Firm Financing Decisions Debt vs Equity Capital Structure and Financial Leverage Capital Structure and Taxes The

Modigliani-M

ECO562-Financial Economics
Semester: Summer 2021

Dr. Zulfiqar Hyder

Institute of Business Administration, Karachi

June 17, 2021

Dr. Zulfiqar Hyder ECO562-Financial Economics Semester: Summer 2021

Firm Financing Decisions Debt vs Equity Capital Structure and Financial Leverage Capital Structure and Taxes The Modigliani-M

Plan of the Today: Chapters 5 & 6 of FNZ

A firm’s managers invest in new plant and equipment to
generate additional revenues and income.
Financing new investment either through debt or additional
equity or any optimal mix.
Decisions about how the firm should be financed are refereed
as capital structure decisions.
How corporate management should choose a capital structure
in a perfect capital market?
Whether there is a capital structure that maximizes the firm’s
value, optimal capital structure.
Modigliani-Miller Theory, which argues that capital structure
is irrelevant.
Chapter 6: Firm Investment decisions (capital budgeting
decisions).
Dr. Zulfiqar Hyder ECO562-Financial Economics Semester: Summer 2021
Firm Financing Decisions Debt vs Equity Capital Structure and Financial Leverage Capital Structure and Taxes The Modigliani-M

Debt vs Equity

A firms capital structure is some mix of three sources:

1 Debt
2 Retained Earnings
3 New equity

Debt Financing: legal commitments to pay interest and

principal
Equity Financing: Dividend payments, capital gain and some
combination of both.
The firm’s value is determined by on the basis of operating
decisions
Example:

Dr. Zulfiqar Hyder ECO562-Financial Economics Semester: Summer 2021

Firm Financing Decisions Debt vs Equity Capital Structure and Financial Leverage Capital Structure and Taxes The Modigliani-M

Example: Debt Financing of $100 million at 10%

Dr. Zulfiqar Hyder ECO562-Financial Economics Semester: Summer 2021

Firm Financing Decisions Debt vs Equity Capital Structure and Financial Leverage Capital Structure and Taxes The Modigliani-M

Debt vs Equity (conti. . . )

Financial Leverage: the use of financing that has fixed, but

limited, payments.
High earnings relative to debt payments
Low earnings relative to debt payments
Financial Distress: a condition where management makes
decisions under pressure to satisfy its legal obligations to its
creditors.
These decisions may not in the best interest of the company.

Dr. Zulfiqar Hyder ECO562-Financial Economics Semester: Summer 2021

Firm Financing Decisions Debt vs Equity Capital Structure and Financial Leverage Capital Structure and Taxes The Modigliani-M

Debt vs Equity (conti. . . )

Management may and often does choose to make dividend

payments
There is not legal obligation to do so.

Dr. Zulfiqar Hyder ECO562-Financial Economics Semester: Summer 2021

Firm Financing Decisions Debt vs Equity Capital Structure and Financial Leverage Capital Structure and Taxes The Modigliani-M

Debt vs Equity and Tax consideration(conti. . . )

Under US (Pak) Tax law, interest paid on debt is deductible

for tax purposes
Whereas dividend payments are not tax deductible.

Dr. Zulfiqar Hyder ECO562-Financial Economics Semester: Summer 2021

Firm Financing Decisions Debt vs Equity Capital Structure and Financial Leverage Capital Structure and Taxes The Modigliani-M

Debt vs Equity and various debt ratios (conti. . . )

Debt Ratio = Par value of debt / Market value of equity

[shows a use of debt to equity financing]
Debt to Assets Ratio = Par value of debt / Market value of
Total Assets [shows a portion of debt in a company’s capital
structure]

Dr. Zulfiqar Hyder ECO562-Financial Economics Semester: Summer 2021

Firm Financing Decisions Debt vs Equity Capital Structure and Financial Leverage Capital Structure and Taxes The Modigliani-M

Capital Structure and Financial Leverage

Capital Structure Decisions and Risks stemming from the

company’s investment decisions.
Debt and equity financing create different types of obligations
for the company.
Leverage and risks of the earnings available for distributions to
the owners.

