Supplementary Notes:

Capital Structure

by Kyung Hwan Shim

University of New South Wales
Australian School of Business
School of Banking & Finance
for FINS 1613 S1 2011

May 14, 2011

These notes are preliminary and under development. They are made available for FINS 1613 S1 2011 students
only and may not be distributed or used without the authors written consent.

1
Contents

1 Introduction 3

2 Financial Leverage 4

3 M&M Proposition I: Capital Structure Irrelevance 5

4 M&M Proposition II: Capital Structure Irrelevance 8

4.1 M&M Proposition II With Riskless Debt . . . . . . . . . . . . . . . . . . . . . . . . 8
4.2 M&M Proposition II with Riskless Debt: Betas . . . . . . . . . . . . . . . . . . . . 11

5 M&M I & II with Taxes: Riskless Debt and Tax Shields 12

6 M&M with Taxes & Cost of Financial Distress 17

6.1 Bankruptcy Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17
6.2 Costs of Financial Distress . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18
6.3 Static Trade O Theory: Tax Shield Gains vs. Bankruptcy & Distress Costs . . . 19

7 Optimal Capital Structure Policy: Empirical Evidence 22

7.1 Asset Type and Debt ratios: the Static Trade O Explanation . . . . . . . . . . . 22
7.2 High Prot & Low Debt Ratio Firms: The Pecking Order Theory Explanation . . 23

8 Final Words on Capital Structure 23

8.1 Debt and Corporate Discipline . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23
8.2 Other Things to Consider . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23

9 Conclusions 24

2
1 Introduction

A rms mix of debt and equity is what is called the rms capital structure. The capital structure
of a company determines how its operating cash ows will be split between equityholders and
debtholders. The cash ows of an all equity nanced company belongs to the equity holders, while
a company that has both debt and equity will have its cash ows split between the debtholders
and equityholders. The debtholders will receive a relatively less risky portion of the cash ows,
while the equityholders collect the remainder.
A natural question that comes to mind is Is there an optimal choice of capital structure?
In other words, can one increase the value of a rm simply by choosing to nance the company
with an optimal mix of debt and equity. If the answer is No, then an investigative eye must
not observe a discernible dierence in capital structure across rms. The capital structure of
rms must vary randomly across companies because capital structure should not impact rm
value. However, if the answer is Yes and if optimal capital structure is dependant on rm
characteristics then rms observed capital structures must reect their optimal targets and one
must observe a discernible dierence in capital structure across rms.
The objective of this chapter is to explore for an answer. To this end, the most important
theories related to capital structure must be covered. To better understand rms capital structure
policies, we must rst understand what are the circumstances when capital structure choices do
not matter. Only then can we begin to investigate circumstances when capital structure start
to matter. The backbone of much of what we know about rms nancial leverage is based on
Modigliani & Miller Propositions. Much of what will be discussed in this chapter is related to
M&Ms propositions.
We will follow the same approach one would take to make a layered cake. It starts with
the foundations and each layer is placed until the cake is nished. Section two describes how
nancial leverage aects the risk of the rms equity. Section three covers Modigliani and Millers
(M&M) First Capital Structure Irrelevance Proposition. The section shows that in perfect capital
markets capital structure choice is irrelevant. Section four covers M&Ms Second Capital Structure
Irrelevance Proposition, which is simply a corollary of the the rst proposition. Next we will
investigate circumstances when the capital structure choices start to matter. Section ve relaxes
M&M no tax assumption and revisits their propositions in a market with corporate taxes. Section
six adds another layer to the cake. M&Ms propositions are investigated when nancial leverage
can increase bankruptcy costs. Section seven discusses some empirical observations in capital
structure policy as evidenced in the cross section. Section eight concludes with some nal remarks
and some factors managers may want to consider when making capital structure decisions.

2 Financial Leverage

Financial leverage is the degree to which a rm is committed to xed charges related to interest
payments from the companys debt. Fixed charges, in contrast to variable charges, are charges to
prots that do not vary with the rms level of prots, sales or revenues. For a rm to turn out
positive earnings, its operating prots must be greater than its debt payment obligations. Firms
with a lot of nancial leverage have high xed charges related to heavy borrowing. For a rm that
has high nancial leverage, its cash ows and earnings are likely to be very sensitive to changes
in sales or revenues. That is because nancial leverage magnies the eect that uctuations in
sales have on earnings. Firms with high nancial leverage tend to perform relatively badly in a
slump but ourishes in a boom compared to rms with low nancial leverage.
To understand nancial leverage, consider a high nancial leverage rm and a low nancial
leverage rm. During good economic times, both rms experience high prots, but the low
leverage rm has to share corporate prots with more equityholders than the high leverage rm,
since the latter has fewer shareholders as some of the stakeholders are the creditors. Consequently,
the earnings per share of the high leverage rm will be greater than the low leverage rm.
The opposite would be the case during economic downturns. During economic downturns,
corporate prots are low for both the high and low leverage rms. However, the low leverage
rm does not have the high level of interest charges to contend with so its prots are likely to be
higher than a rm with high nancial leverage. The end result is that the earnings per share and
dividend payments of high nancial leverage rms experience higher highs and lower lows than
low leverage rms. Similarly, all else equal, the equity of high nancial leverage rms tend to
have higher business risk than the equity of low nancial leverage rms. The concept of nancial
leverage and its eect on the risk of the equity of the rm will become more evident later when
we discuss Modigliani and Millers Propositions.

