Chapter 14 and 15 Capital Structure

In this session we will study capital structure, the structure of financing and consequent
ownership for a firm. We discuss basic concepts of capital structure in Ch. 14 of the RWJJ
textbook and advanced theories in Ch. 15.

Does Capital Structure Matter? is one of the basic questions in corporate finance. Franco
Modigliani and Merton Miller (MM) provided an answer to that question in 1958. Their answer
to the question was No, and it was known as the MM capital structure irrelevancy theory.
MM makes some strong assumptions (known as the perfect capital market assumption) including
there are no taxes, no transactions cost, same interest rate for all investors & firms, same
information for everyone (no inside information), etc. The perfect capital market assumption is
obviously unrealistic because capital markets are not perfect in the real world. It is however the
most useful starting point for analyzing questions related to financing, payment of dividends etc.

We next consider deviations in the real world from MM assumptions like the tax benefit of debt,
the use of debt for signaling, etc. in Ch. 15. These deviations mean that MM does not hold in the
real world. We end the session with a discussion of how firms choose their capital structure.

Ch. 14 Capital Structure: Basic Concepts

14.1 The Capital Structure Question

The value of the firm equals the market value of the debt plus the market value of the equity
(firm value identity). This is just: V = B + S.

14.2 Maximizing Firm Value versus Maximizing Stockholder Interests

The goal of the financial management should be to maximize the value of equity. Managers
should choose the capital structure that they believe will have the highest firm value, because the
(firm value maximizing) capital structure will be more beneficial to the firms stockholders.

Then, what is the optimal capital structure for a firm and how can a firm determine its optimal
capital structure?

If managements goal is to maximize value of firm, then the optimal or target capital
structure is the debt/equity mix that simultaneously (a) maximizes the value of the firm, (b)
minimizes the weighted average cost of capital, and (c) maximizes the market value of the
common stock.

We will find answer(s) in Ch. 15.


14.3 Financial Leverage and Firm Value: An Example

Consider the following firm:
Current Proposed
Assets $8,000,000 $8,000,000
Debt 0 4,000,000
Equity 8,000,000 4,000,000
D/E ratio 0.0 1.0
Share price (assume it does not change when shares are repurchased) $20 $20
Shares outstanding 400,000 200,000
Interest Rate N/A 10%
Current capital structure: No debt
Recession Expected Expansion
EBIT $400,000 $1,200,000 $2,000,000
Interest Expense 0 0 0
Net Income $400,000 $1,200,000 $2,000,000
ROE (=NI/Equity) 5% 15% 25%
EPS (= NI/N of shares) $1.00 $3.00 $5.00
*: Assume no taxes for simplicity.

Proposed capital structure: D/E = 1; interest rate = 10%
(Issue $4 million debt and repurchase stock at $20 a share)
Recession Expected Expansion
EBIT $400,000 $1,200,000 $2,000,000
Interest Expense 400,000 400,000 400,000
Net Income $0 $800,000 $1,600,000
ROE 0% 20% 40%
EPS $0.00 $4.00 $8.00
Also see Table 14.1, 14.2, 14.3 & Figure 14.2 in. p. 434

-------Equity Financing -------Debt Financing















$400k $800k $1,200k
Break-even or Indifference Level of EBIT (i.e., the same EPS)
EPS (Equity) = [EBIT (1 - Tc)]/Ns = [(EBIT Int) (1 - Tc)/N
B
= EPS (Debt)
(Note: Tax rate really doesnt matter, because (1-Tc) in both sides cancels out.)

Breakeven point in Figure 14.3.
EBIT/400,000 = (EBIT- 400,000)/200,000 & solving for EBIT = $800,000 and EPS = $2.00
EPS (debt) will be great than EPS (Equity) if EBIT is greater than $800,000.

We can conclude that:
The effect of financial leverage depends on EBIT.
Financial leverage increases ROE and EPS when EBIT is greater than the cross-over
point.
Variability of EPS and ROE increase with leverage.
Shareholders are exposed to more risk under the proposed capital structure.

EPS-EBIT analysis is a static analysis (i.e., a single period analysis). If a firm issues long-term
bonds and earnings widely fluctuate during the life of debt, this EPS-EBIT analysis may not be
useful tool, because either EPS (equity) or EPS (debt) may not be consistently higher than the
other. You dont want to issue bonds in one year and issue stock the other year, and so on.

