Financial Management

Capital Structure

Prof. Carolina Salva

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Setting and overview
• Suppose you are the CFO of a firm and you want to invest in a major
investment project (an acquisition, a new product, a new facility, etc).
How do you finance it? What mix of D vs E do you choose?

• Sources of funds:
• Internal funds
• External funds: Sell (“issue”) claims on future cash flows
(“securities”) to investors (banks, funds, institutions, individuals, etc)

• What sort of securities (financing instruments)?

• Does it really matter? Is there an optimal capital structure?

– Goal: Maximize shareholder wealth
– Is there a choice of D vs E that maximizes firm value?

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Some terminology
• The capital structure refers to the relative proportion of Debt and
Equity that a firm has outstanding

• Most common choices of outside financing are Equity alone or a mixture

of Debt and Equity:
• Equity of a firm with no debt is called unlevered equity
• Equity of a firm with debt outstanding is called levered equity

• Measuring capital structure:

• Debt to Capital Ratio = Debt / (Debt + Equity)
• Debt to Equity Ratio = Debt / Equity
• Debt includes all interest bearing liabilities, short term and long term
• Equity can be defined either in accounting terms (as book value of
equity) or in market value terms (based upon the current price)

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Sources
of funds:
External
funds

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Financing instruments: Debt vs. Equity

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Financing instruments: Hybrids
• Convertible Debt
– A bond that can be converted into a predetermined number of
shares at the discretion of the bondholder.

• Preferred Stock
– A security that gives a fixed cash payment (dividend) in perpetuity.
Dividends can be missed, accumulated and paid later. There are no
voting rights. Payments are not tax deductible.

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Is there an optimal capital structure?
Does it really matter?

• Capital structure in Perfect Markets

– Theory of Modigliani and Miller
– M&M proposition I
– M&M proposition II

• In practice

• Theories to accommodate market imperfections and empirical evidence:

– The trade-off theory
– The pecking order theory

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Capital Structure in Perfect Markets
• Assume perfect capital markets:
– all securities are fairly priced
– there are no taxes or transaction costs and,
– the total cash flows of the firm’s projects are not affected by how the
firm finances them

• This setting provides an ideal context to focus on main drivers.

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Financing choices through an example:
You start a company, what is the NPV?
• You are an entrepreneur considering an investment opportunity.
• For an initial investment of $800 this year, a project will generate cash
flows of either $1400 or $900 next year, depending on whether the
economy is strong or weak, respectively. Both scenarios are equally
likely.
Project (or Firm) Cash Flows

• Because the project cash flows depend on the overall economy, they
contain market risk.
• Suppose investors (and you, the entrepreneur) demand a risk premium
of 10%. The current risk-free interest rate is 5%.

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Financing choices through an example
• What is the NPV of the investment opportunity?

– The cost of capital for this project is 15%.

– The expected cash flow in one year is $1150.
– The NPV of the project is $200.

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A. All Equity financing:
You want to sell all equity, how much do you get?
• If this project is financed using only equity, how much would investors
be willing to pay for the firm’s shares? [The firm has only this project.
Recall that the price of a security equals the present value of its cash
flows]

1150
PV(equity cash flows) =  1000
1.15

• The market value of the firm’s equity today is $1000.

• The entrepreneur can raise $1000 by selling equity in the firm. After
paying the investment cost of $800, she can keep the remaining $200,
the NPV of the project, as a profit.

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A. All Equity financing:
What is the shareholder expected return?

• Because there is no debt, the cash flows of the unlevered equity are
equal to those of the project.

Project (or Firm) Cash Flows and Returns

• The expected return on the unlevered equity is 15%.

• Because the cost of capital of the project is 15%, shareholders are

earning an appropriate return for the risk they are taking.

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B. Equity vs Debt financing:
Instead you raise Debt and sell Equity

• Alternatively, the entrepreneur can also raise part of the initial capital
using debt. Suppose she decides to borrow $500 initially, in addition to
selling equity.
• Because the project’s cash flow will always be enough to repay the
debt, the debt is risk-free and you can borrow at the risk-free interest
rate of 5%.

Values and Cash Flows for Debt and Equity

• What price E should the levered equity sell for? Which is the best capital
structure choice A. or B. for the entrepreneur?

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B. Equity vs Debt financing:
Equity vs Debt financing through an example
• Modigliani and Miller argued that, with perfect capital markets, the total
value of a firm should not depend on its capital structure.
• They reasoned that the firm’s total cash flows still equal the cash flows
of the project, and therefore have the same present value of $1000.
• Because the cash flows of the debt and equity sum to the cash flows of
the project, by the Law of One Price, the combined values of debt and
equity must be $1000.
• Therefore, if the value of the debt is $500, the value of the levered
equity must be E = $1000 - $500 = $500.
• Because the cash flows of levered equity are smaller than those of
unlevered equity, levered equity will sell for a lower price ($500 versus
$1000).
• However, the entrepreneur is not worse off and still gets $1000. Thus,
she should be indifferent between these two choices A. or B. for
the firm’s capital structure.

