Tutorial VI

Financing and
capital
structure

Academic Year 2025-2026

 Financing and Capital Structure
a) Capital Structure

•The capital structure of a firm refers to the way in

which its operations are financed. How much debt
it has.
•The capital structure is given by the ratio of
Debt/(Debt+Equity).
Remember, the balance sheet:
Assets Liabilities
… Short term debt
Loans
… Long term debt received,
… Equity bonds issued

Shares
issued
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 Financing and Capital Structure
a) Capital Structure

Bond Share (or stock)

is a security under which the issuer owes the is a security that represents a part of the equity.
holders a debt and, is obliged to pay them The issuer pays to the owner a dividend.
periodical interest and to reimburse the
principal amount at the maturity date.
Interest payments are fixed (dates and amounts) Dividend payments are not fixed:
- they are not mandatory,
- amounts and payment dates can vary.
Owner is reimbursed at the maturity: amount is Owner is reimbursed at the dissolution of the
fixed. company: amount depends on the value of the
assets at this moment.
Owner has the right of vote in the general
meetings.
Interests are paid before taxation, so are Dividends are paid after taxation.
deductible from the profits.
If the company goes bankruptcy, the bondholder is paid in first rank; if there remains money, it is
shared between the shareholders.

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Financing and Capital Structure
b) Financing Structure

Consider two firms, U and L, with the same

investment opportunities and only different in
their capital structure:

Firm U is Unlevered: It is financed by equity only.

Firm L is Levered: It is financed by debt and equity.
Equity Equity
Debt Debt
Gov- Gov-
ern- ern-
ment
Distress ment
Distress
Firm U
Firms L

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Financing and Capital Structure
b) Financing Structure

Consider two firms, U and L, with the same

investment opportunities and only different in
their capital structure :

Firm U is Unlevered: It is financed by equity only.

Firm L is Levered: It is financed by debt and equity.

Is there a mix of debt and equity that maximizes

firm value?

Modigliani-Miller I : Abstracting from taxes

The value of firms U is L must be the same.

5
 There is no optimal capital structure
Financing and Capital Structure
Financing Structure and Cost of Capital

What is the cost of financing of a company?

You can see the company as a portfolio:
- It has an equity E who should provide a return rE
- It has a debt D who should provide a return rD

The return to be provided by the whole company

should be:
rA = wE rE + wD rD
We call it WACC:
with: Weighted Average
- wE = weight of the equity = Cost of Capital
- wD = weight of the debt =
E D
rA WACC  rE  rD
E D E D
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Financing and Capital Structure
Financing Structure and Cost of Capital

Modigliani-Miller II: Abstracting from taxes

This weighted average cost of capital (WACC) is a
constant. It does not depend on how much debt
and equity there is.
E D
rA WACC  rE  rD
E D E D
Solving for rE:
D
rE  rA  (rA  rD )
E

Equity
Equity Debt Equity
Debt Gov- Debt
Gov- ern- Gov-
ern- ment
Distress ern-
ment
Distress ment
Distress
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Financing and Capital Structure
Financing Structure and Cost of Capital - Example

Modigliani-Miller II: Abstracting from

taxes
A company has an equity of 1,000 which
provides a return of 8%, and no debt.

If it replaces 30% of its capital by a debt of 300

which return is 2%: rA remains at 8%



 2.57
%
highe
r 8
 Financing and Capital Structure
Financing Structure and Cost of Capital – Why does rE increase?

