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Corporate Finance
Lecture 12
Corporate Finance
Lecture 12 :
Capital Structure
Impact Consultancy & Training Pte Ltd
Central Issue in Capital Structure

! What is Capital Structure?
! Combinations of Wd & We
! What is Optimal Capital Structure?
! Combination that result in the Lowest Weighted Average
Cost of Capital (WACC)
! Consequently, will lead to Maximising Value of Firm
(Highest Net Present Value from investments)
! Key Question : Is there an Optimal Capital Structure?
Corporate Finance
Lecture 12
Fundamentals of Capital Gearing

! Capital Gearing : Existence of debt in a companys capital
structure e.g. bond & LT bank loans
! Capital gearing always involve fixed obligations
! Debt is generally cheaper to the firm than equity because
! Debt holders have lower risk due to asset & earning
priorities resulting in lower required rate of return which in
turn is translated to lower cost to the firm
! Interest on Debt is a tax deductible expense
! Major concern on Capital Gearing for Firms : Risk of nonpayment
Fundamentals of Capital Gearing

! If return from the use of debts > cost of debts then profits will
increase with Higher EPS as number of shares remain
unchanged
! Conversely, if return from the use of debts < cost of debts
then profits will decrease with Lower EPS as number of
shares remain unchanged
! Expectation of capital gearing net effect is always positive i.e.
return > cost BUT uncertainty & priority of debt holders
=> Higher risk for ordinary shareholders
Corporate Finance
Lecture 12
Illustration : Companies with Different

Levels of Gearing
Debt Payoff Profile for Levered Firm

! Payoff profile for debt in a levered firm is the same as that of a
short put with exercise price equal to the face value of the
firms debt B
Payoff
[Vt, B]-
B
Vt
6
Corporate Finance
Lecture 12
Equity Payoff Profile for Levered Firm

! Payoff profile for equity in a levered firm is the same as that
of a long call with exercise price equal to the face value of the
firms debt B
Payoff
[Vt - B, 0]+
Vt
Traditional View of Capital Gearing
! As WD -> WE because WE + WD = 1
! Initially, WACC falls because of increasing proportion of
significantly cheaper debt which outweighs higher return
required by shareholders due to perceived higher risk
Corporate Finance
Lecture 12

! However, as WD increases further i.e. beyond moderate level
! Shareholders see higher risk & will require even higher
return
! Debtholders also perceive higher risk & demand higher
return
=> This will result in WACC increasing

Traditional View of Debt & Cost of Capital
Cost of
Capital
Cost of Equity
Average Cost of Capital

Cost of Debt
Debt-Equity Ratio
Traditional View of Debt & Value of Firm
Market
Value
Value of Firm
Value of Equity
Value of Debt
Debt-Equity Ratio
10
Corporate Finance
Lecture 12
MM Capital Structure Theory

! Assumptions
! Capital markets have no frictions ie. Unlimited access
! No taxes & no transaction costs
! Investors have perfect information & homogeneous
expectations
! Investors only care about their wealth
! Financing decisions do not affect investment decisions
! Possible for 2 firms with different capital structure to
belong to the same risk class
11

! Consider 2 firms with the following details :
! Firm U : A fully equity-financed firm
! Firm L : A levered firm with B units of debt at RD &
balance financed by equity
Assume both firms belong to the same risk class
! An investor holds
! proportion of Firm Us equity
! proportion of Firm Ls equity & proportion of Firm
Ls debt
! Let X represent the firms cash flow ie. Both firms have
the same investment outcomes
12
Corporate Finance
Lecture 12

! 2 possible outcomes 1 period ahead
!
X > Face value of the firms debt B
X < Face value of the firms debt B
! Payoff for the investor under the 2 scenarios for both

Firm U & Firm L are as follows :
Payoff for Firm U
X < B(1 + RD) X > B(1 + RD)
Debt
Payoff for Firm L

