Chapter 17 -- Capital
Structure and Value
 Overview:
 Perfect
markets and capital structure
irrelevance
 Influence on capital structure
 Information problems and capital structure
 Other considerations
 Empirical evidence on capital structure and
value
Perfect markets -- Modigliani
and Miller
 No
taxes, no bankruptcy, same information
sets, no transaction cost
 Capital structure does not matter
 Shareholders will adjust the company’s
structure to whatever they want
Taxes and Capital Structure
 Differential
 Personal
tax rates
ordinary income rate
What shareholders pay if they receive a dividend
 Corporate ordinary income rate
What the corporation shares with the government
 Personal capital gains rate
What you pay on the gain if you sell your stock
Taxes and Capital Structure
 Differential
 May
tax rates within the corporation
have other tax shields such as depreciation
 May not have the income to pay taxes
Bankruptcy or Liquidation
cost and Capital Structure
Legal
cost
Disruption cost
Expected bankruptcy cost and capital
structure
Information Problems: Agency
Cost
Agency
Cost
cost of debt
borne by your debt-holders to
monitor your actions or prospective
actions
very low when debt is low but goes up as
debt in increased
Information Problems: Agency
Costs
Agency
 Cost
cost of equity
borne by shareholders to monitor your actions
 High with no debt but decreases as debt increases
 These cost decrease because
others (debt-holders) are monitoring, often with
better information (monthly statements)
Cost of a loss is less with others participating
Information Problems: Agency
Costs
Look
for the mixture of debt and
equity that minimizes total agency
costs
Information Problems:
Signaling
Management
may have a better
information set than the shareholders
 Actions
speak louder than words
 The assumption of debt signals
management’s confidence in future cash
flows
 Issuing debt to buy back equity is a very
positive signal
Other Considerations and
Capital Structure Choice
Unequal
cost of corporate borrowing
and personal borrowing
This
favors corporate borrowing over
personal borrowing
Other Considerations and
Capital Structure Choice
 Additional
liability of homemade leverage
 Favors
corporate over personal borrowing
 You can only lose the value of your stock
investment
 With homemade leverage you can lose your
personal assets
 Restrictions
on homemade leverage
Empirical Evidence on
Capital Structure and Value
As
theories predict, taxes, bankruptcy
costs, and agency costs all have roles
in determining capital structure
Science is not so complete that we can
predict or prescribe the exact optimal
capital structure