PHASE III
CAPITAL STRUCTURE
Week #11
I. CAPITAL STRUCTURE
A. Structural Considerations.
Capital structure examines the right hand side (RHS) of the balance sheet. The entire
RHS is called the financial structure of the firm; it includes spontaneous sources of
funds (A/P and the accruals), funds obtained in the money markets (short term), and
funds obtained in the capital markets (long term). We are principally concerned with
long term capital (capital structure) obtained through sales of debt and equity.
The way in which a firm finances its asset structure is determined by several factors
in its operating environment. All firms are generally subject to the effects of business
and economic cycles. They are also affected by their labor-capital intensity (or the
degree to which they are automated, also called operating risk) and the extent to which
they use debt (financial risk). The dynamic interaction of these [and other] factors may,
in large part, determine how firms finance assets over time.
1. Business risk; variations in revenues over time.
2. Operating risk; the effects of the degree of operating leverage on EBIT.
3. Financial risk; the effects of the degree of financial leverage on EBT.
B. Optimal Capital Structure;
The existence of an optimal capital structure has been the subject of substantial
debate for more than three decades. While we will not resolve that issue here, the
general assumption made in the following material is that firms are observed to
maintain approximately the same capital structure over time. The central issue in the
debate is what variables affect the value of the firm in the long-run. Modigliani and
Miller (1958, 1961) suggest that the [market] value of a firm is equal to the
appropriately discounted present value of its future income streams and that capital
structure is irrelevant. The discount rate utilized is that which is appropriate for all
firms in a certain risk class. The lower the discount rate, the greater the present value
and the greater the value of the firm. The discount rate reflects the riskiness investors
perceive the company to have; the greater the risk, the higher the discount rate and the
lower the value of the firm. Others suggest that the discount rate is a function of the
firm's capital structure. How a firm mixes debt and equity in its capital structure
determines the weighted average cost of capital (WACC). It is the magnitude of the
WACC which determines the value of the firm. This is analogous to saying that the
value of the firm is equal to the market value of it's debt and equity issues. This is
widely known as the moderate view of capital structure. Herein, we follow the
moderate view; the rate at which future cash flows are discounted is a function of the
firms capital structure.
In the moderate view, the mix of debt and equity that minimizes the cost of capital
and maximizes the value of the firm is defined as the optimal capital structure. The
value of the firm is the appropriately discounted future after-tax cash flows; the greater
the discount rate (or weighted average cost of capital), the lower the PV of future aftertax cash flows, and the lower the value of the firm. Likewise, the lower the discount rate
the greater the value of the firm.
C. Cost Of Capital, Debt And Equity Mix.
1. Modigliani & Miller (1958, 1961);
a. the M&M propositions without taxes (1958).
b. the M&M propositions with taxes (1961).
The value of the firm is the present value of future benefit streams. M&M assume
perfect capital markets; i.e., no taxes or transaction costs, and trivial bankruptcy costs.
Even when taxes are considered, capital structure is irrelevant; The M&M propositions
suggest that given the deductibility of interest expenses, the optimal capital structure
would be one in which 100% debt financing is used.
2. DeAngelo & Masulis (1980);
a. firms have multiple tax shields.
b. capital structure is a affected by all tax shields.
Interest is tax deductible, depreciation and other noncash charges also provide tax
shields. The purpose of tax shields is to increase after-tax cash flows. The implication
is that we don't need to raise large amounts of debt to obtain minimum cost of capital.
Firms will use a blend of equity, debt, and depreciation strategies which result in
maximum cash flow consistent with the risk of the firm. The greater the magnitude of
cash flows the less "outside" capital is required to sustain growth. Hence, the lower the
cost of capital.
3. Black & Scholes; Common Stock in the Call-Option Hypothesis.
a. Bondholders; stockholders have an important option.
b. A strategy for stockholders;

common stock as call option on assets of the firm.

if profitable, stockholders exercise ownership rights.

if not, they can let the firm go bankrupt.

in essence, they expropriate wealth from bondholders.
c. Bondholders protect themselves by;

bond covenant provisions.

claims on collateral.

protections provide by law.
I.
The Empirical Evidence on Capital Structure Research
A. Black and Scholes [1973] Equity ownership in firm with outstanding debt can be
viewed
as a call option. When bonds are sold, equity holders receive cash plus a call option. If
at maturity of the debt the value of the firm is greater than the face value of debt, equity
holders "exercise" the call option and pay off the debt. If not, the equity holders let the
option expire and the debt holders receive the residual value of the firm.
If the value of the firm is related to the amount of debt when the call option hypothesis
is
valid. This is not in agreement with M&M.
B. Masulis [1980]; Studied Exchange Offers -> a change in leverage w/o other changes.
(a pure financial event) When leverage is increased, there is a immediate increase in
stock price; for leverage decreasing events, there is a stock price drop. Both results are
statistically significant. One problem in the former is that existing debt holders may
experience some expropriation of wealth, especially if new debt is not subordinated.
C. Jensen and Mecklin [1976]; The special problems of Agency.
Suppose the equity holders drive a shift to more risky ventures. When debt is used to
finance new ventures, the new debt holders faced an increased probability of not being
paid.
1. The cost of equity rises as debt use increases.
2. The cost of debt may also rise, especially if bankruptcy costs are non-trivial.