MONASH

BUSINESS
SCHOOL

BFF2140
CORPORATE FINANCE I

Joshua Shemesh
 MONASH
BUSINESS
SCHOOL

Teaching Week Eleven

Capital Structure

Readings
Chapter 16, pp. 463-492
Additional Readings (available on Moodle)
Brigham and Ehrhardt: Chapter 17 pp. 663 – 671, and pp. 678-682
 MONASH
BUSINESS
SCHOOL

Learning Objectives

1. Leverage and the risk of the firm’s equity

2. Capital Structure
3. Capital Structure Theory:
1958 MM Propositions (without taxes)
1963 MM Propositions (with tax benefit)
4. Bankruptcy and financial distress costs
5. Agency costs
6. The optimal mix of debt and equity trades off
the costs and benefits of debt
 1. LEVERAGE

 Results from use of fixed-cost assets or funds to magnify returns to

the firm’s owners.

 The extent of leverage in a firm is positively associated with

financial risk and potential return.

 Capital restructuring involves changing the amount of leverage (L)

without changing the amount of assets (A).

↑LEVERAGE by issuing debt and repurchasing shares (↓E)

↓LEVERAGE by issuing new shares (↑E) and retiring debt
LEVERED AND UNLEVERED FIRMS

Value of the firm = value of debt + value of equity

BUT not all firms have both debt AND equity

Some firms are 100% equity firms
 These are called unlevered firms.

Most firms have a mix of equity AND debt

 These are called levered firms.

The term “levered” is thus given to a firm that has some

debt → we will now see that by adding debt we increase
the financial leverage (or risk) of a firm.
BUSINESS RISK

 Business Risk stems from uncertainty about future operating

income (EBIT).
 It depends on how accurately operating income is predicted.

• Business risk is affected mainly by business operations:

- Uncertainty about demand (sales)
- Uncertainty about output prices
- Uncertainty about costs
- Product & other types of liability
FINANCIAL RISK

 In the case of bankruptcy debt holders have a prior claim on

the cash flows of the firm. Equity holders have a residual
claim.

 The more debt in the firm’s capital structure, the higher the
financial leverage of the firm.

 Financial risk is the additional risk concentrated on ordinary

shareholders as a result of financial leverage.

Financial Risk depends only on the capital structure mix

• the more debt is issued: the greater the financial risk.
THE CAPITAL-STRUCTURE QUESTION
AND THE PIE THEORY
Value of Firm (VCompany) = Value of Assets (VAssets)
Value of Firm = Value of Debt (D) + Value of Equity (E)
V = Debt + Equity = D + E
To maximise the value of the firm we need to pick the
combination of debt (D) and equity (E) that maximises
the size of the pie (the value of the firm).

E
S D The question is therefore: “What ratio
of debt to equity maximises the size
of the pie (and thus maximises
shareholder value)?”
 EFFECT OF LEVERAGE ON
ROA, ROE & EPS
ROA = Return on Assets; ROE = Return on Equity; EPS = Earnings Per Share

Consider an unlevered firm that is considering

introducing debt in its capital structure.
Current Proposed
Assets $20,000 $20,000
Debt $0 $8,000
Equity $20,000 $12,000
Debt/Equity ratio 0 2/3
Interest rate n/a 8%
Shares outstanding 400 240
Share price $50 $50

Scenario: The firm borrows $8,000 and buys back 160 shares at $50 per share
 ROA

• In an unlevered firm, cash flows to equity equal the free cash flows
from the firm’s assets

• In a levered firm, the same cash flows are divided between debt and
equity holders

• The total to all investors equals the free cash flows generated by the
firm’s assets

• ROA is unaffected by leverage, but fluctuates with the state of the

economy

• Assume ROA can be either 5, 10 or 15%

EPS & ROE UNDER BOTH
CAPITAL STRUCTURES
UNLEVERED
Recession Expected Expansion
EBIT $1,000 $2,000 $3,000
Interest 0 0 0
Net income $1,000 $2,000 $3,000
EPS = earnings per share $2.50 $5.00 $7.50
ROE = return on equity = NI/E 5% 10% 15%

Current Shares Outstanding = 400 shares

LEVERED
Recession Expected Expansion
EBIT $1,000 $2,000 $3,000
Interest (8% * $8000) $640 $640 $640
Net income $360 $1,360 $2,360
EPS $1.50 $5.67 $9.83
ROE 3% 11% 20%

Proposed Shares Outstanding = 240 shares

The effect of economic conditions on ROE & EPS is exacerbated by leverage.

