The document discusses capital structure and its impact on firm value. It covers the following key points: 1) Modigliani and Miller's proposition that in perfect capital markets, firm value is independent of capital structure. Leverage does not affect total firm value but impacts the riskiness of equity. 2) When corporate taxes are considered, an optimal capital structure exists where tax benefits of debt balance costs of financial distress, maximizing firm value. 3) Traditional views held that the weighted average cost of capital declines with leverage, incentivizing high debt. However, equity risk rises with leverage per M&M proposition two. 4) Real-world capital structures involve a trade-off between

1. Capital Structure
By :- Dinesh khanna

2. Advantages of Debt
Interest is tax deductible (lowers the
effective cost of debt)
 Debt-holders are limited to a fixed return
– so stockholders do not have to share
profits if the business does exceptionally
well
 Debt holders do not have voting rights


3. Disadvantages of Debt

Higher debt ratios lead to greater risk and
higher required interest rates (to
compensate for the additional risk)

4. What is the optimal debt-equity
ratio?

Need to consider two kinds of risk:
◦ Business risk
◦ Financial risk

5. Business Risk
Standard measure is beta (controlling for
financial risk)
 Factors:

◦
◦
◦
◦
◦
◦
Demand variability
Sales price variability
Input cost variability
Ability to develop new products
Foreign exchange exposure
Operating leverage (fixed vs variable costs)

6. Financial Risk

The additional risk placed on the common
stockholders as a result of the decision to
finance with debt

7. Example of Business Risk
Suppose 10 people decide to form a
corporation to manufacture disk drives.
 If the firm is capitalized only with
common stock – and if each person buys
10% -- each investor shares equally in
business risk


8. Example of Relationship Between
Financial and Business Risk
If the same firm is now capitalized with
50% debt and 50% equity – with five
people investing in debt and five investing
in equity
 The 5 who put up the equity will have to
bear all the business risk, so the common
stock will be twice as risky as it would
have been had the firm been all-equity
(unlevered).


9. Business and Financial Risk

Financial leverage concentrates the firm’s
business risk on the shareholders because
debt-holders, who receive fixed interest
payments, bear none of the business risk

10. Financial Risk
Leverage increases shareholder risk
 Leverage also increases the return on
equity (to compensate for the higher risk)


11. Question?

Is the increase in expected return due to
financial leverage sufficient to
compensate stockholders for the increase
in risk?

12. Modigliani and Miller
YES
 Assuming no taxes, the increase in return
to shock-holders resulting from the use of
leverage is exactly offset by the increase
in risk – hence no benefit to using
financial leverage (and no cost).


13. Topics To Be Covered
Leverage in a Tax Free Environment
 How Leverage Affects Returns
 The Traditional Position


14. Capital Structure

When a firm issues debt and equity
securities it splits cash flows into two
streams:
◦ Safe stream to bondholders
◦ Risky stream to stockholders

15. Capital Structure
Modigliani and Miller (1958) show that
financing decisions don’t matter in
perfect capital markets
 M&M Proposition 1:

◦ Firms cannot change the total value of their
securities by splitting cash flows into two
different streams
◦ Firm value is determined by real assets
◦ Capital structure is irrelevant

16. M&M (Debt Policy Doesn’t Matter)

Modigliani & Miller
◦ When there are no taxes and capital markets
function well, it makes no difference whether
the firm borrows or individual shareholders
borrow. Therefore, the market value of a
company does not depend on its capital
structure.

17. M&M (Debt Policy Doesn’t Matter)
Assumptions
By issuing 1 security rather than 2, company
diminishes investor choice. This does not
reduce value if:
◦ Investors do not need choice, OR
◦ There are sufficient alternative securities
 Capital structure does not affect cash flows
e.g...
◦ No taxes
◦ No bankruptcy costs
◦ No effect on management incentives


18. An Example of the Effects of
Leverage
D and E are market values of debt and
equity of Wapshot Marketing Company.
Wapshot has issued 1000 shares and
these are currently selling at $50 a share.
Wapshot has borrowed $25,000 so
Wapshot’s stock is “levered equity”.
 E = 1000 x $50 = $50,000
 D= $25,000
 V = E + D = $75,000


19. Effects of Leverage
What happens if WPS “levers up” again by
borrowing an additional $10,000 and at the
same time paying out a special dividend of $10
per share, thereby substituting debt for equity?
 This should have no impact on WPS assets or
total cash flows:

◦ V is unchanged
◦ D= $35,000
◦ E= $75,000 - $35,000 = $40,000

Stockholders will suffer a $10,000 capital loss
which is exactly offset by the $10,000 special
dividend.

