
• Assume there are two firms with identical assets (hence identical expected asset cash flows):
− Firm A is all equity-financed
− Firm B has equity and debt
− Having the same assets, both firms produce a next-period cash flow of X

• An investor is buying a fraction  of each firm:

− The investor buys  of the equity of firm A, paying *VU
− Also, the investor buys  of the equity and of the debt of firm B, paying *EL+ *DL = *(EL+DL)

• From the investments, the investor is entitled to claims from both firms cash flows, X:
− Firm A is paying the investor:  * X
− Firm B is paying the investor:
− The (prioritised) claims from debt investment:  * rD * DL
− The residual claims from equity investment:  * (X – rD *DL)
− The total claims:  * rD * DL+  * (X – rD *DL) =  * X

− If both investments have the same payoff, then they must have the same value
→ *VU = *(EL+DL) → VU = EL+DL =VL
− The value of the levered and unlevered firm are identical → the financing mix has no impact on firm
value

59
Is there an optimal financing mix?

MM Proposition II: Cost of capital is unaffected by leverage

• With no taxes, the cost of capital for a firm are the weighted average of the costs of debt and the
costs of equity (i.e. weighted average cost of capital , WACC):

𝑀𝑉𝐸 𝑀𝑉𝐷
WACCMM = 𝑟𝐸 + 𝑟𝑑
𝑀𝑉𝐸 +𝑀𝑉𝐷 𝑀𝑉𝐸 +𝑀𝑉𝐷

• If financing decision is irrelevant (MM Prop I), then costs of capital (WACC) is independent from
changes in the proportion of debt and equity
• In other words: In a world of perfect capital markets, a firm’s WACC is independent of its
capital structure:

𝑟𝐴𝑠𝑠𝑒𝑡 = 𝑟𝑈𝑛𝑙𝑒𝑣𝑒𝑟𝑒𝑑 = 𝑟𝐿𝑒𝑣𝑒𝑟𝑒𝑑 = 𝑊𝐴𝐶𝐶

Reality Check:
• BUT: MM Prop I seems unreasonable? rD < rE due to the priority in claims (see above)
• Hence: increasing debt should lower the WACC? → Does it?
60
 Is there an optimal financing mix?

MM Proposition II: Cost of capital is unaffected by leverage

MM argue that
r leverage does not
But leverage increases the rE
increase the firm’s
risk for equity holders → average cost of
leverage increases the capital
expected return (ke) of
the firm’s equity WACC

rD

Costs of debt rises

as default risk
increases

61
Is there an optimal financing mix?

MM Proposition II: Cost of capital is unaffected by leverage

MM proposition II: In this “world” of perfect capital markets (see assumptions above): The
2 cost of capital of levered equity increases with the firm’s market value debt-equity ratio.

D
rE = rA + ( rA − rD )
E
• → Therefore: MM does NOT imply: Individual claimants are indifferent to changes in the capital
structure.
− Equity holders demand more return for increased risk from leverage
− Debt holders demand more return from increased default risk
− But within MM, benefits of replacing more expensive equity with cheaper debt are exactly
offset by a rise in the costs of both (even though rise of debt costs are delayed to entrance of
financial distress)

62
Is there an optimal financing mix?
Illustration of MM with a simple example
• A house is for sale for 1.000.000 USD in 2020
• It is expected to resell for 1.500.000 USD in 2021
100% equity-financed project
• Investment in 2020 = 1.000.000 USD of which
100% is equity-financed
• Pay off in 2021 = 1.500.000 USD
• (Expected) return on equity = 500.000
or 50% on the investment of 1mio USD
20% equity-financed project; rD = 10%
• Investment in 2020 = 1.000.000 USD
• Equity investment is 200.000 USD
• Debt investment is 800.000 USD at a rate of 10%
• Debt service in 2021 = 800.000 USD * 1.1 =
880.000 USD
• (Expected) return on equity = 1.500.000 –
880.000 – 200.000 = 420.000 USD
or 210% (420.000 / 200.000 USD) on the
investment of 200k USD
63
Is there an optimal financing mix?

Illustration of MM with a simple example

100% equity-financed project 20% equity-financed project

• Investment in 2020 = 1.000.000 USD of which • Investment in 2020 = 1.000.000 USD

100% is equity-financed • Equity investment is 200.000 USD
• Pay off in 2021 = 1.500.000 USD • Debt investment is 800.000 USD at a rate of 10%
• (Expected) return on equity = 500.000 • Debt service in 2021 = 800.000 USD * 1.1 =
or 50% on the investment of 1mio USD 880.000 USD
• (Expected) return on equity = 1.500.000 –
D 880.000 – 200.000 = 420.000 USD
rE = rA + ( rA − rD ) or 210% (420.000 / 200.000 USD) on the
E investment of 200k USD

D
• rE = 50% + 0/100 * (50% - 0) = 50% rE = rA + ( rA − rD )
E

• rE = 50% + 800k / 200k * (50% - 10%) = 210%

• MM I: no matter how we finance, the house will still return 50% (i.e. the “asset return”)
• MM II: if leverage is increased, the expected return of levered equity will increase
64
What are the consequences and contribution of MM?

Firm value is independent of the financing decision

• The financing decision becomes irrelevant to the value of the firm. WACC remains constant,
independent from leverage → firm cash flows are always discounted using the same discount factor,
hence the total value remains unchanged

• Assets and liabilities can be managed separately → the investment decision and the financing
decision can be independently
− Foundation of modern Asset / Liability Management Departments of banks

• MM start to “explain” debt ratios in terms of a trade-off instead of management preferences or

comparable firm ratios

• By their irrelevance argument, MM shift attention towards asset-side of B/S and the impact of
good investments on firm value → bad projects cannot be “fixed” with superior financing decisions

• MM assumptions too strong for application in reality but a few situations actually allow for direct
application, e.g. in case of:
− bail-outs / government guarantees → no bankruptcy costs
− tax-allowances for economic stimulus (e.g. to push poorer regions) → no taxes
65