Contemporary Financial Management
Chapter 12:
Capital Structure Concepts
© 2004 by Nelson, a division of Thomson Canada Limited
Introduction
 This chapter examines the basic concepts
related to a firm’s optimal capital structure.
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© 2004 by Nelson, a division of Thomson Canada Limited
Capital Structure Theory
 Studies the relationship between:
 Capital structure
• The mix of debt & equity securities on the right
hand side of the Balance Sheet
 Cost of capital
• The return demanded by investors
• Impacts on the value of the firm
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© 2004 by Nelson, a division of Thomson Canada Limited
Capital vs. Financial Structure
 Capital Structure
 Amount of permanent short-term debt, longterm debt, preferred shares and common equity
used to finance the firm.
 Financial Structure
 Amount of current liabilities, long-term debt,
preferred shares and common equity used to
finance a firm.
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Capital Structure Terminology
 Optimal capital structure
 Minimizes a firm’s weighted average cost of
capital (WACC)
 Maximizes the value of the firm
 Target capital structure
 Capital structure the firm plans to maintain
 Debt capacity
 Amount of debt in the firm’s optimal capital
structure
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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
 Debt holders
 Preferred shareholders
 Common shareholders
 Fixed investment policy leaves the debt capacity
of the firm unchanged
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Factors Affecting Capital Structure
 Business risk of the firm
 Tax structure
 Bankruptcy potential
 Agency costs
 Signaling effects
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Factors Affecting Business Risk
 Variability of sales volume
 Variability of selling price
 Variability of input costs
 Degree of market power
 Extent of product diversification
 Firm’s growth rate
 Degree of operating leverage (DOL)
 Both systematic and unsystematic risk
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Financial Risk
 The variability of earnings per share (EPS)
 Financial risk affects the probability of
bankruptcy
 Indicators of financial risk







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Debt to assets ratio
Debt to equity ratio
Fixed charge coverage ratio
Times interest earned ratio
Degree of Financial Leverage
Probability distribution of profits
EBIT-EPS analysis
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Three Capital Structure Models
Capital Structure With
No Taxes
Optimal Capital Structure With
Taxes
Optimal Capital Structure With
Taxes, Financial Distress Costs & Agency Costs
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© 2004 by Nelson, a division of Thomson Canada Limited
Capital Structure is Irrelevant
 Modigliani & Miller (MM) were the pioneers in
developing the theory of capital structure
 MM began by assuming perfect capital
markets, including:
 No taxes
 No bankruptcy (B) costs
 No agency (A) costs
 MM also recognized that debt will always cost
less than equity because:
 Interest is tax deductible
 Debt securities are less risky than equity
securities
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© 2004 by Nelson, a division of Thomson Canada Limited
MM’s Two Propositions
 Proposition #1:
 The market value of the firm is independent of
capital structure. Therefore, capital structure is
irrelevant.
 Proposition #2:
 The cost of capital remains constant as capital
structure changes. As the quantity of debt
rises, the return demanded by the shareholder
increases linearly, exactly offsetting the benefit
due to the lower cost of debt.
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Modigliani & Miller on Capital Structure
If leverage increases, the cost of equity, ke,
increases to exactly offset the benefits of more
debt, leaving the cost of capital, ka, constant.
Cost of Capital (%)
ke
ka
kd
Financial Leverage (Debt-to-equity ratio)
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MM Arbitrage Proof
 Market value of the firm:
Market value of equity + Market value of debt
 Value of firm with no debt:
Dividends
V=
ke
 Value of firm with debt:
Dividends
Interest
V=
+
ke
kd
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Example: Value of an Unlevered Firm
 A firm with no debt pays out $1 Million in
dividends. If shareholders require a 20%
return, what is the market value of the firm?
Dividends
V 
ke
$1, 000, 000

0.20
 $5, 000, 000
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Example: Value of a Levered Firm
 The same firm now acquires debt at 10%, on
which it pays interest of $250,000. Since this is
world with no taxes, the firm has $750,000
which it pays in dividends. Since the firm is now
more risky, shareholders require a 30% return.
What is the market value of the firm?
V 
Dividends
Interest

