What is Capital Structure?

• Capital structure refers to the relative weights of different financing sources

utilized by the firm.
• Managers need to think about how to balance the benefits of lower demands on cash vs the
risks of prioritized fixed interest payments.

• How should a project with an expected annual return of 10% on invested capital be
financed? With equity requiring an 8% rate of return or debt requiring 5%?
• What (if any) would be the advantages of either alternative?
• Would a blend be better?
Unleveraged Firms Still Face Risks
• A good place to start is by analyzing a company funded entirely with equity.
• Such a firm will have a natural volatility of cash flows associated with its operations. The term
for this baseline amount of uncertainty is business (or asset) risk.
• A firm’s return on investment (ROI) should compensate for this or it will fail in the long-run.

• Some of this results from uncertainty in sales (demand estimation, competitive

dynamics, etc) but it is also a function of the firm’s operational structure.
• Many business models have fixed costs related to long-term assets which are incurred regardless
of sales and constantly consume cash. The “stable” cash flows of the firm are allocated to
paying these first, leaving any uncertainty to be borne by the residual claimants.
Operating Leverage Example
• A company produces boxes by hand at a cost of $10 each which sell for $12. Demand
is stable at ~1000 boxes per year (ranging from 800-1200)
• Assuming no taxes, annual profit = $2000 ($1600-$2400 range)

• Should the firm lease a machine for $4700/yr which cuts costs in half?
• Assuming no taxes, annual profit = $2300 ($900-$3700)
• Based on statistical expectation (EPS), the answer should be yes

• HOWEVER, the volatility has increased along with expected value.

• The project only makes us better off if this expected value is still positive after we increase the
discount rate applied to future cash flows (beware the “EPS Fallacy”!)
• Intuitively, the use of fixed costs increases risk but if they are carefully selected (+NPV), can
increase EPS sufficiently to compensate for this additional risk (and then some).
Financial Leverage Amplifies Business Risk
• Firms can also use financial leverage (borrowing) to increase the asset base in
exchange for a fixed financial burden.
• If used to finance projects with sufficient rates of return, the use of debt financing can increase
the expected returns on equity

• Like operating leverage, cash flows from the operation of the assets will be
allocated to servicing these expenses before shareholders can collect anything.
• Intuitively, the stability of cash flows enjoyed by debt holders comes at the expense of
shareholders who must supply it from their own.
• Return on equity (ROE) must compensate for both business risk AND the extra volatility
induced by the use of financial leverage. RD is the pre-tax cost of debt.
Financial Leverage
• Combining the definitions of ROI and ROE reveals an important relationship:

ROE = ROI + (ROI – KD(1-T))(D/E)

• As long as ROI exceeds the after-tax cost of debt, leverage has a positive impact
on ROE (but increases its risk).
• But if ROI becomes negative (project fails to live up to expectations), leverage also increases
the magnitude of losses.
Empirical Observations
• Most firms use some debt but those with relatively high levels find it expensive to
raise capital due to elevated risk concerns.

• Managers will generally adjust the financing mix to reach a target trade-off
between expected return and TOTAL risk.
• If operational leverage is high, firms use less financial leverage.
• This helps us to understand the differences in capital structure observed between companies
operating at different sizes or in different industries.

• Nonetheless, firms sometimes exhibit significant variation in capital structure

within industries as well.
Theoretical Approaches to Capital Structure
• To understand these variations, researchers focus on the idea that firms minimize
the frictions associated with their operation.
• This means choosing a financing mix which maximizes the value of the firm by minimizing
its exposure to various financing frictions.
• Taxes, distress/bankruptcy, information asymmetries, agency costs, etc

• These models assume that the maximum value of the firm is achieved under
conditions of zero friction and subtract each cost from the firm incrementally.
• In this way, we can learn about each one in isolation and understand how it interacts (if at
all), with the other factors.
• You can think of these frictions as “carving away pieces of the block” of value created by the
firm’s productive assets.
Modigliani and Miller (M&M) Irrelevance Theorem

• The first we will consider is foundational to our modern understanding of firm

financing – the Miller and Modigliani Irrelevance Theorem.
• The opening premise is that in the absence of frictions, it doesn’t matter how you finance assets –
their value in invariant (determined by asset traits, not financing).