X < B(1 + RD)
X > B(1 + RD)
B(1 + RD)
Equity
[X - B(1 + RD)]
Total
13

! Investment Strategy I : Invest % in Firm U
! Investment Payoff = X
! Investment Cost = VU
! Investment Strategy II : Invest % in Firm Ls Debt (DL) &
% in Firm Ls Equity (SL)
! Investment Payoff = X
! Investment Cost = SL + DL = (SL+DL) = VL
! If both strategies have the same investment payoffs then they
must have the same investment costs in a world of no arbitrage
! VU = VL
! VU = VL
14
Corporate Finance
Lecture 12

! Proposition I
! Total market value of any company is independent of its
capital structure & is determined by discounting its
expected cash flows at a discount rate appropriate to its
risk class
=> Value of a company is determined by genuine
economic activities ie. the only driver of a firms
value
15

! Proposition II
! Expected rate of return on equity increases linearly with
gearing ratio
=> Use of cheaper debt capital is fully offset by
increase in equity rate of return to compensate
shareholders for higher risk
16
Corporate Finance
Lecture 12

MM Proposition II - Illustration
Where
K0 =
KL =
KE =
SL =
DL =
KD =
WACC
Return on equity of levered firm
Return on equity of unlevered firm
Equity value of levered firm
Debt value of levered firm
Cost of debt of levered firm
17
Multiplying by SL + DL :
Dividing by SL :
18
Corporate Finance
Lecture 12
Expected Return
on Equity of
=
Levered Firm
Expected Return
on a Pure Equity
Firm
Risk Premium
Dependent on the
Debt-Equity Ratio
Therefore cost of equity increases linearly to fully offset the

lower cost of debt directly resulting in a constant WACC
irrespective of the level of gearing
19

! Proposition III
! The cut-off rate to be used in investment appraisal is
WACC or the rate of return appropriate to an all-equity
firm
=> In an MM World of No Tax, WACC is constant &
equal to cost of equity in an all-equity firm
20
10
Corporate Finance
Lecture 12

MM (No Taxation) & Cost of Capital
Cost of
Capital
Cost of Equity
Average Cost of Capital
Cost of Debt
Debt-Equity Ratio
Market
Value
MM (No Taxation) & Value of Firm

Value of Firm
Value of Debt
Value of Equity
Debt-Equity Ratio
21

! The previous diagram does not mean that the value of the firm
will always remain unchanged
! Only means that it is unaffected by changes in debt-equity
ratio
! Value of the firm can be driven upwards with more genuine
economic activities
22
11
Corporate Finance
Lecture 12
MM Capital Structure Theory with Taxes

! Revised Proposition I
! Market value of a firm is no longer independent of its
capital structure
! Value will increase as debt proportion increases because of
tax advantages of debt finance
!
Does not mean that economic activities no longer drives

the value of the firm
Economic activities remain the main driver of a firms
value which can be further driven up by its capital
structure with debt
23

! Revised Proposition II
! Although expected rate return on equity increases as debt
proportion increases, the rate of increase is less than the
effect of cheaper debt finance because of tax advantage
24
12
Corporate Finance
Lecture 12

Illustrations on Revised MM Propositions with Taxes
Assume in a world of no tax, the following are the capital
structure, investment outcomes & values of debt & equity in
Leverage Inc & Equity Inc respectively
SL = $3m
SE = $4m
VL = VE = $4m
DL = $1m @ 8%
DE = $0
NOIL = $480k
NOIE = $480k
25

Assume Corporate Tax Rate = 30% with the same capital
structure & investment outcomes
Leverage Inc
Equity Inc
NOI
480k
480k
Less : Interest Expense
80k
-- .
400k
480k
Less : Tax (30%)
120k
144k
Available for Equity Holders 280k
336k
Total Amount Available to
Debt & Equity Holders
360k
336k
26
13
Corporate Finance
Lecture 12

With tax, there is an increase of $24,000 to providers of debt &
equity capital. The increase arises from the tax shield on debt
interest i.e. $80,000 x 30%
If we assume KE = 10% p.a. & investment outcomes can be
achieved in perpetuity
27
As presence of debt is assumed to be perpetual, the PV of tax

shield become a perpetuity
28
14
Corporate Finance
Lecture 12
MM Capital Structure Theory with

