Capital Structure: I. Opening Prayer II. Announcements III. Overview of The Topic IV. Discussion and Recitation

MODULE II
CAPITAL STRUCTURE
 I. Opening Prayer
 II. Announcements
 III. Overview of the topic
 IV. Discussion and Recitation
CAPITAL STRUCTURE
Learning Objectives :
After studying this module, you should be able to:
1) Define capital structure
2) Identify the reasons why capital structure changes over time
3) Explain the capital structure theories
4) Distinguish between business and financial risk
5) Measure financial and operating leverage
6) Explain the need for diversification
CAPITAL STRUCTURE
Lesson I : DEFINE CAPITAL STRUCTURE
The capital structure is the particular combination of debt and equity used by a company to
finance its overall operations and growth. Debt comes in the form of bond issues or
loans, while Equity may come in the form of common stock, preferred stock, or retained
earnings. Short-term debt is considered to be part of the capital structure but accounts payable
and accruals are not included.
 Debt consists of borrowed money that is due back to the lender, commonly with interest expense.
 Equity consists of ownership rights in the company, without the need to pay back any investment.
 The Debt-to-Equity (D/E) ratio is useful in determining the riskiness of a company's borrowing
practices.
CAPITAL STRUCTURE
Debt / Equity (D/E) ratio
The debt-to-equity (D/E) is a measure of the degree to which a company is financing its
operations through debt versus wholly-owned funds (equity).
In general, a company with a high D/E ratio is considered a higher risk to lenders and
investors because it suggests that the company is financing a significant amount of its
potential growth through borrowing.
CAPITAL STRUCTURE
Optimal Capital Structure
The optimal capital structure of a firm is the best mix of debt and equity financing that
maximizes a company’s market value while minimizing its cost of capital.
In theory, debt financing offers the lowest cost of capital due to its tax deductibility. However,
too much debt increases the financial risk to shareholders and the return on equity that they
require.
Thus, companies have to find the optimal point at which the marginal benefit of debt equals
the marginal cost. (Benefit = Costs)
CAPITAL STRUCTURE
Capital Restructuring
Activities that alter the firm’s existing capital structure is called capital restructuring.
Such as :
1) Increasing D/E ratio  Negotiating a long-term loan or issue some bonds and use the
proceeds to buy back some stocks.
2) Decreasing D/E ratio  Issuing stock and use the money to pay-off some debt.
CAPITAL STRUCTURE
Lesson 2 : REASON WHY CAPITAL STRUCTURE CHANGES OVER TIME
1) Deliberate management actions

 If a firm is not currently at its target capital structure, it may deliberately raise new money
in a manner that moves the actual structure towards the target.
2) Market actions
 Changes in the market value of the debt and/or equity capital could result in large changes
in its measure of capital structure.
 Factors :
1) Good economic returns
2) Change in interest rates
CAPITAL STRUCTURE
Lesson 3 : EXPLAIN THE CAPITAL STRUCTURE THEORIES
Can a firm increase its shareholders’ wealth by
replacing some of its equity with debt? If so, how much
debt should it use?
1) Traditional Approach
2) Franco Modigliani and Merton Miller Approach (MM)
3) Contemporary Approach
CAPITAL STRUCTURE
It suggests that there is a trade-off between cheaper debt and higher priced equity that leads
to an optimal capital structure. Thus, the cost of capital and the firm’s value are not
independent of its capital structure.
Total market value of the firm can be determined as :

a) Value of the firm = Market Value of Debt + Market Value of Equity
b) Value of the firm = EBIT(1-T) / Weighted Average Cost of Capital
The traditional approach attributes the cost of debt and equity to changing investor attitudes
towards risk.
CAPITAL STRUCTURE
Assumptions :
1) The rate of interest on debt remains constant for a certain
period and thereafter with an increase in leverage, it
increases
2) The expected rate by equity shareholders remains constant
or increase gradually. After that, the equity shareholders
start perceiving a financial risk and then from the optimal
point and the expected rate increases speedily.
3) As a result of the activity of rate of interest and expected
rate of return, the WACC first decreases and then
increases. The lowest point on the curve is optimal capital
Debt / MV of Firm
structure.
Relationship of the Cost of Debt (Kd) and Cost of Equity (Ks)
and Weighted Average Cost of Capital (Ka) to the firm’s total
value.
CAPITAL STRUCTURE
Relationship between Market Value of the

