10 - FINS3625S2Yr2018Wk10CapitalStructure

Topic: Capital Structure
Agenda:
Capital Structure in a Nutshell
Operating Leverage and Business Risk
Financial Leverage and Financial Risk
M&M Propositions with Taxes and Risky Debt
Implementing the Optimal Capital Structure
Merton Structural Model and the Moral Hazard Problem
Qualitative Considerations for Capital Structure Choice
Implementing Capital Structure Changes in Pro Forma Statements

Kyung Hwan Shim, FINS3625S2Yr2018 1
Capital Structure in a Nutshell

Capital Structure
M&M Prop. I : The firm value is given by
The optimal choice of debt ∗ is a compromise between PV of Tax

Shields and PV of Financial Distress Costs.
Alternatively, given , and the
expected value of a firm’s EBIT (a perpetuity). The firm value is
The optimal debt choice ∗

is the one that minimizes
Operating Leverage and Business
Risk

Business Risk
Business risk is the risk that the shareholders assume if the

company has no debt.
Among other things, business risk is dependant on the following

main factors:
(1) variability in sales (quantity and/or price);

(2) operating leverage, which amplifies variation in sales;
(3) industry factors which affect any one of the above.

Operating Leverage
Operating leverage measures the extent to which operations are committed
to fixed costs.
Consider
The break even quantity is . is increasing in
operating leverage.
×( )
Denote return on invested capital .
Given some fixed variation in revenues, e.g. the variation in
is increasing in operating leverage
Operating leverage amplifies business risk to all the investors.

Operating Leverage and Business Risk: Example
Low Operating High Operating

Leverage Leverage
Price (P) 2 2
Mean Quantity (Q) 1200 1200
St. Dev Q 500 500
Variable Cost (VC) 1.2 0.3
Fixed Cost (FC) 800 1800
1000 1058.82
Tax Rate 40% 40%

Operating Leverage and Business Risk:
Monte Carlo Simulations of ROIC for

Financial Leverage and Financial
Risk

Financial Leverage and Equity Risk
Financial leverage measures the extent to which a firm is committed to fixed

charges related to interest payments. Dependent on capital structure choice.
Financial Risk is the risk borne by shareholders steaming from financial

leverage.
Denote as the sum of and , i.e.,

.
Then,
( )×( )
.
Given
Financial leverage amplifies business risk to shareholders (MM Prop. II)

Financial Leverage and Equity Risk: Example
Low Financial High Financial

Leverage Leverage
Price (P) 2 2
Mean Quantity (Q) 1200 1200
St. Dev Q 500 500
Variable Cost (VC) 1.2 1.2
Fixed Cost (FC) 800 800
0 1
Capital = D+E 1000 1000
Tax Rate 40% 40%

Financial Leverage and Equity Risk: Monte Carlo Simulations of
ROE for

Operating and Financial Leverage: Implications for Corporate
Decisions
Operating leverage amplifies both debt and equity risk.
Financial leverage primarily amplifies equity risk.
But at very high levels of debt, even debt holders end up bearing
excess risk.
Implications for Capital Structure Choice: Financial leverage on top

of high operating leverage can compound the risk of business failure.
Implications for Capital Budgeting: Operating leverage makes capital

budgeting more error prone. Errors in projections of sales or prices
get amplified by operating leverage.

M&M Propositions with Taxes
and Risky Debt

M&M with Taxes and Risky Debt
After tax cost of debt: ∗

where ∗
denotes marginal tax
rate.
With bankruptcy costs, ∗ can increase with financial

leverage.
Two reasons. For very high :

• is increasing in ;
- debt gets riskier with additional debt
• and the marginal tax rate ∗
is decreasing in
- tax shields get depleted with additional debt
M&M* Proposition I:
M&M* Proposition II:
Expressed in betas:
*Assuming EBIT is a constant perpetuity.


