EF5158 : Corporate Finance

Capital Structure of the Firm

Unit – 3.2

By Dr Sandeep Rao

Dr Sandeep Rao, DCU Business School

What is Capital Structure?
o What is capital structure?
o Capital structure leverage (or gearing ) is the relative proportions of debt, equity, and
other securities that a firm has outstanding.

Bonds, bank loans

Ordinary shares (common stock),

Securities
Preference shares (preferred stock)

Hybrids, e.g. warrants, convertible bonds

⚫ Financial leverage or gearing: the firm's ratio of debt to total financing

➢ Levered firm: a corporation that has debt outstanding
➢ Unlevered firm: a corporation with no debt
Dr Sandeep Rao, DCU Business School
Why should we care?
Cost of Capital:
➢ Each source of financing has a different cost
➢ The WACC: “Weighted Average Cost of Capital” WACC = wErE + wDrD(1-TC)
➢ Capital structure affects the WACC

By altering capital structure => change their cost of capital => affect market value of
the firm

What is an optimal capital structure?

➢ minimizes the firm’s cost of capital and maximizes firm value

Dr Sandeep Rao, DCU Business School

The Capital Structure Question
How should a firm go about choosing its debt–equity ratio?

• What is the primary goal of financial managers? Maximize stockholder wealth

• Capital structure decisions – essentially the same thing as maximizing the value of the whole firm.
• Changes in capital structure benefit the shareholders if and only if the value of the firm increases.
• We are going to look at how changes in capital structure affect the value of the firm, all else equal.
• Capital restructuring involves changing the amount of leverage a firm has without changing the firm’s assets.
• The firm can increase leverage by issuing debt and repurchasing outstanding shares.
• The firm can decrease leverage by issuing new shares and retiring outstanding debt.
• We can maximize stockholder wealth by maximizing the value of the firm or minimizing the WACC.

Managers should choose the capital structure that they believe will have the highest firm value because this capital
structure will be most beneficial to the firm’s shareholders

Dr Sandeep Rao, DCU Business School

Capital structure patterns

Company D/E Ratio D/E Ratio

% (book value) % (market value)
Wal-Mart 46 9
Berkshire Hathaway 12 18
Southwest Airlines 31 15
Dell 8 1
Microsoft 0 0
FedEx 35 10
IBM 50 10

Dr Sandeep Rao, DCU Business School

The Effect of Financial Leverage

• How does leverage affect the EPS and ROE of a firm?

• When we increase the amount of debt financing, we increase the fixed interest expense.
• If we have a really good year, then we pay our fixed cost and we have more left over for our stockholders.
• If we have a really bad year, we still have to pay our fixed costs and we have less left over for our stockholders.
• Leverage amplifies the variation in both EPS and ROE.

Dr Sandeep Rao, DCU Business School

Break-Even (indifference) EBIT

Find EBIT where EPS is the same under both the current and proposed
capital structures.
If we expect EBIT to be greater than the break-even point, then leverage
may be beneficial to our stockholders.
If we expect EBIT to be less than the break-even point, then leverage is
detrimental to our stockholders.

Dr Sandeep Rao, DCU Business School

Corporate Borrowing Conclusions

Based on what we have seen so far, we can draw the following three
conclusions:
1. The effect of financial leverage depends on the company’s EBIT. When EBIT is relatively
high, leverage is beneficial.

2. Under the expected scenario, leverage increases the returns to shareholders, as measured by
both ROE and EPS.

3. Shareholders are exposed to more risk under the proposed capital structure because, in this
case, the EPS and ROE are much more sensitive to changes in EBIT.

Dr Sandeep Rao, DCU Business School

Debt finance is cheaper and riskier

Arnold, Glen (2008), Corporate financial management, Financial Times & Prentice Hall, 4th Edition, p795
Dr Sandeep Rao, DCU Business School 3
Capital Structure Theory
1. Modigliani-Miller Theorem (1958) - Proposition I – Firm value
➢ The value of the firm is independent of its capital structure.
➢ Financing decisions don’t matter.

2. Modigliani-Miller Theorem (1963) - Proposition II – WACC

➢ A firm should use as much debt as possible to maximise its value.

3. Pecking order theory

4. Trade-off theory

5. Signalling models, etc.

Dr Sandeep Rao, DCU Business School

Modigliani-Miller Theorem
• Debt policy does not matter
• The market value of a company does not depend on its capital structure.