14.4 The Modigliani Miller (MM) Capital Structure Irrelevancy Theory

The Choice between Debt and Equity
We have shown that leverage affects earnings and returns; however, the question remains, does
it impact the value of the firm?

Franco Modigliani and Merton Miller (MM) show that, in a perfect capital market, the value
of the firm does not change in response to changes in capital structure.

MM Proposition I (No Taxes): the relationship between the leverage and the firm value
In a perfect capital market without taxes and bankruptcy costs, the firm cannot affect its
value by altering its capital structure. The value of the levered firm is the same as the value of
the unlevered firm (V
L
= V
U
) (p. 436).

If you think of the value of a firm as a pie, it doesnt matter how you split the pie between equity
and debt. The total size of the pie does not change.

MM: Proposition II (No Taxes): the relationship between the leverage and the cost of capital
The firms overall cost of capital (or the weighted cost of capital) is not affected by changes in its
capital structure, and so R
WACC
= R
o
where R
o
is the cost of capital for an all-equity (or unlevered)
firm. (Figure 14.3, p. 439).

Risk to equityholders rises with leverage. Since bondholders have a priority in receiving cash
flows from a firm before equityholders, equityholders bear additional financial risks when a firm
borrows. So, the cost of equity rises with the financial leverage:

R
S
= R
o
+ (R
o
R
B
)(B/S) (Eq. 14.3, p. 439).

However, the increases in the cost of equity if offset by low cost of debt and the firms WACC
remains unchanged. WACC = R
WACC
= (S/V)R
S
+ (B/V)R
B

See Figure. 14.3 (p. 439).

Example 14.2 illustrates the MM Capital Structure Irrelevancy Theory. Dont spend too
much time on Example 14.2. Their theory is correct (& proven over 50 years) under the
perfect capital market conditions.

14.5 Corporate Taxes

The Basic Insight: Interest payments are tax-deductible business expenses (and dividends are
not), and, therefore, debt financing can reduce corporate income taxes. It is the key benefit from
borrowing over issuing equity.

Present Value of the Tax Shield:
Interest payments = cost of debt x amount borrowed (or B x R
B ).
and
Tax shields on interest = tax rate x interest payments (or B x R
B
x T
C
)



If a firm borrows $B at R
B
% cost of

debt for N years, then the present value of the tax shield
(PVTS) will be:
PV (interest tax shields) =

=
+
n
t t
B
B c
R
B x R T
1
) 1 (
) (


[NOTE: There is no coupon rate in the formula. That means the PVTS is not affected by a
coupon rate of debt. That is, the PVTS from a debt will be the same regardless of the coupon rate.]

If we assume perpetual debt (i. e., N becomes infinity), then the present value of the interest tax
savings (PVTS)

PVTS = [B x R
B
x T
C
] / R
B
= B x T
C
(P. 446)

Examples of Estimating PVTS: Suppose a firm issues $10 million debt at an 8% annual coupon
and also assume that the firms cost of debt is 8% (i.e., bond is selling at par) and its tax rate is
30%. The firm pays $800,000 interest a year and the firm can save taxes by $240,000 a year.
1.) If the firm borrows just one year (N= 1), then = =
08 . 1
mil 10 $ x 08 . 0 x 3 . 0
PVTS $222,222;
2.) If the firm borrows two years (N= 2), then = + =
2
) 08 . 1 (
000 , 240 $
08 . 1
mil 10 $ x 08 . 0 x 3 . 0
PVTS
$427,984;
3.) If the firm issues a 10-year bond (N= 10), =
|
|
.
|

\
|

=

08 . 0
) 08 . 1 ( 1
000 , 240 $ PVTS
10
$1,610,420;
4.) If the firms issues a perpetual debt (N= ), ) ( 000 , 000 , 3 $
08 . 0
000 , 240 $
B x T PVTS
C
= = =

Q: How to compute tax shields on a zero-coupon bond?
Even though a zero-coupon bond does not pay interests regularly, issuing firm can save taxes
on finance charges. A zero-coupon bond is selling at discount and the difference between the
issuing price and the face value can be treated as capital loss which is tax deductible.

