CH. I.

CAPITAL STRUCTURE

Financial Management II (AcFn 3042) – Andualem Z., Asamnew T.

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Chapter Outline
 Meaning of capital structure
 The capital structure question
 Factors that influence capital structure decisions
 Business and financial risk:
• Business risk and operating leverage
• Financial risk and financial leverage
 Determining the optimal capital structure
• EBIT/EPS analysis
• The effect of capital structure on stock price and the cost of capital
 Introduction to the theory of capital structure
• Modigliani and Miller Propositions, Trade-off theory, Signaling theory
• Using debt financing to constrain managers

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Meaning of capital structure

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 Meaning of Capital Structure
Definition
 The mix of debt, preferred stock, and common equity that is used to finance the firm’s assets.…or
 The choice between debt and equity financing …………………the capital structure decision.
 Decision on the sources and amounts of financing
o Involves evaluating type of source, period of financing, cost of financing and the returns thereby
 Financing decisions raise money for investment.
Questions
 What long-term sources of finance are available for a firm?
 What mixture of equity and debt is best/how much to borrow?
 What are the least expensive sources of funds for the firm?
 How and where to raise the money?
 Optimal Capital Structure The capital structure that maximizes a stock’s intrinsic value.

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Meaning of Capital Structure

• The term capital refers to Investor-supplied funds such as long- and short-term loans
from individuals and institutions, preferred stock, common stock, and retained
earnings.

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 The Capital Structure Question
1. How should a firm go about choosing its debt-equity ratio?
• Can financing decisions create value?
2. What is an optimal capital structure? or What is the ratio of debt to equity
that maximizes the shareholders’ interests?

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 The Capital Structure Question…
• The objective of a company is to maximize the value of the company and it is
prime objective while deciding the capital structure.
• Capital structure decisions refers to deciding:
1. the forms of financing (which sources to be tapped);
2. their actual requirements (amount to be funded); and
3. their relative proportions (mix) in total capitalization.
• Capital structure decision will decide weight of debt and equity and ultimately
overall cost of capital as well as the value of the firm.
• So capital structure is relevant in maximizing value of the firm and minimizing overall cost of
capital.
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Factors that influence capital structure
decisions/design – Determinants of
Capital Structure – Checklist of Items

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 Factors that influence capital structure decisions
 Choice of source of funds
- a firm has the choice to raise funds for financing its investment proposals from
different sources in different proportions. It can:
a) exclusively use debt (in case of existing company), or
b) exclusively use equity capital, or
c) exclusively use preference share capital (in case of existing company), or
d) use a combination of debt and equity in different proportions, or
e) use a combination of debt, equity and preference capital in different
proportions, or
f) use a combination of debt and preference capital in different proportions (in
case of existing company).
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 Factors that influence capital structure decisions
 Choice of source of funds…
- the capital structure of a firm depends on a number of factors and these
factors are of different importance.
- the influence of individual factors of a firm changes over a period of time.

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 Factors that influence capital structure decisions

• Sales growth and stability

- a firm whose sales are relatively stable can safely take on more debt and incur
higher fixed charges than a company with unstable sales.
• Asset structure (Cash flow ability)
- holding other factors constant, a company is able to take on more debt if it
has more cash on the balance sheet.

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 Factors that influence capital structure decisions…
• Size of the firm
 Small firms
- find it very difficult to mobilise long - term debt, as they have to face higher rate of interest and
inconvenient terms;
- make their capital structure very inflexible and depend on share capital and retained earnings for their
long - term funds;
- cannot go to the capital market frequently for the issue of equity shares, as it carries a greater danger
of loss of control over the firm to others;
- sometimes limit the growth of their business and any additional fund requirements met through
retained earnings only.
 Large firms
- has relative flexibility in capital structure designing;
- has the facility of obtaining long - term debt at relatively lower rate of interest and convenient terms;
- have relatively an easy access to the capital market.

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 Factors that influence capital structure decisions…
•Profitability.
- firms with very high rates of return on investment use relatively little debt, i.e.
their high rates of return enable them to do most of their financing with
internally generated funds.
• Growth rate.
- other things the same, faster-growing firms must rely more heavily on
external capital.

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 Factors that influence capital structure decisions…

• Taxes.
- interest is a deductible expense, and deductions are most valuable to firms
with high tax rates.
- Therefore, the higher a firm’s tax rate, the greater the advantage of debt.
•Management attitudes.
- some managers tend to be relatively conservative and thus use less debt than
an average firm in the industry,
- whereas aggressive managers use a relatively high percentage of debt in their quest for
higher profits.