4
3 M&M Proposition I: Capital Structure Irrelevance

An interesting concept of academic interest is the perfect capital market. In a perfect capital
market individuals and rms can costlessly trade securities without transaction costs, there are
no taxes, no bid-ask spreads, no dierences in interest rate on borrowing and lending funds, and
information ows eciently so no one has an informational advantage over the rest of the market.
A perfect capital market is a market where capital ows without any frictions. A perfect capital
market is considered to be an idealistic view of what ecient capital markets should strive to be.
While perfect capital market in its strictest denition does not exist in reality, the notion of a
perfect capital market is useful for researchers because it is a perfect experimental laboratory in
which new theories can be developed.
Modigliani & Miller (M&M) proposed that in perfect capital markets where there are no
taxes, transaction costs and other imperfections investors can create homemade leverage
by trading securities. If investors can borrow or lend on same terms as corporations can an
assumption of perfect capital markets then investors can replicate the cash ow pattern of
investments in the equity of a rm with any amount of leverage. For example, if an investor
prefers leverage while he is invested in the stocks of an unlevered rm, then he can borrow an
amount that reects the debt to equity ratio of a levered rm and use these funds to invest in
more stocks to create nancial leverage in his investment portfolio. Similarly, an investor who is
originally invested in the equity of a levered rm, and prefers to have no exposure to nancial
leverage, can simply sell some of his stock holdings and lend that amount to undo the leverage
that is inherent in his investment portfolio.
Since investors can create any level of leverage through their own nancial portfolios, M&M
concluded that investors would not pay a premium for the securities of a rm that follows a
particular capital structure. M&M concluded that any two identical companies that only dier in
their capital structure policies should be priced equally in a perfect capital market. More formally,
M&Ms Capital Structure Irrelevance Proposition I states that

Value of Levered Firm = VL = VU = Value of Unlevered Firm

The next three examples illustrate how to create homemade leverage and motivates M&Ms
rst proposition.

5
 Hackers Example: Hackers R Us is all equity nanced and has 100,000 shares outstanding
valued at $10. Hackers can borrow at an interest rate of 5%. Hackers earns a perpetual before
interest operating cash ows of $200,000 and it operates in a taxless business environment. If you
own 500 shares of Hackers, and assuming that you can borrow or lend on same terms as Hackers
can, how can you replicate the cash ows of an investor who invested in 500 shares of Hackers if
Hackers were to be 25% nanced with debt?
Answer: Hackers is currently valued at VU = 100, 000 $10 = $1M . If Hackers were to be
25% debt nanced, it would have borrowed 25% $1M = $250, 000 at 5% and it would have
$250, 000/$10 = 25, 000 fewer shares outstanding. The per period cash ow of a portfolio that
invested in 500 shares of Hackers if it were levered would be

($200, 000 $250, 000 5%)

pdfL # of Shares= 500 = $1, 250
75, 000

where pdfL are the earnings per share of Hackers if it were 25% debt nanced. To create homemade
leverage, you need to borrow some funds and use it to buy additional shares of the unlevered rm.
Denote x the number of additional shares purchased from the borrowed funds. To replicate the
cash ows of Hackers stocks if it were levered, the per period portfolio cash ow that borrows
and invests in the equity of the unlevered rm must equal to $1, 250

$1, 250 = pdfU # of Shares Interest on Borrowed Funds

$200, 000
= (500 + x) x $10 5%
100, 000
x = 166.6666666666

where pdfU is the earnings per share of Hackers if it were unlevered.

To replicate the cash ows from holding 500 shares of Hackers if it were levered requires you
to borrow x $10 = 166.6666666666 $10 = $1, 666.666666666 in total. You will also have to
buy another x = 166.666666 shares of Hackers for a total holding of 500 + x = 666.666666666
shares.

Hackers Example Contd: How can you replicate the cash ows of an investor who invested
in 500 shares of Hackers if Hackers had a capital structure of 50% debt?

