Chapter 12
Principles of Capital
Structure
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PPTs t/a Business Finance 10e by Peirson
Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
12-1
Learning Objectives
• Explain the effects of financial leverage.
• Distinguish between business risk and financial risk.
• Understand the capital structure irrelevance theory
of Modigliani and Miller (MM).
• Explain the roles of taxes and other factors that may
influence capital structure decisions.
• Understand the concept of an optimal capital
structure, based on a trade-off between the benefits
and costs of using debt.
• Explain the pecking order theory of capital structure.
• Outline Jensen’s free cash flow theory.
Copyright  2009 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 10e by Peirson
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12-2
Introduction
• Capital structure:
– The mix of debt and equity finance used by a company.
• Optimal capital structure:
– The capital structure that maximises the value of a
company.
– Does the value of the net operating cash flow stream
depend on how it is divided between payments to
lenders and shareholders?
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12-3
Effects of Financial Leverage
• Business risk:
– The variability of future net cash flows attributed to the
nature of the company’s operations (the risk faced by
shareholders if the company is financed only by equity).
• Financial risk:
– The risk involved in using debt as a source of finance.
• Effects of financial leverage:
– Expected rate of return on equity is increased.
– Variability of returns to shareholders increases.
– Increasing leverage involves a trade-off between risk
and return.
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12-4
Effects of Financial Leverage (cont.)
• Measures of financial leverage:
– Debt to equity, debt to total assets, and interest coverage.
• Leverage varies significantly between companies
– Differences in leverage can be related to industry
membership and asset type. For example, Computershare,
which is a service company, relies much less on debt finance
than Bluescope Steel, a steel manufacturer, and Amcor, a
packaging manufacturer.
– Since expected return and risk increase due to financial
leverage, question arises as to whether the expected return
is enough for the increase in risk — so that company value
remains unchanged by leverage.
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12-5
Modigliani and Miller Analysis
• Assumptions:
– Capital markets are perfect.
– Companies and individuals can borrow at the same
interest rate.
– There are no taxes.
– There are no costs associated with the liquidation of
a company.
– Companies have a fixed investment policy so that
investment decisions are not affected by financing
decisions.
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12-6
MM’s Proposition 1
• The market value of any firm is independent of its
capital structure.
• If a company has a given set of assets, changing
debt to equity will change the way net operating
income is divided between lenders and shareholders
but will not change the value of the company.
• Value of a company is given by:
annual net operating income
V
k0
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12-7
Proposition 1: Proof
• Two companies that have the same assets but
different capital structures are, under the
assumptions, perfect substitutes. As such, perfect
substitutes should have the same value.
• There is no reason for investors to pay a premium
for shares of levered companies because investors
can borrow to create home-made leverage.
• Home-made leverage — is a perfect substitute for
corporate leverage.
• The central mechanism in MM’s proof is the
substitutability between corporate debt and
personal debt.
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12-8
Proposition 1: Proof
• If a leveraged company (L) is overvalued compared to
unleveraged (U) company, then an investor in levered
company’s shares can replicate his/her risk and return
by investing instead in the shares of an unleveraged
company and adjusting the debt–equity ratio by
borrowing personally.
• Similarly, if an unleveraged company (U) is overvalued
compared to leveraged (L) company, then an investor
in unleveraged company’s shares can replicate his/her
risk and return by investing instead in the shares of a
leveraged company and adjusting the debt–equity ratio
(to zero) by lending personally.
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12-9
What if …
• The companies were not selling for the same price?
• Arbitrage profits could be earned. An opportunity to
make riskless profits exists and arbitragers will exploit
this.
• Arbitrage involves buying an asset and simultaneously
selling it for a higher price, usually in another market,
so as to make a risk-free profit.
• An Arbitrage Illustration:
Example: Two firms: U and L. Firm U is unlevered
and Firm L is levered. Firm L has borrowed $400 000
at 7.5%. Both firms make a profit of $900 000.
Required return is 10%. We want to show that these
two companies are equivalent, otherwise there must
be an arbitrage opportunity.
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12-10
An Arbitrage Opportunity Illustration
(cont.)
• Firm U (unleveraged):
–
–
Value of equity = $900 000/0.10 = $9 000 000
Value of firm = D + E = 0 M + 9 M = $9 000 000
• Firm L (leveraged):
value of equity 
$900,000   0.075  $4,000,000 
0.1
 $6,000,000
• Value of firm = D + E = 4 M + 6 M =$10 000 000
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12-11
The Arbitrage Process
