Capital Structure: Making the
Right Decision
P.V. Viswanath
Based on Damodaran’s Corporate Finance
A Hypothetical Scenario
 Assume you operate in an environment, where
(a) there are no taxes
(b) there is no separation between stockholders and
managers.
(c) there is no default risk
(d) there is no separation between stockholders and
bondholders
(e) firms know their future financing needs
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The Miller-Modigliani Theorem
 In an environment, where there are no taxes, default
risk or agency costs, capital structure is irrelevant.
 The value of a firm is independent of its debt ratio.
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Implications of MM Theorem
(a) Leverage is irrelevant. A firm's value will be
determined by its project cash flows.
(b) The cost of capital of the firm will not change with
leverage. As a firm increases its leverage, the cost
of equity will increase just enough to offset any
gains to the leverage.
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Can debt be irrelevant in a world with
taxes?
 In the presence of personal taxes on both interest income
and income from equity, it can be argued that debt could still
be irrelevant if the cumulative taxes paid (by the firm and
investors) on debt and equity are the same.
 Thus, if td is the personal tax rate on interest income
received by investors, te is the personal tax rate on income
on equity and tc is the corporate tax rate, debt will be
irrelevant if:
(1 - td) = (1-tc) (1-te)
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Is there an optimal capital structure?
The Empirical Evidence
 The empirical evidence on whether leverage affects value is mixed.


Bradley, Jarrell, and Kim (1984) note that the debt ratio is lower for
firms with more volatile operating income and for firms with substantial
R&D and advertising expenses.
Barclay, Smith and Watts (1995) looked at 6780 companies between
1963 and 1993 and conclude that the most important determinant of a
firm's debt ratio is its' investment opportunities. Firms with better
investment opportunities (as measured by a high price to book ratio)
tend to have much lower debt ratios than firms with low price to book
ratios.
 Smith(1986) notes that leverage-increasing actions seem to be
accompanied by positive excess returns while leverage-reducing
actions seem to be followed by negative returns. This is not
consistent with the theory that there is an optimal capital structure,
unless we assume that firms tend to be under levered.
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How do firms set their financing
mixes?
 Life Cycle: Some firms choose a financing mix that reflects
where they are in the life cycle; start- up firms use more
equity, and mature firms use more debt.
 Comparable firms: Many firms seem to choose a debt ratio
that is similar to that used by comparable firms in the same
business.
 Financing Hierarchy: Firms also seem to have strong
preferences on the type of financing used, with retained
earnings being the most preferred choice. They seem to
work down the preference list, rather than picking a
financing mix directly.
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The Debt Equity Trade Off Across the
Life Cycle
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Comparable Firms
 When we look at the determinants of the debt ratios of
individual firms, the strongest determinant is the average
debt ratio of the industries to which these firms belong.
 This is not inconsistent with the existence of an optimal
capital structure. If firms within a business share common
characteristics (high tax rates, volatile earnings etc.), you
would expect them to have similar financing mixes.
 This approach can lead to sub-optimal leverage, if firms
within a business do not share common characteristics.
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Preference rankings : Results of a
survey
Ranking
Source
Score
1
Retained Earnings
5.61
2
Straight Debt
4.88
3
Convertible Debt
3.02
4
External Common Equity
2.42
5
Straight Preferred Stock
2.22
6
Convertible Preferred
1.72
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What managers consider important in
deciding on how much debt to carry...
 A survey of Chief Financial Officers of large U.S.
companies provided the following ranking (from most
important to least important) for the factors that they
considered important in the financing decisions
Factor
Ranking (0-5)
1. Maintain financial flexibility
4.55
2. Ensure long-term survival
4.55
3. Maintain Predictable Source of Funds 4.05
4. Maximize Stock Price
3.99
5. Maintain financial independence
3.88
6. Maintain high debt rating
3.56
7. Maintain comparability with peer group 2.47
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Rationale for Financing Hierarchy
 Managers value flexibility. External financing
reduces flexibility more than internal financing.
 Managers value control. Issuing new equity
weakens control and new debt creates bond
covenants.
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Financing Choices
You are reading the Wall Street Journal and notice a tombstone
ad for a company, offering to sell convertible preferred
stock. What would you hypothesize about the health of the
company issuing these securities?
 Nothing
 Healthier than the average firm
 In much more financial trouble than the average firm
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