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Capital Structure
Marcela Valenzuela
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Capital Structure
In nance, capital structure refers to the way a corporation
nances its assets.
A company nances its assets through some combination of
equity and debt.
How should a rm choose its debt-equity ratio? the pie
model.
The value of the rm is the pie. It is the sum of debt and
equity. We dene the value of the rm to be this sum.
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Capital Structure
The total value of a rm is:
Value of Firm (V) = Value of Debt (D) + Value of Equity (E)
where D is the market value of the debt and E is market value of
equity.
If the goal of the management of the rm is to make the rm
as valuable as possible, then the rm should pick the debt-equity
ratio that makes the piethe total valueas big as possible.
What is the ratio of debt to equity that maximizes the
shareholders interests? Franco Modigliani and Merton Miller
answered that question.
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Modigliani & Miller (M&M)
Modigliani & Miller
Nobel Prize Winners.
Fathers of Corporate Finance.
Famous Theorem: Debt policy does not matter.
When there are no taxes and capital markets function well, it
makes no dierence whether the rm borrows or individual
shareholders borrow.
Therefore, the market value of a company does not depend on
its capital structure.
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Modigliani-Miller Theorem
Under the following assumptions:
1 No taxes.
2 No bankruptcy costs.
3 No agency costs.
4 No asymmetric information.
5 No transactions costs.
6 Ecient capital markets.
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Modigliani-Miller Theorem
Under these assumptions, the value of the rm and the
wealth of the shareholders do not change when you change
capital structure.
In other words, in a perfect capital market, the total value of a
rm is not aected by its choice of capital structure.
In still other words, no capital structure is any better or worse
than any other capital structure for the rms stockholders.
No matter what D and E are, investors can undo anything the
rm does with perfect capital markets, so capital structure doesnt
matter.
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M&M
Unlevered Firms versus Levered Firms:
Consider two identical rms except capital structure, U (for
unlevered) and L (for levered). Compare the following two
strategies:
Portfolio 1: an investor holds 1% of the equity of rm U.
Portfolio 2: consider now buying the same fraction of both
the debt and the equity of rm L: buy 1% of D
L
and 1% of
rm E
L
.
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M&M
Unlevered Firm U (strategy I):
Dollar Investment Dollar Return
0.01V
U
0.01 x Prots
Levered Firm L (strategy II):
Dollar Investment Dollar Return
Debt 0.01D
L
0.01 x Interest
Equity 0.01E
L
0.01 x (ProtsInterest)
Total 0.01(D
L
+ E
L
) 0.01 x Prots
= 0.01V
L
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M&M
This gives us:
E
L
+ D
L
= E
U
V
L
= V
U
Modigliani and Millers Proposition I: the value of a rm is
independent of leverage.
Both strategies lead to exactly the same results. If you hold 1%
of the equity of rm U, another portfolio that you can hold and
would provide you the same cash ows is: buy 1% of rm Ls debt
and 1% of rm Ls equity.
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M&M
Compare now the following two strategies:
Portfolio 1: an investor holds exactly 1% of the equity of rm
L.
Portfolio 2: borrow 1% of D
L
and purchase 1% of the stock of
the unlevered rm U.
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M&M
Levered Firm L (strategy I):
Dollar Investment Dollar Return
0.01E
L
0.01 x (ProtsInterest)
= 0.01 (V
L
D
L
)
Strategy II:
Dollar Investment Dollar Return
Borrowing -0.01D
L
-0.01 x Interest
Equity 0.01 V
U
0.01 x Prots
Total 0.01(V
U
D
L
) 0.01 x (ProtsInterest)
V
U
D
L
= V
L
D
L
V
U
= V
L
Both strategies lead to exactly the same results.
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M&M
To sum up:
If you hold X% of the equity of the unlevered rm U. Another
portfolio that you can hold and would provide the same cash ows
is: buy X% of rm Ls debt and X% of rm Ls equity. You will
get X% of the cash ows.
If you hold X% of equity of levered rm L. Another portfolio
that you can hold and woudl provide the same cash ows is:
borrow X% of D
L
and buy X% of the stock of the unlevered rm
U. You will get X% of (Cash ows - Interest)
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M&M Proposition I
In a perfect capital market the value of the rm is unnaected
by its choice of capital structure. If capital markets are doing their
job, rms cannot increase value by tinkering with capital structure.
Value of the rm is independent of the debt ratio.
V
U
= V
L
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Weighted-Average Cost of Capital (WACC)
Assume market value balance sheet:
Asset value 100 Debt D = 30 at 7.5%
Equity E = 70 at 15%
Asset value 100 Firm value (V) = 100
r
D
is the cost of debt. It is the opportunity cost of capital for
the investors who hold the rms debt. 7.5% in the example.
r
E
is the cost of equity. It is the opportunity cost of capital for
the investors who hold the rms shares. 15% in the example.
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Weighted-Average Cost of Capital (WACC)
r
A
, the expected return on assets, is the company cost of
capital. It is the opportunity cost of capital of investing in the
rms assets.
The company cost of capital is called the weighted-average
cost of capital or WACC.
The WACC is obtained as the average of the return that the
equity holders require and the return that debtholders require:
WACC = r
A
=
D
V
r
D
+
E
V
r
E
where E/V is the proportion of the company nanced by equity
and D/V is the proportion of the company nanced by debt.
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WACC
From the previous table:
Asset value 100 Debt D = 30 at 7.5%
Equity E = 70 at 15%
Asset value 100 Firm value (V) = 100
WACC:
WACC =
D
V
r
D
+
E
V
r
E
=
30
100
x 7.5% +
70
100
15%
= 12.75%
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M&M Proposition II
Using the WACC formula and some algebra:
r
E
= r
A
+
D
E
(r
A
r
D
)
The expected rate of return on the common stock of a levered
rm increases in proportion to the debt-equity ratio (D/E).
A higher debt-to-equity ratio leads to a higher required return
on equity, because of the higher risk involved for equity-holders in
a company with debt.
Any increase in expected return is exactly oset by an increase
in risk This is why leverage does not aect value.
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M&M Proposition II
r
E
= r
A
+
D
E
(r
A
r
D
)
If the rm has no debt r
E
= r
A
.
When a rm is unlevered, equity investors demand a return of
r
A
.
When a rm is levered, equity investors require a premium of
D
E
(r
A
r
D
) to compensate for the extra risk (risk of leverage).
M&Ms proposition II says that the rate of return that
shareholders can expect to receive on their shares increases as the
rms debt-equity ratio increases.