Gagan Deep Sharma

Department of Management Studies

BBSB Engineering College
Fatehgarh Sahib, Punjab
 Capital Structure
 A crucial component of the Financing function
under Corporate Finance

 Deals with strategic long-term financing decisions

that are nearly irreversible in nature
 Capital Structure
 A mix of debt, preferred stock, and common stock
with which the firm plans to finance its
investments

 Objective is to have such a mix of debt, preferred

stock, and common equity which will maximize
shareholder wealth or maximize market price per
share by minimizing the cost of capital
 Capital Structure and WACC
 Weighted Average Cost of Capital (WACC)
depends on the mix of different securities in the
capital structure. A change in the mix of different
securities in the capital structure will cause a
change in the WACC. Thus, there will be a mix of
different securities in the capital structure at
which WACC will be the least
 An optimal capital structure means a mix of
different securities which will maximize the stock
price share or minimize WACC
 Leverage and Capital Structure
 Leverage means use of fixed cost source of funds.
Generally, it refers to use of debt in the capital structure of
the firm
 How much leverage should be there in a firm? Why is this
question important? Two reasons:
 a higher debt ratio can enhance the rate of return on equity capital
during good economic times
 a higher debt ratio also increases the riskiness of the firm’s earnings
stream
 Capital structure decision involves a trade off between risk
and return to maximize market price per share
 Capital Structure
 Notationally
Ko = Ki x (D) + Ke x (E)
(D+E) (D+E)
Ko = Overall Average cost of Capital
Ki = Cost of Debt
D = Amount of Debt
Ke= Cost of Equity
E = Amount of Equity
 Capital Structure
 As Debt is usually cheaper than equity, why is it
not an open and shut case?
 Consider
Return on a project = 15%
Needs £200-00 of capital
Cash Return = £30
If all financing is equity then obviously
ROE (return on equity) = 30 x 100 = 15%
200
 Capital Structure
 Suppose instead it is financed 50/50 debt/ equity
and cost of debt = 10%
 Then: Total Return = 30
Interest cost = 10 (100 x .10)
Net Return 20

20 x 100
ROE = 100
= 20%

So far so good, some very happy shareholders

 Capital Structure
 But disaster strikes and the return falls to £15
 Now the returns are
Total returns = 15
Interest cost = 10
Net return = 5

5 x 100
ROE = 100
= 5%
 Capital Structure
 Whereas if the shareholders had not been so bold and
had financed all Equity

ROE = 15
200
x 100 = 7.5%

What effect has leverage had?

 Capital Structure
 Results
Range of ROEs
%
 Leveraged 20 – 5
 Un-leveraged 15 – 7.5
 What effect will this have on expected/required equity
returns?
 Capital Structure
Theoretical Positions
 Net Operating Approach (the ‘makes no difference
camp’)

 Traditional Approach (the ‘yes it does camp’)

 Modigliani and Miller (the ‘we can prove it does

not matter camp’)
 Capital Structure
 Net Operating Approach
Net operating income 1,000
Capitalisation rate (cost of Capital) .15
Total value of firm 6,667
Market value of debt (cost 10%) 1,000
Market value of equity 5,667
Earnings for equity 1,000 – 100 = 900
ROE = 900 = 15.88%
5,667
 Capital Structure
 Now change debt to 3,000

 Operating income still 1,000

Overall capitalisation rate .15
Total value of firm 6,667
Market value of debt 3,000
Market value of equity 3,667
New equity earnings (1,000 – 300) = 700
ROE = 700 = 19.09
3,667
But note that total value of the firm is constant
 Total Value Principle:
Modigliani and Miller
Market value Market value
of debt ($35M) of debt ($65M)

Market value Market value

of equity ($65M) of equity ($35M)

Total firm market Total firm market

value ($100M) value ($100M)

 Total market value is not altered by the capital structure (the

total size of the pies are the same).
 M&M assume an absence of taxes and market
imperfections.
 Investors can substitute personal for corporate financial
leverage.
 Arbitrage and Total Market
Value of the Firm
Two firms that are alike in every respect
EXCEPT capital structure MUST have the
same market value.
Otherwise, arbitrage is possible.

