Chapter 16: Capital
Structure
Objective
1
Copyright © Prentice Hall Inc. 1999. Author: Nick Bagley
To understand how a firm can
create value through its
capital structure
decisions
Chapter 16 Contents
• 16.1 Internal Verses External Financing
• 16.2 Equity Financing
• 16.3 Debt Financing
• 16.4 The Irrelevance of Capital Structure in a Frictionless
Environment
• 16.5 Creating Value Through Financing Decisions
• 16.6 Reducing Costs
• 16.7 Dealing with Conflicts of Interest
• Weighted Average Cost of Capital
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Introduction
– The basic unit of analysis of this chapter is
the firm as a whole
– We examine how a corporation’s
management should make decisions
regarding the mix of debt and equity
– We start with Modigliani and Miller’s model
of a firm in a frictionless environment with
no tax and cost-free contract compliance,
and later re-introduce frictions
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16.1 Internal Verses External
Financing
• Internal financing
– sources of funds that arise from the
operation of the firm, and includes retained
earnings, increases in accrued wages and
accounts payable
– External funding
– sources of funds from outside lenders and
investors, and includes the proceeds of bond
and equity issues
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Internal Verses External
Financing
• Decision Process
– Financing decisions for an established firm
(not undertaking a major expansion) are
routine and almost automatic, and may
consist of a dividend policy, and maintaining
a bank’s line of credit
– Tapping outside resources is time-consuming
for management because of the need to
satisfy statutory and skeptical investor
demands, but it does expose the company’s
plans to market discipline
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16.2 Equity Financing
• There are three kinds of equity claims on
a company:
– Common stock/shares
– Corporate Stock options/Warrants
– Preferred stock
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Common stock/shares
• The residual claims to the corporation’s
assets
• May be divided into
• Voting stock
• Non-voting stock
• Restricted or Founders stock
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Corporate Stock options/
Warrants
• Options issued by the firm
– Used to attract and compensate key
employees and management in corporate
startups
– Used to ‘sweeten’ the bonds of risky
ventures
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Preferred stock
• A bond-like security that normally cannot
trigger a default for non-payment of
dividend
• Unlike bonds, it has a dividend that is not
an expense for tax purposes
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16.3 Debt Financing
• Corporate Debt is a contractual obligation
of the part of the organization to make
future payments in return for resources
provided to it. It includes:
• loans and debt securities, such as bonds
and mortgages
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• We now describe
– secured debt
– long-term leases
– pension liabilities
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Secured Debt
• An asset pledged as security for a debt is
called collateral, and the debt is said to
be secured
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Secured Debt
– Should a company with secured debt
become insolvent, then the secured
bondholders are paid from the proceeds of
the sale of the collateral
– Any money remaining from the sale of the
collateral is added to the pool used to pay
other creditors: IRS, employee wages,
debenture holders, trade creditors, et cetera
– If the proceeds are inadequate, then the
shortfall becomes a general liability, and is
paid after payment to the IRS, and wages
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Long-Term Leases
– Leasing an asset for a period of time that is
long compared to the asset’s useful life is
similar to buying the asset, and financing the
purchase with debt secured by the leased
assets
– The main difference is in who bears the risk
associated with the residual market value at
the end of the term of the lease
– A secondary difference may occur if the lessor is
unable to fully utilize the depreciation tax shelter
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Pension Liabilities
– Pension funds are either
• defined contribution
• defined benefit
– Some pension plans are funded, and some
are unfunded
• Some jurisdictions require that pension plans
are funded, and/or are disclosed in financial
statements, others do not
– Pension fund liability is often substantial
• resolving precisely what a company’s pension
fund liabilities are is often critical when
determining capital structure
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16.4 The Irrelevance of
Capital Structure in a
Frictionless Environment
• Modigliani and Miller:
• In an economist’s idealized world of
frictionless markets
– the total market value of all securities issued
by a firm
• is governed by the earning power and risk of
its underlying real assets,
• and is independent of the mix of securities
issued to finance the firm
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Frictionless Environment
Assumptions
– no income taxes
– no transaction costs of issuing debt/equities
– investors and management have same
information
– stakeholders are able to resolve conflicts
costlessly
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Example
• Nodett
– Dividends = Earnings = EBIT (no tax, no
interest)
– Common Stock
• Market Value = $100 million
• dividends = $10 million/year
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Example
• Somdett (otherwise identical to Nodett)
– dividends = EBIT - Interest
– Perpetual bonds
• market value= $40 million
• coupon 3.2 million/year (risk-free, see later)
– Common Stock
• Market Value = $100 - $40 = $60 million
• dividends = $10 - $3.2 = $6.8 million/year
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Example
– The probabilities of EBIT (shown later) are
such that the debt is risk-free, but the stock
has risk
– The contingent claims chapter showed that
we could evaluate common stock by
subtracting the (risk-free) bond value from
the value of the company as a whole
– M&M follows from contingent claims theory,
which follows from the Law of One Price
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Example
– Let us see what happens if EBIT is volatile,
with discrete values of $5, $10, and $15
million (each with probability = 33.33%)