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B. Equity vs Debt financing:
The effect of leverage on risk and return

Returns to Equity with and without leverage

• Leverage increases the risk of the equity of a firm.

• While debt may be cheaper, its use raises the cost of equity. Equity
investors will require a higher expected return to compensate the
increased risk.
• Considering debt and equity, the firm cost of capital with leverage is the
same as for the unlevered firm (50%*5+50%*25%=15%)

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Modigliani-Miller I
• MM Proposition I:
• IF:
– Investors and firms can trade the same set of securities at
competitive market prices
– There are no taxes, transaction costs, or issuance costs
– A firm’s financing decisions do not change the cash flows generated
by its investment
• THEN:
– The total value of the firm is not affected by its choice of capital
structure.

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Modigliani-Miller I
• In perfect capital markets, the total cash flow paid out to all of a firm’s
security holders is equal to the cash flow generated by the firm’s
assets.
• Therefore, by the Law of One Price, the total market value of the
firm’s securities is equal to the market value of its assets.
EL  D  EU  A
• Thus, as long as the firm’s choice of securities does not change the
cash flows generated by its assets, this decision will not change the
total value of the firm.
• If the choice of capital structure affects current firm value, then it does
so by changing
– Taxes
– Transaction costs
– Investment policy and investment cash flows

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Example: A leveraged recapitalization
• Leveraged Recapitalization: When a firm uses borrowed funds (Debt)
to pay a large special dividend or repurchase a significant amount of
outstanding shares
• Example:
– Harrison Industries is currently an all-equity firm operating in a
perfect capital market, with 50 million shares outstanding that are
trading for $4 per share.
– Harrison plans to increase its leverage by borrowing $80 million
and using the funds to repurchase 20 million of its outstanding
shares.
– This transaction can be viewed in two stages.
– First, Harrison sells debt to raise $80 million in cash.
– Second, Harrison uses the cash to repurchase shares.

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Example: A leverage recapitalization
• Market Value Balance Sheet after Each Stage of Harrison’s Leveraged
Recapitalization ($ millions)

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Modigliani-Miller II
• MM’s proposition I can be used to derive an explicit relationship
between leverage and the cost of equity
• The required returns on the firm investments, Ra, depends only on the
risk of assets
• If the firm is unlevered, the return on unlevered equity Ru=Ra
• If the firm is levered, the return on unlevered equity (RU) is related to the
returns of levered equity (RE) and debt (RD):

D E
RU  RD  RE
DE DE

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Modigliani-Miller II

• MM Proposition II, in perfect capital markets:

– The cost of levered equity increases with the firm’s market value
debt-to-equity ratio.
– Solving the previous equation for RE :
D
RE  RU  ( RU  RD )
 E 
Risk without  
leverage Additional risk
due to leverage

• MM proposition II also implies that the firm cost of capital (WACC) is

unaffected by its capital structure. That is WACC is constant.

D E
wacc  RU  RD  RE
DE DE

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MM II: the effect of risk on WACC in perfect markets

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The effect of leverage and beta

• The effect of leverage on the cost of equity can also be expressed in

terms of beta:

D E
U  D  E
DE DE

• When a firm changes its capital structure without changing its

investments, its unlevered or asset beta will remain unchanged, but its
equity beta will change to reflect the additional risk brought in by debt:

D
 E  U  ( U   D )
E

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Is there an optimal capital structure?
In practice...
Financial managers care about the capital structure

Capital structure for some U.S industries

Is there an optimal capital structure?
In practice...
• ABC needs to evaluate whether their capital structure is adequate. You
have the following information:
# shares 200.000
Price per share 20
Beta 1,1
Debt 1.000.000
Current Rating BBB
Market interest rate - BBB 8%
Market interest rate - AAA 5%
Tax rate 40%
Market Risk Premium 6%

• If the firm increases debt:

D/(D+E) New Rating Market Rate
35,5% BB 8,5%
38,5% B 10,0%
42,9% B- 12,5%
46,7% C 14%

• What is the adequate capital structure?