• To demonstrate this, the model imagines two firms with the same risks but with
different levels of debt. Both their streams of earnings are perpetual.
• The market is assumed to be frictionless: no taxes, no risk of costly re-organization or financial
distress (fire sale of assets, legal), no transactions costs, no asymmetric information problems

• By assuming away everything we know actually affects the choice, the model’s results
may not line up with the real (frictioned) world.
• Nonetheless it does reveal some important relationships underlying financing choices.
Same Payoffs, Same Value

• Based on a “no arbitrage” argument, M&M show that the value and risk of the
firm are not affected by how it is financed.
• Total cash flows are the same and their variability is independent of how they are split up.
• If you owned all the equity and debt, the mix wouldn’t matter since you would get all the cash
flows and risk anyways.

Net payoffs
are equal
Firm Value is Constant (and thus, so is WACC)
• Where portfolio payoffs are identical, prices should be identical.
• Therefore, the enterprise value of the levered firm (EVL) must equal to the value of its debt plus
the value of its equity (SL + D) and this must equal the enterprise value of a firm that uses no
debt (the unlevered firm; EVU).

[ 21-10] 𝐸 𝑉 𝑈 =𝑆𝐿 +𝐷=𝐸 𝑉 𝐿

• Since firm value remains the same regardless of the financing strategy (EVL =
EVU ), WACC must be constant under such conditions so that the discounted cash
flows to each source of financing produce the same enterprise value.

• With no taxes: WACCU = WACCL

Debt Isn’t “Low Cost” – Equity Carries the Risks
• Though earnings and their volatility are unaffected at the firm level we saw that equity
(profit) experienced more volatility as the use of debt increased.
• This translates into increased uncertainty for equity holders who demand more compensation
for the additional risks they face. Cash flows to levered equity are discounted at a higher rate.

• Remember: the stability of payments to debt holders is subsidized by the equity

holders who absorb all of the firm’s asset risk.
• Rule: leverage increases the risk of equity even when there is no risk the firm will default.
• The relationship between levered and unlevered equity costs is:
M&M and the Cost of Equity Capital (Where Risk Goes)
• Since firm value is unaffected by leverage under these conditions, the higher EPS
from leverage must be exactly offset by a higher discount rate on flows to equity.

• KeU is the required return due to asset risk

while (KeU – KD) is for the impact of leverage.
• The cost of leveraged equity (KeL) varies with
the debt-equity ratio, scaling linearly for the
extra return required by equity investors.
• NOTE: The weight of equity falls as D/E (and KeL) rises
such that WACC remains constant.
The Importance of Imperfections
• These results are driven entirely by the fact that many value consuming
frictions have been assumed away.
• Taxes, financial distress, agency costs, floatation (issuing) costs, etc
• In the real world all these factors matter and they change the math regarding the
(dis)advantages of debt financing for a variety of reasons. We will examine each in turn.

• The first such complications we will layer on is the impact of income taxes and
the deductibility of interest expenses.
The Impact of Taxes
• The introduction of corporate taxes means that some of the firm’s cash flows are
taken by the government.
• As a result, firm value for investors is reduced by corporate taxes.
• The higher the tax rate, the lower the value of the firm.

• Taxes are a % of flows to equity, so SL drops (multiplied by (1-T)) and D/E

changes.
• Since payments to debt holders are made pre-tax, the value of the firm’s debt wouldn’t change
Visualizing the Impact of Taxes
• Consider two firms in the pre-tax world one financed with $100 of equity, the
other with $50 of equity and $50 of debt.
• Both have identical risk and cash flows, and thus the same pre-tax value.

• If a 50% income tax is introduced:

• Unleveraged firm: The value of the all equity firm falls by 50% to $50 as the government
claims half the cash flows headed to investors. Enterprise value is $50 after tax.
• Leverage firm: As above, the value of the leveraged firm’s equity falls by 50% to ($25) but
because debt holders receive their cash flows before the government takes half, the value of
debt is unaffected by tax. Enterprise value is $75 after tax. ($25 + $50)

• Though often described as “adding value”, strictly speaking tax shields limit the
loss of firm value due to taxes (a consolation prize of sorts).
• They add value relative to a taxed but unleveraged firm.
The Value of Tax Shields – Fixed Level of Debt
• The additional value created through debt is based on the present value of
expected future tax shields.

• In the prior example, we assumed a fixed, permanent amount of debt (worth $50)
and that there would always profits which could be shielded from taxes.
• Under such conditions, these tax shields should be discounted at the same rate as interest
payments (KD).

• If the firm survives for a long time, we can approximate them with a perpetuity.
• PV(tax shields with stable permanent debt) = (D * KD * T) / KD = D*T = $50*0.5 = $25
WACC with Taxes

• In many situations however, firms maintain a target debt/equity ratio rather than a
fixed level of debt.
• In these situations, the risk (discount rate) of the tax shields should be equal to those of the firm
as a whole.
• This means discounting them at WACC, which allows us to directly incorporate them into the
required rate of return.

