CAPITAL

STRUCTURE
By: Ms. Gene Pierre
OBJECTIVES
LO 1: BORROWING RATES LO4: PECKING ORDER
Explain the
appropriate
Explain why borrowing rates are borrowing
strategy under the
different based on ability to repay pecking order
hypothesis.
loans.

LO2: BORROWING LO5: OPTIMAL

BENEFITS Develop
CAPITAL the arguments
for the optimal capital
Demonstrate the benefits of structure
taxes and in
noa bankruptcy
world of no
borrowing and in a world
corporate taxes of
with no
bankruptcy costs.
LO3: BREAK EVEN EBIT
Calculate the break-even EBIT for
different capital structures LO6: STATIC THEORY
Understand the static theory of capital
structure and the trade-off between the
benefits of the tax shield and the cost
of bankruptcy

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LO 1: BORROWING RATES
Why do borrowing rates differ based on the ability to
repay loans?

Even though two distinct people or businesses approach to the same

bank and ask for the exact same amount of funding for their
projects, they may wind up paying different costs for the funds.

How come?
The rationale is that two borrowers might not have the same
resources needed to repay the loans.

Thus:
The cost of funding is going to be higher for the "riskier"
borrower. The lender's assessment of the risk of loan repayment
will have a direct impact on the borrowing rate for an individual or
business.

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LO 1: BORROWING RATES
Example:

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LO 1: BORROWING RATES
Example
Solution:

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LO2: BORROWING BENEFITS

At a 900%
borrowing rate
from Sherry
Would anyone
want to borrow
from her?

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LO2: BORROWING BENEFITS

2023 BENEFITS OF BORROWING 7

LO2: BORROWING BENEFITS

FINANCIAL LEVERAGE
From the example, what we have seen is the advantage of Financial Leverage.
In simple terms, it is when you borrow money to make money.

If successful, the borrower would’ve been able to make a profit of

$4,000,000.00. Investing in a project that yielded a 4,900% return.

($5,000,000.00 - $ 100,000) / $100,000.00

$4,900,000/ $100,000 x 100 =4900% return
Which looks quite attractive in comparison to Sherry’s 900% return on her
investment.
Companies with great leverage are called “ highly levered” whilst companies
with no debt are called “ unlevered”

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EPS AS A MEASURE OF THE BENEFITS OF
BORROWING

One way to measure the advantage of financial leverage to the

company’s owners is to examine the company’s EPS ( Earnings
Per Share) before and after borrowing.

Investopedia. EPS

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 EXERCISE 1.

CAPITAL STRUCTURES OF 3 IDENTICAL FIRMS

What can you tell me about their choice of financing?

C1: 100% Equity Financed, Sold 400 shares @ $25
C2: 50% Debt 50% Equity, Sold 200 shares @ $25
C3: 100% Debt Financed, Sold 1 share @ $25

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 EXERCISE 1.

EPS OF FIRMS WITH DIFFERENT FUNDING STRUCTURES

Let’s examine the EPS of each firm if EBIT = $2000.00

10% interest on debt
No Taxes
Calculate EPS

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EXERCISE 1.

EPS OF FIRMS WITH DIFFERENT FUNDING STRUCTURES

Let’s examine the EPS of each firm if EBIT = $800.00

10% interest on debt
No Taxes
Calculate EPS

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 EX 1. TAKE AWAY
According to Table 16.2, the shareholders benefit more from the company's
sale of debt when earnings (EBIT) reach $2,000. When the earnings show a
return higher than the 10% cost of debt, this is the situation.

With an EBIT of $800 as seen in Table 16.3 it now shows that the owners of
Company 1, the all-equity firm, are in a better position. The percentage of
earnings that can be distributed to owners decreases as debt increases since
earnings are less than debt costs.

Therefore, leverage is based on how well the business is doing. A successful

business can handle more debt and provide benefits to its owners. It benefits
the owners to borrow money at a fixed interest rate from debt lenders and use
it to invest in their company, earning a higher rate. Once more, the business
profits off the use of other people's funds. Debt, however, makes losses more
severe when a business performs poorly.
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 LO3: BREAK
EVEN EBIT
Calculate the break-even EBIT for
different capital structures.

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 LO3: BREAK EVEN EBIT
As we change the EBIT, we can see from the preceding
section that the three capital structures have varied
earnings per share.

In addition, we can find the EBIT of any two similar

companies that yields the same EPS. Determining this
break-even EBIT will then help the company decide
how much debt to take on.

Debt financing is not beneficial below the break-even

point. The company profits from financial leverage
above break-even.
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BREAK EVEN EBIT FORMULA

When EBIT is at $1000.00, although the three capital structures vary, the EPS is the same for each company. This
will help the company determine the amount of debt they should take on.

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BREAK EVEN EBIT

Break Even EBIT Depicted on Graph where EPS is the same for all companies at break even point.

