VIII – Capital Structure

Financial Management

Dr. Orhan ÖZAYDIN

Today
Capital Structure
Deciding Optimal Capital Structure
Capital Structure Theories
 • Capital Structure refers to the mix
of debt and equity a firm uses to finance its
operations and assets. It reflects how a
company balances these two primary
funding sources and is commonly expressed
as the debt-to-equity ratio.

• A firm aims to achieve an optimal capital

Debt__
structure—the combination of debt and
Equity
equity that maximizes its market value
while minimizing the overall cost of capital.
This balance ensures efficient funding,
enhances profitability, and aligns with the
company’s risk tolerance and financial
strategy.
When making capital structure decisions, it is
crucial to establish an appropriate debt-to-equity balance
that considers both:

[Link] the Cost of Capital: Optimizing the mix

of debt and equity to minimize the overall Weighted
Average Cost of Capital (WACC), thereby
increasing the firm's value.

[Link] Financial Risk (..company risk):

Managing the level of debt to ensure the company
maintains financial stability and avoids excessive
leverage, which could lead to higher interest
obligations, reduced flexibility, or insolvency risks.

A well-balanced capital structure achieves a trade-off between

cost efficiency and risk management, supporting long-term
financial sustainability and shareholder value creation.
Debt vs. Equity Financing Impact of Increasing Debt
Debt Financing generally costs less than equity. This is As the proportion of debt in the capital structure rises:
primarily because: • Owners' Risk Increases: The certainty of returns to
• Lower Risk for Debt Providers: Lenders (debt shareholders decreases, as fixed obligations to debt
holders) have priority over shareholders in claims providers take precedence.
on the company's assets and earnings, reducing • Bankruptcy Risk Grows: Excessive reliance on debt
their risk compared to equity investors. financing heightens the risk of financial distress or
• Tax Advantages: Interest payments on debt are tax- insolvency.
deductible, reducing the overall cost of debt. • Cost of Debt Rises: Lenders demand higher interest
• Higher Costs of Equity: Raising equity often involves rates to compensate for the increased risk
higher inference costs and a greater return associated with higher leverage.
expectation from shareholders due to the higher
risks they bear.
Pros and Cons of Equity Pros and Cons of Debt

Pros: Pros:
• No interest payments. • Lower cost compared to equity.
• No mandatory fixed payments (dividends • Fixed repayment schedule provides
are discretionary). predictability.
• No maturity dates (no capital repayment). • First claim on the firm’s assets in the event
• Provides ownership and control over the of liquidation.
business. • Investors expect a lower rate of return than
• Offers voting rights (typically). equity.

Cons: Cons:
• High implied cost of capital. • Requires interest payments (typically).
• Investors expect a high rate of return • Comes with covenants and financial
(dividends and capital appreciation). performance metrics that must be met.
• Last claim on the firm’s assets in the event • May impose restrictions on operational
of liquidation. flexibility.
Optimal capital structure
• Since the discount rate is used to calculate the present value of
future cash flows, there is an inverse relationship between the
discount rate and the present value.
• As a result, a company can increase its value by reducing its
Weighted Average Cost of Capital (WACC). Therefore, a capital
structure that minimizes WACC is more favorable than one with a
higher WACC.

• To create an optimal capital structure, it is crucial to carefully

consider the cost of equity (ke​), the cost of debt (kd​), and the
weighted average cost of capital (ka​) at varying debt-to-equity
ratios.
Capital Structure Theories
Different theories provide varying perspectives on how capital structure affects WACC
and, consequently, the value of the business:

Net Income (NI) Approach and Traditional View:

• WACC is dependent on capital structure decisions.
• Increasing the proportion of debt can reduce WACC up to a certain point,
improving the value of the firm.

Net Operating Income (NOI) Approach and Modigliani-Miller (MM) Approach:

• WACC is independent of capital structure decisions.
• Changes in the debt-to-equity ratio do not affect the firm’s value, assuming ideal
market conditions (e.g., no taxes or bankruptcy costs in the MM theory without
taxes).
The Net Income (NI) Approach states that a company's capital structure influences
its value.
• Increasing debt in the capital structure reduces the Weighted Average Cost of Capital
(WACC) because debt is cheaper than equity, leading to higher firm value.
• However, this approach neglects the risks of excessive debt, such as bankruptcy and
increased equity risk.
• It assumes that maximizing debt always benefits the enterprise without accounting for
financial distress.

