Lecture 1: Overview and

Financial Leverage and

Capital Structure Policy
Advanced Corporate Finance

Lei Yu

Summer 2024
The Goal of Financial Management
What is the difference between stock price maximization, stockholder
wealth maximization, and firm value maximization ?
 Stock price maximization is the most restrictive of the three objective
functions. It requires that managers take decisions that maximize stockholder
wealth, that bondholders be fully protected from expropriation, that markets
be efficient and that social costs be negligible.
 Stockholder wealth maximization is slightly less restrictive, since it does not
require that markets be efficient.
 Firm value maximization is the least restrictive, since it does not require that
bondholders be protected from expropriation.
Thus, when we make the argument that an action by a firm (such as investing
or financing) increases firm value, this increase in firm value will necessarily
translate into increasing stockholder wealth and stock price only if the more
restrictive assumptions hold. Conversely, an action that increases the stock
price in a world where the less restrictive assumptions do not hold, may not
necessarily increase firm value.

Lecture 1: Financing Leverage and Capital Structure Policy 2

Review: What is WACC?
Weighted Average Cost of Capital (WACC): WACC is a measure of the
firm’s overall cost of capital. It is the overall return the firm must earn
on its existing assets to maintain the value of its stock. It is also the
required return on any investments by the firm that have essentially the
same risks as existing operations. V= E+D

WACC = (E/V) * Cost of Equity + (D/V) * Cost of Debt *(1-tax rate)

WACC = (E/V) RE + (D/V) (RD) (1 − TC)

Costs associated with the main sources of capital the firm employs: debt D and
equity E

Weights: capital structure weights: percentage of the firm’s financing that

comes from equity and debt

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The Goal of Financial Management
We can maximize the value of the firm by minimizing the WACC.

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The Choices in Financing
 There are two ways in which a business can raise money.
 The first is debt. The essence of debt is that you promise to make

fixed payments in the future (interest payments and repaying

principal). If you fail to make those payments, you lose control of
your business.
 The other is equity. With equity, you do get whatever cash flows are
left over after you have made debt payments.

Lecture 1: Financing Leverage and Capital Structure Policy 5

Measuring a Firm’s Financing Mix …
 The specific mixture of debt and equity the firm uses to finance its
operations is called the firm’s capital structure.
 The simplest measure of capital structure is to look at the proportion of
debt in the total financing. This ratio is called the debt to capital ratio:
Debt to Capital Ratio = Debt / (Debt + Equity) = D / (D+E)
 Debt to Capital Ratio = Debt / (Debt + Equity) = D / (D+E)

 Equivalently
Debt to Equity Ratio = Debt / Equity = D/E

 Debt includes all interest bearing liabilities, short term as well as long
term. It should also include other commitments that meet the criteria for
debt: contractually pre-set payments that have to be made, no matter
what the firm’s financial standing.
 The use of Debt in a firm’s capital structure is called financial leverage.

Lecture 1: Financing Leverage and Capital Structure Policy 6

The Objective in Corporate Finance

Capital Structure / Restructuring Decisions

Degree of Financial Leverage
Debt Policy
Lecture 1: Financing Leverage and Capital Structure Policy 7
 Total Debt vs. Total Liabilities

 Debt constitutes as a part of liabilities

 Total liabilities equal total debt plus the
company’s “free” (non-interest bearing) liabilities.
 Total liabilities = total debt + (accounts payable +
accruals)

 Total debt = short-term debt + long-term debt

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 MSFT Balance Sheet: Liabilities

Liabilities and stockholders’ equity 6/30/2019 6/30/2018

Current liabilities:
Accounts payable $ 9,382 $ 8,617
Current portion of long-term debt 5,516 3,998
Accrued compensation 6,830 6,103
Short-term income taxes 5,665 2,121
Short-term unearned revenue 32,676 28,905
Other 9,351 8,744

Total current liabilities 69,420 58,488

Long-term debt 66,662 72,242
Long-term income taxes 29,612 30,265
Long-term unearned revenue 4,530 3,815
Deferred income taxes 233 541
Operating lease liabilities 6,188 5,568
Other long-term liabilities 7,581 5,211

Total liabilities 184,226 176,130

© 2019 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
A Century of Capital Structure: the
Leveraging of Corporate America

Source: J.R. Graham et al.

