Chapter 9

Theory of Capital Structure

How do we want
to finance our
firms assets?
Debt
Preferred
Equity

Balance Sheet
Current
Current
Assets
Liabilities

Fixed
Assets

Debt and
Preferred
Shareholders
Equity

Balance Sheet
Current
Current
Assets
Liabilities

Fixed
Assets

Debt and
Preferred
Shareholders
Equity

Balance Sheet
Current
Current
Assets
Liabilities

Fixed
Assets

Debt and
Preferred
Shareholders
Equity

Financial
Structure

Balance Sheet
Current
Current
Assets
Liabilities

Fixed
Assets

Debt and
Preferred
Shareholders
Equity

Balance Sheet
Current
Current
Assets
Liabilities

Fixed
Assets

Debt and
Preferred
Shareholders
Equity

Capital
Structure

Why is Capital Structure Important?

1) Leverage: higher financial leverage
means higher returns to stockholders, but
higher risk due to interest payments.
2) Cost of Capital: Each source of financing
has a different cost. Capital structure affects
the cost of capital.
3) The Optimal Capital Structure is the one
that minimizes the firms cost of capital and
maximizes firm value.

Introduction to the Theory

Capital structure is the proportions of
Debt
Preferred stock
Common stock

Assumptions
Definitions
NOI approach
Traditional approach
Miller Modigliani Approach

Assumptions

No taxes & no bankruptcy costs

No transaction costs
Pay all earnings in dividends
Same expected future operating earnings for
all investors
No growth of earnings

Definitions
ki is the yield on the companys debt

Annual interest charges

ki
Market value of debt outstanding

ke is the earnings/price ratio

Required rate of return for investors

Earnings available to common stockholder

ke
Market
value ofrate
stock
outstandin
g
k0 is an overall
capitalization
for the
firm
Weighted average cost of capital (WACC)

Calculating NOI Approach

NOI
X
Overall capitalization rate
=
Total value of firm

Market value of debt

=
Market value of stock

NOI Approach
Required return on equity increases linearly
with leverage
Total valuation of the firm unaffected by its
capital structure

NOI Approach
Cost of
Capital

ke

ke = cost of equity
ki = cost of debt
ko = cost of capital

0% debt

financial leverage

100%debt

NOI Approach
Cost of
Capital

ke

.
ki

ki
0% debt

financial leverage

100%debt

NOI Approach
Cost of
Capital

Increasing leverage causes the

cost of equity to
rise.

ke

ke
ki

ki
0% debt

financial leverage

100%debt

NOI Approach

ke

Increasing leverage causes the

ke
cost of equity to
rise.
What will
be the net effect
on the overall cost
of capital?

ki

ki

Cost of
Capital

0% debt

financial leverage

100%debt

NOI Approach

ke

Increasing leverage causes the

ke
cost of equity to
rise.
What will
be the net effect
on the overall cost
of capital?

ki

ki

Cost of
Capital

0% debt

financial leverage

100%debt

NOI Approach
ke

Cost of
Capital

ke

ko

ki

ki

0% debt

financial leverage

100%debt

NOI Approach

If we have perfect capital markets,

capital structure is irrelevant.
In other words, changes in capital
structure do not affect firm value.

Important Assumptions of NOI

Approach
k0 is constant
Regardless of the degree of leverage

Breakdown between debt and equity

unimportant
If ki remains constant, ke is a constant linear
function of the debt-to-equity ratio
k0 cannot be altered through leverage
No one optimal capital leverage

Traditional Approach
There is an optimal capital structure
Increase the total value of the firm through
leverage
Cost of capital is dependent of the capital
structure
Optimal capital structure exists

Traditional Approach
Cost of
Capital

kc

kc
kd

kd
financial leverage

Traditional Approach
Cost of
Capital

ke
ki
financial leverage

Traditional Approach
Cost of
Capital

ke
ki

ki
financial leverage

Traditional Approach
Cost of
Capital

ke

ki

ki
financial leverage

Traditional Approach
Cost of
Capital

ke

ke

ki

ki
financial leverage

Traditional Approach
Cost of
Capital

ke

ke

ki

ki
financial leverage

Traditional Approach
Cost of
Capital

ke

If a firm borrows too much, the

costs of debt and equity will spike
upward, due to bankruptcy costs
and agency costs.

