Capital Structure

15

Overview
Capital structure is about the funding side of the company’s balance sheet. It’s an
important topic, enabling a better understanding of a company’s risk profile and
health. Previous chapters highlighted the need to consider E and S as capital, just like
F. That implies that we can and should look at capital structure from the perspective
of F, E, and S. In this chapter, we explore how that can be done. We start from
financial capital structure, which can look like Table 15.1, showing debt, equity,
and assets in market values—as opposed to book value balance sheets in accounting.
These values can subsequently be expressed in ratios such as debt/assets.
We consider the theories that explain financial capital structure, such as the
Modigliani-Miller (MM) theorems, which say that in a perfect world, financial
capital structure is irrelevant for financial value (MM1) and that the cost of equity
increases with leverage (MM2). Financial capital structure does affect the cost of
equity in proportion to risk, and the split in debt and equity value, but it does not
change total financial value. From that starting point, several imperfections (e.g.,
information asymmetries, taxes, bankruptcy costs, agency costs) are considered that
try to explain the conditions under which financial capital structure does matter to
financial value. Behavioural issues, such as misvaluations and overconfidence, add
another layer of complexity.
Subsequently, we consider the capital structures of E and S separately.
Companies generate assets and liabilities on E and S, as they do on the financial
side. The main difference is that it is typically much less clear how strong the claims
against the company are, and to what extent they will materialise in financial terms.
However, their presence and size give strong indications of additional risk. For
example, a company might destroy more value on E than it creates, meaning that its
liabilities exceed its assets on E, and its E equity is therefore negative. This is all the
more troublesome if its direct competitors have healthier E capital structures and
lower risk of internalisation.
The analysis of the capital structures of E and S allows us to take the next step,
namely the construction of an integrated capital structure, which is the capital
structure of F, E, and S combined, and which may look like Table 15.2.

# The Author(s) 2023 431

D. Schoenmaker, W. Schramade, Corporate Finance for Long-Term Value, Springer
Texts in Business and Economics, https://doi.org/10.1007/978-3-031-35009-2_15
432 15 Capital Structure

Table 15.1 The market value financial balance sheet

F assets 25 F debt 5

F equity 20

Total F assets 25 Total F liabilies 25

Table 15.2 The integrated balance sheet

S assets 20 S debt 5
S equity 15
E assets 15 E debt 25
E equity -10
F assets 25 F debt 5
F equity 20
Total integrated assets 60 Total integrated liabilities 60

This integrated balance sheet offers a richer perspective on the company’s assets
and liabilities than a balance sheet that is limited to F. In Table 15.2, the integrated
capital structure is riskier than the financial capital structure, with higher integrated
leverage (as measured by integrated debt/integrated assets = [5 + 25 + 5]/60 = 35/
60 = 0.58) than financial leverage (as measured by F debt/F assets = 5/25 = 0.20).
As found in Chap. 13 on the cost of integrated capital, liabilities on S and E make the
integrated capital structure riskier and raise the cost of integrated capital. See Fig.
15.1 for a chapter overview.

This chapter:

15.1 Financial capital structure in perfect capital markets

15.2 Financial capital structure with imperfections
15.3 Behavioural perspective on financial capital structure

15.4 E and S affecting financial capital structure

15.5. Capital structure of E and S

15.6. Integrated capital structure

Fig. 15.1 Chapter overview

15.1 Financial Capital Structure in Perfect Capital Markets 433

Learning Objectives
After you have studied this chapter, you should be able to:

• explain the main theories of financial capital structure, and what they say about
the relevance of financial capital structure to valuation and the financial cost of
capital;
• demonstrate how E and S each have their own capital structure and how they can
be interpreted;
• consider capital structure from an integrated perspective and explain what
implications that has for assessing company risk;
• do capital structure calculations on all types of capital.

15.1 Financial Capital Structure in Perfect Capital Markets

Financial capital structure is about the funding of the company’s business activities.
It refers to the distribution of equity, debt, and hybrid securities that a company has
outstanding. It is also referred to as leverage:
Debt Debt
Leverage = = ð15:1Þ
Value Total assets
whereby leverage is debt divided by the company’s value or total assets. Companies
with a high proportion of debt on their balance sheet are said to be highly levered
(or leveraged). In Table 15.3, debt, equity, and assets are shown on market value
basis for company Keynes Technology. This is important to emphasise: we do not
use the book values that are shown in companies’ annual reports, but we use the
present value of assets, the resulting market value of equity (which is for most listed
companies much higher than the book value—with the notable exception of dis-
tressed companies, for which the reverse is true) and the market value of debt.
Financial capital structure matters because of its potential impact on valuation
(Chaps. 8–10), risk and return (Chap. 12), and cost of capital (Chap. 13). It is
typically measured by means of ratios that express the distribution of the types of
securities (such as debt/equity or debt/assets) or the ability to bear the interest burden
(such as the interest coverage ratio). The main distinction is between debt and equity,
but the picture could become blurred by intermediate or hybrid types of capital such
as convertible bonds (i.e. corporate bonds that can be exchanged for a predefined
number of shares in the issuing company).

Table 15.3 Company Keynes Tech’s market value financial balance sheet

F assets 25 F debt 5
F equity 20
Total F assets 25 Total F liabilities 25
434 15 Capital Structure

In the example in Table 15.3, the debt-equity ratio is 5/20 = 0.25; and the debt/
assets (leverage) ratio is 5/25 = 0.2. At first sight, that seems a moderate level of
leverage, but without any further information, it is hard to tell if that is a healthy
capital structure. It also depends on the company’s ability to service interest
payments, which tends to be higher (easier) for a profitable and stable business.
However, for a fast-growing company that burns cash, even a low level of debt can
be too much. In addition, issues such as tax treatment and management incentives
might be relevant in deciding on a company’s capital structure. In sum, there are
many potential determinants of capital structure.

15.1.1 Theories Explaining Financial Capital Structure in Perfect

Capital Markets

Modigliani and Miller (1958) realised that corporate finance in the real world is a
complex topic, with many effects potentially in play. So, they decided to tackle the
question of optimal capital structure from a very interesting angle: what if we assume
a perfect capital market? In a perfect capital market, there are no distortions such as
taxes, bankruptcy costs, and information asymmetries. In the absence of such
distortions, they asked: does capital structure still matter?
Modigliani and Miller (henceforth MM) postulated that in perfect capital markets,
investors are not dependent on the company to decide the level of leverage. Rather,
investors could create their own desired level of leverage by buying the company’s
shares with borrowed funds (homemade leverage). Due to such buying and selling,
any price differences based on leverage should disappear. This is the arbitrage
argument, the foundation for the law of one price (see also Chap. 4).
This reasoning resulted in the two MM propositions.
MM proposition 1: in a perfect capital market, the value of the levered company
VL equals the value of the unlevered company VU.
Another way to express MM1 is the simple formula:
VU = VL ð15:2Þ

The logic behind it is as follows. The total value of a company equals the total
market value of the cash flows generated by its assets. That is, in the simplified form
of a perpetuity:
FCF U
VU = ð15:3Þ
rU
And in perfect capital markets, the cash flows are not affected by leverage (i.e.,
FCFL = FCFu), nor is their risk (i.e., rL = ru). Hence, VL should have the same total
cash flows and overall cost of capital as VU, and valuation should not be affected by
leverage. However, what does change with leverage is the mix between debt and
equity, and the split of cash flows over debt and equity.
15.1 Financial Capital Structure in Perfect Capital Markets 435

FCF equity FCF debt

VL = þ ð15:4Þ
r equity r debt

Leverage also affects the cost of equity. At 0% debt and 100% equity, requity
equals ru, but as debt levels rise, requity needs to go up as well. Since the WACC (see
Chap. 13) is unchanged by leverage (rL = ru), and since debt has a lower cost of
capital than WACC, an increasing portion of debt will have to be compensated by a
higher cost of equity.
MM proposition 2: the cost of capital of levered equity increases with the
company’s market value debt-equity ratio.
The MM2 formula:
debt
r equity = r U þ  ðr U - r debt Þ ð15:5Þ
equity