Journal of Financial Economics
118 (2015) pp 658–683

Lecture 1: Financing Leverage and Capital Structure Policy 10

Lecture 1: Financing Leverage and Capital Structure Policy 11
The Choices in Financing: Does Capital
Structure Matter?
To maximize shareholders equity
 The capital structure question: is there an
optimal mix of debt and equity?
 If yes, what is the trade off that lets us determine
this optimal mix?
 What are the benefits of using debt instead of equity?
 What are the costs of using debt instead of equity?
 If not, why not?
 The answer depends on what market
imperfections are assumed away
Lecture 1: Financing Leverage and Capital Structure Policy 12
Assumptions: Perfect Capital Markets
Franco Modigliani and Merton Miller, “The Cost of Capital, Corporation
Finance, and the Theory of Investment”, American Economic Review
48 (June 1958), pp. 261-297.

Modigliani and Miller results hold under a set of conditions

 No taxes (corporate or personal)
 A firm’s cash flows do not depend on its financial policy (e.g., no cost
of financial distress, no bankruptcy costs).
 All agents have the same information.
 Investors and firms can trade the same set of securities at competitive market
prices equal to the present value of their future cash flows.
 Individuals and firms can undertake financial transactions at the same prices
(e.g., borrow at the same rate).
 Frictionless markets: no transaction costs, or issuance costs associated with
security trading.
 A firm’s financing decisions do not change the cash flows generated by its
investments, nor do they reveal new information about them.
Lecture 1: Financing Leverage and Capital Structure Policy 13
Modigliani and Miller Proposition I & II
I. A firm's value will be determined by the cash flows generated by its
assets and not by its capital structure. The cost of capital of the firm
will not change with leverage.
II. As a firm increases its leverage, the cost of (levered) equity will
increase just enough to offset any effect to lower cost of debt.

WACC

Debt-to-Capital Ratio

Lecture 1: Financing Leverage and Capital Structure Policy 14

M&M Proposition I & II in Formula
I. VU = VL

Where VU is the value of the unlevered firm (all equity) and

VL is the value of the levered firm

WACC = RU

II. WACC = RU = RL
WACC = (E/V) * RE + (D/V) * RD

RE = RU + (RU – RD) * (D/E)

Lecture 1: Financing Leverage and Capital Structure Policy 15

In-Class Exercise 16.1

Consider an entrepreneur with the following investment opportunity.

For an initial investment of $800 this year, the project will generate
different cash flows, depending on the economic outcomes. The strong
and weak economy outcomes are equally likely,
 Project Cash Flows

Date 0 Date 1
Strong Economy Weak Economy
- $800 $1400 $900

 Given a risk-free interest rate of 5% and a risk premium of 10% of

comparable projects,
 What is the expected return for this project? 5% + 10% = 15%
 What is the NPV of this investment opportunity?
NPV= -800+0.5*(1400+900)/1.15 = 200
 The entrepreneur raise funding for the project through issuing equity. What is the
initial value of the unlevered equity? PV(cash flow) =0.5*(1400+900)/1.15 = 1000
Lecture 1: Financing Leverage and Capital Structure Policy 16
In-Class Exercise 16.2

From the In-Class Exercise 16.1, we calculated the initial value of the
unlevered equity is $1000 at Date 0.

