Chapter 6

Capital Structure
Basic Concepts

Chapter 6 - Capital Structure 1

 Chapter Outline

Capital Structure Policy

• Traditional View to Capital Structure
• Modigliani and Miller (MM) Propositions (No Taxes)
• Modigliani and Miller Propositions (With Taxes)
• High Gearing Problems
– Description of Financial Distress
– Cost of Financial Distress
• Pecking Order Theory
– Rules of Pecking Order Theory
– Implications Associated with Pecking Order Theory

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 Part 1
A WORLD WITHOUT TAXES

Chapter 6 - Capital Structure 3

 The Capital-Structure Question and The Pie Theory

1. The value of a firm is the sum of the value of the financial

claims of the firm i.e. firm’s debt and the firm’s equity.
V = B (debt) + S (equity) Theofmarket value
the equity
The market value
of the debt

If the goal of the management of

the firm is to make the firm as
valuable as possible, then the
S B
firm should choose the debt-
equity ratio that makes the value
as large as possible.

How should a firm choose its debt-equity

ratio? Value of the Firm (V)

Chapter 6 - Capital Structure 4

 The Capital-Structure Question
There are 2 important questions:
1. Why should the stockholders care about
maximizing firm’s value? Perhaps they should be
interested in strategies that maximize shareholders’
value.
2. What is the ratio of debt-to-equity that maximizes
the shareholders’ value?

Chapter 6 - Capital Structure 5

 To answer the 1st question:
 Suria Company: Market Value – RM1,000 (all equity)
consists of 100 shares of stock which sells for RM10
each. Plans to borrow RM500 and pay the RM500 to
shareholders as cash dividend
What is the value of the firm after proposed
restructure?
 3 possible outcomes:
RM1,250
i. Firm value after restructure > original value
ii. Firm value after restructure = original value RM1,000

iii. Firm value after restructure < original value RM750

iv. Restructuring will not change the firm value

v. ** Management believes restructuring will not change firm value more
than RM250 in either direction.
Chapter 6 - Capital Structure 6
 To answer 1st question:
Before Restructuring After Restructuring
I II III
B RM0 RM500 RM500 RM500
S RM1000 RM750 RM500 RM250
V RM1000 RM1,250 RM1000 RM750

Payoff To Shareholders after Restructuring

I II III
The outcome 1 is most likely.
Although the price of the stock
Dividend RM500 RM500 by RM500
declines RM250, the
shareholders received RM500
Capital Gain/Loss (RM250) (RM500)
dividends, net gain(RM750)
of RM250 and
the value of the firm rise by
Gain/Loss to s/h RM250 RM250.
RM0 (RM250)

Conclusion: Capital structure benefit the shareholders if the

value of the firm increases. Chapter 6 - Capital Structure 7
 Financial Leverage and Firm Value: To see how
leverage affects firm’s value and its cost of capital

Consider an all-equity firm proposes to issue debt to

buy back some of its equity
Current Proposed
AssetsRM8,000,000RM8,000,000
Debts 0 RM4,000,000
Equity RM8,000,000
RM4,000,000
Interest 10% 10%
Shares outstanding
200,000
400,000
Share price RM20 RM20

Chapter 6 - Capital Structure 8

 EPS and ROE Under All Equity Capital Structure
(No Debt - Unlevered)

Recession Expected Expansion

EBIT RM400,000 RM1,200,000 RM2,000,000
Interest 0 0 0______
EAI RM400,000RM1,200,000 RM2,000,000
EPS RM1.00 RM3.00 RM5.00
ROA 5% 15% 25%
ROE 5% 15% 25%
Current Shares Outstanding = 400,000 shares

EPS = EAI / # of shares ROA = EBI / Total Assets

ROE = EAI / Total equity

Chapter 6 - Capital Structure 9

 EPS and ROE Under Levered Capital Structure
(With Debt - levered)

Recession Expected Expansion

EBIT RM400,000 RM1,200,000 RM2,000,000
Interest 400,000 400,000 400,000
EAI RM0 RM800,000 RM1,600,000
EPS RM0 RM4.00 RM8.00
ROA 0% 15% 25%
ROE 0% 20% 40%
Proposed Shares Outstanding = 200,000 shares