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Is there an optimal capital structure?
In practice...
D/ (D+E) Beta Re Rating Rd Rd (1-t) WACC
0,0% 0,96 10,7% AAA 5,0% 3,0% 10,74%
20,0% 1,10 11,6% BBB 8,0% 4,8% 10,24%
35,5% 1,27 12,6% BB 8,5% 5,1% 9,96%
38,5% 1,32 12,9% B 10,0% 6,0% 10,24%
42,9% 1,39 13,3% B- 12,5% 7,5% 10,83%
46,7% 1,46 13,8% C 13,5% 8,1% 11,11%

11,40%
11,20%
11,00%
10,80%
10,60%
WACC

10,40%
10,20%
10,00%
9,80%
9,60%
9,40%
9,20%
0,0% 20,0% 35,5% 38,5% 42,9% 46,7%
D/(D+E)

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Is there an optimal capital structure?
In practice...

• The firm expects a FCF of EUR 212,000 by the end of the year that
will grow at 6% forever. What is the value of the firm for the different
D/(D+E) ratios? Assume FCFs are unaffected by the capital
structure.
D/ (D+E) WACC Firm Value 5.500
0,0% 10,74% 4.663 5.000
20,0% 10,24% 5.000

Firm Value
4.500
35,5% 9,96% 5.353
38,5% 10,24% 4.999 4.000
42,9% 10,83% 4.392 3.500
46,7% 11,11% 4.145
3.000
0,0% 20,0% 35,5% 38,5% 42,9% 46,7%
D/(D+E)

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Is there an optimal capital structure?

6.000

12,10% 5.000

11,60% 4.000

Firm Value
Financial
WACC

Taxes
11,10% Distress 3.000

10,60% 2.000

10,10% 1.000

9,60% 0
0,0% 20,0% 35,5% 38,5% 42,9% 46,7%
D/(D+E)

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Trade-off theory
• The trade-off theory states that the firm picks its capital structure by
trading off the benefits of the interest tax shield against the costs of
financial distress
• Thus, the value of a firm when there are taxes and costs involving
financial distress:

VU = value of unlevered firm

VL = value of levered firm

• For low levels of debt, the risk of default is low and the main effect of an
increase of debt is the interest tax shield

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Trade-off theory

V 𝑉 𝑃𝑉 𝑖𝑡𝑠

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Is there an optimal capital structure?
Trade-off theory
Benefit: interest tax shield Cost: Expected cost of financial
distress

Interest payments are tax

The expected cost of distress is a
deductible while dividends are
function of two variables:
not
– the probability of distress
– the cost of financial distress
Tax benefit each year = Tax (and bankruptcy)
Rate * Annual Interest

 The higher the tax rate, the  The greater the expected costs
higher the debt to capital of distress, the less debt the
ratio firm can afford to use

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Interest tax shield

• The total amount available to investors is higher with leverage

• For every year, interest tax shield = tax rate * Interest payment
• PV (Interest tax shield) is the present value of the stream of future
interest tax shields

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Interest tax shield

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Expected cost of financial distress
• The probability of default
– Depends on uncertainty of cash flows AAA 0.01%
– Studies that estimate those probabilities AA 0.28%
A 0.53%
BBB 2.30%
BB 12.20%
B 26.36%
CCC 46.61%
D 75%

• The actual costs of financial distress

– Direct costs (legal expenses, court costs, advisory costs, …):
estimated to be between 5-10% of firm value (but 2-5% of FV for
large caps; 20-25% for small caps)
– Indirect costs: impact on customers, employees, suppliers, unability
to respond to competition or invest in right projects, inefficient
liquidation of assets, etc… hard to estimate

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Trade-off theory
The Cost of Capital in the Presence of Corporate Taxes and Costs of
Financial Distress

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Pecking order theory
• There is empirical evidence that firms have some preference when
choosing how to fund investments:
– Internal funds
– Debt
– Shares

• Why?
– Significant issuance costs
– Managers value financial flexibility
– Owners value control
– Information asymmetries

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The costs of raising external capital

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Pecking order vs trade-off theory
• Implications of the pecking order theory
– A priori, no optimal capital structure
– Profitable firms borrow less and use less debt
– Companies aim to have financial slack

• Which theory works better?

– Trade-off theory => longer run
– Pecking order => shorter run
– Firms have long run optimal capital structures but in the short run
them may deviate

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Are firms in the optimum?

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Are firms in the optimum?

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How to find the optimal capital structure?

• No formula that ties together all the factors that influence a firm’s
capital structure and that identifies an optimal debt ratio for a firm

• Find the D/E ratio that:

– Maximizes firm value
– Minimizes WACC… Subject to other restrictions…

• Look at D/E ratios of comparable firms

• Take into account additional factors: credit rating, financial

flexibility, issuance costs, etc.

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How do firms decide about their debt level?

Source: Graham, John R., and Campbell R. Harvey. “How do CFOs make capital budgeting and capital structure decisions?”
The Journal of Applied Corporate Finance 14, No. 4 (2002).

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