Capital Structure

 So far we have discuss the effect of leverage on shareholders

earnings and risk. Under favorable condition shareholders
return increases with financial leverage, but leverage also
increases the risk of shareholders. Thus, it cannot be stated
definitely whether or not the firm value increase with
leverage.

 If capital structure decisions can affect firms value, then we

would like to have a capital structure with maximize market
value (Max shareholders wealth) of the firm, but conflicting
theories exist on the relationship between capital structure
and the value of a firm

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Relevance of capital structure–
 Net Income Approach
 Traditional Approach

Irrelevance of capital structure –

 Net Operating Income Approach
 Modigliani and Miller (MM) Approach's:
• Proposition I & Proposition II (without taxes)
• Proposition I & Proposition II (with taxes) : capital
structure is relevant

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 Assumptions: Only two source of capital (E&D), perpetual life,
No Taxes, Constant cost of capital (E&D both), Homogeneous
operating risk, perfect capital market, Constant total financing

 The Net Income Approach:

↑ Debt in capital structure ->↑ value of the firm & ↓ WACC
VL > VU

 The Traditional Approach: Relax the assumption of

constant cost of capital
 WACC ↓ only up to the reasonable limit of financial leverage & after
reaching the minimum level it starts increasing with financial
leverage because high financial leverage cause high risk to equity
shareholders thus they expect more return
Before optimum level : VL > VU
After optimum level : VL < VU
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 In perfect capital market without taxes and transaction cost, a
firms market value (V) and the cost of capital (WACC) remain
unaffected by the capital structure mix because the value of
the firm depends on the business risk (operating risk) rather
than the way in which asset have been financed.

 The way of financing can only change the way in which net
operating income is distributed.

 Thus, firm with identical operating business risk, but different

capital structure should have same total value.
 VL = VU

Since in same business risk class, the expected net operating income will not
change with financial leverage, the WACC or opportunity cost of capital would
not change with financial leverage.
Thus: levered firm cost of capital = Unlevered firm cost of capital
∴ WACCL = WACCU

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16-5
 Additional assumption: Firms and investors can borrow/lend at
the same rate
 Investor can create a levered or unlevered position by adjusting the
trading in his own personal account.
 This homemade leverage or personal leverage, suggests that capital
structure is irrelevant in determining the value of the firm:
V L = VU

MM Proposition I: For the firm in same business risk class value will
be independent to Debt Equity mix & will be determined by
capitalizing Net Operating Income with opportunity cost of capital.
VL = VU

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 Financial leverage does not affect the Net Operating Income and
business operating risk. But it does affect shareholders risk.

 And if, Shareholders risk ↑ -> Shareholders required rate return will ↑

MM Proposition II - Leverage increases the risk and return to

shareholders. But still WACC or opportunity cost of capital (Ka ) will
remain constant with financial leverage.

Justification: It stated that Ke will increase enough to offset the risk of

bringing debt in capital structure so that Ka does not change.

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A levered firm will have higher required rate on equity as
compensation for financial risk, thus Ke > Ka.
Ke should be equals to constant Ka + financial risk premium.

◦ The WACC derivation : Ke = Ka + (Ka- Kd ) D/E

financial risk premium

∴ Cost of equity is a linear function of financial leverage

16-8
 ke
Cost of capital

WACCL or kaL =
WACCU or kaU

kd

Leverage

16-9
MM Proposition II (No Taxes) : Under extreme leverage : Excessive use of
debt will increase the risk of default, hence Kd will increase and Ke will
increase at decreasing rate.

ke
Cost of capital

WACCL or kaL = WACCU or kaU

kd

Leverage

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 Proposition I (with Corporate Taxes)
◦ Firm value increases with leverage
VL = VU + PV of tax shield or [PV of (Tax rate * Int on debt)]

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 Vl
Value of the firm

Vu

Leverage

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 Proposition II (with Corporate Taxes)
◦ Some of the increment in equity risk and return is offset by the
interest tax shield. Thus, WACC will decrease with financial
leverage.

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Cost of capital
Ke

Ke

WACC
Kd

Leverage

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Advantages of all equity
 Higher solvency due to no interest payment
 Low chances of bankruptcy
 Low finance cost due to less risk – higher profits
 Attract more investors and results in higher share value

Disadvantages of all equity

 No tax benefits
 Higher cost of capital because debt is a cheaper source

Advantages of leverage
 Personal tax on interest income

Disadvantages of leverage
 Increase chances of financial distress : leads to impaired ability to conduct
business, thus; VL = VU + PV of tax shield – PV of financial distress cost)
 Operating risk could be exaggerated
 Debt is a fixed cost which increases BEP of the firm.