Arbitrage -- Finding two assets that are essentially the

same and buying the cheaper and selling the more
expensive.
 Arbitrage Example
Consider two firms that are identical in
every respect EXCEPT:
 Company NL -- no financial leverage
 Company L -- $30,000 of 12% debt
 Market value of debt for Company L equals its par
value
 Required return on equity
-- Company NL is 15%
-- Company L is 16%
 NOI for each firm is $10,000
Arbitrage Example: Company NL
Valuation of Company NL
Earnings available to =E = O – I common
shareholders = $10,000 - $0
= $10,000
Market value = E / ke of equity
= $10,000 / .15
= $66,667
Total market value = $66,667 + $0
= $66,667
Overall capitalization rate = 15%
Debt-to-equity ratio =0
Arbitrage Example: Company L
Valuation of Company L
Earnings available to =E =O–I
common shareholders = $10,000 - $3,600
= $6,400
Market value = E / ke of equity
= $6,400 / .16
= $40,000
Total market value = $40,000 + $30,000
= $70,000
Overall capitalization rate = 14.3%
Debt-to-equity ratio = .75
Completing an Arbitrage Transaction
Assume you own 1% of the stock of
Company L (equity value = $400).
You should:
1. Sell the stock in Company L for $400.
2. Borrow $300 at 12% interest (equals 1% of debt for
Company L).
3. Buy 1% of the stock in Company NL for $666.67. This
leaves you with $33.33 for other investments ($400 +
$300 - $666.67).
Completing an Arbitrage Transaction
Original return on investment in Company L
$400 x 16% = $64

Return on investment after the transaction

 $666.67 x 16% = $100 return on Company NL
 $300 x 12% = $36 interest paid
 $64 net return ($100 - $36) AND $33.33 left over.

This reduces the required net investment to $366.67

to earn $64.
Summary of an Arbitrage Transaction

 The investor uses “personal” rather than corporate

financial leverage.
• The equity share price in Company NL rises based
on increased share demand.
• The equity share price in Company L falls based on
selling pressures.
• Arbitrage continues until total firm values are
identical for companies NL and L.
• Therefore, all capital structures are equally as
acceptable.
 Effect of Corporate Taxes
The judicious use of financial leverage (i.e.,
debt) provides a favorable impact on a
company’s total valuation.
Consider two identical firms EXCEPT:
– Company ND -- no debt, 16% required return
– Company D -- $5,000 of 12% debt
– Corporate tax rate is 40% for each company
– NOI for each firm is $10,000
Corporate Tax Example: Company ND
Valuation of Company ND (Note: has no debt)
Earnings available to =E =O-I
common shareholders = $2,000 - $0
= $2,000
Tax Rate (T) = 40%
Income available to = EACS (1 - T)
common shareholders = $2,000 (1 - .4)
= $1,200
Total income available to = EAT + I
all security holders = $1,200 + 0
= $1,200
Corporate Tax Example: Company D
Valuation of Company D (Note: has some debt)
Earnings available to =E =O-I
common shareholders = $2,000 - $600
= $1,400
Tax Rate (T) = 40%
Income available to = EACS (1 - T)common
shareholders = $1,400 (1 - .4)
= $840
Total income available to = EAT + I all
security holders = $840 + $600
= $1,440*
* $240 annual tax-shield benefit of debt (i.e., $1,440 - $1,200)
 Tax-Shield Benefits
Tax Shield -- A tax-deductible expense. The expense
protects (shields) an equivalent dollar amount of
revenue from being taxed by reducing taxable income.

Present value of
tax-shield benefits (r) (B) (tc)
= = (B) (tc)
of debt* r

= ($5,000) (.4) = $2,000**

* Permanent debt, so treated as a perpetuity
** Alternatively, $240 annual tax shield / .12 = $2,000, where $240=$600
Interest expense x .40 tax rate.
 Value of the Levered Firm
Value of Value of Present value of
levered = firm if + tax-shield benefits
firm unlevered of debt

Value of unlevered firm = $1,200 / .16

(Company ND) = $7,500*
Value of levered firm = $7,500 + $2,000
(Company D) = $9,500

* Assuming zero growth and 100% dividend payout

Summary of Corporate Tax Effects
 The greater the amount of debt, the greater the tax-shield
benefits and the greater the value of the firm.

• The greater the financial leverage, the lower the cost of

capital of the firm.
• The adjusted M&M proposition suggests an optimal
strategy is to take on the maximum amount of financial
leverage.
• This implies a capital structure of almost 100% debt!
Yet, this is not consistent with actual behavior.
 Thanks

gagan.is.sharma@gmail.com