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Chapter 2
Capital Structure Theory
 Required readings:
 Ehrhardt, M.C. Brigham, E. F. (2011), Financial Management: Theory
and Practice, 13th Ed., South-Western Cengage Learning. (Chapter 15,26)
 Stephen A. Ross, Randolph W. Westerfield, Bradford D. Jordan (2013),
Fundamentals of Corporate Finance, 10th ed. McGraw-Hill. (Chapter 16,)
 Overview of Capital Structure
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 Capital refers to the long-term financing

arrangements(ማደራጀት) of a firm.(ንግድ ድርጅት)
 Debt capital is the firm’s long-term borrowings and
 Equity capital is the longterm funds provided by
the shareholders, or firm’s owners.
 Capital structure is the combination of debt and
equity capital which a firm uses to finance its long-
term operations.
 Capital structure is different from financial structure.
 Cont’d……….
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 Financial structure consists of all liabilities and

equity capital.ፋይናንሻል መዋቅር የተገኘው
 Thus, it is the manner how an organization’s assets

are financed.
 Capital structure is the sum of all long-term sources

of capital.
 Thus, it is a part of the financial structure.

Financial Structure = Current Liabilities + Debt +

Fixed Preference + Ordinary shares
Capital Structure = Debt + Fixed Preference +
Ordinary shares
 Capital Structure Theory
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 MM theory
Zero taxes
Corporate Taxes
Personal Taxes
 Trade-off theory
 Peaking order theory
 Signalling theory
 MM Theory
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 Modern capital structure theory began in 1958, when

Professors Franco Modigliani and Merton Miller
(MM) published the most influential finance article
ever written.

 M&M, Nobel Prize winners in financial economics,

have had a profound influence on capital structure
theory since their seminal work on capital structure
in 1958.
 MM model……
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Modigliani & Miller I: No taxes

 M&M originally argued, very controversially, against
the traditional model of capital structure and
proposed that the value of a firm is independent of
its cost of capital and its capital structure.
 MM model……
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 MM’s study was based on some strong assumptions:

 There are no brokerage costs.
 There are no taxes.
 There are no bankruptcy costs.
 Investors can borrow at the same rate as

corporations.
 All investors have the same information as

management about the firm’s future investment

opportunities.
 EBIT is not affected by the use of debt.
 MM model……
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 Modigliani and Miller imagined two hypothetical

portfolios.
 The first portfolio contains all the equity of an

unlevered firm, so the portfolio’s value is VU, the

value of an unlevered firm.
 Because the firm has no growth (it does not need
to invest in any new net assets) and pays no
taxes, the firm can payout all of its EBIT in the
form of dividends.
 Therefore, Cash flow from owning this first
portfolio is equal to EBIT
 MM model……
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 The second portfolio contains all of the levered

firm’s stock (SL) and debt (D), so the portfolio’s
value is VL.
 If
the interest rate is rd, then the levered firm pays
out interest in the amount rdD.
 Because the firm is not growing and pays no
taxes, it can pay out dividends in the amount EBIT
− rdD.
 If
you owned all of the firm’s debt and equity:
 The cash flow would be equal to the sum of
interest & dividends:
 MM model……
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 MM concluded that two portfolios producing the

same cash flows must have the same value:
VL = SL + D = VU
 MM proved that a firm’s value is unaffected by its
capital structure.
 As leverage increases, more weight is given to low-
cost debt but equity becomes riskier, which drives up
rs.
 Under MM’s assumptions, rs increases by exactly
enough to keep the WACC constant.
 MM model……
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 If MM’s assumptions are correct, then it doesn’t

matter how a firm finances its operations and so
capital structure decisions are irrelevant.
 Even though some of their assumptions are obviously
unrealistic, MM’s irrelevance result is extremely
important.
 MM model……
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Modigliani and Miller II:

The Effect of Corporate Taxes
 In 1963, MM relaxed the assumption that there are

no corporate taxes.
 The Tax Code allows corporations to deduct interest

payments as an expense, but dividend payments to

stockholders are not deductible.
 The differential treatment encourages corporations to

use debt in their capital structures.

 The tax deductibility of the interest payments shields

the firm’s pre-tax income.