Chapter 6 - Capital Structure 10

 EPS and ROE Under Both Capital Structures
1. Under all equity capital structure, EPS is between RM1.00
and RM5.00
2. Under the levered capital structure, EPS is between RM0
and RM8.00
3. EPS under expected condition is higher in a levered
company than in an all equity company (unlevered). It
implies that the expected return rises with leverage (MM
Prop II: No Taxes) because levered firm has fewer shares than
unlevered.
4. EPS and ROE are higher when EBIT is high and lower
when EBIT is low.
5. The effect of financial leverage depends on EBIT
6. Financial leverage increases ROE and EPS when EBIT is
greater than the break-even point
7. The variability of EPS and ROE is increased with leverage
Chapter 6 - Capital Structure 11
 Financial Leverage and EPS: Expected Return rises
with leverage because risk of equity increases with
leverage (Refer to Figure 6.2 – page 195)
EPS 6.00
Imply that higher
5.00 financial leverage Debt
increases the sensitivity
4.00 of EPS to EBIT No
The levered Debt
firms have Advantage to
3.00 Break-even
better return debt
after BEP & in point
good times. 2.00
The unlevered
firms have
1.00
800,000
better return
before BEP & in 0.00
worse time. Disadvantage to 1.2m 2.0m
debt EBIT in RM, no taxes
(2.00)
Chapter 6 - Capital Structure 12
 Financial Leverage and EPS
i. At the BEP, EPS and ROE are the same under both capital
structure.
ii. If EBIT is below the BEP, then the lower financial leverage
will result in a higher EPS and vice versa.
 Conclusion: Equity holders bear more risk with the
proposed capital structure.
 EPS = EBIT – Interest = EBIT – 400,000
400,000 200,000
EBIT = 800,000, if levered interest is RM400,000 if unlevered interest is 0
 The “optimal” or “target” capital structure is the debt/equity
mix that simultaneously
(a) maximizes the value of the firm
(b) minimizes the WACC, and
(c) maximizes the market value of the common stock.

Chapter 6 - Capital Structure 13

 The Modigliani & Miller (MM) Prop I & II
CAPM Assumptions
(a) Well-diversified investors

(b) Perfect capital market exists:

o Investors have the same information
o Upon which they act rationally
o To reach the same views about future earnings and risks

(c) Unrestricted borrowing or lending at the risk-free rate of interest

(d) Uniformity of investor expectations
(e) All forecasts are made in the context of one time period only.
(f) There are no tax or transaction costs.
(g) Debt is risk-free and freely available at the same cost to investors and
companies alike.
(h) Borrowing is moderate levels.

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 To answer Q2:MM Proposition 1
i. Assuming investors can borrow at the same interest as the
firm
ii. 3 investors with 3 different strategies:
Outcome
Buy 15% of unlevered firm Initial Inv. Payoff
SI which generates Earn per 0.15V 0.15 E
year. Value of firm = VU u

SII Buy 15% stock of levered 0.15SL 0.15(E – I)

firm. Value of firm:
VL = SL + BL
SIII Buy 15% of unlevered firm 0.15Vu -0.15BL 0.15E – 0.15I
using personal borrowings 0.15 (E – I)
of 0.15BL plus own capital
Chapter 6 - Capital Structure 15
 To answer Q2:MM Proposition 1
a) Compare SII and SIII = same payoff.
b) If the payoff is the same, the initial investment must
also be the same
 0.15SL = 0.15Vu – 0.15BL
 0.15 SL + 0.15BL = 0.15 Vu
 0.15(SL + BL) = 0.15 Vu
 0.15 VL = 0.15Vu
 VL = Vu

Chapter 6 - Capital Structure 16

 MM Prop 1 (No Taxes) – page 197
1. The value of the all equity firm is the same as the
value of the levered firm i.e. Vu=VL
2. If VL > Vu, shareholders can borrow on personal
account and buy shares in all equity company
(homemade leverage). Shareholders get the same
net dividend as in the levered firm. The equilibrium
result would be: Value of levered firm decreases
and value of all equity firm increases until VL =Vu
3. Implication: Firms cannot change the total value of
its outstanding securities by changing proportions
of its capital structure.
Chapter 6 - Capital Structure 17
MM Proposition II (No Taxes) to see effect of risk and return –
page 198-199

 From the table 6.2 & 6.3, we can see that the
expected return rises with leverage (ROE 0% to
40%). However, it does not mean that leverage
benefits investors because the risk rises as well which
is shown by the greater fluctuations in the EPS (RM0
to RM8) of the levered firm. This leads to MM
Proposition II, which says that:
◦ “the expected return on equity is positively related
to leverage because the risk of equity increases
with leverage.”