This follows from:

equity debt
WACC = r U =  r equity þ  r debt ð15:6Þ
VL VL
This can be converted to: r U - debtþequity
debt
 r debt = debtþequity
equity
 r equity (please note
that VL = debt + equity); and: r equity = equity  r U - equity
debtþequity debt
 r debt ; hence:
r equity = r U þ equity
debt
 ðr U - r debt Þ.
MM2 essentially says that requity rises exponentially with leverage. Let’s see how
that works in numbers and suppose that company Foodmart’s rU is 7% and rdebt is
2% (at least at moderate leverage). Then how does requity develop as leverage
increases? Table 15.4 and Fig. 15.2 illustrate how requity climbs from 7% at 0%
debt (i.e. equal to rU) to over 10% at 40% debt, still assuming rdebt of 2%. Beyond

Table 15.4 Cost of equity with rising leverage at company Foodmart

Equity Debt Equity/ Debt/V Debt/
(as %) (as %) requity rdebt rU V (leverage) equity WACC
100 0 7.0% 2.0% 7.0% 1 0 0.0 7.0%
90 10 7.6% 2.0% 7.0% 0.9 0.1 0.1 7.0%
80 20 8.3% 2.0% 7.0% 0.8 0.2 0.3 7.0%
70 30 9.1% 2.0% 7.0% 0.7 0.3 0.4 7.0%
60 40 10.3% 2.0% 7.0% 0.6 0.4 0.7 7.0%
50 50 11.9% 2.1% 7.0% 0.5 0.5 1.0 7.0%
40 60 14.1% 2.3% 7.0% 0.4 0.6 1.5 7.0%
30 70 16.8% 2.8% 7.0% 0.3 0.7 2.3 7.0%
20 80 20.2% 3.7% 7.0% 0.2 0.8 4.0 7.0%
10 90 25.0% 5.0% 7.0% 0.1 0.9 9.0 7.0%
0 100 n.a. 7.0% 7.0% 0 1 n.a. 7.0%
436 15 Capital Structure

30%

25%
Cost of financial capital

20%

15%

10% WACC

5%

0%
0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%

Leverage = Debt/Value

Fig. 15.2 Cost of equity with rising leverage at company M

that point, we assume rdebt to rise as well, reflecting serious additional risk. At the
extreme, there is 100% debt at rdebt of 7%, effectively becoming as risky as equity.
The very high leverage levels might seem farfetched, but they do occur. Such
bonds are called junk bonds, as opposed to bonds at low levels of debt, which are
rated investment-grade debt (see Chaps. 8 and 13). Example 15.1 shows how one
can calculate the WACC.

Example 15.1 Calculating the WACC

Problem
Suppose your manager is creating a DCF model for company Fastfood and
asks you to calculate the WACC. Suppose the debt to value (leverage) ratio is
30%, the interest rate is 2%, and the shareholders demand a return of 10%.
Calculate the WACC.
Solution
The first step is retrieving the formula to calculate the WACC from Eq. 15.6:
r U = equity
V L  r equity þ V L  r debt The WACC consists of four elements: the return
debt

on equity, the return on debt, the equity ratio, and the debt ratio. Three of these
are given and the equity ratio can be determined via 1-debt ratio = 1–0.3 = 0.7.
The WACC of company Fastfood can be calculated as follows 0.7 * 10%
+ 0.3 * 2% = 7.6%. ◄

However, the above example in Table 15.4 is just a matter of filling in the WACC
formula. A more intuitive way is to consider how a company’s balance sheet and
P&L change with a debt issue, and accordingly its cash flows to equity and cost of
15.1 Financial Capital Structure in Perfect Capital Markets 437

Table 15.5 Company Jevons Motors without leverage

F assets 1,000 F equity 1,000

Total assets 1,000 Total liabilities 1,000

equity. Let’s assume the company Jevons Motors has a WACC of 10%; eternal
yearly cash flows of 100; 100% equity funding; and 200 shares outstanding. Then
using Eq. 15.3 gives: Vu = FCFU/rU=100/10% = 1000. And the value per share is
Vu divided by the number of shares, which is 1000/200 = 5. In the absence of taxes,
EPS (earnings per share) equals FCF per share, i.e. 100/200 = 0.5. Jevons Motors’s
simplified balance sheet can then be constructed as shown in Table 15.5.
Now suppose Jevons Motors issues 400 of debt and pays out the proceeds of
400 as dividends to its shareholders. That means that each shareholder receives a
dividend of 2 (= 400 dividend/200 shares). Its balance sheet and capital structure
then look like Table 15.6.
At first sight, this looks like a loss for shareholders, but it’s not: don’t forget that
the reduction in the value of their shares exactly equals the dividends they are paid.
The debt issue does not affect FCF, WACC (rU), and the number of shares, as
explained in Table 15.7. Of course, there is a change in both F debt (was 0, now 400)
and in F equity (was 1000, now 600, so -40%). So, the value per share also drops by

Table 15.6 Jevons Motors with leverage

F assets 1,000 F debt 400

F equity 600
Total assets 1,000 Total liabilities 1,000

Table 15.7 Jevons Motors No debt With debt

with and without leverage
F assets 1000 1000
(no taxes)
F equity 1000 600
F debt 0 400
rU 10% 10%
rdebt na 2%
requity 10% 15.3%
Free cash flow (FCF) 100 100
Interest 0 8
Cash flow to equity 100 92
Number of shares 200 200
EPS 0.50 0.46
Value per share 5 3
438 15 Capital Structure

40%, from 5 (= 1000/200) to 3 (= 600/200), equal to the dividends per share of

2. Table 15.7 shows the difference between the situations with and without debt.
The most important change is to the P&L and the cost of equity. With rdebt of 2%
and F debt of 400, the annual interest payment (cash flow to debt) is 400*0.02 = 8.
This reduces the net income and cash flow to equity by 8, from 100 to 92. Hence,
EPS = 92/200 = 0.46. So while shareholders sold 40% of the company to the debt
holders, their cash flow is reduced by only 8%. This sounds like a free lunch, but it is
not, since the cost of equity increases in such a way that the value of equity is
reduced by 40% after all. Recall the MM2 formula in Eq. 15.5:
debt
requity = r U þ  ðr U - r debt Þ
equity

Applying it to this case gives requity=10% + 400/600*(10%–2%) = 10% + 2/

3*8% = 15.3%. This gets us to F equity of 92/0.153 = 600; and a value per share of
0.46/0.153 = 3. This illustrates that the change in capital structure does not mean a
change in value (MM1), while it does mean a change in the cost of equity capital
(MM2).
Example 15.2 shows how one can calculate the return on equity with leverage.

Example 15.2 Calculating the Return on Equity with Leverage

Problem
The proposition of Modigliani and Miller indicates that the amount of debt
doesn’t affect the WACC of firm value (MM1). The increase in debt will be
reflected in the return on equity (MM2). Suppose the debt ratio is 30%, interest
rate is 3%, and the unlevered cost of equity is 8%. Calculate the return on equity
with leverage.
Solution
Equation 15.5 can be used to calculate the return on equity:

debt
requity = r U þ  ðr U - r debt Þ
equity

First, we need to determine the D/E ratio by dividing the debt ratio by the
equity ratio, which gives 0.3/(1–0.3) = 0.43. Filling in the equation gives
8% + 0.43 * (8–3%) = 10.15%.
By taking additional leverage, the required return on equity increases from 8 to
10.15%, which makes sense because the equity gets riskier (as debt is repaid
before equity in case of default). To compensate for the additional risk, the equity
holders demand additional return. ◄
15.2 Financial Capital Structure with Imperfections 439

15.2 Financial Capital Structure with Imperfections

The MM propositions show that equity risk increases with leverage (MM2) and that
capital structure is irrelevant for value in perfect capital markets (MM1). MM1
shows the conservation of value principle: in perfect capital markets, financial
transactions do not add or destroy financial value (FV). They just repackage risk,
as shown by MM2. In addition, by showing that capital structure is irrelevant in
perfect capital markets, the MM propositions implicitly also show that imperfections
point the way to what does matter for valuation. Such imperfections that do matter
for financial capital structure include:
• Taxes and bankruptcy costs—formalised in static trade-off theory;
• Information asymmetries—described in pecking order theory.