Perfect capital markets

➢ taxes
➢ transaction costs
➢ issuance costs
➢ bankruptcy costs
➢ effect on management incentives
Merton H. Miller
➢ capital structure does not affect cash flows
Franco Modigliani
1918 - 2003 1923 - 2000
Nobel Prize: 1985 Nobel Prize: 1990

Dr Sandeep Rao, DCU Business School

Modigliani and Miller Theories

The Modigliani and Miller (1958) explained the theorem was originally proven under
the assumption of no taxes. It is made up of two propositions that are

(i) The overall cost of capital and the value of the firm are independent of the
capital structure. The total market value of the firm is given by capitalizing the
expected net operating income by the rate appropriate for that risk class.

(ii) The financial risk increase with more debt content in the capital structure. As a
result, cost of equity increases in a manner to offset exactly the low cost
advantage of debt. Hence, overall cost of capital remains the same.

Dr Sandeep Rao, DCU Business School

M&M Capital Structure: Key Assumptions
1. There is a perfect & frictionless capital market.
i. Capital markets are perfect when investors are free to buy and sell securities
ii. Investors can trade without restrictions and can borrow or lend funds on the same
terms as the firms do
iii. Investors behave rationally investors
iv. No Information asymmetry - capital markets are efficient
v. No costs of financial distress and liquidation
vi. There are no taxes
2. Firms can be classified into homogeneous business risk classes. All the firms in the same
risk sector will have the same degree of financial risk.
3. Firms issue only two types of securities, risk-free debt and equity
4. All investors have the same view for the investment, profits and dividends in the future;
they have the same expectation of a firm’s net operating income.
5. There is no growth, so all cash flow streams are perpetuities
6. The dividend payout ratio is 100%, which means there are no retained earnings.
7. No Agency costs.
Dr Sandeep Rao, DCU Business School
M&M Proposition I (No Tax)
MM Proposition I (or MM’s debt-irrelevance proposition): In a perfect capital
market, the total value of a firm is equal to the market value of the total cash flows
generated by its assets and is not affected by its choice of capital structure.
o If capital markets are doing their job, firms cannot increase value by tinkering with capital structure.
o The total market value of any company is independent of its debt ratio.
o Therefore, if you consider two firms which are identical except for their financial structures, with
one firm being unlevered (VU) and the other being levered (VL), the two firms would have the same
value (VU = VL)

Dr Sandeep Rao, DCU Business School

 M&M Proposition I (No Tax)
• The proposition that the value of the firm is
independent of the firm’s capital structure
• Under a certain market price process, in the
absence of taxes, no transaction costs, no
asymmetric information and in an perfect market,
the cost of capital and the value of the firm are not
affected by the changed in capital structure.
• The firm’s value is determined by its real assets, not
by the securities it issues. In other words, capital
structure decisions are irrelevant as long as the V=D+E
firm’s investment decisions are taken as given.

Dr Sandeep Rao, DCU Business School

Contd…
In the absence of tax world, base on MM Proposition I, the value of the firm is unaffected by its capital
structure. In other words, regardless of whether a company has liabilities, the total risk of its securities
holders will not change even the capital structure is changed. As the weighted average cost of capital
unchanged, so must the same as the total value of the company.
That is VU = VL
The MM Proposition I assumptions are quite unrealistic, there have some implications,
(i) Capital structure is irrelevant to shareholder wealth maximization.
(ii) The value of the firm is determined by the firm’s capital budgeting decisions.
(iii) Increasing the extent to which a firm relies on debt increases both the risk and the expected return
to equity – but not the price per share.
(iv) Milton Harris and Artur Raviv (1991) illustrated the asymmetric information that firm managers
or insiders are assumed to possess private information about the characteristics of the firm’s return
stream or investment opportunities. They will know more about their companies’ prospects, risks
and values than do outside investors. Then it cannot fulfill the assumption of perfect market.

Dr Sandeep Rao, DCU Business School

Example
MM Proposition I: In a perfect capital market, the total value of a firm is equal to
the market value of the total cash flows generated by its assets and is not affected
by its choice of capital structure

£300
£1,000 Debt
V = E + D = £1000
£500 £500
Equity
Debt Equity £700 VL = £1000 = VU
Equity
Leverage does not change a
firm’s value.
Unlevered Firm Levered Firms
VU = £1000 VL = £1000

Dr Sandeep Rao, DCU Business School

 M&M Proposition II (No Tax)

With leverage, equity is riskier and the shareholder’s

required rate of return increases
• The expected return on a levered firm’s equity, rE is a linear function of
firm’s debt to equity ratio.
WACC = (E/V) × rE + (D/V) × rD
Where: rE is the cost of levered equity
rU is the cost of unlevered equity rU = (E/V) × rE + (D/V) × rD
rD is the cost of bonds
D is debt D
rE = rU + ( rU - r D )
E is equity E

Dr Sandeep Rao, DCU Business School

 Proposition II (No Tax)
D
r E = rU + ( rU − r D )
E
Proposition II, rearranged, is just the WACC (Weighted Average Cost
of Capital):

 E   D 
r WA CC = rE   + r D  
 D + E   D + E 

If proposition II holds, WACC is independent of capital structure.