 Cash Flows and Returns for Unlevered Equity

Date 0 Date 1: Cash Flows
Initial Value Strong Economy Weak Economy
Unlevered Equity
Firm VU $1000 $1400 $900
Date 1: Returns
(1400-1000)/1000 (900-1000)/1000
= 40% =-10%

 The strong and weak economy outcomes are equally likely,

 What is the expected return (cost of capital) for the unlevered equity?
0.5*( 40% - 10%) = 15%
 Are shareholders earning an appropriate return for the risk they are taking? Yes
Lecture 1: Financing Leverage and Capital Structure Policy 17
In-Class Exercise 16.3

Alternatively, the entrepreneur can raise part of the initial capital using
mix of debt and a equity. Suppose she decides to borrow $500. The
risk-free interest rate is 5%.
 Value and Cash Flows for Debt and Equity of the Levered Firm

Date 0 Date 1: Cash Flows

Initial Value Strong Economy Weak Economy
Debt $500 $500*1.05=525 $500*1.05=525
Levered Equity E=? $1400-525=875 $900-525=375
Firm VL = ? $1400 $900
 We have calculated that the expected return of the project is 15%
 Assume security holders are earning appropriate returns for the risk they are
taking, what is the cost of capital for the firm ? The cost capital of the firm is
the same as the expected return of the firm’s project. So the cost of capital
of the firm is 15%. (continue on slides 17 for E and VL)

Lecture 1: Financing Leverage and Capital Structure Policy 18

In-Class Exercise 16.3 Continued
 Why is the following calculation of the levered equity value incorrect?
E = PV = (0.5* $875 + 0.5 * $375)/1.15 = $543
 Return to Debt and Equity with and without Leverage
Date 0 Date 1: Cash Flows
Initial Value Strong Economy Weak Economy

Unlevered Equity VU $1000 $1400 $900

Debt $500 $525 $525
Levered Equity E = 500 $875 $375
Firm VL = 1000 $1400 $900
Expected
Date 1: Returns Return
Unlevered Equity VU 40% -10% 15%
Debt 5% 5% 5%
Levered Equity 75% -25% 25%
Firm 15%

Lecture 1: Financing Leverage and Capital Structure Policy 19

In-Class Exercise 16.3 Continued
 Cost of capital of the firm is 15%
WACC = 15%
WACC = (E/VL) * RE + (D/VL) * RD
RD = 5%
D = 500
VL = D+E = 500 + E

15% = (E/(E+500))* RE + (500/(E+500)*5%

E = PV = (0.5* $875 + 0.5 * $375)/(1+ RE)
Solve for E and RE
E= 500 and RE = 25%
 What would VL and E be according to M&M Proposition I?

 VL = D + E = 500 + 500 = 1000

Lecture 1: Financing Leverage and Capital Structure Policy 20

An Example of Homemade Leverage
M&M Propositions are well illustrated by Homemade Leverage

Homemade leverage: investors use leverage in their own portfolio to

replicate the potential leverage choice made by the firm.

Assumption: investors can borrow at the same interest rate as the firm

 Replicating Levered Equity Using Homemade Leverage

Date 0 Date 1: Cash Flows
Initial Value Strong Economy Weak Economy
Unlevered Equity
Firm VU $1000 $1400 $900
Margin Loan -$ 500 -$525 - $525
Replicated Levered
$500 $875 $375
Equity
Lecture 1: Financing Leverage and Capital Structure Policy 21
The Optimal Capital Structure Depends
on Market Imperfections
1. Taxes: the interest tax shield allows firms to repay investors and
avoid the corporate tax.
2. Financial distress costs
3. Bankruptcy costs
4. Agency costs
5. Asymmetric information: when managers have private information
regarding the value of the firm
6. Transaction costs

Lecture 1: Financing Leverage and Capital Structure Policy 22

Interest Tax Shield
Interest Tax Shield = Corporate Tax Rate * Interest Payment
 Example: A.D. Builders’ marginal corporate tax rate is 35%
(in $ million) With Leverage Without Leverage
EBIT $2800 $2800
Interest expense -400 0
Income before tax 2400 2800
Taxes (35%) -840 -980
Net income $1560 $1820

 AD Builders does not owe taxes on the $400 million of earnings it

used to maker interest payments, this $400 is shielded from the
corporate tax, providing the tax savings of 35%* 400 = $140 million
(in $ million) With Leverage Without Leverage
Interest paid to debt holders 400 0
Income available to equity holders 1560 1820
Total available to all investors $1960 $1820
Lecture 1: Financing Leverage and Capital Structure Policy 23
M&M I & II with Corporate Taxes
I. The total value of the levered firm exceeds the value of the firm
without leverage due to the present value of tax savings from debt.
Cash flows to investors with leverage = Cash flows to investors without leverage
+ interest tax shield
II. As a firm increases its leverage, the cost of (levered) equity will
increase while the overall cost of capital (WACC) will decrease.