Firm and the Amount of Debt
Analysis :
Market value of firm first rises, reaches its peak at point
D/V where WACC (Ka) is minimized and finally declines
as leverage or debt increases.
Debt / MV of Firm
TRADITIONAL APPROACH ANSWER :
ILLUSTRATION :
Tarzan Health Center (THC) has no debt but is considering

two plans to add leverage (debt).
Plan A – issue P200,000 bonds
Plan B – issue P300,000 bonds
The proceeds from both plans shall be used to return the MV of D + MV of E
same amount of common stocks.
Management wants to evaluate the impact of increasing
THC’s financial leverage.
MV of Firm = EBIT / WACC
Therefore :
WACC = EBIT / MV of Firm
Using the traditional approach, determine the Market
value of equity, Market value of firm and Weighted
average cost capital.
Which plan is preferable? Why?
Plan A is preferred over both current capital structure
(Higher MV of Firm and Lower WACC)
CAPITAL STRUCTURE
2) The Modigliani and Miller (Perfect World) – version 1
The M&M Theorem, or the Modigliani-Miller Theorem, is one of the most important
theorems in corporate finance. The theorem was developed by economists Franco Modigliani
and Merton Miller in 1958.
The main idea of the M&M theory is that the capital structure of a company does not affect its
overall value.
This theory assumes no taxes, no chance of bankruptcy and no brokerage costs investors
can borrow at the same rate as corporations and symmetric information sets for all all
participants.
CAPITAL STRUCTURE
The first proposition essentially claims that the company’s capital structure does not impact its value.
In perfectly efficient markets, companies do not pay any taxes. Therefore, the company with a 100%
leveraged capital structure does not obtain any benefits from tax-deductible interest payments.
CAPITAL STRUCTURE
Analysis :
All levels of debt, the higher cost of equity, Ks is

sufficient to exactly offset the lower cost of debt Kd, and
thus leads to a constant weighted average cost of capital
(WACC) Ka.
CAPITAL STRUCTURE
Analysis :
The value of the firm is independent of its financial

leverage.
CAPITAL STRUCTURE
2) The Modigliani and Miller (MM) (Real World) – version 2
The second version of the M&M Theorem was developed to better suit real-world conditions. The assumptions of the newer
version imply that companies pay taxes; there are transaction, bankruptcy, and agency costs; and information is not symmetrical.
CAPITAL STRUCTURE
2) The Modigliani and Miller (MM) (Real World) – version 2
This shows that the use of financial leverage lowers a firm’s cost of capital and raises the
firm’s value because interest on debt is tax deductible.
The value of an unlevered firm with corporate taxes is determined as follows :
of an Unlevered Firm
CAPITAL STRUCTURE
2) The Modigliani and Miller (MM) APPROACH 2 (w/ Corporate Taxes)
Analysis :
If the cost of debt, Kd (1-T) is unaffected by financial

leverage then the WACC, Ka declines as the firms
borrows more.
CAPITAL STRUCTURE
2) The Modigliani and Miller (MM) APPROACH 2 (w/ Corporate Taxes)
Analysis :
Value is maximized with virtually 100% debt financing. This

result is consistent with MM assumptions, but it is not
observed in practice.
CAPITAL STRUCTURE
3) Contemporary Approach (Trade-Off Theory)
This asserts that there is an optimal capital structure or at least an optimal range of structures
for every firm. This approach identifies several factors that can lead to an optimal capital
structure for a given firm such as tax effects, financial distress and related costs.
* Corporate Income Taxes
The use of debt in capital structure of a corporation reduces its cost of raising funds because
interest on debt is tax deductible.
CAPITAL STRUCTURE
* Financial Distress and Related Costs
This approach allows for the possibility that the firm may go bankrupt. This implies that debtors that the firm’s
debt holders will have to allow the possibility that might not receive everything they have been promised.
In this realistic type of situation, bondholders will be asked to bear some firm risk in turn will ask for a little
more return.
If a financial distress occurs, the firm could incur some substantial costs such as fees to lawyers, consultants,
accountants, loss of efficiency in the firms operations, reduced sales because of post-sales support concerns,
lightening of credit terms from suppliers.
The risks in bankruptcy increase financial leverage.
CAPITAL STRUCTURE
Trade-off Theory of Leverage
This theory states that firm’s trade off the tax benefits of debt financing against problems caused by potential
bankruptcy. With this theory, the optimal debt level exists at which point the marginal benefits of financial
leverage equal the marginal costs.
Thus, the value of the levered firm considering tax effects, financial distress and related costs could be
determined as:
CAPITAL STRUCTURE
Shows that WACC declines because of
the favorable tax treatment given debt,
and then at relatively high degrees of
financial leverage because of high
bankruptcy costs and related costs.
CAPITAL STRUCTURE
Value of the firm with taxes, financial distress and