• By reducing WACC, the same free cash flows produce a higher enterprise value,
properly reflecting the value added (less friction) by these tax shields.
Cost of Leveraged Equity (Prop II)
• IMPORTANT: The cost of leveraged equity is not affected by the introduction of
taxes!
• Taxes affect the magnitude, not the volatility of cash flows.
• They DO however affect the D/E ratio as the value of equity drops.

• While M&M’s second proposition (above)

includes a tax term, recall that the value of
[ 21-18]
SL (equity) is reduced by taxes so D/E rises
and the effects exactly negate each other.
• If D/E was 1 pre 50% tax, it rises to 2 as the
value of equity falls by half
When M&M met CAPM
• Within a decade of M&M’s publication, our way of modelling the cost of equity
improved with the introduction of the Capital Asset Pricing Model.
• Rather than modelling the cost of equity directly, CAPM breaks it into risk-free and risky
components with the required return increasing as a function of systematic risk.
• Systematic risk is measured using the Beta coefficient on the market risk premium, which
rises as volatility rises (recall that financial leverage induces volatility).
• KeU = Rf + BetaU * (Rm - Rf); KeL = Rf + BetaL * (Rm - Rf)

• Assuming the CAPM holds it is possible to re-formulate the relationship between

levered and unlevered equity costs in terms of levered and unlevered equity Beta.
= + ( - )(1-T)(
Beta of Debt? (For those doing more finance after F650)
• There is no reason we can’t decompose the excess returns on debt (above risk-free) into systematic
and idiosyncratic components, just like we did for stocks.
• The more leverage (debt) a firm uses, the less loss-absorbing capital (equity) lies between the volatility of
free cash flows and the promise of uninterrupted interest payments.
• As the equity buffer thins, asset risk seeps into debt prices and they develop systematic risk.

• Debt betas are difficult to estimate because

corporate bonds are traded infrequently but
panel estimation techniques have helped to
close in average Betas by bond rating.
• They tend to be low, but can be significantly
higher for risky debt with a low credit rating
and a long maturity.
• Section 15.5 (not covered) provides an option-
based technique for estimating this directly.
Beta of Debt? (For those not doing more finance after this)
• As long as we are modelling firms with investment grade debt, the Beta of debt might
be low enough that it could be reasonably ignored.
• If true, BetaD drops out of the equation, leaving us with the popular Hamada equation:

• [this seems to contradict 12.6 but the book is still assuming no taxes at that point]
• The appearance of (1-T) results from tax shields in the equity value of leveraged firms.
• If you are working backwards from an observed levered equity Beta, assuming BetaD equals
zero means underestimating BetaU.

• We use this approach next to benchmark equity costs.

The Pure Play Approach – Comparable Firms
• It is often challenging to directly estimate the appropriate equity cost for a project,
particularly one that is embedded in a firm with diverse investments.
• Our estimates of BetaU should be based on asset risk but this is usually unobservable.
• A firm with half high risk assets (Beta = 1.7) and the other half being low risk (Beta = 0.3) will
produce an average firm Beta of 1 but this is the wrong cost of capital for both types of assets

• To approximate BetaU (and thus KeL and WACC) we identify a number of firms
with similar assets and risks to the project we are trying to value, usually those in
the same industry, jurisdiction, and of similar size.
• The idea is that firms of similar sizes in similar industries are affected by similar risks and
should thus have a similar degree of systematic risk.
• These firms should be “pure plays” to the extent possible, meaning their primary assets are
those we would be using in our own project.
The Pure Play Approach – Estimating Asset Beta
• If the comparable firms use no leverage, their equity Betas equal their asset Betas
• Unleveraged pure plays provide a direct estimate of KeU but are hard to find.

• If comparable firms use leverage, we need to a de-lever their cost of equity capital
using each firm’s market valued D/E ratio, average tax rate, and CAPM-Beta.
• To use Hamada (and assume BetaD = 0) simply avoid highly leveraged comps (if possible).

• Take the mean (or median) of the unlevered Betas and assume it is representative
of firm/project in question. The comp range can be useful in sensitivity analysis.
• Alternatively, you can use the unlevered industry Betas estimated by Aswath Damodaran
(patron saint of valuation): http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/Betas.html
The Pure Play Approach – Estimating Equity Beta &
WACC
• For firms with publicly traded equity using this technique for project or divisional
purposes, Beta should be re-leveraged according to the firm’s own market valued
debt/equity ratio. The tax rate should be specific to our company as well.
• Recall that we don’t allocate specific sources of capital to finance specific assets – the burden
of financing costs are the borne by the firm as a whole.

