Chapter 4

Capital Structure Decision

And
Firm Value
 Introduction
The mixture of debt and equity that a firm uses is
called its capital structure. Hence, the two principal
sources of finance for a business firm are equity and
debt. What should be the proportions of equity and
debt in the capital structure of a firm? Put
differently, how much financial leverage should a
firm employ? Since the objective of FM is to
maximize shareholders’ wealth, the key issue is:
what is the r/ship b/n capital structure and firm
value? Alternatively, what is the r/ship b/n capital
structure and cost of capital? Remember that
valuation and cost of capital are inversely related.
 . . . cont’d
Given a certain level of earnings, the value of
the firm is maximized when the cost of capital is
minimized and vise versa.
There are d/t views on how capital structure
influences value. Some argue that there is no
r/ship whatsoever b/n capital structure and firm
value; others believe that financial leverage (i.e.
the use of debt capital) has a positive effect on
firm value up to a point and negative effect
thereafter; still others contend that, other
things being equal, greater the leverage, greater
the value of the firm.
 . . . Cont’d

• The value of the firm can be thought of as a pie.

• The goal of the manager is to increase the size of the pie.

• The Capital Structure decision can be viewed as how

best to slice up the pie.
• If how you slice the pie affects the size of the pie, then
the capital structure decision matters.
 Assumptions
To examine the r/ship b/n capital structure
and cost of capital (or firm value) the ff
simplifying assumptions are commonly made:
 There is no income tax, corporate or personal.
We shall, however, later consider the
implications of taxes.
 The firm pursues a policy of paying all of its
earnings as dividends. Put differently, a 100
percent dividend payout ratio is assumed.
 Cont’d
 Investors have identical subjective probability
distributions of operating income (EBIT) for
each company.
 The operating income is not expected to grow
or decline over time.
 A firm can change its capital structure almost
instantaneously without incurring transaction
costs.
 Cont’d

The rationale for the above assumptions is to

abstract away the influence of taxation,
dividend policy, varying perceptions about
risk, growth, and market imperfections so that
the influence of financial leverage on cost of
capital can be studied with greater clarity.
 Cont’d

Given the above assumptions, the analysis

focuses on the following rates:
rD = I/D = annual interest charges
market value of debt
Assuming that the debt is perpetual, rD
represents the cost of debt.
rE = P/E = equity earnings
market value of equity
 . . . Cont’d

when the dividend payout ratio is 100% and

earnings is constant, rE, as defined here,
represents the cost of equity.
rA = O/V = Operating income
Market value of firm
Where V = D + E.
rA is the overall capitalization rate of the firm.
Since it is the weighted average cost of capital, it
may be expressed as follows:
rA = rD[D/D+E]+ rE[E/D+E]
 . . . Cont’d

