CHAPTER ONE

Capital Structure Policy and Leverage

OUTLINE
The capital structure question
Factors that influence capital structure
Business and Financial Risk
Determining the optimal capital structure
Introduction to the theory of capital structure
 The capital structure question

 How should a firm go about choosing its debt-equity ratio?

 Every company needs capital to support its
operations. Capital structure is a blend of
various sources of finance.

 To
be more specific, capital structure is a ratio of
short-term and long-term liabilities with equity.

 Depending on the sources of financing, we can

classify these as borrowed (or debt) capital and
equity (owner’s) capital. Together, they form the
company’s employed capital.
Capital Restructuring
Capital restructuring involves changing the
amount of leverage a firm has without
changing the firm’s assets.

The firm can increase leverage by issuing

debt and repurchasing outstanding shares.
The firm can decrease leverage by issuing
new shares and retiring outstanding debt
 Choosing a Capital Structure

 What is the primary goal of financial managers?

◦ Maximize stockholder wealth
 Stockholders’ wealth can be maximized by maximizing firm value
or minimizing WACC
Factors Influencing Capital
Structure Decisions
• Business Risk
• Firm’s Tax Position
• Financial Flexibility
• Managerial Conservatism or Aggressiveness
• Operating Conditions – e.g. when Stock Price is
not equal to Intrinsic Value
• Cost of Equity Capital and Cost of Debt capital
• Regulatory Frameworks
 The Effect of Leverage

How does leverage affect the EPS and ROE of a firm?

◦ When we increase the amount of debt financing, we

increase the fixed interest expense.

◦ If we have a really good year, then we pay our fixed

cost and we have more left over for our stockholders.

◦ If we have a really bad year, we still have to pay our

fixed costs and we have less left over for our
stockholders.
Leverage amplifies the variation in both EPS and ROE.
 Financial Leverage, EPS and ROE,
an example
 We will ignore the effect of taxes at this stage
 What happens to EPS and ROE when we issue debt and buy back
shares of stock?
proposed current

8,000,000 8,000,000 Asset

4,000,000 0 debt

4,000,000 8,000,000 Equity

1 0 Debt-equity ratio

20 20 Share price

200,000 400,000 Shares out standing

10% 10% Interest rate

 Current capital structure : No Debt

expansion expected Recession

1,500,000 1,000,000 500,000 EBIT

0 0 0 Interest

1,500,000 1,000,000 500,000 Net income

18.75% 12.5% 6.25% ROE

3.75 2.5 1.25 EPS

Proposed capital structure : debt= $ 4 million

1,500,000 1,000,000 500,000 EBIT

400,000 400,000 400,000 Interest

1,100,000 600,000 100,000 Net income

27.5% 15% 2.5% ROE

5.5 3 0.5 EPS

 Cont….
Variability in ROE
◦ Current: ROE ranges from 6.25% to 18.75%
◦ Proposed: ROE ranges from 2.50% to 27.50%

Variability in EPS
◦ Current: EPS ranges from $1.25 to $3.75
◦ Proposed: EPS ranges from $0.50 to $5.50

 The variability in both ROE and EPS increases when financial

leverage is increased.
 Business and Financial Risk
What is business risk?
 Uncertainty about future operating income (EBIT), i.e.,
how well can we predict operating income?
 Note that business risk does not include financing effects.
Business risk is affected primarily by:
Uncertainty about demand (sales).
Uncertainty about output prices.
Uncertainty about costs.
Product, other types of liability.
Operating leverage.
What is operating leverage, and how does it affect a
firm’s business risk?
Operating leverage is the use of fixed costs rather than
variable costs.

Ifmost costs are fixed, hence do not decline when

demand falls, then the firm has high operating leverage.

More operating leverage leads to more business risk, for

then a small sales decline causes a big profit decline.
 What is financial leverage?
Financial risk?
Financial leverage is the use of debt and preferred stock.
Financial risk is the additional risk concentrated on
common stockholders as a result of financial leverage.

