Capital Structure ~ Theory & Evidence

 Capital structure decision

 Choice of whether to sell / raise debt or equity
 Choice of best possible combination of debt and equity,
which maximizes shareholder value (achieves goal)
 Deciding optimal leverage of a firm

 Is there a best-possible debt-equity combination?

 How does leverage affect shareholder value of a firm?
 Different theories vs different empirical observations
 Leverage, financial risk and EPS

 Effect of leverage on earnings per share

Company Unlevered Levered
Assets 8,000 8,000
Debt 0 4,000
Equity 8,000 4,000
Interest rate 10% 10%
Total Shares 400 200
Share price 20 20

 Economy in recession, normal growth or boom phase

 RoA ~ 5% in recession, 15% in normal, 25% in boom phase
 Leverage, financial risk and EPS

 Unlevered state
Company Recession Normal Boom
RoA 5% 15% 25%
EBI 400 1,200 2,000
Interest 0 0 0
Net Income 400 1,200 2,000
Total Shares 400 400 400
EPS 1.00 3.00 5.00

 Effect of economic fluctuation on EPS if unlevered

 EPS ~ 1.00 in recession, 3.00 in normal, 5.00 in boom phase
 Leverage, financial risk and EPS

 Levered state
Company Recession Normal Boom
RoA 5% 15% 25%
EBI 400 1,200 2,000
Interest 400 400 400
Net Income 0 800 1,600
Total Shares 200 200 200
EPS 0.00 4.00 8.00

 Effect of economic fluctuation on EPS if unlevered

 EPS ~ 0.00 in recession, 4.00 in normal, 8.00 in boom phase
 Leverage, financial risk and EPS

 Slope of line for levered firm >

slope of line for unlevered firm EPS

 Slope measures risk to share

holders (responsive of RoE to
changes in firm performance, EBI)
 If earnings is above (below)
breakeven point, leverage is good EBI

(bad) for shareholders (higher EPS)

 Levered equity has greater risk,
and hence, should have greater
expected return
 Capital Structure Theories

 Modigliani Miller (MM) model

 With taxes
 Without taxes

 Trade-off theory
 Pecking order model
 Information asymmetry and signalling model
 MM Model without Corporate Taxes

 Proposition I
 Capital structure is irrelevant for firm valuation
 VL = VU

 Proposition II
 There is an equity premium in a levered firm due to
financial risk
 Ke = K0 + (K0 – Kd)*(D/E)
 MM Model without Corporate Taxes

 Assumptions of MM model
 Perfect capital market
 Infinite borrowing / lending allowed at risk-free rates
 No transaction cost, no information asymmetry, no
agency costs (no financial distress costs)
 MM Model without Corporate Taxes

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 Proposition I
 Capital structure is irrelevant for firm valuation
 Homemade leverage ~ Investors can duplicate effects of firm
leverage on their own, if borrowing / lending rates are same for
individuals and firms

 Proposition II
 There is an equity premium in a levered firm due to
financial risk
 Both cost of debt and cost of equity increases, but WACC
remains unchanged
 MM Model without Corporate Taxes

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 MM propositions without corporate taxes

Cost of Capital Value of Firm

VL = VU

Debt-Equity Ratio Debt-Equity Ratio

of firm of firm
 MM Model with Corporate Taxes

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 Proposition I
 Interest expense is tax deductible
 VL = VU + PV (ITS)

 Proposition II
 There is an equity premium in a levered firm due to
financial risk
 Ke,L = Ke,U + (Ke,U – Kd)*(D/E)*(1 – t)
 MM Model with Corporate Taxes

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 MM propositions with corporate taxes

Cost of Capital Value of Firm

VL = VU + PV (ITS)

Debt-Equity Ratio Debt-Equity Ratio

of firm of firm
 Trade-off Theory

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 Benefit of Debt
 Interest tax deductibility
 Added monitoring

 Cost of Debt
 Financial distress costs
 Direct costs ~ fees to lawyers, auditors, consultants
 Indirect costs ~ Impaired ability to conduct business

 Loss of financial flexibility (covenants)

 Conflict of interests (selfish strategies by owners)
 Trade-off Theory

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 Firm value, VL = VU + PV (ITS) – PV(FDC)

 Firm value maximum at optimal capital structure
 Debt and Equity Conflict of Interests

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 Conflict of interests between debt and equity

 Debt and equity have different payoff structures
 In presence of significant financial distress / bankruptcy
risks, shareholders may adopt various selfish strategies
 Incentives to take large risks
 Incentives towards underinvestment
 Milking the property

 How do bondholders protect themselves from such

financial distress costs?
 Covenants ~ reduces financial flexibility of firm
 Pecking Order Theory

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 In presence of information asymmetry between

managers and outside investors
 Hierarchy of capital raising
 Use retained earnings
 Issue safest debt first, then riskier debt
 Issue hybrid securities (convertible debt)
 Issue new equity as last option

 No defined target capital structure

 Corporate and Personal Taxes

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 Dividends incur double taxation

 Taxed both at corporate (Tc) and individual (Te) level

 Interest expense is tax deductible

 Interest income taxed only at individual level (Td)

 Firm is indifferent between debt and equity if

 (1 – Tc)*(1 – Te) = (1 – Td)

 Value of levered firm in presence of personal taxes

 VL = VU + [1 – {(1 – Tc)*(1 – Te)/(1 – Td)}]*D
 Other Capital Structure Considerations

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 Other considerations for capital structure decision

 Tax considerations (clientele effect)
 Free cash flow hypothesis (agency conflicts)
 Firm life cycle hypothesis (cash flow profile)
 Asset structure (industry peers)
 Market outlook (financial flexibility)
 Other Capital Structure Considerations

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 Other considerations for capital structure decision

 Ensure certain credit rating (financial flexibility)
 Signalling to market (debt as signal of firm value)
 Management control (entrenched interest of managers)
 Risk attitude (firm culture)