Chapter Seventeen

17

Sixth Edition

Capital Structure:
Debt Vs Equity

Chapter Outline
15.1 Debt vs Equity
15.2 What securities to issue when financing
new projects
15.3 Is there optimal target debt/ equity ratio?
15.4 Patterns of Long-Term Financing
15.6 Why would Debt/Equity matter?

15.1 The Capital-Structure Question

The Pie Theory: The value of a firm is defined to be the sum of
the value of the firms debt and the firms equity.
V=B+S
If the goal of the management of the
firm is to make the firm as valuable as
possible, then the firm should pick the
debt-equity ratio that makes the pie as
big as possible. The value of a firm is
defined to be the sum of the value of
the firms debt and the firms equity.
V = B + S

S B

Value of the Firm

3

The Capital-Structure Question

Two questions:
1. Why exactly should stockholders care about maximizing
firm value? Rationally, they should be interested in
maximizing shareholder value.
2. What is the ratio of debt-to-equity that maximizes the
shareholders value?
As it turns out, under certain assumptions, changes in capital
structure benefit stockholders if and only if the total value
of firm increases.
4

The Capital Structure and Return Risk

The more leveraged the equity, the riskier it is
Example: Black box firm that generates cash next
year and disappears.
Note: this is admittedly abstract but:
- we dont go for realism but try to illustrate
- this emphasizes we focus on financial structures,
cash-flows are taken as exogenous.
Value next year Probability
120

50%

100

50%

Risk-free rate = 10%;

=0

Financial Structures
Three financial structures:
A. No Debt
B. Debt with PV = $50 (FV = $55)
C. Debt with PV = $90 (FV = $99)
Value of Equity and Return under all three cases:
1
A. Value of Equity
(50%.120 + 50%.100) = $100

1.1

Return in good state = 20%, in bad state = 0%.

B. Debt FV = $55.
Equity value in good state= 65.
Equity value in bad state= 45.
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Example contd
1
(50%.120 + 50%.100) = $100
1.1

Equity PV =
Return in good state: 30%; bad state = -10%
Expected return 10%. Std deviation of return = 20%

C. Debt with FV = $99

Equity
value
21

Good
state
Bad state 1

Return
110%
-90%
7

Example contd..
PV of Equity at t = 0 is:

1
1
(50%.21 + 50%.1) =
$11 = $10
1.1
1.1

Expected return: 10%; Std deviation: 100%

Note that in this example expected return is the same in all
three cases. Thats an artifact of assuming for simplicity that
= 0 so investors discount the project like a riskless one;
with nonzero beta, the greater the leverage the greater the
beta (see the formula in chapter on cost of capital) and
therefore the greater the expected return.
8

Financial Structures
Why are more leveraged firms more risky?
Nominal difference in shareholders value between good
and bad state is the same for all three financial structures
Initial equity value decreases with amount of debt
Difference between good and bad states in percentage
terms greater for more leveraged equity
The more debt, other things equal, the riskier the equity
This was a simplified example of a firm with two possible
cash flow values but the same principle applies if earnings
vary continuously.
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Financial Leverage and EPS

Return or EPS when the share value is the
same for both capital structure

12.00
leveraged

10.00
8.00
6.00
4.00

unleveraged

Advantage
to debt

Break-even
point

2.00
0.00
1,000

(2.00)

Disadvantage
to debt

2,000

3,000

Earnings: EBIT in dollars, no

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taxes

Financial Leverage
Implication: ex post, debt financing preferred if good state or
high earnings, all-equity better, in the bad state
- irrelevant for capital structure chosen ex-ante
- Relevant if you have strong expectation of future earnings
one way or another, different than the markets estimate
Example: Market thinks oil sector will do poorly so oil stocks
are cheap. You think the sector will rebound soon, want to
bet on that by investing in stocks in the sector. You should
invest primarily in high debt/equity ratio.

11

Example
Example; Sector overpriced and will move
down sell off highly leveraged companies
first.
CAVEAT: This heavily relies on your prediction
differing from the markets, otherwise share
prices already reflect that sector wide
expectation and leveraged equity is more
expensive.
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Optimal Ex-ante Choice of Financial

Structure
What is the optimal debt to equity combination for
shareholders?
Under same conditions, one that maximizes the total value of
firm (Vdebt + Vequity)
Sketch of Proof:
A, B two twin companies with identical earnings and cashflows [same assets, employment, competition strategy, same
marketing expenditure and so on] but with different capital
structures: B has more debt.
Assume equity and debt of A, B publicly traded; VA, VB equity
market values; DA, DB debt market value; DA< DB
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Choice of Financial Structure

Assume VA+ DA < VB + DB
Strategy for As shareholders:
Firm A borrows DB DA , its debt now DB
Pay it out to shareholders as dividend
Equity value changes to VB
New value of As shareholders:
V{B
+ DB - DA >
V{A
1
424
3
new equity value

dividend

old value of
A's shareholders

Similarly, assume the unleveraged twin has higher value:

VA + DA > VB + DB

14

Choice of Financial Structure

Strategy for B:
B raises DB DA via a rights offering
Uses the cash to buy back DB DA of its own bonds
Shareholders value :

VA
{

new equity value

DB - DA >
1
424
3
cash

VA
{

old equity value

Implication : an optimal (for shareholders) finance structure

maximizes

{ V,

+V

}buy shareholders

otherwise
equity
debt

could their wealth in the above ways

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The Modigliani-Miller Model

ASSUMPTIONS:
Homogeneous Expectations
Homogeneous Business Risk Classes
Perpetual Cash Flows
Perfect Capital Markets:

Perfect competition
Firms and investors can borrow/lend at the same
rate
Equal access to all relevant information
No transaction costs
No taxes
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The Modigliani-Miller (MM) Propositions I

The Proposition:
Under certain conditions, the firm value D + E is independent
of capital structure
Implication:
- Under those conditions, financial structure is irrelevant:
D/E ratio does not affect D+E sum
- One extra dollar of debt reduces equity value by $1.
- Shareholders should not have a preference over D/E
- Same for any other debt level, interest rate.
- How you split a pie does not change its size
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Proof of MM via an example

Two twin companies A, B. Both live until next year, generate

cash flow then, and disappear. Each has the same random
cash flow stream next year (in the example, 150 in good
state or 100 in bad state). A is all-equity, B has debt with
present value D.
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MM, sketch of proof

Homemade Leverage: a way to replicate
investing in A with investing in B and vice versa
The following pairs of portfolios are each others
replicas in terms of generating same cash flows
in all states
1. { Buy B } equivalent to { borrow D for one year
and buy A }. 2. { Buy A } equivalent to { buy B
and deposit D risk-free for one year }
By No Arbitrage, VA = VB + D. By similar
argument, $1 of extra debt reduces equity value
by exactly $1. End of proof.
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The M-M Propositions I Assumptions

ASSUMPTIONS :
No Taxes
No bankruptcy/distress costs
Cash flows exogenous (do not depend on financial
structure)

No arbitrage
Perfect financial Markets [Firms and investors
can borrow/lend risk free at the same rate]
No asymmetric information
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The M-M Propositions I: Observations

M-M logic applies to any other purely financed repackaging
convertible bonds, preferred stock derivatives etc. As long as
operating cash-flows unchanged, firm value is, too.
M-M is not an attempt at explaining reality but rather a
benchmark to clarify why financial structure should matter
afterall.
Financial structure matters if EITHER homemade
leverage/unleverage is impossible/costly (because for
example capital structure affects cost of credit)
OR, if financial structure [somehow] affects corporate
cash-flows.
21

Modigliani-Miller Model with Taxes

Interest expense tax-deductible
If corporate tax-rate is Tc and you borrow D in perpetuity, PV
of tax shields is D.Tc
Implied financial structure: 100% debt, symbolic value of equity.
Example: 50% corporate tax rate added to the previous

EBIT EBT NI VE+VD

22

Example
EBIT

EBT

NI

VE+VD

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Modigliani-Miller with Taxes.

EA + DA < EB + DB < EC + DC . The more debt, the greater total firm
value D + E.
q

qSharp prediction: with corporate income taxed but other

assumptions of MM still in place, optimal capital structure involves
full debt financing
q This is intuitive: total firm value now has three claim-holders:
shareholders, debtholders and the government. We know that
optimal structure maximizes the value of shareholders and
debtholders. So, holding firms cashflows fixed, the optimal capital
structure minimizes tax burden.
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Miller , Debt and Taxes, 1977

Miller , Debt and Taxes, 1977
Caveat to the story: Need to account for different taxation of
debt and equity at investors level; say equity held by
individuals, not corporation.
Tpe, Tpd are personal tax rates on equity and debt.
If Tpe = Tpd noting is changed, if Tpe < Tpd then the appeal of debt
is reduced.
Another way of transfering $ to shareholders is via share
buybacks. In Ontario maximum marginal tax rate in interest
is approximately 46%, the average tax rate on dividends is
about 31%. The difference, 15% is not enough to offset the
corporate tax rate. Return from buybacks taxed at the capital
gains tax rate, at max 23%.
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Empirical evidence
Empirics: How seriously to take this?
DTC overstates tax benefit of debt, but benefit unlikely to be
zero;
Empirical evidence
Firms with losses cant benefit from tax shields
Equity should be used more often by firms in tax-loss carryforwards (TLCFs)
Mackie-Mason [91]: significant effect of TLCFs on source of
capital for marginal new projects
Regressing debt/ equity vs tax rates (cross country)
No clean results
Other factors influencing D/E vary cross-country, too
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Empirical evidence
Broad picture: Taxes matter somewhat but for
from a dominant influence on observed debt/
equity ratios;
NON-tax reasons for preferring debt:
Higher cost of issuing new equity
(administrative, legal, adverse selection) than
debt especially for public firms
Potential problems with ownership dilution
[so, why dont we see all-debt, symbolic equity
capital structures?]
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Factors favoring equity financing

