What is Capital Structure?

• Capital structure refers to the relative weights of different financing sources

utilized by the firm. These weights are used in the calculation of WACC, which we
use for valuing whole firms and their representative projects.
• A Debt/Equity ratio can be converted into weights by assuming Equity = 1; W e = E / (D+E)

• Empirically, there is significant variation in the weight of debt used by firms.

• Even within the same industry where firms face similar risks there is usually a wide range.
• (We, by industry): [Link]
• (Industry D/E ratio ranges): Mining = 0.4-1.2, retail = 0.5-1.5, utilities = 0.5-2, manufacturing = 1-3

• Our goal in this class and the next is to understand why firms make financing
choices they way they do.
• Along the way we will explore two useful tools: the Pureplay approach, and APV valuation
• Let’s begin by considering the overall impact of leverage.
Unleveraged Firms and Demand
Uncertainty
• A firm using no debt to finance its long-term assets is said to be
unleveraged.
• Such organizations face systematic risks determined by demand uncertainty,
and the asset mix they use to support their operations.
• These factors are combined into a metric called business (or asset) risk.

• Imagine a company which produces boxes by hand at a cost of $10

each which sell for $12. Demand is stable at ~1000 boxes per year
(ranging from 800-1200).
• Uncertainty arises from the determinants of demand (including competition).
• Assuming no taxes for simplicity, annual profit = $2000 ($1600-$2400 range)

• While the investor can’t be certain of how much they will make, as long
as the rate is greater than the cost of capital they are creating value.
Changing the Assets Can Change the Risks
• Many business models have fixed costs related to long-term assets which are
incurred regardless of sales (rentals, depreciation, etc).
• The “stable” cash flows of the firm are allocated to paying these costs first, leaving any
uncertainty to be borne by the residual claimants (ie, equity investors)

• Should our box maker buy a machine for $4700 which cuts costs in half (it lasts 1
year)?
• Assuming no taxes and the same demand forecast, annual profit becomes = $2300 ($900-
$3700)
• Based on statistical expectation, yes. But what about risk? Profit range rose from $800 to
$1,800.

• Using fixed costs increases the risk for shareholders who will demand to be
compensated.
• Be careful: EPS does not consider risk. The machine may make us better off (+NPV) but we will
need to recalculate both the expected cash flows AND their discounted value (higher risk, higher
rate).
• This will be true of financial leverage as well.
Measuring Business Risk
• Range may be intuitive but it’s a basic risk metric that ignores the
distribution, and leaves us unable to process the interactions of a
portfolio of projects.
• Instead, we focus on the net systematic risk that a firm faces, measured by its
CAPM Beta.

• The CAPM estimates the investor’s required rate of return based on the
degree of exposure to systematic risk (Beta).
• This is multiplied by the Market Risk Premium (4-7%) and added to the Risk-Free
Rate.
• Required Return = Rf + Beta*(Market Risk Premium)

• For companies without long-term debt (unleveraged), we denote their

Beta as BU to distinguish it from the Beta coefficient of leveraged firm BL.
• Cost of unleveraged equity (KeU) = R f + BetaU*(Market Risk Premium)
• Cost of leveraged equity (KeL) = Rf + BetaL*(Market Risk Premium)
Financial Leverage Amplifies Business Risk
• Firms can also use financial leverage (borrowing) to increase the asset
base in exchange for a fixed financial burden.
• If used to finance projects with sufficient rates of return, the use of debt financing
can increase the expected returns on equity

• As before, the cash flows from the operation of the assets will be
allocated to servicing these expenses before shareholders can collect
anything.
• The stability of cash flows enjoyed by debt holders comes at the expense of
shareholders who must supply it from their own. Thus, equity investors in
leveraged firms demand returns which compensate for both the business risk AND
the extra volatility induced by the use of debt
• BL = BU + (compensation for financial leverage); THUS KeL > KeU

• But how much is that compensation? And does this risk compression affect
valuation?
Theoretical Approaches to Capital
Structure
• To understand how leverage affects discount rates (and thus firm
value), researchers assumed away everything they knew mattered in
the real world, and then added back the complications one at a time to
study their impact.
• This allows individual effects to be isolated, simplifying our understanding of
the complex processes at play.

