Capital Structure Theory

Dr A Vinay Kumar

Agenda
Discuss Arguments for and against the use debt Discuss the need for the use of debt

Arguments
How do you build an argument against the use of debt?

MM Assumptions(1958)
Firms Risk can be measured by its STDEV (EBIT), Firms thus can be grouped in a risk class All investors are identical expectations about each firms future EBIT and expected future earnings No Transaction costs All debt is riskless All Cash-flows are perpetuities, all earnings are paid out as dividends. Firms have zero growth rate. All earnings are paid out as dividends There are no Taxes

Example
Consider a firm which can earn an EBIT of 3000 which is an all equity firm. The cost of equity is 15%. It is considering to raise Rs 10000 and repurchase stock to alter its capital structure. The cost of debt will be 10%.

MM Propositions
Proposition 1
Value of the levered firm will be equal to the value of unlevered firm belonging to same business risk class. i.e VL=VU , Where VL is the value of levered firm and VU is the value of unlevered firm

Proposition 2
The cost of equity of levered firm will be higher than the cost of equity of unlevered firm by a certain premium which is the compensation for the additional risk. This compensation is the financial leverage. KeL= KeU +(KeU-Kd)D/E, Where KeLis the cost of equity of levered firm and KeU is the cost of equity of un levered firm and Kd is the cost of debt and D/E is debt to equity ratio.

So how our example works?

Value of unlevered firm
VU= 3000/15% =20000 VL= 3000/WACC, we dont know the WACC so lets calculate it. Use proposition 2 we get cost of equity of levered firm, which is equal to 20%
KeL= 15%+(15%-10%)(10000/10000)=20%

So WACC is 15%
WACC= 20%*50%+10*50%=15%

So the overall expectation of the debt + equity holders will remain at 15% and therefore the value of a levered firm will be the same as un levered firm. Any deviation therefore will create an arbitrage.

Argument
How do build an argument for the use of debt? Consider taxes

MM Revised
Proposition 1
Vl=VU+ TD

Propostion 2
KeL=KeU+(KeU-Kd)(1-T)(D/E)

So our example
With taxes of 40% Vu= 3000(1-.4)/.15 =12000 Vl = 12000+(.4)*10000 =16000

Wow we created value by adding debt on capital structure, other wise our equity holder value would have been 2000 but because we pay less taxes their value is now 6000. KeL=15%+(15%-10%)(1-.4)(10000/6000) =20% WACC =20%*(6000/16000)+10%*(1.4)*(10000/16000) =11.25% ( wow WACC reduced) Therefore value increased.

So what about WACC

So some reality
Well debt cant be riskless
Financial distress and bankruptcy costs Agency costs

 Is there an optimal capital structure?