20. Effects of Leverage
What if instead of assuming V is
unchanged we allow V it rise to $80,000
as a result of the change in capital
structure?
 Then E = $80,000 - $35,000 = $45,000
 Any increase or decrease in V as a result
of the change in capital structure accrues
to the shareholders


21. Effects of Leverage
What if the new borrowing increases the
risk of bankruptcy?
 This would suggest that the risk of the
“old debt” is higher (and the value of the
old debt is lower)
 If this is the case, then shareholders
would gain from the increase in leverage
at the expense of the original
bondholders.


22. Modigliani and Miller
Any combination of securities is as good
as any other.
 Example:

◦ Two Firms with the same operating income
who differ only in capital structure
 Firm U is unlevered: VU=EU
 Firm L is levered: EL= VL-DL

23. Modigliani and Miller


Four Strategies
Strategy 1
◦ Buy 1% of Firm U’s Equity
 Dollar investment =
 Dollar Return=

.01VU
.01 Profits
Strategy 2
◦ Buy 1% of Firm L’s Equity and Debt






Dollar investment= .01DL + .01EL = .01VL
Dollar Return=
From owning .01 DL
.01 interest
From owning .01 EL .01 (Profits – interest)
Total
.01 Profits
Both Strategies give the same payoff

24. Modigliani and Miller

Strategy 3
◦ Buy 1% of Firm L’s Equity
 Dollar investment =
 Dollar Return=

.01EL= .01(VL-DL)
.01 (Profits – interest)
Strategy 4
◦ Buy 1% of Firm U’s Equity and borrow on your own
account .01DL (home-made leverage)






Dollar investment=
Dollar Return=
From borrowing .01DL
From owning .01 EU
Total
.01(Vu – DL)
-.01 interest
.01 (Profits)
.01 (Profits – interest)
Both Strategies give the same payoff

25. Modigliani and Miller
It does not matter what risk preferences
are for investors.
 Just need that investors have the ability
to borrow and lend for their own account
(and at the same rate as firms) so that
they can “undo” any changes in firm’s
capital structure
 M&M Proposition 1: the value of a firm is
independent of its capital structure


26. Leverage and Returns
Expected return on assets ra
rA
D
D
E
rD
expected operating income
market value of all securities
E
D
E
rE

27. M&M Proposition II
r
rE
rA
rD
Risk free debt
Risky debt
D
E

28. M&M Proposition 2

Bonds are almost risk-free at low debt levels
◦ rD is independent of leverage
◦ rE increases linearly with debt-equity ratios and the
increase in expected return reflects increased risk

As firms borrow more, the risk of default rises
◦ rD starts to increase
◦ rE increases more slowly (because the holders of risky
debt bear some of the firm’s business risk)

29. The Return on Equity
The increase in expected equity return
reflects increased risk
 The increase in leverage increases the
amplitude of variation in cash flows
available to share-holders (the same
change in operating income is now
distributed among fewer shares)
 We can understand the increase in risk in
terms of Betas


30. Leverage and Returns
BA
D
D
BE
E
BA
BD
D
BA
E
E
D
E
BD
BE

31. The Traditional Position
What did financial experts think before
M&M?
 They used the concept of WACC
(weighted average cost of capital)

◦ WACC is the expected return on the portfolio
of all the company’s securities

32. WACC

WACC is the traditional view of capital
structure, risk and return.
WACC
rA
D
V
rD
E
V
rE

33. WACC
Expected
Return
.20=rE
Equity
.15=rA
All
assets
.10=rD
Debt
BD
BA
BE
Risk

34. WACC
Example - A firm has $2 mil of debt and
100,000 of outstanding shares at $30
each. If they can borrow at 8% and the
stockholders require 15% return what is
the firm’s WACC?
D = $2 million
E = 100,000 shares X $30 per share = $3 million
V = D + E = 2 + 3 = $5 million

35. WACC
Example - A firm has $2 mil of debt and 100,000 of
outstanding shares at $30 each. If they can borrow at 8%
and the stockholders require 15% return what is the firm’s
WACC?
D = $2 million
E = 100,000 shares X $30 per share = $3 million
V = D + E = 2 + 3 = $5 million
WACC
D
V
rD
E
V
rE
2
3
.08
.15
5
5
.122 or 12.2%

36. The Traditional Position
The return on equity (rE) is constant
 WACC declines with increasing leverage
because rD<rE
 Given the two assumptions above, a firm
will minimize the cost of capital by issuing
almost 100% debt
 This can’t be correct!