2. Capital Structure

 Capital Structure refers to the way in which the companies

assets are financed (excluding current liabilities).

 Debt capital generally requires a lower return than equity

capital since debt-holders have the first claim in bankruptcy
and can exert greater legal pressure against the company.

 It is important since it influences cost of capital and as such

the NPV of potential projects.
3. Capital Structure Theory

 Miller and Modigliani wrote a paper in 1958 entitled “The cost

of capital, corporate finance and the theory of investment”.

 They make 3 propositions in regards to capital structure and its

effect on the value of the firm, in a world without taxes.

 In 1963 they published a second paper which introduces

corporate tax and relaxes a number of the assumptions made in
their first paper. They reassess their propositions from 1958 with
these relaxed assumptions.

 They use the concept of homemade leverage to prove their

propositions.
HOMEMADE LEVERAGE

What does the term homemade leverage mean?

 homemade leverage is the use of personal borrowing of investors

to change the amount of financial leverage of the firm. Investors
can use homemade leverage to change an unleveraged firm into a
leveraged firm

Now Consider two Firms: They generate the same operating

income and only differ via their capital structure.

One Levered (Firm L) One unlevered (Firm U)

 Recall EL = VL – DL
HOMEMADE LEVERAGE:
EXAMPLE

First case:
You want to magnify business risk
HOMEMADE LEVERAGE:
EXAMPLE (Continued)
Option One: Buy 1% of Firm L’s shares

Option Two: Borrow 1% on your own account and

purchase 1% of stock in Firm U

Both Strategies offer the same payoff

HOMEMADE LEVERAGE:
EXAMPLE (Continued)
make use of information about firms U and L in slide 9 onwards
Additionally: Assume EBIT = Profit (used below) = $2000.00
Option One: Buy 1% of Firm L’s shares

Option Two: Borrow 1% on your own account and

purchase 1% of stock in Firm U

Both Strategies offer the same payoff

HOMEMADE LEVERAGE

Second case:
You do not want to expose yourself to financial risk
HOMEMADE LEVERAGE:
EXAMPLE
Option One: Buy 1% of Firm U’s shares

Option Two: Buy 1% of both debt and equity in Firm L

Both Strategies offer the same payoff

HOMEMADE LEVERAGE:
EXAMPLE (Continued)
make use of information about firms U and L in slide 9 onwards
Additionally: Assume EBIT = Profit (used below) = $2000.00

Option One: Buy 1% of Firm U’s shares

Option Two: Buy 1% of both debt and equity in Firm L

Both Strategies offer the same payoff

HOMEMADE LEVERAGE

 With homemade leverage we can make the risk of the investment in

the levered firm the same as the risk of the investment of the
unlevered firm.
- To do this we need to remove financial risk (lend money)

 In both cases, the two strategies are perfect substitutes for each other

 This is the fundamental insight of M&M

 MM 1958 - ASSUMPTIONS

1. No taxes

2. Homogenous expectations of the firm’s future EBIT

3. Homogenous business risk classes exist across firms

- i.e. all firms in each class choose the same projects and generate the
same operating income and only differ in their capital structure

4. All cash flows are perpetual and all earnings are paid out as dividends

5.Perfect capital markets

- i.e. perfect competition, no transaction costs, investors &
corporations can borrow & lend at the same rate
 PROPOSITION I - 1958

The value of the firm is independent of its capital

structure.
VL = VU

VL = Value of levered firm (EL+DL)

VU = Value of unlevered firm (EU)

Implication:
 Changing the mix of debt and equity financing (capital
structure) does not affect the value of the firm.
 PROPOSITION II - 1958

The cost of equity of a levered firm is equal to:

(a) the cost of equity of the unlevered firm in the same risk class plus
(b) a risk premium
rE = rU + (D / E) (rU - rd)

rE is the return on (levered) equity (cost of equity)

rU is the return on unlevered equity (cost of capital)
D is the value of debt
E is the value of levered equity
rd is the interest rate (cost of debt)
 PROPOSITION II - 1958

Implication:
 Leverage increases the risk and return to shareholders

How does capital structure affect the cost of equity capital

for a levered firm?

