Capital Structure Decisions
Professor Artur Raviv
Kellogg School of Management
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Capital Structure decisions
Discussion Agenda
A. What is Financial Leverage
B. Effects of Leverage
C. Optimal Financing in Perfect Markets
D. Optimal Financing in Imperfect Markets
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What is Financial Leverage

All-equity Firm
A firm that uses only equity to finance
operations is called an all equity or an
unleveraged firm.
Equity Value
Debt Value
Firm Value
E
=
V
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What is Financial Leverage

Leveraged Firm
A firm that uses sources of financing other
then equity, typically debt, has financial
leverage and is called a leveraged firm.
Equity Value
Debt Value
Firm Value
D+E
=
V
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Effects of Leverage
Four important effects of financial leverage:
1.
2.
3.
4.
Increases expected rates of return on equity and
expected EPS
Increases risk of equity: both variance and beta
Increases the probability of bankruptcy and expected
bankruptcy costs
Increases the interest tax shield
Which effect is positive (improves shareholders welfare)
and which is negative (reduces shareholders welfare)?
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Effects of Leverage
1.
Leverage Increases Expected Rates of Returns on
Equity and Expected EPS.
Example
Consider $100 (all-equity) investment in a house.
Expected return on the house is rEu = 15%.

Expected Net Income is = 15%$100 = $15.

To find EPSU, suppose there are “10 $10 shares
outstanding”. Thus, EPSU = $15/10 = $1.5.

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Effects of Leverage

Consider the following Financial Engineering
Borrow (take a mortgage) $90 and invest only $10 in own equity.
The borrowing rate is the risk-free rate, rD = 10%. (Now there is
only “one $10 share outstanding”.)

rEL 
Expected return to leveraged equity and EPS,
Expected Net Income 15  10%  90
Expected Net Income $6

 60% , EPS L 

 $6
Equity Investment
10
one share outstanding 1

both go up .
90
Alternatively: rEL  15%  (15%  10%) 
 60%
10
D
L
U
U
rE  rE  (rE  rD ) 
E
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Effects of Leverage
2.
Leverage Increases Risk: Both Variance and
Beta.
So far the example looked at expected return of
15%. Suppose the underlying distribution is
.5
.5
30%
0%
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Effects of Leverage

Variability of equity returns in unleveraged firm:
 In “bad” state equity return is 0%.
 In “good” state equity return is 30%
Equity returns in unleveraged firm are ± 15% around
the mean of 15%.
We have here ”double (to 30%) or nothing (to 0%).”
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Effects of Leverage

Variability of equity returns in Leveraged firm:

In “bad” state cash flow to equityholders equal $100 $9 - $90 = $1.


On $10 investment this gives a return of -90%.
In “good” state cash flow to equityholders equals
$130 - $9 - $90 = $31.
On $10 investment this gives a return of 210%.
Equity returns in leveraged firm are ± 150% around
the mean of 60%.

Volatility far exceeds the ”double or nothing”
situation of the unleveraged firm.
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Effects of Leverage
3.
Leverage Increases the Probability of
Bankruptcy and Expected Bankruptcy Costs.
Probability of Bankruptcy =Probability (EBIT < Interest)
It increases with leverage because interest is
increased and EBIT remains the same.
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Effects of Leverage
 Bankruptcy Costs
 Bankruptcy costs = the difference between the
value of the assets before and after bankruptcy.
 The magnitude of bankruptcy costs depends on the
nature of the firm and its industry.
 Firms with tangible assets have lower bankruptcy costs than
firms whose assets are intangible.
 Even absent formal bankruptcy, there are costs of
financial distress. These costs increase with the level of
debt.
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Effects of Leverage
4.
Leverage Increases the Interest Tax Shield.

Interest payments on corporate debt are
deductible from taxable income.

Therefore, debt provides a tax shield for corporations.
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Effects of Leverage:Summary
Leverage Increases
Impact on Shareholders
1.
Equity rate of return and EPS
1.
Positive
2.
Equity risk
2.
Negative
3.
Expected bankruptcy cost
3.
Negative
4.
Tax shields
4.
Positive
The question of optimal leverage is highly controversial.
To gain understanding, we start with an idealized
world, perfect capital markets.
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Capital Structure Under Perfect
Capital Markets - M&M

Perfect Capital Markets are Defined:





no taxes;
no bankruptcy costs;
no transaction costs (buying, selling or issuing
securities);
equal access to the markets (information, size,
etc..);
price taking.
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Capital Structure Under Perfect
Capital Markets - M&M

M&M Proposition 1

Under perfect capital markets capital structure is
V L = VU
irrelevant to firm value

the value of the firm is unchanged when proportions of
debt and equity are changed.
Leveraged
Firm value, VL
VU
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VL
Debt
level 16
Capital Structure Under Perfect
Capital Markets - M&M

Intuition
Since production decisions are fixed, the total cash
flow is unchanged.
Different capital structures have different ways of splitting
the same total.
Firm Value
$100
Equity Value
Debt Value
$50
$50
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Equity Value
Debt Value
$20
$80
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Capital Structure Under Perfect
Capital Markets - M&M

Conclusion

Since firm value does not change with degree of
leverage and since debt is sold in competitive
markets for its fair value, equityholders situation is
not affected by leverage.

