Intermediate

Corporate
Finance
F305
Capital Structure
Theories and Evidence – Perfect World

Professor:
Burcu Esmer 1
 From Last Class: WACC
• An average of the rate of return on a portfolio of all the
firm's securities
• WACC measures what (after-tax) returns a firm’s
investors as a group expect
• How to use WACC?
• Calculate the corresponding free cash flows
• Discount these free cash flows using the WACC
• Where should we use WACC?
• Value an investment project, a firm’s division, and entire
firms
• E.g. in a takeover situation, or to compare your valuation with
that of the financial markets, say for your share repurchase
decisions
• Make capital budgeting decisions, using the NPV approach
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From last class: 3 steps in calculating WACC
• Suppose a capital structure is given
• Individual rate of returns
• Calculate the required return on each security in the
firm’s financing mix
• The weight
• Calculate the market value of each security as a
proportion of the firm's value
• The sum of all weights must be 1
• Take the weighted average
• Calculate a weighted average of the required returns

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 What is a firm’s capital structure?
• Definition: The mix of financial securities (or financial claims)
with which a firm funds itself
• Financial securities are claims on future cash flows
• They may also give the holder of the security various ownership or
control rights
• Commonly seen financial securities
• Debt
• Convertible securities (warrants, convertible debt, convertible
preferred)
• Preferred stock
• Common stock

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News flash

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Does Capital Structure Matter?

“Capital Structure is a … part of a much larger, value

creating equation. At Sears, as in most companies, creating
shareholder value is the main governing objective….There is
considerable effort aimed at achieving the lowest long-term
cost of capital by managing the capital structure…. That
leads to a discussion in which we determine our…target
capital structure…. I can tell you we have dug seriously into
the capital structure question.”
- Alice Peterson, Vice-President and
Treasurer of Sears

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Firm Valuation
• The value of a firm is

FCFFt
V 
t (1  WACC )
t

• If our capital structure doesn’t affect

operations, we maximize firm value by
minimizing WACC, which maximizes the present
value of all future FCFF

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Motivation
• Main questions that we will address:
• Does capital structure affect “firm value,” i.e., the
combined value of all of firm’s securities?
• If so, how do we determine the “optimal” capital
structure that maximizes firm value?
• Outline of chapter:
• Capital structure in a “perfect” market (“Modigliani-
Miller” propositions on irrelevancy of leverage)
• Capital structure with “imperfections”…

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Modigliani & Miller (MM) Propositions
• M&M propositions tell us how capital structure
matters in a “perfect” world…
• …once we understand these, we can better
understand how & why imperfections matter

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“Perfect” & “complete” capital market
• “Perfect” capital market is one in which
there:
• are no taxes
• is no default (i.e., bankruptcy) risk
• are no agency problems
• i.e., no conflict of interest between managers,
shareholders and debtholders
• is no asymmetric information
• i.e., investors know as much as managers do

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MM Proposition I (Debt Irrelevance)

• “In a world with perfect and complete

capital markets, the value of a levered firm
is the SAME AS the value of an unlevered
firm”
• Note 1: By value of firm, we mean the
combined value of all securities that the firm
has issued
• Note 2: Levered firm is a firm with debt (i.e.,
with “leverage”); unlevered firm is a firm
without debt

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 The firm’s cash-flow “pie” is the same
no matter how it’s sliced among capital
providers

E E D

Cash flows generated by the firm’s operations do E

not change with its capital structure
As a group, holders of the firm’s debt and equity
“own” all these cash flows
The overall risk and return of the firm’s investors
D
as a group do not change with the firm’s capital
structure
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Basic M&M Proof
• Suppose two firms have the exact same operating
cash flows

• One firm is financed completely by equity

• Call this firm U (for unlevered)

• One firm is financed partially by equity and partially

by debt
• Call this firm L (for levered)

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 Proof Continued
• Suppose you buy 10% of the unlevered firm
Dollar Investment Dollar Return
.1*VU .1*Profit