Business Risk vs. Financial Risk

Business risk depends on business factors such as

competition, product liability, and operating leverage.
Financial risk depends only on the types of securities
issued: More debt, more financial risk. Concentrates
business risk on stockholders.
 Meaning of leverage
 In business, leverage is the use of fixed costs in an attempt to
increase or (lever up) profitability. These fixed costs could be:
◦ fixed operating costs (e.g. depreciation) or
◦ fixed financing costs (e.g. interest) or in most cases both.
 It is the use of fixed costs with the intent of magnifying the returns of
the firm.
 Leverage magnifies profit as sales increases, and magnifies loses as
sales drops.
 Types of leverage
1. Operating Leverage:
 it is the use of fixed operating costs in the production activities or
operations of the firm.
 It is the use of fixed operating costs to magnify the effects of changes
in sales on the firm’s profits before interest and taxes (PBIT).
 Degree of operating leverage (DOL)

 Degree of operating leverage is the numerical measure of the

firm’s operating leverage.
 It quantifies the responsiveness of operating income to changes in
the level of income.
 It is the variability of operating income (PBIT), due to the use of
fixed operating costs. It is the percentage change in operating profit
(PBIT) as a result of percentage change in sales.


Where,
DOL = Degree of operating leverage
PBIT = profit before interest and taxes (operating profit)

DOL = = Q = sales (units to

be sold).
 Cont…

 As long as DOL is greater than 1, there is operating leverage.

 A large DOL indicates that small change in the level of sales will
produce large changes in the level of operating profit.
 A firm with relatively high leverage level will experience more
variability in operating income if sales changes, thus, a higher level
of leverage can be associated with higher level of risk.
 Due to that decreases in sales results in a larger increase in lose if
the use of leverage is increased.
 Illustration: assume Lakew Company has the following income statement for the year
ended December 31, 2021.
Lakew Company
Income statement
For the year ended December 31, 2021
Sales (in units)…………………………………………………………1, 000
Sales revenue……………………………………………………..birr 10,000
Less: variable operating costs…………………………………………..5,000
Fixed operating costs……………………………………………2, 500
PBIT (Operating income)………………………………………….birr 2,500
Less: interest……………………………………………………………...500
Profit before tax……………………………………………………birr 2,000
Less: tax (40%)…………………………………………………………...800
Profit after tax……………………………………………………...birr 1,200
Ato Lakew is the owner manager of the company, and he is planning to increase the sales
volume to 1,500 units in the year 2022. He assumed the selling price per unit (SPU), VCU
and the total fixed costs would remain the same as they were in the year2021.
Projected operating leverage for the year 2022,
Sales (in units)………………………………………………………...1, 500
Sales revenue……………………………………………………..birr 15,000
Less: variable operating costs (1, 5000 x 5)……………………………7,500
Fixed operating costs……………………………………………2, 500
PBIT (profit before interest and tax)……………………………….birr 5,000
 DOL = = = =2

This indicates that as the company’s sales increases from 1,000 to

1,500, its PBIT will increase from birr 2,500 to birr 5,000. Or a 50%
change in sales results in a 100% increase in PBIT.

If DOL = 1, what does it imply? There is no fixed operating cost

employed and there will be 1% change in PBIT for a 1% change in
sales.
 Example:
Given amount percentage of
sales
Sales………………….. birr 80,000……………………..100%
Less: variable costs …………
32,000……………………...40%
Contribution margin……birr48,
000……………………..60%
Less: fixed costs…………..... 38, 000
Net operating income…birr 10,000
Required:
 Compute the company’s DOL.
 Using the DOL, estimate the impact on net operating income of a 5% change
in sales.
 Verify your estimate from the above by constructing a new contribution;
forget income statement for the company and assuming a 5% increase in sales.
 Operating leverage and risk

 Operating profits will rise and fall more rapidly for a firm with a higher degree
of operating leverage (high operating fixed costs).

 Business (operating risk) is the variability of earnings before interest and tax.
Variability of earnings before interest and tax is due to variability of sales or
variability of expenses (fixed and variable expenses). Or operating risk is the
variability of EBIT caused by the use of operating leverage.