• An increase in leverage increases the cost of equity of the firm

• Cost of equity capital for a levered firm (rE) equals:
 business risk or the underlying risk of the asset (rU) PLUS
additional risk due to leverage (D / E) (rU - rd)
 PROPOSITION III - 1958

Discount rate for NPV will be completely unaffected by the capital

structure of the firm

WACCU = WACCL

Implication:
 An increase in leverage does not affect the discount rate used for a
project.
The Cost of Equity, the Cost of Debt, and the Weighted Average Cost of Capital:
MM Proposition II with No Corporate Taxes
Cost of capital: r (%)

rE = rU + (D / E) (rU - rd)

D E
rE rWACC   rD   rE
V V

rd

D
Debt-to-equity Ratio
E
MM 1963 - ASSUMPTIONS

New assumptions:
1. There are corporate taxes and
2. Debt interest is tax deductible

Note: personal tax is ignored and all other assumptions

from 1958 hold.
 MM 1963 – PROPOSITION I

Firm value increases with leverage

VL = VU + TD

Implication:
The value of the levered firm is equal to:
(a) The value of an unlevered firm in the same risk class
PLUS
(b) The gain from leverage
• This is the value of interest tax shield and is calculated as tax rate (T)
times debt (D) also known as tax shield =TD
• With permanent debt, the present value of the stream of future interest tax
shields is
=PV(T ∙ Future Interest Payments)
=T ∙ PV(Future Interest Payments)
=T ∙ D
LEVERED VS UNLEVERED FIRM

 The value of the levered firm is higher because a smaller piece of

the pie is “lost” to tax.
 Tax saving associated with debt is realised as long as interest is
paid on the firms debt.
MM (1963) – Proposition I

Value of firm (V) Value of firm under

MM with corporate
Present value of tax taxes and debt
shield on debt
VL = VU + TD

VU = Value of firm with no debt

0 Debt – Equity Ratio

(D/E)
 MM 1963 - PROPOSITION II

 Some of the increase in equity risk and return is offset

by the interest tax shield
rE = rU + (D / E) (rU - rd)(1-T)

Implication:
The cost of equity of a levered firm is equal to
(a) the cost of equity of an unlevered firm in the same risk class PLUS
(b) a risk premium to compensate financial risk: The risk premium is less
in a tax world due to tax savings than in a no tax world.
 MM 1963 - PROPOSITION III

 With the introduction of tax, there is now an additional

advantage to gearing-up: the tax relief obtained on the debt
interest.
 Thus weighted average cost of capital (rWACC) becomes

rWACC  ( D / V )(rD )(1  T )  ( E / V ) rE

Implication:
o The more highly geared the company becomes, the more tax relief
it obtains and the smaller its tax liability.
o In a world with tax relief on debt interest we would expect a
company’s after tax WACC to be progressively lowered as it
increases its gearing.
MM 1963 – PROPOSITION II & III

Cost of capital: rE (%) rE = rU + (D / E) (rU – rd) (MM II, 1958)

rE = rU + (D / E) (rsU - rd)(1-T) (MM II, 1963)

rE

rWACC  ( D / V )(rD )(1  T )  ( E / V )rE

Debt-to-equity ratio (D/E)

BEYOND MM

 M&M suggest financial leverage does not matter, or imply

that taxes cause the optimal financial structure to be 100%
debt.