15.2.1 Static Trade-off Theory: Taxes and Bankruptcy Costs

In MM’s perfect capital markets, taxes and bankruptcy costs are absent. But in the
real world, taxes do exist and give incentives for investors to prefer higher debt
levels. In most tax systems, interest is deductible for corporate tax, which means that
debt is effectively subsidised and stimulated. However, the real world also offers a
(partial) countervailing effect, which is the cost of bankruptcy. In perfect capital
markets companies can go bankrupt at zero cost, i.e. they can reorganise their capital
structure (convert debt into equity) without losses on the asset side of the balance
sheet. But in the real world, such losses do occur: key employees, suppliers, and
clients typically leave the company when in distress, which reduces its FCF and the
value of its assets.
Static trade-off theory argues that corporate managers recognise the offsetting
effects of tax benefits and bankruptcy costs. This suggests that there is an optimal
point or range where the combined effects of tax advantages and bankruptcy costs
are most positive, whereby overall cost of capital (WACC) is minimalised. Fig-
ure 15.3 illustrates this.

Fig. 15.3 Optimal capital WACC

structure in static trade-off
theory

Ru Minimal WACC

Debt/V (leverage)
440 15 Capital Structure

15.2.1.1 Taxes
The tax benefits are also known as the interest tax shield, which equals the corporate
tax rate times the interest payments made:
Tax shield = τc  interest payments = τc  r debt  debt ð15:7Þ

Let’s illustrate this with the numbers of the previously mentioned company
Jevons Motors. Table 15.8 shows the company’s simplified P&L for four different
situations with/without debt and with/without taxes.
In the first two cases, there are no taxes, and net income and taxes add up to 100.
In the last two cases, a corporate tax rate of 25% applies. As a result, the sum of net
income and interest payments is reduced to 75 in the third case (the one without debt)
and company value Vu is reduced to 750 (= 75/0.1). However, in the fourth case, the
sum of net income and interest is 77, producing tax savings or a tax shield of
2 (=25% × 8) for financiers. The reason is that the corporate tax rate is levied on
the earnings after the deduction of interest. Hence, it’s in the financiers’ interest to
maximise the tax shield—at least in the absence of bankruptcy costs.
In formulas, the tax shield is typically shown explicitly, as in the after-tax WACC,
whereas the bankruptcy costs are not shown. In an adaption of Eq. 15.6, the after-tax
WACC is then:
equity debt
After - tax WACC =  r equity þ  r debt  ð1 - τc Þ ð15:8Þ
VL VL
That means that, versus the pre-tax WACC, the after-tax WACC is reduced by:
debt
 r debt  τc ð15:9Þ
VL
And since cash flows to financiers also increase, this should result in an increase
of the value of the company. In fact, the increase equals the present value of the
interest tax shield, i.e. the tax shield discounted by the cost of debt.

Table 15.8 P&L effects of taxes and leverage for Jevons Motors
Debt? No debt With debt of 400 No debt With debt of 400
Taxes? No taxes No taxes With taxes With taxes
Cash flow 100 100 100 100
Interest payments (2%) 0 8 0 8
EBIT 100 92 100 92
Corporate tax rate (τc) 0% 0% 25% 25%
Taxes paid 0 0 25 23
Net income 100 92 75 69
Net income + interest 100 100 75 77
Tax shield (τc x interest) 0 0 0 2
15.2 Financial Capital Structure with Imperfections 441

τc  debt  r debt
PVðinterest tax shieldÞ = = τc  debt ð15:10Þ
r debt
Hence, in a world with taxes (and still without bankruptcy costs and other
imperfections) MM proposition 1 becomes:
V L = V U þ τc  debt ð15:11Þ

and the increase in value of equity equals τc  debt, as the advantage goes to the
shareholders.
MM proposition 2 is also different with taxes:
debt
requity = r U þ  ðrU - r debt Þð1 - τc Þ ð15:12Þ
equity

So, as in the original MM2, the cost of equity still increases with leverage, but the
rise is mitigated by the tax break. Example 15.3 shows how one can calculate the
return on equity with corporate tax.

Example 15.3 Calculating the Return on Equity with Corporate Tax

Problem
As discussed, the tax deductibility of interest expenses has an impact on the
cost of capital. We build upon Example 15.2 to demonstrate the effect of this
interest tax shield. Recall, the D/E ratio is 0.43, interest expense 3%, and
unlevered cost of capital is 8%. Assume that the tax rate is 25%. Calculate the
return on equity by taking into account the corporate tax.
Solution
The relevant equation is shown in 15.12:

debt
requity = r U þ  ðrU - r debt Þð1 - τc Þ
equity

Simply filling in the formula gives us 8% + 0.43*(8–3%)*(1–25%) = 9.16%.

The return on equity without tax shield was 10.15%, while with the tax shield the
return on equity drops to 9.16%. The higher firm value benefits the shareholders
since they have the residual claim on the company (see Chap. 3 on shareholders
as residual claimants of the company). Therefore, the required return on equity
drops as a result of the tax shield. ◄

We can apply MM2 to Jevons Motors and observe that the 25% tax rate reduces
the unlevered company value to 750, but part of that reduction is reclaimed in the
levered case (final column), where the value of assets is 850. This is shown in
Table 15.9, which uses the results from Tables 15.7 and 15.8.
After all, MM1 with taxes implies: VL = VU + τc  debt = 750 + 0.25  400 = 850.
And equity value then becomes 850–400 = 450. Knowing the value of equity allows us
442 15 Capital Structure

Table 15.9 Valuation & cost of capital effects of taxes and leverage for Jevons Motors
Debt? No debt With debt No debt With debt
Taxes? No taxes No taxes With taxes With taxes
F assets 1000 1000 750 850
F equity 1000 600 750 450
F debt 0 400 0 400
rU = pre-tax WACC 10% 10% 10% 10%
After-tax WACC na na 10% 8.8%
rdebt na 2% na 2%
requity 10% 15.3% 10% 15.3%
Cash flow 100 100 75 77
Interest 0 8 0 8
Cash flow to equity 100 92 75 69
Number of shares 200 200 200 200
EPS 0.5 0.46 0.375 0.345
Value per share 5 3 3.75 2.25

to fill in MM2 with taxes: requity = 10% þ 850400

- 400  ð10% - 2%Þð1 - 0:25Þ = 15:3%.
This is (perhaps surprisingly) exactly the same as in the levered case without taxes:
the tax benefit (which lowers requity) is exactly offset by the higher weight of
debt (which raises requity). The 15.3% requity also follows from (CF to equity)/
equity = 69/450 = 15.3%. And this gives the following after-tax WACC for
- 400
company X: After - tax WACC = 850850  15:3% þ 400
850  2%ð1 - 0:25Þ = 8:8%.
Given the above calculations, shareholders will be tempted to capture the tax
shield by levering up. In fact, this can be (part of) the rationale for takeovers. For
example, when Kraft Heinz attempted to take over Unilever, a much bigger com-
pany, the idea was to fund the deal with bank debt since Unilever was ‘underlevered’
anyway (see Chap. 18 on the aborted Kraft Heinz-Unilever takeover). But remem-
ber, all of the abovementioned calculations and reasonings are still without bank-
ruptcy costs.
Example 15.4 shows how one can calculate the value of equity with leverage and
corporate tax.

