Capital Structure

Rakesh Arrawatia
Introduction
Relationship between
Debt and Ke
Debt and taxes
Debt and Probability of default or bankruptcy risk
Debt and FCF
Debt and Agency Cost
 Wasteful spending
 Underinvestment

Equity and Signaling Theory

What is business risk?
Uncertainty about future operating income (EBIT),
i.e., how well can we predict operating income?
Probability Low risk

High risk

0 E(EBIT) EBIT
Note that business risk does not include financing
effects.
 What determines business risk?
Demand Variability
Sales Price Variability
Input Cost Variability
Price elasticity
Foreign Exchange
Ability to develop new products
Operating leverage.
Operating Leverage
Operating leverage is the use of fixed operating costs
to magnify the effects of changes in sales to the firm’s
operating earnings.
Operating Leverage Example
A B
Price 20 20
Variable Cost 15 10
Fixed Cost 2,00,000 6,00,000
Capital 20,00,000 20,00,000
Tax Rate 40% 40%

Demand Probability Units Sold

Terrible 0.05 0
Poor 0.20 4,00,000
Normal 0.50 10,00,000
Good 0.20 16,00,000
Wonderful 0.05 20,00,000
Measuring Op. Leverage
Degree of Operating Leverage:
% Change in EBIT
DOL 
% Change in Sales

Stylized form:
DOL (at base Q) 
P  V Q
P  V Q  F

 Note: As DOL increases, volatility in EBIT (operating earnings)

increases.
Problem on Operating Leverage
Levin Corporation has fixed operating costs of Rs
72,000, variable cost of Rs 6.75 per unit and a selling
price of Rs 9.75 per unit.
Calculate the operating break even points in units.
Calculate the degree of operating leverage for the
following unit of sales levels: 25000, 30000 and 40000
Example of Business Risk
Suppose 10 people decide to form a corporation to
manufacture disk drives.
If the firm is capitalized only with common stock –
and if each person buys 10% -- each investor shares
equally in business risk
Example of Relationship Between
Financial and Business Risk
If the same firm is now capitalized with 50% debt and
50% equity – with five people investing in debt and five
investing in equity
The 5 who put up the equity will have to bear all the
business risk, so the common stock will be twice as
risky as it would have been had the firm been all-
equity (unlevered).
Financial Leverage
Financial leverage is the use of fixed financial costs to
magnify the effects of changes in sales to the firm’s net
earnings.
Sources of financial leverage are primarily debt and
preferred stock.
Financial Leverage Example
A B Demand Probability EBIT
Debt Ratio 0% 50%
Terrible 0.05 -60000
Assets 200000 200000
Poor 0.20 -20000
Debt 0 100000
Equity 200000 100000 Normal 0.50 40000

Shares Issued 10000 50000 Good 0.20 100000

Interest Rate 10% Wonderful 0.05 140000
Tax Rate 40% 40%
Measuring Fin. Leverage
Degree of Financial Leverage:
% Change in Net Income
DFL 
% Change in EBIT

Stylized form:
EBIT
DFL (at base EBIT) 
EBIT  I

 Note: As DFL increases, volatility in net earnings increases.

Risk and the Income Statement
Sales
Operating – Variable costs
Leverage – Fixed costs
EBIT
– Interest expense
Financial Earnings before taxes
Leverage – Taxes
Net Income

EPS = Net Income

No. of Shares
Problem on Financial Leverage
Northwestern Savings and Loans has a current capital
structure consisting of Rs 250000 of 16% debt and
2000 shares of common stock. Tax rate is 40%. Using
EBIT values of Rs 80,000 and Rs 120000, calculate EPS
and degree of financial leverage.
Total Leverage
Total leverage is the use of any fixed costs to magnify
the effect of changes in sales on the firm’s net earnings.
The two components of total leverage are operating
and financial leverage.
Categorizing two components depend on where on the
income statement the fixed cost is found.
M-M Theory
Change in capital structure does not affect firm value
Under the following conditions:
1. There are no brokerage costs.
2. There are no taxes.
3. There are no bankruptcy costs.
4. Investors can borrow at the same rate as corporations.
5. All investors have the same information as
management about the firm’s future investment
opportunities.
6. EBIT is not affected by the use of debt.
MM’s argument
Number of Shares 100000
Price per share Rs 10
Market Value of Shares Rs 1 Million

State of the Economy

Slump Normal Boom
Operating Rs 75000 Rs 125000 Rs 175000
Income
EPS 0.75 1.25 1.75
ROE 7.5% 12.5% 17.5%
Effect of Borrowing
Number of Shares 50000
Price per share Rs 10
Market Value of Shares Rs 0.5 Million
Market Value of Debt Rs 0.5 Million

