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5 - Capital Structure

This document discusses capital structure and how firms finance their assets and operations. [1] Capital structure refers to the ratio of a firm's debt to equity, and influences its weighted average cost of capital. [2] A firm's optimal capital structure balances the tax benefits of debt against the costs of financial distress. [3] According to the static trade-off theory, firm value is maximized at the point where the tax shield benefits of debt are offset by the expected costs of financial distress.

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38 views3 pages

5 - Capital Structure

This document discusses capital structure and how firms finance their assets and operations. [1] Capital structure refers to the ratio of a firm's debt to equity, and influences its weighted average cost of capital. [2] A firm's optimal capital structure balances the tax benefits of debt against the costs of financial distress. [3] According to the static trade-off theory, firm value is maximized at the point where the tax shield benefits of debt are offset by the expected costs of financial distress.

Uploaded by

Slim Charni
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© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Corporate Finance Session 5 – Capital Structure

This topic is on how firms finance their asset. Raising debt or equity will have different effects on tax savings and
additional risk of increasing financial leverage. It affects firm stakeholders and is the nature of conflicts of interest.

Capital structure : refers to how it has financed its assets and operations  debt to equity ratio
 In general, companies ten to choose a capital structure that minimizes its WACC
 We use market values of debt and equity when discussing capital structure
 Characteristics that influence debt-to-equity ratio :
o Growth and stability revenue  give the ability to contract debt at a good rate
o Growth and predictability of cash flow  give the possibility to contract debt at a good rate
because the company will be able to payback easily
o Amount of business risk  More business risk (operational risk and demand risk) means greater
variability of earnings and cash flow  decrease ability to contract debt
o Amount and liquidity of company assets  refers to solvency. Assets can be used as collateral to
secure lenders investment. The more the assets are liquid, the more collateral is great  increase
ability to contract debt at a good rate
o Cost and availability of debt financing  debt is more attractive when costs of debt are lower and
investors more willing to lend. This is affected by economics variable as well as the above
characteristics.
 These factors have different effects depending on the stage of the company’s life :
o Start-up stage  operating earnings and CF are low or negative. Business risk is high. Asset and
accounts receivables are low then no collateral. Rising debt is risky  hight rate
Start-up are financed with equity
o Growth stage  Revenue and CF are rising, business risk are reduced. Loans could be secured with a
collateral. Lenders are more willing to lend with a quite good rate. Debt insurance may be as mu as
20% of the firm’s capital structure
o Mature stage  Revenue growth is slowing, CF are significant and stable and business risk is much
lower. Lenders are willing to lend at a good rate. Firm can issue secure or unsecured debt. Debt-to-
equity ratio could be much more than 20%. This ratio tend to go down because the equity value
increase over the time.

Modigliani-Miller proposition 1 : no taxes, Capital structure irrelevance


Under certain assumptions, the value of a firm is unaffected by its capital structure. Assumptions are :
 Capital markets are perfectly competitive  no transactions, taxes or bankruptcy costs
 Investors have homogeneous expectations  same expectations with respect to CF generated by the firm
 Riskless borrowing and lending  investors can borrow and lend at the risk-free rate
 No agency costs  no conflicts of interest between managers and shareholders
 Investment decisions are unaffected by financing decisions  operating income is independent of how the
firm is financed
The CF of the firm do not change, therefore, value doesn’t change
Pie model :
Modigliani-Miller proposition 2 : cost of equity and leverage
 The cost od debt is less than the cost of equity because lenders have a priority on CF
 The greater the amount of debt in a firm’s capital, the more the cost of equity is
 The decrease in financing costs from using debt is offset by the increase in the cost of equity  no change
in the firm’s WACC
o Cost of equity :

MM with taxes : value is maximized at 100% debt


Assumptions :
 Earnings are taxed
 Interest payments to debtholders are tax deductible

Using debt financing provide a Tax Shield that adds value to the company.

With positive tax rate, the formula of the cost of equity is :

Then with the tax shield, the WACC decline as leverage increases :
Costs of financial distress : increased costs a company faces when earnings decline to the point where the firm has
trouble paying its interests on debt

 Costs of financial distress and bankruptcy


o Direct  cash expenses associated to bankruptcy (legal fees and administrative fees)
o Indirect  loosing trust of stakeholders  opportunity cost
o Agency costs of debt
 Probability of financial distress
o Higher leverage increase the probability of financial distress
o Quality of firm’s management and corporate governance

Static trade-off theory : balance the costs of financial distress with the tax shiel benefits from using debt
We try to find the optimal capital structure where the WACC is minimized, and the value of the firm is maximized
The value of a levered firm is then :

MM’s proposition with no taxes or costs of capital structure are irrelevant because its WACC and its value are
unchanged by changes in capital structure.
MM’s proposition with taxes but without costs of financial distress are not possible but WACC would be minimized,
and its value maximized with 100% debt.
Static trade-off theory  firm value initially increase with additional debt financing but at some point, the increase
in expected value of financial distress outweighs the tax benefits (tax shield) of additional debt.

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