Example 15.4 Calculating Equity Value with Leverage and Corporate Tax

Problem
Assume the unlevered value of the company is €5000, the interest rate is 2%,
and the tax rate is 20%. The company has debt of €2500. Please calculate the
equity value of the company, by taking leverage and corporate tax into account.
Solution
The levered value of a company equals the unlevered equity value + the PV of
the interest tax shield given by Eq. 15.11:
15.2 Financial Capital Structure with Imperfections 443

V L = V U þ τc  debt

First, we need to determine the PV (tax shield) by multiplying the debt with the
tax rate. The PV (tax shield) = 2500 * 0.2 = 500. Adding the unlevered value and
the PV (tax shield) gives the levered company value 5000 + 500 = 5500. The
final step is to calculate the equity value. The levered firm value equals the market
value of its debt plus market value of equity. Rewriting the formula gives the
levered equity value of 5500–2500 = 3000. The company creates €500 (€3000–
€2500) in value for its shareholders (but at the expense of other taxpayers) by
taking the benefits of the debt tax shield. ◄

15.2.1.2 Bankruptcy Costs and Costs of Financial Distress

As a company’s leverage increases, the chance also rises that it cannot meet its debt
obligations. And the company is said to be in distress when it’s close to being unable
to meet its debt obligations. This is typically visible in the worsening of ratios, such
as the interest coverage ratio (EBIT/interest payments). For example, with the rise of
online retail, many retail companies that operated stores selling books, clothing or
electronics got into trouble, resulting in a structural decline of their profit levels. As a
result, their debt, which had looked easily serviceable for a long time, became too
high for them. Figure 15.4 illustrates this: in year 1, EBIT is close to 400 and interest
payments are just above 100. Hence, the interest coverage ratio is well above
3. When management considers year 1 a normal year and does not anticipate the
falling EBIT in years 2–5, it feels quite safe at that point in time.
The drop in year 2 will worry management, as the interest coverage ratio falls to
2, but management may still feel this is a temporary setback, especially when year
3 turns out to be better again, though not quite back to ‘normal’. However, the sharp
drop in EBIT in year 4 should have all alarm bells ringing as the company can just

400

350
Amount in €

300

250

200
EBIT
150
interest
100

50

0
1 2 3 4 5
Year

Fig. 15.4 Example of a company getting into financial distress

444 15 Capital Structure

about pay its interest from EBIT (interest coverage at 1). And in year 5, EBIT even
drops below interest payments, with likely negative operational cash flows (also
depending on investment levels). The company can then be described as being in
distress, and confidence in its ability to service its debt will depend on its cash position
and ability to sell assets. If the company is no longer able to service its debt, it will
default on it (i.e., fail to make promised interest payments or return of principal) and
likely go bankrupt. In that case, the capital structure is ‘reorganised’ and debt holders
become equity holders. If the company’s business is deemed no longer viable, it can
even be liquidated with assets being sold off. In both stages, the distress stage and the
bankruptcy stage that might follow, there are costs to the company that reduce its
value: investment opportunities are missed; and suppliers, clients, and employees lose
faith in the company and decide to do business elsewhere.
In a perfect capital market, there are no costs to reorganising the company: the
equity holders simply hand over ownership and control to the debt holders who
become the new shareholders. In reality, however, there are direct and indirect costs
of bankruptcy. Direct costs of bankruptcy include fees paid to administrators,
accountants, investment bankers, lawyers, and courts. Bankruptcies can take years
to unravel, at high costs. The process differs per country since countries have
different bankruptcy codes.
Indirect costs of bankruptcy refer to the value loss of missed sales and
investments the company could not make as a result of its dire financial situation.
Similar types of costs can also occur in the distressed phase and are then called costs
of financial distress. They can happen because employees start leaving the company,
and suppliers and customers start avoiding the company. Moreover, management
may lack the resources or the incentives to make positive NPV investments, espe-
cially if those investments also transfer value from equity holders to debt holders or
vice versa.
As a result, costs of financial distress and both direct and indirect bankruptcy
costs can have a significant impact on company value.

15.2.1.3 Optimal Capital Structure and Trade-off Theory

The imperfections discussed above, taxes and bankruptcy costs, have opposite
implications for capital structure: taxes give incentives for higher leverage, whereas
bankruptcy costs incentivise managers to reduce leverage. This suggests there might
be an optimal capital structure where the overall cost of capital is minimalised as a
sizeable tax benefit is obtained without excessive bankruptcy costs (see Fig. 15.3).
Hence, the trade-off theory predicts that companies’ debt ratios move towards a
target capital structure, which is determined by the balance of tax benefits and
bankruptcy/distress costs. This target capital structure depends on the conditions the
company is exposed to and is therefore company-specific.
15.2 Financial Capital Structure with Imperfections 445

15.2.2 Agency Costs, Information Asymmetries, and Pecking Order

Another issue that might affect capital structure is the presence of agency costs.
These are the costs resulting from the principal-agent conflict, which is about the
tensions between owners/financiers (the principals) and management (the agents), as
well as tensions among financiers (debt holders versus shareholders). Managers
might have incentives to pursue their own interests at the expense of financiers
(or other stakeholders, for that matter), resulting in too much or too little investment.
For example, according to Free Cash Flow (FCF) theory, managers of companies
with excess FCF (i.e., more cash flow than they can invest in positive NPV projects)
will often waste that cash instead of giving it back to shareholders (Jensen, 1986).
Such waste may take the form of spending on perks like private jets or a fancy office,
i.e. non-productive investment, also known as overinvestment. By contrast, heavy
debt burdens (called debt overhang) may result in managers not doing positive NPV
projects because the investments raise the risk of the company not being able to
service its debt obligations (Myers, 1977). This is in effect a transfer of value from
shareholders (who miss out on the value creation of the positive NPV projects) to
debt holders (whose risk is being reduced).
In the conflict of interest between managers and financiers, the former have a key
information advantage: managers, by nature of their role, typically know much better
what is happening at the company than its financiers and the wider capital markets
do. The financiers are aware of this information asymmetry and accordingly charge a
higher cost of capital for those types of capital where the information asymmetry is
more likely to be exploited. This applies first and foremost to equity issues, in which
the valuation effects of information asymmetries are largest. A change in the value
driver assumptions of investors (see Chap. 2) can affect their valuation a lot. This
also applies to a lesser extent to debt issues, but not to cash. From the manager’s
perspective, this results in a pecking order, where they prefer internal finance
(i.e. from cash flow and retained earnings, where they don’t pay a premium) over
external finance (in which financiers charge a higher cost of capital); and external
debt over external equity (Fig. 15.5) (Donaldson, 2000; Myers & Majluf, 1984).
In such a context of asymmetric information, the actions of managers can be seen
as signals about their beliefs on the value of the company. As Myers and Majluf
(1984) argue, when managers issue new equity, in spite of their pecking order

Fig. 15.5 Pecking order of

funding choice Equity issues
(external
Debt equity)
Cash
(internal
equity) Largest valuation effect of
information asymmetries

Most preferred
446 15 Capital Structure

preference, they are basically saying that they believe that the company is
overvalued. As investors see through this, they will place a lower value on the
new equity issue. This also explains why managers issue new equity as a last resort
according to the pecking order theory.

Box 15.1 Effect of an Equity Issue with and Without Information

Asymmetry
Suppose a company has a market capitalisation of €8 billion, and management
announces an equity issue of €2 billion. In the absence of asymmetric infor-
mation, this means that the new market capitalisation will be €8 billion + €2
billion = €10 billion. On the company’s market value balance sheet, €2 billion
in cash is added on the left-hand side, and €2 billion in equity is added on the
right-hand side. Hence, its market value balance sheet first looks like this:

And then like this:

However, it is different in the presence of information asymmetries. Then,

investors will likely react negatively to the announcement, interpreting the
company as overvalued, and the stock price (and market capitalisation) will
drop by, in this case, 3%. Hence, on announcement but before the actual issue,
the market value balance sheet looks like this:

This means that, in order to raise €2 billion, the company needs to issue not
25% additional shares (2/8), but 25.8% additional shares (2/7.76). So, if the
number of shares outstanding was 1000, the company will now have to issue
257.7 shares instead of 250 shares. The new shareholders now own 20.5%
(257.7/1257.7) of the shares, versus 20% in the case without asymmetric
information.