State of the Economy

Slump Normal Boom
Operating Income Rs75000 Rs 125000 Rs 175000
Interest Rs 50000 Rs 50000 Rs 50000
Equity Earnings Rs 25000 Rs 75000 Rs 125000
EPS 0.50 1.50 2.5
ROE 5% 15% 25%
Case of Individual Investment
Suppose the firm does not borrow.
An individual investor goes to a bank borrows Rs 10
and invests Rs 20 in the shares
Slump Normal Boom
Earning on Rs 1.5 Rs 2.5 Rs 3.5
two shares
Less interest Rs 1 1 1
Net earning 0.5 1.5 2.5
Return on 5% 15% 25%
Investment
Conclusion: MM’s Proposition I
As long as investors can borrow or lend on their own
account on the same terms as the firm, they are not
going to pay more for a firm that has borrowed on
their behalf.
Value of firm remains unaffected by its capital
structure
How Borrowing Affects Risk and
Return
Case 1: 100% Equity of $1 million
Firm Value: $1 million
Expected Income: $125000
Case 2: $0.5 million Equity and $0.5 million Debt
Firm Value: 0.5+0.5=$1 million
Equity Income: $75000 and Debt Interest $50000
Debt finance does not affect operating leverage but
affects financial leverage
What is the effect of financial leverage on price of
share?
MM’s Proposition II
In the earlier case, in case there was no financial
leverage,
rE=rA = (Expected op income)/(Market value of all
securities)
= 125000/1 million = 12.5%
If the firm borrows:
rE = rA +D/E(rA-rD)
=15%
 All Equity Equity and Debt
Earnings Per Share Rs 1.25 Rs 1.50
Expected Return 12.5% 15%
Share Price Rs 10 Rs 10

rE=rA + D/E (rA-rD)

MM’s Proposition II: Expected return on common stock

of a levered firm increases in proportion to D/E expressed
in market values.
MM Proposition: Snapshots
Proposition I says that financial leverage has no effect
on shareholders’ wealth.
Proposition II says that the rate of return they can
expect to receive on their shares increases as the firm’s
debt–equity ratio increases.
How can shareholders be indifferent to increased
leverage when it increases expected return?
The answer is that any increase in expected return is
exactly offset by an increase in risk and therefore in
shareholders’ required rate of return.
Ansal, a well-known consumer goods company, is evaluating whether or not to
change its all-equity capital structure to one that is 40 percent debt. Presently,
there are 2,000 shares outstanding and the price per share is Rs. 70. EBIT is
expected to remain at Rs. 16,000 per year till perpetuity. The interest rate on
new debt is 8 percent, and there are no taxes.
A shareholder of the firm owns 100 shares of stock. What is her cash flow
under the current capital structure, assuming the firm has a dividend
payout rate of 100 percent?
What will the shareholders’ cash flow be under the proposed capital
structure of the firm? Assume that she keeps all 100 of her shares.
Suppose Ansal does not convert, but the shareholder prefers the new
capital structure. Show how she could recreate the new capital structure.
Suppose Ansal does convert, but the shareholder prefers the current all-
equity capital structure. Show how she could unlever her shares of stock
to recreate the original capital structure.
Using your answer to part (c and d), explain why Ansal's choice of capital
structure is irrelevant.
 Corporate Taxes and Capital
Structure
Zero Debt Rs 500000 of
Debt
Expected Operating Rs 125000 Rs 125000
Income
Debt interest at 10% 0 50000
Before tax income 125000 75000
Tax at 35% 43750 26250
After tax income 81250 48750
Combined Income for 81250 98750
bondholders and
stockholders
Corporate Taxes and Capital
Structure
P.V of tax shields
Value of Levered firm = Value if all equity firm + P.V of
tax shields
WACC

P.V of tax shields

Market
value

Debt Ratio
Cost of Financial Distress
Overall market value = value if all equity firm + P.V of
tax shields – P.V costs of financial distress

P.V of financial
distress
Market
value

Debt Ratio
The Trade-off Theory
Trade of between interest shield and cost of financial
distress
Predicts the variation in debt-equity ratio from firm to
firm
Safe, tangible assets: Higher D/E equity ratio
Unprofitable firms and risky firms: Equity financing higher
Static and dynamic trade off theory
Why some of the most successful firms thrive with little
debt?
Ex: Asian Paints Ltd.
A Pecking Order Theory
Asymmetric information
Investors unsure of true prospects and profitability of
firm
Managers know more than investors
Will issue stocks when the shares are overpriced or
managers are pessimistic about the future of the firm
Will avoid issuing stocks when optimistic about firms
Thus, Pecking order is
Internal Equity > Debt > External Equity
Bradget & Co. expects its EBIT to be Rs. 95,000 every year
till perpetuity. The firm can borrow at 11 percent. Bradget
at present has no debt, and its cost of equity is 22 percent.
If the tax rate is 35 percent, what is the value of the firm?
What will the value be if Bradget borrows Rs. 60,000 and
uses the proceeds to repurchase shares?
Tool Manufacturing has an expected EBIT of Rs. 35,000 in
perpetuity and a tax rate of 35 percent. The firm has Rs.
70,000 in outstanding debt at an interest rate of 9 percent,
and its unlevered cost of capital is 14 percent. What is the
value of the firm according to M&M Proposition I with
taxes? Should Tool change its debt-equity ratio if the goal
is to maximize the value of the firm? Explain.
Old School Corporation expects an EBIT of Rs. 9,000
every year forever. Old School currently has no debt,
and its cost of equity is 17 percent. The firm can
borrow at 10 percent. If the corporate tax rate is 35
percent, what is the value of the firm? What will the
value be if Old School converts to 50 percent debt? To
100 percent debt? (Rs 40,433, 46,456)
Problem on Optimal Capital Structure
A firm is trying to determine its optimal capital structure,
which now consists of only debt and common equity. To
estimate how much its debt would cost at different debt
levels , the company’s treasury staff has consulted with
investment bankers and created following table:
The company estimates that the
risk free rate is 5%, the market Debt to Bond Kd
Asset Rating
risk premium is 6% and its tax Ratio
rate is 40%. Estimates suggest 0.0 A 7%
unlevered beta, bu would be 1.2. 0.2 BBB 8%
Estimate the optimal capital
0.4 BB 10%
structure.
0.6 C 12%
0.8 D 15%