FIN 740: Corporate Finance

Topic #7
Capital Structure
Motivation for looking at capital structure
*
• Beyond choosing which
projects to undertake,
financial managers also
choose how best to
finance those projects
– This is referred to as the
“capital structure” decision
– CFOs often list it as their
most important decision*
Source: Servaes and Tufano, “CFO Views on the Importance and Execution
of the Finance Function” (Deutsche Bank, 2006)
Firms make this choice all the time!
• When raising new capital, firms must decide between
whether they want to do so via debt and/or equity; e.g.,
– In 2012, Facebook raised about $16 billion in new equity financing as
part of its initial public offering (IPO)
– In 2013, Apple decided to raise additional capital via debt for the first
time ever via a massive bond issuance

• Firms can also simply decide to restructure their financing;

e.g., Home Depot issued debt and bought back equity in 2007
And lots of variation in the
choices being made…
• E.g., share of financing
that comes from debt, Figure 16.1: Berk, Demarzo, and
D/(D+E), varies a lot Harford, Fundamentals of
Corporate Finance, 5th Ed.

across industries
• This lecture will help
you understand why!
Outline for this topic
• Intuition for how managers choose their capital structure
• An unrealistic benchmark: “perfect capital markets”
• Introduction to the “trade-off model”

Note: The following slides pull loosely from

material in Chapter 16 of textbook
Some initial questions…
• How do you think managers decide the optimal share of funding
from debt [i.e., D/(D+E)] when raising capital?
• Will this financing decision affect the capital budgeting decision?
I.e., does the choice of how to raise capital need to be made
jointly with the decision on how to allocate that capital?
Intuition for “capital structure” choice
• Deciding how to optimally finance a company’s projects is
not all that different than deciding how to allocate resources
– Manager will weigh cost & benefits of each possible value of D/(D+E)
– Then, manager will choose D/(D+E) that maximizes the firm’s value!

Will the debt-to-equity mixture that minimizes the firm’s cost of capital, WACC,
always coincide with what would maximize firm value?
No. It is not just about minimizing “cost of capital”
• From topic #5, we learned that:
𝐹𝐶𝐹 1 𝐹 𝐶𝐹 2 𝐹 𝐶 𝐹∞
𝐹𝑖𝑟𝑚 𝑣𝑎𝑙𝑢𝑒=𝐶𝑎𝑠h 0 + + +…+
( 1+𝑟 𝑤𝑎𝑐𝑐 ) ( 1+ 𝑟 𝑤𝑎𝑐𝑐 )
2
( 1+𝑟 𝑤𝑎𝑐𝑐 )
∞

• All else equal, lowering cost of capital (rwacc) increases firm value
– But sometimes that ‘lower’ cost of capital adversely affects expected
cash flows, FCF, thus reducing firm value [Example?]
– Hence, while choosing D/E that minimizes cost of capital is often
the best choice, there are circumstance where it is not
And financing & allocation decisions are separate
• If advantageous to do so, a firm can typically restructure its
financing without changing its existing assets… E.g.,
– Issue debt to buy back equity
– Issue equity to pay off debt

• Thus, financing decision can be solved separately from

decision of which assets to purchase (capital budgeting)
Outline for this topic
• Intuition for how managers choose their capital structure
• An unrealistic benchmark: “perfect capital markets”
• Introduction to the trade-off model
Establishing a baseline: “Perfect capital markets”
• In a world with “perfect capital markets” the choice is irrelevant;
i.e., share of funding from debt will not affect firm value
• Perfect capital markets occur when:
– Issued securities (e.g., bonds & stock) are always correctly priced,
– No transaction costs associated with raising capital,
– The financing choice has no impact on taxes,
– And a firm’s financing choice does not affect the cash flows generated
by that firm’s investments
M&M Propositions
• This finding that capital structure does not matter comes from
what are called the M&M propositions
– From famous 1958 paper written by Merton Miller & Franco Modigliani
– Each won Nobel prizes for their work on this topic [1990 & 1985]

• The result was surprising (at the time)…

– Previously, most assumed using more debt (which tends to have lower
cost, rd, then equity, re) would lower cost of capital and increase firm value
– What was wrong with this logic?
Two ways to think about why…
• Using more debt will not lower firm’s cost of capital
– More debt, makes returns to equity more volatile [see textbook]
– So, equity investors will demand higher return, re
– M&M showed increase in re would result in no change in WACC!