• The results suggest we sell Firm L and buy Firm U.
• Calculate the investor’s dollar investment and the
return this is generating:
– Investment:
 10% of equity of L: 10% x 6 000 000 = $600 000
– Return:
 10% x net income of L: 10% x 600 000 = $60 000 p.a.
• Borrow an amount such that personal financial
leverage is equivalent to the Firm L’s financial
leverage.
– Firm L’s financial leverage: 4M/6M
– Gear individual the same: D/600 000 = 4/6
– Hence, investor should borrow $400 000 at 7.5%
Copyright  2009 McGraw-Hill Australia Pty Ltd
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12-12
The Arbitrage Process (cont.)
• To show a higher return for the same investment:
– work out funds available to invest in the unlevered firm:
Sell shares in L
$600 000
Borrowings
$400 000
Total available
$1 000 000
• So, we have shorted Firm L and borrowed and will invest in
Firm U.
• Work out the return if all of these funds are invested in Firm U:
1, 000, 000
Return 
 $900, 000
9, 000, 000
 $100, 000
• This ($100 000) is a gross return and does not factor in costs.
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12-13
The Arbitrage Process (cont.)
• Work out the net return:
– Return from unlevered firm
– less Interest on borrowings
– Net return
$100 000
$ 30 000
$ 70 000 p.a.
• This represents an increase in income of $10 000 per
year, as the investor’s old return, by investing in Firm L,
was only $60 000 p.a.
• It is not necessary for arbitrage transactions to involve
personal borrowing. The only requirement is that investors
are able to trade in both debt securities and shares.
• The point is that, if such equivalent firms are not offering
the same return, arbitrage is possible.
• Eventually, the market will force returns to be the same —
implying the degree of leverage does not have any impact
on firm value and can be replicated by investors.
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12-14
MM’s Proposition 2
• The cost of equity of a levered firm is equal to the cost of
equity of an unlevered firm plus a financial risk premium,
which depends on the degree of financial leverage:
where:
k0  expected return on assets
D
E
k0  ke    k d  
V 
V 
ke  expected return on equity
kd  expected return on debt
E  market value of company's equity
D  market value of company's debt
V  E  D  market value of company
• While Proposition 1 is a law of conservation of value,
Proposition 2 is based on the natural conservation of risk.
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12-15
MM’s Proposition 3
• The appropriate discount rate for a particular
investment proposal is independent of how
the proposal is to be financed.
• The key factor determining the discount rate
or a proposal is the level of risk associated
with the project.
• This is consistent with the irrelevance of the
financing decision: Proposition 1.
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12-16
Why is MM’s Analysis Important?
• Showing what does not matter can also show, by implication,
what does matter (Miller, 1988).
• By implication, if capital structure does in fact matter, then
taxes and default risk could be good places to look for
reasons why it matters.
• An understanding of the MM proposition helps to distinguish
between logical and illogical reasons for particular financing
decisions.
• The fundamental MM message is that any combination of
finance sources is as good as another. No matter how many
sources of finance are used, the resulting capital structure is
just another way of dividing the NCF between the people who
have contributed the capital that sustains the company’s
operations.
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12-17
Including Factors MM Excluded
• Capital market imperfections will impede the
MM 1958 propositions:
– Company Income taxes.
– Transaction costs.
– Costs associated with financial distress.
– Agency costs.
– Different cost of borrowing for corporations and
individuals.
– Non-constant cost of debt.
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12-18
The Effects of Taxes on Capital
Structure Under a Classical Tax System
• Company Income taxes:
– Leaving all original assumptions in place except to relax
the assumption of no corporate tax, MM extended their
analysis.
• Classical system:
– Leverage will increase a firm’s value because interest
on debt is a tax deductible expense resulting in an
increase in the after-tax net cash flows to investors.
– The main implication of Proposition 1 with company tax is
clear but extreme: A company should borrow so much that
its company tax bill is reduced to zero.
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12-19
The Effects of Taxes on Capital Structure
Under a Classical Tax System (cont.)
• Company tax and personal tax:
– In practice, company tax system and personal tax system
interact in complex ways.
– The preferred source of finance depends on comparison
between (1 – tp) and (1 – tc)(1 – ts).
• Personal taxes (Miller, 1977):
– Suggested that the presence of taxes on personal income
may reduce the tax advantage associated with debt
financing.
– Why? Firms could save corporate taxes by raising the D/E
ratio, but investors would pay additional personal tax and,
therefore, require higher returns to compensate for this fact
and the higher associated risks.
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12-20
The Effects of Taxes on Capital Structure
Under a Classical Tax System (cont.)
• Proposition 1: (with company tax)
– Value of a levered firm is equal to the value of an unlevered firm
of the same risk class plus the present value of the tax saving:
 tc k d D 
VL  VU  