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 Factors that influence capital structure decisions…
• Market conditions.
- in the case of depressed conditions in the share market, the firm should not
issue equity shares but go for debt capital.
- On the other hand, under boom conditions, it becomes easy for the firm to mobilise
funds by issuing equity shares.
• Control
- control considerations can lead to the use of debt or equity because the type
of capital that best protects management varies from situation to situation. In
any event, if management is at all insecure, it will consider the control
situation (e.g. risk of dilution, risk of bankruptcy and loss of job, risk of
takeover, etc.).
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 Factors that influence capital structure decisions…
• Financial flexibility.
- flexibility means the firm's ability to adapt its capital structure to the needs of the
changing conditions.
- which from an operational viewpoint means maintaining adequate “reserve borrowing capacity.”
- capital structure should be flexible enough to raise additional funds whenever
required, without much delay and cost.
- the capital structure of the firm must be designed in such a way that it is possible to
substitute one form of financing for another to economise the use of funds.
- preference shares and debentures offer the highest flexibility in the capital structure,
as they can be redeemed at the discretion of the firm.

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 Factors that influence capital structure decisions…
• Cost of capital
- an ideal pattern of capital structure is one that minimises cost of capital and
maximises earnings per share (EPS).
- The overall cost of capital depends on the proportion in which the capital is mobilised
from different sources of finance.
• Legal requirements
- the various guidelines issued by the government from time to time regarding
the issue of shares and debentures should be kept in mind while determining
the capital structure of a firm.
- these legal restrictions are very significant as they give a framework within
which capital structure decisions should be made.
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 Factors that influence capital structure decisions…
• Financial leverage/Financial risk
- the use of long - term debt and preference share capital, which are fixed income-
securities is called financial leverage or trading on equity.
- the use of long-term debt capital increases the earnings per share (eps) as long as the return
on investment (ROI) is greater than the cost of debt.
- preference share capital will also result in increasing EPS.
- But the leverage effect is more pronounced in case of debt because of two reasons : i) cost of
debt is usually lower than the cost of preference share capital, and ii) the interest paid on
debt is tax deductible.
• leverage is a two edged sword (needs caution)
• producing highly favorable results when things go well (i.e. the firm yields a return higher than the cost of debt),
and quite the opposite under unfavorable conditions (i.e. the rate of return on long-term loan is more than the
expected rate of earnings of the firm).
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 Factors that influence capital structure decisions…

• Operating leverage/business risk

- the single most important determinant of capital structure,
- other things the same, a firm with less operating leverage is better able to employ financial
leverage because it will have less business risk.
• Other considerations
- Other factors such as nature of industry, timing of issue and competition in the
industry should also be considered. Industries facing sever competition also
resort to more equity than debt.

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Leverage: Business Risk and Financial Risk

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 Business Risk--Definition
- Uncertainty in future EBIT
- is the risk a firm’s common stockholders would face if the firm had no debt or is
debt-free or unlevered.
- is the risk inherent in the firm’s operations
- the equity risk that comes from the nature of the firm’s operating activities.
- the risk to the firm of being unable to cover its operating costs.
- Business risk is an unavoidable risk.
- It varies from time to time, industry to industry and also among firms in a given industry

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 Factors affecting Business Risk
a.Competition - other things held constant, less competition lowers business risk.
b.Demand variability - the more stable the demand for a firm’s products, other
things held constant, the lower its business risk.
c. Sales price variability - firms whose products are sold in volatile markets are
exposed to more business risk than firms whose output prices are stable, other
things held constant.
d.Input cost variability - firms whose input costs are uncertain have higher
business risk.
e. Product obsolescence - the faster its products become obsolete, the greater a
firm’s business risk.

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Factors affecting Business Risk …
f. Foreign risk exposure - firms that generate a high percentage of their
earnings overseas are subject to earnings declines due to exchange rate
fluctuations.
g. Regulatory risk and legal exposure - Firms that operate in highly regulated
industries such as financial services and utilities are subject to changes in the
regulatory environment that may have a profound effect on the company’s
current and future profitability.
h. The extent to which costs are fixed: operating leverage - if a high percentage
of its costs are fixed and thus do not decline when demand falls, this
increases the firm’s business risk.
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 Leverage
• it refers to the use of special force and effects to produce more than normal
results from a given course of action..
• In business, leverage refers to the employment of fixed cost items in anticipation
of magnifying returns at high levels of operation.
• “the employment of an asset or fund for which the firm pays a fixed cost or fixed
return – (James Horne).
o Fixed costs that are operating costs (such as depreciation or rent) create operating
leverage….and fixed costs that are financial costs (such as interest expense) create financial
leverage.
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 Leverage…
• a firm with higher fixed costs has greater leverage, and vice versa.
• you should recognize that leverage is a two-edged sword—producing highly
favorable results when things go well and quite the opposite under negative
conditions.
o Magnifies both returns and risks.