Chapter 6 - Capital Structure 18

 Implication of MM Prop II (without taxes)
1. RWACC for a company is constant either with or without
leverage. Cost of equity + Cost of debt (Table 6.5 – page 200)
2. RWACC =

3. RWACC = R in a world no taxes (15% as per Table 6.5)

O

4. RO = cost of capital for an all-equity firm RO = EBIT

= Expected earnings to all equity firm Vu
Unlevered equity (Vu)
= RM1,200,000 = 15% Vu = EBIT
RM8,000,000 RO
MM II relates the return on equity, Rs to leverage.
Rs = Ro + B/S (Ro –RB): The required return on equity is a
linear function of the firm’s B/S.
Chapter 6 - Capital Structure 19
The Cost of Equity, the Cost of Debt, and the Weighted Average
Cost of Capital: MM Proposition II with No Corporate Taxes

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 The Cost of Equity, the Cost of Debt, and the Weighted
Average Cost of Capital:
MM Proposition II with No Corporate Taxes – page 201

1. The required ROE is a linear function of firm’s debt

to equity ratio that is positively related to leverage
2. Relation between the cost of equity, rS and the debt
to equity ratio (B/S) is a straight line & linear.
3. As the firm raises the B/S ratio, each dollar of
equity is levered with additional debt. This raises
the risk of equity and therefore the required return,
rS on the equity.
4. rWACC is unaffected by leverage

Chapter 6 - Capital Structure 21

 The MM Propositions I & II (No Taxes)
1. Proposition I
◦ Firm value is not affected by leverage
VL = VU

2. Proposition II
◦ Leverage increases the risk and return to
stockholders
rs = r0 + (B / SL) (r0 - rB)

Chapter 6 - Capital Structure 22

 Part 2
A WORLD WITH TAXES

Chapter 6 - Capital Structure 23

 Total Cash Flow to Investors Under
Each Capital Structure with Corp. Taxes
All-equity firm/Unlevered firm Levered firm

Taxes Taxes
S S
B

The levered firm pays less in taxes

than does the all-equity firm. VL > VU
Thus, the sum of the debt plus the Levered firm paying the
equity of the levered firm is greater least in taxes
than the equity of the unlevered firm.

Chapter 6 - Capital Structure 24

 MM Proportion I (with taxes)
Illustration (Example 6.3) – page 209
 Consider two alternative plans:
Plan I: No debt
Plan II: Debt RM4 million with RB = 10%
Tax: 25%
EBIT: RM1 million
Assuming all cash flows are constant
(perpetual without growth)

Chapter 6 - Capital Structure 25

 Illustration Interest = RB x B

Plan I Plan II
EBIT 1,000,000 1,000,000
Interest - (400,000)
EBT 1,000,000 600,000
Tax 250,000 150,000
EAT 750,000 450,000
CF to S/H and B/H 750,000 850,000

100,000

Tax Shield = Tax saved for levered firm = 25% x 10% x

4m T xR xB
Chapter 6 - Capital Structure C B 26
 Findings
 Findings
All Equity Firm Levered Firm

Taxable Income EBIT EBIT – RBB = EAI

Total Taxes EBIT (TC) (EBIT – RBB)Tc

EAT to S/holders EBIT(1-Tc) (EBIT-RBB)(1-Tc)

(CF)
CF to both EBIT(1-Tc) EBIT(1-Tc) + TcRBB
S/holders &
B/holders

Chapter 6 - Capital Structure 27

 Value of Tax Shield
1. Cash flow of levered firm is greater than the unlevered
firm by TcRBB = Tax shield from debt (interest is tax deductible)
2. PV of TcRBB at RB interest rate = TcRBB / RB
3. Value of the Levered Firm: EBIT (1-Tc) + TcRBB

PV of All Equity Firm/unlevered (VU) PV of the tax shield

= EBIT (1 – Tc) = TcRBB = TcB
Ro RB

VL = Vu + TcB

Chapter 6 - Capital Structure 28

 MM Proportion II (with taxes)
Illustration (Example 6.4) – page 211
 Consider two alternative plans:
Plan I: No debt
RO = 20%
Plan II: Debt RM200 with RB = 10%
Tax rate: 25%
EBIT: RM154
Assumptions:
 All cash flows are constant
 All EAT are paid out as dividend
Chapter 6 - Capital Structure 29
 MM Proposition II (with taxes)
1. RS decreases slightly because the tax effect; (1-tc).
RS decreases with leverage (with tax) RWACC declines with
leverage (with
2. RWACC = 𝐵 𝑆
× 𝑅 𝐵 ×(1 −𝑇 𝐶 )+ × 𝑅𝑆 taxes)
𝐵+ 𝑆 𝐵+ 𝑆