 kd

 VU  tc D
where
tc Drepresents the
present value of the tax
shield associated with
interest payments.
– The gain from leverage can be identified as:
 1  tc 1  ts  
gains from leverage  1 
D
1 t p  

where:
tc corporate tax rate
ts personal tax rate on equity
tp personal tax rate on debt
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12-21
Miller’s Analysis
• Implications:
– There is an optimal debt–equity ratio for the corporate
sector as a whole, which will depend on the company
income tax rate and on the funds available to investors
who are subject to different tax rates.
– Securities issued by different companies will appeal
to different clienteles of investors. Consequently, in
equilibrium there is no optimal debt–equity ratio for
an individual company.
– Shareholders of levered companies end up receiving no
benefit from the company tax savings on debt because
the saving is passed on to lenders in the form of a
higher interest rate on debt.
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12-22
The Effect of Taxes on Capital
Structure: Imputation Tax System
• The imputation tax system:
– Income distributed as franked dividends to resident
shareholders is effectively taxed only once at the
shareholder’s personal tax rate.
– Interest paid to lenders is taxed only once at lender’s
personal tax rate.
• The imputation system has the potential to lead to
neutrality between debt and equity.
• However, there is a possible bias towards equity for
investors with personal income tax rates greater than the
company tax rate, who may favour companies retaining,
rather than distributing, profits to achieve a lower tax
burden.
• In summary, the imputation system has the potential to be
neutral and any bias will favour equity rather than debt.
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12-23
The Costs of Financial Distress and
Agency Costs
• There are non-tax factors that can cause a company’s
value to depend on its capital structure.
• Financial distress:
– Situation where a company’s financial obligations cannot
be met or can be met only with difficulty. In serious cases,
financial distress can lead to liquidation of the company.
• Indirect Costs of Financial Distress:
– Financial distress leads a range of stakeholders to behave
in ways that can disrupt its operations and reduce its value.
– Effect of lost sales and reduced operating efficiency.
– Cost of managerial time devoted to attempts to avert failure
(less attention paid to issues such as product quality and
employee safety).
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12-24
The Costs of Financial Distress and
Agency Costs (cont.)
• Bankruptcy costs:
– Direct and indirect costs.
– Due to issuing risky debt, a company gives outsiders a
potential claim against its assets that decreases the value
of the claims held by investors.
• Incorporating the benefits and costs of debt leads to the
following expression of the value of a leveraged firm:
VL  VU   PV of Debt 
  PV of expected bankruptcy costs 
• The PV of expected bankruptcy costs depends on the
probability of bankruptcy and PV of costs incurred if
bankruptcy occurs.
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12-25
The Costs of Financial Distress and
Agency Costs (cont.)
• Agency Costs:
– Agency costs arise from the potential for conflicts of
interest between the parties forming the contractual
relationships of the firm.
– Management may make decisions that transfer wealth
from lenders to shareholders.
– Sources of potential conflict:
 Claim dilution.
 Dividend payout.
 Asset substitution.
 Underinvestment.
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12-26
The Costs of Financial Distress and
Agency Costs (cont.)
• Agency Costs (cont.):
– Claim dilution:
 A company may issue new debt that ranks higher than
existing debt.
 Holders of the old debt now have a less secure claim on
the company’s assets.
 Wealth can be transferred from the holders of the old debt
to shareholders.
– Dividend payout:
 A company may significantly increase its dividend payout.
 This decreases the company’s assets and increases the
riskiness of its debt.
 Again, this results in a wealth transfer from lenders to
shareholders.
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12-27
The Costs of Financial Distress and
Agency Costs (cont.)
• Agency Costs (cont.)
– Asset substitution:
 A company’s incentive to undertake risky
investments increases because of the use of debt.
 If risky investments prove successful, most of the
benefits will flow to shareholders, but if it fails,
most of the costs will be borne by lenders.
 Undertaking such investments (negative NPV)
causes the total value of the company to
decrease, but the value of the shares will increase
and the value of the debt will fall.
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12-28
The Costs of Financial Distress and
Agency Costs (cont.)
• Agency Costs (cont.)
– Underinvestment:
 A company may reject proposed low-risk
investments that have a positive net present value.
 If a company’s debt is very risky it may not be in the
interest of shareholders to contribute additional
capital to finance new investments.
 Although the investment is profitable, shareholders
may lose because the risk of the debt will fall and its
value will increase.
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12-29
The Costs of Financial Distress and
Agency Costs (cont.)
• Agency Costs (cont.):
– Potential conflict of interest between lenders and
shareholders, and the likelihood of conflict increases
with greater financial leverage.
– Costs borne by shareholders: Higher interest rates,
restrictive covenants:
VL  VU   PV of Debt 
 PV of agency costs, bankruptcy costs 


