Financial Management

Session -19
Capital Structure

What is Capital Structure?

The combination of debt and equity used to finance a
firms projects is referred to as its capital structure.
The capital structure of a firm is some mix of debt,
internally generated equity, and new equity.
But what is the right mixture?
Why do some industries tend to have firms with
higher debt ratios than other industries?

Financial Leverage and Risk

Equity owners can reap most of the rewards through
financial leverage when their firm does well.
But they may suffer a downside when the firm does
poorly.

Capital Structure and Taxes

Income taxes play an important role in a firms capital
structure decision because the payments to creditors
and owners are taxed differently.
The basic framework for the analysis of capital
structure and how taxes affect it was developed by
two Nobel Prize winning economists, Franco
Modigliani and Merton Miller (M&M).

M&M Hypothesis
M&M reasoned that if the following conditions hold,
the value of the firm is not affected by its capital
structure:
Condition #1: Individuals and corporations are able to
borrow and lend at the same terms (referred to as equal
access).
Condition #2: There is no tax advantage associated with
debt financing (relative to equity financing).
Condition #3: Debt and equity trade in a perfect market.
Condition #4: There are no bankruptcy costs
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M&M HypothesisContd
M&M reasoned that if the following conditions hold,
the value of the firm is not affected by its capital
structure:
Condition #5: All cash flow streams are perpetuities (i.e.,
no growth)
Condition #6: Corporate insiders and outsiders have the
same information (i.e., no signalling opportunities)
Condition #7: Managers always maximize shareholders
wealth (i.e., no agency cost)

Capital Structure and the Pie

The value of a firm is defined to be the sum of the
value of the firms debt and the firms equity.
V=B+S
If the goal of the firms
management is to make the
firm as valuable as possible,
then the firm should pick the
debt-equity ratio that makes
the pie as big as possible.

S B

Value of the Firm

Stockholder Interests
There are two important questions:
1.Why should the stockholders care about maximizing
firm value? Perhaps they should be interested in
strategies that maximize shareholder value.
2.What is the ratio of debt-to-equity that maximizes the
shareholders value?

As it turns out, changes in capital structure

benefit the stockholders if and only if the value
of the firm increases.

Financial Leverage, EPS, and ROE

Consider an all-equity firm that is contemplating going into
debt. (Maybe some of the original shareholders want to cash
out.)

Current
Assets
$20,000
Debt
$0
Equity
$20,000
Debt/Equity ratio
0.00
Interest rate
n/a
Shares outstanding
400
Share price
$50

Proposed
$20,000
$8,000
$12,000
2/3
8%
240
$50

EPS and ROE Under Current Structure

Recession

Expected

Expansion

EBIT
$1,000
$2,000
$3,000
Interest
0
0
0
Net income
$1,000
$2,000
$3,000
EPS
$2.50
$5.00
$7.50
ROA
5%
10%
15%
ROE
5%
10%
15%
Current Shares Outstanding = 400 shares

EPS and ROE Under Proposed Structure

Recession

Expected

Expansion

EBIT
$1,000
$2,000
$3,000
Interest
640
640
640
Net income
$360
$1,360
$2,360
EPS
$1.50
$5.67
$9.83
ROA
1.8%
6.8%
11.8%
ROE
3.0%
11.3%
19.7%
Proposed Shares Outstanding = 240 shares

Financial Leverage and EPS

12.00
Debt

10.00

EPS

8.00
6.00
4.00

No Debt

Advantage
to debt

Break-even
point

2.00
0.00
1,000

(2.00)

Disadvantage
to debt

2,000

3,000

EBIT in dollars, no taxes

Homemade Leverage: An Example

Recession

Expected

Expansion

EPS of Unlevered Firm

$2.50
$5.00
$7.50
Earnings for 40 shares
$100
$200
$300
Less interest on $800 (8%) $64
$64
$64
Net Profits
$36
$136
$236
ROE (Net Profits / $1,200)
3.0%
11.3%
19.7%
We are buying 40 shares of a $50 stock, using $800 in
margin. We get the same ROE as if we bought into a
levered firm.