• For companies without publicly traded equity, there are a few choices for how to
choose the appropriate D/E ratio for re-leveraging, none of which are “good”:
• Book values; selected target; benchmark to comparable firms

• Equipped with a project cost of equity, we can now include this in our WACC and
NPV calculations to determine whether they are worth pursuing.
Pure Play Example
• Hydra is involved in numerous businesses. Their restaurant division is considering
the value in trying to push its brand into a new geographical market and thus needs
to estimate the appropriate cost of capital for this highly complex project.
• Hydra has $11.3 billion in debt, a market capitalization of $26 billion, and its tax
rate is 34%. New bonds require a 6.74% coupon rate and there are sufficient
retained earnings to allow the firm to maintain its existing capital structure.
• The closest competitor for the restaurant chain, Extra Chicken, has a beta of 1.8
and faces the same tax rate. Their D/E ratio is 0.63. The risk-free rate is 3.2% for
the appropriate time horizon and the market risk premium is estimated at 5.7%.
• What cost of capital should be applied to Hydra's restaurant division?
Pure Play Example - Solution
• Work backwards: What is needed for WACC?
• WACC = Wd*(Y)(1-T) + We*(Rf + (BetaL * MRP))
• Wd = 11.3/37.3 = .30295; We = .69705; D/E = .43462
• Y = 6.74%; T = 34%; Rf = 3.2%; MRP = 5.7%; Need BetaL

• Benchmark to Extra Chicken’s BetaU:

• we use Hamada here so BU and next WACC may be (slightly) underestimated
• EC’s BL = 1.8 = BU * (1+(1-.34)(.63)); BU = 1.27137

• Assuming BetaU is the same for both firms:

• BetaL for Hydra = (1.27137)(1+((.66)(.43462) = 1.636
• KeL for Hydra = 3.2% + 1.636 * 5.7% = 12.525%
• WACC for Hydra’s restaurants = 10.08%
Limits of the Tax Shield (Got Earnings?)
• To receive the full tax benefits of leverage, a firm need not use 100% debt
financing, but the firm does need to have taxable earnings.
• This constraint limits the optimal amount of debt to that needed to generate a sufficient tax
shield to reduce taxes to zero (interest = EBIT).

• Consider the table below:

• With no leverage, the firm receives no tax benefit.
• With high leverage, the firm saves $350 in taxes.
• With excess leverage, there is a net operating loss and no increase in the tax savings.
Recapitalization (Add Debt, Get a Tax Shield!)
• If a firm is confident that its future cash flows could accommodate larger debt
payments, then it might be a value creating move for the company to borrow to
buy-back shares from investors (swap equity for debt in the capital structure).

• MIDCO has 20 x $15 shares outstanding and pays a 35% tax rate.
• Management is planning to borrow $100 in perpetuity to buy these back

• With stable permanent debt, the value of tax shields will be = D*T = $35
• Thus EVL = $300 + $35 = $335. With $100 in debt, the value of leverage equity is $235
• They might have less equity ($300 vs $235) but they have $100 in cash as well so they
capture the full value of the tax shield.
• Under no arbitrage, it doesn’t matter which shareholders sell, they will receive the same
total compensation regardless ($16.75 per share - see 18.3 for details)
Personal Taxes
• While the preceding work showed the impact of corporate taxes on a firm’s
optimal capital structure (max debt to add value), a realistic model of corporate
behaviour must consider the personal taxes as well.
• In Canada, these are double the rate of capital gains.

• For a firm with permanent debt, we can model this by substituting the “effective
tax advantage of debt” (T*) for the corporate tax rate (T) in our relationship of
leveraged to unleveraged enterprise value.

• The net result is that the tax advantages of debt are reduced.
• How much exactly depends on jurisdiction and tax status.
Other Capital Structure Frictions
• Thus far we have only considered the impact of a single leverage related friction.
• With corporate taxes capturing a slice of cash flows to equity, the optimal capital structure
which maximizes firm value is to finance with debt until interest payments equal EBIT.

• In the real world, this would be incredibly risky as any disruption in EBIT in turn
disrupt its ability to make interest payments, making default a real possibility.
• Financial distress is the major friction we will be discussing next class.

• There are other frictions related to conflicting incentives, and asymmetric

information, but these aren’t as readily quantified.
• Nonetheless it is valuable for us to consider how each cost is related to the use of leverage and
what systematic or idiosyncratic implications they have.