• influenced by managers choice of a specific capital structure.

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Leverage…
• Leverage can be classified into three major headings according to the nature
of the finance mix of the company.

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 Leverage
 Fixed costs
- costs that do not rise and fall with changes in a firm’s sales.
- must be paid irrespective of whether business conditions are good or bad.
- may be operating costs, such as the costs incurred by purchasing and operating
plant and equipment, or they may be financial costs, such as the fixed costs of
making debt payments.

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 Operating Leverage
- Indicates the extent to which fixed costs are used in a firm’s operations.
- Is the use of fixed operating costs to magnify the effects of changes in sales on the
firm’s earnings before interest and taxes.
- when costs of operations are largely fixed, small changes in sales will lead to much
larger changes in EBIT.
- other things held constant, the higher a firm’s operating leverage, the higher its
business risk.
- is associated with investment activities of the company.
- projects with a relatively heavy investment in plant and equipment will have a
relatively high degree of operating leverage.
- not affected by tax rate and interest rate. 28
 Operating Leverage…
Breakeven analysis
P = average sale price per unit;
Q = sales quantity in units;
FC = fixed operating cost per period;
VC = variable operating cost per unit
• where Q is the firm’s
operating breakeven point.
• Operating breakeven point
(in dollars/birr -
multiproduct firms is: (NB.
VC% total sales)

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 Operating Leverage…
Measuring operating breakeven point…
- Firms use breakeven analysis, also called cost-volume-profit analysis, to
1) determine the level of operations necessary to cover all costs, and
2) evaluate the profitability associated with various levels of sales.
- The firm’s operating breakeven point is the level of sales necessary to cover
all operating costs.
- At that point, earnings before interest and taxes (EBIT) equals zero.

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 Operating Leverage…
Degree of Operating Leverage (DOL)
- the degree of operating leverage (DOL) is a numerical measure of the firm’s
operating leverage.
- It can be derived using the equation: %EBIT = %S * DOL
-

- a more direct formula for calculating the degree of operating leverage at a base
sales level, Q, is

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Example

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 Financial Risk
- is the additional risk placed on the common stockholders as a result of using
debt or
- an increase in stockholders’ risk, over and above the firm’s basic business risk, resulting
from the use of financial leverage.
- is an avoidable risk if the firm decides not to use any debt in its capital
structure,
- i.e. a totally equity financed firm will have no financial risk.
- the variability of EPS caused by the use of financial leverage.
- the equity risk that comes from the financial policy (the capital structure) of the firm.

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 Financial Risk and Financial Leverage
Financial Leverage
• is the use of fixed financial costs to magnify the effects of changes in earnings before
interest and taxes on the firm’s earnings per share,
• i.e. concerned with the relationship between the firm’s EBIT and its common stock EPS.
• refers to the extent to which a firm relies on debt, i.e. the more debt financing a firm uses in
its capital structure, the more financial leverage it employs.
• the two most common fixed financial costs are
1) interest on debt and
2) preferred stock dividends.
• Financial leverage is employed in the hope of increasing the return to common
shareholders
• will change due to tax rate and interest rate.
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 Financial Risk and Financial Leverage…
Degree of Financial Leverage (DFL)- is the numerical measure of the firm’s
financial leverage.
- %EPS = %EBIT * DFL

- Whenever the percentage change in EPS resulting from a given percentage change
in EBIT is greater than the percentage change in EBIT, financial leverage exists.
- The effect of financial leverage is such that an increase in the firm’s EBIT results in a
more-than-proportional increase in the firm’s earnings per share, or vice versa.