Implementing the Optimal
Capital Structure

M&M w/ Taxes & Risky Debt:
Steps:
(1) Estimate the marginal tax rate and cost of debt for
various ratios
(2) Compute the cost of equity for each ratio
(3) Compute the for each ratio
(4) Compute the firm value for each ratios and choose the one
with the maximum

(5) Rebalance the capitalKyung
structure
Hwan Shim, FINS3625S2Yr2018 19
M&M w/ Tax & Bankruptcy:
Example: Assume the following,
.
𝑫
(1) Estimate the cost of debt 𝑫 for various ratio
𝑬
0% 10% 20% 30% 40% 50% 60% 70% 80%
0 0.1111 0.25 0.4286 0.6667 1 1.5 2.3333 4
5% 5.5% 6.5% 7% 7.5% 8% 9% 9.5% 10%
∗ 40% 40% 40% 40% 40% 30% 20% 10% 5%

𝑫
(2) Compute the cost of equity 𝑬 for each ratio
𝑬
∗
or ∗
0% 10% 20% 30% 40% 50% 60% 70% 80%
0 0.1111 0.25 0.4286 0.6667 1 1.5 2.3333 4
5% 5.5% 6.5% 7% 7.5% 8% 9% 9.5% 10%

∗ 40% 40% 40% 40% 40% 30% 20% 10% 5%
10% 10.3% 10.53% 10.77% 11.0% 11.40% 11.20% 11.05 10%

𝑫
(3) Compute the WACC for each ratio
𝑬
0% 10% 20% 30% 40% 50% 60% 70% 80%
0 0.1111 0.25 0.4286 0.6667 1 1.5 2.3333 4

5% 5.5% 6.5% 7% 7.5% 8% 9% 9.5% 10%
∗ 40% 40% 40% 40% 40% 30% 20% 10% 5%
10% 10.3% 10.53% 10.77% 11.0% 11.40% 11.20% 11.05 10%
10% 9.6% 9.2% 8.8% 8.4% 8.5% 8.8% 9.3% 9.6%
𝑫
(4) Compute the Firm Value for each ratio and choose the maximum.
𝑬
0% 10% 20% 30% 40% 50% 60% 70% 80%
0 0.1111 0.25 0.4286 0.6667 1 1.5 2.3333 4

5% 5.5% 6.5% 7% 7.5% 8% 9% 9.5% 10%
∗ 40% 40% 40% 40% 40% 30% 20% 10% 0%
10% 10.3% 10.53% 10.77% 11.0% 11.40% 11.20% 11.05 10%
10% 9.6% 9.2% 8.8% 8.4% 8.5% 8.8% 9.3% 9.6%
(in K$) 600 625 652.174 681.818 714.286 705.882 681.818 645.16 625
The Optimal is 40%.
(5) Rebalance the company’s capital structure
Denote primed values (‘) post-recapitalization values, and star values

(*) optimal values, the number of shares to repurchase, the pre-
recapitalization number of shares outstanding, and the stock price
in the repurchase or sale.
and must obey the following 2 conditions:

Solving for and gives:
Assuming zero initial debt :
(714.286
714.286 714.286
714.286 714.286
In order to increase debt from 0 to 40% of total firm value, repurchase

stocks. The repurchase price is expected to be .
Merton Structural Model and the
Moral Hazard Problem

Merton Model
Robert Merton: The equity of an indebted company is akin to a call

option on the assets of the firm.
The debt holders of the firm have a covered call strategy.
Covered Call: Strategy that sells call options on assets already

owned.
The debt liability and the debt due date comprise the strike price
and the expiration date on the option, respectively.
As such, one can value D and E by resorting to the Black and Scholes
model.
Merton Model: Equity as a Call Option

Merton Model: Debt as a Covered Call

Merton Model
Equity Payoff: 𝑻
where
Debt Payoff: 𝑻 𝑻 𝑻
Yield on debt:
* In Excel NORMDIST(x) will give youKyung
the Hwan
standard normal cumulative distribution to the left of30x.
Shim, FINS3625S2Yr2018
Merton Model Example : The Moral Hazard Problem
0.1 1.5642 8.4358 0.0583

0.2 2.0924 7.9076 0.0814
0.3 2.6805 7.3195 0.1096
0.4 3.2738 6.7262 0.1413
0.5 3.8568 6.1432 0.1763
0.6 4.4218 5.5782 0.2148
0.7 4.964 5.036 0.2569
0.8 5.4796 4.5204 0.303
0.9 5.9659 4.0341 0.3534
1 6.4209 3.5791 0.4085
Qualitative Considerations for
Capital Structure Choice

Qualitative Considerations about Capital Structure Choice
Most agree that companies have a unique optimal capital structure.
The empirical evidence (John Graham, Duke Univ.) suggests that

firms tend to be under-levered.
Possible reasons:
to retain debt capacity (timing options);
to retain cash reserves for future investments (mitigates
asymmetric information problem related to raising external
financing);
operating leverage;
non-debt related tax shields;
low asset tangibility and/or high asset specificity;
flat relationship between firm value and financial leverage around
optimal leverage point. Kyung Hwan Shim, FINS3625S2Yr2018 33
Implementing Capital Structure
Changes in Pro Forma Statements