and
costs
of
increased
debt


– Conflicts of interest between shareholders and managers.
Can be reduced by aligning the objectives of managers
with those of shareholders:
 Employee share ownership schemes.
 Remuneration for top-level managers in the form of options.
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12-30
The Costs of Financial Distress and
Agency Costs (cont.)
• Agency Costs (cont.)
– Would it be best to eliminate the costs associated with the
separation of ownership and control by having a company’s
equity capital provided only by its managers?
– No
 Few individuals have the combination of wealth and skills
to both own and manage a company involved in activities
such as large-scale industrial operations.
 While uniting the functions of management and provision
of capital has advantages in terms of agency costs, it has
disadvantages in terms of risk bearing (investors can
easily diversify simply by combining the shares of many
companies in a portfolio).
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12-31
Incentive Effects of Debt
• Tendency for managers to overinvest.
• The more likely overinvestment, the higher the
company’s free cash flow.
• Such free cash flows should ideally be paid out;
however, dividends are at the discretion of
management.
• Borrowing forces the payout of cash, which
reduces the potential for overinvestment.
• Optimal Capital Structure
– Trade-off theory:
 The possibility of a trade-off between the opposing effects
of the benefits of debt finance and the costs of financial
distress may mean that an optimal capital structure exists.
Management should aim to maintain a target debt–equity
ratio.
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12-32
Capital Structure with Information
Asymmetry
• Pecking order theory:
– In raising finance, managers follow a pecking order in
which internal funds are preferred, followed by debt, hybrid
securities and then, as a last resort, a new issue
of ordinary shares.
• Myers explains this pecking order based on
information asymmetry.
– Information asymmetry is a situation where all relevant
information is not known by all interested parties. Typically,
this involves company insiders (managers) having more
information about the company’s prospects than outsiders
(shareholders and lenders).
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12-33
Capital Structure with Information
Asymmetry (cont.)
• Example:
– A company has 100 000 ordinary shares with a
market price of $4.50, but management believes
that the true value of the shares is $5.
– The company has an investment opportunity that
requires an outlay of $200 000, has an NPV of
$17 000 and will have to be financed externally.
– The existence of the investment opportunity is not
known to the market and is, therefore, not reflected
in the current share price.
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12-34
Capital Structure with Information
Asymmetry (cont.)
– Information asymmetry exists with respect to both the
company’s existing assets and the new investment.
– Should the investment be implemented?
– How should it be financed?
•
Let’s consider four scenarios:
1) Suppose that investment had been made before the
market learnt the true value of the existing assets —
and then new shares are issued.

Initially share price is $4.50.

The number of new shares to be issued is 44 444.

What is the value of shares after the issue?
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12-35
Capital Structure with Information
Asymmetry (cont.)
Ps 
old market value+cash raised+NPV of Project
Number of shares on issue
$450,000 + $200,000 +$17,000

144,444
 $4.62
 Since this value > $4.50, shareholders will benefit from
the issue and the project in the short term.
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Capital Structure with Information
Asymmetry (cont.)
 In the long term, the share market learns the true value
of the existing assets and the share price will be:
PL 

$500,000+$200,000+$17,000
144,444
$4.96
 In this case, the new shareholders gain both in short
term and long term, but the old shareholders will only
gain in short term because $4.62 exceeds $4.50. But in
the long term, shareholder is better off without the new
investment and the new share issue. ($4.96 < $5.00).
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Capital Structure with Information
Asymmetry (cont.)
2) Investment made after the market learns the true value
of the existing assets — and new shares are issued.
 In the short term, share price remains $4.50 but in the long
run, share price increases from $4.50 to $5.00.
 After the new investment is announced and the new
shares are issued, the share price is:
Ps

$500,000+$200,000+$17,000
140,000
 $5.12
 Both old and new shareholders benefit as they both gain
12 cents per share in the long run.
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12-38
Capital Structure with Information
Asymmetry (cont.)
3) Investment made before the market learns the true
value of the existing assets — and new debt is issued.