The new market capitalisation is not €10 billion, but €9.76 billion. More on
this in Chap. 16 on payouts and issues.
15.3 Behavioural Perspective on Financial Capital Structure 447

15.3 Behavioural Perspective on Financial Capital Structure

Surveys among financial practitioners show that the traditional view (i.e. of the
abovementioned imperfections) is not the whole story. Corporate financial policies
such as capital structure choices are also driven by behavioural issues: those of the
managers themselves (internal errors) and those of the markets they operate in
(external errors).

15.3.1 Internal Errors

On internal errors, there is evidence that optimistic managers use leverage more
aggressively (Malmendier et al., 2011). As they overestimate cash flow (see also
Chap. 6 on behavioural biases), managers also overestimate the interest level they
can afford to pay; see Fig. 15.6 where the manager’s EBIT estimate is higher than the
unbiased EBIT estimate.
In addition, optimistic managers tend to think their company’s stock is
undervalued, which makes them perceive equity issues as costly (Malmendier &
Tate, 2005). At the same time, they might think debt is cheap, underestimating how
debt (even at low interest rates) raises the cost of equity (see MM2). As a result,
optimistic managers are likely to choose higher debt levels than rational managers
(Hackbarth, 2008). In fact, empirical research finds that men tend to be more
optimistic than women and that female CFOs significantly reduce leverage when
taking over from male CFOs (Schopohl et al., 2021).
Table 15.10 illustrates how managers may underestimate leverage if they over-
value their company. In this case, management overvalues the NPV of its assets by
30% (= [338–260]/260), resulting in an overvaluation of equity by 46% (=

400

350

300
Amount in €

250
EBIT
200
interest
150
EBIT estimate by
100
overconfident manager
50

0
1 2 3 4 5
Year

Fig. 15.6 Overoptimistic manager not seeing the company getting into financial distress
448 15 Capital Structure

Table 15.10 Leverage effect of optimistic management

Fair value
F assets 260 F debt 90
F equity 170
Total assets 260 Total liabilities 260

F debt / F assets 0.35

Management's assessment
F assets 338 F debt 90
F equity 248
Total assets 338 Total liabilities 338

F debt / F assets 0.27

[248–170]/170) and an underestimation of the leverage (F debt/F assets) ratio by

23% (= [0.27–0.35]/0.35).

15.3.2 External Errors

It’s not just managers who can act irrationally, but financial market participants as
well, which may result in serious undervaluation or overvaluation of company
securities. This can also be challenging, for managers who do behave rationally.
They need to anticipate market irrationality and its consequences. For example, if
your company is significantly undervalued, you will want to avoid issuing equity
since it would mean giving away value. Let’s again consider the company of
Table 15.10, and assume the fair value is the same (top balance sheet of
Table 15.10), but now the market is wrong in its assessment of the company: it
undervalues the company’s assets by 20% (= [260–208]/260) and its debt by 2% (=
[90–88.2]/90). As a result, equity falls to 119.8, an undervaluation of 29.5% (=
[170–119.8]/170]). This is given in Table 15.11.
The company now has a perceived leverage (F debt/F assets) ratio of 0.42, which
makes additional debt funding tough. And equity funding is expensive due to its
undervaluation. Suppose the company needs 20 of cash for an investment with a PV
of 26, hence an NPV of 6. If the company raises that 20 by means of an equity issue,
it is effectively giving up 28.4 (= 20/0.295) in shares for 20 in cash; remember that
equity is undervalued at 29.5%. This result in an NPV of -8.4 (= 20–28.4), which
cancels out the positive NPV of the investment, for an adjusted NPV of -2.4 (=
6–8.4). So, the company will not do the investment. The implication is that (tempo-
rarily) irrational markets can result in the absence of funding opportunities for
positive NPV projects. This means there are limits to financial flexibility, and
managers seem to be aware of this. So, to enhance their financial flexibility,
15.4 E and S Affecting Financial Capital Structure 449

Table 15.11 Leverage effect of a pessimistic market

Fair value
F assets 260 F debt 90
F equity 170
Total assets 260 Total liabilities 260

F debt / F assets 0.35

Market’s assessment
F assets 208 F debt 88.2
F equity 119.8
Total assets 208 Total liabilities 208

F debt / F assets 0.42

managers may keep extra cash for special circumstances and maintain costly credit
lines with banks (which can be activated when needed). Managers might have to
make their decisions about capital structure and investment jointly rather than
separately, as investment might be sensitive to the amount of cash the company
has. There is evidence that CFOs try to time the market, for example by issuing debt
when they feel interest rates are very low, and try to maintain financial flexibility
(Graham & Harvey, 2001).
External and internal errors can of course also happen in tandem and may even
reinforce each other. In sum, it seems that capital structure is not so much a
conscious decision on having a specific debt/equity ratio, but more the cumulative
outcome of a long series of incremental financing decisions. If market timing-
motivated decisions are not quickly balanced away, low-leverage firms will tend
to be the ones that raise equity when their stock prices are high (Baker & Wurgler,
2002).

15.4 E and S Affecting Financial Capital Structure

Before considering the capital structures of E and S in their own right, let’s first
explore if S or E risks could make a company’s financial capital structure more
(or less) risky. The answer is that they can have that effect on financial risk, either
through the business model and operations of the company, which can affect interest
coverage ratios and project NPVs; or by means of investor perceptions (typically
anticipating the former) that affect a company’s cost of capital, valuation, and
financial capital structure. Managers, in turn, can take these effects into account in
their decision-making and adapt capital structure accordingly.
450 15 Capital Structure

15.4.1 E and S Affecting Financial Capital Structure Through

the Business Model and Operations

To see how E and/or S could affect financial capital structure through a company’s
business model, let’s consider the example of an airline. Before internalisation, the
company is moderately profitable and its assets are valued at 30, based on the NPV
of its expected future cash flows. At a debt burden of 12, this leaves 18 in equity. The
upper part of Table 15.12 gives the resulting market value balance sheet. However,
the airline’s cash flows are generated in a business model that externalises a large
amount of environmental costs: the airline emits a lot of CO2, nitrogen, and other
harmful substances. These are not taxed, unlike the emissions of alternative modes
of transport. What’s more, there is not (yet) a tax on airline ticket prices. All of this
leads to a huge E debt that is not yet internalised, but which looms large as a risk for
the company, in terms of F as well. This sheds a very different light on the
company’s current capital structure, as well on its target capital structure, that is
deemed optimal. Taking the E risk into account, one probably arrives at a much
lower target capital structure.
With internalisation, this risk materialises: the airline industry’s subsidies disap-
pear, its costs go up strongly because of carbon taxes, and demand for air travel
drops. As a result, both the industry and this particular airline see a drop in volumes
and need to shrink their fleets. The resulting losses are partly offset by higher ticket
prices and possibly lower levels of competition after restructuring of the industry.
The bottom part of Table 15.12 gives the company’s market value balance sheet after
internalisation. Since this airline is relatively well managed, it is able to survive and

Table 15.12 Market value balance sheet of an airline before and after internalisation

Before internalisation
F assets 30 F debt 12
F equity 18
Total assets 30 Total liabilities 30

F debt / F assets 0.40

After internalisation
F assets 21 F debt 10.8
F equity 10.2
Total assets 21 Total liabilities 21

F debt / F assets 0.51

15.4 E and S Affecting Financial Capital Structure 451

its loss in NPV is reduced by only 30%, to 21—as opposed to some airlines that fail
and see a reduction in value of nearly 100% (i.e. bankruptcy). The reduced asset base
jeopardises the company’s ability to service its debt, and its probability of default
rises. As a result, the value of its debt falls by 10%, to 10.8. Nominally, in terms of
book values, debt stays the same, and so do its interest payments, but the market
value of debt is reduced by higher risk. Since the company’s NPV drops by 9, and its
debt falls less, its equity falls from 18 to 10.2 (= 21–10.8). Accordingly, its leverage
(F debt/F assets) ratio rises from 0.40 to 0.51.
For the sake of simplicity, we project the effect of the possible removal of airline
subsidies as the unfolding of a forward-looking scenario in the bottom panel of
Table 15.12. Of course, other scenarios are also possible. As discussed in Chaps. 2
and 12, companies can use scenario analysis with a probability structure surrounding
E and S and their costs.
While the company was relatively well managed, it was still ill-prepared for
transition risks. If this company had been managed in a more visionary way, it would
have anticipated the internalisation of its externalities and prepared accordingly. For
example, it could have forged alliances with high-speed rail companies to replace
short-haul flights with rail and to connect rail to the more profitable long-haul flights.
In addition, the company could have invested more aggressively in fuel savings and
the use of alternative fuels. And in doing so, the company would have been able to
build a credible transition pathway and a superior reputation with clients.