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 Financial Risk and Financial Leverage
• Example
XYZ Co. expects EBIT of Birr10,000 in the current year. It has a Birr20,000 bond
with a 10% (annual) coupon rate of interest and an issue of 600 shares of Birr4
(annual dividend per share) preferred stock outstanding. It also has 1,000 shares
of common stock outstanding. The annual interest on the bond issue is Birr2,000
(0.10 * Birr20,000). The annual dividends on the preferred stock are Birr2,400
(Birr4.00/share * 600 shares). Consider the following two situations:
Case 1 A 40% increase in EBIT (from Birr10,000 to Birr14,000) results in a 100%
increase in earnings per share (from Birr2.40 to Birr4.80).
Case 2 A 40% decrease in EBIT (from Birr10,000 to Birr6,000) results in a 100%
decrease in earnings per share (from Birr2.40 to Birr0).
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 Financial Risk and Financial Leverage

 These calculations show that when XYZ Co.'s EBIT changes, its EPS
changes 2.5 times as fast on a percentage basis due to the firm’s
financial leverage. The higher this value is, the greater the degree of
financial leverage.
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 Financial Risk and Financial Leverage
• A more direct formula for calculating the degree of financial leverage at a base
level of EBIT is given by • Note that in the denominator the
term 1/(1 - T) converts the after-tax
preferred stock dividend to a before-
tax amount for consistency with the
• Example other terms in the equation.
Given: EBIT = Birr10,000, I = Birr2,000,
PD = Birr2,400, and the tax rate (T = 0.40)

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Exercise

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 Relationship of Operating and Financial Leverage
 Total (or Combined) Leverage
- the use of fixed costs, both operating and financial, to magnify the effects
of changes in sales (Q) on the firm’s earnings per share (EPS).
- the total impact of the fixed costs in the firm’s operating and financial
structure.
- is the combined effect of operating and financial leverage.
- concerned with the relationship between the firm’s sales revenue and EPS.
 Relationship of Operating, Financial, and Total Leverage
- the relationship between operating leverage and financial leverage is
multiplicative rather than additive.
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 Relationship of Operating and Financial Leverage
 Relationship of Operating, Financial, and Total Leverage…
- the relationship between the degree of total leverage (DTL) and the
degrees of operating leverage (DOL) and financial leverage (DFL) is given
by:
- a more direct formula for calculating the degree of total leverage at a
given base level of sales, Q, is given by the following equation.

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 Exercise

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Relationship of Operating and Financial Leverage

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Exercise

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CAPITAL STRUCTURE THEORIES

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 Introduction
• Definition: Capital Structure is the mix of financial securities used to finance the
firm.
• Capital structure decision is a significant decision in financial management.
• Our goal is to see if there is an optimal way for firms to finance.
o Should a firm have a higher or lower D/E ratio.
o What factors affect the optimal D/E choice?
• The value of an enterprise depends on expected earnings and cost of capital.
• Capital structure may influences the value of the firm by operating on either
expected earnings or the cost of capital or both.
• In order to optimize the D/E ratio, our overall goal is to maximize the total value
of the firm and thus maximize expected shareholder wealth.
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Capital Structure Theories

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 The Net Income Approach
• Developed by David Durand.
• The essence of this approach is that the firm can lower its cost of capital by
using debt.
• Assumption:
• the use of debt does not change the risk perception of the investor.
• the interest rate on debt (Kd) and the equity capitalization rate (Ke) remain constant when D/E
increase
˭with the increased use of leverage overall cost of capital declines and the total value of
firm rises.
• The overall cost of capital (Ko) under this approach is measured by :

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 The Net Income Approach…

From the graph, it is clear that as D/E increases, rA () decreases because the proportion of debt, the cheaper source of
finance, increases in the CS .

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 The Net Operating Income Approach
• Contends that the capital structure does not matter, and
• that the firm cannot affect its overall cost of capital through leverage.
• Overall cost of capital remains constant.
• As more debt is incurred, equity investors, in order to compensate for the increased
financial risk, increase their capitalization rate of earnings in such a way as to cancel out
the benefit derived from the use of debt, and the average cost remains unchanged.
• Thus, there is no single point or range where the capital structure is optimum.

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 The Net Operating Income
Approach…
Using an equation

• The critical premise of this approach is that the market capitalises the firm as a whole at
a discount rate which is independent of the firm’s debt-equity ratio.
• As a consequence, the division between debt and equity is irrelevant.
• An increase in the use of debt funds which are ‘apparently cheaper’ is offset by an
increase in the equity capitalization rate.

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The Net Operating Income
Approach…

Where rA is the overall cost of capital.