In terms of the above definitions, the question

of interest to us is:
What happens to rD, rE, and rA when financial
leverage, D/E, changes?
The important answers to these questions are
discussed in the up coming sections.
 Business Risk and Financial Risk
 Business risk- refers to the risk to the firm of being
unable to cover its operating costs.
It refers to the relative dispersion (variability) in the
firm’s expected EBIT induced by the firm’s
investment decisions.
• That is the composition of the firm’s assets
determines its exposure to business risk. Thus,
business risk is the result of investment decisions.
• In general, the greater the firm’s operating
leverage- which is the result of the use of fixed
operating costs- the higher its business risk.
 . . . Cont’d
• Financial risk is the additional risk placed on
the common stockholders as a result of the
decision to finance with debt.
• Conceptually, stockholders face a certain
amount of risk that is inherent in a firm’s
operations—this is its business risk, which is
defined as the uncertainty inherent in
projections of future operating income.
• If a firm uses debt (financial leverage), this
concentrates the business risk on common
stockholders.
 . . . Cont’d
• To illustrate, suppose ten people decide to form a
corporation to manufacture disk drives. There is a
certain amount of business risk in the operation.
If the firm is capitalized only with common equity,
and if each person buys 10 percent of the stock,
then each investor shares equally in the business
risk.
• However, suppose the firm is capitalized with 50
percent debt and 50 percent equity, with five of
the investors putting up their capital as debt and
the other five putting up their money as equity.
 . . . Cont’d
• In this case, the five investors who put up the
equity will have to bear all of the business risk,
so the common stock will be twice as risky as it
would have been had the firm been financed
only with equity.
• Thus, the use of debt, or financial leverage,
concentrates the firm’s business risk on its
stockholders.
• This concentration of business risk occurs
because debt-holders, who receive fixed interest
payments, bear none of the business risk.
 The concept of leverage
• Businesses have fixed costs, both operating
and financial, which will be incurred regardless
of the firm’s performance. Thus leverage
magnifies the impact of a change in sales in to
a higher change in EBIT or a change in EBIT
into a higher EPS.
 Operating Leverage
• In physics, leverage implies the use of a lever
to raise a heavy object with a small force.
• In politics, if people have leverage, their
smallest word or action can accomplish a lot.
• In business terminology, a high degree of
operating leverage, other factors held
constant, implies that a relatively small
change in sales results in a large change in
EBIT.
 . . . Cont’d
• Other things held constant, the higher a firm’s
fixed costs, the greater its operating leverage.
• Higher fixed costs are generally associated with
more highly automated, capital intensive firms
and industries.
• However , businesses that employ highly skilled
workers who must be retained and paid even
during recessions also have relatively high fixed
costs, as do firms with high product development
costs, because the amortization of development
costs is an element of fixed costs.
 . . . Cont’d
Operating leverage is the responsiveness of
the firm’s EBIT to fluctuations in sales. It refers
to the magnification of gains or losses in EBIT
by changes that occur in sales.
It also refers to the potential use of fixed
operating costs to magnify the effects of
changes in sales on the firm’s EBIT.
 . . . Cont’d
Example: assume that Mulu company has fixed
operating costs of br 2,500, unit selling price of Br
10, and variable operating cost per unit of Br 5.
now let’s assume two changes in sales volume
and see what will happen to the firm’s EBIT as a
result:
case 1: a 50% increase in sales, and
case 2: a 50% decrease in sales.
The table in the next slide shows the resultant
change in EBIT from the two changes in sales.
note: EBIT = (P.Q) – (V.Q) - FC
 . . . Cont’d
Case Sales in units Increase EBIT Increase
(decrease) in (decrease) in
sales EBIT

Base case 1,000 - 2,500 -

I 1,500 50% 5,000 100%

II 500 (50%) 0 (100%)

 . . . Cont’d
 We see that the rate of change in EBIT is more than
proportional to the corresponding change in sales. That is a
50% change in sales is magnified into 100% change in EBIT.
 It is the existence of fixed operating costs that magnifies
the effects of a given change in sales on the EBIT.
 The higher the percentage of fixed costs to total costs in a
firm’s cost structure, the greater the firm’s degree of
operating leverage, and then the higher the
responsiveness of EBIT to a given change in sales.
 As discussed above, operating leverage is related to the
firm’s business risk, which refers to the risk inherent in the
firm’s investments- the uncertainty surrounding sales and
costs.
Measuring the degree of operating leverage
(DOL)
the degree of operating leverage (DOL) at a given
point of sales can be measured by using the
following equations:
DOL = %age change in EBIT/%age change in sales
Another way to compute DOL,
DOL = 1 + fixed operating costs
EBIT
In the Mulu company’s case above, at 1,000 unit sales,
the DOL is:
DOL = 1 + (2,500/2,500) = 2.0
 . . . Cont’d
The meaning of a 2.0 DOL is that from the
current base sales level, for every 1 percent
change in sales within the relevant range,
there will be a 2% change in EBIT in the same
direction as the sales change.
If sales increase (decrease) by say, 10%, EBIT
will increase (decrease) by 20%(10 x2).
As long as DOL is greater than 1, there is an
operating leverage.
 Financial leverage
FL results from the presence of fixed financing costs
in the firm’s capital structure.
The fixed- cost financing sources are debt (requiring
interest payments), preferred stock (requiring the
company to make preferred dividend payments),
and leases (which require specified lease payments).
The financing cost on these capital sources must be
paid regardless of the amount of EBIT available to
pay them.
Financial leverage is then the responsiveness of the
firm’s EPS to changes in EBIT.
 . . . Cont’d
• Example: GG company expects EBIT of Br 10,000 in
the current year. It has a Br 20,000 bond with a
10% coupon rate of interest and an issue of 600
shares of Br 4 (annual dividend per share)
preferred stock outstanding. It also has 1,000
shares of common stock outstanding.
– Annual interest on the bond = Br 20,000 x 0.1 = 2,000
– Annual dividends on the preferred stock = 600 shares
x Br 4 per share = Br 2,400
• The table below presents the EPS corresponding to
EBIT of Br 6,000, Br 10,000 and Br 14,000,
assuming a tax rate of 40%.
 . . . Cont’d