 Firms with high DOL (i.e. relatively large fixed operating costs) are generally
riskier than firms with lower DOL (i.e. relatively lower fixed operating costs).
 The DOL shows how increase or decrease in the level of fixed operating costs
will affect the firm’s operating profits.
 Management needs to be aware of that an increase in fixed operating costs may
increase:
 Changes in operating profits as sales changes.
 The level of sales necessary for the firm to be profitable, and
 The level of business risk.
2. Financial Leverage
Financial leverage is the use of fixed costs in the
financing of the firm’s assets such as interest costs and
preferred stock dividends.

Itis the use of fixed financing costs to magnify the effects

of changes in operating profit on the firm’s earnings per
share (EPS).
The two fixed financing costs are:
Interest on debt financing, and
Preferred stock dividends – these costs must be paid
regardless of the amount of PBIT available to pay them.
Degree of financial leverage
The Degree of Financial Leverage (DFL), like the DOL,
is a measure of responsiveness.
It measures the responsiveness of EPS (Earning per
share) to changes in operating profits.
It is the numerical measure of the firm’s financial
leverage.

DFL =
Illustration:
Assume Nile Company has earned profit before interest and
tax of birr 10,000 in the current year. It has an interest cost of
birr 2,000 on its outstanding debt and 600 shares of birr 4
(annual preferred stock dividend per share) preferred stock
outstanding. The firm is in the 40% tax bracket.
Nile Company’s financial manager, Mr. Abel, wants to see the
effects of changes in operating profits on the company’s EPS.

Particularly, he is interested to see the effects of increase or

decrease the current operating profit by 40%.
 Preferred stock dividend = birr 4 x 600 = birr 2,400
 Common stock outstanding = 1,000 shares.
The EPS (earning per share) for various levels of PBIT for Nile company:
40% decrease in PBIT current year PBIT 40% increase in
PBIT
PBIT…………..birr 6,000…….……...birr 10,000………….birr 14,000
Less: interest……....2,000………………….2, 000………………..2,000
Profit before tax…..4,000………………….8, 000………………12, 000
Less: tax (40%)……1,600………………….3, 200………………...4,800
Net profits after
tax……………....2,400………………….4,800………………...7, 200
Less: preferred stock dividends.................2,400…………………
2,400………………...2,400
Earnings available for
common stock holders..birr 0…………birr 2,400…………...birr 4,800

 EPS…… = birr 0… = birr 2.40…. Br4.80

 When PBIT increases from birr 10,000 to birr 14,000, EPS increases
from birr 2.4 to birr 4.8.
 Increase (change) in EPS = birr 4.8 – birr 2.4 = birr 2.4.
 Percentage increase (change) in EPS = x 100 = 100%
 So, when PBIT increases by 40%, EPS will increase by 100%.
 Cont…
 When PBIT decreases from birr 10,000 to birr 6,000,
EPS will decrease from birr 2.4 to Br 0.
 Decrease (changes) in EPS = birr 0 – birr 2.4 = -birr
2.4.
 Percentage decrease in EPS = x 100 = -100%.
 Similarly, a 40% decrease in PBIT results in a 100%
decrease in EPS.
 What is the DFL for Nile Company?
 DFL = = DFL = = 2.5

 Thenumerical value of DFL 2.5 means that a 40%

change in the firm’s operating profit results in a 100%
change (i.e. 2.5 x40% = 100%) in earnings per share.
 Cont…
Alternative formula:
 DFL = where, I = interest
 PD = annual preferred stock
dividend
 T = Tax rate
 Example: if PBIT = birr 10,000, I = birr 2,000, PD =
birr 2,400, and T = 40%
 DFL =

 DFL =

 DFL = = 2.5
Financial leverage and risk
 The use of financial leverage increases the owner’s rate
of return. When the firm’s degree of financial leverage
(DFL) increases, its financial risk also increases.

 Financial risk is the risk to a firm that it is unable to

cover required financial obligations as they become due.
The penalty for not meeting financial obligations is
bankruptcy.

