Capital Structure

Varnita Srivastava
Assistant Professor
Indian Institute of Management Shillong
What is Capital Structure?
• The combination of debt and equity used to finance a
firm’s projects is referred to as its capital structure.

• What is the optimal ratio of debt and equity?

• Why do some industries tend to have firms with

higher debt-equity ratios than other industries?

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Financial Leverage and Risk
• Equity owners can reap most of the rewards through
financial leverage when their firm does well.

• But they may suffer a downside when the firm does

poorly.

3
Capital Structure and
Taxes
• Income taxes play an important role in a firm’s capital
structure decision because the payments to creditors
and owners are taxed differently.

• The basic framework for the analysis of capital

structure and how taxes affect it was developed by
two Nobel Prize winning economists, Franco
Modigliani and Merton Miller (M&M).

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 Capital Structure and the Pie
• The value of a firm is defined to be the sum of the
value of the firm’s debt and the firm’s equity.
V=B+S
•If the goal of the firm’s
management is to make the S B
firm as valuable as possible,
then the firm should pick the
debt-equity ratio that makes
the pie as big as possible.
Value of the Firm
 Stockholder Interests
1. Why should the stockholders care about
maximizing firm value? Perhaps they should be
interested in strategies that maximize shareholder
value.

2. What is the ratio of debt-to-equity that maximizes

the shareholder’s value?

As it turns out, changes in capital structure

benefit the stockholders if and only if the
value of the firm increases.
 Max. firm value vs. Max. Stockholder Interests

• Equity capital for an unlevered firm is $1000.

• Company plans to borrow $500 to
pay dividends.
No Debt After Dividend Payment
I II III
Debt 0 500 500 500
Equity 1,000 750 500 250
Firm Value 1,000 1250 1000 750
 Max. firm value vs. Max. Stockholder Interests

• Equity capital for an unlevered firm is $1000.

• Company plans to borrow $500 to
pay dividends.
Payoff to shareholders after div pmt
I II III
Capital gain -250 -500 -750
Dividends 500 500 500
Net gain/loss to 250 0 -250
shareholders
 Financial Leverage, EPS, and ROE
Consider an all-equity firm that is contemplating going into
debt. (Maybe some of the original shareholders want to
cash out – buyback equity)
Current Proposed
Assets $20,000 $20,000
Debt $0 $8,000
Equity $20,000 $12,000
Debt/Equity ratio 0.00 2/3
Interest rate n/a
8%
Shares outstanding 400
240
Share price $5
0 $50
EPS and ROE Under Current Structure
Recession Expected Expansion
EBIT $1,000 $2,000 $3,000
Interest 0 0 0
Net income $1,000 $2,000 $3,000
EPS $2.50 $5.00 $7.50
ROA 5% 10% 15%
ROE 5% 10% 15%
Current Shares Outstanding = 400 shares
EPS and ROE Under Proposed Structure
Recession Expected Expansion
EBIT $1,000 $2,000 $3,000
Interest 640 640 640
Net income $360 $1,360 $2,360
EPS $1.50 $5.67 $9.83
ROA 1.8% 6.8% 11.8%
ROE 3.0% 11.3% 19.7%
Proposed Shares Outstanding = 240 shares
 Financial Leverage and EPS
12.00