Case 1 Base Case Case 2

EBIT Br 6,000 Br 10,000 Br 14,000

Less: Interest 2,000 2,000 2,000

Net Profits before taxes 4,000 8,000 12,000

Less: Taxes (T = 0.40) 1,600 3,200 4,800

Net Profit after taxes 2,400 4,800 7,200

Less: Preferred stock 0 2,400 2,400

dividends (PD)

Earnings available for 0 2,400 4,800

common shareholders

Earnings per share (EPS) 0/1000 = 0 2,400/1,000 = 2.40 4,800/1,000 = 4.80

 . . . Cont’d
• Two situations are illustrated in the table above:
• Case 1: a 40% decrease in EBIT (from Br 10,000
to 6,000) resulted in a 100% decrease in EPS
( from Br 2.40 to 0).
• Case 2: a 40% increase in EBIT (from Br 10,000
to 14,000) resulted in a 100% increase in EPS
(from Br 2.40 to 4.80).
• The effect of financial leverage is such that a
change in the firm’s EBIT results in a more than
proportional change in the firm’s EPS.
 Measuring the Degree of Financial Leverage (DFL)

• The DFL is the numerical measure of the firm’s

financial leverage. It is used as a measure of the
leverage in the firm that is due solely to the
firm’s financing policy. It shows the percentage
change in EPS that will result from a 1% change
in EBIT.
– DFL = %age change in EPS
%age change in EBIT
Example: compute the DFL for GG Co. for case 1
above. DFL = 100%/40% = 2.5
 . . . Cont’d
• A more direct formula for calculating the DFL is:
– DFL at a base level EBIT = EBIT
EBIT – I – L- [PD/(1-T)]
Where: I = Interest payments
L = lease payments
PD = preferred dividends payments
T = tax rate
Example, in the GG Co. case,
DFL = Br 10,000
Br 10,000 – 2,000 – [2,400/(1- 0.4)]
= 10,000/4,000 = 2.50
As long as DFL is greater than 1, there is financial
leverage.
 . . . Cont’d
• Unlike interest and lease payments, preferred dividend
payments are not tax deductible.
• Therefore, a birr paid in preferred dividends is more costly
to the firm than a birr paid in interest or lease payments.
• Dividing any preferred dividend paid by (1-T) accounts for
this and thus puts interest, lease, and preferred dividend
payments on an equivalent basis.
• The DFL reflects the leverage that is due solely to the
firm’s financing policy.
• The effects of financial leverage is to magnify changes in
EBIT into larger changes in EPS.
• Thus in effect, FL is a second stage leverage, taking up
where operating leverage, which affects EBIT, leaves off.
Total leverage: The Combined Effect
• Combined leverage consists of operating
leverage and financial leverage. Operating
leverage links revenues to EBIT, while financial
leverage links EBIT to earnings after tax.
• The degree of combined leverage (DCL) is
calculated as:
– DCL = %age change in EPS
%age change in sales
• The DCL is simply the product of DOL and DFL.
i.e.: DCL = DOL x DFL
 . . . Cont’d
• Example: if a firm has a DOL of 2.25 and a DFL
of 1.4, the DCL will be 2.25 times 1.4 = 3.15.
this means that for every 1% change in sales,
EPS will change 3.15% in the same direction.
This magnification is the result of both
operating leverage and financial leverage.
 Capital structure theory

• In the previous section, we showed how capital

structure choices affect a firm’s ROE and its risk. For a
number of reasons, we would expect capital structures
to vary considerably across industries.
• For example, pharmaceutical companies generally have
very different capital structures than airline companies.
Moreover, capital structures vary among firms within a
given industry. What factors explain these differences?
• In an attempt to answer this question, academics and
practitioners have developed a number of theories, and
the theories have been subjected to many empirical
tests.
The following sections examine several of these theories.
 . . . Cont’d
Some of the theories/positions/approaches
taken by varies practitioners and writers are:
– Net income approach
– Net operating income approach
– Traditional position
– Modigliani and Miller Position
– Trade-off theory
– Pecking order theory
– Signaling theory
– Agency theory
 Net Income Approach
According to this approach, the cost of debt, rD,
and the cost of equity, rE, remain unchanged
when D/E varies.
The constancy of rD and rE with respect to D/E
means that rA, the average cost of capital,
measured as
rA = rD[D/D+E]+ rE[E/D+E]
declines as D/E increases. This happens b/s when
D/E increases, rD, which is lower than rE, receives
a higher weight in the calculation of rA.
 . . . Cont’d
The NI approach is graphically shown as follow:

(to be inserted here)

From the graph it is clear that as D/E increases, rA

Decreases b/s the proportion of debt, the cheaper
source of finance, increases in the capital structure.
 . . . Cont’d

Example: there are two firms A and B similar in

all aspects except in the degree of leverage
employed by them.
Financial data for these firms are show below:
Firm A Firm B
O Operating income (EBIT) $10,000 $10,000
I Interest on debt 0 3,000
P Equity earnings 10,000 7,000
rE Cost of equity capital 10% 10%
rD Cost of debt capital 6% 6%
E Market value of equity 100,000 70,000
D Market value of debt 0 50,000
V Total value of the firm 100,000 120,000
 . . . Cont’d

The average cost of capital for firm A is

6% x 0 + 10% x 100,000 = 10%
100,000 100,000

The average cost of capital for firm B is:

6% x 50,000 + 10% x 70,000 = 8.33%

120,000 100,000
 Net Operating Income Approach (NOI)
According to the NOI approach, the overall
capitalization rate and the cost of debt remain
constant for all degree of leverage. In the
equation
rA = rD[D/D+E] + rE[E/D+E]
rA and rD are constant for all degrees of
leverage. Given this the cost of equity can be
expressed as:
rE = rA +(rA – rD)(D/E)
 . . . Cont’d

The above behavior of rD, rE, and rA in response

to changes in (D/E) is shown graphically
hereunder:

( to be inserted here later)

 . . . Cont’d
The critical premise of this approach is that the market
capitalizes the firm as a whole at a discount rate which is
independent of the firm’s debt-equity ratio. As a
consequence, the division b/n debt and equity is
irrelevant.
An increase in the use of debt funds which are ‘
apparently cheaper’ is offset by an increase in the equity
capitalization rate.
This happens b/s equity investors seek higher
compensation as they are exposed to greater risk arising
from increase in the degree of leverage.
They raise the capitalization rate rE (lower the price-
earning ratio, P/E), as the degree of leverage increases.
 Cont’d

The NOI position has been advocated eloquently

by David Durand. He argued that the market
value of a firm depends on its NOI and business
risk.
The change in the degree of leverage employed
by a firm cannot change these underlying
factors. It merely changes the distribution of
income and risk b/n debt and equity without
affecting the total income and risk which
influence the market value of the firm.
 . . .Cont’d
Hence the degree of leverage cannot influence
the market value (equivalently the average cost
of capital) of the firm. Arguing in a similar vein,
Modigliani and Miller, in a seminal contribution
made in 1958, forcefully advanced the
proposition that the cost capital of a firm is
independent of its capital structure.
 Traditional Position
The main propositions of the traditional approach are:
1. The cost of debt capital, rd, remains more or less
constant up to a certain degree of leverage but rises
thereafter at an increasing rate.
2. The cost of equity capital, rE, remains more or less
constant or rises only gradually up to a certain degree
of leverage and rises sharply thereafter.
3. The average cost of capital, rA, as a consequence of
the above behavior of rE and rD, i) decreases up to a
certain point; ii) Remains more or less unchanged for
moderate increases in leverage thereafter; and iii)
Rises beyond a certain point.
 . . . Cont’d

The traditional approach is not as sharply

defined as the NI approach or the NOI
approach.
Several shapes of rD, rE and rA are consistent
with this approach.

(a graph is to be inserted here later)

 Cont’d
The principal implication of the traditional position
is that the cost of capital is dependent on the
capital structure and there is an optimal capital
structure which minimizes the cost of capital.
At the optimal capital structure the real marginal
cost of debt and equity is the same.
Before the optimal point the real marginal cost of
debt is less than the real marginal cost of equity
and beyond the optimal point the real marginal
cost of debt is more than the real marginal cost of
equity.
 Modigliani and Miller: No Taxes

