7/10/2021

FIN222 Lecture 9
Capital Structure
CH16

Recording 1: The Impact of Debt on V – MM1

Lecture 9 Chapters Lecture 10 Chapters

• 17.1
• 16.1
• 17.2
• 16.2
Alternative 1
• 16.3
Alternative 2
• 16.4
• 16.5 • 17.3
• 16.6 • 17.5
• 17.6
• 17.7

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Learning Outcome 6
• Explain capital structure and dividend policy and their
impact on the value of a company.

Notations
• MM1 = Modigliani and Miller’s Proposition 1
• MM2 = Modigliani and Miller’s Proposition 2
• D = Market value of debt
• E = Market value of equity
• V= Value of a firm = D+E
• rE= Cost of ordinary shares
• rD= Cost of debt
• rWACC = Weighted average cost of capital
• VL = Value of the firm with debt
VU = Value of the firm without debt
• rU= Cost of unlevered equity
• Tc= Corporate tax rate

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Source: Parrino et al (2014), Figure 1.2, Fundamentals of Corporate Finance

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Capital Structure
• Relative proportions of debt, equity and other
securities that a firm has outstanding constitute
its capital structure.
– Always include ordinary shares
– Often include debt and preference shares
• To be affected by financing decision made by
financial managers in a corporation
– How to finance? Debt issue or Equity issue?
• Financing decision to be made consistent with
the goal of maximising shareholders’ wealth
(=firm value)

Capital Structure
•A firm’s debt-to-value ratio is the fraction of the
firm’s total value that corresponds to debt:
D /(E+D) or D/V

• Another common measure of capital structure :

Debt-to Equity ratio or leverage ratio
D/E

Three worlds to go through

No 1. Perfect Capital Market
(=MM world)

Tax

Cost

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Capital Structure in Perfect Capital Market

• Perfect Capital Market is a market in which
– Securities are fairly priced.
• Investors and firms can trade the same set of
securities at competitive market prices equal to the
present value of their future cash flows.
– There are no tax consequences or transaction
costs.
• No Tax, No transaction costs
– Investment cash flows are independent of
financing choices.

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Modigliani and Miller’s Proposition 1(MM1)

D/V

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Modigliani and Miller’s Proposition 1(MM1)

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MM 1
• How should you raise the funds?
Equity Financing
How much can you raise by selling equity?
= PV (FCF) = $34,500/1.15 = $30,000
How much equity holders expect to receive in Y1?
FCF1= $34,500
Levered Financing
Suppose that you can borrow $15000 at rf today. How
much equity holders expect to receive in Y1?
Part of FCF1 going to debtholders = $15,000*1.05=$15,750
The rest to shareholders = 34,500-15,750=18,750

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MM 1 With perfect capital market,

total amount paid to all investors still corresponds
to free cashflows generated by the firm’s assets.

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More on MM1
Would investors prefer an alternative capital structure?

$100 100 100 100 100 100 100 100 100 ……

1. All equity financed company A is expected to produce
a FCF of $100 perpetually (rWACC= 10%).
Vcompany A=FCF/rWACC= 100/0.1= 1000
2. V = E (why? All equity financed! So D=0)
Company A now wants to change its capital structure
$300
$1000 $700 Debt
HOW?
Equity Equity

– By selling $300 worth of perpetual bonds at 5%&

– Paying shareholders $300 one time special dividend

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Understanding MM 1
• Before restructuring • After restructuring
$100/y to shareholder $15/y to bondholder
CF CF (=$300x0.05)
$0 to bondholder $85/y to shareholder
+ one-off $300

• What if you, as a shareholder, wish to continue to receive an

annual income of $100. =LEND
• HOW? Use a special dividend of $300 to purchase the bond
$85 from shareholding (income under new capital
CF structure)
$15 from bondholding (income from your personal
=$100/y lending of $300)

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Understanding MM 1
Alternative scenario:
This time, management has no intention of adding debt but
you wish they would as you want 70% equity +$300
dividend
• You can produce the same effect by creating your own debt
• You could borrow $300 at 5% and pay interest on the
personal debt out of cash flow you receive from your firm
Homemade leverage
• How you do it under 100% Equity?
• Your ideal CFs
$100 to shareholder
$15/y to bondholder CF (income under 100% equity)
CF (=$300debt x 0.05) You borrow $300 &
$85/y to SH Pay $15 on personal debt
+ one-off $300 =$85/y + one-off $300

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Conclusion of MM 1
• In perfect market in which three conditions are
met
• Investors can make changes in their own
accounts that will replicate cash flows for any
capital structure that company wants or that
you desire.
• As investors can do this on their own, they are
not willing to place more value on companies
which change capital structure for them.
• Therefore, V will be the same regardless of its
capital structure. This is true because
• Capital structure does NOT change V if it does
not affect total cash flows to security-holders.