 Financial risk is the variability of EPS (earning per

share) caused by the use of financial leverage. It is
avoidable risk if the firm decides to not to use any debt
in its capital structure.
TOTAL (COMBINED) LEVERAGE AND EFFECTS OF LEVERAGE

The combined effect, or total leverage can be defined as

the potential use of fixed costs, both fixed operating costs
and fixed financial costs, to magnify the effect of changes
in sales on the firm’s EPS (Earning per share).

Itis viewed as the total impact of the fixed costs in the

operating and financial structure of the firm.
 DTL =

 DTL = DOL X DFL

 Total leverage and risk

 The use of operating leverage increases business risk because

the firm must now meet higher fixed costs to be profitable.

 The use of financial leverage increases financial risk because

the firm must now meet costs (especially interest and preferred
stock dividend payments) associated with debt and preferred a
stock financing.

 It is generally not wise to use a large amount of both financial

and operating leverages.

 Any firm that has substantial amount of fixed equipment and

is financed with borrowed funds has both operating and
financial leverages. The use of both sources of leverages will
certainly increase the risk exposure of the firm.
 Both return on equity (ROE) and earning per share (EPS) decline as more debt
is used.
 The financial leverage will have a favorable impact on EPS and ROE only
when the firm’s return on investment (ROI) exceeds the interest cost of debt.
 Example: the firm is paying 15% on debt and earning a return of 24% on funds
employed.

 The financial leverage will have unfavorable impact on EPS and ROE only
when the firm’s return on investment (ROI) is less than the interest cost of debt.
 Example: the firm is paying 15% on debt and earning a return of 12% on funds
employed. The shareholders will have to meet the deficit 3%, as a result, EPS
and ROE decline.
 If the rate of return on assets were just equal to the cost of debt, the financial
leverage will have impact on the shareholders return. EPS and ROE would be
the same under all plans.
Effect of leverage on return on equity(ROE) and earning per share (EPS):
 Favorable……………………………………ROI> interest rate
 Unfavorable…………………………………ROI< i interest rate
 Neutral……………………………………...ROI =i interest rate
 Determining the Optimal Capital Structure
What is the optimal capital structure in practice?

There does not seem to be any single method or technique that

enable a firm to ‘hit’ the optima capital structure. As you explore
capital structure Decision, you will realize that it is not agreeable
to a precise, structured solution.

A variety of analyses are done in practice to get a handle over the

capital structure decision.
 One analysis looks at how alternative capital structure influence
the earnings per share.
 A second analysis assesses the impact of alternative capital
structure on return on equity.
 A third analysis relies on certain leverage ratios.
 A fourth analysis determines the level of debt that can be
serviced by the expected cash flows of the firm.
 A fifth analysis relies on what comparable firms are doing.

Admittedly, each of these analyses are incomplete and

provides a partial answer to the question” what capital
structure maximize the value of the firm?”

In practice, Firms commonly use one or more of these

kinds of analysis along with qualitative guidelines to
address the capital structure issue.

The target capital structure is the mix of debt, preferred

stock, and common equity with which the firm intends to
raise capital.
 Thecost of debt is lower than the cost of other
forms of financing.

 Lenders demand relatively lower returns

because they take the least risk of any
contributors of long-term capital.

 Lenders have a higher priority of claim against

any earnings or assets available for payment,
and they can exert far greater legal pressure
against the company to make payment than can
owners of preferred or common stock.

 Thetax deductibility of interest payments also

lowers the debt cost to the firm substantially.
 Unlike debt capital, which the firm must eventually repay,
equity capital remains invested in the firm indefinitely—it has
no maturity date.

 The two basic sources of equity capital are (1) preferred stock
and (2) common stock equity, which includes common stock
and retained earnings.

 Common stock is typically the most expensive form of equity,

followed by retained earnings and then preferred stock.

 Whether the firm borrows very little or a great deal, it is

always true that the claims of common stockholders are
riskier than those of lenders, so the cost of equity always
exceeds the cost of debt.
 EBIT-EPS Analysis
 The EBIT–EPS analysis is an approach for selecting the capital
structure that maximizes earnings per share (EPS) over the
expected range of earnings before interest and taxes (EBIT).