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 Traditional Approach
• The traditional approach is midway between the NI and NOI approaches
• The crux of the traditional view relating to leverage and valuation is that
• through judicious use of "debt to equity proportions", a firm can increase its total value
and thereby reduce its overall cost of capital.
• Rationale:
• that debt is a relatively cheaper source of fund as compared to ordinary shares.
• By using more debt in the place of equity, a cheaper source of fund replaces a
source of fund which involves, by comparison, a higher cost.
• However, beyond a certain level of leverage, investors may perceive a high
degree of financial risk and this increases equity and debt capitalization rates.

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 Traditional Approach…
• The impact of leverage on cost of capital and value of the firm can be studied in
three distinct stages (Solomon Ezra, 1963).
• Stage 1: cost of equity rises as debt is added but does not increase fast enough
to offset the advantage of low cost debt ; cost of debt remains constant or rises
modestly.
o the value of the firm increases or the overall cost of capital falls with increasing leverage.
• Stage 2: the addition of debt, after a certain degree of leverage has been
reached, provides only a moderate increase in market value.
o As a consequence cost of capital remains relatively constant
• Stage 3: beyond the acceptable limit of leverage, the value of the firm decreases
or the cost of capital increases with the leverage.

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 Modigliani - Miller Approach
• Modern capital structure theory began in 1958 with Professors Franco
Modigliani and Merton Miller (hereafter, MM).
• Suggest that it does not matter how a firm finances its operations,
hence capital structure is irrelevant.

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Modigliani - Miller Approach…
• MM approach provides behavioural justification for constant overall cost of
capital and, therefore, total value of the firm.

MM Approach – 1958: without tax

• MM Approach
MM Approach – 1963: with tax

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 MM Approach – 1958: without tax
• M&M began looking at capital structure in a very simplified world
so that we would know what does or does not matter.
• Assumptions:
1. There are no brokerage costs.
2. There are no taxes.
3. There are no bankruptcy costs.
4. Investors can borrow at the same rate as corporations.
5. All investors have the same information as management about the firm’s future
investment opportunities.
6. EBIT is not affected by the use of debt.

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 M&M No Tax: Result
• A change in capital structure does not matter to the overall value of the firm.
• The total cash flows produced are the same, thus the total value of the cash flows is
the same.
• It doesn’t matter if the cash flows from the firm to its security holders are
called debt or equity cash flows.

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 The M&M Propositions I (No Taxes)
• Firm value is not affected by leverage.
o VL = VU
• The derivation is straightforward
• Shareholders in a levered firm receive Bondholders receive
o EBIT − rBB rBB
• Thus, the total cash flow to all stakeholders is:
o (EBIT − rBB) + rBB
• The present value of this stream of cash flows is VL
o (EBIT − rBB) + rBB = EBIT
• The present value of this stream of cash flows is VU
∴VL = VU
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 The M&M Propositions I (No Taxes)…
- Intuition: Through homemade leverage/arbitrage process, individuals can either
duplicate or undo the effects of corporate leverage.
- for the firms in the same risk class, the total market value is independent of capital
structure and is determined by capitalising net operating income by the rate appropriate
to that risk class.
- the average cost of capital is not affected (i.e. constant) by degree of leverage and is
determined as follows:
- MV of Firm (V) = MV of Equity (S) + MV of Debt (D) = Net Operating Income (NOI)/K 0
- K0 = Cost of capital = NOI/V

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 The M&M Propositions I (No Taxes)…
- Arbitrage process - if levered firms are priced too high, rational investors will arbitrage
by borrowing on their personal accounts to buy shares in unlevered firms. This
substitution is often called homemade leverage; or investors replicate the firm’s
proposed capital structure or debt-equity ratio (i.e. at company level) at the personal
level.
- Because of this arbitrage process, the market price of securities in higher valued
market will come down and the market price of securities in the lower valued market
will go up, and this switching process is continued until the equilibrium is established
in the market values.

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 The M&M Propositions I (No Taxes)…
- view the capital structure question in terms of a “pie” model,
- i.e. given for two firms with identical on the left side of the balance sheet (i.e. their assets and
operations are exactly the same); the right sides are different because the two firms finance their
operations differently; the size of the pie is the same for both firms because the value of the assets is
the same;
- thus the size of the pie doesn’t depend on how it is sliced.