• Ultimately, firm value is determined by the present value

of all the cash flows it generates
– If choice does not affect firm’s cash flows or taxes (as assumed in
perfect capital markets), then firm value must be unchanged!
Miller quotes on understanding M&M
• “If you take money out of your left pocket and put it
in your right pocket, you’re no richer. Reporters
would say, you mean they gave you guys a Nobel
See textbook if
Prize for something as obvious as that? And I’d
you are
add, Yes, but remember, we proved it rigorously.”
interested in
• “You understand the M&M theorem, if you know learning more
why this is a joke: The pizza delivery man comes about M&M
to Yogi Berra after the game and says, Yogi, how theorems
do you want this pizza cut, into quarters or
eighths? And Yogi says, cut it in eight pieces. I’m
feeling hungry tonight.”
Clearly, M&M gets something wrong
• In real world, managers do think a lot about how they finance
their firm’s operations… Why?
– Because we do not have perfect capital markets!
– I.e., choice of financing does affect firm’s cash flows (and value) for
numerous reasons [to be discussed shortly…]

• This will lead managers to think about trade-offs of choosing a

certain D/(D+E) level; let’s now think about how…
Outline for this topic
• Intuition for how managers choose their capital structure
• An unrealistic benchmark: “perfect capital markets”
• Introduction to the trade-off model
A trade-off model
• Managers will weigh trade-offs of financing choice
• Easiest to think about this from perspective of “how much debt
financing should I use?” I.e.,
– What are the benefits of using more debt?
– What are the costs of using more debt?

• Firm will choose D/(D+E) ratio to maximize the present value

of benefits minus present value of the costs!

What is a key benefit of using

more debt financing?
Example of key benefit…
• In April 2013, a big technology firm announced it would issue
bonds for the very first time…
– Proceeds would be used to repurchase shares & fund dividends
(i.e., firm is just increasing debt & reducing equity)
– Company stated, “Incorporating debt into our capital structure will
provide several benefits, including… a reduction in overall cost of
capital and efficient leverage of our very strong balance sheet”

• What company was this?

• Why would it lower WACC or increase value?
Example of key benefit… [continued]
• The company was Apple, and it said issuing debt would help it
lower taxes (in two ways)! See WSJ article:
http://online.wsj.com/article/SB1000142412788732447
4004578442783946669310.html

1. Can use interest expenses to offset its huge profits & lower its taxes
2. Also provided way to bring home (and payout) profits from outside
the US in way that would avoid the repatriation tax

• I.e., key benefit of debt = lower taxes

Key benefit of debt = lower taxes
• For intuition, think of earlier analogy given by Merton
about holding money; whether you hold your money in
your left or right pocket doesn’t matter…
– But with corporate taxes, it is as if one pocket now has a hole!
For every $ you put in, you’ll only get 80 cents back [Why?]
Answer = Interest tax deduction!
• Interest expense (i.e., payment to debt) is tax deductible; but
dividends or repurchases (i.e., payment to equity) is not
– I.e., underlying cash flows driving firm’s value don’t change, but firm
can reduce government’s take (slice of the pie) by using more debt

“If you can eliminate the federal government

as a 48 per cent partner in your business, it’s
got to be worth more.”

-- Warren
Buffett
Given this, why don’t firms only use debt?
• Two answers…
– There is a cost of using debt (i.e., trade-off)… What?
– And additional interest expenses only create value if have profits to
shield or they do not exceed allowed tax deductions; e.g., in the US,
• Interest expense deduction capped at 30% of EBITDA starting in 2018
• And in 2021, the cap was reduced to 30% of EBIT

The above tax changes hurt value of highly levered firms,

like health firms; for more details, see
https://www.wsj.com/articles/the-one-tax-change-that-really
-bites-businesses-1513708835
Key cost of debt = financial distress costs
• Additional debt increase risk that firm will experience financial
distress (i.e., difficulty meeting its debt obligations)
• Financial distress is costly because it adversely affects a firm’s
cash flows both directly and indirectly [How?]