10.00 Debt

8.00 No Debt

6.00 Break-even Advantage

EPS

point to debt
4.00

2.00

0.00
1,000 2,000 3,000
(2.00) Disadvantage EBIT in dollars, no taxes
to debt
 Financial Leverage and EPS
• In case of no leverage, the line begins at the origin, indicating that
earnings per share would be zero if earning before interest was
zero.
• In case of leverage, the EPS is negative if earning before interest
is zero because the interest must be regardless of the firm’s
profits.
• The slope of the dotted line is steeper than the slope of the solid
line because the levered firm has fewer shares of stock
outstanding than the unlevered firm.
• Therefore any increase in earning before interest leads to a greater
rise in EPS for the levered firm because the earnings increase is
distributed over fewer shares of stock.
• Earnings above the BEP lead to a greater EPS for the levered firm
and earnings below the BEP lead to a greater EPS for the
unlevered firm.
M&M Hypothesis
• M&M reasoned that if the following conditions hold,
the value of the firm is not affected by its capital
structure:
– Condition #1: Individuals and corporations are able to
borrow and lend at the same terms (referred to as
“equal access”).
– Condition #2: There is no tax advantage associated
with debt financing (relative to equity financing).
– Condition #3: Debt and equity trade in a market where
assets that are substitutes for one another trade at
the same price. This is referred to as a perfect
market.
– Condition #4: There are no bankruptcy costs
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M&M Hypothesis…Cont’d
• M&M reasoned that if the following conditions hold,
the value of the firm is not affected by its capital
structure:
– Condition #5: All cash flow streams are perpetuities
(i.e., no growth)
– Condition #6: Corporate insiders and outsiders have the
same information (i.e., no signalling
opportunities)
– Condition #7: Managers always maximize shareholders’
wealth (i.e., no agency cost)

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Homemade Leverage

• If levered firms are priced too high, rational

investors will borrow on their personal
accounts to buy shares in unlevered firm –
this substitution is known as homemade
leverage.
• As long as individuals borrow and lend on
the same terms as firms, they can duplicated
the effects of corporate leverage on their
own.
 Homemade Leverage: An Example
Recession Expected Expansion
EPS of Unlevered Firm $2.50 $5.00 $7.50
Earnings for 40 shares $200 $300
$100
Less interest on $800 (8%) $64 $64

$64
We Net
are Profits
buying 40 shares of a $50$136 stock, using
$236
$800 in margin. We get the same ROE as if we
$36
bought
ROE into a Profits
(Net levered firm.
/ $1,200) 11.3% 19.7%
Equity Investment = 1200 3.0%
Our personal debt-equity ratio is:
B $800
S   3

2$1,200
 Homemade (Un)Leverage: An
Example Recession Expected Expansion
EPS of Levered Firm $1.50 $5.67 $9.83
Earnings for 24 shares $36 $136 $236
Plus interest on $800 (8%) $64 $64 $64
Net Profits $100 $200 $300
ROE (Net Profits / $2,000) 5% 10% 15%

Buying 24 shares of an otherwise identical levered firm along

with some of the firm’s debt gets us to the ROE of the unlevered
firm.

Investment = 2000

This is the fundamental insight of M&M

 MM Proposition I (No Taxes)
• The value of the levered firm is the same as the value of the unlevered
firm.
• Through homemade leverage, individuals can either duplicate or
undo the effects of corporate leverage.
• We can create a levered or unlevered position by adjusting the
trading in our own account.
• This homemade (un)leverage suggests that capital structure is
irrelevant in determining the value of the firm:
VL = VU
(value of levered firm equals the value of unlevered firm)
 MM Proposition II (No Taxes)
• Effect of leverage on the cost of equity
The cost of equity rises with leverage because the risk to
equity rises with leverage.
• An investor’s expected return rises with the amount of the leverage
present.
– Leverage increases the risk and return to stockholders
Rs = R0 + (B / S) (R0 - RB)
RB is the interest rate (cost of debt)
Rs is the return on (levered) equity (cost of equity)
R0 is the return on unlevered equity (cost of capital). In a
world with no taxes, the WACC for a levered firm is equal to
R0.
B is the value of debt
 MM Proposition II (No Taxes)
The derivation is straightforward:
B S
rWACC  rB
S Then set WACC  0
B S  B S r r
B S r
r  r r
B S
B S B
B S S
multiply bothsides by S
0

B
B  S  B B  B  S  S S
S 0
S
r r
S B S S B r
 B S
B S
 0
S S S
r
r
BBBr  S  B 0  0 rS  0  B (r0 r B )
S r S r S
r r r
 MM Proposition II (No Taxes)
Cost of capital: r (%)