• These models assume that the maximum value of the firm is achieved
under conditions of zero friction and subtract each cost from the firm
incrementally.
• This means firms are choosing a financing mix which maximizes their value
by minimizing their exposure to various financing frictions, including
taxes, distress/bankruptcy, information asymmetries, agency costs, etc
• You can think of these frictions as “carving away pieces of the block” of value
created by the firm’s productive assets.
Modigliani and Miller (M&M) Irrelevance
Theorem
• The first we will consider is foundational to our modern understanding of
firm financing – the Miller and Modigliani Irrelevance Theorem.
• The opening premise is that in the absence of frictions, it doesn’t matter how you
finance assets – their value is determined by asset traits, not the financing used to
acquire them.
• Total cash flows are the same and their variability is independent of how they are
split up.

• To demonstrate this, imagine two firms with the same risks but with
different levels of debt (none vs some). The earnings of both are
perpetual and identical.

• Importantly, the market here is assumed to be frictionless: no taxes,

no risk of costly re-organization or financial distress (fire sale of assets,
legal), no transactions costs, no asymmetric information problems.
• Unsurprisingly, the results seem unusual but they help up quantify the relationship
between the costs of unleveraged equity (KeU) and leveraged equity (KeL).
Same Payoffs, Same Value
• If an investor (A) buys all the equity of the unleveraged firm, they earn EBIT which has a
value of VU (value of the unlevered firm).
• If an investor (B) buys all the equity (SL) AND debt (D) of the leveraged firm, they earn
[EBIT – Interest], plus [Interest] = EBIT. SL + D = VL (value of the leveraged firm).
• With the same cash flows and risks, the value of the unleveraged
and leveraged firms must be the same! (no arbitrage condition)

Net payoffs are

equal so values
are equal
If Firm Value is Constant, so is WACC
• In a frictionless world the value of the capital structure underpinning
identical leveraged and unleveraged firms is also identical.

𝑉 𝑈 =𝑆 𝐿 + 𝐷=𝑉 𝐿
• Since firm value doesn’t change, WACC must be constant as well
such that the discounted cash flows to each funding source produce
the same enterprise value.

• With no taxes: WACCU = WACCL. Thus, the following expression

must also hold:
• WACCU = KeU = WACCL = (We*KeL) + (Wd*Kd)
• KeU = (E/D+E)*(KeL) + (D/D+E)*(Kd)
• Isolating KeL allows us to quantify how much extra comp equity investors
require to offset the extra volatility induced by the use of debt
Debt Isn’t “Low Cost” – Equity Carries the
Risks
• The relationship between levered and unlevered equity costs is:

• Rule: leverage increases the equity risk even when there is no risk
of default.

• Recall that although earnings and their volatility are unaffected at the firm
level we saw that equity profit experienced more volatility as the use of
debt increased.
• This translates into increased uncertainty for shareholders who demand more
compensation for the additional risks they face. Cash flows to levered equity are
discounted at a higher rate.

• Try it! Solve WACCL when KeU = 10%, Kd = 5%, and D/E = 1
• WACCL = (We*KeL) + (Wd*Kd) = 0.5*KeL + 0.5*Kd
• WACCL = (.5)*[10% + (10% - 5%)(1)] + (.5)*5% = 7.5% + 2.5% = 10%
M&M and the Cost of Equity Capital (Where
Risk Goes)
• Since firm value is unaffected by leverage under these
conditions, the higher EPS from leverage must be exactly offset
by a higher discount rate on flows to equity.

• KeU is the required return due to

asset risk while (KeU – KD) is for the
impact of leverage.
• The cost of leveraged equity (KeL)
varies with the debt-equity ratio,
scaling linearly for the extra return
required by equity investors.
• NOTE: The weight of equity falls as D/E (and
K ) rises such that WACC remains constant.
The Importance of Imperfections
• These results are driven entirely by the fact that many value
consuming frictions have been assumed away.
• Taxes, financial distress, agency costs, floatation (issuing) costs, etc
• In the real world all these factors matter and they change the math
regarding the (dis)advantages of debt financing for a variety of reasons.
We will examine each in turn.

• The first such complications we will layer on is the impact of

income taxes and the deductibility of interest expenses.
The Impact of Taxes
• The introduction of corporate taxes means that some of the firm’s
cash flows are taken by the government.
• As a result, firm value for investors is reduced by corporate taxes.
• The higher the tax rate, the lower the value of the firm.

• Taxes are a % of flows to equity, so SL drops (multiplied by (1-T))

and D/E changes.
• Since payments to debt holders are made pre-tax, the value of the firm’s
debt wouldn’t change 𝐸𝐵𝐼𝑇 ∗(1 −𝑇 )
𝑉 𝑈=
𝐾𝑒𝑈
Visualizing the Impact of Taxes
• Consider two firms in the pre-tax world one financed with $10,000 of
equity, the other with $5,000 of equity and $5,000 of debt.
• Both have identical risk and cash flows, and thus the same pre-tax value.