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 The M&M Propositions II (No Taxes)
• Leverage increases the risk and return to stockholders.
• The use of supposedly “cheaper” debt funds is offset exactly by the increase
in the required equity return, rS.
• rS = r0 + (B/S) (r0 - rB)
• rB is the interest rate (cost of debt)
• rs is the return on (levered) equity (cost of equity)
• r0 is the return on unlevered equity (cost of capital)
• B is the value of debt
• S is the value of levered equity

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 The M&M Propositions II (No Taxes)
…
• The derivation is straightforward:
rWAAC =rB ) + rS) Then set rWAAC = r0

rB ) + rS)= r0 multiply both sides by

rB + rS= r0

rS= r0 - rB

rS = r0 + (B/S) (r0 - rB)

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 The M&M Propositions II (No Taxes)
…
- Intuition: The cost of equity rises with leverage, because the risk to
equity rises with leverage. (required return/risk to equity holders rises with
leverage).
- Although changing the capital structure of the firm does not change the firm’s total
value, it does cause important changes in the firm’s debt and equity.
- Proposes that a firm’s cost of equity capital is a positive linear function of the firm’s
capital structure.

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 The M&M Propositions II (No Taxes)…
Graphically

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 The M&M Propositions II (No Taxes)…Example
- A Co. has a weighted average cost of capital (ignoring taxes) of 12%. It can borrow
at 8%. Assuming that the Co. has a target capital structure of 80% equity and 20%
debt, what is its cost of equity? What is the cost of equity if the target capital
structure is 50% equity? Calculate the WACC using your answers to verify that it is
the same.
- The cost of equity, rS = r0 + (B/S) (r0 - rB) MM II
- Case -1: the debt-equity ratio is .2/.8 = .25, so the cost of the equity is 13%.
RE = .12 + (.12 − .08) × .25 = .13, or 13%.

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 The M&M Propositions II (No Taxes)…
Example
- Case – 2: the debt-equity ratio is 1.0, so the cost of equity is 16%.
RE = .12 + (.12 − .08) × 1.0 = .16, or 16%.
- The WACC
- Case – 1: assuming that the percentage of equity financing is 80%, the cost of equity is
13%, and the tax rate is zero:
WACC = (E / V) × rS + (B / V) × rB = .80 × .13 + .20 × .08 = .12, or 12%
- Case – 2: assuming that the percentage of equity financing is 50% and the cost of
equity is 16%.
WACC = (E / V) × rS + (B/ V) × rB = .50 × .16 + .50 × .08 = .12, or 12%
- As calculated, the WACC is 12% in both cases.

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 M&M with Corporate Taxes
• When corporate taxes are introduced, then debt financing causes a positive
benefit to the value of the firm.
• The reason for this is that debt interest payments reduce taxable income and
thus reduce taxes.
o Thus with debt, there is more after-tax cash flow available to security holders (equity
and debt) than there is without debt.
o Thus the value of the equity and debt securities combined is greater.

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 M&M Proposition I (with Corporate
Taxes)
• Firm value increases with leverage
VL = V U + T B
o where T is the corporate tax rate and B is the amount of debt.
• Shareholders in a levered firm receive Bondholders receive
o (EBIT − rBB) x(1-T) r BB
• Thus, the total cash flow to all stakeholders is:
o (EBIT − rBB) x (1-T) + rBB= EBIT x (1-T)− rBB + rBB T + rBB
= EBIT x (1-T) + rBBT
• The present value of this stream of cash flows is V L
o EBIT x (1-T)
• The present value of this stream of cash flows is V U
∴VL = VU + T B
• Note that the present value of rBBT is BT.
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 M&M Proposition I (with Corporate
Taxes)…
- Implications of Proposition I:
• Debt financing is highly advantageous, and, in the extreme, a firm’s optimal capital structure
is 100 percent debt.
- Example:
- EBIT is expected to be Br1,000 every year forever for both firms (L & U).
- Firm L has issued Br1,000 worth of perpetual bonds with 8% interest each year
(i.e. pays Br80 interest every year forever). The tax rate is 21%.

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 M&M Proposition I (with Corporate
Taxes)…
- the net income for firms U & L is:

- the cash flow from assets is equal to EBIT – Taxes assuming that depreciation
is zero; capital spending is zero and that there are no changes in NWC for
firms U and L:

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 M&M Proposition I (with Corporate
Taxes)…
- the cash flow to stockholders and bondholders is:

- Firm L has Br16.80 more total cash flow due to the tax savings/ the interest tax
shield = Br80 × .21 = Br16.80.