6
 Answer: If Hackers adopted a capital structure of 50% debt, it would have to convert
50% $1M = $500, 000 of equity into debt. Hackers would have to borrow $500, 000 at 5% and
repurchase $500, 000/$10 = 50, 000 shares leaving 50,000 shares outstanding. The per period cash
ow from a portfolio that invested in 500 shares of the levered rm would be

($200, 000 $500, 000 5%)

pdfL # of Shares= 500 = $1, 750
50, 000

To create homemade leverage, you need to borrow some funds and use it to buy additional shares
of the unlevered rm. Denote x the number of additional shares purchased from the borrowed
funds. To replicate the cash ows of Hackers stocks if it were levered, the portfolio cash ow that
borrows and invests in the equity of the unlevered rm must equal to $1, 750

$1, 750 = pdfU No of Shares Interest on Borrowed Funds

$200, 000
= (500 + x) x $10 5%
100, 000
x = 500

To create homemade leverage equivalent to investing in Hackers shares if it were 50% debt
nanced, you must borrow x $10 = 500 $10 = $5, 000 and purchase x = 500 additional shares
of Hackers.

Hackers Example Contd: Based on the answers from the previous examples, what con-
clusion do you make about optimal capital structure policy?
Answer: In a perfect capital market where investors can create homemade leverage, capital
structure does not matter. An investor can always replicate the cash ows of investing in the
equity of a levered rm simply by investing in the equity of an unlevered rm and borrowing.
Moreover, if an investor has a dierent preference for leverage exposure than his current leverage
exposure through his investment portfolio, he can simply borrow or lend a certain amount on his
own account to reect his risk preference. Because investors do not need rms to borrow on their
behalf, investors would not pay a premium for the securities of a rm that follows a particular
capital structure.

7
4 M&M Proposition II: Capital Structure Irrelevance

M&Ms First Capital Irrelevance Proposition says that identical rms that adopt dierent capital
structures should be valued equally in a perfect capital market. Though the proposition seems
like a very simple argument, much more insight can be attained from its corollaries. This section
discusses M&Ms Second Capital Structure Irrelevance proposition, rst if the rms debt is
riskless and then if we allow the debt to become risky.

4.1 M&M Proposition II With Riskless Debt

While M&Ms Proposition I focuses on the rm values of levered and unlevered rms in perfect
capital markets, M&Ms proposition II relates a levered rms cost of equity to the cost of equity
D
of an identical unlevered rm and the rms nancial leverage E.

An important corollary to M&Ms Proposition I is that the overall cost of capital of two
identical rms that dier only in their capital structure are the same. One way to rationalize this
corollary is to view the value of the rm as the present value of all of its future cash ows. Denote
X the perpetual cash ow of two identical rms that dier only in how their nanced. The value
of the unlevered rm is given by
X
VU =
W ACCU

where W ACCU is the weighted average cost of capital for the unlevered company. Since M&M
X X
Proposition I says that VU = VL , then W ACCU = W ACCL , and W ACCU = W ACCL , and one
arrives at the conclusion that

DL EL
rA = rU = W ACCU = W ACCL = rD + rE (1)
VL VL

where rA = rU denotes the return on the rms real assets and it should equal the return on the
equity of an all equity nanced rm, and the last equality is simply the formula for the W ACC

8
for a levered company that does not pay any taxes. One can manipulate equation (1) to arrive at

DL EL
rU = rD + rE
VL VL
VL DL
rE = rU rD
EL EL
DL + EL DL
= rU rD
EL EL
DL
= rU + (rU rD )
EL

The last equality is the much celebrated M&Ms Capital Structure Irrelevant Proposition
II.
We restate M&Ms Proposition II

D
rE = rU + (rU rD ) (2)
|{z} |{z}
|E {z }
required rate of required rate of return
required rate of return
return on equity on real assets
due to nancial leverage

Equation (2) shows that a levered equitys required rate of return comes from two sources: (i)
the required return from the assets of the company (or unlevered returns), and (ii) the required
return from exposure to nancial leverage. M&Ms Prop I, coupled with M&Ms Prop. II, suggests
D
that while the W ACC of the rm remains unchanged, rE increases in the E ratio. To further
understand the proposition, consider the rms W ACC

DL EL
W ACCL = rD + rE
VL VL

D D E D
M&Ms Prop. II says that while rE increases in the E ratio, V increases and V decreases in E

ratio in proportions to make the levered rms overall cost of capital constant across any amount
of nancial leverage. While rE increases in leverage, the required return on the total package of
the securities of the rm remains unchanged.
M&Ms Prop. II is important because it provides us with a way to understand how investments
in levered stock returns must be compensated for their exposure to nancial leverage. As discussed
earlier, nancial leverage increases business risk for the equityholders. All else equal, the higher
the nancial leverage of a stock, due to greater corporate borrowing, the greater the required rate
of return due to greater business risk exposure.

9
 M&M Proposition II: r =r +D/E(r r )
E U U D

rE
rD
The expected return on equity
rU=WACC
rE increases linearly in
0.25
the D
E ratio.

0.2

0.15 But the W ACC

stays constant
r

0.1

0.05

rD

0 0.5 1 1.5 2 2.5 3 3.5 4

D
E ratio

Figure 1: M&M Proposition II: rE = rA = W ACC when D E = 0, however rE increases linearly

in the D
E ratio while r A = W ACC remains constant; hence the result from M&M Prop. I that
VL = VU . The slope of the rE line is (rA rD ).