Modigliani and Miller

had a follow-up
papers published
that discussed taxes
issues: “Corporate
Income Taxes and
the Cost of Capital: A
Correction,“ 1963.
Debt-to-Capital Ratio

Lecture 1: Financing Leverage and Capital Structure Policy 24

M&M Proposition I & II with Corporate
Taxes in Formula
I. VL = VU + PV(Interest Tax Shield)
Where VU is the value of the unlevered firm (all equity) and
VL is the value of the levered firm

In the special case where the firm maintains a fixed dollar amount of
outstanding debt (permanent debt) D
VL = VU + TC * D * interest rate / interest rate = VU + TC * D
where is TC the marginal corporate tax rate

II. WACC = RL
WACC = (E/V) RE + (D/V) (RD) (1 − TC)

RE = RU + (RU – RD) * (D/E) * (1 − TC)

Lecture 1: Financing Leverage and Capital Structure Policy 25

In-Class Exercise 16.4
 Suppose A.D. Builders plans to pay $100 million in interest each
year for the next 10 years, and then to repay the principal of $2
billion in year 10. These payments are risk free, and A.D. Builders’
marginal tax rate will remain 35% throughout this period. If the risk-
free interest rate is 5%, by how much does the tax shield increase
the value of A.D. Builders?

 The interest tax shield is 35%* 100 million = $35 million each year
for the next 10 years.
 PV(Interest tax shield) = 10-year annuity of $35 per year with 5%
discount rate = 35*(1/5%)*(1-1/1.05^10) = $270 million
 (use financial calculator)

Lecture 1: Financing Leverage and Capital Structure Policy 26

In-Class Exercise 16.5
 A.D. Builders expects to have free cash flow in the coming year of
$4.25 million, and its free cash flow is expected to grow at a rate of
4% per year thereafter. A.D. Builders has an equity cost of capital of
10% and a debt cost of capital of 6%, and it pays a corporate tax
rate of 35%. If A.D. Builders maintains a debt-equity ratio of 0.5,
what is the present value of its interest tax shield?
 Pretax WACC=(E/(E+D))*RE + (D/(E+D))*RD
= (1/(1+0.5))*10% + (0.5/(1+0.5))*6% = 8.67%
 Value a constant growth perpetuity (use financial calculator)
VU =4.25/(8.67%-4%) = $91 mil = VL if no tax
 WACC =(E/(E+D))*RE + (D/(E+D))*RD*(1 − TC)
= (1/(1+0.5))*10% + (0.5/(1+0.5))*6%*(1-35%) = 7.97%
 Value a constant growth perpetuity (use financial calculator)
VL =4.25/(7.97%-4%) = $107 mil
 PV(Interest tax shield) = VL - VU = 107-91 = $16 million

Lecture 1: Financing Leverage and Capital Structure Policy 27

M&M I & II with Corporate Taxes and
Financial Distress and Bankruptcy Costs

Lecture 1: Financing Leverage and Capital Structure Policy 28

In-Class Exercise 16.6

The entrepreneur’s project is equally likely to success or fail. She can

raise part of the initial capital using mix of debt and a equity. The risk-
free interest rate is 5%, for simplicity, the risk of the project is
diversifiable so the beta is 0.
 Cash Flows of Debt and Equity with and without Leverage

(in $ million) Without Leverage With Leverage

Success Failure Success Failure
Debt 100 80
Equity 150 80 50 0
Firm 150 80 150 80

 The expected return of the project is 5%

 What is the value of the unlevered equity? VU = 0.5*(150+80)/1.05 = $109.52 mil
 What is the value of the levered firm? E = 0.5*(50+0)/1.05 = $23.81 mil
D = 0.5*(100+80)/1.05 = $85.71 mil. VL= E+D = 23.81 + 85.71 = $109.52 mil
Lecture 1: Financing Leverage and Capital Structure Policy 29
In-Class Exercise 16.6 Continued
The costs of financial distress represent an important departure form
M&M’ assumption of perfect capital market. M&M assumed that the
cash flows of a firm’s asset do not depend on its choice of capital
structure. However, levered firms risk incurring financial distress costs
that reduce the cash flows available to investors
 Cash Flows of Debt and Equity with and without Leverage

