Financial Management :

Theory & Practice

Professor Dr. Hussein Seoudy

October 2018

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 Chapter 15

Capital Structure Decisions

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 Topics in Chapter

A preview of capital structure issues

Business versus financial risk
The impact of debt on returns
Capital structure theory
Example: Choosing the optimal structure
Setting the capital structure in practice
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 A Preview of Capital
Structure Issues

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 Capital Structure Decisions

 A preview of capital structure issues

 Business versus financial risk
 The impact of debt on returns
 Capital structure theory
 Example: Choosing the optimal structure
 Setting the capital structure in practice
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 Basic Definitions

Definition of Capital Structure

“The mix of a firm’s permanent

long-term financing represented
by debt, preferred stock, and
common stock equity”

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 Basic Definitions

V = value of firm
FCF = free cash flow
WACC = weighted average cost of
capital
rs and rd are costs of stock and debt
We and wd are percentages of the
firm that are financed with stock and
debt.
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 How can capital structure affect value?


FCFt
V 
t 1 (1  WACC) t

WACC = wd (1-T) rd + we rs

(Continued…)
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 A Preview of Capital Structure Effects

The impact of capital structure on

value depends upon the effect of
debt on:

WACC

FCF

(Continued…)
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 The Effect of Additional Debt on WACC

 Debtholders have a prior claim on

cash flows relative to stockholders.
Debtholders’ “fixed” claim increases
risk of stockholders’ “residual” claim.

Cost of stock, rs, goes up

(Debt increases the cost of stock).
(Continued…)
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 The Effect of Additional Debt on WACC

Firm’s can deduct interest expenses.

Debt reduces the taxes paid

Frees up more cash for payments to

investors

Reduces after-tax cost of debt

(Continued…)
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 The Effect on WACC (Continued)

Debt increases risk of bankruptcy

Causes pre-tax cost of debt, rd, to increase.

Adding debt increase percent of firm

financed with low-cost debt (wd) and
decreases percent financed with high-
cost equity (we)

Net effect on WACC = uncertain.

(Continued…)
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 The Effect of Additional Debt on FCF

Additional debt increases the

probability of bankruptcy.
Direct costs: Legal fees, “fire” sales, etc.

Indirect costs: Lost customers,

reduction in productivity of managers
and line workers, reduction in credit (i.e.,
accounts payable) offered by suppliers

(Continued…)
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 Impact of indirect costs

NOPAT goes down due to lost

customers and drop in productivity

Investment in capital goes up due to

increase in net operating working
capital (accounts payable goes up as
suppliers tighten credit).

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 Business Versus
Financial Risk

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 Business Risk and Financial Risk

 Business risk is the risk a firm’s common

stockholders would face if the firm had no
debt.

 It is the risk inherent in the firm’s

operations, which arises from uncertainty
about future operating profits and capital
requirements.

 It is the uncertainty in projections of future

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EBIT, NOPAT, and ROIC.
 Factors That Influence Business Risk

 Uncertainty about demand (unit sales).

 Uncertainty about output prices.
 Uncertainty about input costs.
 Product and other types of liability.
 Degree of operating leverage (DOL).

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 Business Risk and Financial Risk

 Financial risk is the additional risk placed

on common stockholders as a result of
the decision to finance with debt.

 If a firm debt financial leverage), then the

business risk is concentrated on the
common stockholders.

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 Business Risk versus Financial Risk :
A conclusion
 Business risk:
 Uncertainty in future EBIT , NOPAT, and ROIC.
 Depends on business factors such as
competition, operating leverage, etc.

 Financial risk:
 Additional business risk concentrated on
common stockholders when financial leverage
is used.
 Depends on the amount of debt and preferred
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 The Impact of Debt on
Returns

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 Consider Two Hypothetical Firms

Firm U Firm L
No debt $10,000 of 12% debt
$20,000 in assets $20,000 in assets
40% tax rate 40% tax rate

Both firms have same operating leverage,

business risk, and EBIT of $3,000. They
differ only with respect to use of debt.
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 Impact of Leverage on Returns

Firm U Firm L
EBIT $3,000 $3,000
Interest 0 1,200
EBT $3,000 $1,800
Taxes (40%) 1 ,200 720
NI $1,800 $1,080

ROE 9.0% 10.8%

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 Why does leveraging increase return?

More EBIT goes to investors in Firm L.