Cost of Capital
ka: k-avarage (WACC)
ke: k-equity
kd: k-debt

Debt/Equity
The Traditional Approach suggests there is an optimal capital structure where the
Weighted Average Cost of Capital (WACC) is minimized.
• Moderate use of debt reduces WACC and increases firm value, but excessive debt leads to
sharp increases in both the cost of equity and cost of debt due to heightened financial risk.
• The cost of debt also increases, as lenders demand higher returns to compensate for the
increased risk of non-payment.
• The approach balances the benefits of debt with the risks of over-leverage to achieve optimal
financing.

Cost of Capital

ka: k-avarage (WACC)

ke: k-equity
kd: k-debt

Debt/Equity
The Net Operating Income (NOI) Approach states that capital structure does not
affect company value or WACC, meaning there is no optimal capital structure.
• While increased debt lowers costs initially, the resulting higher financial risk raises the cost
of equity, offsetting any benefits and keeping WACC constant.
• Company value depends on operating income and business risk, not on financing
decisions.

Cost of Capital

ka: k-avarage (WACC)

ke: k-equity
kd: k-debt

Debt/Equity
According to Modigliani and Miller (MM), under certain perfect market assumptions,
the capital structure of a business (debt/equity mix) does not affect its value. They argue that the
way a company finances its operations is irrelevant to its overall value.

Assumptions of Perfect Markets:

• No Taxes: There are no tax advantages or disadvantages to debt financing.
• No Bankruptcy Costs: Financial distress has no impact on the firm's cost structure or value.
• Equal Borrowing Conditions: Investors and companies have equal access to borrowing at the
same rates.

Cost of Capital

ka: k-avarage (WACC)

Debt/Equity
 Comparison of Theories
Net Income: Net Operating Income: Traditional: Modigliani-Miller:
Higher debt = higher value Capital structure doesn’t matter Optimal mix of debt and equity Irrelevant without taxes;
exists leverage is beneficial with taxes
• It states that as the share of • It explains that the cost of • It explains that the advantage • Says that the capital structure
debt resources -whose cost equity will increase due to the obtained due to the use of is irrelevant in determining the
less- in the capital structure increase in financial risk when debt -whose cost less- can be weighted average cost of
increases, there will be a the debt resource weight in sustained up to a certain capital under perfect market
decrease in the WACC. the enterprise increases. point. assumptions.
• It is assumed that cost of • And as a result, the weighted • Thus, it will allow the WACC to • Leverage increases value only
equity and cost of debt is average cost of capital will be reduced. with taxes; without taxes, no
constant for every level of remain constant. • However, beyond that certain optimal structure exists.
debt/equity ratio. • It is assumed that cost of debt point risk of company will • Highlights the benefits of debt
is constant for every level of increase, so does cost of debt under tax advantages.
debt/equity ratio. and equity.
Modern Theories: 1. Financial Hierarchy Theory

In the Financial Hierarchy Theory, company managers prioritize different

capital components to meet the resource needs of the business. The
hierarchy of financing choices is as follows:
1. Internal Funds: The company first uses internal funds, allocating
profits based on investment opportunities and utilizing cash reserves
when necessary.
2. External Financing: If internal funds are insufficient, the company
seeks external financing, starting with the least risky debt, followed by
riskier debt resources and hybrid instruments.
3. Stock Issuance: Issuing equity is considered the last resort.
Reasoning Behind the Hierarchy

The hierarchy in capital structure decisions is driven by the desire to:

•Preserve the company's borrowing capacity.
•Minimize dependence on external influences.
•Avoid inference costs associated with raising equity.
•Prevent sending negative signals to the market, which may arise from
equity issuance, as it is often perceived as a lack of internal resources or
financial instability.
Modern Theories: 2. Stakeholder Theory

• The company's interaction with its stakeholders is also an important factor in

determining the optimal capital structure.
• Stakeholders include not only those who provide financial resources, such as
investors and lenders, but also customers, suppliers, employees, and the
community in which the business operates.
• If the company experiences financial distress, stakeholders may become
reluctant to engage in business with the company. Even in the absence of
bankruptcy, high levels of debt can negatively impact the company's
profitability.
• When maintaining a reputation as a stable business is a priority, excessive
leverage or high levels of indebtedness are generally not preferred.
Thank you