CAPITAL

STRUCTURE

Ivan Christian K, S.E., M.M.

CAPITAL STRUCTURE
This lecture will explore the determinants of the mix of debt and
equity the firm uses to finance its operations.
We will first explore the situations under which capital structure
is irrelevant to a firms operations.
Examining these situations will allow us to explore how the
following factors influence the mix of debt and equity a firm uses
to finance its operations.
TAXES
RISK
FINANCIAL SLACK
ASSET CHARACTERISTICS
COSTS OF FINANCIAL DISTRESS.
THE CAPITAL STRUCTURE
QUESTION
MODIGLIANI - MILLER:
IRRELEVANCE OF CAPITAL STRUCTURE
A. Firm Value and Capital Structure:
Modigliani-Miller Proposition I: The value of
the firm is independent of the capital
structure of the firm UNDER certain
assumptions.
1st Arbitrage Proof in Finance:
Concept of Homemade Leverage.
ASSUMPTIONS of Modigliani
- Miller:
COMPLETE AND PERFECT CAPITAL
MARKETS
Capital Structure Does Not Matter IF:
No Taxes - Assumption Relaxed.
No Bankruptcy Costs
No Costs of Enforcing Debt Contracts or issuing
securities.
Investment Opportunities are Given
Homogeneous Expectations about the Investment
Opportunities of Firms
 Modigliani-Miller Proposition
II:
The cost of equity capital for a levered firm =
The constant overall cost of capital + a risk premium

Where the risk premium = the spread between the

overall cost of capital and the cost of debt multiplied
by the firm's debt equity ratio. and:
 The CAPM and MM
Proposition II
Both address equity risk & are actually equivalent. MM II has the
advantage of showing directly how equity risk depends on capital
structure.
How can we see this?
Remember the following:

Substitute equation 3 into eq. 1 and then substitute eq. 2 into this new
expression, rearrange and you will get the MM proposition II for a firm
with RISKLESS debt.
Note equation 3 does not hold for risky debt. For a firm with risky debt,
MM II is more useful than the equation to releverage a firms Beta. All
you need is observed YTM on risky debt.
 Modigliani-Miller Value of the
Firm
The Value of the Firm (Leveraged/With Debt)
= The value of the unlevered firm + the present value of the tax
shield.

(Yearly tax shield = tc*Interest rate*Debt/expected return)

==> Optimal Capital Structure: 100% financed with debt.

 GRAPHICALLY:

Note I have written ra as (they are the same

thing) in
the above graph
 More Taxes:
The tax dis-advantage of debt to personal investors
mitigates some of this advantage of debt.
Miller (1977) Journal of Finance, pp. 261-275, shows
that the gain to leverage, GL can be expressed

GL = Gain to leverage,
tc = corporate tax rate,
tPS = personal tax rate on stock capital gains,
tPB = personal tax rate on interest income.
DL = Debt of leveraged firm.
OTHER FACTORS
INFLUENCING DEBT:
(VIOLATING ASSUMPTIONS OF MM)
BANKRUPTCY COSTS:
Including bankruptcy costs gives an interior optimum.
VL = Vu + tD - B
where B = PV OF THE COSTS OF FINANCIAL
DISTRESS.
Do This: Try out your intuition. What would the
previous graphs look like if you include bankruptcy
costs?
Including the cost of enforcing debt contracts also
shifts the debt optimum to the left, with the shift
affected by how the enforcement costs vary with the
amount of the debt.
 AGENCY COSTS
(Investment Opportunities are not fixed.)
Managers may have incentives to decrease
risk.
Stockholders may have incentives to increase
DIFFERENTIAL
risk. INFORMATION
Investors have diff. information than management
or insiders about the firms prospects and
investments
Capital structure may tell or signal something
about firms prospects.
II. THE DETERMINATION OF
OPTIMAL CAPITAL STRUCTURE:

PRACTICAL MATTERS
How much debt is right for your
company?
FACTORS TO CONSIDER.
1. TAXES
2. RISK
3. FINANCIAL SLACK
4. ASSET CHARACTERISTICS
5. COSTS OF FINANCIAL DISTRESS.
TAXES:
Debt is Tax Deductible: Increase in Debt reduces the
income tax paid IF the company is in a tax-paying
position.
However, the company has to MAKE money.
OTHER potential tax shields do exist - such as
accelerated write-offs of plant and equipment.
Remember the equation presented earlier from Miller
which shows that the tax advantage is less as
corporations have to "gross up" the interest paid on
bonds to compensate personal investors for a tax
advantage.
RISK

Two types of risk: Financial and Operating

1. FINANCIAL: Directly controlled by
managers. This can be noted in the formula
for unleveraging and levering Betas. The
following example shows how the risk
increases for the firm as it increases debt.
2. OPERATING OR ASSET RISK: Can be
controlled by managers through their choice
of scale or size of fixed assets.
FINANCIAL RISK
A. The Impact of Financial Leverage
EXAMPLE:
A proposed change in financial leverage

Current Proposed
Assets $ $
5,000,000 5,000,000
Debt $ $
0 2,500,000
Equity $ $
5,000,000 2,500,000
Debt/Equity ratio 0 1
Share price* $ $
10 10
Shares outstanding 500,000 250,000
Interest rate na 10%
Scenario analysis of current
and proposed capital
structures:
Current capital structure: No debt

Recession Expected Expansion

EBIT $300,000 $650,000 $1,000,000

Interest 0 0 0
Net income $300,000 $650,000 $1,000,000
ROE 6% 13% 20%
EPS $0.60 $1.30 $2.00
Scenario analysis of current
and proposed capital
structures:
Proposed capital structure: D/E = 1; interest
rate = 10%
Recession Expected Expansion

EBIT $300,000 $650,000 $1,000,000

Interest 250,000 250,000 250,000
Net income $50,000 $400,000 $750,000
ROE 2% 16% 30%
EPS $0.20 $1.60 $3.00
CONCLUSIONS
1. The effect of financial leverage
depends upon EBIT.
2. When EBIT are high, financial
leverage raises EPS and ROE.
3. The variability of EPS and
ROE is increased with
financial leverage.
Corporate Borrowing and
Homemade Leverage
Homemade leverage - investors can create or adjust leverage
how they see fit.
Example: Homemade leverage
Suppose the firm in the previous example does not change its
capital structure & the investor wants High Debt.
An investor can replicate the returns of the proposed borrowing
on personal account by making his or her own D/E ratio equal 1
for the investment.
That is, suppose an investor buys a total of 100 shares,
50 shares with their own money and
50 shares by borrowing $500 at 10% interest.
The payoffs are:
Recession Expected Expansion

