EMBA 514
Capital Structure
Theory
1
Capital Structure Effects on Value

The impact of capital structure on value
depends upon the effect of debt on:
 WACC
 Feedback
to FCF

EV  
t 1
FCFt
t
(1  WACC )
2
Cost of Equity effect



In seeking to minimize the WACC, firms trade-off
the benefit of using more lower cost debt against
a rising cost of equity
We need an equation for how the cost of equity
might be expected to behave as debt increases
The Modigliani and Miller model provides a
framework for estimating the cost of equity at
different capital structures
3
Modigliani and Miller Assumptions

No taxes

All debt is riskless, so the cost of debt is constant

no possibility of default

Capital structure has no impact on operating cash flows

No agency costs

No information asymmetry

Perpetual cash flows
4
In MM Enterprise Value depends
entirely on level and volatility of EBIT
Current Assets
-
Oper. Current Liab.
Net Working Capital
PP&E
Debt
Equity
Capital investment generates

EBIT = Free Cash Flow here
EV  
t 1
FCFt
(1  WACC )t
Same EBIT, same risk (WACC), same Enterprise Value
5
MM Proposition 1 with Zero
Taxes

Under the previous restrictive assumptions, we can argue
that two firms with the same EBIT and variance in EBIT (‘operating
risk’) should have the same Enterprise Value (Debt + Stock)

VL = VU = EBIT capitalized at WACC (zero growth and no
tax, so EBIT=NOPAT=FCFF)
V
EBIT
WACC
EBIT
V
rsU
For an unlevered company, the cost of equity (rsU) is the same as
WACC, since the capital structure is 100% equity
6
MM Proposition 2 with Zero
Taxes

The cost of equity of a levered firm (rsL) is equal to the cost
of equity of an unlevered firm plus a risk premium which
depends on the degree of financial leverage.
rsL  rsU  (rsU  rd )

D
S
proof shown below
Reductions in capital costs as a result of using more lower
cost debt (rd) are exactly offset by increases in the cost of
levered equity (rsL) due to added financial risk.

As a result the WACC is constant at all debt levels, as is Enterprise
Value (V)
7
Proposition 2 equation for the
levered cost of Equity (see MM
example in Excel)
For a zero-growth company with no taxes, Free Cash Flow to Equity =
Net Income = EBIT – Interest Expense = EBIT - rdD
(1)
(2)
EBIT  rd D
S
EBIT
V SD
rsU
rsL 
From Proposition 1
EBIT  rsU (S  D)
rsL 
EBIT = Return to capital x Capital
rsU ( S  D)  rd D
S
rsL  rsU  (rsU  rd )
D
S
Substitute (2) into (1)
This is the Proposition 2 equation
8
MM Proposition 2: No taxes
Cost of
Capital (%)
rs
rsU
WACC
rd
Debt/Value
Ratio (%)
9
MM Proposition 1 with Taxes

The value of an unlevered firm is equal to EBIT (1-T)
capitalized at the cost of equity
VU 

EBIT(1  T )
rsU
The value of a levered firm is equal to the value of an
unlevered firm of the same risk class, plus the value of the
interest tax savings capitalized at the cost of debt
VL  VU 
rd TD
 VU  TD
rd
10
MM Proposition 2 with Taxes

The cost of equity of a levered firm is
equal to the cost of equity of an
unlevered firm plus a risk premium
which depends on both the degree of
leverage and the corporate tax rate.
11
MM Proposition 2 with Taxes
(1)
(2)
rsL 
EBIT(1  T )  rd D(1  T )
SL
rsL 
VL 
(3)
( EBIT  rd D)(1  T )
SL
EBIT(1  T )
 TD
rsU
The no-tax eq (1) with taxes
Rearrange (1)
From proposition 1
VL rsU  EBIT(1  T )  rsU TD
Rearrange
EBIT(1  T )  (VL  TD)rsU
Rearrange
rsL 
(VL  TD)rsU  rd D(1  T )
SL
rsL 
VL rsU  TDrsU  rd D  rd TD
SL
Substitute (3) into (2) for EBIT(1-T)
Rearrange
12
MM Proposition 2 with Taxes
VL rsU  TDrsU  rd D  rd TD
SL
(4)
rsL 
(5)
VL  S L  D
rsL 
Last equation from prior slide
Value = Stock + Debt
S L rsU  DrsU  TDrsU  rd D  rd TD
SL
rsL  rsU  (rsU  TrsU  rd  rd T )
rsL  rsU  (rsU  rd )(1  T )
D
SL
D
SL
Substitute (5) into (4)
Factor out D/S
This is Proposition 2 with taxes
13
MM Proposition 2 with Taxes
D
rsL  rsU  (rsU  rd )(1  T )
SL
Risk premium now includes (1-T)