Taxes & Financial Distress
Cost of Financial Distress Reduce The Optimal Debt Ratio
Firm Value
PV Costs of Distress
PV Tax Shield
Optimum
A Tradeoff Theory
Debt Ratio
29

Taxes & Financial Distress
The Value of the Geared Business (VL)
Equals
The Value of the Equivalent Ungeared Business (VU) Driven by
Genuine Economic Activities only
Plus (Further Driven Up by)
The Value of the Tax Advantage on Debt (DLT)
Minus (Offsetted by)
The Value of the Cost of Financial Distress
30
15
Corporate Finance
Lecture 12

Corporate & Personal Taxation
! Different taxation rates
Corporate tax rate (TC)
! Personal tax rate on interest income (TD)
! Personal tax rate on equity income (TE)
! If a firm is infinitely levered with debt amounting to D & pay
nominal interest rate of RD then the interest expense for the
firm will be RDD
=> Interest income to debt investors would be RDD
!
31

! As interest payments are tax deductible by the firm, the
interest income to debt investor are taxable
=> Net amount accruing to the debt investors after
personal tax is RDD(1 - TD)
! In a particular period t, the taxable profit of a firm will be
EBITt - RDD
! The amount of income payable to equity holders is (EBITt RDD)(1 - TC)
! The net amount accruing to equity holder after personal tax
on equity income is (EBITt - RDD)(1 - TC)(1 - TE)
32
16
Corporate Finance
Lecture 12

! Therefore, the total income paid out by the firm to both the
debt & equity investors in period t is
!
Ct = Net Income to Equity Holders + Net Income to Debt

Holders
= [(EBITt - RDD)(1 - TC)(1 - TE)] + RDD(1 - TD)
Re-arranged the above equation

Ct = [(EBITt (1 - TC)(1 - TE)] + RDD[(1 - TD) (1 - TE)(1 - TC)]
33

!
The components in the equation for Ct can be represented

as follows :
Ct = Cash Flow Accruing to Equity Holders in an
Unlevered Firm + Extra Money Paid Out Due to
the Presence of Debt in its Capital Structure
where
Extra Money Paid Out Due to the Presence of Debt in its
Capital Structure represents the tax shield of debt
34
17
Corporate Finance
Lecture 12

! The value of a levered firm (VL) can be determined by the
aggregation of the following :
! Discounting the 1st term of the cash flows accruing to the
equity holders with an appropriate RE will result in VU
[(EBITt (1 - TC)(1 - TE)] /RE
! Discounting the 2nd term of the cash flows (tax shield) due
to presence of debt by the after-tax RD i.e. RD(1 TD)
RDD[(1 - TD) (1 - TE)(1 - TC)]/RD(1 TD)
35

! From the equation for VL derived :
If TD = TE = 0 => VL = Vu + DTC
If (1 - TC)(1 - TE) > (1 - TD) => Tax advantage is negative

suggesting that the optimal capital structure should then be
all equity
36
18
Corporate Finance
Lecture 12
Capital Structure & Agency Costs

! In most western corporations, ownership & control are
separate
! Owners entrust day-to-day operations to managers
! Although owners know that the optimal strategy of the firm
should ultimately maximise their wealth but it is impossible
to force managers to follow the strategy
37

!
Managers may then behave opportunistically such as taking

inflated salaries, investing in pet projects & enjoying other
perks thereby maximising their own utility
This is known as agency problem which was first
addressed by Jensen & Meckling (1976) in relation to
capital structure
38
19
Corporate Finance
Lecture 12

