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Capital Structure Theory - Notes

Financial Strategy? (University of Derby)

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Cost of Capital and Capital Structure Theories

The lower the cost of the pot (Equity + Debt) the higher the value of the firm.

Traditional Theory
This theory can be summarised by the following graph which shows the cost of equity (Ke), cost of
debt (Kd) and WACC change as the proportion of debt in the company’s capital structure increase’s:

x - This is the optimum point:

- The cost of capital is at its lowest.
- The Market Value of the firm is maximised.

Companies try to keep the same level of gearing so they’re maximising the value of their firm. As
debt goes up the WACC will go down, but when it pasts the optimum point the WACC starts to
increase again. This is because of the following:

Why the WACC decrease’s

 The WACC decreases initially because of the increasing proportion of low cost debt. This is
because the cost of equity is much higher than the cost of debt.

Why the WACC increase’s

 More borrowing means more risk (Financial Risk). Financial Risk is where a company is at risk of
not being able to make interest payments, even if it’s illegal not to.
- E.g. not being able to pay the bank interest owed from a loan.

 Therefore, the higher the financial risk is, the bigger demand the shareholders will want in return
for their investments. Ke increase’s due to the increased risk of the company.

 Although the cost of debt Kd is reasonably constant at low levels of gearing, it increases at higher
levels of gearing just like Ke does.

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Modigliani & Miller Theory

The way we finance the firm should not have an impact on how we value the firm.

Pre-Tax Theory
The basic proposition of MM which ignores corporation tax is that the value of a company is
dependent on its earnings and not on the way it happens to be financed. Therefore, if two
companies have different capital structures but the same earnings they ought to have the same
value.

It follows from this that if we view the value of the a company as the discounted value of its future
earnings stream, then the cost of capital (the discount rate) of the company must also be constant.
The theory is illustrated in the following graph:

The Ke increases by just enough to offset the

benefit of using cheaper debt.

The WACC is constant because it is thought

that debt offsets with equity keeping it the
same.

The Kd is assumed to be constant at all levels

of gearing.

If the cost of capital remains constant then the cost of equity in a geared company will equal the cost
of equity in an ungeared company. (Plus a premium for the financial risk associated with the debt in
its capital structure).

Although, this theory does not take into account the effect of tax!

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Modigliani & Miller Theory

When we assume that the cost of debt is not constant at all levels of gearing.

After-Tax Theory
If the tax position is considered, the cost of debt will be reduced. This is because the interest
received tax relief and the higher the interest payments the lower the company’s tax bill.

WACC t
Kd (1 - t)

The result of a lower cost of debt is that the WACC will no longer be constant as seen above in the
diagram. This means that when debt increases, the tax relief increases resulting in the WACC to
decrease.

The market value of the company will therefore increase as the level of gearing increases.

Must remember to use the market value of the company formulae:

Vg = Vu + Dt

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