Figure 1 provides a graphical illustration of M&M Proposition II. It shows that rE is linearly
D D
increasing in the leverage ratio E. Initially, rE = rU when nancial leverage E is zero. rE
D
increases linearly in the E ratio while W ACC remains constant. Note that the cost of debt rD
is constant because debt is assumed riskless and rD < rU . Increases in rE resulting from greater
nancial leverage is exactly oset by a shift in weight toward rD . Equation (2) shows that as
nancial leverage increases the equity holders command a higher rate of return due to increased
nancial leverage. The required rate of equity return is equal to the required rate of return on
the real asset of the rm plus a premium related to the equitys exposure to nancial leverage.
However, no matter how much the rm borrows, the required rate of return on the package of all

10
the debt and equity (the overall rm) is unchanged.
The next examples illustrate M&M Propositions I and II.

Hackers Example Contd: What is Hackers overall cost of capital, cost of equity and rm
value if it were unlevered?
Answer: Since Hackers has 100,000 shares outstanding each priced at $10, the value of the
rm is VU = 100, 000 $10 = $1 Million. Since Hackers generates a perpetual operating cash ow
X $200,000
of $200, 000, its rE = rU = W ACC is rE = VU = $1M = 20%.

Hackers Example Contd: If Hackers decides on one of the proposed capital restructuring
either 25% or 50% debt what would Hackers new rE , W ACC and rm value be under each
capital structure?
Answer: The following table summarizes the computations under each capital structure
choice

E (r U r D ) VL +r E VL
W ACC = rU = rD D
D D
V E rE = r U + D L E X
V = W ACC
200,000
0 0 .20 .20 .2 = 1M
200,000
25% 25% 1
75% = 3 .2+ 13 (.2 .05) = .25 05 25% + .25 75% = .2 .2 = 1M
200,000
50% 50%
50% = 1 .2+ 11 (.2 .05) = .35 05 50% + .35 50% = .2 .2 = 1M

As it can be seen from the table, even though Hackers rE is increasing in the leverage ratio
D
E, its W ACC and total rm value remain constant under dierent capital structure. This former
is M&Ms Prop. II and the latter is M&Ms Prop. I.

4.2 M&M Proposition II with Riskless Debt: Betas

It is instructive to express the levered returns in M&M Proposition II in beta form. Since the
expected levered return increases in the leverage ratio due to greater business risks, then the
levered beta should also increase in the leverage ratio. To see that the risk of a levered equity is
D
increasing in the E ratio, one can simply substitute in the CAPM equation into rE , rD and rU

11
in equation (2) to arrive at the following result

D
r E = rU + (rU rD )
E
D
rf + E (rM rf ) = rf + A (rM rf ) + (rf + A (rM rf ) rf D (rM rf ))
E
D
E (rM rf ) = A (rM rf ) + (A D ) (rM rf )
E
D
E = A + (A D ) (3)
|{z} |{z} |E {z }
equity risk business risk
risk from nancial leverage

where A is the beta of the rms real assets and A = U for an unlevered rm. Equation (3)
is the beta version equivalent to equation (2). The levered equity beta E is linearly increasing
D D
in the E ratio. Initially, E = A when E = 0; in other words, since the equityholders own the
entire rm, the equity holders bear all of the rms business and operational risk. The levered
D
beta E increases linearly in the E ratio while the A remains constant. This implies that while
the risk of the equity increases because of nancial leverage, the overall risk of the real assets of
D
the rm remains unchanged as the leverage ratio E increases. The latter interpretation is intuitive
because one tends to think of the operational risk of a rm to be related to the product markets
and the real assets of the rm, not to how the rm is nanced.

5 M&M I & II with Taxes: Riskless Debt and Tax Shields

M&M Props. I and II assumed perfect capital markets. That includes the assumption that rms
do not pay corporate taxes. However, in taxable business environments the cost of debt is a
tax deductible expense for the rm. Interest on the rms debt, like depreciation claims, shields
operating prots from being taxed. This section modies M&Ms proposition when companies
are subject to corporate taxes.
When looking at M&M propositions without taxes, the cost of debt was simply given as
the required rate of return on the debt, rD . Moreover, the W ACC was the same for identical
rms that only diered in their capital structure. If corporate taxes are taken into consideration
in a taxable business environment, the eective cost of debt is lower by a factor (1 TC ) (ie.
rD (1 TC ) < rD ), which leads to a lower W ACC as nancial leverage increases.
M&M Proposition II with Taxes adjusts for this lower cost of debt when there are

12
corporate taxes and its is given by

DL
rE = rU + (rU rD ) (1 TC ) (4)
EL

where rU , as before, denotes the rms unlevered cost of capital, and TC denotes the corporate
tax rate. The WACC of the levered rm is given by

DL EL
W ACCL = rD (1 TC ) + rE (5)
VL VL

M&M II with Taxes: r =r +D/E (1T )(r r )

E U C U D

rE
rD (1TC)
WACC
0.25 rE

0.2
Unlevered cost of equity
rE =rU if D
E =0

With taxes, the W ACC of the

0.15
firm is decreasing in the DE ratio
r

because the tax shield gains lower the

overall cost of capital for the firm

0.1

0.05

riskless debt
0

0 0.5 1 1.5 2 2.5 3 3.5 4

D
E ratio

Figure 2: M&M Proposition II with Taxes: Initially rE = rU = W ACC when D E = 0. However,

rE is increasing while the W ACC is decreasing in the DE ratio. The slope of the rE line is
(rU rD ) (1 TC ).