! Jensen & Meckling (1976) argue that the understanding of
agency costs is critical in understanding why firm value is not
invariant to capital structure
!
In an all-equity firm where a proportion of the equity is

held by management, Jensen & Meckling argue that firm
values are lower than would be if management was sole
owner
Manager is the agent of the owners & suppose to undertake

activities that add value to the firm
39

!
Lets call these activities effort such that increased effort

supply leads to greater firm value but it costs the manager
Hence, it may not make sense for the manager to bear the
entire cost of effort supply & reap only portion of the
benefit
This induces the manager to supply lower levels of effort

resulting in lower firm value when proportion of equity
held by outsiders is increased
This is known as agency cost of outside equity
40
20
Corporate Finance
Lecture 12

!
Proportion of outstanding equity held by managers will

increase with leverage assuming that the firm repurchases
outside equity with debt
As his share of residual value of the firm increased, the

manager chooses to supply more effort, leading to increase
in firm value
This implies that as leverage increases, agency cost of

outside equity decreases
41

! Jensen & Meckling highlighted a 2nd agency cost known as
asset substitution or risk shifting problem associated with
debt finance
Example
Assume a manager runs a levered firm in the interest of
equity-holders
Need to consider two investment projects assumed to have
zero cost & mutually exclusive as follows
42
21
Corporate Finance
Lecture 12

State 1
State 2
State 3
Probabilities
0.25
0.50
0.25
NPV A
40
50
60
NPV B
20
40
80
Both projects expected to have positive NPV with Project A

having lower risk & higher expected NPV of 50 while Project B
is riskier with lower expected NPV of 45
43

Assume debt holders have a claim of 50 that must be repaid from
the chosen project
Project A :
Only in State 3 will equity holders get a payoff of 10
(i.e. 60 50)
=> Expected pay-off to equity holders of (10)(0.25) = 2.50
While the expected payoff to debt holders is
(0.25)(40) + (0.50)(50) + (0.25)(50) = 47.50
44
22
Corporate Finance
Lecture 12

Project B :
Only in State 3 will equity holders get a payoff of 30
(i.e. 80 50)
=> Expected payoff to equity holders of (30)(0.25) = 7.50
While the expected payoff to debt holders is
(0.25)(20) + (0.50)(40) + (0.25)(50) = 37.50
45

Manager chooses Project B as it maximises expected payoff to
equity holders but debt holders are worse off & firm value lower
than when Project A is chosen i.e. expected NPV of 50 for
Project A vis--vis 45 for Project B
If debt repayment were 30 then expected pay-off to equity holder
are as follows :
Project A : (0.25)(10) + (0.50)(20) + (0.25)(30) = 20
Project B : (0.50)(10) + (0.25)(50) = 17.50
46
23
Corporate Finance
Lecture 12

Manager will then choose Project A which will cause debt
holders to be happy as their payoffs are better as well as follows :
Project A : (0.25)(30) + (0.50)(30) + (0.25)(30) = 30
Project B : (0.25)(20) + (0.50)(30) + (0.25)(30) = 27.50
When the face value of debt is lower, the manager switches &
chooses the low-risk, high expected return project implying that
the lower the debt, the higher the firm value
47

! Combining the two agency costs, it can be argued that an
optimal capital structure might exist
!
Agency cost of outside equity decreases with leverage
Agency cost of debt increases with leverage
=> Firm value would be maximised when total agency cost

are minimised leading to the optimal leverage ratio
48
24
Corporate Finance
Lecture 12

Total Agency Cost
Cost
Cmin
Agency Cost of
Outside Equity
Agency Cost of
Debt
0
D/E*
D/E
49
Myers (1977) Debt Overhang Problem

! An agency cost of debt argument
! Management of firms with large level of debt outstanding will
choose to reject some positive NPV projects resulting in
reduction in corporate value
Example
A firm is presented with the opportunity to invest in a project
where payoff is $20,000 in time t + 1 regardless of the state of
economy & cost at time t is $10,000
Assuming zero interest, projects NPV = $10,000
50
25
Corporate Finance
Lecture 12

Further the firm receives cash flow at time t, reflecting its past
investments but the cash flow is uncertain with the following
probabilities
($000)
Probabilities
CF from Existing Assets
Cost of New Project
Return from New Project
State 1
0.25
50
10
20
State 2
0.50
80
10
20
State 3
0.25
120
10
20
51