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 M&M Proposition I (with Corporate
Taxes)…
- Present value of the interest tax shield = (T × B × rB) / rB = T × B
- the present value (PV) of the tax shield is: PV = Br16.80/.08 = (.21 × Br1,000
× .08)/.08 = .21 × Br1,000 = Br210.
- because the tax shield is generated by paying interest, it has the same risk as the
debt, and 8% (the cost of debt) is the appropriate discount rate.
- VL = VU + T× B. if the cost of capital for Firm U is 10%, then

- VU = (EBIT × (1 − T))/RU = Br790/.10 = Br7,900

- VL = VU + T × B = Br7,900 + .21 × 1,000 = Br8,110

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 M&M Proposition II (with Corp. Taxes)
- This proposition is similar to Prop. II in the no tax case, however, now the risk and return
of equity does not rise as quickly as the debt/equity ratio is increased because low-risk
tax cash flows are saved.
- Some of the increase in equity risk and return is offset by interest tax shield.
- The cost of equity, rS, is: rS = r0 + (B/S) (r0 - rB) × (1 − T)

- Where:
• rB is the interest rate (cost of debt)
• rs is the return on (levered) equity (cost of equity)
• r0 is the return on unlevered equity (cost of capital)
• B is the value of debt
• S is the value of levered equity
• T is corporate tax rate
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 M&M Proposition II (with Corp.
Taxes)…
- Unlike the case with Proposition I, the general implications of Proposition II are the
same whether or not there are taxes.
- Given the following information for the Format Co.:
- EBIT = Br 126.58; T = .21; B = Br500; r0 = .20; The cost of debt capital is 10%.
1. What is the value of Format’s equity?
2. What is the cost of equity capital for Format?
3. What is the WACC?

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 M&M Proposition II (with Corp. Taxes)
…
1) Ve is:
Vf without debt: VU = (EBIT − Taxes)/RU = (EBIT × (1 − T))/RU = Br100/.20= Br500
Vf with debt (from MM Proposition I with taxes): VL = VU + T × B= Br500 + (.21 × Br500)= Br605
Ve = VL − B= Br605 − Br500= Br105.
2) Cost of equity (rS) is:
rS (MM Proposition II with taxes) = r0 + ( r0 − rB) × (B / S) × (1 − T)
= .20 + (.20 − .10) × (500 / 105) × (1 − .21)
= .5762, or 57.62%
3) WACC is:
WACC = (105 /605) × .5762 + (500 /605) × .10 × (1 − .21) = .1653, or 16.53%
 Hence, this is lower than the cost of capital for the firm with no debt (r0 = 20%), so
debt financing is advantageous.
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M&M Proposition II (with Corp.
Taxes)…

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 Other Capital Structure Theories
• So far we have examined capital structure without and with corporate taxes.
Our conclusions have been that capital structure does not matter to the value
of the firm (no-tax case) or the optimal capital structure is 100% debt.
• In this section, we shall examine other factors that affect the optimal capital
structure.
o Cost of financial distress
o Agency costs of equity
o costs of external financing
o Signaling
• The end result is an intermediate capital structure that depends on firm-
specific characteristics.

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 Trade-off theory
- The capital structure theory that states that firms trade off the tax benefits of debt
financing against problems caused by potential bankruptcy.
- As the debt level increases, the value of the expected tax shields from debt
increases; however so does the value lost due to the expected financial
distress costs.
- At some point, the marginal benefit from interest tax shields is just offset by
the marginal cost of more expected financial distress costs.
- This leads to a limit on the optimal amount of debt in the firm’s capital
structure.

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 Trade-off theory…
• what are costs of financial distress?
o refers to the additional expenses that a firm in financial distress incurs
beyond the cost of doing business.
o Direct costs – legal and admin costs e.g Bankruptcy filing fees.
o Indirect costs
Losses of customers, suppliers, good employees, etc.
Agency costs of debt
 Incentive to take large risks (even if assets are redeployed to negative NPV projects).
 Incentive to milk the property
 Incentive toward underinvestment

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 Trade-off theory…

Value of the firm with financial distress:

• VL= VU +T●B–PV expected financial distress
• The value of the levered firm is reduced by the present value of the expected
financial distress.

