Capital Structure
Damodaran:
Chapter 17: 6,8,10,16,24
Chapter 18: 4,6,10a-e,20,24
Chapter 19: 6,12,18,22
I. Characteristics of common stock, preferred stock, & debt securities.
Debt vs. Equity
Fixed vs. residual claim
Tax treatment
Priority in liquidation
Finite life
voting rights
private vs. public securities
Choices in issuing Debt securities:
• security
• seniority
• callable
• convertible (value of equity component = value of convertible - value of straight
bond)
• covenant structure
• maturity structure
Capital structure - 1
II. Modigliani-Miller (MM) Capital Structure Propositions
Assumptions include:
Homogeneous expectations,
Homogeneous business risk classes
Perpetual cash flows: V = CF/r
Perfect capital markets:
No taxes, transaction costs, costs of distress
Firms and investors borrow and lend at the
same rate rd
MM Proposition I: VL = VU
MM Propositions II: re = ra + D/E(ra - rd)
Extensions:
MM with corporate taxes: VL = VU + TcD
Capital structure - 2
The Impact of Financial Leverage.
Example - Financial Leverage, EPS and ROE:
Assets
Debt
Equity
Debt/Equity ratio
Share price
Shares outstanding
Interest rate
Current
Proposed
$5,000,000
$5,000,000
$
0
$2,500,000
$5,000,000
$2,500,000
0
1
$10
$10
500,000
250,000
na
10%
Capital structure - 3
EPS and ROE under current capital structure
EBIT
Interest
Net Income
Recession
Expected
Expansion
$300,000
$650,000
$800,000
$
0
$
0
$
0
$300,000
$650,000
$800,000
EPS
$0.60
$1.30
$1.60
ROE
6%
13%
16%
EPS and ROE under proposed capital structure
Recession
Expected
Expansion
EBIT
$300,000
$650,000
$800,000
Interest
$250,000
$250,000
$250,000
$50,000
$400,000
$550,000
EPS
$0.20
$1.60
$2.20
ROE
2%
16%
22%
Net Income
Capital structure - 4
Ignoring taxes for the moment, consider the following 2 alternatives:
Firm does not adopt proposed capital structure.
An investor puts up $500 and borrows $500 to buy 100 shares
EPS of
unlevered firm
$0.60
$1.30
$1.60
Earnings for
100 shares
$60.00
$130.00
$160.00
less interest on
$500 at 10%
$50.00
$50.00
$50.00
Net earnings
$10.00
$80.00
$110.00
16%
22%
ROE
2%
The ROE is the same as that of the levered firm.
Firm adopts proposed capital structure.
An investor puts up $500, $250 in stock and $250 in bonds
EPS of
levered firm
$0.20
$1.60
$2.20
Earnings for
25 shares
$5.00
$40.00
$55.00
plus interest on
$250 at 10%
$25.00
$25.00
$25.00
Net earnings
$30.00
$65.00
$80.00
ROE
6%
13%
The ROE is the same as that of the unlevered firm.
16%
With no taxes, WACC = RA = (E/V) x RE + (D/V) x RD .
Solving for RE,
RE = RA + (RA - RD)x(D/E)
Capital structure - 5
Debt & Taxes
PV of the interest tax shield = (TC x RD x D)/RD = TC x D.
Limits to use of debt: bankruptcy & distress costs.
An optimal capital structure will balance the valuable interest tax shield against the
higher probability of facing bankruptcy costs.
Direct costs of financial distress
Indirect costs of financial distress
Capital structure - 6
Capital structure - 7
III. Agency costs of debt & equity:
Excessive consumption of percs
Overinvestment in risky projects
Underinvestment in +NPV projects
An optimal capital structure balances the agency costs of debt vs. equity.
IV. Pecking order theory of capital structure
V. Empirical Implications of Capital Structure Theories
Effects of changing capital structure
Stock repurchases
Debt/equity swaps
Capital structure - 8
Example: Optimal capital structure
Firm invests $500,000 in PPE, WC; generates EBIT of $120,000 in perpetuity
100% dividend payout; capex = depreciation; no sales growth; tax rate = .5
1. Debt in capital structure
2. EBIT
3. Interest
4. Profit before tax
5. Tax
6. Profit after tax
7. Dividends
8. Total pmts to security
holders
0%
10%
20%
30%
40%
50%
$120,000 $120,000 $120,000 $120,000 $120,000 $120,000
0
4,125
8,750 14,625 22,000 31,250
120,000 115,875 111,250 105,375 98,000 88,750
60,000 57,938 55,625 52,688 49,000 44,375
60,000 57,938 55,625 52,688 49,000 44,375
60,000 57,938 55,625 52,688 49,000 44,375
60,000 62,063 64,375 67,313 71,000 75,625
9. Cost of debt
10. Cost of equity
8.00%
12.00%
11. Market value of debt
12. Market value of equity
13. Market value of firm
0 50,000 100,000 150,000 200,000 250,000
500,000 463,500 427,885 390,278 337,931 277,344
500,000 513,500 527,885 540,278 537,931 527,344
14. Book value of debt
15. Book value of equity
16. Book value of firm
17. Return on total capital
18. Return on equity
0 50,000 100,000 150,000 200,000 250,000
500,000 450,000 400,000 350,000 300,000 250,000
500,000 500,000 500,000 500,000 500,000 500,000
12.0%
12.4%
12.9%
13.5%
14.2%
15.1%
12.0%
12.9%
13.9%
15.1%
16.3%
17.8%
19. Number of shares
outstanding
20. Price per share
21. EPS
22. PE ratio
23. Book value debt ratio
24. Market value debt ratio
25. WACC
26. FCFF
27. Market value of firm
5,000
8.25%
12.50%
4,513
8.75%
13.00%
4,053
9.75%
13.50%
3,612
11.00%
14.50%
3,141
12.50%
16.00%
2,630
$100.00 $102.70 $105.58 $108.06 $107.59 $105.47
$12.00 $12.84 $13.73 $14.59 $15.60 $16.88
$8.33
$8.00
$7.69
$7.41
$6.90
$6.25
0.0%
10.0%
20.0%
30.0%
40.0%
50.0%
0.0%
9.7%
18.9%
27.8%
37.2%
47.4%
12.0%
11.7%
11.4%
11.1%
11.2%
11.4%
$60,000 $60,000 $60,000 $60,000 $60,000 $60,000
$500,000 $513,500 $527,885 $540,278 $537,931 $527,344
Capital structure - 9
VI. Implementing capital structure models.
Operating income approach
How much debt can the firm afford to carry based on its cash flows?
• Estimate the distribution for expected operating income
• Estimate the interest and principal payments for an given level of debt
• Estimate the probability that it will be unable to make these payments for any
given level of debt
• Specify a tolerance limit on the probability of being unable to meet debt
payments; and
• Find the debt level so that the estimated probability of being unable to meet
debt payments is just below the tolerance limit.
Cost of capital approach**
The optimal financing mix will result in a minimum cost of capital.
Return differential approach
Maximize the difference between the return on equity and the cost of equity.
APV approach**
Value of firm = value of unlevered firm + present value of tax benefits of debt –
present value of expected bankruptcy costs.
PV of expected bankruptcy costs = probability of bankruptcy * PV of bankruptcy
cost
Comparables approach
Debt ratio =
α0 + α1* tax rate + α2*pretax return + α3*variance in operating income
Capital structure - 10