Understanding Capital Structure

Understanding Capital
Structure
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Capital Structure
 A company can obtain long-term financing in
the form of equity, debt or a combination of
both.
 Capital structure is the proportion of debt
and preference and equity shares on a firm’s

balance sheet.
Capital Structure
 Optimal Capital structure is the capital is the
capital structure at which the weighted
average cost of capital is minimum and
thereby maximum value of the firm.
Capital Structure
 The relative proportions of debt, equity and
other securities that a firm has outstanding
constitute its capital structure.
 When corporations raise funds from outside
investors, they must choose which type of

security issue.
Capital Structure
 The most common choices are financing
through equity alone and financing through a
combination of debt and equity.
 So V = B + S = D + E
Capital Structure
Capital Structure
 Shareholders are interested in maximizing
the value of the firm’s shares.
 A key question is: What is the ratio of debt to
equity, if any, that maximizes the

shareholder’s value?
Capital Structure
 As it turns out, changes in capital structure
benefit shareholders if and only if the value
of the firm increases.
 So we concern ourselves with the question of
which proportion of debt versus equity

maximizes the overall value of the firm.
Capital Structure
 We assume perfect capital markets in the
following analysis:
◦ Perfect competition
◦ Equal access to information
◦ No transaction costs
◦ No taxes (later we drop this assumption)
 We also assume that the individual can
borrow at the same rate as the firm.
Example:
Capital Structure
 We will compare a firm whose capital
structure is all equity, with a firm that is
identical, except that it has some debt in its
capital structure.
Example:
Capital Structure
 Suppose a firm has 1000 shares, a share
price of $10, a market value of $10,000, and
operating income as described in the table
below.
 This income is a perpetuity, and all earnings
are paid out as a dividend to investors.

Expected income is $1500 and expected
return is 15%.
Example:
Capital Structure
Outcomes
Operating 500 1000 1500 2000
Income
Earnings Per 0.50 1.00 1.50 2.00
Share
Return On 5% 10% 15% 20%

Equity
Expected!
Example:
Capital Structure
 Suppose the firm borrows $5,000 at 10% rate
of interest and buys back 500 of its shares to
create the following new situation: # shares
500, B = $5000, S = $5000, shares value:
$10, annual interest: $500
Example:
Capital Structure
Outcomes
Operating 500 1000 1500 2000
Income
Interest 500 500 500 500
Equity Earnings 0 500 1000 1500

Earnings Per 0 1 2 3
Share
Return On 0% 10% 20% 30%
equity
Expected
Example:
Capital Structure
 Argument that value has increased: If
operating income is greater than $1,000 then
the expected Return On Equity increases.
 Since we expect operating income of $1,500,
leverage must have added value.
Shareholders expect 20% ROE with leverage.
Example:
Capital Structure
 Counter-argument: Suppose an investor
takes $10 of his/her own money and borrows
$10 at 10% interest and invests the $20 to
buy 2 shares of the unlevered firm.
Example:
Capital Structure
Outcomes
Operating 500 1000 1500 2000
Income
Earnings on 1 2 3 4
2 Shares
Interest on $10 1 1 1 1
at 10%
Net Earnings on 0 1 2 3
2 shares
Return on $10 0% 10% 20% 30%
Investment
Expected
Example:
Capital Structure
 Note: Investor gets the same result from
borrowing personally as he/she gets from
investing in the leveraged firm.
 Therefore, the firm is not doing anything by
leveraging that the investor could not do on
his/her own.
 This implies VL = VU. This is the famous
Modigliani-Miller Proposition I.
Example:
Capital Structure
 So leverage increases the expected earnings
per share, but not the share price. How can
that be?
Example:
Capital Structure
 Leverage also increases the riskiness of the
earnings. We must discount those higher
expected earnings at a higher discount rate.
 All equity: 1.50/.15 = $10
 Leveraged: 2.00/.20 = $10
 Recall: The value of a firm = the PV of the
future cash flows.
Example:
Capital Structure
 If the firm is all equity financed, then VU = C1/
(1+r0) + C2/(1+r0)2 + … where r0 is the cost
of capital of an all equity financed firm.
 If there is some debt in the capital structure,
the cost of capital is given by:
Example:
Capital Structure
 r = [B/(B+S)]rB + [S/(B+S)]rS where rS is the
cost of equity capital of the now leveraged
firm.
 and V = C /(1+r) + C /(1+r)2 + ...
L 1 2
Example:
Capital Structure
 Since the value of the company doesn’t
change with leverage, VL = VU, and so r must
equal r0 – that is, r must be constant as debt
is added to the capital structure (remember
here we are assuming no taxes etc.).
Example:
Capital Structure
 The idea is that as “expensive” equity is
replaced with “cheap” debt, the risk to equity
increases, as a result of the increased
leverage, and so rS increases.
 The increase in rS just balances against the
increased fraction of cheaper debt, so that r
stays constant.
Example:
Capital Structure
 r0 = cost of capital for the all equity firm = ra
= required/expected return on the assets –
reflects business risk – not financial leverage.
If we solve:
 r = [B/(B+S)]r + [S/(B+S)]r for r , we get r
0 B S S S
= r0 +[B/S](r0 – rB)
Example:
Capital Structure
 This is Modigliani-Miller Proposition II.
 In our example above, r = 1500/10,000 =
a
15%. If B = S = 5000, then:
 r = 15% + [5000/5000](15% - 10%) = 20%
S
 Initially the firm was all equity, had 1,000
shares at $10/share and equity worth
$10,000
 V = 1500/.15 = (CF/r ) = $10,000
S
Example:
Capital Structure
 With $5,000 debt at 10% and $5,000 equity,
now rS = 20%, up from 15% and:
 V = 500/.10 + 1000/.20 = interest
payment/rB + CF/rS = 5,000 + 5,000 =
10,000
Example:
Capital Structure
 Essentially, we split a single cash flow of
1500/year, discounted at 15% into 2 cash
flows of 500 and 1000, the former
discounted at 10% and the latter discounted
at 20%
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Understanding Capital

and preference and equity shares on a firm’s

investors, they must choose which type of

equity, if any, that maximizes the

which proportion of debt versus equity

are paid out as a dividend to investors.

Return On 5% 10% 15% 20%

Equity Earnings 0 500 1000 1500

future cash flows.

the cost of capital is given by:

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