Figure 2 provides a graphical illustration of equations (4) and (5). The gure shows that

13
 D
initially rE = rU = W ACC when E = 0. Furthermore, rE is increasing while W ACC is
D
decreasing in the E ratio. The gure shows that the companys overall cost of capital is decreasing
in nancial leverage because debt shield prots from being taxed, providing an advantage over
equity.
The Debt Tax Shield is the rms operating cash ows which was prevented from being taxed.
Eectively, debt results in larger cash ows being shared among the debt and equityholders be-
cause less of the rms cash ows is collected by the government in the form of taxes. Consequently,
the total rm value increases in the amount of debt. In a taxable environment, the debt is a source
of value creation.
To see this, assume that a company has a certain debt amount D that is to be maintained
with a cost of rD . In each period, the operating prots of this rm will be prevented from being
taxed. The total tax shield gained each period is given by

Tax Shield = TC D rD

Assume furthermore that these tax shields have the same business risk as the rms debt. To
value this asset, one simply computes the present value of the tax shield by discounting them
with rD . Their present value is given by

TC D rD
PV of Tax Shields = = TC D
rD

In a taxable business environment, the value of a levered rm is greater than the value of an
otherwise identical unlevered rm by the present value of its tax shields

VL = VU + TC DL (6)

Equation (6) is known as M&Ms Proposition I with Taxes and a graphical illustration of
the proposition is shown in Figure 3. The gure plots the value function of the levered rm as
a function of D. Initially, VU = VL when D = 0. However, as indicated by equation (6), VL
is increasing in D as the interest tax shield becomes larger in the amount of nancial leverage.
In presence of taxes, debt is preferred to equity and the propositions suggest that rms must be
nanced with as much debt as possible.
The next example illustrates M&M propositions I and II when there are corporate taxes.

14
 M&M with Taxes: Firm Value in D
18

17

16
VL=VU+TC D
15

14

13 TC D
V

12

11 VU

10

9 VU

8
0 5 10 15 20
D

Figure 3: M&M Proposition I with Taxes: Initially, VU = VL when D = 0. However, VL is

increasing in D because of Tax Shield Gains.

Hackers Example Contd: If Hackers now operates in a taxable environment where the tax
rate is TC = 20%, what are Hackers new rm value, rE and new W ACC if Hackers is all equity
nanced and if Hackers decides to adopt each of the proposed capital restructuring of 25% and
50% debt?
Answer: Since Hackers has 100,000 shares outstanding each priced at $10, the value of
the rm is VU = 100, 000 $10 = $1 Million if it were to be all equity nanced. Since Hackers
X(1TC )
generates a perpetual operating cash ow of $200, 000, its rE = rU = W ACC is VU =
$200,0000.8
$1M = 16%. The following table summarizes the computations for the rm values, rE and
the W ACC under each proposed capital structure based on equations (4) and (5).

15
 rE = r U W ACC = rE E L
D
V
D
E
VL
V = X(1T
W ACC
C)

E (r U r D ) (1 T C )
+D +rD D
VL (1 T C )
L

$200,0000.8
0 0 .16 .16 .16 = 1M
$200,0000.8
25% 1
.16+ 13 (.16 .05) .8 .18933 75% .152
25% 75% = 3
= .18933 +.05 .8 25% = .152 = 1.052632M
$200,0000.8
50%
.16+ 11 (.16 .05) .8 .248 12 .144
50% 50% = 1
= .248 +.05 .8 12 = .144 = 1.111111M

Alternatively, one could simply compute Hackers rm value under each capital structure using
equation (6), and deduce the W ACC corresponding to each level of capital structure based on
the rm values and the operating cash ows. To this end, note that

DL = VL debt percentage of levered rm value

and

VL = VU + DL TC

VL = VU + VL debt percentage of levered rm value TC

VU
VL =
1 debt percentage of levered rm value TC

The next table summarizes the computations

X(1T C )
D
V
D
E VL = V U +DL T C W ACC = VL
$200,0000.8
0 0 1M 1M = .16

25% 1
VL = 1M + V L 25% 20% $200,0000.8
25% 75% = 3 1.052632M = .152
= V L = 1.052632M

50%
VL = 1M + V L 50% 20% $200,0000.8
50% 50% = 1 1.111111M = .144
= V L = 1.111111M

which gives results that are consistent with the results from the rst table. As the exercise shows,
the value of the rm is increasing in leverage. Moreover, the W ACC is decreasing in leverage.

