Capital Structure Decisions

By Dr.Bhavish Jugurnath

Learning Objectives
◼ You should understand how capital structure
affect corporate value
◼ You should understand the financial risk -
leverage
◼ You should understand capital structure
theories and their implications for managers

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 How can capital structure
affect value?

∞ FCFt
V = ∑
t=1 (1 + WACC)t

WACC= wd (1-T) rd + wcers

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Capital Structure Effects

◼ The impact of capital structure on value
depends upon the effect of debt on:
◼ WACC
◼ FCF

(Continued…)
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 The Effect of Additional
Debt on WACC
◼ Debtholders have a prior claim on cash flows relative
to stockholders.
◼ Debtholders’ “fixed” claim increases risk of stockholders’
“residual” claim.
◼ Cost of stock, rs, goes up.
◼ Debt increases risk of bankruptcy
◼ Causes pre-tax cost of new debt, rd, to increase
◼ Adding debt increase percent of firm financed with
low-cost debt (wd) and decreases percent financed
with high-cost equity (wce)
◼ Net effect on WACC = uncertain.
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The Effect of Additional Debt

on FCF
◼ Additional debt increases the probability
of bankruptcy.
◼ Direct costs: Legal fees, “fire” sales, etc.
◼ Indirect costs: Lost customers, reduction in
productivity of managers and line workers,
reduction in credit (i.e., accounts payable)
offered by suppliers

(Continued…)
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 Agency costs
◼ Additional debt can affect the behavior of
managers.
◼ Reductions in agency costs: debt “pre-commits,”
or “bonds,” free cash flow for use in making
interest payments. Thus, managers are less likely
to waste FCF on perquisites or non-value adding
acquisitions.
◼ Increases in agency costs: debt can make
managers too risk-averse, causing
“underinvestment” in risky but positive NPV
projects.
(Continued…)
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Asymmetric Information
and Signaling
◼ Managers know the firm’s future prospects
better than investors.
◼ Managers would not issue additional equity if
they thought the current stock price was less
than the true value of the stock (given their
inside information).
◼ Hence, investors often perceive an additional
issuance of stock as a negative signal, and
the stock price falls.
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 Business Risk versus Financial
Risk
◼ Business risk:
◼ Uncertainty in future EBIT.
◼ Depends on business factors such as competition,
type of product, etc.
◼ Financial risk:
◼ Additional business risk concentrated on common
stockholders when financial leverage is used.
◼ Depends on the amount of debt financing.

Capital Structure Theory

◼ MM theory
◼ Zero taxes
◼ Corporate taxes
◼ Corporate and personal taxes
◼ Trade-off theory
◼ Signaling theory
◼ Pecking order
◼ Debt financing as a managerial constraint
◼ Windows of opportunity
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 MM Results: Zero Taxes
◼ MM assume: (1) no transactions costs; (2) no
restrictions or costs to short sales; and (3) individuals
can borrow at the same rate as corporations.
◼ Under these assumptions, MM prove that if the total
CF to investors of Firm U and Firm L are equal, then
the total values of Firm U and Firm L must be equal:
◼ V L = V U.
◼ Because FCF and values of firms L and U are equal,
their WACCs are equal.
◼ Therefore, capital structure is irrelevant.

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MM Theory: Corporate Taxes

◼ Corporate tax laws allow interest to be deducted,
which reduces taxes paid by levered firms.
◼ Therefore, more CF goes to investors and less to
taxes when leverage is used.
◼ In other words, the debt “shields” some of the
firm’s CF from taxes.
◼ MM then show that: VL = VU + TD.
◼ If T=40%, then every dollar of debt adds 40 cents of extra value
to firm.

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 MM relationship between value and debt
when corporate taxes are considered.
Value of Firm, V

VL
TD
VU

Debt
0

Under MM with corporate taxes, the firm’s value

increases continuously as more and more debt is used.
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Miller’s Theory: Corporate and

Personal Taxes
◼ Personal taxes lessen the advantage of
corporate debt:
◼ Corporate taxes favor debt financing since
corporations can deduct interest expenses.
◼ Personal taxes favor equity financing, since
no gain is reported until stock is sold, and
long-term gains are taxed at a lower rate.