 In practice, most executives do not like a capital structure of

100% debt because that is a state known as “bankruptcy”.
 With more debt, there is a greater chance that the firm will default on
its debt obligations
 A firm that has trouble meeting its debt obligations is in financial
distress
4. BANKRUPTCY COSTS
 Debt provides tax benefits but puts pressure on the firm - Why?
 Interest and Principal payments are obligations & if not met, might
result in bankruptcy
 Bankruptcy costs thus tend to offset the advantages of having debt

Example:

Firms A and B plan to be in business for one more year. They

forecast a cashflow of either $100,000 or $50,000 in the coming
year, each occurring with 50% probability. The firms have no
other assets. Previously issued debt requires payments of $49,000
of interest and principal in Firm A. Previously issued debt requires
payments of $60,000 of interest and principal in Firm B. Assume
that stockholders and bondholders are risk neutral and expect 10%
return. Show the impact of bankruptcy costs.
BANKRUPTCY COSTS

Example:
Firm A
Boom Recession
Cash Flow $100,000 $50,000
Probability of event. 0.5 0.5
Debt (Int. + Principal) $49,000 $49,000

Firm B
Boom Recession
Cash Flow $100,000 $50,000
Probability of event. 0.5 0.5
Debt (Int. + Principal) $60,000 $60,000
PV of expected cashflows:

Value of the firm $68,181.82

 BANKRUPTCY COSTS

 If the cash flow is only $50,000 bondholders will be informed

that they will not be paid in full.

 These bondholders are likely to hire lawyers to negotiate or even

sue the company.

 The firm is likely to hire lawyers to defend itself.

 BANKRUPTCY COSTS

Consider Firm B (Assume legal costs = $10,000)

 INDIRECT COSTS

 Difficult to measure accurately, and often much larger than the

direct costs of bankruptcy. Examples:
 Customers may be unwilling to purchase products whose value depends
on future support or service from the firm
 Suppliers may be unwilling to provide a firm with inventory if they fear
they will not be paid

 Many indirect costs may be incurred even if the firm is not yet in
financial distress, but simply faces a significant possibility that it
may occur in the future
 The present value of financial distress costs depends on the
likelihood that a firm will default
BANKRUPTCY COSTS

 The possibility of bankruptcy has a negative effect on the

value of the firm.
 It is not the risk of bankruptcy itself that lowers the value
but the cost (in expectation) associated with bankruptcy.
WHO BEARS THE COSTS OF POTENTIAL FUTURE
BANKRUPTCY?
Shareholders: debtholders will require higher interest rates to
reflect the likelihood of default. The higher interest payments
reduce earnings left for shareholders.
5. AGENCY COSTS & SELFISH
STRATEGIES

When a firm has debt, conflicts of interest arise between

shareholders and bondholders. These conflicts of interests
(called AGENCY COSTS), are magnified when financial
distress is incurred.

Why? Agency costs tempt shareholders to become involved in

selfish strategies.
• managers may take actions that benefit shareholders but harm
creditors and lower the total value of the firm
• most likely to occur when the risk of financial distress is high

Examples:
1. Overinvestment in risky projects (aka asset substitution)
2. Underinvestment (aka debt overhang)
3. Milking the property (aka illegal dividends)
INCENTIVE TO TAKE LARGE RISK

Consider two mutually exclusive projects, a low risk one and high risk
one. There are two equally likely outcomes, recession and boom.
Previously issued debt requires a payment of $100,000 of interest and
principal.

Value of the firm if the low risk project is accepted

Market Outcome Prob. Value of firm (V)
Recession 0.5 $100,000
Boom 0.5 $200,000

Value of the firm if the high risk project is accepted

Market Outcome Prob. Value of firm (V)
Recession 0.5 $50,000
Boom 0.5 $240,000
INCENTIVE TO TAKE LARGE RISK

- Stockholders will select the high risk project, even if it means

accepting a negative NPV project

Expected value of the firm if the low risk project is accepted = $ 150,000
Prob. Stocks Bonds EV(S) EV(B)
Recession 0.5 $0 $100,000 $0 $50,000
Boom 0.5 $100,000* $100,000 $50,000 $50,000
$50,000 $100,000
*V – D (previous slide)

Expected value of the firm if the high risk project is accepted = $ 145,000
Prob. Stocks Bonds EV(S) EV(B)
Recession 0.5 $0 $50,000 $0 $25,000
Boom 0.5 $140,000* $100,000 $70,000 $50,000
$70,000 $75,000
*V – D (previous slide)
Note: EV refers to expected value
INCENTIVE TOWARD
UNDERINVESTMENT
Stockholders of a firm with a significant probability of bankruptcy
often find that new investment helps the bondholders at the
stockholders expense.

