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Capital Structure Concepts
©2006 Thomson/South-Western
Introduction

This chapter examines some of the basic
concepts used in determining a firm’s
optimal capital structure. It deals only
with the total permanent sources of a
firm’s financing.
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Capital Structure Vs Financial
Structure

Capital Structure

Financial Structure
Permanent S-T
Total current
debt
liabilities

L-T debt

L-T debt

P/S

P/S

C/S

C/S
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Capital Structure Terminology

Optimal capital structure



Target capital structure


Minimizes a firm’s weighted cost of capital
Maximizes the value of the firm
Capital structure at which the firm plans to
operate
Debt capacity

Amount of debt in the firm’s optimal capital
structure
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What Determines the Optimal
Capital Structure ?

Business risk of the firm

Tax structure

Bankruptcy potential

Potential agency costs

Signaling effects
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Capital Structure Assumptions


Firm’s investment policy is held
constant.
Capital structure changes the
distribution of the firm’s EBIT among the
firm’s claimants.




Debtholders
Preferred stockholders
Common stockholders
Constant investment policy leaving the
debt capacity of the firm unchanged
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Factors Influencing a Firm’s
Business Risk

Variability of sales

diversification
volume

Extent of product
Variability of selling

Firm’s growth rate
price

Degree of operating

Variability of cost

Amount of market
power
leverage (DOL)

Both systematic and
unsystematic risk
Web site for more info: http://finance.yahoo.com/
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Financial Risk


Variability of EPS and increased
probability of bankruptcy
Factors indicating financial risk
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Debt-to asset ratio
Debt-to-equity ratio
Fixed charge coverage ratio
DFL
Probability distribution of profits
Times interest earned ratio
EBIT-EPS analysis
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Capital Structure Theory

Studies the relationship between

Capital structure


Debt/assets
Cost of capital

Value of the firm
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Capital Structure Models

The simplest model considers only


Taxes
More complex models account for

Taxes

Financial distress costs

Agency costs
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Modigliani and Miller (MM) On
Capital Structure

Assumed perfect capital markets
including




No taxes
No bankruptcy (B) costs
No agency (A) costs
If leverage increases, the cost of
equity, ke, increases to exactly offset
the benefits of more debt financing, kd,
leaving the cost of capital, ka, constant.
see model 1
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Model 1 (MM)
Cost of
Capital
ke
ka
kd
The overall cost of capital is independent
of the capital structure. The firm’s value
is independent of the capital structure.
Debt
Total
Assets
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MM Arbitrage Proof


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Value (V) of U = D/ke
Value (V) of L = D/ke + I/kd
D paid to L’s stockholders are reduced by
the amount of I paid on the debt.
ke is higher for L because of the additional
leverage-induced risk.
The values of U and L are identical due to
arbitrage.
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What Happens with Taxes ?





Same two equations
VU = D/ke
VL = D/ke + I/kd
D distributed to U’s stockholders are
reduced by the taxes paid on operating
income and the value of U drops.
Since I is tax deductible, L realizes a tax
savings.
PV of tax shield = value of debt (B)  tax
rate (T).
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VL = VU + Value of Tax Shield
Mkt
Value
of Firm
VL
PV
of
Tax Shield
VU
Debt $
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Model 2 (MM with taxes)
Cost of
Capital
ke
ka
ki = kd (1 – T)
Debt
Total Assets
The cost of capital decreases with the amount of debt. The firm
maximizes its value by choosing a capital structure that is all debt.
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What Happens With Taxes,
Bankruptcy, and Agency Costs ?



B&A costs increase with the amount of
leverage.
Eventually offsets the marginal benefits
from the value of the tax shield
Market value of leveraged firm
= Market value of unleveraged firm
+ PV of tax shield
– PV of bankruptcy costs
– PV of agency costs See optimal debt ratio slide
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Bankruptcy Costs

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Lenders may demand higher interest
rates.
Lenders may decline to lend at all.
Customers may shift their business to
other firms.
Distress incurs extra accounting & legal
costs.
If forced to liquidate, assets may have to
be sold for less than market value.
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Agency Costs
Stockholder-Bondholder Relationship




Investing in projects with high risk and high
returns can shift wealth from bondholders to
stockholders.
Stockholders may forgo some profitable
investments in the presence of debt.
Stockholders might issue high quantities of new
debt and diminish the protection afforded to
earlier bondholders.
Bondholders will shift monitoring and bonding
costs back to the stockholders by charging
higher interest rates.
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Optimal Debt Ratio
Market Value
of the Firm
PV
B&A
Costs
VL
PV
of
Tax
Shield
VU
Optimal Debt Ratio
Debt
Ratio
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Model 3
Least Cost Capital Structure is Optimal
Cost of
Capital
Optimal capital structure
occurs where weighted
cost of capital is minimized
ke
ka
ki
0
Optimal Capital
Structure
B
B+E
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Other Impacts on the Optimal
Capital Structure

Personal tax effects

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Industry effects

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Profitability and bankruptcy patterns
Signaling effects


Could reverse some tax benefits
Asymmetric information
Managerial preferences

Pecking order theory
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Capital Structure Implications for
Managers


A centrally important management
decision
Benefits of the tax shield from debt
provide an incentive to use debt
financing.
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To the point that increasing A&B costs
offset the debt advantage
Info on debt: http://www.thomsoninvest.net/
Optimal capital structure is heavily
influenced by business risk.
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Capital Structure Implications for
Managers

Changes in capital structure signal important
information to investors.

Pecking order theory

Internal equity
First choice

Debt

External equity Least preferred by management
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LBO (Leveraged buyout)


Can eliminate agency problems
Increased operating efficiencies are often
achieved.




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Eliminating jobs
Reducing other payroll expenses
Closing inefficient plants
Bondholders typically realize a loss in the
value of their bonds.
Ethical issues



Is it in the long-run interest of employees?
Are bondholders harmed in a LBO?
Managers acting as both buyers and sellers
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Multinational Firms
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Have more complex capital structure decisions
Finance investments in host country funds
Some countries use more financial leverage than
others.
Some host countries restrict foreign investment.
Risk of expropriation
Some host countries provide low-cost financing.
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