rsL increases with leverage at a slower rate when corporate taxes
are considered.

Taxes are an additional variable cost that reduce the variability in
cash flow.

The government now shares in the risk of the cash flows.

The WACC continues to decline as new debt is added, and entity
value continues to rise. Pile on the debt!
14
MM Proposition II: With taxes
Cost of
Capital (%)
rsU
rs
WACC
rd(1 - T)
Debt/Value
Ratio (%)
15
MM relationship between value and debt
with taxes
Value of Entity, V (%)
VL
TD
VU
VU
Debt
VL = VU + TxD
16
Adjusting Beta for Capital Structure
Effects

In practice, the effect of capital structure on the Equity
cost of capital is recognized by adjusting Beta in the
Capital Asset Pricing Model




MM theory implies that beta increases with leverage
As firms borrow, they create fixed costs (interest
payments) that make their cash flows to equity investors
more volatile (financial risk)
This increased earnings volatility increases the equity
Beta
Need equation for beta as a function of leverage

Hamada’s Equation
17
Hamada’s Equation
rsL  rRF  BL (rM  rRF )
CAPM equation for a levered firm
rsU  rRF  BU (rM  rRF )
CAPM equation for an unlevered firm
rd  rRF
Riskless debt assumption
rsL  rsU  (rsU  rd )(1  T )
D
S
Proposition 2
Substitute levered CAPM in left side of Proposition 2 and unlevered CAPM in right side:
rRF  BL (rM  rRF )  rRF  BU (rM  rRF )  [rRF  BU (rM  rRF )  rRF ](1  T )
rsL
rsU
rsU
D
S
rd  rRF
Cancel the rRF and divide by (rM-rRF)
D
S
D

BL  BU 1  (1  T ) 
S

BL  BU  BU (1  T )
Hamada’s Equation
18
Trade-off Theory

MM theory assumes away financial distress costs, which
increase as more leverage is used:
 Higher debt costs, including negotiation and monitoring
by creditors (MM assume constant cost of debt)
 Feedback to Free Cash Flow


Growth





Rejection of +NPV investments (under-investment)
Growth prospects suffer as business reduces R&D and
Marketing expenditures
Loan covenants, which constrain growth
Fire sales of assets to raise cash
Lost customers, suppliers, and employees
Investment in Capital increases as lose trade credit
Contradicts assumption of MM that capital structure
doesn’t effect operating cash flows
19
Trade-off Theory (cont.)

Trade-off theory suggests optimal capital
structure is reached at point where
marginal distress costs exceed the
marginal tax benefit from adding debt in
the MM model.

At this same point the WACC is minimized
and entity value is maximized.
20
Trade-off tax shield against distress
costs
VL
VL = VU + TD
Distress costs
Max VL
VL = VU + TD – distress
VU
VL = Total value with debt
VU = Total value with no debt
T = Tax rate
D = Debt
Optimal
Debt Level
Debt
21
Trade-off theory suggests these types of
firms will use more debt (least impacted by
financial distress)






Low growth opportunities (predictable funds needs and
less risk of jeopardizing growth investments)
High and stable free cash flow
Large size (safety and lower growth)
Marketable collateral (less service or R&D intensive)
Product not subject to ongoing maintenance/warranties,
observable quality
Profitable enough to benefit from tax shelter
22
Debt can reduce Equity Agency
Costs

Equity agency problem is that managers
might:
 use corporate funds for non-value maximizing
purposes (e.g. perks, acquisitions, valuedestroying growth)
 or seek low risk due to undiversified interest in firm

Problem is most significant in large firms with
diffuse stockholders where management
ownership is low
23
Debt can reduce Equity Agency
Costs (cont.)

