3 Capital Structure VGU SUMMER 2023

3 Capital Structure
Prof. Dr. Leef H. Dierks – Corporate Finance – June/July 2023 © VGU (2023) 239
3.1 Capital Structure in a Perfect Market
3.2 Debt and Taxes
3.3 Agency Problems
3.4 Payout Policy
3.1 Capital Structure in a Perfect Market
Equity versus Debt Financing
§ relative proportions of debt, equity, and other securities that
firm has outstanding constitute its capital structure
§ when corporations raise funds from outside investors, they must

choose which type of security to issue
§ most common choices are financing through equity alone and

financing through combination of debt and equity
Financing a Firm with Equity
§ recall that in absence of arbitrage, price of security equals
present value (PV) of its cash flows
§ as firm has no other liabilities, equity holders will receive all of

cash flows generated by an investment project
§ equity in firm with no debt is referred to as “unlevered equity”
§ as there is no debt, cash flows of unlevered equity are equal to

those of an investment project
Financing a Firm with Debt and Equity
§ financing firm exclusively with equity typically is not the only
option
§ equity in firm that also has debt outstanding is referred to as

levered equity
§ recall that payments to debt holders need to be made before

any payments to equity holders are distributed
Financing a Firm with Debt and Equity
!
§ Modiglinani and Miller (1958) argued that with perfect capital
markets, the total value of a firm does not depend on its capital
structure as the firm’s total cash flows still equal the cash flows of
an investment project and therefore have the same present
value (recall the Law of One Price)
Effect of Leverage on Risk and Return
§ in principle, Modiglinani and Miller’s view is against the common
view that even in case of perfect capital markets, leverage would
affect a firm’s value
§ as the debt’s return bears no systemic risk, its risk premium is

zero
§ leverage increases risk of equity even when there is no risk that

firm will default
§ thus, while debt might be cheaper when considered on its own,

it raises the cost of capital for equity
Modigliani-Miller
§ Law of One Price suggests that leverage does not affect total
value of firm!
§ Modigliani and Miller showed that this result generally holds in

perfect capital markets:
Modigliani-Miller
1. investors can trade that same set of securities at competitive

market prices equal to the present value of their future cash
flows;
2. there are no taxes, transaction costs, or issuance costs

associated with security trading;
3. a firm’s financing decisions do not change the cash flows

generated by its investments, nor do they reveal new
information about them.
Modigliani-Miller Proposition I
§ 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
§ Modigliani and Miller (1958) argued that in the absence of taxes

or other transaction costs, the total cash flow paid out to all of a
firm’s security holders is equal to the total cash flow generated
by the firm’s assets
Modigliani-Miller Proposition I
§ thus, according to the law of one price, the firm’s securities and
its assets must have the same total market value
§ as long as the firm’s choice of securities does not change the

cash flows generated by its assets, this decision will not change
the total value of the firm or the amount it can raise
Modigliani-Miller
§ a firm‘s financing choice does not affect its value
§ although debt features a lower cost of capital than equity, this

cost cannot be considered in isolation
§ while debt itself may be cheap, it increases the risk and

therefore the cost of capital of the firm’s equity
§ Modigliani and Miller’s first proposition can be used to derive an

explicit relationship between leverage and the equity cost of
capital
Modigliani-Miller
§ Modigliani and Miller’s first proposition states that
E+D=U=A
§ i.e. the total market value of the firm’s securities is equal to the
market value of its assets, whether the firm is unlevered or
levered
§ by holding a portfolio of the firm’s equity and debt, the cash
flows from holding unlevered equity can be replicated
(E / (E + D)) RE + (D / (E + D)) RD = RU
Modigliani-Miller Proposition II
§ solving for RE leads to the following expression for the return of
levered equity
RE = RU + (D / E) (RU – RD)
§ equation reveals effect of leverage in return of levered equity
§ cost of capital of levered equity increases with the firm’s market