• If a 50% income tax is introduced:

• Unleveraged firm: The value of the all-equity firm falls by 50% to $5,000 as the
government claims half the cash flows headed to investors. Enterprise value is
$5,000 after tax.
• Leverage firm: As above, the value of the leveraged firm’s equity falls by 50% to
($2,500) but because debt holders receive their cash flows before the government
takes half, the value of debt is unaffected by tax. Enterprise value is $7,500
after tax. ($2,500 + $5,000)

• Though often described as “adding value”, strictly speaking tax shields

limit the loss of firm value due to taxes (a consolation prize of sorts).
• They add value relative to a taxed but unleveraged firm.
The Value of Tax Shields – Fixed Level of
Debt
• The additional value created through debt is based on the
present value of expected future tax shields.

𝑉 𝐿 =𝑉 𝑈 +𝑃𝑉 (Interest Tax Shield)

• In the prior example, we assumed a fixed, permanent amount of
debt (worth $5,000) and that there would always profits which
could be shielded from taxes.
• Under such conditions, these tax shields should be discounted at the same
rate as interest payments (KD).

• If the firm survives for a long time, we can approximate the

present value of all future tax shields with a simple perpetuity.
• PV(tax shields with stable permanent debt) = (D * KD * T) / KD = D*T =
$5,000*0.5 = $2,500
WACC with Taxes

• In many situations however, firms maintain a target debt/equity

ratio rather than a fixed level of debt.
• In these situations, the risk (discount rate) of the tax shields should be equal to
those of the firm as a whole (WACC). This allows us to directly incorporate
them into the discount rate.

• Incorporating the tax shield on interest into the WACC calculation

necessarily brings down the average cost of capital.
• By reducing WACC, the same free cash flows produce a higher enterprise
value, properly reflecting the value added (less friction) by the associated
tax shields.
𝐸 𝐷
𝑊𝐴𝐶𝐶=𝐾 𝑒𝐿 +𝐾 𝐷 (1−𝑇)
𝐷+𝐸 𝐷+ 𝐸
Cost of Leveraged Equity (Prop II)
• IMPORTANT: The cost of leveraged equity is not affected by the
introduction of taxes!
• Taxes affect the magnitude, not the volatility of cash flows.
• They DO however affect the D/E ratio as the value of equity drops.

• While M&M’s second proposition

(above) includes a tax term, recall that
[ 21-18] the value of E (equity) is reduced by
taxes so D/E rises and the effects
exactly negate each other.
• If D/E was 1 pre 50% tax, it rises to 2 as
the value of equity falls by half!
Summary of Tax Impacts (with and without
debt)
• We have explored two dichotomies, yielding four
situations (at right – see spreadsheet on A2L).

• DEBT: Assuming no defaults, debt holders gets stable

cash flows out of unstable assets because shareholders
absorb the associated risks for them.
• This raises the required return on equity (10% to
17%).
• KeL = KeU + (KeU – Kd)*(1-T)*D/E
• Absent friction, debt re-organizes risk but creates no
value.

• TAXES: With corporate taxes (and deductible interest),

equity values fall by a proportion equal to the tax rate.
• This doesn’t reduce the investment shareholder makes,
only the value of the expected future cash flows from
those investments. If returns get too low, firms don’t
invest.
• With taxes present, the value of the enterprise
(green + red) is higher if the firm uses debt: V L = VU
+ PV(TS)
• Bottom right: WACC falls to 6.67%, raising firm value to $7,500.
Recapitalization (Add Debt, Get a Tax
Shield!)
• If a firm is confident that its future cash flows could accommodate larger
debt payments, then it might be a value creating move for the company
to borrow to buy-back shares from investors (swap equity for debt in the
capital structure).

• MIDCO has 20 x $15 shares outstanding and pays a 35% tax rate.
• Management is planning to borrow $100 in perpetuity to buy these back

• With stable permanent debt, the value of tax shields will be = D*T = $35
• Thus VL = $300 + $35 = $335. With $100 in debt, the value of leverage equity is
$235
• They might have less equity ($300 vs $235) but they have $100 in cash as well so
they capture the full value of the tax shield.
• Under no arbitrage, it doesn’t matter which shareholders sell, they will receive the
same total compensation regardless ($16.75 per share - see 18.3 for details)
Limits of the Tax Shield (Got Earnings?)
• To receive the full tax benefits of leverage, a firm need not use
100% debt financing, but the firm DOES need to have taxable
earnings.
• This constraint limits the optimal amount of debt to that needed to generate
a sufficient tax shield to reduce taxes to zero (interest = EBIT).