$800 2

3
S $1,200

Our personal debt-equity ratio is: B

Homemade (Un)Leverage: An
Example
Recession

Expected

Expansion

EPS of Levered Firm

$1.50
$5.67
$9.83
Earnings for 24 shares
$36
$136
$236
Plus interest on $800 (8%)
$64
$64
$64
Net Profits
$100
$200
$300
ROE (Net Profits / $2,000)
5%
10%
15%
Buying 24 shares of an otherwise identical levered firm along
with some of the firms debt gets us to the ROE of the unlevered
firm.
This is the fundamental insight of M&M

MM Proposition I (No Taxes)

We can create a levered or unlevered position
by adjusting the trading in our own account.
This homemade leverage suggests that capital
structure is irrelevant in determining the value
of the firm:
VL = VU

MM Proposition II (No Taxes)

Proposition II
Leverage increases the risk and return to stockholders

Rs = R0 + (B / SL) (R0 - RB)

RB is the interest rate (cost of debt)
Rs is the return on (levered) equity (cost of equity)
R0 is the return on unlevered equity (cost of capital)
B is the value of debt
SL is the value of levered equity

MM Proposition II (No Taxes)

RS R0

R0

RW ACC

B
( R0 RB )
SL

B
S
RB
RS
BS
BS
RB

RB

Debt-to-equity Ratio B
S

MM Propositions II
(With Taxes)
Proposition I (with Corporate Taxes)
Firm value increases with leverage
VL = VU + TC B

Proposition II (with Corporate Taxes)

Some of the increase in equity risk and return is offset
by the interest tax shield
RS = R0 + (B/S)(1-TC)(R0 - RB)

RB is the interest rate (cost of debt)

RS is the return on equity (cost of equity)
R0 is the return on unlevered equity (cost of capital)
B is the value of debt
S is the value of levered equity

MM Propositions II
(With Taxes)
The total cash flow to all stakeholde rs is
( EBIT RB B ) (1 TC ) RB B
The present value of this stream of cash flows is VL

Clearly ( EBIT RB B) (1 TC ) RB B

EBIT (1 TC ) RB B (1 TC ) RB B
EBIT (1 TC ) RB B RB BTC RB B
The present value of the first term is VU
The present value of the second term is TCB

VL VU TC B

The Effect of Financial Leverage

Cost of capital: R
(%)

RS R0
RS R0

B
( R0 RB )
SL

B
(1 TC ) ( R0 RB )
SL

R0

RW ACC

B
SL
RB (1 TC )
RS
BSL
B SL
RB

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Personal Tax and Capital Structure

If debt income (interest) and equity income (dividends and
capital appreciation) are taxed at the same rate, the interest tax
shield is still D and increasing leverage increases the value of
the firm.
If debt income is taxed at rates higher than equity income,
some of the tax advantage to debt is offset by a tax
disadvantage to debt income.

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Personal Tax and Capital StructureContd

If investors can use the tax laws effectively to reduce
to zero their tax on equity income, firms will take on
debt up to the point where the tax advantage to debt is
just offset by the tax disadvantage to debt income.

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Optimal Capital Structure

The mix of debt and equity that maximizes the value
of the firm is referred to as the optimal capital
structure.
There is a tradeoff between the value of the interest
tax shields and the costs of distress.
Because financial distress is costly, even without
legal bankruptcy, the likelihood of financial distress
depends on the business risk of the firm, in addition
to any risk from financial leverage.
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Capital Structure: Different Industries

The greater the marginal tax rate, the greater the benefit from
the interest deductibility and, hence, the more likely a firm is
to use debt in its capital structure.
The greater the business risk of a firm, the greater the present
value of financial distress and, therefore, the less likely the
firm is to use debt in its capital structure.
The greater extent that the value of the firm depends on
intangible assets, the less likely it is to use debt in its capital
structure.
Financial slack. The availability of funds to take advantage of
profitable investment opportunities is valuable.

Therefore, having cash, marketable securities, and unused debt capacity

is valuable.

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Tax Effects and Financial Distress

There is a trade-off between the tax advantage of debt and the
costs of financial distress.
It is difficult to express this with a precise and rigorous
formula.

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Tax Effects and Financial Distress

Value of firm (V)

Value of firm under

MM with corporate
taxes and debt

Present value of tax

shield on debt

VL = VU + TCB
Maximum
firm value

Present value of
financial distress costs
V = Actual value of firm
VU = Value of firm with no debt

Debt (B)
B*
Optimal amount of debt
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The Pie Model Revisited

Taxes and bankruptcy costs can be viewed as just
another claim on the cash flows of the firm.
Let G and L stand for payments to the government
and bankruptcy lawyers, respectively.
VT = S + B + G + L
S
B
L

The essence of the M&M intuition is that VT depends on the

cash flow of the firm; capital structure just slices the pie.
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The Pecking-Order Theory

Theory stating that firms prefer to issue debt rather
than equity if internal financing is insufficient.
Rule 1
Use internal financing first.
Rule 2
Issue debt next, new equity last.