related costs.
CAPITAL STRUCTURE
In a nutshell …
The MM model without corporate taxes leads to the conclusion that there is no one optimal capital
structure. Both the traditional and contemporary approaches hold that there is an optimal capital
structure for each firm, but for different reasons.
CAPITAL STRUCTURE
In a nutshell …
Both Traditional and MM theories share several common assumptions.
1) Financing occurs only through 2 types of capital : long-term debt and ordinary equity share.
2) The firm’s investment decision is fixed, but its capital structure can be changed by issuing bonds
repurchase stock or issuing stock to retire debt.
3) There are no taxes or bankruptcy costs.
4) All earnings are paid out as dividends
5) Net operating income, also called earnings before interest and taxes (EBIT), is constant.
6) Business risk is constant.
CAPITAL STRUCTURE
Checklist for Capital Structure Decisions :
Factors Influencing Optimal Capital Structure
CAPITAL STRUCTURE
Assessment :
1) An optimal capital structure occurs under the :
a. Traditional approach
b. MM approach
c. Contemporary approach
d. Both traditional and contemporary approach
CAPITAL STRUCTURE
Assessment :
2) The traditional approach to capital structure management assumes
a. no taxes
b. all earnings are paid out as dividends
c. EBIT is constant
d. all of the given choices
CAPITAL STRUCTURE
Assessment :
3) The MM approach without corporate taxes (PERFECT) suggests that the firm’s WACC
a. remains constant as the proportion of debt increases
b. increases as the proportion of debt increases
c. decreases as the proportion of debt increases
d. increases as the proportion of debt decreases
CAPITAL STRUCTURE
Assessment :
4) The MM approach with corporate taxes (REAL), all of the following occurs as the use of debt
financing increases except
a. cost of equity increases
b. cost of debt increases
c. weighted cost of capital increases
d. market value of the firm increases
CAPITAL STRUCTURE
Assessment :
5) Which of the following asserts that the value of the firm is independent of its capital structure?
a. Traditional approach
b. MM approach without taxes (perfect)
c. MM approach with taxes (real)
d. Contemporary approach
THE MODIGLIANI AND MILLER (PERFECT WORLD) – NO TAX
Proposition 1 : The value of the firm is independent of its capital structure
Proposition 1 :
An all equity firm (100% equity-financed) has a market value of P300,000 and 50,000 shares outstanding.
It is thinking of changing its capital structure by borrowing P120,000 in debt and repurchasing the shares.
(Ignore taxes)
Current Structure :
Proposition 1 :
An all equity firm (100% equity-financed) has a market value of P300,000 and 50,000 shares outstanding.
It is thinking of changing its capital structure by borrowing P120,000 in debt and repurchasing the shares.
(Ignore taxes)
Current Structure : Proposed Structure :
Implications :
1) Share price is constant
Proposition 1 :
EBIT is representing the
CF attributed to Debt and
How to derive the GENERAL formula : Equity
Weighted average of Kd
and Ks
Proposition 1 :
Constant
Constant
Implications :
2) WACC is constant
Constant
Proposition 2 : Return on Equity (Re) / Cost of Equity (Ks) increases with more leverage
UNLEVERED DEBT LEVERED
Implications : Implications :
1) Share price is constant 1) Share price is constant
2) Equity is less risky 2) Equity is more risky
3) Return on equity increases
Proposition 2 : Return on Equity / Cost of Equity (Ks) increases with more leverage
DEBT Return on Debt