3. Because the tax shield (firm pays less tax since interest is
tax-deductible) increases with the amount of debt, the firm
can raise its total cash flow and its value by substituting
debt for equity. Therefore, the value of the levered firm will
increase.
4. VL = EBIT (1-Tc)
Another way to
RWACC determine the value
5. S =(EBIT – RBB)(1 – Tc)
RS Chapter 6 - Capital Structure 30
The Effect of Financial Leverage on the Cost of Debt
and Equity Capital with Corporate Taxes

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The MM Propositions I & II
(with Corporate Taxes)

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 The MM Propositions I & II
(Summary)
No Taxes With Taxes
1. In a world of no taxes, the
value of the firm is 1. In a world of taxes, but no
unaffected by capital bankruptcy costs, the value of the
structure. firm increases with leverage.
2. This is M&M Proposition I:
2. This is M&M Proposition I:
V L = VU
VL = V U + TC B
3. Prop I holds because
shareholders can achieve any
3. In a world of taxes, M&M
pattern of payouts they desire
Proposition II states that leverage
with homemade leverage.
increases the risk and return to
4. In a world of no taxes, M&M
stockholders. (But, the tax effect
Proposition II states that
cause it increases at lower rate)
leverage increases the risk
and return to stockholders

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Examples
 Look at Examples 6.5, 6.6,
6.7, 6.8, 6.9, 6.10
 (page 216 – 223)

Chapter 6 - Capital Structure 34

Tutorial/Exercises
 Text Book: Questions and Problems:
 Q10,11,12,13,14,23,25

 PYQs

Chapter 6 - Capital Structure 35

 Chapter 7

• High Gearing Problems

– Description of Financial Distress
– Cost of Financial Distress

• Pecking Order Theory

– Rules of Pecking Order Theory
– Implications Associated with Pecking Order
Theory

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 High Gearing Problems

• Gearing is the amount of debt finance a company

uses relative to its equity finance.
• High gearing means that profits available for
dividends are much more variable than in a low
geared company.
• If operating profits fall by 60%, all the geared
company's profits would have been consumed by
interest.
• Gearing magnifies variability and so increases risk.
• Gearing is called 'leverage' in some countries.

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 High Gearing Problems

Gearing introduces additional risk for equity shareholders

because:
• The amount available for dividends will be more volatile.
• There is the risk that if interest cannot be paid the
company will be wound up.
• On liquidation, lenders are paid before shareholders.
• Therefore more gearing will increase the cost of equity.
• Initially, the cost of debt is lower than the cost of equity
(less risk). But as gearing increases, the costs of both
debt and equity increase as risks for both increase.

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 High Gearing Problems

And as gearing continue increases to very high levels:

• Lenders suffer more risk as good security will become
used up and there is a greater risk of default. The cost
of debt will increase.
• Tax exhaustion: not enough profits to obtain tax relief for
interest so the cost of debt will increase.
• Risk of bankruptcy will drive up the cost of equity.
• Agency costs: high borrowing implies lenders will need
to monitor their investments closely.

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 Description of Financial Distress
• Debt finance provides tax benefits to the firm. However, if
these obligations are not met, the firm may risk a financial
distress.
• The ultimate distress is “bankruptcy” where ownership of the
firm’s legal assets is legally transferred from stockholders to
bondholders. Bankruptcy costs inter alia the “cost of financial
distress” can lower the value of the firm:
• Direct Costs Bankruptcy risk versus bankruptcy cost
• Indirect Costs  The possibility of bankruptcy has a negative effect on the
value of the firm.
• Agency Costs  However, it is not the risk of bankruptcy itself that lowers
value. Rather, it is the costs associated with bankruptcy.
 It is the stockholders who bear these costs.