Reasons for equity or against debt:
Costs of bankruptcy/ financial distress
[in examples above, firm always has at least $100,
enough to pay debt]
What if PV of debt is $100, r = 10%, FV = 110?
Problem: in bad state only 100 repaid
Expected return on debt would only be 5% or so.
That is why corporate debt has higher nominal
interest than T-bills.
The greater probability of default, the greater YTM
interest rate higher than 10%; so that the expected
return is 10%
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Example contd..
Still as long as E(r) = 10%, MM logic about size of pie
being unchanged still applies; Occurrence of default
alone NOT a reason against $100 of debt.
Legal and administrative costs of bankruptcy and
transferring control to shareholders.
The more debt, the greater chance of incurring these
costs
Example: Firm A Black Box As value next year: either
10 or 20 or 30 or 40 or or 100
Probabilities: 10%, 10%, 10%.
Debt with FV < $10 0% chance of bankruptcy
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Example contd..
$10 < FV of Debt < $20 10% chance
$20 < FV of Debt < $30 20% chance
and so on
More debt higher chance of default
Direct legal administrative costs = 3 5% of firms
value
Indirect: company difficult to run when in or near
bankruptcy: other reluctant to do business with
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Example
Example: when Air Canada was nearing bankruptcy
in 2004:
Customers were afraid their frequent flier miles
would be useless so tickets were not being
bought with cash but by redeeming miles at
unusual pace;
Months-in-advance flight purchases plummeted
Service companies and other business partners
started demanding cash on the spot payments
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Agency Problems
Share holder vs Bond-holders Agency Problems
Bondholders have claim on part of cash flows
Only shareholders choose strategy affecting cash
flows
Shareholders may maximize their share of pie
while total pie size decreases
We know that optimal capital structure
maximizes total pie size so optimal capital
structure should align shareholders incentives
with the objective of firm value maximization
Example: Betting debtors money:
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Example
Firm cash flows on the left
r = 10%, = 0
Nominal Debt Value $100,
Promised future value = $110;
Cash flow split below
FV shareholders

FV Bondholders

Good

40

110

bad

100
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Example, continued
FV
shareholders

FV
Bondholders

Good 50

110

bad

50

Shareholders prefer the latter strategy

Note: They would not if FV debt were less than
50 Betting Debtors Money only really a
problem when default/bankruptcy probable
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Agency problems example 2

Example: Do not bet your own money
New project to be financed by shareholders:
{invest $8 this year get $10 next year risk free}
NPV > 0 at r = 10%; cash flows without project:
FV shareholders

FV Bondholders

Good

40

110

bad

100
35

Example contd
FV shareholders

FV Bondholders

Good

50

110

bad

110

Table above: cash flows if project implemented

From shareholders perspective:
Cost at t = 0: $8
Cash flow at t = 1: $10 with probability 50%, Expected: $5.
Project increases firm value because NPV > 0, but project will not
be undertaken because for shareholders NPV < 0. This would not
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be an issue with lower indebtness.

Agency Problems, contd

[Similarly anything that requires effort by
management: why exert effort if the companies
may go bankrupt and well be out anyway?]
- Company where defaulkt/bankruptcy likely is less
likely to invest in R & D or anything long term

Note: bondholders-shareholders conflict matter

only to the extent that they change value of the
firm as a whole
Example: Milking property would not be an
argument against high D/E as its posibility only
increases ex-ante riskiness of debt.
37

Trade-off theory of Capital Structure

Trade-off theory of Capital structure
Tax benefit of Debt linear

38

Trade-off theory of Capital Structure

Agency cost of Debt convex:

39

Trade-off theory of Capital Structure

[Idea: increasing debt from 0% to 10%
marginally very little; from 10% to 20% more,
20% to 30% even more, etc. ]
Optimal financial structure such that marginal
cost = marginal benefit:
D* is the optimal debt level in graph above.

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Pecking Order Theory of Capital Structure

Financing New Projects:
Informational assymetries worst so:
Internal funding first (retained cash flows)
(decreasing D/E ratio)
If no internal then issue debt (only to value
debt, only to evaluate chance of default; with
collateral, no need for even that)
Debt unavailable issue outside equity
41

Empirics
Empirics: In publicly listed companies debt to
equity ratio is in the ballpark of one to one
Empirics: Retained earnings: 60%
Share issues 4%
Debt issues 24%
Change in account payables 12%
(kind of like debt)
By age:

- startups reply on own capital

- then bank debt
- going public equity
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Conclusions
Debt: agency costs; direct and indirect distress costs
Equity: adverse selection costs, ownership dilution
costs, tax costs
Optimal capital structure minimizes the sum of all
these costs
Problems with use of debt may be mitigated by
covenants. Problems with adverse selection may be
alleviated by hybrid securities: preferred shares,
bonds convertible into shares and vice versa.
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