Assuming the firm is run by a manager who acts in the
interest of current shareholders & the firm had issued debt of
$100,000
The debt of $100,000 must be repaid from the cash flow to the
firm resulting in rejection of the new project
In States 1 & 2, the $20,000 generated from new project goes
to pay debt holders through the required payment of $100,000
52
26
Corporate Finance
Lecture 12

Only in State 3 will the $20,000 from new project accrues to
equity holders resulting in expected payoff of
(0.25)(20) 10 = 5
This implies that when debt levels are high, a firm may reject
a project with positive NPV as little of that projects payoff
accrues to equity holders resulting in firm values that are suboptimal
53

When debt level is lower at $80,000, then the cash flow
generated from existing assets is sufficient to service the debt
in States 2 & 3 leading to the equity holders reaping all the
rewards from the new project except in State 1
Thus, the expected payoff to equity holders from the new
project is (0.50)(20) + (0.25)(20) 10 = 5 leading to a project
acceptance
54
27
Corporate Finance
Lecture 12
Firm Value & Asymmetric Information

! Ross (1977) Signalling Argument for Debt
! Firms differ according to their future cash flow prospects
! High quality firms expect large future cash flows whereas
low quality firms expect cash flows to be small
! Firm quality is not observable to outsiders of the firm
! Managers of high quality firms have an incentive to signal
their quality to the market
55

!
One way to signal is through debt policy with high quality

firm choosing large leverage ratios & low quality firms
choose low leverage ratios
Leverage is a credible signal as it is assumed that managers

are risk averse, hence only managers of high quality firms
are willing to expose themselves
56
28
Corporate Finance
Lecture 12

! Illustration
!
Assume a population of firms, each with future cash flow

that is uniformly distributed
A high quality firm may have cash flow distributed on [0,

t1] & low quality firm might have cash flow distributed on
[0, t2] where t1 > t2
Manager of a firm knows the value of t for his own firm

but the market does not
57

Managerial utility is increasing in date 0 firm value & date
1 firm value but is decreasing in the expected cost of
bankruptcy
! Although managers will try to use debt to signal their
quality but non-zero debt levels imply that bankruptcy is
possible
!
58
29
Corporate Finance
Lecture 12

!
Hence, the managerial optimisation of D problem can be

written as follows :
where
t
= Firm quality at the upper bound of cash flow

distribution
V0(D) = Firm value now with debt level of D
L
= Bankruptcy cost
, (1 - ) = Weightages
59

!
Managers knows the true distribution of firm cash flow, his

assessment of date 1 firm value is t/2
At the debt level of D, the probability of firm going

bankruptcy is D/t & expected utility cost of bankruptcy is
LD/t
Assume market assigns (based on credit rating) a firm with

debt level D & a date 0 value of f(D) then
60
30
Corporate Finance
Lecture 12

!
To compute the optimal level of debt, the 1st order

condition with respect to D must be determined
Assuming in equilibrium, the markets belief about firm

quality being debt related is correct then
where it is also acknowledged that the dependence of the

debt level D on firm quality through managerial actions
61

!
Differentiating this condition & substituting into previous

equation will yield the following
where
c is a constant term that can be assigned a value through
noting that the lowest quality firm in the population has no
incentive to signal & will hence set D = 0
62
31
Corporate Finance
Lecture 12

!
Denoting the lowest quality by tc with D = 0
Substituting into the previous equation
63

! This formula essentially represents the key results from
the Ross (1977) model
! Debt level (D) is increasing in firm quality (t)
! Firms with higher debt levels will have greater date 0
market values
! Debt is a costly signal due to the possibility of bankruptcy
it entails & its use imply higher quality firms
64
32
Corporate Finance
Lecture 12

! Myers-Majhif (1984) Pecking Order Theory of finance
! Concentrate on the information or signal revealed when
securities are issued
! Illustration
Assume the following
! A population of firms with varying future prospects & need
to raise funds to finance a positive NPV investment
65