• Modern capital structure theory began in 1958,

when Professors Franco Modigliani and Merton
Miller (hereafter MM) published what has been
called the most influential finance article ever
written. MM’s study was based on some strong
assumptions, including the following:
1.There are no brokerage costs.
2.There are no taxes.
3.There are no bankruptcy costs.
4.Investors can borrow at the same rate as
corporations
 . . . Cont’d
5. All investors have the same information as management
about the firm’s future investment opportunities.
6. EBIT is not affected by the use of debt.
• If these assumptions hold true, MM proved that a
firm’s value is unaffected by its capital structure,
hence the following situation must exist:
V L = V U = SL + D
• Here VL is the value of a levered firm, which is
equal to VU, the value of an identical but
unlevered firm. SL is the value of the levered firm’s
stock, and D is the value of its debt.
 . . . Cont’d
Recall that the WACC is a combination of the
cost of debt and the relatively higher cost of
equity, rs. As leverage increases, more weight
is given to low-cost debt, but equity gets
riskier, driving up rs. Under MM’s assumptions,
rs increases by exactly enough to keep the
WACC constant. Put another way, if MM’s
assumptions are correct, it does not matter
how a firm finances its operations, so capital
structure decisions would be irrelevant.
 . . . Cont’d
• Despite the fact that some of these assumptions
are obviously unrealistic, MM’s irrelevance result is
extremely important.
• By indicating the conditions under which capital
structure is irrelevant, MM also provided us with
clues about what is required for capital structure to
be relevant and hence to affect a firm’s value.
• MM’s work marked the beginning of modern
capital structure research, and subsequent
research has focused on relaxing the MM
assumptions in order to develop a more realistic
theory of capital structure.
 Cont’d

• Another extremely important aspect of MM’s work

was their thought process. To make a long story short,
they imagined two portfolios.
• The first contained all the equity of the unlevered firm,
and it generated cash flows in the form of dividends.
• The second portfolio contained all the levered firm’s
stock and debt, so its cash flows were the levered
firm’s dividends and interest payments.
• Under MM’s assumptions, the cash flows of the two
portfolios would be identical. They then concluded
that if two portfolios produce the same cash flows,
then they must have the same value.
 Modigliani and Miller: The Effect of Corporate Taxes

• MM published a follow-up paper in 1963 in which they

relaxed the assumption that there are no corporate taxes.
• The Tax Code allows corporations to deduct interest
payments as an expense, but dividend payments to
stockholders are not deductible.
• This differential treatment encourages corporations to
use debt in their capital structures. This means that
interest payments reduce the taxes paid by a corporation,
and if a corporation pays less to the government, more of
its cash flow is available for its investors. In other words,
the tax deductibility of the interest payments shields the
firm’s pre-tax income.
 Cont’d
• As in their earlier paper, MM introduced a second
important way of looking at the effect of capital
structure:
• The value of a levered firm is the value of an
otherwise identical unlevered firm plus the value of
any “side effects.” While others expanded on this idea,
the only side effect MM considered was the tax shield:
VL = VU + Value of side effects = VU + PV of tax shield
• Under their assumptions, they showed that the
present value of the tax shield is equal to the corporate
tax rate, T, multiplied by the amount of debt, D:
VL = VU + TD
 . . . Cont’d

• With a tax rate of about 40 percent, this implies

that every dollar of debt adds about 40 cents of
value to the firm, and this leads to the
conclusion that the optimal capital structure is
virtually 100 percent debt.
• MM also showed that the cost of equity, rs,
increases as leverage increases, but that it
doesn’t increase quite as fast as it would if there
were no taxes.
As a result, under MM with corporate taxes the
WACC falls as debt is added.
 Detailed MM-Capital structure theory

• Modigliani and Miller Theory of Capital

Structure
– Proposition I – firm value
– Proposition II – WACC
• The value of the firm is determined by the
cash flows to the firm and the risk of the firm’s
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
– No corporate or personal taxes
– No bankruptcy costs
• Case II – Assumptions
– Corporate taxes, but no personal taxes
– No bankruptcy costs
• Case III – Assumptions
– Corporate taxes, but no personal taxes
– Bankruptcy costs
 Case I – Propositions I and II
• 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 risk of 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)
 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%
• Suppose instead 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%
WACC and D/E
 Case II – Cash Flows
• 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
Unlevered firm Levered firm

EBIT 5,000 5,000

Less: Interest 0 500

= Taxable income 5,000 4,500

Less: Taxes (34%) 1,700 1,530

= Net income 3,300 2,970

CFFA 3,300 3,470

 Interest Tax Shield
• Annual interest tax shield
– Tax rate times interest payment
– $6,250 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 = $2,125
– PV = D(RD)(TC) / RD = D*TC = $6,250(.34) =
$2,125
 M&M Theory: Case II
• 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 + D*TC
 Example: Case II
• 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
Firm Value and Debt
 M&M Theory: Case II
• The WACC decreases as D/E increases
because of the government subsidy on
interest payments
– RA = (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%
– RA = (86.67/161.67)(.1369) +(75/161.67)(.09)
(1-.35)
• RA = 10.05%
 Case II – Example