• Consider the table below:

• With no leverage, the firm receives no tax benefit.
• With high leverage, the firm saves $350 in taxes.
• With excess leverage, there is a net operating loss and no increase in the
tax savings.
Tax Interest vs. Tax Shields on Debt
• When estimating the value of tax shields on debt, recall that the
interest earned on marketable securities is fully taxable.
• This means that managers estimating the value of debt tax shields
should not be fooled by the idea of simply borrowing money and parking
it in cash (or equivalent securities) to raise debt and thus “create value
through a tax shield”.
• Managers borrowing at a risky rate to invest at a risk-free rate destroy
investor value.

• To properly assess the value of tax shields to a recapitalizing a

firm, consider its “net” debt position (debt less any excess cash or
securities).
• Firms with excess idle funds invested in low risk assets may actually
generate “negative tax shields” (more appropriately, a tax burden)
resulting from their net interest income.
Personal Taxes
• While the preceding work showed the impact of corporate taxes on a
firm’s optimal capital structure (max debt to add value), a realistic
model of corporate behaviour must consider the personal taxes as
well.
• In Canada, these are double the rate of capital gains.

• For a firm with permanent debt, we can model this by substituting

the “effective tax advantage of debt” (T*) for the corporate tax rate
(T) in our relationship of leveraged to unleveraged enterprise value.
∗ 1   i   1   c 1   e  1   c 1   e 
𝑉 𝐿 =𝑉 𝑈 +𝜏 𝐷 * 
1   i 
1 
1   i 
• The net result is that the tax advantages of debt are
reduced.
• How much exactly depends on jurisdiction and tax status.
When M&M met CAPM
• Within a decade of M&M’s publication, our way of modelling the
cost of equity improved with the introduction of the Capital Asset
Pricing Model.
• Rather than modelling the cost of equity directly, CAPM breaks it into
risk-free and risky components with the required return increasing as a
function of systematic risk.
• Systematic risk is measured using the Beta coefficient on the market risk
premium, which rises as volatility rises (recall that financial leverage
induces volatility).
• KeU = Rf + BetaU * (Rm - Rf); KeL = Rf + BetaL * (Rm - Rf)

• Assuming the =CAPM

+ ( - holds
)(1-T)( it is possible to re-formulate the
relationship between levered and unlevered equity costs in terms
of levered and unlevered equity Beta.
Beta of Debt? (For those doing more finance after
F610)
• There is no reason we can’t decompose the excess returns on debt (above risk-free)
into systematic and idiosyncratic components, just like we did for stocks.
• The more leverage (debt) a firm uses, the less loss-absorbing capital (equity) lies between
the volatility of free cash flows and the promise of uninterrupted interest payments.
• As the equity buffer thins, asset risk seeps into debt prices and they develop systematic risk.

• Debt betas are difficult to estimate

because corporate bonds are traded
infrequently but panel estimation
techniques have helped to close in
average Betas by bond rating.
• They tend to be low, but can be
significantly higher for risky debt with
a low credit rating and a long
maturity.
• An option-based technique for
estimating this directly exists but is
beyond this course.
Beta of Debt? (For those not doing more finance after
this)

• As long as we are modelling firms with investment grade debt,

the Beta of debt might be low enough that it could be reasonably
ignored.
• If true, BetaD drops out of the equation, leaving us with the popular
Hamada equation:  D
 L U 1  (1  T )
 E 

• If you are working backwards from an observed levered equity

Beta (BL), assuming BetaD equals zero means underestimating
BetaU (BU).
• We use this approach next to benchmark equity costs.
The Pure Play Approach – Comparable
Firms
• It is often challenging to directly estimate the appropriate equity cost for a
project, particularly one that is embedded in a firm with diverse
investments.
• Our estimates of BetaU should be based on asset risk but this is usually unobservable.
• A firm with half high risk assets (Beta = 1.7) and the other half being low risk (Beta =
0.3) will produce an average firm Beta of 1 but this is the wrong cost of capital for
both types of assets

• To approximate BetaU (and thus KeL and WACC) for a project, we identify a
number of firms with similar assets and risks to the project we are trying
to value, usually those in the same industry, regulatory jurisdiction, and of
similar size.
• The idea is that firms of similar sizes in similar industries are affected by similar risks
and should thus have a similar degree of systematic risk.
• These firms should be “pure plays” to the extent possible, meaning their primary
assets are those we would be using in our own project.
The Pure Play Approach – Estimating Asset
Beta
• If the comparable firms use no leverage, equity Betas (B L) equal asset Betas
(BU).
• Unleveraged pure plays can provide a direct estimate of KeU but are hard to find.