B
rS  0r S (r
0 B
L
r )

B S
r0 rWACC  Br S
 B  B r
S S

rB

B
Debt-to-equity Ratio S
MM Proposition II (No Taxes)
• The cost of equity capital, Rs, is positively
related to the firm’s debt-equity ratio.
• The firm’s WACC is invariant to the firm’s
debt-equity ratio.
• The cost of capital for an all-equity firm is
represented by a single dot, R0, on the graph.
By contrast, WACC is an entire line.
MM Propositions I & II (With Taxes)

In the presence of corporate taxes, the firm’s

value is positively related to its debt.
 MM Propositions I & II (With Taxes)

• Proposition I (with Corporate Taxes)

– Firm value increases with leverage
V L = V U + TC B
• Proposition II (with Corporate Taxes)
– Some of the increase in equity risk and return is offset by
the interest tax shield
RS = R0 + (B/S)×(1-TC)×(R0 - RB)
RB is the interest rate (cost of debt)
RS is the return on equity (cost of equity)
R0 is the return on unlevered equity (cost of capital)
B is the value of debt
S is the value of levered equity
TC is the corporate tax rate
 MM Propositions I
(With Taxes)
Shareholders in a levered firm receive Bondholders receive
( EBIT r B ) (1 T ) rB B
Thus, total cash flow to all stakeholders is
( EBIT r B ) (1 T ) r
B
The present
Clearly value rof
( EBIT B Bthis stream
) (1 ofrBcash
TC )  B flows
is VL  EBIT (1 T )  r B (1 T )  r B
 C B
C
(1 T )  r B  r BT BrB
C B B C
B
 EBIT
The present value of the first term is VU
The present value of the second term is T C B
L
V U TC B
MM Proposition II (With Taxes)
Effect of Financial Leverage

Financial leverage adds to the firm’s equity. As compensation, the cost of equity rises with
firm’s risks. In no taxes Rwacc is not affected by leverage. Because debt is tax advantaged
to equity, it can be shown that Rwacc declines with leverage.Ro is a single point wheras Rs,
Rb and Rwacc are all entire lines.
Total Cash Flow to Investors

All-equity firm Levered firm

S G S G

The levered firm pays less in taxes than does the all-equity firm.
Thus, the sum of the debt plus the equity of the levered firm is
greater than the equity of the unlevered firm.
This is how cutting the pie differently can make the pie “larger.”
-the government takes a smaller slice of the pie!
Optimal Capital Structure
• The mix of debt and equity that maximizes the value
of the firm is referred to as the optimal capital
structure.

• While we cannot specify a firm’s optimal capital

structure, we do know the factors that affect the
optimum.

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Capital Structure: Different Industries
• The greater the marginal tax rate, the greater the
benefit from the interest deductibility and,
– hence, the more likely a firm is to use debt in its
capital
structure.

• The greater the business risk of a firm, the greater the

present value of financial distress and,
– therefore, the less likely the firm is to use debt in its
capital structure.

• The greater extent that the value of the firm depends

on intangible assets,
– the less likely it is to use debt in its capital structure.
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Financial Distress

• A situation where a firm’s operating cash

flows are insufficient to satisfy current
obligations (such as trade credits or interest
expense) and the firm is forced to take
corrective action.
Bankruptcy
• Debt puts pressure on the firm because
interest and principal payments are
obligations.
• If these obligations are not met, the firm may
risk some sort of financial distress.
• The ultimate distress is bankruptcy –
ownership of the firm’s assets is legally
transferred from the stockholders to the
bondholders.
 Costs of Financial Distress