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 Cost of Financial Distress
• Direct Costs
– Legal and administrative costs
• Indirect Costs
– Impaired ability to conduct business (e.g., lost potential sales,
loss of customers’ confidence, switch to competitors)
• Agency Costs
– Selfish Strategy 1: Incentive to take large risks
– Selfish Strategy 2: Incentive toward underinvestment
– Selfish Strategy 3: Milking the property

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 Cost of Financial Distress – Agency Costs
(Page 240-244)
• When a firm has debt and there is a probability of bankruptcy or
financial distress, conflicts of interest may arise between stockholders
(S) and bondholders (B). Due to this, stockholders are tempted to
pursue selfish strategies (reduce the value of B) such as:
– Selfish Strategy 1: Incentive to take large risks (The S will receive
nothing in recession regardless of high or low risk project is selected. Thus S take
value from B by selecting high risk project)
– Selfish Strategy 2: Incentive toward underinvestment (Though
the investment has positive NPV but if it the increase in value cannot prevent
bankruptcy, S will turn it down)
– Selfish Strategy 3: Milking the property (Liquidating dividends by
paying out extra dividends or increase perquisites to S. This leaves the firm
insolvent, with nothing for the bondholders, but plenty for the former shareholders)
• The strategies usually to hurt bondholders and help stockholders.
These strategies are costly because it will lower the value of firm and
ultimately stockholders bear the cost of selfish strategies.
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 Example: Company in Distress

Assets BV MV Liabilities BV MV
Cash $200 $200 LT bonds $300 $200
Fixed Asset $400 $0 Equity $300 $0
Total $600 $200 Total $600 $200

What happens if the firm is liquidated today?

The bondholders get $200; the shareholders get nothing.

 Tax Effects and Financial Distress
Value of firm (V) Value of firm under
MM with corporate
Present value of tax taxes and debt
shield on debt
VL = VU + TCB

Maximum Present value of

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

There is a trade-
off between the
tax advantage of
debt and the
0 Debt (B) costs of financial
B *
distress.
Optimal amount of debt
 Tax Effects and Financial Distress

• Taxes and bankruptcy costs can be viewed as just another

claim on the cash flows of the firm.
• Let G and L stand for payments to the government and
bankruptcy lawyers, respectively.
• VT = S + B + G + L S
B
• The essence of the M&M
intuition is that VT depends L G
on the cash flow of the firm;
capital structure just slices the pie.
 Pecking Order Theory
• Businesses will try to match investment opportunities with internal
finance provided this does not mean excessive changes in dividend
pay-out ratios.
• If not enough internal funds, external finance will be issued in the
pecking order, starting with straight debt.
• Theory stating that firms prefer to issue debt rather than equity if
internal financing is insufficient.
• Rule of pecking order theory:
– Rule 1
• Use internal financing first – finance project from out of
retained earnings
– Rule 2
• Issue debt next, new equity last

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 Rules of Pecking Order Theory

It is based on the view that companies will seek additional finance in a

specific order of preference:
Retained earnings Most preferable: no issue costs
Straight debt
Convertible debt
Preference shares
Least preferable: issue costs possible
New issue equity shares dilution of control

Pecking order theory do not appear to base They have a preference for sources of
financing decisions on the objective of finance in the order of retained
achieving an optimal capital structure. earnings, bank loans, ordinary debt,
convertible debt and equity.

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 Implications Associated with Pecking Order Theory

• Not pursue a target ratio of debt to equity:

– There is no target D/E ratio. Trade-off model each firm
balances the benefits of debt, such as tax shield with the cost of
debt, such as distress cost. The optimal amount of debt occurs
where the marginal benefit of debts equals to the marginal cost
of debt.
– By contrast, the pecking-order theory does not imply a target
amount of debt but rather based on the financing needs with the
use of with retained earnings first and followed by debt later.
Thus, the amount of debt is determined by the circumstances of
available project.

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 Implications Associated with Pecking Order Theory

• Profitable firms use less debt.

- Profitable firms generate cash internally, implying less need
for outside financing end up relying on less debt.
- The greater cash flow of more profitable firms creates greater
debt capacity.
- These firms will use the debt capacity to capture the tax shield
and the other benefits of debt.
• Companies like financial slack.
- Intention to have free cash flow ahead of time to fund profitable
project at various time in the future, firms accumulate cash today.
Therefore, not forced to go to the capital market when a project
comes up.
- However, too much free cash may tempt managers to pursue
wasteful activities that lead to increase in agency costs.
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Sources was adapted from:
• Ross, Westerfield, Jaffe, Rodziah, Shelia, (2016) Corporate Finance (2nd.
Ed), McGraw Hill.
• ACCA F9 Financial Management Study Text 2016

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