• If comparable firms use leverage, we need to a de-lever their cost of equity

capital using each firm’s market valued D/E ratio, average tax rate, and
CAPM-Beta.
• To use Hamada (and assume BetaD = 0) simply avoid highly leveraged comps (if
possible).

• Take the mean (or median) of the unlevered Betas and assume it is
representative of firm/project in question. The comp range can be useful in
sensitivity analysis.
• Alternatively, you can use the unlevered industry Betas estimated by Aswath
Damodaran (patron saint of valuation):
[Link]
The Pure Play Approach – Estimating
Equity Beta & WACC
• For firms with publicly traded equity using this technique for
project or divisional purposes, Beta should be re-leveraged
according to the firm’s own market valued debt/equity ratio. The
tax rate should be specific to our company as well.
• Recall that we don’t allocate specific sources of capital to finance specific
assets – the burden of financing costs are the borne by the firm as a whole.

• For companies without publicly traded equity, there are a few

choices for how to choose the appropriate D/E ratio for re-
leveraging, none of which are “good”:
• Book values; selected target; benchmark to comparable firms

• Equipped with a project cost of equity, we can now include this in

our WACC and NPV calculations to determine whether they are
worth pursuing.
Pure Play Example
• Hydra is involved in numerous businesses. Their restaurant
division is considering the value in trying to push its brand into a
new geographical market and thus needs to estimate the
appropriate cost of capital for this highly complex project.
• Hydra has $11.3 billion in debt, a market capitalization of $26
billion, and its tax rate is 34%. New bonds require a 6.74%
coupon rate and there are sufficient retained earnings to allow
the firm to maintain its existing capital structure.
• The closest competitor for the restaurant chain, Extra Chicken,
has a beta of 1.8 and faces the same tax rate. Their D/E ratio is
0.63. The risk-free rate is 3.2% for the appropriate time horizon
and the market risk premium is estimated at 5.7%.
• What cost of capital should be applied to Hydra's restaurant
Pure Play Example - Solution

• Work backwards: What is needed for WACC?

• WACC = Wd*(Y)(1-T) + We*(Rf + (BetaL * MRP))
• Wd = 11.3/37.3 = .30295; We = .69705; D/E = .43462
• Y = 6.74%; T = 34%; Rf = 3.2%; MRP = 5.7%; Need BetaL

• Benchmark to Extra Chicken’s BetaU:

• we use Hamada here so BU and next WACC may be (slightly) underestimated
• EC’s BL = 1.8 = BU * (1+(1-.34)(.63)); BU = 1.27137

• Assuming BetaU is the same for both firms:

• BetaL for Hydra = (1.27137)(1+((.66)(.43462) = 1.636
• KeL for Hydra = 3.2% + 1.636 * 5.7% = 12.525%
• WACC for Hydra’s restaurants = 10.08%
Pureplay Approach for Firm Valuation
• This same technique can be used to estimate the cost of equity capital (and
thus WACC) for a company.
• Such an approach is useful when we benchmark to companies with different capital
structures – we can’t simply take an average observed equity Beta (B L) as this
means assuming that our capital structure will be an average of the comparable
firms.

• The correct approach is such circumstances would be to use either debt

Betas (for risky firms), or to assume risk-free debt and use Hamada’s
approximation to estimate the BU for each comparable firm (using their own
tax rates).
• This allows us to use the average (or median) of the unleveraged Betas to
benchmark our own firm’s business risk. This assumes we have a similar asset
structure to the comps.
• Once this step is complete, we re-leverage our Beta U to reflect our financing policies.
Other Capital Structure Frictions
• Thus far we have only considered the impact of a single leverage
related friction.
• With corporate taxes capturing a slice of cash flows to equity, the optimal
capital structure which maximizes firm value is to finance with debt until
interest payments equal EBIT.

• In the real world, this would be incredibly risky as any disruption

in EBIT in turn disrupt its ability to make interest payments,
making default a real possibility.
• Financial distress is the major friction we will be discussing next class.

• There are other frictions related to conflicting incentives, and

asymmetric information, but these aren’t as readily quantified.
• Nonetheless it is valuable for us to consider how each cost is related to the
use of leverage and what systematic or idiosyncratic implications they have.