16
6 M&M with Taxes & Cost of Financial Distress

The previous section investigated M&M propositions when companies are subject to corporate
taxes. All else equal, the value of the levered rm should be greater than the value of the unlevered
rm by the present value of the tax shields the debt generates. If there are corporate taxes, M&M
propositions seem to indicate that the optimal capital structure for all rms is to borrow as much
as possible.
However, the propositions discussed so far neglected bankruptcy costs. There are at least two
reasons to believe why a rm can not always increase rm value by increasing debt as much as
possible. First, the value creation from corporate debt is limited by the rms ability to generate
sucient taxable income to take advantage of the tax shields. If a company has little prots,
having a large interest payment will not result in large tax shields. Consequently, increasing a
rms debt beyond a certain level would not increase rm value, contradicting M&M Propositions.
Secondly, a direct consequence of increasing debt past a certain level is the increasing possi-
bility that the rm will default on its debt obligation. Bankruptcy and nancial distress costs
can be quite substantial and they must be considered when making the optimal capital structure
choice. This section investigates how such costs impacts the optimal capital structure.

6.1 Bankruptcy Costs

Bankruptcy is a legal mechanism that allows the creditors of a company to take over the assets of
the rm if the rm is not able to repay its creditors. Bankruptcy Protection, on the other hand,
is a legal mechanism that allows the management and the shareholders of the rm to keep
operating the business as a going concern without having the assets of the rm seized by the
creditors.
The costs associated with bankruptcy are called Bankruptcy Costs. These are fees involved
in bankruptcy proceedings, such as lawyers and court fees. Bankruptcy costs are normally paid
by the creditors of the company because the assets of the rm is possessed by the debtholders
after lawyer and court fees are paid.
For a company that has borrowed, the total market value of the rm should reect the costs
of possible bankruptcy in the future. Creditors foresee the possibility that bankruptcy can occur
when the rm holds excessive amounts of debt and they demand a higher yield on the loans.
Bankruptcy costs are usually about 1 to 5% of rm value for large companies, and sometimes

17
greater than 25% of rm value for small rms.

6.2 Costs of Financial Distress

Another term closely related to (and more broadly dened than) bankruptcy cost is the Cost
of Financial Distress. Cost of nancial distress are all costs and value destruction resulting
from distorted business decisions made by the management and the employees of the rm due to
rms nancial insolvency, or fears of nancial insolvency. Financial distress costs includes direct
bankruptcy costs and many of the indirect costs from fears that the rm will become bankrupt.
One source of nancial distress costs is associated with the managements eort to prevent
bankruptcy. The management can engage in distorted business decision resulting from the possi-
bility of bankruptcy. Instead of focusing on running the business as usual, the management of a
distressed rm is likely to devote most of its time looking for ways to stay aoat. Even with good
intentions, the management of a distressed rm may be reluctance to liquidate the rm and pay
the creditors possibly leading to further value destruction. This is likely to happen to rms that
are in bankruptcy protection, or rms that foresee possible bankruptcy looming, when the rm
is allowed to operate for a prolonged period of time without any real prospects of successfully
emerging out of distress.
Distress costs can also sometimes result from debtholders that are reluctant to liquidate the
rm because they think that it is possible to nurse the company back to nancial health. While
some companies can successfully emerge from bankruptcy, for most companies the longer they
are allowed to be operated without success, the larger are the nancial distress costs.
Financial distress can also hurt the business of the company. For example, some companies
experience loss of customer loyalty, goodwill, company image, and brand name reputation when
the public learns of their nancial troubles. Some distressed companies must pay their employees
a higher salary just to keep talents from leaving, while others end up losing their most talented
employees resulting in signicant human capital losses. Distress also causes loss of credit and
liquidity from creditors and suppliers resulting in diculties of running the business seamlessly.
Distressed companies also commonly run into trouble honouring contractual agreements with
suppliers and customers resulting in costly lawsuits. Lastly, and not exhaustively, distress costs
also lead to value destruction resulting from game playing between debtholders and equityholders
of the rm due to their conicts of interest.1 In conclusion, it is not surprising that nancial
1
Value destruction from debtholder and equityholder conflicts will be discussed in the next section.

18
distress costs can be many times larger than bankruptcy costs and they are by far the largest cost
associated with nancial leverage.

Financial Distress Cost Example: AirWaves Airlines is a passenger air carrier that operates
in Australia and New Zealand. AirFresh AirScent is a hygiene product manufacturer that sells
soaps and deodorants in Australia and New Zealand. If both AirWaves and AirFresh are on
the verge of ling for bankruptcy and both have been under signicant nancial distress, which
companys rm value do you think will suer the most due to nancial distress?
Answer: Personal safety concerns is much higher for AirWaves than AirFresh. If AirWaves is
cash strapped, it is questionable if AirWaves will be able to upkeep proper maintenance on their
airplanes. Financial distress costs is likely to be much higher for AirWaves than for AirFresh from
losses in customer loyalty and business. Previous AirWaves customers are much more likely to y
with another air carrier, but AirFreshs customers are still likely to continue using their products
if the quality of their products are unaected by the bankruptcy ling.

