Financial Leverage

and Capital Structure

Policy

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Capital Structure
 Capital structure refers to the relative mix of debt and equity
securities in the long term financial structure of the
company.
 Capital structure usually is applied strictly to the
“permanent” or long term capital that undergirds a
company’s operations.
 Does capital structure matter or not?
Observed Capital structure patterns
 Observed Capital structure show distinct national
patterns
 Capital structure have pronounced industry patterns
and these are the same
 Within industries leverage is inversely related to
profitability
 Taxes clearly influence capital structure
 Leverage ratios appear to be inversely related to the
perceived costs of the financial distress
Observed Capital structure patterns conti….
 Existing shareholders invariably consider leverage
increasing events to be good new
 Changes in the transaction costs of issuing new
securities have impact on structure
 Ownership structure clearly seems to influence
capital structure
 Corporations that are forced away from a preferred
capital structure tend to return to that structure over
time
 Capital Structure Theories
 Modigliani and Miller model
 Trade-off theory
 Agency theory
 Signaling theory

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Modigliani and Miller model
Modigliani and Miller, two professors in the 1950s, studied
capital-structure theory intensely. From their analysis, they
developed the capital-structure irrelevance proposition.
Essentially, they hypothesized that in perfect markets, it does
not matter what capital structure a company uses to finance
its operations. They theorized that the market value of a firm is
determined by its earning power and by the risk of its
underlying assets, and that its value is independent of the way
it chooses to finance its investments or distribute dividends. 
Modigliani and Miller model
The basic M&M proposition is based on the following key
assumptions:
 No taxes
 No transaction costs
 No bankruptcy costs
 Equivalence in borrowing costs for both companies and investors
 Symmetry of market information, meaning companies and
investors have the same information
 No effect of debt on a company's earnings before interest and
taxes
Modigliani and Miller's Tradeoff
Theory of Leverage
 The tradeoff theory assumes that there are benefits to
leverage within a capital structure up until the optimal
capital structure is reached. The theory recognizes the
tax benefit from interest payments - that is, because
interest paid on debt is tax deductible, issuing bonds
effectively reduces a company's tax liability. 
Modigliani and Miller's (P I and II)
 In summary, the MM I theory without corporate taxes says that a firm's relative
proportions of debt and equity don't matter; MM I with corporate taxes says that
the firm with the greater proportion of debt is more valuable because of the
interest tax shield.
 MM II deals with the WACC. It says that as the proportion of debt in the
company's capital structure increases, its return on equity to shareholders
increases in a linear fashion. The existence of higher debt levels makes investing
in the company more risky, so shareholders demand a higher risk premium on
the company's stock. However, because the company's capital structure is
irrelevant, changes in the debt-equity ratio do not affect WACC. MM II with
corporate taxes acknowledges the corporate tax savings from the interest tax
deduction and thus concludes that changes in the debt-equity ratio do affect
WACC. Therefore, a greater proportion of debt lowers the company's WACC.
Financial Choices

Trade-off Theory - Theory that capital structure is

based on a trade-off between tax savings and
distress costs of debt.

Pecking Order Theory - Theory stating that firms

prefer to issue debt rather than equity if internal
finance is insufficient.
Trade-off Theory
 MM theory ignores financial distress costs, which increase
as more leverage is used:
 Higher debt costs, including negotiation and monitoring
by creditors (MM assume constant cost)
 Feedback to Free Cash Flow
 Rejection of high risk but +NPV investments (under-
investment)
 Lost customers, suppliers, and employees
 Loan covenants, which constrain growth
 ‘Fire sales’ of assets to raise cash
 Contradicts assumption of MM that capital structure
doesn’t effect operating cash flows

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Trade-off Theory (cont.)
 Trade-off theory suggests optimal capital
structure is reached at point where marginal
distress costs exceed the marginal tax benefit
from adding debt in the MM model.
 Since these costs are only significant at high
levels of debt, WACC could be relatively
unaffected for many capital structures