• Bankruptcy risk versus bankruptcy cost

• The possibility of bankruptcy has a negative effect
on the value of the firm.
• However, it is not the risk of bankruptcy itself that
lowers value.
• Rather, it is the costs associated with bankruptcy.
• It is the stockholders who bear these costs.
 Description of Financial Distress
•Costs
Direct Costs
– Legal and administrative costs
• Indirect Costs
– Impaired ability to conduct business (e.g., lost sales)
• Agency Costs – In a firm with debt, conflict of
interest arise between debt and equity holders
due to which stockholders are tempted to pursue
selfish strategies.
– Selfish Strategy 1: Incentive to take large risks
– Selfish Strategy 2: Incentive toward underinvestment
– Selfish Strategy 3: Milking the property
 Example: Company in Distress

Assets BV MV Liabilities BV MV
Cash Rs.200 Rs.200 LT bonds Rs.300 Rs.200
Fixed Asset Rs.400 Rs.0 Equity Rs.300 Rs.0
Total Rs.600 Rs.200 Total Rs.600 Rs.200

What happens if the firm is liquidated today?

The bondholders get Rs.200; the shareholders get

nothing.
 Selfish Strategy 1: Take Risks

The Gamble Probability Payoff

Win Big 10% Rs.1,000
Lose Big 90% Rs.0
Cost of investment is Rs.200 (all the firm’s cash)
Required return is 50%
Expected CF from the Gamble = Rs.1000 × 0.10 + Rs.0 x
0.9 = Rs.100
Rs.100
NPV = –Rs.200 +
(1.50)
NPV = –Rs.133
 Selfish Strategy 1: Take Risks

• Expected CF from the Gamble

– To Bondholders = Rs.300 × 0.10 + Rs.0 = Rs.30
– To Stockholders = (Rs.1000 – Rs.300) × 0.10 +
Rs.0 = Rs.70
• PV of Bonds Without the Gamble = Rs.200
• PV of Stocks Without the Gamble = Rs.0

• PV of Bonds With the Gamble:Rs.20 =

(1.50)
Rs.30
• PV of Stocks With the Gamble: Rs.47 =
(1.50)
Rs.70
Selfish Strategy 2: Underinvestment
• Consider a government-sponsored project that guarantees Rs.350
in one period.
• Cost of investment is Rs.300 (the firm only has Rs.200 now), so
the stockholders will have to supply an additional Rs.100 to
finance the project.
• Required return is 10%.
Rs.350
NPV = –Rs.300 +
(1.10)
NPV = Rs.18.18
 Should we accept or reject?
 Selfish Strategy 2: Underinvestment
Expected CF from the government sponsored project:
To Bondholder = Rs.300
To Stockholder = (Rs.350 – Rs.300) = Rs.50

PV of Bonds Without the Project = Rs.200

PV of Stocks Without the Project = Rs.0

Rs.300
PV of Bonds With the Project: Rs.272.73 =
(1.10)
Rs.50
PV of Stocks With the Project: – Rs.54.55 = – Rs.100
(1.10)
Selfish Strategy 3: Milking the
Property
• Liquidating dividends
– Suppose our firm paid out a Rs.200 dividend to the
shareholders. This leaves the firm insolvent,
with nothing for the bondholders, but plenty for
the former shareholders.
– Such tactics often violate bond indentures.

• Increase perquisites to shareholders and/or

management
 Can Costs of Debt Be Reduced?

• Protective Covenants

• Debt Consolidation:
• If we minimize the number of parties, contracting
costs fall.
• Bond holders can purchase stocks to minimize agency
cost
 Tax Effects and Financial Distress

• There is a trade-off between the tax advantage of

debt and the costs of financial distress.
• Bankruptcy and related costs reduce the value of
the levered firm.
Integration of Tax Effects and Distress Cost
Value of firm (V) Value of firm under
Present value of tax MM with corporate
shield on debt taxes and debt
VL = VU + TCB

Maximum Present value of

firm value financial distress costs
V = Actual value of firm
VU = Value of firm with no debt