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 Trade off Theory :Trade off between tax
shield advantage and financial distress cost)
 Signaling Theory : Equity is a bad signal and
debt is a good signal for market
 Agency Theory: Based on free cash flow
hypothesis
 The Pecking-Order Theory: Fund raising
hierarchy – first internal funds(RE) after that
debt and lastly equity.

 EBIT & EPS Analysis

16-16
 12.00

10.00 Debt

8.00 No Debt

6.00 Advantage
EPS

Break-even to debt
4.00 point

2.00

0.00
1,000 2,000 3,000
(2.00) Disadvantage EBIT in dollars
to debt
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Q8) Star inc. a prominent consumer product firm, is debating whether or not to convert it's all
equity capital structure to one that is 35% debt. Currently there are 6000 shares outstanding and
the price per share is $58. EBIT is expected to remain at $39600 per year forever. The interest rate
on new debt is 7% and there are no Taxes.
a. Ms. Brown, a shareholder of the firm, own 100 shares of stock. What is her cash flow under
the current capital structure, assuming the firm has a dividend payout rate of 100%?
b. What will Ms. Brown’s cash flow be under the proposed capital structure of the firm? Assume
that she keeps all 100 of her shares.
c. Suppose the company does convert, but Ms. Brown prefers the current all equity capital
structure. Show how she could unlever her share of stock to recreate the original capital
structure.
d. Using your answer to part C, explain why company’s choice of capital structure is irrelevant
Ans:a. EPS $ 6.60
Shareholder's cash flow $ 660.00

b. V $ 3,48,000
D $ 1,21,800
Shares bought 2,100
NI $ 31,074
EPS $ 7.97
Shareholder's cash flow $ 796.77

c. Sell 35 shares of stock and

lend the proceeds at 7%
Interest cash flow $ 142.10
Cash flow from shares held $ 517.90
Total cash flow $ 660.00
d. The capital structure is irrelevant because shareholders can create their own leverage
or unlever the stock to create the payoff they desire, regardless of the capital structure the
firm actually chooses.
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Q4) Franklin corporation is comparing two different capital structure,
an all equity plan (Plan I) and a levered plan (Plan II). Under plan I,
the company would have 315000 shares of stock outstanding. Under
Plan II, there would be 225000 shares of stock outstanding and
$4140000 in debt outstanding. The interest rate on debt is 10% and
there are no taxes.
a. If EBIT is $750000 which plan will result in the highest EPS?
b. If EBIT is $1750000 which plan will result in the higher EPS?
c. What is the break-even EBIT?
a. NI EPS
Plan I $ 7,50,000 $ 2.38
Ans: Plan II $ 3,36,000 $ 1.49

b. Plan I $ 17,50,000 $ 5.56

Plan II $ 13,36,000 $ 5.94

c. Breakeven EBIT $ 14,49,000.00

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Q6) Kolby Corp. is comparing two different capital structure. Plan I would
result in the 1300 shares of stock and $80640 in debt. Plan II would result in
2900 shares of stock and $19,200 in debt. The interest rate on the debt is
10%.
a. Ignoring taxes, compare both of these plan to all equity plan assuming that
EBIT will be $10,500. The all-equity plan will result in 3400 shares of stock
outstanding. Which of three plans has the highest EPS? the lowest?
b. In part (a) what are the breakeven levels of EBIT for each plan as compared
to that for an all equity plan? Is one higher than the other? Why?
c. Ignoring Taxes, when will EPS be identical fore plan I and plan II?
d. Repeat part A B & C assuming that the corporate tax rate is 40%. Are the
breakeven levels of EBIT different from the before? why or why not?

Ans: Next Slide

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a. I II All-Equity
EBIT $ 10,500 $ 10,500 $ 10,500
Interest 8,064 1,920 -
NI $ 2,436 $ 8,580 $ 10,500
EPS $ 1.87 $ 2.96 $ 3.09

EBIT
b. Plan I vs. all equity $ 13,056
Plan II vs. all equity $ 13,056
The break even levels of EBIT are the same because of M&M Proposition I.

c. Breakeven EBIT: Plan I vs. Plan II $ 13,056

This break-even level of EBIT is the same as in part (b) again, because of M&M
Proposition (I).

d. I II All-equity
EBIT $ 10,500 $ 10,500 $ 10,500
Interest 8,064 1,920 -
Taxes 974 3,432 4,200
NI $ 1,462 $ 5,148 $ 6,300
EPS $ 1.12 $ 1.78 $ 1.85

Breakeven EBIT
Plan I vs. all-equity $ 13,056
Plan II vs. all-equity $ 13,056
PLanI vs. Plan II $ 13,056

The break-even levels of EBIT do not change because of additions of taxes reduces
the income of all three plans by the same percentage; therefore they do not change
relative to one another. 16-21