(The WACC of a levered company is the same as the cost of equity for an identical
unlevered company)

Dr Sandeep Rao, DCU Business School

 M&M Proposition II (Ignoring Taxes)
• Proposition II states that the cost of equity is directly related and
incremental to the percentage of debt in capital structure.
• The proposition that a firm’s cost of equity capital is a positive linear
function of the firm’s capital structure.
MM II (no tax) → WACC = rA = (E/V) rE + (D/V) rD
• Where V = D + E. We also saw that one way of interpreting the WACC is
as the required return on the firm’s overall assets. To remind us of this, we
will use the symbol RA to stand for the WACC
• If we rearrange this to solve for the cost of equity capital, we see that:
• RE = rA + (rA – rD)(D/E)

▪ rA is the “cost” of the firm’s business risk, i.e., the risk of the firm’s
assets.
▪ (rA – rD)(D/E) is the “cost” of the firm’s financial risk, i.e., the
additional return required by stockholders to compensate for the risk
of leverage.
▪ The WACC of the firm is NOT affected by capital structure.
▪ M&M Proposition II tells us that the cost of equity depends on three
things: The required rate of return on the firm’s assets, rA ; The firm’s Source: Keown et al. (2013)
cost of debt, rD and The firm’s debt–equity ratio, D/E.
Dr Sandeep Rao, DCU Business School
M&M Propositions I (with tax)

The Interest Tax Shield : The tax saving Unlevered Levered

attained by a firm from interest expense Firm Firm
Interest is tax deductible. Therefore, when EBIT 5,000 5,000
a firm adds debt, it reduces taxes, all else Interest 0 500
equal. Taxable 5,000 4,500
The reduction in taxes increases the Income
cash flow of the firm. Taxes (21%) 1,050 945
Net Income 3,950 3,555
Cashflows 3,950 4,055
(from assets to (3555+500)
all investors)

Dr Sandeep Rao, DCU Business School

Contd..
M&M Proposition I with taxes: The value of the firm levered (VL) is equal to the value
of the firm unlevered (VU) plus the present value of the interest tax shield
The value of the firm increases by the present value of the annual interest tax shield.
▪ Value of a levered firm (VL) = Value of an unlevered firm (VU) + PV of interest tax shield
▪ Value of Equity = Value of the firm – Value of debt

• Assuming perpetual cash flows

▪ VU = EBIT(1- TC) / rU
▪ M&M Proposition I with corporate taxes
VL = VU + PV of interest tax shield
VL = VU + ( TC x D x rD )/rD
VL = VU + (TC x D )

Dr Sandeep Rao, DCU Business School

M&M Proposition I & II (with Tax)
WACC = rA = (E/V) rE + (D/V)(rD)(1 - TC)

r E = rU + ( r U - r D
) D (1 - TC)
E

RU is the the unlevered cost of capital.

Some of the increase in equity risk and return is offset

by interest tax shield.

M&M Proposition I with tax tells us WACC declines

as the debt-equity ratio grows. This illustrates again
that the more debt the firm uses, the lower is its WACC

M&M Proposition II with tax tells us Cost of Equity

rises as the debt-equity ratio grows.

Dr Sandeep Rao, DCU Business School

Tax Shield
▪ Corporations pay taxes on their profits after interest payments are deducted. This
creates an incentive to use debt.
▪ By using more debt, firms shelter more cash flow from taxes (the tax shield
feature). Interest Tax Shield: tax savings resulting from deductibility of interest
payments.

Example
You own all the equity of Space Babies Diaper Co. The
company has no debt. The company’s annual cash flow is
$1,000, before interest and taxes. The corporate tax rate is
40%. You have the option to exchange 1/2 of your equity
position for 10% bonds with a face value of $1,000. Should
you do this and why?