These costs are large! Estimates

suggest they range from 10-20%
of firm value
Direct costs of financial distress
• Legal expenses involved with bankruptcy process or with
restructuring the firm’s debt obligations; e.g.,
– Enron spent $750 million on legal and accounting fees
– Lehman Brothers spent $2.2 billion
– Between 2003 and 2005, United Airlines hired 30 advisory firms and
spent $8.6 million per month related to its bankruptcy reorganization

• Estimated direct costs range from about 3% of firm value for

larger firms up to 12% for smaller firms
Indirect costs of financial distress
• Indirect costs are from things the firm does to avoid default or
from things others do in response to your default risk; e.g.,
– Lost customers [Why? Examples?]
– Loss of best employees or need to pay higher wages to retain them
– Loss of suppliers [Why? Examples?]
– Lost value because of fire sales
– May constrain ability to do vital investments
• E.g., GM vs. Toyota during 2008 crisis. GM struggled with debt payments, cut R&D
by 30%. Toyota did not and emerged from crisis with stronger pipeline of cars.
• See “GM’s Drive: Getting out of Debt” WSJ article for more details:
http://www.wsj.com/articles/SB10001424052748703296604576005702436485320
Trade-off model for capital structure
• Firms weigh these benefits & costs and will choose the share of
debt financing, D/(D+E), that maximizes:

Present value (tax shields) – present value(distress costs)

• Easier said than done…
– Present value of tax shields is relatively easy to calculate
– But present value of distress costs more nebulous as it will depend on
uncertain probability of distress & costs of distress
Evidence suggests managers weigh these trade-offs
• We observe each of the following in the data; why do they make
sense in the context of this ‘trade-off’ model?
– Firms with higher tax rates tend to use more debt
– Firms with more volatile earnings tend to use less debt
– Firms with more tangible assets tend to use more debt

Back to Apple’s first issuance of bonds… What about

the firm suggests the net benefits of debt will great?
What factors suggest it might not be?
Additional costs & benefits of debt
• There are yet additional, subtle ways using more debt
can affect a firm’s expected cash flows
1. FCF problems These will make you want
2. “Costly effort” problem to use more debt
3. “Playing it safe” problem
These will make
4. Under-investment problem
you want to use
5. Excessive risk-taking less debt
1.
The first 3 come from “agency conflicts”
• Corporations are subject to agency conflicts because of
separation of ownership & control
– Shareholders own and ultimately control the firm [e.g., they elect the
board of directors, which can hire and fire the manager]
– But day-to-day, their “agent” (the financial manager) is the individual
making all the important decisions
– When the manager’s goals do not coincide with that of the
shareholders, we call this an “agency conflict” [Examples?]

Tangent: What is a common way firms try to

reduce such agency conflicts”?
Agency conflicts #1 and #2 explained…
• “FCF problem”
– The more cash managers have, the more
they spend; i.e., they will tend to squander
it on pet projects or “empire building”
Increasing a firm’s use of
• “Costly effort” debt reduces these problems
– Working is hard, and to the extent they (and benefit shareholders)
can, managers will seek to exert as little … How?
effort as possible or make decisions that
make their job easier
How debt can help with #1 and #2…
• Regular debt payments can enforce discipline
– Cash is constantly pushed out of the firm (via interest payments),
minimizing managers’ ability to waste money on pet projects
– And fear of distress will hold managers’ “feet to the fire,” motivating
them to exert more effort