value debt-equity ratio
rE = rU + (D / E) (ru – rd)
Modigliani-Miller
with
E = market value of equity
D = market value of debt
U = market value of equity if firm is unlevered
A = market value of firm’s assets
RE = returns of levered equity
RD = returns of levered debt
RU = returns of unlevered equity
Modigliani-Miller
§ if a firm is financed with both equity and debt, then the risk of its
underlying assets will match the risk of a portfolio of its equity
and debt
§ the appropriate cost of capital for the firm’s assets is the cost of
capital of this portfolio, which corresponds to the weighted
average of the firm’s equity and debt cost of capital
§ this corresponds to the cost of capital of the firm’s unlevered
cost of capital
Modigliani-Miller
§ assuming perfect capital markets, neither taxes nor transaction
costs exist, i.e. the firm’s unlevered cost of capital correspond to
its WACC
rWACC = rU = rA
Modigliani-Miller
§ in other words, with perfect capital markets, a firm’s WACC is
independent of its capital structure and is equal to its equity cost
of capital if it is unlevered, which matches the cost of capital of
its assets
§ although debt has a lower cost of capital than equity, leverage

does not lower a firm’s WACC
§ as a result, the value of the firm’s free cash flow evaluated using
the WACC does not change and so the enterprise value of the
firm does not depend on its financing choices
Modigliani-Miller
§ with perfect capital markets, the firm’s weighted average cost of
capital is unaffected by how the firm chooses to finance the new
investment!
Common Mistake
§ as debt has a lower cost of capital than equity, a common mis-
take is to assume that a firm can reduce its overall WACC by
increasing the amount of debt financing
§ argument ignores fact that even if debt is risk-free and firm will
not default, adding leverage increases the risk of equity
§ given increase in risk, equity holders will demand higher risk

premium and, therefore, higher expected return
§ increase in costs of equity exactly offsets benefit of greater

reliance on cheaper debt capital, so that firm's overall cost of
capital remains unchanged
3.2 Debt and Taxes
Perfect Capital Markets
§ in a perfect capital market, a firm’s choice of capital structure is
unimportant
§ a perfect capital market exists under the following assumptions
1. Investors and firms can trade the same set of securities at

competitive market prices equal to the present value of their
future cash flows
Perfect Capital Markets
2. there are no taxes, transaction costs, or issuance costs
associated with security trading
3. a firm’s financing decisions do not change the cash flows

generated by its investments, not do they reveal new
information about them
§ thus, if capital structure does matter, then it must stem from

market imperfection
Using Leverage to Reduce Taxes
§ one such market imperfection are taxes, e.g. the income tax
corporates or investors have to pay
§ however, a firm can enhance its value by using leverage in an
attempt to minimize the taxes it, and its investors, pay
§ generally, corporations have to pay taxes on the income they
earn
§ as they pay taxes on their profits after interest payments are
deducted, interest expenses reduce the amount of corporate tax
firms must pay
§ this feature of the tax code creates an incentive to use debt
§ at first glance, it might seem odd that a firm can be better off
with leverage even though its earnings are lower
§ yet, the value of a firm is the total amount it can raise from all
investors, not just equity holders
§ as leverage allows the firm to pay out more in total to its

investors (including interest payments to debt holders) it will be
able to raise more total capital initially
§ in general, the gain to investors from the tax deductibility of
interest payments is referred to as the interest tax shield, i.e. the
additional amount that a firm would have paid in taxes in case it
had not had the leverage
interest tax shield = corporate tax rate * interest payments
Valuing Interest Tax Shield
§ in case a firm uses debt, the interest tax shield provides a corporate
tax benefit each year
§ in other words, each year a firm makes interest payments, the cash
flows it pays to investors will be higher than they would be without
leverage by the amount of the interest tax shield, i.e. the cash flows
to investors with leverage equals the cash flows to investors without
leverage plus the interest tax shield
Valuing Interest Tax Shield
§ as cash flows of a levered firm are equal to sum of cash flows from an
unlevered firm plus the interest tax shield, by Law of One Price same
must be true for present value of cash flows
§ total value of levered firm exceeds value of firm without leverage due
to present value of tax savings from debt
Valuing the Interest Tax Shield
§ thus, in the presence of taxes, this leads to the following change
to Modigliani and Miller’s first proposition:
§ total value of the levered firm exceeds the value of the firm
without the leverage due to the present value of the tax savings
from debt
§ in other words, there is an important tax advantage to the use of

debt financing
Valuing the Interest Tax Shield
§ in order to determine the increase in the firm’s total value
associated with the interest tax shield, it needs to be estimated
how a firm’s debt and therefore its interest payments will vary
over time
§ given a forecast of future interest payments, the interest tax

