CAPITAL STRUCTURE IN

PERFECT CAPITAL MARKETS

Is there an optimal (superior) capital structure /financing mix?

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PLAN
1. The weighted average cost of capital (WACC)
2. How to measure capital structure (weights), the cost of equity (CoE)
and the cost of debt (CoD)
3. Characteristics of perfect capital markets
4. The leverage effect of debt for shareholders
5. Firm value, WACC and capital structure – M&M’s proposition 1
6. Equity value, CoE and capital structure – M&M’s proposition 2

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1. THE WEIGHTED AVERAGE COST OF
CAPITAL
• When valuing investment projects:
• Expected free cash-flows to the firm (FCFs), irrespective of how FCFs will be
distributed/used
• Therefore the discount rate must be the rate reflecting the cost of capital for
the firm
• If the firm uses both debt and equity, the discount rate is the combined cost of
both for the firm
• The combination: each source is weighted by its proportion in total
financing/capital structure:
• WACC = wE*CoE + wD*CoD (general formula, to be adjusted later on for
imperfect markets)
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2. HOW AND WHERE TO MEASURE WEIGHTS
AND THE DIFFERENT COSTS OF CAPITAL
• Weights: avoid book/accounting weights measured from the Balance sheet
• Rather choose market value weights based on
• The market value of equity (number of outstanding shares times the market price of shares)
• The market value of total financing debt (short and long-term); the book value of debt may
sometimes represent a satisfactory approximation; financing debts are liabilities but other
liabilities are not debts, so don’t include them with debt)
• Target weights may alternatively be used
• The cost of equity: the CAPM is commonly accepted as a starting point
• The cost of debt: either the company’s average interest rate on outstanding debt
or the current average yield-to-maturity (if par value differs from market value)

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3. CHARACTERISTICS OF PERFECT MARKETS

• Rational investors
• Costless information instantaneously available to all (therefore no
need for intermediaries)
• Costless transactions
• No restrictions on transactions (possibility to buy/sell fractions of
securities, short-selling feasible, etc.)
• No taxes (or same flat tax rate for everybody and every type of
revenue)

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4. THE LEVERAGE EFFECT OF DEBT FOR
SHAREHOLDERS
• In perfect markets, the way the firm finances itself does not affect
operations and investment
• But it affects the way free cash-flows to the firm are split between
debtholders and equity holders.
• Refer to the Excel example posted on the course Website
• Summary:
• The leverage effect of debt = the amplification of good and bad results for equity
holders (because of fixed charges that have priority)
• More risk for equity holders = higher required/expected return
• Total firm risk (=business risk) unaffected by debt (same expected FCF to the firm)
but debt increases the risk of equity.

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5. FIRM VALUE, WACC AND CAPITAL
STRUCTURE
• Because FCFs to the firm and total risk are unaffected by debt
• Total firm value is insensitive to capital structure: Vu = Vl = D + E, where D may
be equal to 0
That’s M&M Proposition 1
• Therefore: WACC = D/V*CoD + E/V*CoE = All-Equity CoE

• M&M offered a proof of these results by recourse to arbitrage

• Arbitrage: market transactions meant to benefit from «anomalies» (for
example, Vu not equal to Vl); their end result is to erase anomalies.
• See the Excel file for an example
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6. EQUITY VALUE, CoE AND CAPITAL
STRUCTURE
• All other things equal (same operations and investment), more debt
means less equity: the total value of equity decreases when debt is
substituted for equity
• More debt means more leverage effect for equity holders and more
risk for them; therefore the CoE increases with debt
• M&M’s Proposition 2: CoE = All-E CoE + D/E*(All-E CoE – CoD)

• BACK TO THE WACC: it is unaffected by debt because when debt

increases, even though the CoE increases, the weight of the most
expensive source of funds (equity) decreases.
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