 To understand how the EBIT-EPS method works, first we must

understand the two primary metrics involved, EBIT and EPS.

 EBIT refers to a company's earnings before interest and taxes. This

metric strips out the impact of interest and taxes, showing an investor
or manager how a company is performing excluding the impacts of
the balance sheet's composition.

 In terms of EBIT, it doesn't matter if a company is overloaded with

debt or has no loans at all. EBIT will be the same either way.
 Cont….
 EPS stands for earnings per share, which is the profit the company
generates including the impact of interest and tax obligations. EPS
is particularly helpful to investors because it measures profits on a
per share basis.

 Ifa company's total profit is soaring but its profit per share is
declining, that's a bad thing for the investor owning a fixed number
of shares. EPS captures this dynamic in a simple, easy to
understand the way.

 The ratio between these two metrics can show investors and
management how the bottom line results, the company's EPS,
relates to its performance independent of its capital structure, its
EBIT.
 Cont…

For example, let's say a company wants to maintain

stable EPS but is considering taking out a new loan to
grow its balance sheet. In order for EPS to remain stable,
the company's EBIT must also increase at least as much
as the new interest expense from the debt.

If EBIT increases the same as the next interest expense,

then EPS should remain stable, assuming no change in
taxes.
Basic Relationship
(EBIT – i) (1 – t)
EPS =
n
Where,
i = interest
t = tax rate
n = number of equity share
When Preference dividend (Dp) is payable, the relationship becomes,
(EBIT – i) (1 – t) - Dp
EPS =
n
Problem:

Existing Capital Structure : 1 million equity shares of Tk. 10

each.
Tax rate : 50%.
Falcon Limited plans to raise additional capital of Tk. 10 million
for financing an expansion projects. In this context, it is evaluating
two alternatives financial plans: (1) issue of Equity shares ( 1
million Equity shares @ Tk. 10 each.) and (2) issue of debentures
carrying 14% interest.

Required: What will be the EPS under the two alternative financial
plans for two levels of EBIT, say Tk. 4 million & 2 million?
 Equity Financing Debt Financing
EBIT 2000000 EBIT EBIT 2000000 EBIT
4000000 4000000
Interest 1,400,000 1,400,000

Profit Before 2,000,000 4,000,000 600,000 2,600,000

Taxes

Taxes 1,000,000 2,000,000 300,000 1,300,000

Profit after 1,000,000 2,000,000 300,000 1,300,000

Taxes

No. of Equity 2,000,000 2,000,000 1,000,000 1,000,000

Shares

EPS 0.50 1.00 0.30 1.30

Finding Optimal Capital Structure
The firm’s optimal capital structure can
be determined in two ways:
◦ Minimizes WACC.
◦ Maximizes stock price.
Both methods yield the same results.
 Capital Structure Theory

 It
is not yet possible to provide financial managers with a precise
methodology for determining a firm’s optimal capital structure.

 Nevertheless, financial theory does offer help in understanding how

a firm’s capital structure affects the firm’s value.

 In 1958, Franco Modigliani and Merton H. Miller (commonly

known as “M and M”) demonstrated algebraically that, assuming
perfect markets, the capital structure that a firm chooses does not
affect its value.
 Modigliani and Miller (M&M)Theory of Capital Structure

 Proposition I – firm value

 Proposition II – WACC
◦ Proposition I: the value of the firm is independent of the firm’s capital
structure
◦ The value of the firm is NOT affected by changes in the capital
structure.
◦ The cash flows of the firm do not change; therefore, value doesn’t
change.
 The value of the firm is determined by the cash flows to the firm and the
risk of the assets
 Changing firm value
 Change the risk of the cash flows
 Change the cash flows
 Capital Structure Theory Under Three
Special Cases

Case I – Assumptions (M&M)