15.4.2 E and S Affecting Financial Capital Structure Through

Investor Perceptions

The above airline example showed how the materialisation of an E risk affected the
business model and cash flows, leading to an increase in its leverage ratio. But of
course, such E or S risks can also affect capital structure through the cost of capital.
In anticipation of a possible internalisation, investors may perceive a heightened
financial risk, which results in lower F assets by means of a higher discount rate
and/or lower expected cash flows. This diminishes the value of F equity and hence
the buffer for F debt. This can result in distress and increased conflicts of interest
(agency costs) between debt and equity, as well as financial distress. Chapter 12
shows how E and S risk increase the financial discount rate (see Sect. 12.5).
In practice, the effects of higher cost of capital and lower expected cash flows can
of course reinforce each other, but they are separate channels. The lower expected
cash flows result from investors attaching higher probabilities to more negative
scenarios (often even the first time they consider such negative scenarios). The
higher cost of capital results from higher expected variations in outcomes and
sensitivity to market returns (higher beta).
452 15 Capital Structure

15.4.3 E and S Affecting Financial Capital Structure Through

Management Action

Ideally, managers see the risks of large E and S externalities, interpret them as
additional leverage, and take strategic action. If they have the future of the company
and its stakeholders in mind, they will reduce potential E and S liabilities (de-lever)
accordingly, for example by replacing harmful processes or products with less
harmful or even harmless ones. However, if managers are in it for vested interests
(i.e. to maintain negative externalities) or to maximise short-term shareholder value
related to their variable pay, they may prefer to lever up (by payouts to shareholders;
see Chap. 16) and double down on the risk—thereby endangering the future of the
company, while inflicting harm on stakeholders and the environment.

15.4.4 Academic Evidence of E and S Affecting Financial Capital

Structure

There is quite some empirical evidence that E risks do indeed have such effects. For
example, Ginglinger and Moreau (2022) find that greater climate risk leads to lower
leverage in the post-2015 period, i.e. after the Paris agreement. The reduction in
leverage related to climate risk is shared between a demand effect (the company’s
optimal leverage decreases) and a supply effect (bankers and bondholders increase
the spreads when lending to companies with the greatest risk). Similarly, Nguyen
and Phan (2020) attain that Kyoto protocol ratification in Australia led to a decrease
in leverage at heavy carbon emitting firms.
Evidence of S affecting capital structure is more sparse. Chemmanur et al. (2013)
show that labour costs limit the use of debt and hence reduce leverage. In addition,
Bae et al. (2011) find that companies that treat their employees better have lower
leverage. In a similar vein, Ghaly et al. (2015) observe that companies that are more
committed to employee well-being tend to hold more cash. And this relation is
stronger if human capital is more important to the firm.

15.5 Capital Structure of E and S

Just like FV has a capital structure with debt and equity, so do EV and SV have a
capital structure. Their relevance might not be obvious at first sight, but they are an
interesting expression of the claims that nature and society might have on
companies. They are also important indications of risk. Just consider the Inditex
example from Chap. 11, which showed large negative externalities on both E and
S. Expressing them in capital structure ratios helps in identifying and understanding
the size of the risks involved and allows comparison to other companies.
One could try to express E and S capital structure in their own units. For example,
a packaging and forestry company might report 10 million tonnes of CO2 emitted,
creating a liability; 3 million tonnes of CO2 stored, an asset; and 15 million tonnes of
15.5 Capital Structure of E and S 453

Table 15.13 Company Keynes Tech’s S capital structure

S assets 20 S debt 15
S equity 5
Total assets 20 Total liabilities 20

Table 15.14 Company Keynes Tech’s E capital structure

E assets 15 E debt 25
E equity -10
Total assets 15 Total liabilities 15

CO2 avoided, an asset. However, it would be hard to compare these units: the stored
CO2 is less ‘hard’ than emitted CO2, as it can be questioned how long it will be
stored. And avoided emissions are relative. So, these numbers cannot be simply
added and subtracted. It is also hard to compare them with other companies and
across time. Ideally, these flows are expressed in monetary terms (by putting prices
on them) and discounted to arrive at values, which can denote a capital structure.
Doing this is hard work but it can be done, as shown in impact accounts (see
Chap. 17). Tables 15.13 and 15.14 give examples of S and E capital structures,
respectively, for our earlier fictional company Keynes Tech (see Sect. 15.1).
One can interpret Keynes Tech’s S capital structure as follows: the S assets
indicate value creation by the company for society. S assets are not factually
owned by society, but they are desirable for society and have the potential for F
value creation. Remember from Chap. 4 that society is a company’s counterpart on
social and environmental value. In contrast, S liabilities (called S debt) indicate value
destruction by the company at the cost of society (on a different aspect of S than
where the value creation is happening), and hence an infringement on rightsholders,
and a potential claim for compensation by society. However, one should be careful
in their phrasing, since the value destruction on one aspect of S might be inevitable
for value creation on other aspects of S. In addition, in Keynes Tech’s case the S
assets are larger than the S debt, which means there is net value creation and positive
S equity. One can also express the S capital structure in ratios: the S leverage ratio is
S debt/S assets = 15/20 = 0.75. This is higher than the typical F leverage ratio.
Let’s now have a look at Keynes Tech’s E capital structure in Table 15.14, which
looks quite different compared to its S capital structure. As was the case for S above,
the existence of E assets indicates value creation for society, while E debt indicates
value destruction for society. However, Keynes Tech’s E assets are smaller than its E
debt, so there is net value destruction on E, which is typical for many if not most
companies in the current fossil fuels-based economy. In fact, there are likely a lot of
companies that have (almost) zero E assets and significant E debt.
454 15 Capital Structure

There are exceptions that do have E assets in excess of E debt. For example,
Danish enzyme maker Novozymes has annual GHG emissions of 0.5 million ton,
while saving (avoiding) 60 million tons at their clients (Scope 4), because the
company’s enzymes reduce energy use in various applications such as transport,
baking and washing (see Box 16.6 in Chap. 16). That is a wide margin.
It is useful to express capital structure in ratios, to make it comparable across
companies and over time. With the above numbers, Keynes Tech has an E leverage
ratio of E debt/E assets = 25/15 = 1.67, which is very high. But for companies with
0 or near 0 E assets, the E leverage ratio goes to infinity. Such high leverage means a
high risk for companies to lose their licence to operate (see Introduction of this
book). For further context, we will compare the capital structure ratios of E, S, F, and
I (integrated) in Sect. 15.6. This is at the core of taking double materiality seriously,
as discussed in Chap. 2.
Just like in financial capital structure, one could ask what optimal or healthy
levels are in the capital structures of E and S. To be healthy, equity needs to be
positive and debt needs to be minimal. But it can be hard to reduce liabilities without
also reducing assets and perhaps even killing the business. Hence, a transition
pathway is needed. For example, the best speed and order of change also depends
on internal capabilities, competitive positions, and pricing incentives (see Chap. 2).
To assess this properly, an integrated perspective is needed.
It should be noted that E and S assets and liabilities can be manipulated by
management, just like F assets and liabilities. Chapter 5 proposed a materiality test to
determine which E and S issues are material (relevant) for the company and should
be incorporated in the analysis. Chapter 17 discusses that auditors are starting to
include E and S in their audit of company reports. Such audits provide ‘reasonable’
assurance on the reliability of information in company reports.

