Capital Structure

Theory and Policy

 In the Last Class:
Leverage and EPS
• Higher the leverage higher will be the
expected EPS.
• Higher the volatility of the EPS
• Higher the Financial Leverage higher will
be the D/E ratios
 Capital Structure
How do we want to finance our firm’s assets?

Capital structure
– Mix of debt and equity
– The mix effects WACC therefore Firm Value
– Remember: Firm value depends on FCF and
WACC.
 Balance Sheet
Assets Liabilities

Debt
Fixed
Capital
Assets
Structure
+ Equity
Net CA
 Why is Capital Structure
Important?
1)Leverage: higher financial leverage means
higher returns to stockholders, but higher
risk due to interest payments.
2)Cost of Capital: Each source of financing
has a different cost. Capital structure affects
the cost of capital.
3)The Optimal Capital Structure is the one that
minimizes the firm’s cost of capital and
maximizes firm value.
 What is the Optimal Capital
Structure?
• In a “perfect world” environment with no
taxes, no transactions costs and perfectly
efficient financial markets, capital structure
does not matter.
• This is known as the Independence
Hypothesis of capital structure: firm value
is independent of capital structure.
 Independence
Hypothesis

Cost of
Capital
ke = cost of equity
kd = cost of debt
k = cost of capital

ke .
0% debt financial leverage 100%debt
 Independence Hypothesis

Cost of
Capital
If we have an all-equity
financed firm, what is
the cost of capital?
ke .

financial leverage
 Independence Hypothesis

Cost of
Capital
If we have an all-equity
financed firm, the cost of
capital is just the “cost of
k=ke . Equity”.

financial leverage
 Independence Hypothesis

Suppose we begin adding debt

Cost of financing at a cost of kd.
Capital

ke
kd

financial leverage
 Independence Hypothesis

Suppose we begin adding debt

Cost of financing at a cost of kd.
Capital
kd is lower than ke, so what
should happen to the cost
of capital?
ke
kd kd

financial leverage
 Independence Hypothesis

Cost of It should go down.

Capital
But how should increasing
leverage affect ke?

ke
kd kd

financial leverage
 Independence Hypothesis

Cost of According to the

Capital
Independence Hypothesis,
the increase in debt will cause
ke to rise.
ke
kd kd

financial leverage
 Independence Hypothesis
Increasing leverage causes the
ke
Cost of cost of equity to
Capital rise.

ke
kd kd

financial leverage
 Independence Hypothesis
Increasing leverage causes the
ke
Cost of cost of equity to
Capital rise.
What will
be the net effect
on the overall cost
ke of capital?

kd kd

financial leverage
 Independence Hypothesis
The cost of capital does ke
Cost of not change. Leverage has
Capital no effect on the cost
of capital and
therefore, it has no effect on
the value of the firm.
ke k
kd kd

financial leverage
 Independence Hypothesis

In a “perfect markets” environment,

capital structure is irrelevant. In other
words, changes in capital structure do
not affect firm value.
 MM Proposition I without taxes
1. Capital structure is irrelevant.
2. The value of levered firm and unlevered
firm would be equal.
3. VU= VL
 Independence Hypothesis
t Policy Doesn’t Matter)
Example - All Equity Financed
Data
Number of shares 1,000
Price per share $10
Market Value of Shares $ 10,000

Outcomes
A B C D
Operating Income $500 1,000 1,500 2,000 Expected
Earnings per share $.50 1.00 1.50 2.00 outcome
Return on shares (%) 5% 10 15 20
19
 Independence Hypothesis
Example Data
cont.
50% debt Number of shares 500
Price per share $10
Market Value of Shares $ 5,000
Market value of debt $ 5,000

Outcomes
A B C D
Operating Income $500 1,000 1,500 2,000
Interest $500 500 500 500
Equity earnings $0 500 1,000 1,500
Earnings per share $0 1 2 3
Return on shares (%) 0% 10 20 30
20
 Independence Hypothesis
Example - - All Equity Financed
- Debt replicated by investors