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Trade-off theory suggests these types of
firms will use more debt
 Strong cash flow
 Low variability in cash flow
 Low growth opportunities (predictable funds needs and
less risk of jeopardizing growth investments)
 Large size (safety and lower growth)
 Profitable enough to benefit from tax shelter

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Debt can reduce Equity Agency
Costs
 Equity agency problem is that managers
might:
 use corporate funds for non-value maximizing
purposes (perks, acquisitions, value-destroying
growth)
 or seek low risk due to undiversified interest in firm
 Problem is most significant in large firms with
diffuse stockholders where management
ownership is low

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Debt can reduce Equity Agency
Costs (cont.)
 The use of financial leverage:
 Bonds free cash flow for firms generating more
cash than required to fund +NPV opportunities,
reducing perk consumption and value-destroying
growth.
 Increases free cash flow by forcing efficiencies:
failure risk gets managers’ attention
 Substitute for other strategies: outside board
members, stock ownership, large outside
blockholders, takeover threat

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Debt can reduce Equity Agency
Costs (cont.)
 Debtholders can serve as monitors for
diffuse free-riding stockholders
 However, debt agency costs will
increase: negotiation, monitoring,
covenants, under-investment

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Signaling Theory
 MM assumed that investors and managers have the
same information.
 Where significant information asymmetries exist,
stockholders assume:
 Company issues new stock when it is overvalued
 Bonds are issued when stock is undervalued
 Stock issues indicate lower expected FCF, unwilling
to commit to increased debt service
 Leverage-decreasing events signal overvalued stock,
and vice versa, supported by empirical data

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 MM relationship between value and debt
with taxes
Value of Firm, V (%)

VL
TD
VU VU

Debt

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Signaling theory results in Pecking
Order Hypothesis
 Firms will choose the following sequence of funding sources to
maintain financial flexibility and avoid negative signals
 Retained earnings Maintain
 Excess cash borrowing
capacity
 Debt issuance
 Stock issuance
 Evidence: profitable firms use less debt (surprise) because they
can build more equity internally. Contradicts Trade-off theory
which suggests high debt due to low default risk and need for tax
shelters.

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PECKING
PECKING ORDER
ORDER OF
OF FINANCING
FINANCING CHOICES
CHOICES

 MANAGERS KNOW MORE ABOUT THEIR FIRM

THAN OUTSIDERS
 PROSPECTS, RISKS
 ASYMMETRIC INFORMATION
 MANAGERS KNOW MORE THAN INVESTORS
 DIVIDEND SIGNALING
 INVESTORS INTERPRET INCREASE IN DIVIDEND AS
SIGN OF MANAGEMENT CONFIDENCE
 ASYMMETRIC INFORMATION AFFECTS CHOICE
BETWEEN
 INTERNAL VS EXTERNAL FINANCING
 ISSUING DEBT VS EQUITY
Pecking Order Theory
The announcement of a stock issue drives down the stock price
because investors believe managers are more likely to issue when
shares are overpriced.

Therefore 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.
PECKING
PECKING ORDER
ORDER
 LEADS TO FOLLOWING PECKING
ORDER
 INVESTMENTS FIRST FINANCED WITH
 INTERNAL FUNDS
 NEW DEBT

 NEW EQUITY
Pecking Order Theory

Some Implications:
 Internal equity may be better than external
equity.
 Financial slack is valuable.
 If external capital is required, debt is better.
(There is less room for difference in opinions
about what debt is worth).
Summing the theories

This leaves us with:

VL = VU + tax benefit – financial distress

+ equity agency – debt agency + signaling

Capital structure decision requires judgment!

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 Other factors in setting the target
capital structure
 Effect on sustainable growth: willingness to
increase debt allows for higher growth rate
now.
 Debt ratios of other firms in the industry.
 Lender and rating agency attitudes
(impact on bond ratings).

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