(rD)
ASSETS
EQUITY Return on Equity

(rE)
Return on Assets
(rA)
Implications :
2) WACC (rA) is constant
3) rD is constant
PROPOSITION 1 PROPOSITION 2
1) The value of the firm is independent of 1) Return on Equity (rE) increases with
its capital structure leverage
* share price is constant
* WACC is constant
WACC for ALL EQUITY (VU) FIRM

THE MODIGLIANI AND MILLER (REAL WORLD) – WITH TAX
MM (without Taxes) MM (with Taxes)
DEBT DEBT Interest is tax

deductible
ASSETS ASSETS
EQUITY EQUITY
MM (with Taxes)
Interest is
DEBT tax
deductible
ASSETS
EQUITY
Assumptions :
1) More Debt  More Interest  Larger Interest Tax Shield  Less Taxes
 Larger Firm Value
2) Interest Tax Shield = (Interest) (Tax Rate)
= (Debt) (Interest Rate) (Tax Rate)
Proposition 1 :
DEBT
Present Value of
Unlevered Levered
(VU)
+ Interest Tax = (VL)
Shield
Proposition 1 : VL = VU + PV of Interest Tax Shield
A firm is currently unlevered with 1,000,000 shares each priced at P50. The firm is debating of changing
its capital structure by taking 20 million pesos in debt and repurchasing shares. It will pay down this debt
by 4M every year. If the tax rate is 40% and cost of debt is 8%, what is the value of the restructured firm?
Current Restructured
DEBT
Present Value of
Unlevered Levered
(VU)
+ Interest Tax = (VL)
Shield
PV of Interest Tax Shield

DEBT
VL = VU + PV of Interest Tax Shield
VL = 50,000,000 + 1,611,610
VL = 51,611,610
An all equity firm currently has free cash flows of 10M a year and a cost of equity of 10%. They will take
on 30M of debt and repurchase shares. If the firm only plans to make interest payments, the interest rate
is 6% and tax rate is 40%, what is the value of the levered firm?
Compute for the value of firm Current
Restructured
PV of Interest Tax Shield
Option 1 :
Option 1 : Option 2 :
DEBT
VL = 100,000,000 + 12,000,000
VL = 112,000,000
Proposition 2 :
Increases with Constant

debt
also called free
cash flows
Implications : (FCF)
1) WACC decrease with

leverage
Decrease with
more debt
Proposition 2 : WACC decreases with leverage
REAL
PERFECT REAL
A firm has free cash flows of 20M with an unlevered cost of capital of 10%, permanent debt of 50M, cost
of debt 8% and tax rate of 40%. What is the WACC of the firm?

10.35294
9.0909
8% (1-.40)
CAPITAL STRUCTURE
Lesson 4 : BUSINESS RISK AND FINANCIAL RISK
Financial risk and business risk are two different types of warning signs that
investors must investigate when considering making an investment.
Financial risk
 refers to a company's ability to manage its debt and financial leverage.
 the risk that a company may default on its debt payments.
 is the additional risk placed on shareholders as a result of the decision to finance with debt.
Business risk
- refers to the company's ability to generate sufficient revenue to cover its operational expenses.
- the risk that the company will be unable to function as a profitable enterprise.
CAPITAL STRUCTURE
Lesson 4 : BUSINESS RISK & FINANCIAL RISK
Factors that affect Business Risk
CAPITAL STRUCTURE
Lesson 5 : FINANCIAL AND OPERATING LEVERAGE
LEVERAGE
Leverage is actually borrowed from Physics
In Physics :
Gaining larger benefits by using lesser
amount of force
In Financial Management :
To gain higher financial benefits (return)
compared to the fixed charges payables
(cost of debt).
CAPITAL STRUCTURE
OPERATING LEVERAGE (DOL)
 is a cost-accounting formula that measures the degree to which a firm or project can increase
operating income by increasing revenue.
 is the measure of how sensitive net income is to a given change in peso of sales.
 if operating leverage is high, a small percentage in sales can produce a much larger percentage
increase in net income.
OPERATING LEVERAGE
A company sells a product for P30/unit with variable costs of P12/unit. Fixed costs are P30,000.
OPERATING LEVERAGE
If the production level increased by 10%
OPERATING LEVERAGE
If the production level decreased by 10%
OPERATING LEVERAGE
DOL = 6
% of FC over Sales : Implications :