Outcomes
A B C D
Earnings on two shares $1.00 2.00 3.00 4.00
LESS : Interest @ 10% $1.00 1.00 1.00 1.00
Net earnings on investment $0 1.00 2.00 3.00
Return on $10 investment (%) 0% 10 20 30
21
 MM’s Proposition II without
taxes
• With increasing leverage the cost of equity
rises exactly to offset the advantage of
reduced cost of debt
• To keep the value of the firm constant.
• The cost of equity for varying levels of
debt is given by:
D
rE  rA   rA  rD 
E
 M&M Proposition II

D
rE  rA   rA  rD 
E

expected operating income

rA 
market value of all securities
1500
  .15
10,000

23
 M&M Proposition II
D
rE  rA   rA  rD 
E

expected operating income

rA 
market value of all securities
1500
  .15
10,000

5000
rE  .15   .15  .10
5000
 .20 or 20%
24
 Pie theory

Debt Equity Debt Equity

Value of Firm does not go up because they are financed from a particular source
Value of a firm = PV of Assets

IF the securities are exchanged at fair value then the financial transactions do not
create or destroy the firm value (exception: when these transaction effect the taxes
or investment decisions structure)
 Dependence Hypothesis

 Since debt is less expensive than

equity, more debt financing would
provide a lower cost of capital.
 A lower cost of capital would increase
firm value.
 Dependence Hypothesis
Even if the cost of equity rises
Cost of as leverage increases, the ke
Capital cost of debt is
lower...

ke

kd kd

financial leverage
 Dependence Hypothesis
Even if the cost of equity rises
as leverage increases, the ke
Cost of
cost of debt is
Capital
lower...
because
of the tax benefit
ke associated with debt financing.

kd kd

financial leverage
 Dependence Hypothesis
So,
So, what
what will
will happen
happen toto the
the
cost
cost of
of capital
capital as
as leverage
leverage ke
Cost of
increases?
increases?
Capital

ke

kd kd

financial leverage
 Dependence Hypothesis
The low cost of debt ke
Cost of reduces the overall
Capital cost of capital.

ke
k
kd kd

financial leverage
 Dependence Hypothesis
• So, what does the tax benefit of debt financing mean for
the value of the firm?
• The more debt financing used, the greater the
tax benefit, and the greater the value of the firm.
• So, this would mean that all firms should be financed
with 100% debt, right?
• Why are firms not financed with 100% debt?
 Why is 100% debt not optimal?

Bankruptcy costs: costs of financial

distress.
• Financing becomes difficult to get.
• Customers leave due to uncertainty.
• Possible restructuring or liquidation costs if
bankruptcy occurs.
 Why is 100% debt not optimal?
Agency costs: costs associated with protecting
bondholders.
• Bondholders (principals) lend money to the firm
and expect it to be invested wisely.
• Stockholders own the firm and elect the board
and hire managers (agents).
• Bond covenants require managers to be
monitored. The monitoring expense is an
agency cost, which increases as debt
increases.
 Cost of Capital
with Bankruptcy and Agency Costs

Cost of At some point, there will be a ke

Capital minimum cost of
capital!
k
ke kd

kd

financial leverage
 Optimum Capital Structure:
Trade-off Theory

• The optimum capital structure is a

function of:
– Agency costs associated with debt
– The costs of financial distress
– Interest tax shield
• The value of a levered firm is:
Value of unlevered firm
+ PV of tax shield
– PV of financial distress

35
 Optimum Capital Structure:
Trade-off Theory
Maximum value of firm
Costs of
Market Value of The Firm

financial distress

PV of interest
tax shields
Value of levered firm

Value of
unlevered
firm

Optimal amount
of debt
Debt
36
 Pecking Order Theory
• The announcement of a share issue reduces the share
price because investors believe managers are more
likely to issue when shares are overpriced.