Dr Sandeep Rao, DCU Business School

Tax Shield example (cont.)
You own all the equity of Space Babies Diaper Co. The company has no debt. The
company’s annual cash flow is $1,000, before interest and taxes. The corporate tax rate is
40%. You have the option to exchange 1/2 of your equity position for 10% bonds with a
face value of $1,000. Should you do this and why?
All Equity 1/2 Debt
EBIT 1,000 1,000
Total Cash Flow
Interest Pmt 0 100
All Equity = 600
Pretax Income 1,000 900
1/2 Debt = 640
Taxes @ 40% 400 360
(540 + 100)
Net Cash Flow $600 $540

Dr Sandeep Rao, DCU Business School

Tax Shield: Example 2

(£ million) With Leverage Without Leverage

EBIT £2500 £2500
Interest expense -430 0
Income before tax 2070 2500
Tax(20%) -414 -500
Net Income £1656 £2000
Interest paid to debt holders 430 0
Income available to equity holders 1656 2000

Total available to all investors £2086 £2000

Dr Sandeep Rao, DCU Business School

Interest Tax Shield: the gain to investors from the tax
deductibility of interest payments

Corporate Tax Rate × Interest Payment

Dr Sandeep Rao, DCU Business School

Financial Distress
o In the real world firms are careful to raise their debt-to-equity ratio too much.
o Higher levels of debt increases the firm’s risk of financial distress.
o Financial distress is the situation where obligations to creditors are not met or met with difficulty.
o As you borrow more, you increase the probability of bankruptcy and hence the expected bankruptcy costs
o The risk to incur in the cost of financial distress has a negative effect on a firm’s value which offset
the value of tax relief of increasing debt level.
o Costs of Financial Distress: costs arising from bankruptcy or distorted business decisions before
bankruptcy.
o The cost of going bankrupt:
o Direct costs: Legal and other deadweight costs
o Indirect costs: Costs arising because people perceive you to be in financial trouble

Dr Sandeep Rao, DCU Business School

Trade-off Theory
Benefits of debt:
• Tax deductibility
• Reduce the free cash flow
problem (conflicts between
managers and shareholders).

Costs of debt:
• Bankruptcy cost

Trade-off Theory: theory that capital structure

is based on a trade-off between the benefits
and costs of debt.

Dr Sandeep Rao, DCU Business School

Pecking Order Theory
It states that there is a “peaking order” for financing. Aggregate Sources of Funding for Capital Expenditures, U.S.
Corporations
➢ Internal funds
➢ External funds
• Debt
• Equity when companies run out of debt
capacity

POT states that firms prefer to issue debt rather than

equity if internal finance is insufficient.
➢ Asymmetric information (Managers know
better than investors) Source : Federal Reserve Flow of Funds

➢ Costs of raising funds

Dr Sandeep Rao, DCU Business School

 Pecking Order Theory
• The pecking order theory states that managers display the following preference of sources to fund investment opportunities: first,
through the company’s retained earnings, followed by debt, and choosing equity financing as a last resort.
• The pecking order theory arises from the concept of asymmetric information. Asymmetric information, also known as information
failure, occurs when one party possesses more (better) information than another party, which causes an imbalance in transaction
power.
• Company managers typically possess more information regarding the company’s performance, prospects, risks, and future outlook
than external users such as creditors (debt holders) and investors (shareholders). Therefore, to compensate for information asymmetry,
external users demand a higher return to counter the risk that they are taking. In essence, due to information asymmetry, external
sources of finances demand a higher rate of return to compensate for higher risk.
• In the context of the pecking order theory, retained earnings financing (internal financing) comes directly from the company and
minimizes information asymmetry. As opposed to external financing, such as debt or equity financing where the company must incur
fees to obtain external financing, internal financing is the cheapest and most convenient source of financing.
• When a company finances an investment opportunity through external financing (debt or equity), a higher return is demanded because
creditors and investors possess less information regarding the company, as opposed to managers. In terms of external financing,
managers prefer to use debt over equity – the cost of debt is lower compared to the cost of equity.
• The issuance of debt often signals an undervalued stock and confidence that the board believes the investment is profitable. On the
other hand, the issuance of equity sends a negative signal that the stock is overvalued and that the management is looking to generate
financing by diluting shares in the company.
• When thinking of the pecking order theory, it is useful to consider the seniority of claims to assets. Debtholders require a lower return
as opposed to stockholders because they are entitled to a higher claim to assets (in the event of a bankruptcy). Therefore, when
considering sources of financing, the cheapest is through retained earnings, second through debt, and third through equity.

Dr Sandeep Rao, DCU Business School

Signalling : Leverage as a credible signal

➢ Information asymmetries (signalling): the situation in which different

parties have different information.

➢ In a corporation, manager’s information > outside investors

➢ Assume a firm has a large new profitable project, but cannot discuss the
project due to competitive reasons.
The use of leverage as a way to signal ‘good’ information to investors.
➢ Thus a firm can use leverage as a way to convince investors that it does
have information that the firm will grow.

Dr Sandeep Rao, DCU Business School

Thank You

Dr Sandeep Rao, DCU Business School