CORPORATE FINANCE
Session – 11 & 12 Bipin K Dixit
Capital Structure Policy
Concepts
Choosing a Capital Structure
What is the ‘primary goal’ of financial managers?
Maximize stockholder wealth
We want to choose the capital structure that will
maximize stockholder wealth
We can maximize stockholder wealth by maximizing
the value of the firm or minimizing the WACC
Capital Structure Theory
Modigliani and Miller (M&M) Theory of Capital
Structure
Proposition I: Firm Value is independent of capital structure
Proposition II: Cost of Equity increases with increase in debt
The value of the firm is determined by the cash flows
to the firm and the risk of the assets
Changing firm value
Change the risk of the cash flows
Change the cash flows
Modigliani & Miller Proposition I
When firm pays no taxes and capital markets function
well, no difference if firm borrows or individual
shareholders borrow
Hence market value of company does not depend on
capital structure
Capital structure does not affect cash flow as
No taxes
No bankruptcy costs
No effect on management incentives
Effect of Financial Leverage on EPS and ROE – Part I
We will ignore the effect of taxes at this stage
What happens to EPS and ROE when we issue
debt and buy back shares of stock?
Break-Even EBIT
Find EBIT where EPS is the same under both the
current and proposed capital structures
EBIT EBIT 250,000
500,000 250,000
500,000
EBIT EBIT 250,000
250,000
EBIT 2EBIT 500,000
EBIT $500,000
500,000
EPS $1.00
500,000
Homemade Leverage and ROE
Current Capital Structure Proposed Capital Structure
Investor borrows $500 and Investor buys $250 worth of
uses $500 of her own to buy stock (25 shares) and $250
100 shares of stock worth of bonds paying 10%.
Payoffs: Payoffs:
Recession: 100(0.60) - Recession: 25(.20) +
.1(500) = $10 .1(250) = $30
Expected: 100(1.30) - Expected: 25(1.60) +
.1(500) = $80 .1(250) = $65
Expansion: 100(2.00) - Expansion: 25(3.00) +
.1(500) = $150 .1(250) = $100
Mirrors the payoffs from Mirrors the payoffs from
purchasing 50 shares of the purchasing 50 shares under
firm under the proposed the current capital structure
capital structure
Capital Structure Theory Under Three Special Cases
Case I – Assumptions
No corporate or personal taxes
No bankruptcy costs
Case II – Assumptions
Corporate taxes, but no personal taxes
No bankruptcy costs
Case III – Assumptions
Corporate taxes, but no personal taxes
Bankruptcy costs
Case I – Propositions I and II
Proposition I
The value of the firm is NOT affected by
changes in the capital structure
The cash flows of the firm do not change;
therefore, value doesn’t change
Proposition II
Cost of Equity increases with increase in debt
Case I - Equations
WACC = RA = (E/V)RE + (D/V)RD
RE = RA + (RA – RD)(D/E)
RA is the “cost” of the firm’s business risk, i.e., the risk
of the firm’s assets
(RA – RD)(D/E) is the “cost” of the firm’s financial risk,
i.e., the additional return required by stockholders to
compensate for the risk of leverage
Leverage and Cost of Capital (under
no taxes and bankruptcy costs)
Case I - Example
Data
Required return on assets = 16%; cost of debt = 10%;
percent of debt = 45%
What is the cost of equity?
RE = 16 + (16 - 10)(.45/.55) = 20.91%
Suppose instead that the cost of equity is 25%, what is the
debt-to-equity ratio?
25 = 16 + (16 - 10)(D/E)
D/E = (25 - 16) / (16 - 10) = 1.5
Based on this information, what is the percent of equity in
the firm?
E/V = 1 / 2.5 = 40%
Case II – Cash Flow
Interest is tax deductible
Therefore, when a firm adds debt, it reduces taxes,
all else equal
The reduction in taxes increases the cash flow of the
firm
How should an increase in cash flows affect the
value of the firm?