!
Managers are better informed about the firm quality than

outsiders & they act in the interest of existing
shareholders
With information asymmetries, it implies that market can

mis-price equity which only managers know thus allowing
them to exploit the market for benefit of existing
shareholders
66
33
Corporate Finance
Lecture 12

!
Managers of firm whose equity is overpriced will issue

new equity to new shareholders to finance the investment
(such firms are considered bad)
Bad firm does not mean it is a lousy firm, it strictly
means that the its equity is overpriced
Good firms are underpriced & hence are reluctant to

issue new equity
Similarly, Good firms do not mean they are well rated
firms, it just means that they are underpriced
As such good firms dont issue equity because their

existing shareholders will be disadvantaged, but bad firms
do as their shareholders will be advantaged
67

! Pecking Order Theory on the issuance of different security
will be as follows :
!
Risk-free debt
No risk => Convey no information => No effect on
share price
Only highest quality firms issue risk-free debt
Risky debt
Possibility of default => Could be overpriced if market
underestimate the probability of default => Convey
information but less clearly than equity issues => Slight
price decrease as fairly low-quality firms issue risky
debt
68
34
Corporate Finance
Lecture 12

! Hence, the conclusions of Pecking Order Theory are
!
Equity issues cause stock prices to decline
Risky debt issues cause small stock price declines
Riskless debt issues cause no price impact as only high

quality firms issue them
! This implies that capital structure decisions do affect firm

values
69
35

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Corporate Finance

Impact Consultancy & Training Pte Ltd

Central Issue in Capital Structure

Impact Consultancy & Training Pte Ltd

Fundamentals of Capital Gearing

Impact Consultancy & Training Pte Ltd

Fundamentals of Capital Gearing

Impact Consultancy & Training Pte Ltd

Illustration : Companies with Different

Impact Consultancy & Training Pte Ltd

Debt Payoff Profile for Levered Firm

Equity Payoff Profile for Levered Firm

Impact Consultancy & Training Pte Ltd

Traditional View of Capital Gearing

Impact Consultancy & Training Pte Ltd

Traditional View of Capital Gearing

Impact Consultancy & Training Pte Ltd

Traditional View of Capital Gearing

Average Cost of Capital

MM Capital Structure Theory

Impact Consultancy & Training Pte Ltd

MM Capital Structure Theory

MM Capital Structure Theory

X > Face value of the firms debt B

X < Face value of the firms debt B

! Payoff for the investor under the 2 scenarios for both

Payoff for Firm L

X > B(1 + RD)

Impact Consultancy & Training Pte Ltd

MM Capital Structure Theory

MM Capital Structure Theory

Impact Consultancy & Training Pte Ltd

MM Capital Structure Theory

Impact Consultancy & Training Pte Ltd

MM Capital Structure Theory

MM Capital Structure Theory

Impact Consultancy & Training Pte Ltd

MM Capital Structure Theory

Therefore cost of equity increases linearly to fully offset the

MM Capital Structure Theory

Impact Consultancy & Training Pte Ltd

MM Capital Structure Theory

MM (No Taxation) & Value of Firm

MM Capital Structure Theory

Impact Consultancy & Training Pte Ltd

MM Capital Structure Theory with Taxes

Does not mean that economic activities no longer drives

MM Capital Structure Theory with Taxes

Impact Consultancy & Training Pte Ltd

MM Capital Structure Theory with Taxes

Impact Consultancy & Training Pte Ltd

MM Capital Structure Theory with Taxes

Impact Consultancy & Training Pte Ltd

MM Capital Structure Theory with Taxes

Impact Consultancy & Training Pte Ltd

MM Capital Structure Theory with Taxes

As presence of debt is assumed to be perpetual, the PV of tax

Impact Consultancy & Training Pte Ltd

MM Capital Structure Theory with

Impact Consultancy & Training Pte Ltd

MM Capital Structure Theory with

MM Capital Structure Theory with

Impact Consultancy & Training Pte Ltd