The pecking-order theory is at odds with the tradeoff

theory:
There is no target D/E ratio.
Profitable firms use less debt.

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Multiple Choice Question - 1

A Company increases amount of debt finance in its
capital structure keeping total amount of capital
employed the same. Capital market is perfect with
no taxes. Will the companys WACC :
a) remain the same
b) fall
c) rise
d) fall to a minimum and then rise

Multiple Choice Question - 1

Ans. (a)

Multiple Choice Question - 2

As a company goes from zero debt to
successively higher levels of debt, what
happens to the value of the company?
a) steadily rises
b) steadily falls
c) rises to a maximum and then falls
d) remains the same

Multiple Choice Question - 2

Ans. (c)

Multiple Choice Question - 3

A Company is planning its target capital structure. It has
estimated after-tax costs of debt and equity at different
levels of debt as follows :
Total assets/Debt ratio
Cost of equity
Cost of debt
0
12.0 %
0.10
12.0 %
8.0 %
0.20
12.0 %
8.0 %
0.30
13.0 %
8.5 %
0.40
13.5 %
9.0 %
0.50
14.0 %
9.5 %
0.60
14.5 %
10.0 %
What is the target debt-equity ratio for the company?
a) 0.25, b) 0.50, c) 1.00, d) 1.50

Multiple Choice Question - 3

Ans. (a)
Solution:
Debt to Total assets ratio
WACC
0
12.0 %
0.10
9 * 12 + 0.1 * 8 = 11.6 %
0.20
8 * 12 + 0.2 * 8 = 11.2 %
0.30
7 * 13 + 0.3 * 8.5 = 11.65 %
0.40
6 * 13.5 + 0.4 * 9.0 = 11.7 %
0.50
5 * 14 + 0.5 * 9.5 = 11.75 %
0.60
4 * 14.5 + 0.6 * 10.0 = 11.8 %
So, target debt to total assets ratio = 0.2
And debt to equity ratio
= 0.2/0.8
= 0.25

Multiple Choice Question - 4

A Company has some unused land, which, it has
been recently discovered, contains huge quantity
crude oil. The company needs additional funds to
extract the oil. The information has been kept
confidential. How should the company raise the
additional capital?
a) Issue bonds
b) Issue equity
c) Issue convertible bonds
d) Issue bonds and equity in 50 : 50 ratio

Multiple Choice Question - 4

Ans. (a)
Solution: The existing shareholders will
benefit the most if bonds are issued.

Multiple Choice Question - 5

A Company borrows money at 12 % but only
half the interest expense is allowed as a tax
deduction. The corporate tax rate is 40 %.
What is the post-tax cost of debt?
a) 12 %
b) 9.6 %
c) 4.8 %
d) 7.2 %

Multiple Choice Question - 5

Ans. (b)
Solution:
Pre-tax cost of debt for total borrowings
= 12 %
Post-tax cost of debt for 50 % of borrowings
= 12 * (1-0.4) = 7.2 %
Post tax cost of debt for the balance 50 % of the
borrowings = 12 %
So, post-tax cost of debt
= 0.5 * 7.2 + 0.5 * 12 =
9.6 %

Problem
A Company needs Rs.10 million capital for its new green
field project. The net operating earnings is expected to be
30 % of investment and the corporate tax rate is 40 %. The
company
expects the following alternatives for raising the capital.
a) 100 % equity at Rs.20 per share
b) 40 % debt at 12 % interest and 60 % equity at Rs.16 per share
c) 30 % debt at 11 % interest, 20 % 12 % preference shares and
50 % equity at Rs.18 per share.
Which is the best alternative for the company for raising the
capital?

Problem
Ans. Alternative (c)
Solution: We will undertake EBIT-EPS analysis
for the three alternatives.

Problem

Value of equity
Value of pref. shares
Value of debt
No. of shares (million)
EBIT
Interest
EBT

(a)
10
0.5
3.0
3.0

EBIT-EPS Analysis
(Fig. in Rs. Million)
Alternatives
(b)
(c)
6
5
2
4
3
0.375
0.278
3.0
3.0
0.48
0.33
2.52
2.67

Problem
EBT
3.0
2.52
2.67
Taxes
1.2
1.01
1.07
EAT
1.8
1.51
1.60
Preference dividend
0.24
Earnings available to
1.8
1.51
1.36
Equity holders
EPS
3.60
4.03
4.89
Alternative (c) is the best since EPS is maximized in this
case.

Thank You!

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