Case II - Example
Unlevered Firm Levered Firm
EBIT 5,000 5,000
- Interest 0 500
EBT 5,000 4,500
- Taxes (34%) 1,700 1,530
Net Income 3,300 2,970
CF to Firm 3,300 3,470
Interest Tax Shield
Annual interest tax shield
Tax rate times interest payment
5,000 in 10% debt = 500 in interest expense
Annual tax shield = .34(500) = 170
Present value of annual interest tax shield
Assume perpetual debt for simplicity
PV = 170 / .10 = 1,700
PV = D(RD)(TC) / RD = DTC = 5,000(.34) = 1,700
Value of Levered and Unlevered Firm
The value of the firm increases by the present
value of the annual interest tax shield
Value of a levered firm = value of an unlevered firm
+ PV of interest tax shield
Value of equity = Value of the firm – Value of debt
Assuming perpetual cash flows
VU = EBIT(1-T) / RU
VL = VU + DTC
Example: Case II – Proposition I
Data
EBIT = 25 million; Tax rate = 35%; Debt = $75 million;
Cost of debt = 9%; Unlevered cost of capital = 12%
VU = 25(1-.35) / .12 = $135.42 million
VL = 135.42 + 75(.35) = $161.67 million
E = 161.67 – 75 = $86.67 million
Value of Levered Firm under corporate taxes
Case II – Proposition II
The WACC decreases as D/E increases because
of the ‘government subsidy’ on interest payments
RA = (E/V)RE + (D/V)(RD)(1-TC)
RE = RU + (RU – RD)(D/E)(1-TC)
Example
RE = 12 + (12-9)(75/86.67)(1-.35) = 13.69%
RA = (86.67/161.67)(13.69) + (75/161.67)(9)(1-.35)
RA = 10.05%
Example: Case II – Proposition II
Suppose that the firm changes its capital structure so
that the debt-to-equity ratio becomes 1.
What will happen to the cost of equity under the new
capital structure?
RE = 12 + (12 - 9)(1)(1-.35) = 13.95%
What will happen to the weighted average cost of
capital?
RA = .5(13.95) + .5(9)(1-.35) = 9.9%
Leverage and Cost of Capital (taxes
but no bankruptcy cost)
Case III
Now we add bankruptcy costs
As the D/E ratio increases, the probability of bankruptcy
increases
This increased probability will increase the expected
bankruptcy costs
At some point, the additional value of the interest tax
shield will be offset by the increase in expected
bankruptcy cost
At this point, the value of the firm will start to decrease,
and the WACC will start to increase as more debt is
added
Leverage and Cost of Capital
Leverage and the Value of Firm
Bankruptcy Costs
Direct costs
Legal and administrative costs
Ultimately cause bondholders to incur additional
losses
Disincentive to debt financing
Financial distress
Significant problems in meeting debt obligations
Firms that experience financial distress do not
necessarily file for bankruptcy
More Bankruptcy Costs
Indirect bankruptcy costs
Larger than direct costs, but more difficult to measure
and estimate
Stockholders want to avoid a formal bankruptcy filing
Bondholders want to keep existing assets intact so they
can at least receive that money
Assets lose value as management spends time worrying
about avoiding bankruptcy instead of running the
business
The firm may also lose sales, experience interrupted
operations and lose valuable employees
Conclusions
Case I – no taxes or bankruptcy costs
Capital structure is irrelevant
Case II – corporate taxes but no bankruptcy costs
Optimal capital structure is almost 100% debt
Each additional dollar of debt increases the cash flow of the
firm
Case III – corporate taxes and bankruptcy costs
Optimal capital structure is part debt and part equity
Occurs where the benefit from an additional dollar of debt is
just offset by the increase in expected bankruptcy costs
Ratios of Debt to Debt-Plus-Equity for
Nonfinancial Businesses
Note: Debt to total capital ratio = D/(D + E), where D and E are book values of
long-term debt and equity (2013)
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
Companies like financial slack
Concept Check
Explain the effect of leverage on EPS and ROE
What is the break-even EBIT, and how do we
compute it?
How do we determine the optimal capital
structure?
What is the optimal capital structure in the three
cases that were discussed in this chapter?
What is the difference between liquidation and
reorganization?