Consider an investment in the levered firm where you

purchase 10% of the equity and 10% of the debt of firm L

Dollar Investment Dollar Return

Debt .1*DL .1*Interest
Equity .1*EL .1*(Profit-Interest)
Total .1*(DL+EL)=.1*VL .1*Profit

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Proof Conclusion
• Since the cash flows from each investment are
exactly the same, they must have exactly the
same price in a perfect market
VL  VU
• Capital structure is irrelevant… the firm value
is independent of capital structure

• M&M: A firm’s capital structure does not matter in a

“perfect world” (Note that we are still in the context
of no bankruptcy costs and no taxes)
• But the world is not perfect!

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 M&M Prop 1
V

VU V(D/E)

*
No optimal D E exists! D/E
Note that increasing D has no effect on firm
value! 16
Implications of M&M Prop 1
• Mix of equity and debt is irrelevant
• Types of equity and debt securities used to finance
the company is irrelevant
• Common vs preferred stock
• Long-term vs short-term debt
• Etc
• None of these decisions have any effect on
shareholder wealth

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The intuition behind
• Cash flows generated by the firm’s operations do
not change with its capital structure
• As a group, holders of the firm’s debt and equity
“own” all these cash flows
• The overall risk and return of the firm’s investors as a
group do not change with the firm’s capital structure
• The firm’s cash-flow “pie” is the same no matter how
it’s sliced

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But how can that be?

• Earlier we saw that (if Tax rate=0):

D E
WACC   Rd   Re
DE DE

• Since Rd < Re, if you increase D and lower E,

shouldn’t WACC decrease?

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MM Proposition II (1)
• NO, because leverage increases risk to shareholders
• More volatile returns
• Debt increase EPS/ROE in good times…
• i.e., shareholders can “leverage” debt to improve their returns
• …however, in bad times, debt hurts

• “In a world with perfect and complete capital markets, the required
return to equityholders (i.e., Re) increases with leverage”

• As I show on the next slide, this follows from MM Proposition 1,

which suggests that WACC does not change with leverage

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M&M Proposition 2
• From Prop 1, we know that VL=VU
• By assumption our capital structure doesn’t affect our
operations, so the firm has the same stream of FCFF with any
amount of leverage
• From our formula for firm value,

FCFFt
VU  
t (1  WACCU )
t

FCFFt
VL  
t (1  WACC L ) t

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Prop 2 Continued

• Since VL=VU, then

FCFFt FCFFt
t (1  WACC )t  t (1  WACC )t
L U

 WACCL  WACCU
• So, M&M Prop 2 states that the firm’s cost of
capital is unaffected by capital structure

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Understanding MM Proposition II (2):
Cost of equity, Re
• Let Ru denote the WACC for an all-equity firm (i.e.,
an unlevered firm)
• As per MM Proposition I, WACC doesn’t change with
capital structure, i.e., WACC = Ru always
• Substituting Ru for WACC, and rearranging
equation, we obtain:

Re  Ru   Ru  Rd 
D
E
Risk without leverage Additional risk due to leverage

Please note: Ru=Ra 23

Example
• The Corner Bakery has a debt-equity ratio of .62.
The firm's required return on assets is 14.2 percent
and its cost of equity is 16.1 percent. What is the
pretax cost of debt based on M&M Proposition II
with no taxes?

• Solution:

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Understanding MM Proposition II (3)
• Why doesn’t WACC change in the MM world?
• Remember the crucial assumption: In the MM world,
there is no risk of bankruptcy
• As a result, Rd doesn’t change with leverage
• So as leverage increases:
• Rd is unchanged; Re increases, but weight of equity (i.e. E/V)
decreases
• Overall, WACC is unchanged
• Note: If risk of bankruptcy exists, then
• Rd will also increase with the firm’s leverage (Why?). As
a result, WACC will increase
• We will study this in next class…

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Understanding MM Proposition II (4)
Cost of equity, Re
• The equation for Re on the earlier slide implies that
the cost of equity depends on the following factors:

• Business risk, or the risk arising from the nature of

the firm’s operating activities
• It determines the firm’s Ru

• adjustment for financial risk, or the risk arising from

debt in the financial structure
• This is the term (D/E)×(Ru –Rd)
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 What’s in a Beta? (the one you get off the web)

• Business cycle sensitivity (covariance with

or Operating risk
Business Risk

market)
• Operating leverage (fixed vs. variable costs).
• How flexible is cost structure? Can you quickly
adapt to changing sales conditions? [cost
effects]
• Financial Leverage
Financial Risk

• Leverage increases ROE in good times and

decreases ROE in bad. If “good” and “bad”
correlated with overall market conditions, what
will increasing leverage do to a company’s
equity Beta?

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Business & financial risk in terms of s
This measures firm’s operating
• With no taxes: (business) risk!

u   DD E   d    DE E   e 
and  e   u  DE  u   d 
• where,
• u is the asset  (“unlevered ”) that reflects only the
business risk of the firm’s assets
• Note that u is unobserved
• e measures risk of levered equity, and d reflects the
risk of firm’s debt

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Leverage and 

• Since e depends on financial risk, changes in the

firm’s capital structure impact e

• How do we compute the new e after a change in

capital structure?
• Step 1 – “Unlever” the  (asset )
• Compute u implied by original capital structure
• Step 2 – “Re-lever” the :
• Use the u from step 1 to compute the new e

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Example I
• A firm recently overhauled its capital structure, by
replacing debt with equity:
• Before the overhaul, it had 20% equity and 80% debt in
its capital structure. Its equity beta was 1.8 and its debt
beta was 0.6.
• After the overhaul, it has 50% equity and 50% debt in its
capital structure.
• Assume zero taxes…
• Questions:
• What is the firm’s equity beta after the change?
• What will the firm’s equity beta be if it gets rid of all its
debt?

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Answer Key to Example I

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Example II

• (Assume perfect world) A firm has a D/V ratio of

0.4, a cost of equity of 12.8%, and a cost of debt of
4%. Risk free rate is 4%, and the market risk
premium is 8%.

• Suppose the firm’s D/V ratio rises to 0.6 (firm is

raising debt to repurchase stock)
• What are the firm’s old and new equity betas?
• What is the firm’s new cost of equity?
• What are the old and new WACCs?

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Answer Key to Example II

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 M&M Summary
(No Taxes, No Bankruptcy)
• Proposition 1: Firm value (and shareholder value) is
unaffected by financing decisions

VL  VU
• Proposition 2: The cost of equity is increasing in debt-to-
equity, and the firm cost of equity is independent of
financing decisions

WACCL  WACCU
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Summary
• In the “perfect” world of MM, capital structure
is irrelevant, i.e., it doesn’t impact firm value
• Cost of debt doesn’t change with leverage (mainly
because there is no risk of bankruptcy)
• Cost of equity increases with leverage
• …but WACC doesn’t change because increase in cost
of equity is offset by decrease in the weight attached
to equity capital

• New concepts in this class:

• distinction between levered and unlevered firms’
cost of equity and 
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So is Capital Structure Irrelevant?
• So far, we have seen that under certain assumptions,
capital structure is independent of firm value (and
shareholder value)
• Tells us not to waste our time considering capital structure
• But, firms spend a lot of time considering capital
structure, and definite patterns emerge in the data
• Capital structures are not being randomly determined by
companies
• Are CFOs wasting their time considering capital
structure? Or do things change when we relax
assumptions?
• Let’s look at the characteristics of debt that may lead us
to believe that debt policy and capital structure matter

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Our story so far
• MM Propositions tell us that, in a “perfect” and
“complete” world, as capital structure changes:
• Firm value and WACC do not change (WACC=Ru)
• Cost of equity increases with financial leverage
• There is no particular capital structure that can be
considered optimal
• Remember key assumptions behind MM:
• No taxes
• No risk of bankruptcy
• No agency problems
• No asymmetric information
• Investors can borrow at the same rate as corporations

But the world is not perfect!

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