◦ No corporate or personal taxes
◦ No bankruptcy costs
Case II – Assumptions (M&M)
◦ Corporate taxes but no personal taxes
◦ No bankruptcy costs
Case III – Assumptions (Static Theory)
◦ Corporate taxes but no personal taxes
◦ Bankruptcy costs
Case I – No Taxes or Bankruptcy Costs
M&M Proposition I
◦ The value of the firm is NOT affected by
changes in the capital structure
◦ The cash flows of the firm do not change,
therefore value doesn’t change
Proposition II
◦ The WACC of the firm is NOT affected by
capital structure
Case I - Equations
WACC = RA = (E/V)RE + (D/V)RD

RE = RA + (RA – RD)(D/E)

◦ RA is the “cost” of the firm’s business risk,

i.e., the required return on the firm’s assets
◦ (RA – RD)(D/E) is the “cost” of the firm’s
financial risk, i.e., the additional return
required by stockholders to compensate for
the risk of leverage
Cost of Equity and WACC (M&M
without taxes)
Case I - Example
Data
◦ Required return on assets = 16%, cost of debt
= 10%; percent of debt = 45%
What is the cost of equity?
◦ RE = .16 + (.16 - .10)(.45/.55) = .2091 =
20.91%
Supposeinstead that the cost of equity is
25%, what is the debt-to-equity ratio?
◦ .25 = .16 + (.16 - .10)(D/E)
◦ D/E = (.25 - .16) / (.16 - .10) = 1.5
Based on this information, what is the percent
of equity in the firm?
◦ E/V = 1 / 2.5 = 40%
The CAPM, the SML and Proposition II
How does financial leverage affect
systematic risk?
CAPM: RA = Rf + A(RM – Rf)
◦ Where A is the firm’s asset beta and
measures the systematic risk of the firm’s
assets
Proposition II
◦ Replace RA with the CAPM and assume that
the debt is riskless (RD = Rf)
◦ RE = Rf + A(1+D/E)(RM – Rf)
Business Risk and Financial Risk
RE = Rf + A(1+D/E)(RM – Rf)
CAPM: RE = Rf + E(RM – Rf)
◦ E = A(1 + D/E)
Therefore,the systematic risk of the
stock depends on:
◦ Systematic risk of the assets, A, (Business
risk)
◦ Level of leverage, D/E, (Financial risk)
Case II – With Corporate Taxes
Interest is tax deductible
Therefore, when a firm adds debt, it
reduces taxes, all else equal
The reduction in taxes increases the
cash flow of the firm
How should an increase in cash flows
affect the value of the firm?
Case II – Example 1

Unlevered Firm Levered Firm

EBIT 5000 5000

Interest 0 500

Taxable Income 5000 4500

Taxes (34%) 1700 1530

Net Income 3300 2970

CFFA 3300 3470

Example 1 continued
Assume the company has $6,250, 8% coupon
debt and faces a 34% tax rate.
Annual interest tax shield
◦ Tax rate times interest payment
◦ 6250 in 8% debt = 500 in interest expense
◦ Annual tax shield = .34(500) = 170
Present value of annual interest tax shield
◦ Assume perpetual debt for simplicity
◦ PV = 170 / .08 = 2125
◦ PV = D(RD)(TC) / RD = DTC = 6250(.34) = 2125
Case II – Proposition I
The value of the firm increases by the
present value of the annual interest tax
shield
◦ Value of a levered firm = value of an
unlevered firm + PV of interest tax shield
◦ Value of equity = Value of the firm – Value of
debt
Assuming perpetual cash flows
◦ VU = EBIT(1-T) / RU
◦ VL = VU + DTC
Example 2 – Case II – Proposition I
Data
◦ EBIT = $25 million; Tax rate = 35%; Debt =
$75 million; Cost of debt = 9%; Unlevered
cost of capital = 12%
VU = 25(1-.35) / .12 = $135.42 million
VL = 135.42 + 75(.35) = $161.67
million
E = 161.67 – 75 = $86.67 million
M&M Proposition I with Taxes
Case II – Proposition II
The WACC decreases as D/E increases
because of the government subsidy on
interest payments
◦ WACC = (E/V)RE + (D/V)(RD)(1-TC)
◦ RE = RU + (RU – RD)(D/E)(1-TC)
Example
◦ RE = .12 + (.12-.09)(75/86.67)(1-.35) =
13.69%
◦ WACC = (86.67/161.67)(.1369) +
(75/161.67)(.09)
(1-.35)
WACC = 10.05%
Example: Case II – Proposition II
Suppose that the firm changes its
capital structure so that the debt-to-
equity ratio becomes 1.