15.6 Integrated Capital Structure

Analysing the capital structures of E and S separately allows us to move on to the

integrated capital structure, which is the capital structure of E, S, and F combined.
The integrated capital structure gives a picture of the overall risk of the company,
which might differ substantially from the risk picture that emerges from the financial
capital structure. For example, in the case of Inditex (see Chap. 11), there is no
financial leverage in the company, but a lot of S leverage and especially E leverage.
Following Eq. 15.1, we introduce integrated leverage:
Integrated debt
Integrated leverage = ð15:13Þ
Integrated assets
whereby integrated debt is the sum of S, E, and F debt and integrated assets is the
sum of S, E, and F assets. Table 15.15 visualises the integrated capital structure of
our company Keynes Tech in an integrated balance sheet.
15.6 Integrated Capital Structure 455

Table 15.15 Company Keynes Tech’s integrated balance sheet

S assets 20 S debt 5
S equity 15
E assets 15 E debt 25
E equity -10
F assets 25 F debt 5
F equity 20
Total integrated assets 60 Total integrated liabilities 60

Let’s explore how this works and what it means. First, the asset side of the
integrated balance sheet is constructed by including S assets, E assets, and F assets,
which add up to I assets (integrated assets).
Second, on the liabilities side, S debt, E debt, and F debt are the starting point,
which add up to I debt (integrated debt). S equity, E equity, and F equity then follow
from the balance of assets and liabilities for each type of value. In the above
example:

• S equity = S assets minus S debt = 20–5 = 15;

• E equity = E assets minus E debt = 15–25 = -10; and
• F equity = F assets minus F debt = 25–5 = 20.

So, for S, E, and F individually, debt and equity add up to assets.

Third, where debt is larger than assets, the equity turns negative. In Table 15.15
this happens for E. This negative E equity remains on the liabilities side of the
balance sheet (indicating severe underfunding of E assets).
Fourth, the sum of S equity, E equity, and F equity is I equity (integrated equity),
which might have a minus sign. The principle of balanced integrated value (Chap. 6)
implies that a company needs to be positive on all three dimensions to be a healthy
company.
Fifth, the above observations imply that S, E, and F have both their own capital
structures and joint capital structures that can be analysed. For example, by
expressing them in ratios. Table 15.16 distinguishes three types of integrated capital
structure ratios: leverage (debt/assets) ratios; composition of assets ratios
(fractions); and composition of debt rations (fractions).

Table 15.16 Integrated capital structure ratios for company K

Leverage ratios Composition of assets Composition of debt
F debt/F assets 0.20 F assets/I assets 0.42 F debt/I debt 0.14
S debt/S assets 0.25 S assets/I assets 0.33 S debt/I debt 0.14
E debt/E assets 1.67 E assets/I assets 0.25 E debt/I debt 0.71
I debt/I assets 0.58 Total 1.00 Total 1.00
456 15 Capital Structure

When looking at this company from an F perspective, its capital structure looks
conservative with a low financial leverage ratio of 0.20; and this also applies to S
leverage (0.25). But it is quite different for E leverage. This is visible both in the
leverage ratios (1.67 on E vs 0.2–0.25 for F and S) and in the composition of debt
ratios (0.71 for E, and 0.14 for S and F), which are high for E debt while having
moderate values for F and S. Especially the value of 1.67 for E leverage is high and
worrisome. As a result, the integrated leverage (=I debt/I assets) ratio of 0.58 is
much higher than the financial leverage (=F debt/F assets) ratio of 0.20.
The economic interpretation is that the company is not treating residual E
claimants (i.e. future generations) well, which can hurt them in future court cases
(as already seen with Royal Dutch Shell). It’s important to use the three types of
ratios in relation to each other. For example, the E leverage ratio of 1.67 is
worrisome. But in theory, it could also have been the result of very low E assets
without having high E debt. The E debt/I debt fraction therefore matters as well. In
this case, that one is high, which indicates that E leverage is indeed high and
problematic.
The composition of debt ratios show what type of debt represents what portion of
total debt. The three of them add up to one. In this example, E debt represents 71% of
I debt, whereas the assets ratios are more balanced. Example 15.5 shows how one
can calculate integrated capital structure ratios.

Example 15.5 Calculating Integrated Capital Structure Ratios

Problem
You are conducting an analysis on the capital structure ratios of company
AZ. Your investment team is a frontrunner in the field of impact investing and
therefore assesses the integrated capital ratios. That means that you investigate
the F, S, and E leverage ratios separately as well as the integrated leverage ratio.
Additionally, you want to know the debt and equity composition in relation to
integrated debt and assets.
Use Table 15.17 to calculate the integrated capital structure ratios for company
AZ. Briefly discuss the results.

Table 15.17 Integrated balance sheet for company AZ

S assets 30 S debt 40
S equity -10
E assets 20 E debt 10
E equity 10
F assets 40 F debt 20
F equity 20
Total integrated assets 90 Total integrated liabilities 90
15.6 Integrated Capital Structure 457

Solution
First, calculate the leverage ratios separately:

F debt/F assets = 20/40 = 0.50

S debt/S assets = 40/30 = 1.33
E debt/E assets = 10/20 = 0.50
I debt/I assets = 70/90 = 0.78

Second, calculate the composition of assets:

F assets/I assets = 40/90 = 0.44

S assets/I assets = 30/90 = 0.33
E assets/I assets = 20/90 = 0.22
Sum of asset fractions = 0.44 + 0.33 + 0.22 = 1.00
Please note the fractions have to add up to 1 exactly. Due to rounding of the
fractions, the fractions may add up to 0.99 or 1.01.

Third, calculate the composition of debt:

F debt/I debt = 20/70 = 0.29

S debt/I debt = 40/70 = 0.57
E debt/I debt = 10/70 = 0.14
Sum of debt fractions = 0.29 + 0.57 + 0.14 = 1.00

If the leverage ratio is greater than 1, there is a liability to the claimants, so a

negative claim. We see that in the financial and the environmental perspective, the
company has a decent capital structure (0.50 both). However, AZ is harming the
claimants of S with a high leverage ratio of 1.33. In other words, the company
extracts value from society. The integrated leverage ratio of 0.78 is considered to
be risky. Moreover, most assets represent financial capital, and most debt relates
to societal activities. Via this analysis, you can detect where the strengths and
weaknesses of the company lie. Ideally the company would reduce its S debt or
alternatively increase S assets to moderate the impact.
Chapter 2 discussed the financial impact: S and E assets can turn into F assets
through internalisation, while S and E liabilities can materialise in F liabilities
(F debt) through, for example, lawsuits. ◄

Interpretation also depends on a company’s context. Ratios of peer companies are

an interesting reference. In Table 15.18, packaging company 1 has a low E leverage
ratio compared to the average mining company, but a high one compared to other
packaging companies, which suggests it is at a competitive disadvantage. In contrast,
mining company 1 has a high E leverage ratio compared to the average packaging
company, reflecting more serious issues in mining, but it has a low ratio compared to
other mining companies, which suggests it is at a competitive advantage. These
comparisons show that sector analysis is very important. Market risk calculations in
the CAPM are also typically done at the industry level (see industry asset betas in
Chap. 13).
458 15 Capital Structure

Table 15.18 E leverage ratios for two peer groups

Peer group 1 E debt/E assets Peer group 2 E debt/E assets
Packaging company 1 1.67 Mining company 1 3.41
Packaging company 2 1.22 Mining company 2 7.58
Packaging company 3 1.37 Mining company 3 6.19
Packaging companies 1.42 Mining companies 5.73
average average

These ratios also suggest that the mining companies have a higher cost of
integrated capital than the packaging companies. More generally, the application
of such ratios casts a different light on the US shareholder model in which companies
tend to hold high levels of debt to exploit the tax shield. This now looks less
sustainable than the European Rhineland model in which companies often hold
more liquidity and less debt, which makes them less fragile and more resilient.