shield and its present value can be determined
3.3 Agency Problems
Agency Costs
§ the capital structure can also alter managers’ incentives and
change their investment decisions
§ if these feature a negative NPV, the decision will be costly for

the firm
§ costs that arise in case of conflicts between stakeholders are

usually referred to as agency costs
Agency Costs
§ in principle, in case a firm has leverage, a conflict of interest
arises if investment decisions have different consequences for
the value of the equity and the value of debt
§ any such conflict is likely to arise in case of financial distress

being high
Asset Substitution Problem
§ generally, when a firm faces financial distress, shareholders can
gain from decisions that increase the risk of the firm sufficiently,
even if they have a negative NPV
§ as leverage gives shareholders an incentive to replace low-risk

assets with riskier ones, this result of often referred to as the
asset substitution problem
Asset Substitution Problem
§ it could also lead to over-investment, as shareholders may gain if
the firm undertakes negative-NPV, but sufficiently risky, projects
§ in either case, if the firm increases risk through a negative-NPV

decision or investment, the total value of the firm will be
reduced
§ anticipating this behaviour, security holders will pay less for the
firm initially
Debt Overhang / Under Investment
§ when a firm is in financial distress, it may choose not to finance
new, positive NPV projects
§ in this case, when shareholders prefer not to invest in a positive

NPV project, there is a so-called debt overhang or under-
investment problem
Debt Overhang / Under Investment
§ this failure to invest is costly for debt holders and for the overall
value of the firm, because it is giving up the NPV of the missed
opportunities
§ the cost is highest for firms that are likely to have profitable
future growth opportunities requiring large investments
Leverage Ratchet Effect
§ when an unlevered firm issues new debt, equity holders will bear
any anticipated agency or bankruptcy costs via a discount in the
price they receive for that debt
§ discount deters from taking on high leverage initially if doing so

would reduce value of the firm
§ once a firm already has debt in place, some of the agency or

bankruptcy costs that result from taking on additional leverage
will fall on existing debt holders
§ as this debt has already been sold, the negative consequences
for these debt holders will not be borne by shareholders
§ thus, shareholders may benefit from taking on higher leverage

even though it might reduce the total value of the firm
§ further, debt overhang will inhibit firms from reducing leverage
once it is in place
§ if the firm tried to buy back debt, existing debt holders will gain
(and debt holders who sell will demand a premium) due to the
reduction in risk, agency costs, and bankruptcy costs associated
with lower leverage
§ leverage ratchet effect captures the observation that, once
existing debt is in place, shareholders may have an incentive to
increase leverage even if it decreases the value of the firm, and
shareholders will not have an incentive to decrease leverage by
buying back debt, even if it will increase the value of the firm
Agency Benefits of Leverage
§ separation of ownership and control creates the possibility of
management entrenchment: facing little threat of being fired
and replaced, managers may take decisions that benefit
themselves at the expense of the investors
§ one advantage of using leverage is that it allows the original

owners of a firm to maintain their equity stake
§ agency costs can arise due to the dilution of ownership that

occurs when equity financing is used
Moral Hazard
§ arises because an individual or institution does not take the full
consequences and responsibilities of its actions, and therefore
has a tendency to act less carefully than it otherwise would,
leaving another party to hold some responsibility for the
consequences of those actions
§ moral hazard may occur where the actions of one party may
change to the detriment of another after a financial transaction
has taken place
Asymmetric Information
§ typically, managers‘ information about the firm and its future
cash flows is likely to be superior to that of outsiders, i.e. there is
asymmetric information between managers and investors
§ Credibility Principle: claims in one’s self-interest are credible

only if they are supported by actions that would bee too costly
to take if the claims were untrue (“actions speak louder than
words”)
§ use of leverage as way to signal good information to investors is

known as the signalling theory of debt
Adverse Selection
§ idea that buyers will be sceptical of a seller‘s motivation for
selling was formalised by George Akerlof
§ George Akerlof, ‘The Market for Lemons: Quality, Uncertainty,

and the Market Mechanism’, Quarterly Journal of Economics 84
(1970): pgs. 488 - 500
!
§ Akerlof showed that if the seller has private information about
the quality of a car, then his desire to sell reveals that the car
probably is of an inferior quality
§ buyers therefore are reluctant to buy - except at heavily