6.3 Static Trade O Theory: Tax Shield Gains vs. Bankruptcy & Distress
Costs

M&M Propositions I and II showed that in perfect capital markets, everything else equal, the
value of the levered rm must be equal to the value of the unlevered rm (VL = VU ) and there
is no optimal capital structure. When there are corporate taxes to contend with, then M&M
propositions suggest that rm value increases with nancial leverage and rms should borrow
as much as possible. What about if there are costs of nancial distress? How are the M&M
propositions modied to account for bankruptcy?
In presence of bankruptcy, M&Ms propositions suggest that rms have an optimal capital
structure that maximizes the total value of the rm. The optimal capital structure is a balanced
trade o between the rm value gained from tax shields and the rm value loss from nancial
distress costs. This is called the Static Trade O Theory of Capital Structure. The value
of a levered rm is given by

VL = VU + PV of Tax Shields PV of Cost of Financial Distress (7)

19
 Static Trade Off Theory: Firm Value vs. Debt
26
V is maximized when slope is zero
25.5
Firm Value

25

Optimal debt level

24.5

24

0 2 4 6 8 10 12 14 16
Debt D

Static Trade Off Theory: WACC vs. D/E ratio

0.102
0.101 W ACC is minimized
0.1 when V is maximized
WACC

0.099
0.098
0.097 D
Optimal E ratio
0.096
0.095
0.094
0 2 4 6 8 10 12 14 16
D D
E ratio E

Figure 4: Static Trade O Theory: Initially, VU = VL when D E = 0. However, VL is increasing in

the D
E ratio because of Tax Shield Gains but eventually it starts decreasing because the gains from
tax shields start to diminish and they are more than oset by the increase in nancial distress
costs. The rm value maximizing amount of debt gives rise to the rmss lowest attainable
W ACC.

The top panel of Figure 4 plots equation (7) across increasing amount of debt D. As it can be
X(1TC )
seen, when the rm is unlevered, its value is given by VU = rU . If the debt level increases,
the rm value is initially increasing in debt due to larger tax shield gains, but eventually it starts
decreasing because the gains from tax shields start to diminish and they are more than oset
by the increase in nancial distress costs. An optimal level of debt D achieves the highest rm
value.
D
The bottom panel of the gure shows that the optimal leverage ratio E corresponding to the
optimal debt level D is the one that minimizes the levered rms W ACC. This result is not
surprising since the optimal value is achieved when the W ACC is the lowest (i.e. the rm value
X
and the W ACC have an inverse relationship, V = W ACC ). The minimum W ACC leverage gives

20
the debt level that is consistent with the maximum rm value.
The gure also shows another important fact. The top panel of the gure shows that the
optimal level of debt is located exactly when the slope of the value function is zero. A slope of
zero means that a at line can be balanced on the peak of the value function curve. Keeping in
mind that the slope of a function is the rise over the run of the function, a zero slope implies that

VL
=0
D

where denotes marginal change, $1 for example. Substituting equation (7) into the above
condition we arrive at the following result

VL
=0
D
(VU + PV of Tax Shields PV of Cost of Financial Distress )
=0
D
VU + PV of Tax Shields PV of Cost of Financial Distress
=0
D
PV of Tax Shields PV of Cost of Financial Distress
= (8)
D D

VU
where equation (8) accounts for the fact that D = 0. The optimality condition in equation
(8) shows that the optimal amount of debt is attained when the rm value can not be increased
any further by changing the amount of debt. This optimality condition essentially says that the
optimal amount of debt in a rms capital structure is when the marginal gain in the present value
of tax shields is exactly oset by the marginal increase in the present value of distress costs from
a small increase in debt. A rm should increase or decrease nancial leverage until the equality
in equation (8) is attained. The next example illustrates the point.

RightChoice Corp. Example: RightChoice Corp. always makes the right business
decisions and it is highly protable. Currently RightChoice is 30% and 70% debt and equity
nanced, respectively and currently has a total market valuation of $50M . If by increasing its
D 3 3.5
debt to equity ratio of E = 7 to 6.5 increases nancial distress costs by about $2.5M and the
present value of tax shields by $3M , should RightChoice increase debt?
Answer: Because the marginal increase in the present value of tax shields is greater than the
marginal increase in distress costs, RightChoices right decision is to increase debt. RightChoices

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total market value will increase from $50M to $50.5M .