ke

ki

ki
financial leverage

Traditional Approach
Cost of
Capital

ke

ke

ki

ki
financial leverage

Traditional Approach
ke

Cost of
Capital

ke

ko

ki

ki
financial leverage

Traditional Approach
Cost of
Capital

ke

ke

Ideally, a firm should use leverage

to obtain their optimum capital
structure, which will minimize theko
firms cost of capital.
ki

ki
financial leverage

Traditional Approach
Cost of
Capital

ke

ko
ke

ki

ki
financial leverage

Traditional Approach
Cost of
Capital

ke

ko
ke

ki

ki
financial leverage

Modigliani-Miller (MM) Position

Assumptions are important
Capital structure is irrelevant
Total investment value of a corporation
depends on profitability and risk
Value is the same regardless of financing mix
Homemade leverage
Arbitrage efficiency

Irrelevance in a CAPM
Framework

As leverage increases

Expected return and beta increase

proportionally

The change in expected return and beta

offset each other with respect to share price
Share price is invariant with respect to
leverage

Taxes and Capital Structure

Important market imperfections
Corporate taxes
Components of overall value
Value if levered + Value of tax shield

Optimal strategy is to maximize leverage

Not consistent with corporate behavior

Uncertainty of Tax Shield

Income is consistently low or negative
Bankruptcy
Change in the corporate tax rate
Redundancy

Remember this example?

Tax effects of financing with debt
with stock
EBIT
400,000
- interest expense
0
EBT
400,000
- taxes (34%)
(136,000)
EAT
264,000
- dividends
(50,000)
Retained earnings
214,000

with debt
400,000
(50,000)
350,000
(119,000)
231,000
0
231,000

Remember this example?

Tax effects of financing with debt
with stock
EBIT
400,000
- interest expense
0
EBT
400,000
- taxes (34%)
(136,000)
EAT
264,000
- dividends
(50,000)
Retained earnings
214,000

with debt
400,000
(50,000)
350,000
(119,000)
231,000
0
231,000

New Value Equation

Value of Value if
Pure value
Value lost
firm = Unlevered + of corporate through tax
tax shield
shield
uncertainty

Corporate Plus Personal Taxes

Personal taxes can reduce the corporate tax
advantage
Dividends versus capital gains
Debt or stock income

Merton Millers Equilibrium

In market equilibrium personal and corporate tax
effects cancel out
Investor clienteles and market equilibrium
Completing the market
Counterarguments
Zero personal tax on stock income is suspect
Disturbing relationship between
Corporate debt
Stock returns
Returns on tax-exempt municipal bonds

Recapitulation
Tax advantage to borrowing
Moderate amounts of debt
Tax shield uncertainty is not great

Some lessening of the corporate tax effect

Owing to personal taxes

Greater the tax wedge

Lower the overall tax shield

Effects of Bankruptcy Costs

Less than perfect capital markets
Administrative costs to bankruptcy
Assets liquidated at < economic value

Relationship to leverage
Deadweight loss to suppliers of capital

Taxes and bankruptcy costs

Trade-off between
Tax effects of leverage
Bankruptcy costs associated with high leverage

Most important imperfections

Other Imperfections
Corporate and homemade leverage not being
perfect substitutes
Advantage to corporation borrowing
Arbitrage process

Institutional restrictions
Adverse effects on market value

Greater the importance of imperfections

Less effective MM arbitrage process
Greater the case for an optimal capital structure

Incentive Issues and Agency

Costs
Agency costs
Stakeholders monitoring

Equity holders
Debt holders
Management
Other stakeholders

Debt Holders Versus Equity

Holders
Equity of a firm
Call option on the firms total value

Debtholders are the writers of the option

Effect of Variance and the

Riskiness of Assets
By increasing the riskiness of the company
Stockholders increase the value of their stock
At the direct expense of the debt holders

Changing the Proportion of Debt

Will affect the relative valuation
Of debt
Of equity

Relationship between the proportion of debt

and valuation
Increasing the proportion of debt
Results in a decline in the price of debt
Results in an increase in share price

Protective Covenants
Restrict the stockholders ability
To increase the assets riskiness
To increase leverage

MM argument
Me-first rules

The Underinvestment Problem

Result of equity holders not wishing to
invest when the rewards favor debt holders
Disappears when
Investors own both stocks and bonds
By contracting between debt holders and
stockholders

Agency Costs More Broadly

Defined
Monitoring
Cost is born by stockholders
Debt holders charge more interest
May limit the optimal amount of debt

Optimal balance between

Monitoring costs
Interest rate charged on debt

Organizational Incentives to
Manage Efficiently
Leveraged companies
May be lean because management cuts the fat
Running scared

Debt brings capital-market discipline to

management
Company with little debt
Significant free cash flow
Have a tendency to squander funds

Asymmetric Information
Signaling effect
Assumes there is information asymmetry

Credibility of a financial signal depends on

asymmetric information
The greater the asymmetry in information the
greater the likely stock reaction to a financing
announcement
What is significant?
The signal conveyed by a changed capital structure