discounted prices
Adverse Selecion
§ owners of high-quality cars are reluctant to sell because they
know buyers will think they are selling lemon and offer only low
price
§ consequently, quality and prices of cars sold in used-car market
are both low
§ result is referred to as adverse selection; quality of cars sold in
used-car market is below average
§ adverse selection leads to the lemons principle: when seller has

private information about value of good, buyers will discount
price they are willing to pay due to adverse selection!
Issuing Equity and Adverse Selection
1. Stock price declines upon the announcement of an equity issue
2. Stock price tends to rise prior to the announcement of an equity

issue
3. Firms tend to issue equity when information asymmetries are

minimized, such as immediately after earnings announcements
Implications for Capital Structure
§ as managers find it costly to issue equity that is undervalued,
they may seek alternative forms of financing
§ while debt issues may also suffer from adverse selection, degree
of under-pricing will tend to be smaller for debt than for equity
§ firm can avoid under-pricing altogether by financing investment

using its cash (retained earnings) when possible
§ managers who perceive firm‘s equity to be undervalued will have

preference to fund investment using retained earnings, or debt,
rather than equity (“pecking order hypothesis”)
3.4 Payout Policy
Cash Dividend versus Stock Repurchase
Cash Dividend
§ dividends are rarely cut back, managers do not increase

dividends unless confident that dividend can be maintained
Stock Repurchase
§ repurchases are more flexible and repurchases are tax-

advantaged
Example: Dividends
„A rebalancing of a grossly unequal relationship is one reason Tesco says its
full-year trading profit to February will not exceed £1.4bn. This compares with
guidance of £2.4bn-2.5bn in August, a current City consensus of £1.8bn-
£2.2bn, and a figure of £3.3bn for 2013-2014.
Mr Lewis cut the dividend by three-quarters to 1.16p at the interim stage. He

has little choice but to cut or pass the final dividend, too.
This stood at 10.13p last year – when dividends costing £1.2bn already looked
unsustainable against free cash flow of £455m, according to S&P CIQ.“
Source: Financial Times, December 9th, 2014
Dividend Payments
Cash Dividend
§ Payment of cash by firm to shareholders
Ex-Dividend Date
§ Date that determines when stockholder is entitled to dividend
payment
Record Date
§ Person who owns stock on this date receives dividend
Dividend Payments
Stock Dividend
§ Distribution of additional shares to firm’s stockholders
Stock Splits
§ Issue of additional shares to firm’s stockholders
Stock Repurchase
§ Firm buys back stock from its shareholders

Types of Dividends
§ Cash Dividend
§ Regular Cash Dividend
§ Special Cash Dividend
§ Stock Dividend
Types of Dividends
§ Stock Repurchases
1. Buy Shares on Market
2. Tender Offer to Shareholders
3. Dutch Auction
4. Private Negotiation (greenmail)
Information Content of Payout Decision
§ managers are reluctant to make dividend changes that may be
reversed
§ managers worry about rescinding dividend increases and raising

new funds to maintain payout
§ to avoid risk of reduction in payout, managers “smooth” dividends
§ dividend changes follow shifts in long-run sustainable earnings
Information Content of Payout Decision
§ transitory earnings changes unlikely to affect dividend payouts
§ managers focus on dividend changes over absolute levels
§ paying a dividend of €2.00 per share is important if last year's

dividend was €1.50
§ paying a dividend of €2.00 is not important if last year's dividend

was €2.00
Information Content of Dividends
§ dividend stock repurchase decisions contain information
§ information contained in decisions vary
§ asymmetric information may be conveyed
§ dividend increases could mean overpriced stock or increased

future profits
§ signal varies based on prior information about company
Information in Payouts
Varying attitudes toward dividend targets
DIV1 = target dividend = target ratio x EPS1
Dividend change
DIV1 – DIV0 = target change = target ratio × EPS1 – DIV0
Dividend changes confirm the following

DIV1 – DIV0
= adjustment rate × target change
= adjustment rate × target ratio × EPS1 – DIV0
Dividends or Repurchases?
Important Repurchases
§ calculate Market Capitalization
§ done by forecasting and discounting free cash flow paid to
shareholders
§ to calculate share price, divide market capitalization by number
of outstanding shares
§ calculate Value of Dividends Per Share