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Recording 2: The Impact of Debt on rE – MMII

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MM Proposition 2 (MM2)
• Although capital structure DOES NOT affect V( =
Value of company), it AFFECTS rE (=cost of equity
= required return on equity)
• MM2 states that the cost of (required return on) a
company’s ordinary shares is directly related to
the debt-to-equity ratio.
• To see why, let’s return to the WACC formula

D E
rWACC  rD (1  Tc )  rE
E D E D
• Two things to look at!
Ignore (1-Tc)
– In the MM world, no taxes so ________________
– In the MM world, does WACC change with leverage?

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Does WACC change with leverage?

Given
WACC = 15% =rU
rE = FCF1=$34,500
0 1

D=$15,000 *(1.05)= D1=$15,750

E=$15,000(=V-D) E1=$18,750
where V = 34,500/1.15
=30,000 D E
rWACC  rD  rE
ED E D
=rWACC=rU

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MM2
By rearranging, D E
rWACC= rU  rD  rE
E D E D
You arrive at MM2 in an equation form.

D
rE  rU  (r  r )
E U D
MM2: The cost of equity is equal to the cost of capital of
unlevered equity (=rU) plus a premium that is proportional to
the debt-equity ratio (=D/E).

D 15000
rE  rU  (rU  rD )  15%  (15%  5%)  25%
E 15000
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In the MM World,

=Risk arising from the use

Of the debt .
-> increases the variability
of shareholders’ return

=Risk relating to
the nature of a firm’s assets

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Implication of MM Propositions
• What if we relax MM assumptions?
– With the existence of market frictions such as taxes
and costs, would capital structure matter in
determining the value of a company?
– The value of MM analysis is that it tells us exactly
where we should look if we want to understand how
capital structure affects firm value and cost of equity
From now on, we REVISIT MM1 but after relaxing tax
and transaction cost assumptions. So we want to learn
– Let us first consider the impact of taxes

MM 1 with taxes MM 1 with taxes & costs

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Recording 3: The Impact of Debt on V – MM I with tax

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Three worlds to go through

No 2. MM I with tax(Tc)

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Three worlds to go through

No 2. MM I with tax(Tc)

Tax

Cost

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Impact of Corporate Tax (Tc)

Benefit of interest tax shield

• Firms can deduct interest payments for tax purposes but

cannot deduct dividend payment
• Interest tax shield
– Defined as Tax savings resulting from deductibility of interest
payments.

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Impact of Corporate Tax (Tc)

Benefit of interest tax shield
Eg) Firm L (having debt) borrowed $1000 at 8%. EBIT is
$1000 and corporate tax rate (t) is 30%. Compare total
income to both bondholders and shareholders between
Firm L and Firm U (having no debt).
• Interest payment = cost of debt X amount borrowed
rD*D=0.08*$1000=$80
=______________________
• Annual tax saving on interest (=Annual tax shield)
= Interest payment X corporate tax rate =$1000*0.30
rD*D*Tc= $1000*0.08*0.30 =$24
=___________________________ =$300
• Assuming such saving is perpetual, PV (tax shield) is
$24
AnnualTaxShield ________ $24 r * D * TC
  ൌ 300  D  D * TC
rD rD 0.08 rD

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Capital Structure & Corporate Taxes

Income Income
Statement of Statement of
Firm U Firm L
Earnings before interest and taxes $1,000 $1,000
Interest paid to bondholders - -80
Pretax income 1,000 920
_____
30%
Tax at 35% -300
______ -276
_____
Net income to stockholders 700 644
Total income to both bondholders and
stockholders 0+700=700 ______________
_____________ 80+644=724

.3 x interest)
Interest tax shield (.35 0 _____________
_____________ $24
The tax deductibility of interest increases the total distributed income to
both bondholders and shareholders. (by the amount of tax shield of $ 24)

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Impact of Tax
Benefit of interest tax shield

•If only tax condition is violated, the more debt it has

the31more the firm will be worth.

