Rest of Chapter 14


Capital Structure
M&M (Modigliani and Miller) concepts
2
skim






Capital structure refers to the mix of a firm’s debt
and equity financing
Financial leverage refers to using borrowed money
to enhance the effectiveness of invested equity
Measured with the debt ratio (TL/TA)
More leverage means more risk (measures used
debt ratio, TIE, and DFL)
Higher leverage increases the company’s beta
(higher cost of equity)
More risk means a higher cost of capital (higher
required rate of return on investments)
3





Equity at a point in time is fixed
Add equity over time with retained earnings
Do not have easy access to equity capital
market
Capital structure is an extremely important
business decision and directly affects the size
of the business
Trade off of more risk as additional debt is
taken versus the additional return from
adding the debt
4
skim




Capital structure is independent (mostly) of
the size of the company and its asset mix
The question is: can the use of debt
increase the firm’s stock price?
An optimal capital structure maximizes
stock price
The relationship between capital structure
and stock price is not precise nor fully
understood
5




Borrowing money (leverage) is used to
increase average ROE and EPS
The use of borrowed money incurs interest,
which increases DFL and decreases TIE
When the rate of return (BEP) is greater than
the interest rate then financial leverage will
improve a firm’s ROE and EPS
However, if BEP is lower than the interest rate
then borrowing money will worsen EPS and
ROE
6

Return on Capital Employed (ROCE)
◦ Measures the profitability of operations before
financing charges but after taxes on a basis
comparable to ROE
ROCE =



EBIT 1 - tax rate 
debt + equity
When the ROCE exceeds the after-tax cost of debt,
more leverage improves ROE and EPS
When ROCE is less than the after-tax cost of debt,
more leverage makes ROE and EPS worse
BEP: Can compare
to pre tax interest rate.
7
As the firm’s debt
ratio rises, both
EPS and ROE rise
dramatically. While
EAT falls, the
number of shares
outstanding falls at
a faster rate as
debt replaces
equity.
8
ABC is now
doing rather
poorly—ROE and
ROCE are quite
low. As the firm
adds leverage,
EPS and ROE
decrease.
9

Leverage enhances returns while it adds risk,
pushing stock prices in opposite directions
◦ Enhanced performance increases dividends, which
increases the PV of dividends per share (driving up
the stock’s price)
◦ The increased risk increases the stocks beta and
this decreases the PV of dividends per share (drives
down the stock’s price)
 Which effect dominates is a big question?

Principle of increasing. Risk increases at an
increasing rate as leverage increases.
◦ At low leverage an increase in debt increases risk a
little
◦ At high leverage an increase in debt increases risk a
lot
10



When leverage is low an increase in debt has
a positive effect on stock prices
At high debt levels concerns about risk
dominate and adding more debt decreases
the stock’s price
As leverage increase its effect goes from
positive to negative, which results in an
optimum capital structure
11
12

There is no way to determine the exact optimum
amount of leverage for a particular company at a
particular time
◦ Appropriate level tends to vary according to
 Nature of a company’s business
 If firm has high business risk (DOL) it should use less
leverage
 Economic climate
 If the outlook is poor investors are likely to be more sensitive
to risk


As a practical matter the optimum capital structure
is a guess
The best we can usually do is compare to the
industry average
13

A firm’s target capital structure that we use in
calculating the WACC is management’s
estimate of the optimal capital structure
◦ An approximation or best guess as to the amount
of debt that will maximize the firm’s stock price
14

Restrictive Assumptions in the Original Model
◦ In 1958 MM published their first paper on capital
structure
 Included numerous restrictions such as
 No income taxes
 Securities trade in perfectly efficient capital markets with
no transaction costs
 No costs to bankruptcy
 Investors and companies can borrow or lend as much as
they want at the same rate
15

The Result
◦ Under MM’s initial set of restrictions, value is
independent of capital structure
◦ As cheaper debt is added the cost of equity
increases because of increased risk
 However the weight of the more expensive equity is
decreasing while the weight of the cheaper debt is
increasing, leading to a constant weighted average
cost of capital
 Thus the PV of the firm does not change
16


The Assumptions and Reality
◦ Income taxes exist and favor debt
◦ The costs of bankruptcy are quite large
◦ Individuals cannot borrow at the same rate as
companies and interest rates usually rise as more
money is borrowed
Interpreting the Result
◦ The MM result implies that leverage affects value
because of market imperfections
 Such as taxes and transaction costs (including
bankruptcy)
17

Financing and the U.S. Tax System
◦ Tax system favors debt financing over equity financing
 Interest expense on debt is tax deductible while dividends
on stock are not

Bankruptcy costs
(favor equity financing)
◦ Greater chance of incurring cost as more debt is used,
thus causes value of stock to decline at some point as
risk gets too high


Interest rate on debt rises as debt increases –
causing stock price to decline at some point
Relaxing MM assumptions suggests that an optimal
amount of debt exists for a corporation, but doesn’t
really help us find it.
18
Capital Structures
Around the World
Capital Structure Percentages for Selected Countries Ranked by Common Equity
Ratios, 1995
Country
Equity
United Kingdom
United States
Canada
Germany
Spain
France
Japan
Italy
68.3%
48.4
47.5
39.7
39.7
38.8
33.7
23.5
Total Debt Long-Term Short-Term
Debt
Debt
31.7%
N/A
N/A
51.6
26.8%
24.8%
52.5
30.2
22.7
60.3
15.6
44.7
60.3
22.1
38.2
61.2
23.5
37.7
66.3
23.3
43.0
76.5
24.2
52.3
Source: Essentials of Managerial Finance by Besley and Brigham