EPS of unlevered firm $0.60 $1.30 $2.00

Earnings for 100 shares $60.00 $130.00 $200.00

Less interest on $500 at 50.00 50.00 50.00

10%
Net earnings $10.00 $80.00 $150.00
Return on investment 2% 16% 30%
(net earnings/$500)
Individual investors can also "unleverage" the firm's
borrowing by lending to the firm.
Thus, investors can do or undo any pattern of
financing for themselves
OPERATING RISK: Degree of
Operating Leverage (DOL)
Degree of operating leverage (DOL) - The degree to
which a percentage change in Q (quantity) affects
operating cash flow.
Percentage change in OCF = DOL x percentage
change in Q
DOL = 1 + FC/OCF
Selection of high risk projects: RISK may increase
with debt ratio ==> "go for broke since you will get
nothing otherwise (limited liability)
A project can have a positive NPV for one group of
claimants, while it is a negative NPV project in
aggregate.
FINANCIAL SLACK: VALUE
OR COST
Financial Slack can be defined as the amount of
funds a firm has available to invest without visiting
the external financial markets after paying interest
and before paying dividends +Depreciation.
The following factors influence whether firms should
have more equity (financial slack) or more Debt in
their capital structures.
Firms Track Record of Picking Good Investments.
The likelihood of good investments and opportunities arising.
How Likely is it that + NPV
Investments Arise?
1. Firms Track Record: PROBLEM OF
LEMONS
Firms may be willing to take risks and negative
NPV projects because they are investing other
peoples money.
2. Is Financing Available When Good
Investments Arise?
Small growing firms may have problems raising
financing when they have positive NPV projects.
The problem arises in convincing investors that
their projects have merit out of a pool of potential
investments.
COSTS OF FINANCIAL
SLACK:
AGENCY COSTS AND LBOs.
A. Conflicts between Managers and
Shareholders: Uneconomic Expansion
Serious examples include the incentives of
executives to build "empires". A possible
example: ATT's takeover of NCR.
McConnell and Muscarella, Journal of Financial
Economics, 1985, OIL EXPLORATION.
Debt can be a mechanism that "ties the
manager's hands".
Agency Costs Continued
B. Conflicts between Shareholders, Managers and
Employees: Tough Decisions
High debt can also be a mechanism that
reduces the pool of profits that labor wants to try to
bargain over.
facilities adjustment to a new economic environment.
Helps managers avoid the difficult emotionally costly
decisions.
Reduces incentives to over-diversify. Managers want to
ensure that their jobs are protected against bankruptcy.
They may have substantial human capital tied up in the
firm and may thus over-diversify.
Possible reversal of this trend: 1980s Focus and Core
Competencies
 ASSET TYPE
The type of assets is one of the most
important influence on capital structure. The
types of assets determines:
differential growth opportunities, and
differential agency costs, and
differential information.
FACTORS LEADING TO MORE EQUITY:
Growth opportunities combined with
differential information.
Costs of Financial Distress: Higher for firms
with intangible assets or assets that are hard
to sell.
FACTORS LEADING TO
MORE DEBT:
Tax advantages unrealized.
Firms with stable cash flows will be able to use the tax
advantages of debt.
A computation of historical variances of cash flows
compared with interest coverage in low case scenarios, will
allow some evidence of the ability to use tax credits.
Stable firms with high free cash flow from current
operations without profitable investment opportunities will
tend to increase debt - thus avoiding over-investment.
High debt may signal good stable opportunities:
Example of the Benefits of
increased Debt
The Tale of EQUITY vs. DEBT (EXAMPLE OF Increased Effort.)
Consider Two individuals both working the corner grocer store.
Neither has enough money to open and operate the store.
They must finance the store by raising money.
Kelly Nesbitt finances the store with EQUITY.
Sells 90% of the business to an investor for 90,000
Tom Garvey finances his store with DEBT - keeps 100% of the
ownership,
Finances 90% of the company with debt.
Gets 90,000 in DEBT.
By JUNE it becomes apparent that both stores have made 90,000.
The profit opportunity during the summer is 10,000. It is very
tough work and it takes 2,500 to get owner to forego the beach.
Who works, and who goes to the beach?
Solution:
Tom knows that he will get all $10,000 of the PROFIT
so he stays and works
Kelly realizes that she will only get $1,000 of the
$10,000 so GOES to the BEACH.
==>Debt can produce higher efficiency and less waste
(A reduction of Agency Costs.)
We could repeat this example with the desire to buy
jet planes or to buy other companies.
For example: A fancy office costs $50,000 but adds
only $25,000 TO corporate profits. Tom DOESN'T
BUY.
Kelly GETS $25,000 of benefits - only costs her
$5,000 of her money. Kelly installs the fancy office.
COSTS OF FINANCIAL
DISTRESS
Types of bankruptcy costs: Direct costs and
Indirect Costs.
A. DIRECT COSTS OF BANKRUPTCY:
LAWYERS AND ACCOUNTINGS:
Cost of dividing up the pie - enforcement
costs.
Jerold Warner, Journal of Financial
Economics, 1977 has shown these to be
small for bankrupt railroads. Enron?
WorldCom?
ON TAXES: Loss of PV of Tax Credits.
INDIRECT COSTS OF
BANKRUPTCY:
On Sales and customers: Future Service and
reliability.
Large costs of switching suppliers
Lost up-front relationship specific costs.
On Firm Opportunities: Higher Supplier Charges /
trade credit
Cutback in R&D, advertising.
On Operating Costs: Higher Labor Costs / Higher
costs
of investing in long term relationship.
On Flexibility: Debt restrictions and covenants.
Expected(Costs) = Prob. of bankruptcy * Cost of Bankruptcy