15.6.1 Inditex Case Study

We can now calculate the financial and integrated leverage ratios for Inditex.
Example 15.6 gives the basic data and shows the calculations. The valuation data
from Chap. 11 can be turned into an integrated balance sheet for Inditex. Table 15.20
shows the results.

Example 15.6 Calculating the Leverage Ratios of Inditex

Problem
For 2021, Inditex had an integrated value of €42 billion. Table 15.19 shows
the components of the integrated value (taken from Table 11.18 in Chap. 11). In
addition, Inditex had an equity value of €82 billion and negative debt of -€3
billion (taken from Table 11.6; debt is negative due to Inditex’s large cash
position).
Please calculate Inditex’s financial leverage ratio and integrated leverage ratio.
Solution
Let’s first turn Inditex’s value components into an integrated balance sheet.
The FV enterprise value represents F assets; negative SV is S debt, positive SV is
S assets, and negative EV is E debt. Equity is each time assets minus debt.
Table 15.20 provides Inditex’s integrated balance sheet for 2021.
We can now calculate the leverage ratios from the integrated balance sheet in
Table 15.20. Inditex’s financial leverage ratio is F debt/F assets = -3/79 = -4%.
Due to its negative F debt position, Inditex has a negative financial leverage ratio.
So, Inditex looks very conservatively financed from a financial perspective.
Inditex’s integrated leverage ratio is I debt/I assets = (-3 + 137 + 183)/
362 = 317/362 = 87%. This is a very high leverage ratio. So, Inditex’s leverage
looks very risky from an integrated perspective. ◄
15.7 Conclusions 459

Table 15.19 Integrated IV calculation Value (euro billions)

value of Inditex, in €
FV (enterprise value) 79
billions, 2021
Positive SV 283
Negative SV -137
Negative EV -183
IV 42

Table 15.20 Integrated balance sheet of Inditex, in € billions, 2021

F assets 79 F debt -3
F equity 82
S assets 283 S debt 137
S equity 146
E assets 0 E debt 183
E equity -183
Total integrated assets 362 Total integrated liabilities 362

Example 15.6 shows that Inditex’s financial leverage ratio is extremely conser-
vative at -4% (the negative number is due to Inditex’s negative net debt position).
By contrast, Inditex’s integrated leverage ratio is very high at 87% and indicates a
risky integrated capital structure. So, we get two diametrically opposed messages
from the leverage calculations. The high integrated leverage ratio is caused by the
high S debt (workers in the supply chain) and the high E debt (carbon emissions and
other environmental damages).
Inditex’s high integrated leverage ratio raises the question of how to manage
leverage from an integrated perspective. A first step for Inditex to address such high
leverage is to reduce liabilities. Given that Inditex has no financial liabilities, it can
reduce E and S liabilities by lowering carbon emissions and improving working
conditions in the supply chain (e.g. paying a living wage, abiding by health & safety
standards, and respecting human rights). A second step is to increase equity to
finance investment for this transition to a sustainable business model. As explained
in Chap. 16, it makes sense to increase investment, while reducing annual dividend
payouts.

15.7 Conclusions

Capital structure is an important topic since it helps in understanding a company’s

risk profile and health. This chapter started with theories that explain financial capital
structure, such as the Modigliani-Miller theorems, which say that in a perfect world,
financial capital structure is irrelevant for financial value (MM1) and that the cost of
equity increases with leverage (MM2). Financial capital structure does affect the cost
of equity in proportion to risk, and the split in equity and debt value, but it does not
460 15 Capital Structure

change total financial value. From that starting point, several imperfections (e.g.,
information asymmetries, taxes, bankruptcy costs, agency costs) were considered
that try to explain under what conditions financial capital structure does matter to
financial value. Behavioural issues, such as misvaluations and overconfidence, add
another layer of complexity.
Subsequently, we looked into the effects of E and S on financial capital structure.
Such risks can affect capital structure through changes in the business model that
affect the expected cash flows, and hence the valuation of assets and equity versus
debt; or through investor perceptions that affect the cost of capital, thereby also
changing the valuation of assets and equity versus debt.
We then considered the capital structures of E and S separately. As they do on the
financial side, companies also generate assets and liabilities on E and S. The main
difference is that it is typically much less clear how strong the claims against the
company are and to what extent they will materialise in financial terms. However,
their presence and size are strong indicators of additional risk. For example, a
company might destroy more value on E than it creates, meaning that its liabilities
on E exceed its E assets, and its E equity is negative. This is all the more troublesome
if its direct competitors have healthier E capital structures and lower risk of
internalisation.
The analysis of the capital structures of E and S allows us to take the next step,
namely the construction of an integrated capital structure, which is the capital
structure of E, S, and F combined, and an integrated leverage ratio. The integrated
balance sheet offers a richer perspective on the company’s assets and liabilities than
a balance sheet that is limited to F. As found in Chap. 13 on the cost of integrated
capital, liabilities on S and E increase the integrated leverage ratio (making the
integrated capital structure riskier) and thus raise the cost of integrated capital.

Key Concepts Used in this Chapter

Agency theory describes conflicts of interest between principles and agents
Asset substitution refers to a company’s exchange of lower risk investments for
higher risk investments
Bankruptcy is a legal proceeding initiated when a person or business is unable to
repay outstanding debts or obligations
Capital structure is the combination of debt and equity used by a company to finance
its overall operations and growth
Costs of financial distress are due to the company’s uncertain financial condition;
there are costs to the company that reduce its value, such as investment
opportunities that are missed, and suppliers, clients, and employees lose faith in
the company and decide to do business elsewhere
Debt overhang theory means that heavy debt burdens may result in managers not
doing positive NPV projects because the investments raise the risk of the com-
pany not being able to service its debt obligations
Direct bankruptcy costs are the costs of the bankruptcy process itself, such as fees
paid to administrators, accountants, investment bankers, lawyers, and courts
Financial distress is a condition in which a company struggles to meet its financial
obligations
Suggested Reading 461

Free Cash Flow (FCF) theory is the idea that managers of companies with excess
FCF (i.e., more cash flow than they can invest in positive NPV projects) will often
waste that cash instead of giving it back to shareholders
Financial distress is a condition in which a company struggles to meet its financial
obligations
Homemade leverage is the process of recreating an investment in a company with no
leverage into the effect of leverage by personal borrowing
Imperfections are limitations that reduce the range of financial contracts that can be
signed or honoured
Indirect bankruptcy costs are costs similar to those of distress (see above), but then in
the bankruptcy stage
Information asymmetry arises when one party in a transaction is in possession of
more information than the other
Integrated capital structure is a capital structure expressed not just in types of
financial capital but in types of social and environmental capital as well
Leverage refers to funding with borrowed money
Market value balance sheet is a balance sheet expressed in market value terms
instead of book values
Optimal (financial) capital structure refers to the capital structure that minimises the
cost of (financial) capital
Pecking order theory posits that managers prefer internal finance (i.e. from cash flow
and retained earnings, where they don’t pay a premium) over external finance
(in which financiers charge a higher cost of capital); and external debt over
external equity
Perfect capital markets are capital markets in which there are never any arbitrage
opportunities
Static trade-off theory assumes trading off taxes and bankruptcy costs in determining
optimal capital structure
Tax shield is a reduction in taxable income achieved through claiming allowable
deductions from corporate or income tax such as interest payments

Suggested Reading
Ginglinger, E., & Moreau, Q. (2022). Climate risk and capital structure. ECGI finance working
paper N° 737/2022.
Jensen, M. (1986). Agency costs of free cash flow, corporate finance, and takeovers. American
Economic Review, 76(2), 323–329.
Modigliani, F., & Miller, M. (1958). The cost of capital, corporation finance and the theory of
investment. American Economic Review, 48(3), 261–297.
Myers, S., & Majluf, N. (1984). Corporate financing and investment decisions when firms have
information that investors do not have. Journal of Financial Economics, 13(2), 187–221.
462 15 Capital Structure

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