Fall 2019 Corporate Finance, Lecture 6 1

Capital Structure (I)

Professor Siyi Shen

Fall 2019 Corporate Finance, Lecture 6 2

Introduction
• Capital structure is usually the first topic in corporate finance:
– relative proportions of debt, equity, and other securities
that a firm has outstanding

• Big picture: Does each firm have an optimal structure

– to maximize its market values?

• When firms issue both debt and equity, we can decompose the
market value of firm into the market value of their debt and
equity
MV of the firm = MV of debt + MV of equity

• Why shareholders care about maximizing firm value?

Fall 2019 Corporate Finance, Lecture 6 3

Debt versus Equity

• Debt and equity are the most frequently used securities
– we focus on these two securities to form capital structure
decisions

– debt is senior to equity: it must be paid in full before the

firm can make any payments to the shareholders (owners)

– interest payments to debt holders are a tax-deductible

expense of the firms (come back to it later). In contrast,
dividends to shareholders are a payout of profits and not a
tax-deductible expense
Fall 2019 Corporate Finance, Lecture 6 4

Example: Financing A Project

• You are considering an investment opportunity:
– initial investment: $800 million this year
– future cash flows: $1400 or $900 million next year (equally
likely)
– The risk premium is 10%. With a risk-free rate of 5%, the
cost of capital is 15%.
Fall 2019 Corporate Finance, Lecture 6 5

All Equity Financing

• If you finance this project using only equity, how much would
equity investors be willing to pay for the project?
– in basic finance course: the price of a security equals the
present value of its cash flows
– firm has no other liabilities: equity holders will receive all
of the cash flows generated by this project
0.5 ×1400 + 0.5 × 900
PV (equity ) = = 1000
1 + 15%
• Why equity investors are willing to pay 200 more than the
project’s cost?
Fall 2019 Corporate Finance, Lecture 6 6

All Equity Financing – Cont’d

• Equity in a firm with no debt is called unlevered equity
– expected return on unlevered equity:

0.5 ×1400 + 0.5 × 900

ru = = 15%
1000

• Shareholders earn an appropriate for the risk they take (the risk
of unlevered equity equals the risk of the project).
Fall 2019 Corporate Finance, Lecture 6 7

Equity and Debt Financing

• For the same firm with the same project, suppose now
– finance $500 million with debt (5% interest rate. why?) and
the rest in equity
– what will be the market value of the firm’s equity today?
– what is the expected return for a shareholder?
Fall 2019 Corporate Finance, Lecture 6 8

Equity and Debt Financing –

Cont’d
• Equity in a firm that also has debt outstanding is called levered
equity
– promised payments to debt holders must be made before
any payments to equity holders are distributed

• With a perfect financial market (no tax), what will be firm

value in this case? What is the debt value?
0.5 × 525 + 0.5 × 525
PV (debt ) = = 500
1 + 5%
PV (equity ) = PV ( firm) − PV (debt ) = ?
Fall 2019 Corporate Finance, Lecture 6 9

Equity and Debt Financing –

Cont’d
• Expected return on levered equity:

0.5 × 875 + 0.5 × 475

rl = =?
PV (equity )
• What is the relationship between rl and ru ?

• Why does the expected returns on levered equity change?

Think about the riskiness of cash flows to shareholders in
these two cases
Fall 2019 Corporate Finance, Lecture 6 10

MM Theory – Proposition 1
• Developed by Modigliani and Miller (1958):
– surprised researchers and practitioners at the time.
– the seminal works on corporate capital structure got Merton
Miller Nobel prize in Economics in 1990.

• Proposition 1
– In a perfect capital market, the total value of a firm is
equal to the market value of the total cash flows generated
by its assets and is not affected by its choice of capital
structure.
Dl + El = Vl = PV (cashflow) = Vu = Eu
Fall 2019 Corporate Finance, Lecture 6 11

MM Theory – Perfect Market

• What MM means for a perfect financial market:
– Investors can trade the same set of securities at competitive
market prices equal to the PV of their future cash flows (no
arbitrage)
– There are no taxes, transaction costs, or issuance costs
associated with security trading
– No bankruptcy costs
– No agency problem

• This is a classic example of a model with extremely unrealistic

assumptions providing extremely useful results.
Fall 2019 Corporate Finance, Lecture 6 12

Cost of Capital
• From the previous example:
– We can see that total cost of asset does not change with the
leverage (firm value and cash flow stay the same)
– but the cost of equity (expected return on equity) changes
with leverage

• Consider a portfolio with two assets (equity and debt):

– The return of the portfolio (firm or unlevered equity) =
weighted average of the securities in it:
Dl El
rA = ru = × rd + × rl
Dl + El Dl + El
Fall 2019 Corporate Finance, Lecture 6 13

Cost of Capital – Cont’d

• It is a pre-tax version of WACC:
– With a perfect capital market, a firm’s WACC is
independent of its capital structure

• Rearrange terms:
Dl
rl = ru + × (ru − rd )
El
• Insights from the equation:
– two components in cost of capital of levered equity
– it increases with firm’s debt-to-equity ratio
– taking leverage is great when firm performs well
Fall 2019 Corporate Finance, Lecture 6 14

MM Theory – Proposition 2
• Proposition 2
– The cost of capital of levered equity increases with the
firm’s market value debt-equity ratio
Fall 2019 Corporate Finance, Lecture 6 15

An Example
• You are the manager of Honeywell International Inc. (HON):
– The company currently has a debt-equity ratio of 0.5, its
debt cost of capital is 6.5%, and its equity cost of capital is
14%.
– If HON issues equity and uses the proceeds to repay its
debt and reduce its debt-equity ratio to 0.4, it will lower its
debt cost of capital to 5.75%.
– With perfect capital markets, what effect will this
transaction have on HON’s equity cost of capital and
WACC?
Fall 2019 Corporate Finance, Lecture 6 16

Levered and Unlevered Betas

• Insert CAPM into the cost of capital function, we will have:

Dl El
βu = × βd + × βl
Dl + El Dl + El
• Similar takeaways:
– when a firm changes its capital structure without changing
its investments, its unlevered (asset) beta will remain
unaltered
– however, its equity beta will change to reflect the effect of
the capital structure change on its risk
– Think about β d
Fall 2019 Corporate Finance, Lecture 6 17

Capital Structure Fallacy

• Fallacy: issuing equity will dilute existing shareholders’
ownership, so debt financing should be used instead

• In general, as long as the firm sells the new shares of equity at

a fair price, there will be no gain or loss to shareholders
associated with the equity issue itself
Fall 2019 Corporate Finance, Lecture 6 18

Key Takeaways
• Conservation of Value Principle for Financial Markets
– With perfect capital markets, financial transactions neither
add nor destroy value, but instead represent a repackaging
of risk

• This implies that any financial transaction that appears to be a

good deal may be exploiting some type of market
imperfection.