§ account for increased dividend growth rate per share
§ caused by declining number of shares as shares are repurchased
Dividend Theories
Leftists
§ Dividends do not affect value
Rightists
§ Dividends increase value
Middle of Roaders
§ Leftist theory with some reality thrown in
The Leftists
§ “dividend policy is irrelevant”
§ “investors do not need dividends to convert shares to cash”
§ “they will not pay higher prices for firms with higher dividend
payouts”
§ “dividend policy will have no impact on value of firm”
The Rightists
Market Imperfections Clientele Effect
§ natural clients high-payout stocks
§ “firms cannot benefit by increasing dividends”
§ high-dividend clientele have several high-dividend stocks to

choose from
§ clients increase price of stock through demand for dividend-

paying stock
The Rightists
§ dividends increase value
§ dividend increases send good news about cash-flow earnings
§ dividend cuts send bad news
§ high-dividend payout policy will be costly to firms that do not

have cash flow to support it
§ dividend increases signal company’s good fortune
§ increase in manager’s confidence in future cash flow
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3 Capital Structure

§ when corporations raise funds from outside investors, they must

§ most common choices are financing through equity alone and

§ as firm has no other liabilities, equity holders will receive all of

§ equity in firm with no debt is referred to as “unlevered equity”

§ as there is no debt, cash flows of unlevered equity are equal to

§ equity in firm that also has debt outstanding is referred to as

§ recall that payments to debt holders need to be made before

§ as the debt’s return bears no systemic risk, its risk premium is

§ leverage increases risk of equity even when there is no risk that

§ thus, while debt might be cheaper when considered on its own,

§ Modigliani and Miller showed that this result generally holds in

1. investors can trade that same set of securities at competitive

2. there are no taxes, transaction costs, or issuance costs

3. a firm’s financing decisions do not change the cash flows

§ Modigliani and Miller (1958) argued that in the absence of taxes

§ as long as the firm’s choice of securities does not change the

§ although debt features a lower cost of capital than equity, this

§ while debt itself may be cheap, it increases the risk and

§ Modigliani and Miller’s first proposition can be used to derive an

§ equation reveals effect of leverage in return of levered equity

§ cost of capital of levered equity increases with the firm’s market

§ although debt has a lower cost of capital than equity, leverage

§ given increase in risk, equity holders will demand higher risk

§ increase in costs of equity exactly offsets benefit of greater

§ a perfect capital market exists under the following assumptions

1. Investors and firms can trade the same set of securities at

3. a firm’s financing decisions do not change the cash flows

§ thus, if capital structure does matter, then it must stem from

§ as leverage allows the firm to pay out more in total to its

interest tax shield = corporate tax rate * interest payments

§ in other words, there is an important tax advantage to the use of

§ given a forecast of future interest payments, the interest tax

§ if these feature a negative NPV, the decision will be costly for

§ costs that arise in case of conflicts between stakeholders are

§ any such conflict is likely to arise in case of financial distress

§ as leverage gives shareholders an incentive to replace low-risk

§ in either case, if the firm increases risk through a negative-NPV

§ in this case, when shareholders prefer not to invest in a positive

§ discount deters from taking on high leverage initially if doing so

§ once a firm already has debt in place, some of the agency or

§ thus, shareholders may benefit from taking on higher leverage

§ leverage ratchet effect captures the observation that, once

existing debt is in place, shareholders may have an incentive to

increase leverage even if it decreases the value of the firm, and

shareholders will not have an incentive to decrease leverage by

§ one advantage of using leverage is that it allows the original

§ agency costs can arise due to the dilution of ownership that

§ Credibility Principle: claims in one’s self-interest are credible

§ use of leverage as way to signal good information to investors is

§ George Akerlof, ‘The Market for Lemons: Quality, Uncertainty,

§ buyers therefore are reluctant to buy - except at heavily

§ adverse selection leads to the lemons principle: when seller has

2. Stock price tends to rise prior to the announcement of an equity

3. Firms tend to issue equity when information asymmetries are

§ firm can avoid under-pricing altogether by financing investment

§ managers who perceive firm‘s equity to be undervalued will have

§ dividends are rarely cut back, managers do not increase