Total dollars paid to investors:
• U: NI = $1,800.
• L: NI + Int. = $1,080 + $1,200 = $2,280.
Taxes paid:
• U: $1,200; L: $720.

Equity $ proportionally lower than NI.

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 The Trade-off Between
Profitability And Risk
If a company decides to use debt, it
will be faced with a trade-off between
the following:
Debt can be issued to increase
expected EPS, but then the firm’s
shareholders will have to take
more risk.

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 The Trade-off Between
Profitability And Risk
Stay all-equity financed, but then the
firm shareholders will end up with
lower expected EPS
To find out what to do, we need to
determine how debt financing affects
the firm’s value, not just EPS
The pizza theory of capital structure
provides the answer.
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 Capital Structure Theory

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 Capital Structure Theory

 MM theory
Zero taxes
Corporate taxes
Corporate and personal taxes
 Trade-off theory
 Signaling theory
 Pecking order theory
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 Who are Modigliani and Miller (MM)?

They published theoretical papers

that changed the way people thought
about financial leverage.
They won Nobel prizes in economics
because of their work.
MM’s papers were published in 1958
and 1963. Miller had a separate
paper in 1977. The papers differed in
their assumptions about taxes.
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 What assumptions underlie the MM
and Miller models?

Firms can be grouped into

homogeneous classes based on
business risk.
Investors have identical
expectations about firms’ future
earnings.
There are no transactions costs.
(More...)
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 All debt is riskless, and both
individuals and corporations can
borrow unlimited amounts of money
at the risk-free rate.
All cash flows are perpetuities. This
implies perpetual debt is issued,
firms have zero growth, and
expected EBIT is constant over time.

(More...)
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 MM’s first paper (1958) assumed
zero taxes. Later papers added
taxes.
No agency or financial distress
costs.
These assumptions were necessary
for MM to prove their propositions
on the basis of investor arbitrage.

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 MM Theory: Zero Taxes

 MM prove, under a very restrictive set of

assumptions, that a firm’s value is
unaffected by its financing mix:
 VL = VU.
 Therefore, capital structure is irrelevant.
 Any increase in ROE resulting from financial
leverage is exactly offset by the increase in
risk (i.e., rs), so WACC is constant.

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 MM Theory: Corporate Taxes
 Corporate tax laws favor debt financing
over equity financing.
 With corporate taxes, the benefits of
financial leverage exceed the risks: More
EBIT goes to investors and less to taxes
when leverage is used.
 MM show that: VL = VU + TD.
 If T=40%, then every dollar of debt adds 40
cents of extra value to firm.

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 MM relationship between value and debt
when corporate taxes are considered.
Value of Firm, V

VL
TD
VU

Debt
0

Under MM with corporate taxes, the firm’s value

increases continuously as more and more debt is used.
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 MM relationship between capital costs
and leverage when corporate taxes are
considered.
Cost of
Capital (%)
rs

WACC
rd(1 - T)
Debt/Value
0 20 40 60 80 100 Ratio (%)
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 Miller’s Theory: Corporate and
Personal Taxes

Personal taxes lessen the advantage

of corporate debt:
Corporate taxes favor debt financing
since corporations can deduct interest
expenses.
Personal taxes favor equity financing,
since no gain is reported until stock is
sold, and long-term gains are taxed at a
lower rate.
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 Miller’s Model with Corporate and
Personal Taxes

(1 - Tc)(1 - Ts)
VL = VU + 1 -[ (1 - Td) ]D.
Tc = corporate tax rate.
Td = personal tax rate on debt income.
Ts = personal tax rate on stock income.
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 Tc = 40%, Td = 30%, and Ts = 12%.

VL = VU + 1 - [
(1 - 0.40)(1 - 0.12)
(1 - 0.30) D]
= VU + (1 - 0.75)D
= VU + 0.25D.

Value rises with debt; each $1 increase in

debt raises L’s value by $0.25.
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 Conclusions with Personal Taxes

Use of debt financing remains

advantageous, but benefits are less
than under only corporate taxes.
Firms should still use 100% debt.
Note: However, Miller argued that in
equilibrium, the tax rates of marginal
investors would adjust until there
was no advantage to debt.
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 Trade-off Theory

 MM theory ignores bankruptcy (financial

distress) costs, which increase as more
leverage is used.
 At low leverage levels, tax benefits
outweigh bankruptcy costs.
 At high levels, bankruptcy costs outweigh
tax benefits.
 An optimal capital structure exists that
balances these costs and benefits.