From the above example, suppose a firm issues one-year zero-coupon bond. The issuing
price will be $1,000/1.08 = $925.93 per bond. To get $10 million, the firm should issue
$10,000,000/$925.93 = 10,800 bonds and pays $1,000 per bond at maturity for $10,800,000.
So, the firm can claim a capital loss of $74.07 per bond and $800,000 for 10,800 bonds. The
effective tax saving in year one will be $240,000 the same amount as 1.), and PVTS =
$222,222.

What if the firm issues 10-year zero-coupon bonds?

The issuing price = $1,000/(1.08)
10
= $463.19 and issue 21,589 bonds to get $10 million. At
maturity, the firm pays $21,589,000 and $11,589,000 is the capital loss (or finance charge). So,
the firm saves taxes by 30% of $11,589,000 in year 10.

= =
10
08 . 1
000 , 589 , 11 $ x 3 . 0
PVTS $1,610,420 (same as 8% coupon bonds)

And also you learned in Chapter 5 (p. 149), that firms are required to report (amortized) interests
on zero-coupon bonds to IRS. In any case, PVTS will be the same for the fixed amount of debt
regardless of coupon rates. So, financial managers dont have to spend time in determining
coupon rates, because the PVTS will be the same.

What if a firm issues a 100% coupon bond?
Bond premiums (over par) are subject to a capital gains tax at maturity.
1) Issuing price:
0
= $1,000[
11.08
10
0.08
] +
$1,000
1.08
10

= $7,173.27

2) To get $10 million, N = $10M/7,173.27 = 1,394 bonds

3) Annual tax savings on interests = 0.3x$1,000x1,394 bonds = $418,200

4) Capital gains tax at maturity = 0.3x(7,173.27-1,000)x1,394 bonds = $2,581,662

So, = $418,200[
11.08
10
0.08
]
$2,581,662
1.08
10

= $1,610,347 (small rounding error)
FC: N= 10, I% = 8, PMT= 418,200, FV= --2,581,662 & solve for PV

Perpetual debt: Realistically, no private firm is able to issue a perpetual bond. However, if a firm
keeps refinancing existing debt at maturity, then the firm can effectively maintain debt permanently.

MM Proposition I and II with Corporate Income Taxes

MM capital structure irrelevancy theory is correct under the perfect capital market conditions
(e.g., no transactions costs, no issuing costs of securities, no bankruptcy costs, symmetric
information, riskless debt, same borrowing and lending rate for all investors, etc.) and perpetual
cash flows (i.e., perpetual earnings and perpetual debt).

Value of an unlevered firm: V
U
= EBIT (1 T
C
)/R
o
, where R
o
is the (unlevered) cost of equity
capital for an all-equity firm. (p. 446)

Value of the Levered Firm: V
L
= EBIT (1 T
C
)/R
W
(with riskless perpetual debt)
In general, V
L
= S + B

MM Proposition I (Corporate Taxes): If an all-equity (or unlevered) firm structure its capital
structure (by issuing riskless debt & repurchase common stock) ,then:

Value of a levered firm, V
L
= V
U
+ B T
C
(Eq. 14.5)

MM Proposition II (Corporate Taxes)

i) Cost of levered equity: R
S
= R
o
+ (R
o
R
B
)(B/S)(1- T
c
)

ii) Weighted Average Cost of Capital: R
W
= R
S
(S/V
L
) + R
B
(1- T
c
) (B/V
L
)
OR, R
W
= R
O
(1 T
C
B/V)

(Note: This relationship between Ro & Rw holds only for riskless perpetual debt.
For firms with risky non-perpetual debt, estimate the cost of capital as the way we
discussed in Chapter 12.)

Examples: Problems #14, 15 & 17 in p. 455.
Please review Ch. 14 Answers to Chapter Problems.

The optimal capital structure is the debt-equity mix that minimizes the WACC and, therefore,
maximizes firm value. With taxes, as the firm increases debt, the cost of equity increases, but the
deductibility of interest more than offsets this increase, which reduces the WACC. (Figure 14.6)

Stock Price and Leverage under Corporate Taxes (p. 449)

Firm value, and therefore equity value, increases with the optimal capital structure. This results
in a higher stock price. We should also note that all value created is awarded to stockholders.
The value of the debt is a contracted amount, i.e., fixed.

Bankruptcy costs and other disadvantages of debt will be addressed in Ch. 15.