As investments are mainly funded through shareholders, yet benefit

bondholders directly (through increased cash flow) shareholders might
be tempted to reject some positive NPV projects.

Example:

Consider a firm with a $40,000 payment of principal and interest due at the end of the year.
It will be pulled into bankruptcy by a recession because its cashflow will be only $24,000 in
that state. The firm could avoid bankruptcy in a recession by raising new equity to invest in
a new project. The project costs $10,000.
INCENTIVE TOWARD
UNDERINVESTMENT
Relevant cash flow:
Without Project With Project
Boom Recession Boom Recession
CF $50,000* $24,000 $67,000* $41,000*
BH $40,000 $24,000 $40,000 $40,000
SH $10,000 $0 $27,000 $1,000
*Additional Funds: Not given directly in the example in previous slide.

Expected value of shareholders’ interest without investment

= 0.5 x $10,000 + 0.5 x 0 = $5,000
Expected value of shareholders’ interest with investment
= 0.5 x $27,000 + 0.5 x $1,000 = $14,000
The shareholders’ interest rises only by $9,000 while costing $10,000.
Stockholders will not accept this project.
MILKING THE PROPERTY

 To pay out extra dividends in times of financial distress,

equity is withdrawn through dividend payments.

 There is thus less left for bondholders, who have the first
claim to the assets in case of bankruptcy.
CAN COSTS OF DEBT BE REDUCED?

 Because stockholders must pay higher interest rates as insurance

against their own selfish strategies, they frequently make
agreements with bondholders in the hope of lower rates.

 These agreements are called protective covenants and they are

incorporated into the loan document (or indenture) between
shareholders & bondholders.
6. Optimal Capital Structure

Bankruptcy

Tax Bondholders

Shareholders

 There is a trade-off between the tax advantage of debt and the

costs of financial distress.
 This is often called the static trade-off theory of capital
structure.
 Integration of Tax Effects and Financial
Distress Costs

Value of firm (V) Value of firm under

MM with corporate
Present value of tax taxes and debt
shield on debt
VL = VU + TD

Maximum Present value of

firm value financial distress costs
V = Actual value of firm
VU = Value of firm with no debt

0 Debt (D)
D*
Optimal amount of debt
It is difficult to express the optimal level of debt with a precise and rigorous formula.
EXAMPLE (in your own time)

Nostradamus Inc. is unlevered and is valued at $820,000.

Nostradamus Inc. is currently deciding whether including debt in
its capital structure would increase its value. The current cost of
equity is 14%. Under consideration is issuing $300,000 in new debt
with an 10% interest rate. Nostradamus Inc. would repurchase
$300,000 of stock with the proceeds of the debt issue. There are
currently 55,000 shares outstanding and effective marginal tax
bracket is 30%. Given the proposed changed in capital structure
clearly identify the following

a) what will be the new value of the firm?

b) what will be the new cost of equity?
c) what will be the new WACC?
EXAMPLE (solution)

a) Value of levered firm:

VL = VU + D * Tc
= $820,000 + ($300,000)*(0.30) = $910,000
b) New value of equity of levered firm
EL = VL – D = 910,000 – 300,000 = $610,000
Using proposition 2, MM 1963:
rE = 0.14 + (300/610)*(0.14 - 0.10)*(1 - 0.30)
= 0.15377 or 15.38%
c) WACC = (300/910)*(0.10)*(1 - 0.30) + (610/910)*(0.15377)
= 12.62%
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