Capital Structure in Pro Forma Statement Analysis
The M&M framework is quite restrictive. Among other things, M&M

assumes:
• is a constant perpetuity But companies expand, grow, and

contract, and experience variability in ;
• unlimited tax shields. But corporate profits are finite;
• no other tax shields. But firms can exploit non-debt tax shields;
• markets are free of imperfections such as transaction costs,
asymmetric information, moral hazard, etc… But these are real
imperfections that afflict firms and investors.
It is possible to implement optimal capital structure in pro forma

statements free of these assumptions.

Capital Structure in Pro Forma Statement Analysis
∗
Denote the target debt to equity ratio for a given period. Then, the
target debt and target equity satisfies the following conditions:
∗
(1)
(2)
Solving for and gives:

∗
∗

JT Ltd. Example: Pro Forma Modelling Assumptions
We assume as we did in previous lectures that current period

performance ratios are good representations of the future.
Other assumptions:
WACC is ,
Sales growth projected at 10% for the next 5 years.
Free cash flows to grow at 5% after year 5.
Future common dividends to be maintained at 40% of net income.
Current return on Short Term Investments :

JT Ltd. Example: Model Assumptions
Current Cost of Debt: . Future rates

are current rates plus 0.5% on previous period balances (avoids the
circular problem).
Corporate tax rate is 40% and to remain constant.
Current end of period book D/E is 65.55%. Target book D/E ratio to
be 60%, 50%, 45%, 40% and 30% for years 1, 2, 3, 4, 5 respectively.
Recapitalization with Long Term Debt and/or Common Equity based

on .
Financial slack/surplus to be address with Long Term Debt and/or

Common Equity. No more plugs.
JT Ltd. Example: Projected Income Statement
Projected Income Statement (thousands $)
1 2 3 4 5
Sale 1650 1815 1996.5 2196.15 2415.77
Cost before
Depreciation 825 907.5 998.25 1098.08 1207.88
Depreciation 186.89 221.34 260.99 306.56 358.84
Operating Costs 1011.89 1128.84 1259.25 1404.63 1566.72
EBIT 638.11 686.16 737.25 791.52 849.04
Interest 50.23 52.36 51.18 52.43 53.11
EBT 587.89 633.8 686.08 739.09 795.94
Taxes 235.15 253.52 274.43 295.64 318.38
Net Income 352.73 380.28 411.65 443.45 477.56
Preferred Dividends 2.2 2.2 2.2 2.2 2.2
Net Income After Pref.
Dividends 350.53 378.08 409.45 441.25 475.36
Common Dividends 141.09 152.11 164.66 177.38 191.03
Increases in Retained
Earnings 209.44 225.97
Kyung Hwan Shim, FINS3625S2Yr2018 244.79 263.87 284.34
39
JT Ltd. Example: Projected Balance Sheet, Assets
Projected Balance Sheet (thousands $): Assets

1 2 3 4 5
Cash 41.25 45.38 49.91 54.90 60.39
Short Term
Investments 0 0 0 0 0
Accounts Receivables 41.25 45.38 49.91 54.90 60.39
Inventory 165 181.5 199.65 219.62 241.58
Current Assets 247.5 272.25 299.48 329.42 362.36
Cost Prop Plant Equip 1868.89 2213.43 2609.95 3065.58 3588.4

Accumulated
Depreciation 636.89 858.23 1119.23 1425.78 1784.62
Net Prop Plant Equip 1232 1355.2 1490.72 1639.79 1803.77

Total Assets 1479.5 1627.45 1790.2 1969.22 2166.13
JT Ltd. Example: Projected Balance Sheet, Liabilities
Projected Balance Sheet (thousands $): Liabilities
1 2 3 4 5
Accounts Payable 33 36.3 39.93 43.92 48.32

Accruals 99 108.9 119.79 131.77 144.95
Notes Payable 35 35 35 35 35
Long Term Debt 470.31 459.08 471.01 477.43 420.28
Total Liabilities 637.31 639.28 665.73 688.13 648.54

JT Ltd. Example: Projected Balance Sheet, Equity, and
Projected D/E ratio
Projected Balance Sheet (thousands $): Equity