Consider a company for which E + D Let us

= 10 mio suppose
Debt: 2 mio, return Debt: 5 mio, return that rE
= 5% = 5%
does not
change.
Initiall Equi Foresee
y: ty Equit
n:
Debt y
Equity: 8 mio, return
Equity: 5 mio, return still
Debt
= 20%
= 20%???
Profit total should be: Profit total should be:
5% * 2 mio + 20% * 8 mio = 5% * 5 mio + 20% * 5 mio =
1.7 mio 1.25 mio

If we go from the left to the right, i.e. if we increase the

debt and reduce the equity, we increase the proportion of
financing with low rate  one could say that it is most
interesting for the company as the total profit should only
be 1.25 mio instead of 1.7 mio, to provide the return
required by both the debtholders and the shareholders.
However, saying this, we miss something… (see next 9
pages)
 Financing and Capital Structure
Financing Structure and Cost of Capital – Why does rE increase? (cont’d)

Imagine a company for which E + D = 10 mio

Debt: 2 mio, return Debt: 5 mio, return

= 5% = 5%

Equi Equi
ty ty
Debt Debt
Equity: 8 mio, return Equity: 5 mio, return still
= 20% = 20%???
Profit total should be: Profit total should be:
5% * 2 mio + 20% * 8 mio = 5% * 5 mio + 20% * 5 mio =
1.7 mio 1.25 mio
Imagine that the company goes into default. A lawyer is
designed, he sells the assets (whose value is, let us say, 6
mio) and gives the money back to the investors: debtholders
are paid in first rank.
In the left situation, debtholders get all their money back,
then it remains 4 mio for the shareholders who receive half
of their money only. It means that shareholders take more
risks than debtholders … this is why they require a higher 10
 Financing and Capital Structure
Financing Structure and Cost of Capital – Why does rE increase? (end)

Imagine a company for which E + D = 10 mio

Debt: 2 mio, return Debt: 5 mio, return

= 5% = 5%

Equi Equi
ty ty
Debt Debt
Equity: 8 mio, return Equity: 5 mio, return still
= 20% = 20%???
Profit total should be: Profit total should be:
5% * 2 mio + 20% * 8 mio = 5% * 5 mio + 20% * 5 mio =
1.7 mio 1.25 mio
In the right situation, debtholders get again all their money
back, then it remains 6 mio – 5 mio = 1 mio for
shareholders… who receive only one fifth of their money. It
means that this situation is now much more uncomfortable for
the shareholders.
For this reason, they will require a higher return (> 20%) -
finally 29%.The company should in this case too make a profit11
of 1.7 mio  return at the level of the company (WACC) is
Financing and Capital Structure
Financing Structure and Beta

Similarly, the beta of the firm is a weighted

average of the betas of the individual securities.
 D   E 
A   D     E 
D E  D E 
Modigliani-Miller II: The riskiness of the firm
(measured by its beta) is constant. It does not
depend on how much debt and equity there is.

Solving for βE :
D
E   A  ( A   D )
E

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Financing and Capital Structure
Financing Structure and impact of Taxation

The MM proposition changes once taxes are

taken into account:
Interest payments are tax deductible from the
profits
whereas
dividends and retained earnings are not tax
deductible

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Theoretical example: company with equity, but no debt

Sales 10
Operational costs 8

EBIT 2 10 - 8
=

Interest payment for the debt 0

Profit 2 =2-0

Taxes 0.70 = 35% * 2

Free for the shareholder 1.30 = 2 – 0.70

Total paid to investors: 0 + 1.30 = 1.30

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Theoretical example: company with equity and a debt

Sales 10
Operational costs 8

EBIT 2 10 - 8
=

Interest payment for the debt 1

Profit 1 =2-1

Taxes 0.35 = 35% * 1

Free for the shareholder 0.65 = 1 – 0.35

Total paid to investors: 1 + 0.65 = 1.65

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 Theoretical example: company with a debt and no equity

Sales 10
Operational costs 8

EBIT 2 10 - 8
=

Interest payment for the debt 2

Profit 0 =2-2

Taxes 0

Free for the shareholder 0

Total paid to investors: 2

he higher the debt, 16
the higher the amount of money given to the investor
Unlevered company U (i.e. not debt)
Sales xxxxx
Operational costs yyyy

EBIT Ct
= xxxxx - yyyy

Interest payment for the debt 0

Profit Ct = Ct - 0

Taxes TC * C t

= Ct – T C * Ct
Free for the shareholder (1 - TC) * Ct

Total: (1 - TC) * Ct
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Levered company L (i.e. with a debt)
Sales xxxxx
Operational costs yyyy