37. WACC
(if rE does not change with
increases in leverage )
r
rE
rA =WACC
rD
D
V

38. An intermediate position




A moderate degree of financial leverage may
increase the return on equity (but less than
predicted by M&M proposition 2)
A high degree of financial leverage increases
the return on equity (but by more than
predicted by M&M proposition 2)
WACC then declines at first, then rises with
increasing leverage (U-shape)
Its minimum point is the point of “optimal
capital structure”.

39. WACC (intermediate view)
r
rE
WACC
rD
D
E

40. The intermediate position
Investors don’t notice risk of “moderate”
borrowing
 They wake up with debt is “excessive”
 The problem with this view is that it confuses
default risk with financial risk.

◦ Default risk may not be serious for moderate
amounts of leverage
◦ Financial risk (in terms of increased volatility of return
and higher beta) will increase with leverage even with
no risk of default

41. Modigliani and Miller Revisited


M&M proposition 1: A firm’s total value is
independent of its capital structure
Assumptions needed for Prop 1 to hold:
1. Capital markets are perfect and complete
2. Before-tax operating profits are not affected by
capital structure
3. Corporate and personal taxes are not affected by
capital structure
4. The firm’s choice of capital structure does not
convey important information to the market

42. Modigliani and Miller Revisited
M&M Proposition 2: The return on equity
will rise as the debt-equity ratio rises in
order to compensate equity holders for
the additional (financial) risk.
 Note: Proposition 2 does not rely on
default risk – rE rises because of the rise
in financial risk


43. WACC (M&M view)
r
rE
WACC
rD
D
E

44. Capital Structure and Corporate Taxes
Financial Risk - Risk to shareholders resulting from
the use of debt.
Financial Leverage - Increase in the variability of
shareholder returns that comes from the use of
debt.
Interest Tax Shield- Tax savings resulting from
deductibility of interest payments.

45. Capital Structure and Corporate Taxes
Example - You own all the equity in a company. The
company has no debt. The company’s annual
cash flow is $1,000, before interest and taxes.
The corporate tax rate is 40%. You have the
option to exchange 1/2 of your equity position
for 10% bonds with a face value of $1,000.
Should you do this and why?

46. Capital Structure and Corporate Taxes
All Equity
1,000
Interest Pmt
1,000
0
EBIT
1/2 Debt
100
Pretax Income1,000
900
Taxes @ 40%
400
360
Total Cash Flow
Net Cash Flow $600
$540
All Equity = 600
*1/2 Debt = 640
(540 + 100)

47. Capital Structure
PV of Tax Shield =
(assume perpetuity)
D x rD x Tc
rD
= D x Tc
Example:
Tax benefit = 1000 x (.10) x (.40) = $40
PV of 40 perpetuity = 40 / .10 = $400
PV Tax Shield = D x Tc = 1000 x .4 = $400

48. Capital Structure
Firm Value =
Value of All Equity Firm + PV Tax Shield
Example
All Equity Value = 600 / .10 = 6,000
PV Tax Shield = 400
Firm Value with 1/2 Debt = $6,400

49. Capital Structure and Financial
Distress
Costs of Financial Distress - Costs arising
from bankruptcy or distorted business
decisions before bankruptcy.
Market Value = Value if all Equity Financed
+ PV Tax Shield
- PV Costs of Financial
Distress

50. Weighted Average Cost of Capital
without taxes (traditional view)
r
Includes Bankruptcy Risk
rE
WACC
rD
D
E

51. Financial Distress
Market Value of The Firm
Maximum value of firm
Costs of
financial distress
PV of interest
tax shields
Value of levered firm
Value of
unlevered
firm
Optimal amount
of debt
Debt/Total Assets

52. M&M with taxes and bankruptcy
WACC now is more hump-shaped (similar
to the traditional view – though for
different reasons).
 The minimum WACC occurs where the
stock price is maximized.
 Thus, the same capital structure that
maximizes stock price also minimizes the
WACC


53. Financial Choices
Trade-off Theory - Theory that capital
structure is based on a trade-off between
tax savings and distress costs of debt.
Pecking Order Theory - Theory stating that
firms prefer to issue debt rather than
equity if internal finance is insufficient.

54. Pecking Order Theory
The announcement of a stock issue drives down the stock price
because investors believe managers are more likely to issue
when shares are overpriced.
Therefore firms prefer internal finance since funds can be
raised without sending adverse signals.
If external finance is required, firms issue debt first and equity as
a last resort.
The most profitable firms borrow less not because they have
lower target debt ratios but because they don't need external
finance.

55. Pecking Order Theory
Some Implications:
Internal equity may be better than
external equity.
Financial slack is valuable.
If external capital is required, debt is
better. (There is less room for difference
in opinions about what debt is worth).