If company borrows to finance the project, all the benefit of the
positive NPV will go to the current shareholders. After new
investment is announced and new debt is issued the share
price is:
Ps  $500,000+$200,000+$17,000
140,000

In the short term, shareholders gain 17 cents. While in the long
term share price is $5.17, this means the shareholders gain by
17 cents per share.
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12-39
Capital Structure with Information
Asymmetry (cont.)
4) Investment made after the market learns the true value of
the existing assets — and new debt is issued.

In the short term, share price remains $4.50, but in the long
run share price increases from $4.50 to $5.00.

After the new investment is announced and the new debt is
issued the share price is:
PL  $500,000+ $17,000
100,000

In this scenario, the shareholders gain in the long term by
17 cents per share.

In summary, without the new investment the short-term
outcome is a share price of $4.50 while the long-term
outcome is a share price of $5.00. The clear winner is
Scenario 3.
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12-40
Capital Structure with Information
Asymmetry (cont.)
• What do the previous scenarios imply about
financing policy?
– If there is information asymmetry, and management
believe that its company’s shares are undervalued, they
will prefer to borrow.
– If management believe the shares are overvalued, they
will prefer to issue new shares (p. 392).
• Difference between pecking order theory and
trade-off theory is that pecking order theory does
not depend on target debt–equity ratio.
• Instead, it is about availability of internal funds
and information asymmetry.
Copyright  2009 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 10e by Peirson
Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
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Implication of Information Asymmetry
for Financing policy
• Information asymmetry can cause the share market to
undervalue or to overvalue a company.
• If share is undervalued — prefer to borrow.
• If share is overvalued — prefer to issue new shares.
• However, outside investors understand managers’
motives and, therefore, will tend to react to the
announcement of a share issue by reducing the
company’s share price because the chances are that
the issue signals bad news.
• The main implication for managers is that there are
advantages in restricting financial leverage so the
company could borrow at a short notice if a profitable
investment arises.
Copyright  2009 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 10e by Peirson
Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
12-42
Jensen’s Free Cash Flow Theory
• Information asymmetry implies that reserve borrowing capacity
is valuable, but it is important to note that its value can differ
between companies depending on investment prospects.
• Reserve borrowing capacity is more valuable for high growth
companies. In more mature, stable companies it can cause free
cash flows. When reserve borrowing capacity results in FCF, it
offers slack for management.
• These reserves may not generate adequate returns and should
be paid out to investors rather than retained in the company.
• Jensen (1986) argues that free cash flows should be paid out to
investors in order to avoid poor use of funds by managers.
• Ways of returning funds include dividends and share buyback
schemes.
• Debt offers a control effect — generating a credible
commitment not to misuse free cash flow, as it is required to
service debt.
Copyright  2009 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 10e by Peirson
Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
12-43
Summary
• Leverage and its effects on financial risk.
• Modigliani and Miller — capital structure does not
change the value of an entity.
• If the company tax saved by borrowing is different
from the extra tax incurred at the investor level,
capital structure can affect the value of companies.
• Issue of debt has a range of associated costs and
benefits such as expected bankruptcy costs and
agency costs.
– There is a trade-off between costs and benefits in
determining optimal capital structure — trade-off theory.
Copyright  2009 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 10e by Peirson
Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
12-44
Summary (cont.)
• The trade-off theory suggests that management
should aim to maintain a target debt–equity ratio.
• An alternative to the trade-off theory is the pecking
order theory:
– Information asymmetry can lead managers to have
a preference for debt over equity.
– The pecking order approach does not rely on the existence
of a target debt–equity ratio.
• Jensen argues that free cash flows have the potential
to be misused by management.
• One way to control use of free cash flow and enhance
firm value is to increase debt levels, though there are
associated risks.
Copyright  2009 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 10e by Peirson
Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
12-45