• Firms prefer internal finance since funds can be raised

without sending adverse signals.

• If external finance is required, firms issue debt first and

equity as a last resort.

• The most profitable firms borrow less not because they

have lower target debt ratios but because they don't
need external finance.
37
 Pecking Order Theory

Implications:
 Internal equity may be better than external
equity.
 Financial slack is valuable.
 If external capital is required, debt is better.

38
 Approaches to Establish
Appropriate Capital Structure
• The Cost of Capital: The Optimal debt ratio is the one
that minimizes the cost of capital for the firm
• Adjusted Present Value: The Optimal debt ratio is the
one that maximize the value of the firm
• The Sector Approach: The Optimal debt ratio is the one
that is followed by others firms in the group
• The Life Cycle Approach: The Optimal debt ratio is the
one that best suits where the firm is in its life cycle
• EBIT—EPS approach for analyzing the impact of debt on
EPS.
• Cash flow approach for analyzing the firm’s ability to
service debt.
39
So, what can we say about optimal capital
structures?
• Debt has tax benefits, so firms should use some debt
• Financial distress and agency costs limit debt usage
– Distress costs higher for firms with intangible assets
• Because of asymmetric information, firms will follow
pecking order
• Because of asymmetric information, firms should
maintain reserve for borrowing
• capital structure decisions have a large judgmental
content
• Results of calculations may not give precise answers,
as the inputs are at best guesstimates.
• Due to these reasons and other considerations we end
up with capital structures varying widely among firms,
even similar ones in same industry.
 Practical Considerations in
Determining Capital Structure
• Control
– Widely-held Companies
– Closely-held Companies
• Loan Covenants
• Reserve Capacity
• Assets Structure (Tangible Assets)
• Market Conditions
• Flotation Costs

41
 Miller’s Approach with Corporate and
Personal Taxes
– What matters is ultimate after tax cash flows in
the hands of investors

– To establish an optimum capital structure both

corporate and personal taxes paid on operating
income should be minimized.

– The personal tax rate is difficult to determine

because of the differing tax status of investors,
and that capital gains are only taxed when shares
are sold.

42
 Miller’s Approach with Corporate and
Personal Taxes
– Merton miller proposed that the original MM
proposition I holds in a world with both corporate
and personal taxes because he assumes the
personal tax rate on equity income is zero
– Companies will issue debt up to a point at which
the tax bracket of the marginal bondholder just
equals the corporate tax rate. At this point, there
will be no net tax advantage to companies from
issuing additional debt.
– It is now widely accepted that the effect of
personal taxes is to lower the estimate of the
interest tax shield.
43
LEVERAGE BENEFIT UNDER CORPOATE AND PERSONAL TAXES
Unlev Lev Unlev Lev Unlev Lev
Corp tax 0% 0% 35% 35% 35% 35%
Corp tax on div 0% 0% 10% 10% 10% 10%
Pers tax on div 0% 0% 0% 0% 0% 0%
Pers tax on int 0% 0% 0% 0% 30% 30%

PBIT 2500 2500 2500 2500 2500 2500

Int 0 700 0 700 0 700
PBT 2500 1800 2500 1800 2500 1800
Corp tax 0 0 875 630 875 630
PAT 2500 1800 1625 1170 1625 1170
Div 2500 1800 1477 1064 1477 1064
Div tax 0 0 148 106
Tol corp tax 0 0 875 630 1023 736

Div income 2500 1800 1477 1064 1477 1064

Pers tax on div 0 0 0 0 0 0
AT div income 2500 1800 1477 1064 1477 1064
Int income 0 700 0 700 0 700
Pers tax on int 0 0 0 0 0 210
AT int income 0 700 0 700 0 490
AT total income 2500 2500 1477 1764 1477 1554 44
Net leverage benifit 0 287 77