7 Optimal Capital Structure Policy: Empirical Evidence

The previous sections led us to conclude that capital structure choices matter a lot. For example,
M&M Proposition with Taxes indicate that highly protable rms should utilize debt as much
as possible. However, the Trade O Theory suggests that borrowing too much can lead to rm
value loss due to distress costs. The optimal capital structure is one that balances gains and
losses. Lastly, rm value destruction arising from conicts of interest between equityholders and
debtholders seem to indicate that distress costs can arise intentionally if the management is willing
to play games with debtholders money.
Armed with all of this information, can one explain the capital structure choices evidenced
empirically? As it turns out, many empirical facts on debt ratios across rms can indeed be
explained.

7.1 Asset Type and Debt ratios: the Static Trade O Explanation

The trade o theory can explain why rms with mostly safe and tangible assets, such as utilities,
real estate and heavy manufacturing, tend to have higher debt ratios than rms with risky in-
tangible assets, such as high technology, pharmaceutical, advertising and consulting companies.
Financial distress costs for rms with mostly tangible real assets such as equipment, building,
machinery, production plants, properties and lands, are likely to be low since these assets dont
tend to lose value signicantly due to their resale values. Financial distress costs are likely to
be much higher for rms whose operations are human capital intensive and dependant mostly
on intangible assets, such as copyrights and patents from research and development. In distress,
talented employees leave for higher pay in other companies and copyrights and patents are usually
disposed at substantial discounts. Consequently, rms with safer and tangible assets have a much
greater debt capacity than rms with riskier and intangible assets.

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7.2 High Prot & Low Debt Ratio Firms: The Pecking Order Theory Expla-
nation

The trade o theory can explain much of the capital structure choices made by rms. However,
there are still examples of companies that virtually have no debt and yet are some of the most
protable companies around. One would conclude that these companies are not fully utilizing tax
shelters by increasing debt.2 A possible explanation why some of the most protable companies
borrow the least lies in the Pecking Order Hypothesis.
The pecking order theory says that highly protable rms prefer to raise capital internally
through retained earnings, followed by issuing debt and, lastly, followed by issuing equity. The
main motivation behind the pecking order theory is that highly protable rms prefer to grow
by investing in positive NPV projects through retained earnings instead of distributing earnings
to debtholders and shareholders through interest and dividend payments and later incurring
oatation costs to raise external capital. Regarding the preference for debt over equity, these
rms have little debt to begin with, so according to the trade o theory, the marginal gains in
tax shields from debt is greater than the marginal losses from distress costs.

8 Final Words on Capital Structure

8.1 Debt and Corporate Discipline

As an aside, debt has an additional benet (other than tax shields). Debt has been used to
discipline management. With the right amount of debt, debt has the potential to keep the man-
agement on their toes, give motivation for lower management compensation and cut operational
costs, force management to make sound economic decisions ones that maximize the total value
of the rm and give the management less incentive to spend lavishly on such things as corpo-
rate jets, large executive oces, and dinning (and wining) with corporate clients, among other
perquisites.

8.2 Other Things to Consider

Lastly, some other points are made regarding capital structure decisions.
2
Microsoft is a perfect example. Even though most of Microsofts assets are intangible human capital talents
and copyrights on software source codes Microsoft has a large corporate tax bill. Microsoft is so profitable that it
scores a high credit rating and should not have any problems raising debt capital. Companies like Microsoft could
substantially increase firm value by increasing debt and still avoid concerns of financial distress.

23
i) Taxes: If the rm is in a tax paying position, the increase in leverage reduces the tax bill. If the
rm is expected to have negative prot, or if there were negative prots in the past (accumulated
losses), the company can make use of carry backs or carry forwards to shield taxes in periods of
high prots. These rms could do without increase in nance leverage.
ii) Risks: All else equal, distress is more likely for rms with high business risk. So these
companies should stay away from too much debt.
iii) Asset type: Distress costs are higher for rms with more intangible assets. These assets
tend to erode in value rapidly in case of default. These rms should borrow considerably less than
rms with more tangible assets.
iv) Financial Slack: Financial slack may be very important when it comes time to invest in
positive NPV projects in a competitive and timely manner. Moreover, external nancing is more
quickly accessible when the rms debt is low and credit rating is high.
v) Tax Shelters: There are other tax shelters that are not related to debt. For example, depre-
ciation of depreciable assets is a tax shelter and lower taxes. Also, local governments sometimes
provide certain rms investment incentives so they can help improve the economic conditions of
a city or state. These companies are allowed to operate in a low tax environment for a prolonged
period of time. Other rms receive incentives from governments to invest in R&D by being al-
lowed to claim R&D investment costs as depreciable expenses. All of these factors can lead a
company not to borrow up to capacity.

9 Conclusions

The optimal capital structure choice for a rm should be rm specic. Firms dier in operations
leading to dierences in how taxes and bankruptcy costs aect their rm value. In a market
without frictions and imperfections the mix of debt and equity is irrelevant. However, we live in
a world where managers need to balance the osetting factors related to taxes and bankruptcy
costs. This chapter showed that the optimal mix of debt and equity for a rm is the mix that
maximizes its total rm value. Its without coincidence that the optimal debt to equity ratio is
the one what minimizes the rms overall cost of capital.

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