The use of financial leverage:
 Bonds free cash flow for firms generating
more cash than required to fund +NPV
opportunities, reducing perk consumption and
value-destroying growth.
 Increases free cash flow by forcing
efficiencies: failure risk gets managers’
attention
24
Signaling Theory



MM assumed that investors and managers have the
same information.
Where significant information asymmetries exist,
stockholders assume:
 Stock issues may indicate lower expected FCF,
unwilling to commit to increased debt service
 Company issues new stock when it is overvalued
 Bonds are issued when stock is undervalued
Leverage-decreasing events signal overvalued stock,
and vice versa, supported by empirical data
25
Signaling theory results in Pecking
Order Hypothesis






Firms will choose the following sequence of funding
sources to maintain financial flexibility and avoid
negative signals
Maintain
Retained earnings
borrowing
Excess cash
capacity
Debt issuance
Stock issuance
Maintenance of borrowing capacity is most important for
high-growth firms, where value depends on the ability to
fund growth investments
26
Evidence on Signaling Theory

Profitable firms use less debt (surprise) because
they can build more equity internally
 Contradicts
Trade-off theory which suggests they
should have high debt due to low default risk and
need for tax shelters
 Suggests capital structure decision is a residual that
depends on cash flow, and the investment and
distribution decisions

Mature firms issue stock very infrequently
27
Steps in the distribution decision
How many + NPV investments?
Reinvestment:
Capex +
Working Capital
NOPAT
Free
Cash
Flow
How much will you borrow?
How much cash on
CF to Debt:
Principal +
Interest
Balance Sheet?
Cash held on
Balance Sheet
Cash flow
available
to stockholders
Cash paid out
Which type of distribution?
Repurchases
Dividends
Suggest stock repurchases are a residual from the FCF forecast
Evidence on Signaling Theory (cont.)

1.
2.
3.
4.

When setting capital structure targets, survey
evidence indicates managers consider, in rank
order:
Financial Flexibility
Long-term survival
Maintenance of predictable funds sources
Maximization of stock price
Suggests concerns over feedback to operating
performance
29
Summing the theories
This leaves us with:
VL = VU + tax benefit – financial distress
+ equity agency + signaling
Capital structure decision requires judgment!
30
Practical approach to quantifying
capital structure choice




Use Hamada’s equation to estimate changes in
cost of Equity
Use credit ratios to estimate changes in cost of
debt
Find weights where WACC is minimized
Compare result to peers and use judgment to
incorporate the other factors:
1) financial distress; 2) agency; 3) signaling
See Excel example
31
Additional considerations in
setting the target capital structure

Effect on sustainable growth:
willingness to increase debt allows for
higher growth rate today
Sustainable g = ROE x (1 – Dividend Payout Ratio)
ROE = ROIC + [ROIC - rd(1-t)] x D/E
Example of target D/E given target growth:
Dividend payout = 40%; Target growth = 15%;
ROIC = 12%; rd(1-t) = 5.5%
Required ROE = g ÷ (1-DPR) = .15 ÷ (1-.40) = 25%
Required D/E = (25% - 12%) ÷ (12% - 5.5%) = 2.0
See Excel example
32
Additional considerations in
setting the target capital structure (cont.)

Lender and rating agency attitudes
(impact on credit ratings)

Debt ratios of other firms in the industry

Risk aversion of managers

Intersection with distribution policy
33
Additional considerations in
setting the target capital structure (cont.)

Use debt to retain control and avoid
takeover
 Realize
value of tax shield to boost stock price
 Concentrate
ownership in friendly hands
 Signal
operating improvements that will lead to
increased profit and stock price
 Signal
strategy to disgorge excess FCF
34