 MM model……
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 The value of a levered firm is value of an identical

unlevered firm plus value of any “side effects.”
VL = VU + Value of side effects
= VU + PV of tax shield
 Present value of the tax shield is equal to the
corporate tax rate, T, multiplied by the amount of
debt, D:
VL = VU + TD
 MM model……
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 With a tax rate of 40%, every dollar of debt adds

about 40 cents of value to the firm, and this leads to
the conclusion that the optimal capital structure is
virtually 100% debt.
 MM also argued that rs, increases as leverage
increases but it doesn’t increase quite as fast as it
would if there were no taxes.
 As a result, under MM with corporate taxes, the
WACC falls as debt is added.
 MM model……
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Miller: The Effect of Personal Taxes

 Miller (1977) later brought-in the effects of personal

taxes.
 The income from bonds is interest, which is taxed as

personal income at rates (Td) going up to 35%, while

income from stocks comes partly from dividends and
partly from capital gains.
 Long-term capital gains are taxed at 15%, and this

tax is deferred until the stock is sold and the gain

realized.
 If stock is held until the owner dies, no capital
 MM model……
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 So, on average, returns on stocks are taxed at lower

effective rates (Ts) than returns on debt.
 Because of the tax, Miller argued that investors are
willing to accept relatively low before-tax returns on
stock relative to the before-tax returns on bonds.
 Thus, Miller pointed out,
 The deductibility of interest favors the use of debt

financing, but
 The more favorable tax treatment of income from

stock lowers the required rate of return on stock

and thus favors the use of equity financing.
 MM model……
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 Most observers believe that there is still a tax

advantage to debt if reasonable values of tax rates
are assumed.
 Thus, it appears that the presence of personal taxes

reduces but does not completely eliminate the

advantage of debt financing.
 Trade-off Theory

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 MM theory ignores bankruptcy costs, which

increases as more leverage is used.
 However, bankruptcy can be quite costly.
 Firms in bankruptcy have very high legal and
accounting expenses, and they also have a hard time
retaining customers, suppliers, and employees.
 Bankruptcy often forces a firm to liquidate or sell
assets for less than they would be worth if the firm
were to continue operating.
 Therefore, bankruptcy costs discourage firms from
pushing their use of debt to excessive levels.
 Trade-off Theory
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 Bankruptcy-related costs have two components:

 The probability of financial distress and
 The costs that would be incurred if financial distress
does occur.
 Thus, firms should trade-off the benefits of debt
financing (favorable corporate tax treatment) against
higher interest rates and bankruptcy costs.
 At low leverage levels, tax benefits outweigh

bankruptcy costs.
 At high levels, bankruptcy costs outweigh tax

benefits.
 Trade-off Theory
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 The trade-off theory states that the Value of a levered

firm is equal to the value of an unlevered firm plus
the value of any side effects, which include the tax
shield and the expected costs due to financial
distress.
VL = VU + PV tax shied – Financial distress costs
 Signaling Theory
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 MM assumed that investors have the same

information about a firm’s prospects as its managers,
called symmetric information.
 However, managers have better information than
outside investors, called asymmetric information.
 This has an important effect on the optimal capital

structure.
 Managers use issues of debt and equity to signal
information about a firm’s future prospects to less
informed owners and investors.
 Signaling Theory
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 Suppose that a biotechnology company made a secret

breakthrough in genetic engineering which could be
deemed to be of considerable benefit in the
prevention of coronary heart disease.
 Only management is aware of the breakthrough

that the company’s prospects are very favorable

(asymmetric information).
 The company needs to raise substantial funds for

the manufacturing, marketing and distribution of

its new product.
 Signaling Theory
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 If a new equity issue is made, the share price will rise

when the company starts to generate the net cash
flows from the investment (assumed to have a
substantial positive NPV).
 Both new and existing shareholders will benefit

from the financial windfall.

 However, the existing shareholders will be less

wealthy than if the funds had been raised by

issuing debt.
 The creation of new shareholders has diluted the

wealth of the existing shareholders.

 Signaling Theory
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 With a debt issue, existing shareholders would not

have to share the new wealth.
 From the existing shareholders’ standpoint, issuing
debt to fund the development would be the preferred
option.
 By issuing debt, the company would be signaling to
investors and current shareholders that the future
outlook of the company is bright.
 Issuing debt would be interpreted as a positive

signal about the company’s future.

 Signaling Theory
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 In contrast, the decision to issue equity would

generally be interpreted by shareholders and
investors as a negative signal.
 It indicates that the company’s future prospects are

not so good and its equity is currently overvalued.