• 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?
– RA = .5(.1395) + .5(.09)(1-.35) = 9.9%
WACC and D/E
 M&M Theory: Case III
• 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 costs
• 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
Firm Value and Debt
 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
M&M Theory: All Cases
 Additional 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
 Pecking order theory of capital structure

• If friction exist and there is an optimal capital

structure then firms will try and keep close to
that optimal capital structure. If however it is
costly to return to your optimal capital
structure, firms will not continually do so.
• They will exert the cheapest capital structure
control mechanisms first and resort to the
most expensive last. Heuristically firms seem
to order sources of financing thus:—
 Cont’d

1. Retained earnings, i.e. available liquid assets

2. Straight Debt Financing
3. Lease Financing
4. Convertible Debt Financing
5. Preferred Equity Financing
6. Ordinary Equity Financing
• Thus firms may chose their dividend policy (as
well as their borrowing and equity issuance
policy) to optimally control their capital
structure.
 Trade-Off Theory

• Integration of tax effects and financial distress costs:

I. Static trade-off theory: a firm’s capital structure decisions can

be thought of as a trade-off b/n the tax benefits of debt and
the costs of financial distress.
II. The implication is that there is an optimum amount of debt
for any individual firm (debt capacity).

III. Total value of the firm = market claims (debt + equity) + non-
marketed claims (taxes, potential lawsuits and bankruptcy
claims). Marketed claims can be bought and sold in financial
markets, and the non-marketed claims cannot
 Pecking-Order vs. trade-off:
a. There is no target amount of leverage in PO:
In TO, the optimal amount of leverage occurs
where the marginal benefit of debt equals the
marginal cost of debt. In PO, the amount of
leverage is determined by the happenstance
of available projects. Firms do not pursue a
target ratio of debt to equity.
 . . . Cont’d
b. Profitable firms use less debt in PO: profitable
firms generate cash internally, implying less
need for outside financing. Because firms
desiring outside capital turn to debt first,
profitable firms end up relying on less debt.
The TO doesn’t have this implication. The
greater cash flow of more profitable firms
creates greater debt capacity. These firms will
use that debt capacity to capture the tax shield
and the other benefits of leverage.
 Signaling Theory
• MM assumed that investors have the same
information about a firm’s prospects as its managers
—this is called symmetric information. However, in
fact managers often have better information than
outside investors. This is called asymmetric
information, and it has an important effect on the
optimal capital structure.
• To see why, consider two situations, one in which the
company’s managers know that its prospects are
extremely positive (Firm P) and one in which the
managers know that the future looks negative (Firm
N).
 Cont’d
• Suppose, for example, that Firm P’s R&D labs have
just discovered a nonpatentable cure for the
common cold.
• They want to keep the new product a secret as long
as possible to delay competitors’ entry into the
market. New plants must be built to make the new
product, so capital must be raised. How should Firm
P’s management raise the needed capital? If it sells
stock, then, when profits from the new product start
flowing in, the price of the stock would rise sharply,
and the purchasers of the new stock would make a
bonanza.
 Cont’d
• The current stockholders (including the managers)
would also do well, but not as well as they would
have done if the company had not sold stock
before the price increased, because then they
would not have had to share the benefits of the
new product with the new stockholders.
Therefore, one would expect a firm with very
positive prospects to try to avoid selling stock and,
rather, to raise any required new capital by other
means, including using debt beyond the normal
target capital structure.
 . . . Cont’d
• Now let’s consider Firm N. Suppose its managers have
information that new orders are off sharply because a
competitor has installed new technology that has improved its
products’ quality.
• Firm N must upgrade its own facilities, at a high cost, just to
maintain its current sales. As a result, its return on investment
will fall (but not by as much as if it took no action, which would
lead to a 100 percent loss through
bankruptcy).
How should Firm N raise the needed capital? Here the situation
is just the reverse of that facing Firm P, which did not want to sell
stock so as to avoid having to share the benefits of future
developments.
A firm with negative prospects would want to sell stock, which
would mean bringing in new investors to share the losses.
 Cont’d
• The conclusion from all this is that firms with
extremely bright prospects prefer not to finance
through new stock offerings, whereas firms with poor
prospects like to finance with outside equity. How
should you, as an investor, react to this conclusion?
• You ought to say, “If I see that a company plans to
issue new stock, this should worry me because I know
that management would not want to issue stock if
future prospects looked good. However, management
would want to issue stock if things looked bad.
• Therefore, I should lower my estimate of the firm’s
value, other things held constant, if it plans to issue
new stock.”
 Cont’d
• If you gave the above answer, your views would be
consistent with those of sophisticated portfolio
managers.
• In a nutshell, the announcement of a stock offering is
generally taken as a signal that the firm’s prospects as
seen by its management are not bright. Conversely, a
debt offering is taken as a positive signal.
• Notice that Firm N’s managers cannot make a false
signal to investors by mimicking Firm P and issuing
debt.
• With its unfavorable future prospects, issuing debt
could soon force Firm N into bankruptcy.
 Cont’d