1 2 3 4 5
Pref Equity 25 25 25 25 25
Common Equity 561.75 481.76 373.27 266.02 218.19
Retained Earning 255.4 481.41 726.19 990.07 1274.40
Total Equity 842.188 988.17 1124.47 1281.09 1517.6
Total Liab+Equity 1479.5 1627.45 1790.2 1969.2 2166.14
Projected D/E ratio

1 2 3 4 5
D/E 0.6 0.5 0.45 0.4 0.3
Conclusions
In an environment with taxes and bankruptcy costs, the ideal mix of

debt and equity is one that:
(i) maximizes firm value or
(ii) minimizes the firm’s
Optimal debt choice is where the incremental increase in the PV of tax

shields is equal to the incremental increase in the PV of distress
cost
Firms seem to take other considerations into account with leverage
choice.
Note: some Ch 17 Questions & Problems entail valuation-related

concepts.
Problems: 16-1 to 16-6, 16-8 to 16-12, 17-1 to 17-9

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Topic: Capital Structure

Operating Leverage and Business Risk

Financial Leverage and Financial Risk

M&M Propositions with Taxes and Risky Debt

Implementing the Optimal Capital Structure

Merton Structural Model and the Moral Hazard Problem

Qualitative Considerations for Capital Structure Choice

Implementing Capital Structure Changes in Pro Forma Statements

Kyung Hwan Shim, FINS3625S2Yr2018 2

M&M Prop. I : The firm value is given by

The optimal choice of debt ∗ is a compromise between PV of Tax

The optimal debt choice ∗

Kyung Hwan Shim, FINS3625S2Yr2018 4

Business risk is the risk that the shareholders assume if the

Among other things, business risk is dependant on the following

(1) variability in sales (quantity and/or price);

Kyung Hwan Shim, FINS3625S2Yr2018 5

Operating leverage amplifies business risk to all the investors.

Kyung Hwan Shim, FINS3625S2Yr2018 6

Low Operating High Operating

Kyung Hwan Shim, FINS3625S2Yr2018 7

Kyung Hwan Shim, FINS3625S2Yr2018 8

Kyung Hwan Shim, FINS3625S2Yr2018 9

Financial leverage measures the extent to which a firm is committed to fixed

Financial Risk is the risk borne by shareholders steaming from financial

Denote as the sum of and , i.e.,

Financial leverage amplifies business risk to shareholders (MM Prop. II)

Low Financial High Financial

Kyung Hwan Shim, FINS3625S2Yr2018 11

Kyung Hwan Shim, FINS3625S2Yr2018 12

Financial leverage primarily amplifies equity risk.

Implications for Capital Structure Choice: Financial leverage on top

Implications for Capital Budgeting: Operating leverage makes capital

Kyung Hwan Shim, FINS3625S2Yr2018 13

Kyung Hwan Shim, FINS3625S2Yr2018 14

After tax cost of debt: ∗

With bankruptcy costs, ∗ can increase with financial

Two reasons. For very high :

M&M* Proposition II:

*Assuming EBIT is a constant perpetuity.

Kyung Hwan Shim, FINS3625S2Yr2018 16

Kyung Hwan Shim, FINS3625S2Yr2018 17

Kyung Hwan Shim, FINS3625S2Yr2018 18

(2) Compute the cost of equity for each ratio

(3) Compute the for each ratio

with the maximum

0% 10% 20% 30% 40% 50% 60% 70% 80%

0 0.1111 0.25 0.4286 0.6667 1 1.5 2.3333 4

5% 5.5% 6.5% 7% 7.5% 8% 9% 9.5% 10%

∗ 40% 40% 40% 40% 40% 30% 20% 10% 5%

0% 10% 20% 30% 40% 50% 60% 70% 80%

0 0.1111 0.25 0.4286 0.6667 1 1.5 2.3333 4

5% 5.5% 6.5% 7% 7.5% 8% 9% 9.5% 10%

10% 10.3% 10.53% 10.77% 11.0% 11.40% 11.20% 11.05 10%

0% 10% 20% 30% 40% 50% 60% 70% 80%

0 0.1111 0.25 0.4286 0.6667 1 1.5 2.3333 4

0% 10% 20% 30% 40% 50% 60% 70% 80%

0 0.1111 0.25 0.4286 0.6667 1 1.5 2.3333 4

The Optimal is 40%.

(5) Rebalance the company’s capital structure

Denote primed values (‘) post-recapitalization values, and star values

and must obey the following 2 conditions:

Kyung Hwan Shim, FINS3625S2Yr2018 24