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LO4: PECKING ORDER
According to the pecking order hypothesis, a company should use its own
resources before relying on outside funding. If outside funding is needed, it should
borrow money from the lowest-cost source up until it runs out. If the company
needs to borrow additional money, it gradually increases the cost of borrowing
until it runs out of all potential funding. The pecking order theory is based on the
idea of asymmetric information. When one party to a transaction possesses
different information from the other party, the information is asymmetric.
In this particular situation, asymmetric information refers to the reasonable belief
that managers or business owners have a better understanding of the company's
future performance than do possible outside lenders.
PECKING ORDER 2023 18
LO4: PECKING ORDER
CHEAPEST SOURCES OF FUNDING ACCORDING TO THE PECKING ORDER
1st Internal Funding _ Savings/ Retained Earnings
2nd Debt_ Loans
3rd Equity_ Stocks

THE PECKING ORDER CONCEPT HAS THE FOLLOWING THREE

IMPLICATIONS:
1. Companies that are profitable will borrow less since they can take on more debt and have
more available internal finances.
2. In an asymmetric world, less profitable businesses will require more outside capital and may
prioritize debt financing over the equity financing.
3. Businesses will sell equity as a last resort to finance investment prospects.
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LO5: OPTIMAL CAPITAL
Modigliani
World of Noand Miller
Taxes & No Proposition
Bankruptcy) 1. ( A
Two financeand
Modigliani professors
Merton Franco
Miller,in looked at
the OPTIMAL
concluded that capital
the structure
financing choice 1956
had and
no
influence
Their firston the firm's
venture valuation.
into thebegan
optimalwith a
capital
simple structure
model and question
a hypothetical world of
no
thistaxes and
conclusion no bankruptcy.
M&M They
Proposition labeled
I.
We also represent
equation in which this
the proposition
value of an inall-
an
equity firm (VE)
of a levered is equal to the value
firmVE(VL)
M&M Proposition =
1not VL
simply states that the
value
capital of a firm
structure. does
In other depend
words, on its
it doesn’t
matter
same. how you slice it; the value is the
We can capture
Proposition I the essence
with a of M&M
convenient “Yogi-
ism,”
pizza an
and expression:
when the “Yogi
pizza ordered
was ready ato be
served,
cut the the
pizza server
into asked
four or Yogi
eight if slices.
he should
Yogi
eat replied,” The
eight.’ ‘Four,sizeI don’t
of the think
pie is I can
the
same,
of no no matter
taxes and how
no it is sliced.
bankruptcy, the In a world
borrowing mix of a firm is irrelevant.
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LO5: OPTIMAL CAPITAL
Modigliani and Miller Proposition 1 (Cont’d)

So, If the firm’s value doesn’t depend on how, it structures its financing, then on what
does it depend?

M&M Proposition states that it depends on three things:

1. The required rate of return on the firm’s assets (which is the same for firms

with identical assets or investment choices)

2. The cost of debt to the firm

3. The firm’s debt-to-equity ratio (measures how much debt a company has compared to
its assets)
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LO5: OPTIMAL CAPITAL
Modigliani and Miller ( In a World with Corporate Taxes & No Bankruptcy)

Following up on their first research, Modigliani and Miller created a new model that
considered a world with corporation taxation.

Given that taxes are an inevitable part of existence, why then did we consider a world
without them? The rationale is that we require a standard to evaluate against to
comprehend how taxes impact the financing decision.

M& M Proposition I, declares that with taxes all debt financing is optimal.

How so you may ask? By using Tax Shields.

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TAX SHIELD
The tax shield is a tax-deductible expense that lowers taxes and raises the value of the company. The
company gives its shareholders access to this tax shield.

Therefore, the value of the company to its shareholders rises when the government's portion of the
company decreases. The government's stake in the company decreases and the tax shield increases with
the amount of debt sold.

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TAX SHIELD
Table 16.5 Illustrates
that the greater the
debt share the lesser
the governments
share

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LO6: STATIC THEORY

Understand the Static Theory of Capital Structure

Why wouldn't businesses seek to use leverage to

finance 100% of their operations with debt to reduce
government taxes?
One word to describe the response is Bankruptcy.

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BANKRUPTCY

A firm’s shareholder gains from an

interest tax shield when it adds debt to
its financing mix, but they also assume
risk of the company going bankrupt.
The moment a company's equity value
reaches zero is when bankruptcy
occurs. Meaning that at that moment,
the assets' worth is either the same as
or lower than the liabilities of the
company. The debt holders now "own"
the company after the equity investors
have lost all of their value due to
bankruptcy.

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LO6: STATIC THEORY

The Static Theory makes the assumption that having a tax shield
may raise a company's worth; but, as the amount of debt in the
company's financial structure rises, so do the expenses associated
with financial difficulties. Financial distress expenses increase as a
company takes on more and more debt in a world of taxes and
bankruptcy. Eventually, the advantages of the growing tax shield
are outweighed by this rising expense. When the marginal costs of
financial distress are equal to the marginal advantages of the tax
shield, a corporation will find its optimal capital structure, or the
maximum amount of debt financing.

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SUMMARY

An OPTIMAL CAPITAL
STRUCTURE is a GOOD MIX of
both debt and equity funding that
reduces a company’s cost of capital
and increases its market value.
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THANK YOU
Ms. Gene Pierre