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 Signaling Theory

MM assumed that investors and

managers have the same information.
But, managers often have better
information. Thus, they would:
Sell stock if stock is overvalued.
Sell bonds if stock is undervalued.
Investors understand this, so view
new stock sales as a negative signal.
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 Pecking Order Theory

Firms use internally generated funds

first, because there are no flotation
costs or negative signals.
If more funds are needed, firms then
issue debt because it has lower
flotation costs than equity and not
negative signals.
If more funds are needed, firms then
issue equity.
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 Choosing the Optimal
Capital Structure:
Example

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 Choosing the Optimal Capital Structure:
Example

Currently is all-equity financed.

Expected EBIT = $500,000.
Firm expects zero growth.
100,000 shares outstanding; rs = 12%;
P0 = $25; T = 40%; b = 1.0; rRF = 6%;
RPM = 6%.
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 Estimates of Cost of Debt

Percent financed
with debt, wd rd
0% -
20% 8.0%
30% 8.5%
40% 10.0%
50% 12.0%
If company recapitalizes, debt would be
issued to repurchase stock.
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 The Cost of Equity at Different Levels
of Debt: Hamada’s Equation

MM theory implies that beta changes

with leverage.
bU is the beta of a firm when it has no
debt (the unlevered beta)
bL = bU [1 + (1 - T)(D/S)]

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 The Cost of Equity for wd = 20%

Use Hamada’s equation to find beta:

bL = bU [1 + (1 - T)(D/S)]
= 1.0 [1 + (1-0.4) (20% / 80%) ]
= 1.15
Use CAPM to find the cost of equity:
rs = rRF + bL (RPM)
= 6% + 1.15 (6%) = 12.9%
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 Cost of Equity vs. Leverage

wd D/S bL rs
0% 0.00 1.000 12.00%
20% 0.25 1.150 12.90%
30% 0.43 1.257 13.54%
40% 0.67 1.400 14.40%
50% 1.00 1.600 15.60%

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 The WACC for wd = 20%

WACC = wd (1-T) rd + we rs
WACC = 0.2 (1 – 0.4) (8%) + 0.8 (12.9%)
WACC = 11.28%

Repeat this for all capital structures

under consideration.
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 WACC vs. Leverage

wd rd rs WACC
0% 0.0% 12.00% 12.00%
20% 8.0% 12.90% 11.28%
30% 8.5% 13.54% 11.01%
40% 10.0% 14.40% 11.04%
50% 12.0% 15.60% 11.40%

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 Corporate Value for wd = 20%

V = FCF / (WACC-g)
g=0, so investment in capital is zero;
so FCF = NOPAT = EBIT (1-T).
NOPAT = ($500,000)(1-0.40) = $300,000.

V = $300,000 / 0.1128 = $2,659,574.

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 Corporate Value vs. Leverage

wd WACC Corp. Value

0% 12.00% $2,500,000
20% 11.28% $2,659,574
30% 11.01% $2,724,796
40% 11.04% $2,717,391
50% 11.40% $2,631,579

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 Debt and Equity for wd = 20%

The dollar value of debt is:

D = wd V = 0.2 ($2,659,574) = $531,915.
S = V – D
S = $2,659,574 - $531,915 = $2,127,659.

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 Optimal Capital Structure

wd = 30% gives:

Highest corporate value
Lowest WACC

But wd = 40% is close. Optimal

range is pretty flat.

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 What other factors would managers
consider when setting the target
capital structure?

Debt ratios of other firms in the

industry.
Pro forma coverage ratios at
different capital structures under
different economic scenarios.
Lender and rating agency attitudes
(impact on bond ratings).
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 Reserve borrowing capacity.
Effects on control.
Type of assets: Are they tangible,
and hence suitable as collateral?
Tax rates.

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 Setting the Optimal
Capital Structure

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 Optimal Capital Structure

 Optimal capital structure is the capital

structure at which the weighted average
cost of capital is minimum and thereby
the value of the firm is maximum.
 Optimal capital structure may be defined
as “the capital structure or combination
of debt and equity, that leads to the
maximum value of the firm”.
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 Objectives of Capital Structure

 Decision of capital structure aims at the

following two important objectives:
 Maximize the value of the firm.
 Minimize the overall cost of capital.

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 Chapter 15
Capital Structure Decisions

The End

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