(in $ million) Without Leverage With Leverage

Success Failure Success Failure
Debt 100 60
Equity 150 80 50 0
Firm 150 80 150 60
 We have calculated that the value of the unlevered equity
 What is the value of the levered firm? E = 0.5*(50+0)/1.05 = $23.81 mil
D = 0.5*(100+60)/1.05 = $76.19 mil. VL= E+D = 23.81 + 76.19= $100mil
 What is the present value of financial distress costs? VU -VL = 109.52 –100 = 9.52
Lecture 1: Financing Leverage and Capital Structure Policy 30
In-Class Exercise 16.6 Continued
Suppose at the beginning of the year, the firm has 10 million shares
outstanding and no debt. The firm then announces plans to issue one-
year debt with face value of $100 million and to use the proceeds to
repurchase shares.

 Cash Flows of Debt and Equity with and without Leverage

(in $ million) Without Leverage With Leverage
Success Failure Success Failure
Debt 100 60
Equity 150 80 50 0
Firm 150 80 150 60
 We have calculated that the value of the unlevered equity is
 What is the share price after the announcement? VL= $100 mil , price=100/10=10
 Although debt holders bear the cost of financial distress in the end, shareholders
pay the present value of the cost of financial distress upfront.
Lecture 1: Financing Leverage and Capital Structure Policy 31
M&M Proposition I with Corporate
Taxes and Financial Distress in Formula
I. VL = VU + PV(Interest Tax Shield) – PV(Financial Distress Cost)
Where VU is the value of the unlevered firm (all equity) and
VL is the value of the levered firm

Lecture 1: Financing Leverage and Capital Structure Policy 32

Debt: Summarizing the Trade-off

Lecture 1: Financing Leverage and Capital Structure Policy 33

M&M Proposition I with Corporate
Taxes, Financial Distress, and Agency
Costs in Formula
I. VL = VU + PV(Interest Tax Shield) – PV(Financial Distress Cost)
– PV(Agency Cost of Debt) + PV(Agency Benefits of Debt)
Where VU is the value of the unlevered firm (all equity) and
VL is the value of the levered firm

As the leverage increases, the firm benefits from improved incentives

for management, which reduces wasteful investment and perks.
If the leverage level is too high, however, firm value is reduced due to
the loss of tax benefits (when interest exceeds EBIT), the increase
of financial distress costs, and the agency costs of leverage.???

Lecture 1: Financing Leverage and Capital Structure Policy 34

Asymmetric Information and Pecking
Order Theory
The manager has better information about the firm’s cash flows than
investors. Increase leverage can signal manager’s confidence in
the firm’s ability to meet its debt obligations.
“Lemon cost”: managers can benefit current shareholders by issuing
the most overpriced securities. Therefore new investors will lower
the price they are willing to pay for new equity.
Pecking Order Theory: internal financing > issue debt > issue equity
The pecking-order theory is at odds with the static trade-off theory:
 There is no target D/E ratio.

 Profitable firms use less debt.

 Companies like financial slack.

Lecture 1: Financing Leverage and Capital Structure Policy 35

The Significance of M&M Theorem

2018 marks the sixtieth anniversary of the publication of Franco

Modigliani and Merton Miller’s The Cost of Capital, Corporation
Finance, and the Theory of Investment, which purports to
demonstrate that a firm’s value is independent of its capital structure.

Reverse M&M Theorem

if capital structure matters it must work through one of the original M&M
theorem’s assumptions.

Some have referred the firm’s choice of capital structure as a marketing

problem. The financial manager’s problem is to find the combination
of securities that has the greatest overall appeal to investors,
therefore investors will assign the maximum value of the firm.

Lecture 1: Financing Leverage and Capital Structure Policy 36