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Impact of Corporate Tax

Benefit of interest tax shield
• VL= The value of a levered firm ( Firm with debt)
• VU= The value of an unlevered firm (Firm without debt)
• VL=VU + PV of interest tax shield (=PV of tax savings on
interest)
VL=VU+ TcD (MM1 with taxes)
• Implications
– The more it borrows, the more firm value increases
– Then a company should borrow so much that its tax bill is reduced
to zero??
– In reality, few of them borrows that much.
– Let’s consider the costs arising from the use of debt which offset the
benefit of debt
– Bankruptcy costs
– Agency cost

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Recording 4: The Impact of Debt on V – Real World

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Three worlds to go through

No 3. Real World

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Bankruptcy Costs (=financial distress costs)

• Costs associated with financial difficulties a firm might
experience because it uses debt financing
• Financial distress occurs when a firm is not able to make all of
the interest and principal payments that it owes its lenders.
• VL= VU + PV (InterestTax Shield)- PV (Financial distress costs)
• Costs can be direct or indirect
DIRECT COST:
• fees paid to parties such as lawyers, accountants and
consultants
INDIRECT COST:
• The cost arising from a change in behaviour of your
stakeholders
– Customers starting to buy the competitors’ products.
– Suppliers demanding cash on delivery
– Employees starting to leave
– Sales of assets at a lower price

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Trade‐off theory
• Managers choose a specific target capital structure
based on the trade-off between the benefits of debt and
costs of debt. The optimal capital structure is where the firm
value is maximised.
Value of firm with only benefits
from debt
Costs of financial distress
Firm Value

PV of tax shield (=D*Tc) Value of firm with debt

Value of Target capital structure:

firm with Capital structure that
no debt maximises Vcompany

Optimal debt ratio D/V

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Trade-off theory
• PV (interest tax shield) initially increases as the firm
borrows more.
• At moderate debt levels the probability of financial
distress is low  PV(financial distress costs) is small
 tax advantages dominate.
• At some point the probability of financial distress
increases rapidly with additional borrowing
• The cost of distress begins to outweigh the benefit of
debt.
• Optimum (which maximises firm value) occurs
when PV(tax shield) is just offset by increase in
PV(financial distress costs)

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ADDITIONAL COSTS? Agency Cost

• Agency costs result when there are conflicts of
interest between stakeholders. The implication
is
VL= VU + PV (Tax Shield) - PV (Agency costs)
Managerial Entrenchment
– A situation arising as a result of the separation of ownership and
control, in which managers may make decisions that benefit
themselves at investors’ expense.
– The use of debt financing at a moderate level can contribute to
reducing agency costs.
 Under the presence of debt, using debt financing provides
managers with incentives to focus on maximising the
company’s free cash flow.
 Limits the ability of bad managers to waste the stockholders’
money on non-value-maximising projects.

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Agency Cost: Equity-debt holder Conflicts

• When investors lend money to a company, they
delegate authority to the shareholders to decide
how that money will be used.
Lenders
• Principal? __________ Shareholders
Agent? _____________
– Lenders expectation is that the shareholders, through
the managers they appoint, will invest the money in a
way that enables the firm to make all of the interest and
principal payments that have been promised.
HOWEVER, WHEN A FIRM is FINANCIALLY DISTRESSED,
– Shareholders might decide that instead of investing the
money to grow the firm, they will distribute it to
themselves as a dividend.
– Excessive risk-taking: Shareholders have an incentive to
invest in risky negative NPV projects.=risky & high return
– Under-investment problem: shareholders have an
incentive to choose NOT to invest in a positive NPV
project. =Safe & low return

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Risky negative NPV project

NPV
95% -100,000
5% 1,000,000

NPV= 0.95*(-100,000)+0.05*(1,000,000)
= -45,000

40 Document title

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Pecking order hypothesis

• Emerges under asymmetric information.
– Insiders know better and more than outsiders.
• Theory recognises that different types of capital
have different costs and this leads to a pecking
order in financing choices that managers make.
– Internal funds  issuing(selling) debt selling equity
– The announcement of share issue Pshare as investors
believe managers are more likely to issue when shares
are overpriced. (i.e. bad signal!)
– Therefore firms prefer internal finance since funds can
be raised without sending adverse signals.
– If external finance is required, firms issue debt first and
equity as a last resort.

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Summary
• What is capital structure?
• What are the assumptions behind MM
propositions?
• What does MM proposition 1 tell us?
• What does MM proposition 2 tell us?
• What are two types of risk reflected in MM
proposition 2?
• Can you compute the benefit of interest tax
shield? (for both annual and perpetual benefit)
• What are bankruptcy costs and how do they
affect firm value?
• Why use of debt can reduce agency costs
between
42 shareholder and manager?

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Summary
• What causes Equity-debt holder agency costs
and what kind of opportunistic behaviour can be
undertaken by shareholders?
• Can you describe the value of the firm as a
function of the proportion of debt when tax
assumption is relaxed (i.e. Presence of corporate
tax) under MM proposition 1?
• Can you describe the value of the firm as a
function of the proportion of debt when both tax
and transaction cost assumptions are relaxed
under MM proposition 1?
• Can you discuss the trade-off theory?
• Can 43
you discuss the pecking order theory?

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