The first two effects of leverage are a perfect wash:
The increase in expected return to equity just
compensates shareholders for the increased risk.
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Capital Structure Under
Imperfect Capital Markets
Tax Consideration - Debt Provides Tax Shield

VL= VU + PV of tax shields
•
Consider a firm with perpetual debt level D that
pays annual interest rate rD.
•
•
•
Annual interest payment equals rDD
Annual tax shield equals TrDD
PV of tax shield equals TrDD/rD = TD
VL
VL = Vu + TD
VL = Vu + TD
VU
D
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Capital Structure Under
Imperfect Capital Markets

Intuition
As debt increases, the government share of the
given pie decreases.

The figures below assume pre-tax value of $100; thus,
with T = 34%, VU = $66 (first figure on left).
Shareholders
Government
Debtholders
=
$66
VL = $50 + $33 = $83
$17
$34
$66
Shareholders
Debtholders
Government
Government
Debtholders
VU
Shareholders
$33
$50
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VL = $80 + $13.2 = $93.2
$7 $13
$80
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Capital Structure Under
Imperfect Capital Markets
Expected Bankruptcy Costs (EBC)
VL= VU + PV of tax shields - EBC
VL
VL = Vu + TD
VL*
VL = Vu + TD - EBC
VU
D*
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D
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Capital Structure Under
Imperfect Capital Markets

With bankruptcy costs, as debt levels increase the expected
value lost due to expected bankruptcy cost increases.
Riskless Debt
Risky Debt
Riskier Debt
Shareholders
Government
Shareholders
Debtholders
Shareholders
Debtholders
Debtholders
EBC
Government
EBC
Government
EBC
$8
$10
$31
$20
$16
$42
$59
$30
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$14
$10
$60
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Capital Structure Under
Imperfect Capital Markets


Firms within an industry tend to have similar debt levels.
Different industries tend to have different debt levels.

Examples:



In 1981 Chrysler restructured by mainly giving debtholders
equity. Makes sense, given that Chrysler had heavy losses
accumulated, so their effective TD was basically zero.
Real-Estate companies tend to use extensive leverage. Makes
sense, given that expected bankruptcy cost is very low.
What is the capital structure of McKinsey? Why?
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Capital Structure Under
Imperfect Capital Markets

Agency Costs

Conflict Between Shareholders and Managers
a) Debt increases the fraction of equity held by managers
b) Debt commits the firm to pay out “free cash”. This
prevents “empire building” but may result in underinvestment.

Conflict Between Debtholders and Equityholders
a) Equityholders may benefit from “going for broke- ”asset
substitution.”
b) Equityholders may refuse to contribute additional funds even if
the firm has a positive NPV project because the benefits accrue to
debtholders - “debt overhang” problem.
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Capital Structure Under
Imperfect Capital Markets

Asymmetric Information


Capital markets underprice equity issuance since
they view the firm as issuing equity when it is
overpriced. This results in “pecking order” theory
- issue new securities in order of increasing
sensitivity to market valuation (risk free debt,
risky debt, convertible debt, and equity as last
resort)
Firms issuing debt signal that they are of high
quality.
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Capital Structure Under
Imperfect Capital Markets

Product/ Input Market Interactions



Increase in leverage gives incentive to equityholders to
pursue riskier more aggressive strategies. Also, to avoid
bankruptcy, they are pushed toward strategies that generate
early cash.
Predation - More highly leveraged firms might be easier
predation targets.
Interaction with customers/ suppliers - more debt affects
these interactions since customers and suppliers bear the
costs of bankruptcy.
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Capital Structure Under
Imperfect Capital Markets

Corporate Control


Capital structure affects the outcome of takeover
contests and their likelihood through its effect on
the distribution of votes. It will affect the fraction
of votes owned by large “insiders”.
Debt contracts give various level of control to
debtholders (covenants could be very restrictive).
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Capital Structure under
Imperfect Capital Markets

Personal Taxation

The firm tries to minimize PV of all taxes, not
just corporate. On the personal level, equity has a
more favorable treatment than debt thus, offsetting
part of debt’s corporate tax advantage.
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Summary of two-day announcement effects associated with exchange offers, security sales with designated uses of funds, and calls of
convertible securities. With sources and uses of funds associated, these transactions represent virtually pure financial structure
changes.
Type of Transaction
Security
Issued
Security
Retired
Average
Sample
Size
Two-Day
Announcement
Period Return
Debt
Debt
Preferred
Debt
Income bonds
Common
Common
Common
Preferred
Preferred
45
52
9
24
24
21.9%
14.0
8.3
2.2
2.2
Debt
Debt
Debt
Debt
36
83
0.6*
0.2*
Common
Common
Convertible debt
Common
Preferred
Common
Common
Convertible preferred
Convertible bond
Debt
Preferred
Debt
Debt
Debt
57
113
15
30
9
12
20
-0.4*
-2.1
-2.4
-2.6
-7.7
-4.2
-9.9
LEVERAGE-INCREASING
TRANSACTIONS
Stock Repurchase
Exchange Offer
Exchange Offer
Exchange Offer
Exchange Offer
TRANSACTIONS WITH NO
CHANGE IN LEVERAGE
Exchange Offer
Security Sale
LEVERAGE-REDUCING
TRANSACTIONS
Conversion-Forcing Call
Conversion-Forcing Call
Security Sale
Exchange Offer
Exchange Offer
Security Sale
Exchange Offer
*Not statistically different from zero.
Source: C. W. Smith, "Investment Banking and the Capital Acquisition Process," Journal of Financial Economics, 1986, p. 12.
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