EBIT Ct - yyyy
= xxxxx

Interest payment for the debt D * rD

Profit C t - D * rD

Taxes TC * (Ct - D * rD)

= C - D * rD
Free for the shareholder (1 - TC)* (Ct - D * rtD)
- TC * (Ct - D * rD)
Total: D * rD + (1 - TC) * (Ct - D * rD)
= (1 - TC) * Ct + TC * D * rD
Total for company U Tax shield =
Tax rate * Interest
(company with no debt) paid
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Levered company L (i.e. with a debt)

Investors = bondholders
) & shareholders
–T
c

1
*(
Ct
Ct from production
Tax shield: Tc * rD * D

Ct
*
Tc

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 Levered company L (i.e. with a debt)

Total available for the investors:

D * rD + (1 - TC) * (Ct - D * rD)
= (1 - TC) * Ct + TC * (D * rD)
Interest
Taxation Amount of
rate on
rate debt
debt

Amount of interest (yearly)

 Everything happens just like the company pays less interest to the ba
Gain on interest is equal to: Tc * amount of interest

 Everything happens just like the true interest amount paid wa

D * rD * (1 – TC) instead of D * rD
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Financing and Capital Structure
Financing Structure and impact of Taxation

In conclusion, the MM proposition changes

once taxes are taken into account:
Interest payments are tax deductible
whereas
dividends and retained earnings are not tax
deductible
The cash flows of firms U and L differ by the “tax-
shield” created by the tax-deductibility of interest
Paid interest
expenses:

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 Financing and Capital Structure
Financing Structure and impact of Taxation

The free cash flows of the year are higher for the levered
company, by a term Tc * rD * D (tax shield).

As the value of a firm is the present value of the future cash

flows1, the levered company has a higher value: We use the WACC
as rate r to
compute the
present value

 By increasing the debt, we can increase the value of the

company (the higher the taxation rate, the higher the
increase).

1
Remember tutorial 3, value of a stock was the sum of the present value
of all future dividends. Here, we compute the value of the firm which is the
sum of the value of its equity plus the value of its debt: PV of all future
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cash flows generated for its investors (shareholders and debtholders).
 Financing and Capital Structure
Financing Structure and impact of Taxation

The value of two firms in the same risk class will differ by
the present value of their tax shield:

Example:
- Company A is initially financed by 2,000 shares whose value is
€10 and whose return is 9%  value of A = 20,000 € and WACC is
9%
- It changes its structure, buying back 1,000 shares by
contracting a debt of 10,000 € on 5 years (interest rate = 4%).

Assets Liabilities Assets Liabilities

….. Debt: 0€ ….. Debt: 10,000 €
….. Equity: 20,000 € ….. Equity: 10,000 €
20,000 € 20,000 € 20,000 € 20,000 €

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Financing and Capital Structure
Financing Structure and impact of Taxation

It changes its structure, buying back 1,000 shares by contracting a

debt of 10,000 € on 5 years (interest rate = 4%).

If taxation rate is 30%, it will make a yearly tax shield equal to:
30% x 4% x 10,000 = €120 during 5 years.
120 120 120 120 120

0 1 2 3 4 5

As this is an annuity:

New value of the company is thus 20,466.76 € Discount rate

is the WACC

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 Financing and Capital Structure
Financing Structure and impact of Taxation

Modigliani-Miller Proposition II: with

Corporate Taxes

The firm’s weightedEaverage D cost of capital (WACC)

is: rA  WACC  rE  rD (1  Tc )
E D E D

D
rE  rA  (rA  rD (1  T c ))
In the presence ofE taxes:

10 , 0 00
In𝑟 the
𝐸 =9example
%+ ( 9 % − 4 % ∗ ( 1− 30 % ) )=15.20 %
above:
10 , 0 00
instead of
25
if the company is located in a country without taxes