What will happen to the cost of equity

under the new capital structure?
◦ RE = .12 + (.12 - .09)(1)(1-.35) = 13.95%

What will happen to the weighted

average cost of capital?
◦ WACC = .5(.1395) + .5(.09)(1-.35) = 9.9%
Case III – With Bankruptcy Costs
Now we add bankruptcy costs
As the D/E ratio increases, the probability
of bankruptcy increases

This increased probability will increase

the expected bankruptcy costs
At some point, the additional value of the
interest tax shield will be offset by the
expected bankruptcy cost

At this point, the value of the firm will

start to decrease and the WACC will start
to increase as more debt is added
Bankruptcy Costs
Direct costs
◦ Legal and administrative costs
◦ Ultimately cause bondholders to incur
additional losses
◦ Disincentive to debt financing
Financial distress
◦ Significant problems in meeting debt
obligations
◦ Most firms that experience financial distress
do not ultimately file for bankruptcy
More Bankruptcy Costs
Indirect bankruptcy costs
◦ Larger than direct costs, but more difficult to
measure and estimate
◦ Stockholders wish to avoid a formal bankruptcy
filing
◦ Bondholders want to keep existing assets intact
so they can at least receive that money
◦ Assets lose value as management spends time
worrying about avoiding bankruptcy instead of
running the business
◦ Also have lost sales, interrupted operations and
loss of valuable employees
Static Theory of Capital
Structure
So what is the optimal capital structure?
A firm borrows up to the point where
the tax benefit from an extra dollar in
debt is exactly equal to the cost that
comes from the increased probability of
financial distress
This is the point where the firm’s WACC
is minimized.
Conclusions
Case I – no taxes or bankruptcy costs
◦ No optimal capital structure
Case II – corporate taxes but no bankruptcy
costs
◦ Optimal capital structure is 100% debt
◦ Each additional dollar of debt increases the
cash flow of the firm
Case III – corporate taxes and bankruptcy
costs
◦ Optimal capital structure is part debt and part
equity
◦ Occurs where the benefit from an additional
dollar of debt is just offset by the increase in
expected bankruptcy costs
Managerial Recommendations
The tax benefit is only important if the
firm has a large tax liability
Risk of financial distress
◦ The greater the risk of financial distress, the
less debt will be optimal for the firm
◦ The cost of financial distress varies across
firms and industries. As a manager you
need to understand the cost for your
industry
The Value of the Firm
Valueof the firm = marketed claims +
non-marketed claims
◦ Marketed - claims of stockholders and
bondholders
◦ Non-marketed - claims of the government
and other potential stakeholders
The overall value of the firm is
unaffected by changes in capital
structure
The division of value between marketed
claims and non-marketed claims may be
impacted by capital structure decisions
Observed Capital Structures
Capital structure differ by industry

There is a connection between different

industry’s operating characteristics and
capital structure

Firms and lenders look at the industry’s

debt/equity ratio as a guide
Trade-off Theory
MM theory ignores bankruptcy
(financial distress) costs, which increase
as more leverage is used.
At low leverage levels, tax benefits
outweigh bankruptcy costs.
At high levels, bankruptcy costs
outweigh tax benefits.
An optimal capital structure exists
that balances these costs and benefits.
 SIGNALING THEORY
Signaling theory suggests firms should
use less debt than MM suggest.
This unused debt capacity helps avoid
stock sales, which depress stock price
because of signaling effects
Assumptions:
Managers have better information
about a firm’s long-run value than
outside investors.
Managers act in the best interests of
current stockholders.
 Cont….
Therefore, managers can be expected to:
issue stock if they think stock is
overvalued.
issue debt if they think stock is
undervalued.
As a result, investors view a common
stock offering as a negative signal--
managers think stock is overvalued.
 THE END
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