But this can also

backfire; how?
Agency conflict #3 explained…
• “Playing it safe”
– Because managers have more to lose than
shareholders if firm goes bankrupt (e.g.,
much of their wealth & career is tied to
firm), they will have incentive to take on too
little risk relative to what shareholders want
My research has
Increasing a firm’s use of debt documented this
will make this agency conflict conflict is important
worse! for firms in US
Breakout session – Agency conflicts
• Please take 15 minutes to discuss as a group the below
questions; we will discuss your answers after breakout
[you do not need to turn anything in]
– Technology firms, such as Google & Apple, use notoriously little debt
– With agency conflicts in mind, what might be an argument for why they
should use more debt than they do? And what might be an argument
for why they should not use more debt?
Equity-debt holder conflicts
• The last two, “under-investment” and “excessive risk-taking,”
occur because of conflicts between debtholders and shareholders
• Each reduces firm value and debtholders willingness to fund the
firm, thus lowering a firm’s desired amount of debt
#4 – Under-investment problem explained…
• Basic intuition is as follows…
– More debt increases risk of default;
– And when default is likely, shareholders will not necessarily recoup their
required return on any new investments they make in the firm;
– So, shareholders will not fund some positive NPV investments;
– This destroys firm value, and anticipating this, debtholders will be less
willing to fund the firm as well;
– Firm uses less debt
Easiest to illustrate with
example; see next slide
Under-investment problem [example]
• Consider the following:
– Firm has debt payment due next year of $50
– 50% chance firm only has $25 and defaults
– But there is a project today that would cost $10 and yield $20 next year,
and we assume the PV of that is $15; i.e., NPV = $5
– Will shareholders fund the project?
Under-investment problem [example continued]
• Answer = No!
– If shareholders put up $10, there is 50% chance the $20 goes to
paying off the existing debt burden
– So, because of the existing debt and the chance of default, the
NPV for equity holders is just 0.5015 – 10 = –2.5
– They will not fund it, reducing firm value!
#5 – Excessive risk-taking explained…
• Basic intuition is as follows…
– When distress is likely, shareholders will prefer to take
on greater risk than is optimal [because they basically
get to gamble with the debtholders’ money]
– This destroys firm value, and anticipating this,
debtholders will be less willing to fund the firm;
– Firm uses less debt

Again, easiest to illustrate with

example; see next slide
Excessive risk-taking [example]
• Consider the following: Which project is riskier?

– A firm has $50 of outstanding debt Which project will result in

higher firm value?
– It has 2 project choices: A and B
– The possible returns are… Which project will
shareholders choose?
Excessive risk-taking [example continued]
• Answers…
– Project B is safer because return is less volatile
– Project B has higher expected value of $115 compared to riskier project
A, which only has expected value of $100
– But shareholders choose riskier project A, because its expected value
(to them) is $75, which is higher than expected value of $65 for project B
– Value is destroyed!
Firms consider many more trade-offs
• And some can be quite interesting
• E.g., evidence shows that presence of a strong labor union
causes firms to use more debt financing [Any guesses why?]

If interested, see this academic paper:

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=933698
And other factors matter as well…
• A key one is “asymmetric information”
• M&M assume managers & shareholders have same information,
and hence, all debt and equity securities are priced correctly
– Not likely! In practice, who will likely have more information about a
firm’s prospects, and hence, true value of the stock?
Why asymmetric information matters (in general)
• Suppose you know a car is worth either $5,000 (blue book
value) or $3,000 (if it has some hidden problems with it)…
– For you, probability is 50/50, but dealer knows true value
– What is the expected value (for you)?
– If dealer offers you a “deal” at $3,500, should you take it?

• Example illustrates the “lemons problem;” i.e., the dealer will

only want to sell you a “lemon,” and his choice to sell is a
“signal” the car is likely to have a lot of problems
Asymmetric information & capital structure
• Same problem occurs when firms issue (i.e., sell) equity!
– Managers have incentive to issue when they know their equity is
overvalued, and would never want to sell when it is undervalued

• So, managers issuing equity is seen as “bad signal” by investors

– Consistent with this, we see companies’ stock price decline immediately,
on average, about 3% when they announce a stock issuance
– This is yet another cost managers must consider when deciding
how best to raise capital for their projects
Key points to remember
• Firms choose share of funding from debt to maximize the
PV(benefits) – PV(costs) of this choice
• These costs & benefits are important but will vary by firm, industry,
etc. and are not always easy to quantify

• On average, debt usage will be…

– Higher due to tax shield benefits
– Lower due to financial distress costs
– Higher because it makes managers work harder and waste less cash
– Lower due to under-investment & excessive risk-taking problems
– Higher due to asymmetric information & signaling concerns