 This theory argues that shareholders and investors
understand these issues that managers have more
information about a firm’s prospects and use
financing policy to signal this information to
shareholders and investors.
 Signaling Theory
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 The key implication for capital structure

management is that, if possible, firms should retain
some degree of reserve borrowing capacity which
would allow them to take full advantage of wealth
enhancing investment opportunities when they
arise.
 Pecking Order Theory
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 This corporate capital structure theory was developed

in 1984 by Myers.
 Myers argues that the management of firms follow a
distinct order in their preferences of sources of
finance for investment and therefore do not seek to
maintain an optimal or target capital structure.
 Managers will prefer first to use retained earnings for
financing investment rather than issuing debt or
equity.
 If retained earnings are exhausted to fund projects
and additional financing needs to be raised
 Pecking order theory
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 Thus, a firm’s capital structure at any point in time is

simply a reflection of its past pecking order
preferences for long-term financing.
 Donaldson followed by Myers suggests that
management follows a preference ordering when it
comes to financing.
 Optimal Capital Structures
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 Optimal capital structure is one that minimizes the

firm’s cost of capital and maximizes firm value.
 Empirical evidences show that companies tend to
operate within a target or optimal capital structure
range.
 If companies have to move outside the optimal

range by taking on more debt than they would

prefer because of business circumstances (e.g.
financing a substantial expansion program) they
will revert to their considered optimal or target
structure range as soon as is feasible.
 Optimal Capital Structures
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 The basic approach to determine the optimal capital

structure is to consider a trial capital structure, based
on the market values of the debt and equity, and then
estimate the wealth of the shareholders under this
capital structure.
 This approach is repeated until an optimal capital

structure is identified.
 The objective is to find the amount of debt financing
that maximizes the value of operations.
 Optimal Capital Structures
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 The basic steps in analysis of each potential capital

structure:
 Estimate the interest rate the firm will pay.
 Estimate the cost of equity.
 Estimate the weighted average cost of capital.
 Estimate the value of operations, i.e., the present

value of free cash flows discounted by the WACC.

 Optimal Capital Structures
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Percent of firm financed with debt (wd)
0% 10% 20% 30% 40% 50% 60%
Ws 100% 90% 80% 70% 60% 50% 40%
rd 7.7% 7.8% 8% 8.5% 9.9% 12% 16%
b 1.09 1.16 1.25 1.37 1.52 1.74 2.07
rs 12.82% 13.26% 13.8% 14.5% 15.43% 16.73% 18.69%
rd(1-T) 4.62% 4.68% 4.8% 5.1% 5.94% 7.2% 9.6%
WACC 12.82% 12.4% 12% 11.68% 11.63% 11.97% 13.24%
Vop 233.98 241.96 250 256.87 257.86 250.68 226.65
Debt 0 24.2 50 77.06 103.14 125.34 135.99
Equity 233.98 217.76 200 179.81 154.72 125.34 90.66
#shares 12.72 11.34 10 8.69 7.44 6.25 5.13
Stock price 18.4 19.2 20 20.69 20.79 20.07 17.66
NI 30 28.87 27.6 26.07 23.87 20.98 16.95
EPS 2.36 2.54 2.76 3 3.21 3.36 3.3
 Capital Structure Decision
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 Four primary factors influence capital structure

decisions.
1. Business risk, or the risk inherited in the firm’s
operations.
2. The firm’s tax position. A major reason for using
debt is that interest is deductible, which lowers the
effective cost of debt.
3. Financial flexibility, or the ability to raise capital on
reasonable terms under adverse conditions.
Corporate treasurers know that a steady supply of
capital is necessary for stable operations, which is
vital for long-run success.
 Observed Practices…..
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 The greater the marginal tax rate, the greater the

benefit from the interest deductibility and, hence, the
more likely a firm is to use debt in its capital
structure.
 The greater the business risk of a firm, the greater the
present value of financial distress and, therefore, the
less likely the firm is to use debt in its capital
structure.
 The greater extent that the value of the firm depends
on intangible assets, the less likely it is to use debt in
its capital structure.
 Within an industry there may not be a homogeneous
 Observed Practices…..
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 Firms prefer using internally generated capital to

externally raised funds.
 Firms try to avoid sudden changes in dividends.
 When internally generated funds are greater than
needed for investment opportunities, firms pay off
debt or invest in marketable securities.
 When internally generated funds are less than needed
for investment opportunities, firms use existing cash
balances or sell off marketable securities.
 If firms need to raise capital externally, they issue the
safest security first; for example, debt is issued
before preferred stock, which is issued before
 Business and Financial risk
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 Business risk arises from the nature of the firm’s

business environment and the particular
characteristics of the industry in which it operates
and it is a variable which lies largely outside
management’s control.
 It is possible to measure a firm’s business risk by the
degree of variability of its EBIT.
 This type of risk is a function of the firm’s regulatory
environment, labor relations, competitive position,
etc.
 Business and Financial risk
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 Financial risk represents the risk that arises from a

firm’s level of gearing and is a variable which can be
directly controlled by management.
 This type of risk is a direct result of management
decisions regarding the relative amounts of debt and
equity in the capital structure.
 The more debt a firm introduces into its capital
structure, the greater the level of financial risk and
the greater the return the equity shareholders require
to compensate for the additional financial risk.
 It creates the variability of the firm’s EPS.
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The End!

Thank you!