• Given the resulting damage to the personal

wealth and reputations of N’s managers, they
cannot afford to mimic Firm P. All of this
suggests that when a firm announces a new
stock offering, more often than not the price of
its stock will decline. Empirical studies have
shown that this situation does indeed exist.
 . . . Cont’d
• What are the implications of all this for capital
structure decisions?
• Because issuing stock emits a negative signal and
thus tends to depress the stock price, even if the
company’s prospects are bright, it should, in normal
times maintain a reserve borrowing capacity that
can be used in the event that some especially good
investment opportunity comes along.
This means that firms should, in normal times, use
more equity and less debt than is suggested by the
tax benefit/bankruptcy cost trade-off model
expressed above.
 . . .Cont’d
• Finally, the presence of asymmetric information
may cause a firm to raise capital according to a
pecking order. In this situation a firm first
raises capital internally by reinvesting its net
income and selling off its short-term marketable
securities.
• When that supply of funds has been exhausted,
the firm will issue debt and perhaps preferred
stock. Only as a last resort will the firm issue
common stock.
 Asymmetric Information and Agency Costs
• There is asymmetric information between shareholders
and managers.
• How to induce managers to act in the shareholders’
interests ?
– The shareholders can devise contracts that align the
incentives of the managers with the goals of the
shareholders.
– The shareholders can monitor the managers behavior.
• (Agency Cost) This contracting and monitoring is costly.
 Bankruptcy and agency costs

1. Costs of Financial Distress:

The possibility of bankruptcy has a negative effect on the value
of the firm. However, it is not the risk of bankruptcy itself that
lowers value. Rather it is the costs associated with bankruptcy
that lower value.
• If bondholders are paying a fair price if they are realistic about
both the probability and the cost of bankruptcy. It is the
stockholders who bear these future bankruptcy costs.
2. Description of Costs:
- I. Direct costs of financial distress: legal and administrative costs of
liquidation or reorganization.
- II. Indirect costs of financial distress: impaired ability to conduct
business. Andrad and Kaplan (1998) estimate total distress costs to be
b/n 10% and 20% of firm value.
 . . . Cont’d
III. Agency costs: conflicts of interest b/n stockholders and bondholders.
a. Incentive to take large risks when near bankruptcy. Stockholders
expropriate value from the bondholders by selecting high-risk
projects.
b. Incentive toward underinvestment: in both a and b, leverage results
in distorted investment policy. Whereas the unlevered corporation
always chooses projects with positive NPV, the levered firm may
deviate from this policy.
c. Milking the property: pay out extra dividends or other distributions
in times of financial distress.
d. It is ultimately the stockholders who pays for the cost of selfish
investment strategies, because bondholders protect themselves
accordingly by raising the interest rate that they require on the bonds .
 Observed Capital Structures
• Capital structure does differ by industries
• Differences according to Cost of Capital 2004
Yearbook by Ibbotson Associates,Inc.
– Lowest levels of debt
• Drugs with 6.39% debt
• Electrical components with 6.97% debt
– Highest levels of debt
• Airlines with 64.35% debt
• Department stores with 46.13% debt
Checklist for Capital Structure Decisions
• Firms generally consider the following factors when making
capital structure decisions:
1. Sales stability. A firm whose sales are relatively stable can
safely take on more debt and incur higher fixed charges than
a company with unstable sales. Utility companies, because
of their stable demand, have historically been able to use
more financial leverage than industrial firms.
2. Asset structure. Firms whose assets are suitable as security
for loans tend to use debt rather heavily. General-purpose
assets that can be used by many businesses make good
collateral, whereas special-purpose assets do not. Thus, real
estate companies are usually highly leveraged, whereas
companies involved in technological research are not.
 . . . Cont’d
3. Operating leverage. Other things the same, a firm with
less operating leverage is better able to employ
financial leverage because it will have less business risk.
4. Growth rate. Other things the same, faster-growing
firms must rely more heavily on external capital.
Further, the flotation costs involved in selling common
stock exceed those incurred when selling debt, which
encourages rapidly growing firms to rely more heavily
on debt.
At the same time, however, these firms often face
greater uncertainty, which tends to reduce their
willingness to use debt.
 . . . Cont’d
5. Profitability. One often observes that firms with very
high rates of return on investment use relatively little
debt. Although there is no theoretical justification for
this fact, one practical explanation is that very
profitable firms such as Intel, Microsoft, and Coca-
Cola simply do not need to do much debt financing.
Their high rates of return enable them to do most of
their financing with internally generated funds.
6. Taxes. Interest is a deductible expense, and
deductions are most valuable to firms with high tax
rates. Therefore, the higher a firm’s tax rate, the
greater the advantage of debt.
 . . . Cont’d