– The total dividends of Nodett will be $5, $10,
and $15 million
– The total dividends of Somdett will be $1.8,
$6.8, and $11.8 million
• (note that, given the facts, the interest will
always be paid: the bondholders are riskless)
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Example
– The expected dividends are
• Nodett $10 million
• Somdett $6.8 million
– (the same values as in the case of no volatility,
results from the distribution)
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Example Conclusion
• If Nodett were to issue $40 million of
debt, and repurchase 400,000 shares at
$100 each, the value of the outstanding
shares would remain unchanged at
$(100,000,000 - 40,000,000)/(1,000,000
- 400,000) = $100 each
• If the debt was not, in fact, risk-free,
then the analysis will become a little
more complex, but the essential
conclusions are unchanged
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16.5 Creating Value Through
Financing Decisions
• We now take a step in the direction of
greater realism. The trade-off is
generally between:
– tax benefits of increasing debt, and
– financial distress costs of increasing debt
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16.6 Reducing Costs
• Optimal capital structure seeks to
minimize the sum of the taxes paid to the
govt. and the costs of financial distress
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Example
• Reconsider Nodett and Somdett, this
time in a world where there is a 34% tax
on earnings after interest, and no
personal income taxes
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Claimant Classes
Nodett
Somdett
1
Creditors
No
Yes
2
Government
Yes
Yes
3
Shareholders
Yes
Yes
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Leverage (Gearing) Equations
CFSomdett  Net Earnings  Interest
 (EBIT - Interest) * (1 - Tax_Rate)  Interest
 EBIT * Tax_Rate  Interest * Tax_Rate
 CFNodett  Interest * Tax_Rate
Tax_Rate  34% 
CFSomdett  CFNodett  Interest * 0.34
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Maximization of Somdett’s
Cash Flow
• The cash flows above are the combined
flows to the shareholders & stockholders
– The greater the annual interest payment, the
greater the combined cash flow, and the
greater the value of the firm as a whole
• The Market Value of Somdett = Market
Value of Nodett + PV Interest Tax Shield
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Maximization of Somdett’s
Cash Flow
• Earlier, we showed that the $40 million
debt issue at 8% was risk-free, given the
distribution of earnings
• The market values of claims is then given
in the next table:
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Market Values of Claims
Claimant
Creditors
Shareholders
Government
Total
Nodett
Somdett
$0.0 million $40.0 million
$66.0 million $39.6 million
$34.0 million $20.4 million
$100.0 million $100.0 million
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Value of Tax Shield
– The value of the tax shield is the loss of
value to the government of issuing bonds,
$(34.0-20.4) million = $13.6 million = value
of bonds * Tax rate
– Recall from before, we converted Nodett into
an image of Somdett by purchasing shares
and issuing $40 million of bonds
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Value of Tax Shield
– Directly after the announcement, the share
price will rise from $66 to $(66+13.6) =
$79.6 each
– The company would repurchase $40 million /
$79.6 = 502,513 shares, leaving 497,487
outstanding
– Sellers will be subject to an additional capital
gain of $13.6/share, and holders to an
unrealized capital gain of the same amount
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Reducing Costs: Financial
Distress
• Let’s look at a firm where there is a
probability of financial distress
– Financial distress: the imminent danger of
defaulting on debt
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Stock Price and Leverage
(Real Estate Project with High Bankruptcy Costs)
$100
$90
$80
Stock Price
$70
$60
$50
$40
$30
$20
$10
$0
0%
20%
40%
60%
Debt Ratio
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80%
100%
16.7 Dealing with Conflicts of
Interest: ‘Free Cash Flow’
• Having debt outstanding reduces the
‘free cash flow’ and this makes managers
more accountable to the market
– The need for new financing occurs more
frequently, making managers less likely to
invest in projects that increase their power,
prestige or perks
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Increasing Risks
– Management (acting in the interests of
shareholders) may increase total risk at the
expense of total value of the firm
• Badpenny currently has bonds and stock outstanding,
each with a market value of $50 million, and has
assets invested in short-term T-bills
• Management enters into a project with Capone
Enterprises in which an unfair coin (with a probability
60% heads) is tossed in the air
• If a ‘tail’ shows, Capone Industries will double
Badpenny’s investment in T-bills, otherwise, Capone
takes all Badpenny’s T-bills
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Badpenny (Continued)
– If Badpenny is unlucky, its bonds and stock
will be worth nothing
– If Badpenny is lucky, its bonds retain the
original value, but the stock price will triple
• The expected wealth of Badpenny’s bond holders is
$(1-0.60)*50 million = $20 million
• The expected wealth of the stockholders is $(10.60)*(200-50) million = $60 million
• New expected value of the firm = $80 million
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Weighted Average Cost of
Capital
• The cost of capital depends upon its use
not its source
– A firm’s cost of equity is the
• expected rate of return investors require on
an investment in a firm’s common stock
– A firm’s weighted average cost of capital
(WACC) is the
• discount rate used in computing a firm’s value
from its future cash flows
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The Firm’s Weighted-Average
Cost of Capital
– As a practical matter, determining the cost of
capital of a company with transaction costs
is quite difficult, and involves optimizing the
timing of new debt and equity issues
– Assuming a M&M economy, the following
equations apply:
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M&M Equations
D
ke  k  (k  r )
E
E
D
WACC  ke
r
DE
DE
k  the cost of equity w/o ut leverage
r  the risk - free rate of interest
D  market value of a firm' s debt
E  market value of the firm' s equity
V  D  E  market value of the firm
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