0 Debt (B)
B* Optimal amount of debt

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 Integration of Tax Effects and Distress Cost
• The parallel straight line represents the value of a firm in a world without
bankruptcy cost - Vu.
• V represents the value of the firm with these costs:
• This curve rises as the firm moves from all equity to a small amount of debt.
• The present value of the distress cost is minimal here because the probability
of distress is less.
• As more and more debt is added, the PV of these costs rises at an increasing
rate.
• The point where the PV of these costs from an additional rupee of debt equals
the increase in the PV of the tax shield – the debt level maximizing the value
of the firm, represented by B* - is the optimal amount of debt.
• Bankruptcy cost increase faster than the tax shield beyond this point.
• WACC falls as debt is added to the capital but after reaching B* it rises again.
• The optimal amount of debt produces the lowest WACC.
 The Pie Model Revisited
• Taxes and bankruptcy costs can be viewed as just another
claim on the cash flows of the firm.
• Let G and L stand for payments to the government and
bankruptcy lawyers, respectively.

VT = S + B + G + L

• The essence of the M&M intuition is that VT depends on the

cash flow of the firm; capital structure just slices the pie.
 Signaling
• The firm’s capital structure is optimized where the
marginal subsidy to debt equals the marginal cost.
• Investors view debt as a signal of firm value.
– Firms with low anticipated profits will take on a
low level of debt.
– Firms with high anticipated profits will take on a
high level of debt.
• A manager that takes on more debt than is optimal
in order to fool investors will pay the cost in the
long run.
 Agency Cost of Equity
⚫ An individual will work harder for a firm if he is one of the
owners than if he is one of the “hired help.”
⚫ While managers may have motive to partake in perquisites,
they also need opportunity. Free cash flow provides this
opportunity.
⚫ The free cash flow hypothesis says that an increase in
dividends should benefit the stockholders by reducing the
ability of managers to pursue wasteful activities.
⚫ The free cash flow hypothesis also argues that an increase in
debt will reduce the ability of managers to pursue wasteful
activities more effectively than dividend increases.
 The Pecking-Order Theory
• Timing of issuing an instrument.
• Theory stating that firms prefer to issue debt rather than equity if internal
financing is insufficient.
• Rule 1
• Use internal financing first
• Rule 2
• Issue the safest security first
• Issue debt next, new equity last
• If outside financing is required, debt should be issued before equity.
• Issue straight debt before issuing convertibles.
• The pecking-order theory is at odds with the tradeoff theory:
• There is no target D/E ratio
• Profitable firms use less debt
• Companies like financial slack
 Personal Taxes

• Individuals, in addition to the corporation, must

pay taxes. Thus, personal taxes must be considered
in determining the optimal capital structure.
 Personal Taxes

• Dividends face double taxation (firm and shareholder),

which suggests a stockholder receives the net
amount:
(1-TC) x (1-TS)

• Interest payments are only taxed at the individual level

since they are tax deductible by the corporation, so
the bondholder receives:
(1-TB)
 Personal Taxes

• If TS= TB then the firm should be financed primarily

by debt (avoiding double tax).

• The firm is indifferent between debt and equity when:

(1-TC) x (1-TS) = (1-TB)
 How Firms Establish Capital Structure
• Most corporations have low Debt-Asset ratios.
• Changes in financial leverage affect firm value.
– Stock price increases with leverage and vice-versa;
this is consistent with M&M with taxes.
– Another interpretation is that firms signal good
news when they lever up.
• There are differences in capital structure across industries
and even through time.
• There is evidence that firms behave as if they had a target
Debt-Equity ratio.
 Factors in Target D/E Ratio
• Taxes
– Since interest is tax deductible, highly profitable firms
should use more debt (i.e., greater tax benefit).

• Types of Assets
– The costs of financial distress depend on the types of
assets the firm has.

• Uncertainty of Operating Income

– Even without debt, firms with uncertain operating
income have a high probability of experiencing
financial distress.
Thank You!

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Thank You!

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