FINANCE 601, Introduction to Finance

Chapter 11, Capital Structure: The Key Issues

Clarence C.Y. Kwan, November 13, 2022

Business Risk and Financial Risk

The higher the …xed cost, the higher is a …rm’s business risk.

The higher a …rm’s …nancial leverage, the higher is the …rm’s …nancial risk.

(Financial leverage is about the use of debt for …nancing a …rm’s project.)

Impact of Financial Leverage on the Firm’s Earnings per Share

The higher the …nancial leverage, the more volatile is a …rm’s EPS.

In response to an increase in the …nancial leverage, shareholders’required return will increase.

The Modigliani-Miller (MM) Theory of Capital Structure

If there is NO corporate tax, the value of a …rm is una¤ected by its …nancial leverage. The
…rm’s weighted average of capital (WACC) is also una¤ected by its …nancial leverage.

If there is corporate tax, the value of a …rm increases with its …nancial leverage. The …rm’s
WACC will decrease with increasing …nancial leverage.

In both cases, with debt treated as risk-free, an increase in the debt/equity ratio will lead to
an increase in the required return for investing in the …rm’s stock.

In the latter case, the required return for investing in the …rm’s stock will increase at a lower
rate due to tax bene…ts from interest payments to bondholders.

The …rm’s investment decisions can be explained in the MM framework.

Violations of the MM results will lead to arbitrage opportunities.

The Modigliani-Miller (MM) Theory of Capital Structure in a CAPM Framework

The use of the CAPM allows the risk in equity investments to be captured.

If debt is risk-free, the same conclusions from the MM theory can be retained.

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If debt is NOT risk-free when it reaches a certain level, bondholders’ required return will
increase. Issues such as limited liability of shareholders and risk sharing between bondholders
and shareholders need to be considered as well. Given limited liability for shareholders, the
increase in shareholders’required return in response to an increase in …nancial leverage will
be at a lower rate as soon as debt becomes risky.

Is There an Optimal Capital Structure?

To answer this question, issues such as industrial practice, stability or volatility of a …rm’s
earnings, debt capacity, risk of bankruptcy and bankruptcy costs, and principal-agent prob-
lems need to be considered.