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 Conclusions with Personal
Taxes
◼ Use of debt financing remains
advantageous, but benefits are less
than under only corporate taxes.
◼ Firms should still use 100% debt.

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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.
◼ See Figure 4 on textbook
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 Signaling Theory
◼ MM assumed that investors and managers
have the same information.
◼ But, managers often have better information.
Thus, they would:
◼ Sell stock if stock is overvalued.
◼ Sell bonds if stock is undervalued.
◼ Investors understand this, so view new stock
sales as a negative signal.
◼ Implications for managers?

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Pecking Order Theory

◼ Firms use internally generated funds
first, because there are no flotation
costs or negative signals.
◼ If more funds are needed, firms then
issue debt because it has lower flotation
costs than equity and not negative
signals.
◼ If more funds are needed, firms then
issue equity. 18

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 Debt Financing and Agency
Costs
◼ One agency problem is that managers can use
corporate funds for non-value maximizing purposes.
◼ The use of financial leverage:
◼ Bonds “free cash flow.”
◼ Forces discipline on managers to avoid perks and non-value
adding acquisitions.
◼ A second agency problem is the potential for
“underinvestment”.
◼ Debt increases risk of financial distress.
◼ Therefore, managers may avoid risky projects even if they
have positive NPVs.

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Investment Opportunity Set and

Reserve Borrowing Capacity
◼ Firms with many investment
opportunities should maintain reserve
borrowing capacity, especially if they
have problems with asymmetric
information (which would cause equity
issues to be costly).

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 Empirical Evidence (Continued)
◼ After big stock price run ups, debt ratio falls,
but firms tend to issue equity instead of debt.
◼ Inconsistent with trade-off model.
◼ Inconsistent with pecking order.
◼ Consistent with windows of opportunity.
◼ Many firms, especially those with growth
options and asymmetric information
problems, tend to maintain excess borrowing
capacity.

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Implications for Managers

◼ Take advantage of tax benefits by issuing debt,
especially if the firm has:
◼ High tax rate
◼ Stable sales
◼ Less operating leverage
◼ Avoid financial distress costs by maintaining excess
borrowing capacity, especially if the firm has:
◼ Volatile sales
◼ High operating leverage
◼ Many potential investment opportunities
◼ Special purpose assets (instead of general purpose assets that
make good collateral)
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 Implications for Managers
(Continued)

◼ If manager has asymmetric information

regarding firm’s future prospects, then
avoid issuing equity if actual prospects
are better than the market perceives.
◼ Always consider the impact of capital
structure choices on lenders’ and rating
agencies’ attitudes

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RECAP

 In the previous lecture we introduced the concept of perfect

capital markets
 → capital structure irrelevance.

 We then introduced corporate taxation as a market

imperfection:

VL = VU + PV (Interest Tax Shield)

E D
rwacc = rE + rD (1 −  c )
E + D E + D

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 WACC

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REDEEMABLE BONDS
 Redeemable bonds
 Face value is repaid at maturity.
 The value of a bond is determined by
 Face Value
 Present value of a single value

 Coupon payments

 Present value of an annuity

 Number of periods to maturity PV of

 Yield to maturity PV of the the
coupon Face
payments Value

 1 − (1 + YTM )− N  F
VB = C  +
 YTM  (1 + YTM ) N 26

 

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 VALUATION OF ORDINARY EQUITY

 Dividend Growth Model

 Value = PV of future dividends
 If dividends are growing at a constant rate, then;
Div1
P0 =
rs − g
 Where
Div1 = Div0 (1 + g )

ke = cost of equity

g = future constant growth rate in dividends

 Therefore P0 is the current value of all dividends

AFTER year 0 27

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