Chapter Five

Capital structure
theory
 Capital
Structure
 Capital structure is the mix (or proportion) of a firm’s
permanent long-term financing represented by
 debt,
 preferred stock, and
 common stock equity.
 Deciding the suitable capital structure is the important
decision of the financial management because
 it is closely related to the value of the firm.
 Cont…

 Optimum capital structure is the capital structure at

which
 the weighted average cost of capital is minimum and
 thereby the value of the firm is maximum.
 So, objective of capital structure is
 to keep WACC to minimum possible point and
 maximize the firm value
What is “Capital
Structure”?
Balance Sheet
Current Current
Assets Liabilities

Debt
Fixed Preference
shares
Financial
Assets

Structure
Ordinary
shares
What is “Capital
Structure”?
Balance Sheet
Current Current
Assets Liabilities

Debt
Fixed
Assets Preference
shares
Capital
Ordinary
Structure
shares
Capital Structure Theories
Capital Structure
Theories
◼ MM theory
 Zero corporate taxes
 Corporate taxes
 Corporate and personal
taxes
◼ Trade-off theory
◼ Signaling theory
◼ Pecking order theory
MM – Zero Corporate
Taxes
• Modern capital structure theory began in 1958, when
Professors Franco Modigliani and Merton Miller
(hereafter MM) published what has been called the
most influential finance article ever written.
• MM’s results suggest that it does not matter how a firm
finances its operations, hence capital structure is
irrelevant.
Cont…
• However, MM’s study was based on some unrealistic
assumptions, including the following:
1. There are no brokerage costs.
2. There are no taxes.
3. There are no bankruptcy costs.
4. Investors can borrow at the same rate as
corporations.
5. All investors have the same information as
management about the firm’s future investment
opportunities.
6. EBIT is not affected by the use of debt.
Cont. …
• Despite the fact that some of these assumptions are
obviously unrealistic,
• MM’s irrelevance result is extremely important.
• By indicating the conditions under which capital
structure is irrelevant,
• MM also provided us with clues about what is required for
capital structure to be relevant and hence to affect a firm’s
value.
• MM’s work marked the beginning of modern capital
structure research, and subsequent research has
focused on relaxing the MM assumptions in order to
develop a more realistic theory of capital structure.
 MM Theory – Zero Corporate
Taxes
Firm X Firm Y
◼ EBIT Br. 3,000 Br. 3,000
◼ Less: Interest 0 1,200
◼ Net Income Br. 3,000 Br. 1,800
◼ CF to Br. 3,000 Br. 1,800
shareholders 0 Br. 1,200
◼ CF to debt-holders Br. 3,000 Br. 3,000
 Total CF
◼ Notice that the total CF are identical for both firm and
their WACCs are equal.
 Therefore, capital structure is irrelevant.
MM Theory – With Corporate Taxes
 MM published a follow-up paper in 1963 in which they
relaxed the assumption that there are no corporate
taxes.
 The Tax Code allows corporations to deduct interest
payments as an expense, but dividend payments to
stockholders are not deductible.
MM theory – With Corporate Taxes
Proposition 1
• In a tax environment, the value of a levered company
is higher than the value of an unlevered company by
an amount equal to the product of absolute amount of
debt and tax rate.
• This can be expressed mathematically as follows:
VL = VUL + t × D
• Where VL is the value of levered company i.e. company
with some debt in its capital structure,
• VUL is the value of an un-levered company i.e. with no or
lower debt,
• t is the tax rate and
• D is the absolute amount of debt.
Cont. …
Proposition 2
 Since interest expense is tax-deductible, our equation for
the weighted average cost of capital as follows:

Where:
Ke –cost of equity
Kd –cost of debt
E/V – portion of equity
D/V – portion of debt
T- tax rate
MM theory – Corporate and Personal Taxes

• Personal taxes lessen the advantage of corporate

debt:
• Corporate taxes favor debt financing since
corporations can deduct interest expenses.
• Personal taxes favor equity financing, since no
gain is reported until stock is sold, and long-term
gains are taxed at a lower rate.
 Trade-off Theory
 MM theory ignores bankruptcy (financial distress)
costs, which increase as more leverage is used.
 At low leverage levels, tax benefits outweigh
bankruptcy costs.

 At high levels, bankruptcy costs outweigh

tax benefits.
 An optimal capital structure exists that balances these
costs and benefits.
 Article reading:
• Graham, J. R., and C. R. Harvey, 2001, The theory and practice of corporate finance:
Evidence from the field, Journal of Financial Economics, 60, 187-243.
 Signaling
◼
Theory
MM assumed that investors and managers have the same
information.
◼ But, managers often have better information. Thus,
they would:
 Sell stock if stock is overvalued.

 Sell bonds if stock is undervalued.

◼ Investors understand this, so view new stock sales as a
negative signal.

◼ Article reading:
• Ross, Stephen A., 1977. “The determination of financial structure:
The incentive signaling approach”, Bell Journal of Economics 8, 23,
40.
Pecking Order
Theory
 The pecking order theory suggests that there is an
order of preference for the firm of capital sources
when funding is needed.
 The firm will seek to satisfy funding needs in the
following order:

 Internal funds: R/E

 External funds: debt and then equity

Cont…
 The pecking order theory suggests that the firm will first
use internal funds.
 More profitable companies will therefore have less use of
external sources of capital and may have lower debt-
equity ratios.
 If internal funds are exhausted, then the firm will issue
debt until it has reached its debt capacity .
 Only at this point will firms issue new equity.
 This theory also suggests that there is no target
debt equity mix for a firm.
What other factors would managers consider
when setting the target capital structure?

Debt ratios of other firms in the industry.

 Proforma coverage ratios at different

capital structures under different economic
scenarios.

 Lender and rating agency attitudes (impact on bond

ratings).
Cont…

Reserve borrowing capacity.

Effects on control.

 Type of assets: Are they tangible, and

hence suitable as collateral?
Tax rates.
End of the
course!