7. Control. The effect of debt versus stock on a

management’s control position can influence
capital structure. If management currently has
voting control (over 50 percent of the stock) but is
not in a position to buy any more stock, it may
choose debt for new financings. On the other hand,
management may decide to use equity if the firm’s
financial situation is so weak that the use of debt
might subject it to serious risk of default, because if
the firm goes into default, the managers will almost
surely lose their jobs. However, if too little debt is
used, management runs the risk of a takeover.
 . . . Cont’d
• Thus, control considerations could lead to the use of
either debt or equity, because the type of capital that
best protects management will vary from situation to
situation. In any event, if management is at all insecure,
it will consider the control situation.
8. Management attitudes. Because no one can prove that
one capital structure will lead to higher stock prices
than another, management can exercise its own
judgment about the proper capital structure. Some
managements tend to be more conservative than
others, and thus use less debt than the average firm in
their industry, whereas aggressive managements use
more debt in the quest for higher profits.
 Cont’d
9. Lender and rating agency attitudes. Regardless of
managers’ own analyses of the proper leverage factors
for their firms, lenders’ and rating agencies’ attitudes
frequently influence financial structure decisions.
• In the majority of cases, the corporation discusses its
capital structure with lenders and rating agencies and
gives much weight to their advice.
For example, one large utility was recently told by
Moody’s and Standard & Poor’s that its bonds would
be downgraded if it issued more debt.
• This influenced its decision to finance its expansion
with common equity.
 . . . Cont’d

10. Market conditions. Conditions in the stock and bond

markets undergo both long- and short-run changes that
can have an important bearing on a firm’s optimal
capital structure. For example, during a recent credit
crunch, the junk bond market dried up, and there was
simply no market at a “reasonable” interest rate for any
new long-term bonds rated below triple B.
Therefore, low-rated companies in need of capital were
forced to go to the stock market or to the short-term
debt market, regardless of their target capital
structures.
When conditions eased, however, these companies sold
bonds to get their capital structures back on target.
 . . . Cont’d
11. The firm’s internal condition. A firm’s own internal
condition can also have a bearing on its target capital
structure.
For example, suppose a firm has just successfully
completed an R&D program, and it forecasts higher
earnings in the immediate future. However, the new
earnings are not yet anticipated by investors, hence are not
reflected in the stock price. This company would not want
to issue stock—it would prefer to finance with debt until
the higher earnings materialize and are reflected in the
stock price. Then it could sell an issue of common stock,
retire the debt, and return to its target capital structure.
This point was discussed earlier in connection with
asymmetric information and signaling.
 . . . Cont’d

12. Financial flexibility. Firms with profitable

investment opportunities need to be able to fund
them. An astute corporate treasurer made this
statement to the authors:
Our company can earn a lot more money from good
capital budgeting and operating decisions than from
good financing decisions. Indeed, we are not sure
exactly how financing decisions affect our stock price,
but we know for sure that having to turn down a
promising venture because funds are not available will
reduce our long-run profitability. For this reason, my
primary goal as treasurer is to always be in a position
to raise the capital needed to support operations.
 Cont’d

• We also know that when times are good, we

can raise capital with either stocks or bonds,
but when times are bad, suppliers of capital
are much more willing to make funds available
if we give them a secured position, and this
means debt.
• Further, when we sell a new issue of stock,
this sends a negative “signal” to investors, so
stock sales by a mature company such as ours
are not desirable.
 . . . Cont’d

• Putting all these thoughts together gives rise to

the goal of maintaining financial flexibility,
which, from an operational viewpoint, means
maintaining adequate reserve borrowing
capacity. Determining an “adequate” reserve
borrowing capacity is judgmental, but it clearly
depends on the factors discussed above,
including the firm’s forecasted need for funds,
predicted capital market conditions,
management’s confidence in its forecasts, and
the consequences of a capital shortage.