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Integration of Tax Effects and Financial Distress Costs

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 Agency Costs of Equity
• The more discretionary cash flow management controls, the more it will be
tempted to spend money on perquisites or to shirk in its duties.
• Higher debt levels reduce discretionary cash flows controlled by management,
and therefore reduce the waste caused by management shirking or spending
on perquisites.
• Thus higher debt levels add to firm value.
• Value of the firm with agency costs of equity (or agency costs of free cash
flow):
• VL= VU +T●B – PV expected financial distress + PV savings of shirking and perquisites costs

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 Agency Costs of Equity…
• The value of the levered firm is reduced by the present value of the expected
financial distress costs.
• However, now it is increased as debt increases because of the savings of the
agency costs of equity.
• Save costs related to excessive perquisites or shirking of management.

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 Pecking Order Theory
• Suggests that firms prefer to finance their investment projects internally using
retained earnings before issuing debt or equity.
• The theory is based on the assumption that internal funds are the cheapest
and least costly form of financing, followed by debt, and then equity.
• The firms want to avoid the costs associated with external financing, such as
underwriting fees, interest payments, and dilution of ownership.

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 Pecking Order Theory…
Reasons why firms may prefer to use internal funds to finance their investment
projects:
a. internal funds are typically the most readily available form of financing.
b. internal funds do not have to be repaid, unlike debt, and they do not dilute ownership,
unlike equity.
c. internal funds can be used to finance investment projects without having to disclose
information about the projects to investors, which can be advantageous in some cases.

∴ The Pecking Order Theory thus states that managers will finance first with
retained earnings, then debt, and finally additional equity issue.

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 Signaling theory
- Information asymmetry - The situation where managers have different (better)
information about firms’ prospects than do investors, contrary to MM assumption
of information symmetry.
- Signal - An action taken by a firm’s management that provides clues to investors
about how management views the firm’s prospects.
- a firm with very favorable prospects would be expected to avoid selling stock and
instead raise any required new capital by using new debt, even if this moved its
debt ratio beyond the target level.
- a firm with unfavorable prospects would want to finance with stock, which would
mean bringing in new investors to share the losses.
- the announcement of a stock offering is generally taken as a signal that the firm’s
prospects as seen by its management are not bright.

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 Signaling theory…

• Because management knows more about the true value of the firm, investors
will interpret an equity issue to signal management’s assessment that the
firm’s equity value must be overvalued.
• Debt has contractual payments, thus there is less of an over-valued signal
when debt is issued. In fact, debt can signal that management is confident in
its firm and believes servicing the debt will not be a problem.

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Signaling theory…
Result: markets react very negatively to additional equity issues, less negatively to additional
debt issues:
- Issuing stock emits a negative signal and thus tends to depress the stock price; even
if the company’s prospects are bright.
∴ a firm should, in normal times, maintain a reserve borrowing capacity that can be used in the
event that some especially good investment opportunity comes along.
- This means that firms should, in normal times, use more equity and less debt than is
suggested by the tax benefit/bankruptcy cost trade-off model.
- Firms often use less debt than specified by the MM optimal capital structure in
“normal” times to ensure that they can obtain debt capital later if necessary.

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……Leverage……………
• “Having a large amount of leverage is like driving a car with a dagger on the
steering wheel pointed at your heart. If you do that, you will be a better
driver. There will be fewer accidents but when they happen, they will be
fatal.” Warren Buffett

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 Exercise
• What is the optimal capital structure?
• What is the value of the firm under the optimal capital structure?
• What is the value of the firm’s debt and its equity under the optimal capital
structure?

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 Leverage - Synopsis
• “Leverage” is a general term that refers to an ability to multiply the effect of some effort. The term
comes from physics where a lever is used to multiply force. Financial leverage refers to using
borrowed money to multiply the effectiveness of the equity invested in a business enterprise.
• The borrowed money with which financial leverage is concerned is the debt in a company’s capital
structure. Hence, the terms “financial leverage” and “capital structure” are somewhat synonymous.
• To be leveraged means to have debt.
• To be unleveraged means to operate with only equity capital.
• In an unleveraged firm (one with no debt), the variation in ROE and EPS is identical
to the variation in EBIT.
• In a leveraged firm, the variation in ROE and EPS is always greater than the variation in EBIT.

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• The effects of financial and operating
leverage compound one another.
• Financial and operating leverage are similar in that both
can enhance results while increasing variation.
• A firm’s target capital structure is management’s estimate
of the optimal capital structure.
• Operating income (EBIT) is unaffected by financial
leverage.
• Under certain conditions, changing leverage increases
stock price. An optimal capital structure maximizes
stock price.
• Capital restructuring involves changing leverage by
shifting the mix of debt and equity
• Financial leverage refers to debt in the capital structure.
It multiplies the effectiveness of equity but adds risk.

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