ke
kd
$750, 000 $250, 000

0.30
0.10
 $2,500, 000  2,500, 000  $5, 000, 000

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Why?
 Dividends paid to shareholders of the levered
firm are reduced by the amount of interest paid
on the debt.
 ke is higher for the levered firm because of the
additional leverage-induced risk.
 The values of the levered and the unlevered firm
are identical due to arbitrage.
 Thus MM’s Proposition #1: the value of the firm
is independent of capital structure (in a world
with no taxes)
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What Happens with Taxes ?
 The firm’s operating income is now reduced by
the amount of taxes paid
 Since dividends to shareholders are paid out of
after-tax income, the value of the unlevered firm
should drop
 But interest is a tax-deductible expense,
creating a valuable tax-shield
 The result - the value of the levered firm should
be higher than the value of the unlevered firm
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© 2004 by Nelson, a division of Thomson Canada Limited
The Tax Shield due to Interest
 A tax shield is the amount of tax the firm
would have paid, had it not incurred the
interest expense.
 The annual tax shield is equal to:
Annual Tax Shield = i×D×T
 The PV of the tax shield is equal to:
i×D×T
PVTax Shield=
= D×T
i
I = interest rate
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D = Face value of debt
© 2004 by Nelson, a division of Thomson Canada Limited
T = Tax rate
Example: The Impact of Tax
Firm U
EBIT
$1,000
$1,000
0
100
1,000
900
Less Tax @ 40%
400
360
Income (for Dividends)
600
540
Interest + Dividends
600
640
Return on debt
-
5%
Market value of debt
-
2,000
10%
11.25%
Market value of equity
$6,000
$4,800
Market value of firm
$6,000
$6,800
Less Interest
Income before Tax
Return on equity
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Firm L
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Market Value of the Unlevered Firm
 Market value of the firm:
Market value of equity + Market value of debt
VUnlevered
Firm
Dividends
=
ke
600
=
0.10
= $6,000
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© 2004 by Nelson, a division of Thomson Canada Limited
Market Value of the Levered Firm
 Market value of the firm:
Market value of equity + Market value of debt
VLevered
Firm
Dividends
Interest
=
+
ke
kd
540
100
=
+
0.1125
0.05
= $6,800
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© 2004 by Nelson, a division of Thomson Canada Limited
Why the Difference?
 The difference in value between the levered and
the unlevered firm in a world including taxes is
due to the value of the tax shield
 Therefore:
 Market value (MV) of levered firm =
MV of unlevered firm + PV of the tax shield
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© 2004 by Nelson, a division of Thomson Canada Limited
VL = VU + Present Value of Tax Shield
Mkt
Value
of Firm
VL
PV of
Tax Shield
VU
Debt $
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© 2004 by Nelson, a division of Thomson Canada Limited
Capital Structure
The cost of capital decreases with the amount of
debt. The firm maximizes its value by choosing
a capital structure that is all debt.
Cost of Capital (%)
ke
ka
ki = kd (1 – T)
Financial Leverage (Debt-to-equity)
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© 2004 by Nelson, a division of Thomson Canada Limited
The Problem?
 If the value of the firm increases linearly with
debt, the logical conclusion would be that all
firms should be financed with 100% debt!
 This conclusion defies logic and is counter to
customary practice
 What are we missing?
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© 2004 by Nelson, a division of Thomson Canada Limited
Financial Distress (Bankruptcy) Costs
 Financial distress costs include:
 Costs incurred to avoid bankruptcy
• Pay higher interest rates due to greater risk
 Direct & indirect costs incurred if the firm files
for bankruptcy
• Direct costs – costs paid by debtors in the
bankruptcy & restructuring process
• Indirect costs – costs due to loss of customers,
suppliers, employees plus the cost of
management’s time
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Bankruptcy Costs
 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 and legal costs
 If forced to liquidate, assets may have to be sold
for less than market value
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Agency Costs
 The firm’s debt & equity holders (the principals)
are usually not the firm’s managers
 The principals employ agents (firm
management) to manage the firm on their
behalf
 Conflicts often develop between the interests of
the principals and the interests of the agents
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Agency Costs & Shareholders
 Shareholders have an incentive to undertake
risky projects financed with debt
 If the project succeeds, the shareholders win
 If the project fails, the bondholders suffer the
loss
 Therefore, bondholders will
 Charge higher interest rates, or
 Implement protective covenants to protect
themselves
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Agency Costs & Shareholders
 Investing in high risk/high return projects can
shift wealth from bondholders to shareholders
 Shareholders may forgo some profitable
investments in debt is required
 Shareholders may issue high quantities of new
debt, diminishing the protection afforded to
earlier bondholders
 Bondholders will shift monitoring and bonding
costs back to the shareholders by charging
higher interest rates & imposing covenants
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Taxes, Bankruptcy and Agency Costs
 Bankrupcty and agency costs increase with the
amount of leverage
 At some point, these offset the positive benefits
from the value of the tax shield
Market value of unlevered firm
+ PV of tax shield
– PV of bankruptcy costs
– PV of agency costs
Market value of leverage firm
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© 2004 by Nelson, a division of Thomson Canada Limited
Optimal Debt Ratio
Market Value
of the Firm
PV
B&A
Costs
VL
PV
of
Tax
Shield
VU
Optimal Debt Ratio
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© 2004 by Nelson, a division of Thomson Canada Limited
Debt
Ratio
Least Cost Capital Structure
Cost of
Capital
ke
ka
ki
Optimal Capital
Structure
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© 2004 by Nelson, a division of Thomson Canada Limited
D
D+E
Other Considerations
 Personal tax costs (interest is fully taxable)
 Could offset some corporate tax advantages
 No optimal capital structure when both
corporate & personal taxes are considered
 Industry effects
 Firms with stable cash flows tend to have higher
debt ratios
 More profitable firms tend to have lower debt
ratios
 Market appears to reward firms with capital
structures appropriate to their industry
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© 2004 by Nelson, a division of Thomson Canada Limited
Other Considerations
 Signaling effects (Asymmetric Information)
 Firm management have access to confidential
information
 Management decisions may be a signal to the
market
 Managerial preferences (Pecking order theory)
 Firms prefer internal to external financing
• New issues incur flotation costs
• External financing incurs more monitoring by the
market
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Pecking Order Theory
 Firms have a definite preference in the order in
which they finance new projects
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Most
Preferred
Least
Preferred
Internal
Equity
External
Equity
Debt
© 2004 by Nelson, a division of Thomson Canada Limited
Major Points
 Choosing an appropriate capital structure is an
important management decision
 In a world with no taxes, the value of the
unlevered firm equals the value of the levered
firm
 In a world with taxes, interest creates a valuable
tax shield.
 The value of the levered firm equals the value of
the unlevered plus the PV of the tax shield
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© 2004 by Nelson, a division of Thomson Canada Limited
Major Points
 Financial distress & agency costs increase as
debt rises, eventually offsetting the marginal
value of the interest tax shield
 Optimal capital structures appear to be
influenced by
 Variability of cash flows
 Nature of the industry
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© 2004 by Nelson, a division of Thomson Canada Limited