Dr. Zulfiqar Hyder ECO562-Financial Economics Semester: Summer 2021

Firm Financing Decisions Debt vs Equity Capital Structure and Financial Leverage Capital Structure and Taxes The Modigliani-M

Example: Capital Structure and Financial Leverage

(conti. . . )

Consider a firm with assets of $ 20 million, all financed with

equity [unleveraged]
1 million shares issued at $ 20 per share
New investment opportunity requiring $ 10 million of new
funds.
Three financing decisions:

Dr. Zulfiqar Hyder ECO562-Financial Economics Semester: Summer 2021

Firm Financing Decisions Debt vs Equity Capital Structure and Financial Leverage Capital Structure and Taxes The Modigliani-M

Example: Capital Structure and Financial Leverage

(conti. . . )

Dr. Zulfiqar Hyder ECO562-Financial Economics Semester: Summer 2021

Firm Financing Decisions Debt vs Equity Capital Structure and Financial Leverage Capital Structure and Taxes The Modigliani-M

Example: Capital Structure, EPS and Financial Leverage

(conti. . . )

Earnings Per Share (EPS) is the ratio of the earnings

available to owner divided by number of shares outstanding

Dr. Zulfiqar Hyder ECO562-Financial Economics Semester: Summer 2021

Firm Financing Decisions Debt vs Equity Capital Structure and Financial Leverage Capital Structure and Taxes The Modigliani-M

Example: Capital Structure, EPS for different ROA and

Financial Leverage (conti. . . )

Dr. Zulfiqar Hyder ECO562-Financial Economics Semester: Summer 2021

Firm Financing Decisions Debt vs Equity Capital Structure and Financial Leverage Capital Structure and Taxes The Modigliani-M

Financial Leverage and Financial Flexibility

Use of debt also reduces a company’s financial flexibility.

A company with unused debt capacity, sometimes referred to
as financial slack, is more prepared to take advantage of
future investment opportunities.
The ability to exploit new strategic investment opportunity is
valuable.
Booth and Cleary (2006) suggests that companies with more
cash flow volatility tend to build up more financial slack.
which allow these companies to exploit investment
opportunities more quickly without need to generate
additional cash flow.

Dr. Zulfiqar Hyder ECO562-Financial Economics Semester: Summer 2021

Firm Financing Decisions Debt vs Equity Capital Structure and Financial Leverage Capital Structure and Taxes The Modigliani-M

Capital Structure and Taxes

The deductibility of interest represents a government subsidy

of debt financing.
Owners benefits from this subsidy as can be seen from return
on equity (ROE) ratio [ratio of earnings available to owners
divided by total equity]: under capital structure A ROE 10%
vs capital Structure C ROE is 14%.
Dr. Zulfiqar Hyder ECO562-Financial Economics Semester: Summer 2021
Firm Financing Decisions Debt vs Equity Capital Structure and Financial Leverage Capital Structure and Taxes The Modigliani-M

The Modigliani-Miller Theorem

Franco Modigliani and Merton Miller (MM) developed a theory

that helps us understand how taxes and financial distress affect a
companys capital structure decision. In an idealized financial
environment, capital structure does not affect the firm’s
market value.

Dr. Zulfiqar Hyder ECO562-Financial Economics Semester: Summer 2021

Firm Financing Decisions Debt vs Equity Capital Structure and Financial Leverage Capital Structure and Taxes The Modigliani-M

Assumptions of the Modigliani-Miller Theorem

Investors have homogeneous expectations regarding future

cash flows.
Bonds and stocks trade in perfect markets.
Investors can borrow and lend at the same rate and they
cannot individually affect ruling market interest rates.
There are no agency costs, no tax advantage and no costs
associated with voluntarily liquidation or bankruptcy.
Investment and financing decisions are independent of one
another.

Dr. Zulfiqar Hyder ECO562-Financial Economics Semester: Summer 2021

Firm Financing Decisions Debt vs Equity Capital Structure and Financial Leverage Capital Structure and Taxes The Modigliani-M

Propositions of the Modigliani-Miller Theorem

MM Proposition I: The market value of a company is not

affected by the capital structure of the company.
Based on the assumptions that there are no taxes, costs of
financial distress, or agency costs, so investors would value
firms with the same cash flows as the same, regardless of how
the firms are financed.
Reasoning: There is no benefit to borrowing at the firm level
because there is no interest deductibility. Firms would be
indifferent to the source of capital and investors could use
financial leverage if they wish.
MM Proposition II: The cost of equity is a linear function
of the companys debt/equity ratio.

Dr. Zulfiqar Hyder ECO562-Financial Economics Semester: Summer 2021

Firm Financing Decisions Debt vs Equity Capital Structure and Financial Leverage Capital Structure and Taxes The Modigliani-M

The Modigliani-Miller Theorem

Dr. Zulfiqar Hyder ECO562-Financial Economics Semester: Summer 2021