= 30,000/60,000 Higher fixed cost relative to sales =
= 50% Higher DOL = More sensitive
operating income to Δ in sales.
DOL = 1.5
% of FC over Sales :
= 30,000/150,000
= 20%
OPERATING LEVERAGE
1) Lower VC
2) Higher FC 1) Higher VC
3) Capital/machine intensive 2) Lower FC
(Automation) 3) Labor intensive
OPERATING LEVERAGE
HIGH OPERATING LEVERAGE LOW OPERATING LEVERAGE
• More operating income • Less operating income

sensitivity sensitivity
• Higher fixed costs • Lower fixed costs
• More machines • Less machines
• Less people • More people
• Capital/machine intensive • Labor intensive

(Automation)
• Stable
• Volatile
CAPITAL STRUCTURE
FINANCIAL LEVERAGE (DFL)
 reflects the amount of debt used in the capital structure of the firm.
 is a leverage ratio that measures the sensitivity of a company’s earnings per share (EPS) to
fluctuations in its operating income (EBIT), as a result of changes in its capital structure.
 may be defined as the percentage change in earnings (% Δ EPS) that occurs as a result of a
percent change in earnings (% Δ EBIT).
FINANCIAL LEVERAGE (DFL)
Let’s compute for the degree of financial leverage for Plan A and Plan B at an EBIT level of P36,000.
Plan A calls for P12,000 of interest at all level of financing and Plan B requires P4,000.
Plan A has higher

DFL , at an EBIT
level of P36,000, 1%
increase in earnings
will produce 1.5
percent increase in
earnings per share.
FINANCIAL LEVERAGE EFFECTS ON EPS AND ROE
A firm has a total market value of P175,000, no debt and 20,000 shares outstanding. In a normal economy, the EBIT is
P30,000. The EBIT will be 30% higher and 40% lower in an expansion and recession respectively.
Tax rate is 30%
Tax rate is 30%
If a firm is considering a recapitalization by issuing P71,750 worth of debt that has 6% interest, and using it to
repurchase shares.
Tax rate is 30%
repurchase shares.
Kd = 6%
Tax rate is 30%
repurchase shares.
Implications :
1) Financial Leverage magnifies ROE and EPS
2) It makes equity more volatile and risky
3) Increases risk to shareholders
DEGREE OF COMBINED LEVERAGE (DCL)
DCL use the entire income statement to show the impact of change in sales or volume on
botton-line earnings per share (EPS).

Capital Structure: I. Opening Prayer II. Announcements III. Overview of The Topic IV. Discussion and Recitation

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Capital Structure: I. Opening Prayer II. Announcements III. Overview of The Topic IV. Discussion and Recitation

Uploaded by

Copyright:

Available Formats

MODULE II

1) Deliberate management actions

Total market value of the firm can be determined as :

Relationship between Market Value of the

Tarzan Health Center (THC) has no debt but is considering

MV of Firm = EBIT / WACC

All levels of debt, the higher cost of equity, Ks is

The value of the firm is independent of its financial

If the cost of debt, Kd (1-T) is unaffected by financial

Value is maximized with virtually 100% debt financing. This

Value of the firm with taxes, financial distress and

Current Structure : Proposed Structure :

UNLEVERED DEBT LEVERED

DEBT Return on Debt

EQUITY Return on Equity

WACC for ALL EQUITY (VU) FIRM

MM (without Taxes) MM (with Taxes)

DEBT DEBT Interest is tax

PV of Interest Tax Shield

VL = VU + PV of Interest Tax Shield

VL = VU + PV of Interest Tax Shield

Increases with Constant

1) WACC decrease with

VL = VU + PV of Interest Tax Shield

% of FC over Sales : Implications :

• More operating income • Less operating income

• Higher fixed costs • Lower fixed costs

• More machines • Less machines

• Less people • More people

• Capital/machine intensive • Labor intensive

Plan A has higher

You might also like