Laurence Booth
Sean Cleary
21
Capital Structure Decisions
LEARNING OBJECTIVES
21.1
Explain how business and financial risk affect a firm’s ROE and EPS and identify
the financial break-even points.
21.2
Identify the factors that influence capital structure.
21.3
Explain how Modigliani and Miller (M&M) “proved” their irrelevance
conclusion that the use of debt does not change the value of the firm.
21.4
Explain how the introduction of corporate taxes affects M&M’s irrelevance
result.
21.5
Describe how financial distress and bankruptcy costs lead to the static tradeoff theory of capital structure.
21.6
Explain how information asymmetries and agency problems lead firms to
follow a pecking-order approach to financing.
21.7
Describe other factors that can affect a firm’s capital structure in practice.
21.8
Explain how the introduction of personal taxes on investment income affects
the corporate tax advantage to using debt.
21.1 FINANCIAL LEVERAGE
• Leverage is the increased volatility in operating income over time,
created by the use of fixed costs in lieu of variable costs; it
magnifies profits and losses
• There are two types: operating leverage and financial leverage
• Both types of leverage have the same effect on shareholders, but
are accomplished in very different ways, for very different purposes
strategically
• Operating leverage is the increased volatility in operating income
caused by fixed operating costs
• Managers make decisions affecting the cost structure of the firm
and decide to invest in assets that give rise to additional fixed costs
with the intent to reduce variable costs
• Operating leverage is commonly accomplished when a firm
becomes more capital intensive and less labour intensive
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21.1 FINANCIAL LEVERAGE
• Advantages of operating leverage include:
– Magnification of profits to shareholders if the firm is profitable
– Operating efficiencies, such as faster production, fewer errors, higher
quality, etc., usually resulting in increased productivity
• Disadvantages of operating leverage include:
– Magnification of losses to shareholders if the firm loses money
– Higher break-even points
– High capital cost of equipment and illiquidity
• Financial leverage is the increased volatility in operating income caused by
the corporate use of sources of capital that carry fixed financial costs
• Financial leverage can be increased by selling bonds or preferred stock (i.e.,
taking on financial obligations with fixed annual claims on cash flow), and
then using the proceeds from the debt to retire equity (as long as lenders
do not prohibit this through the bond indenture or the loan agreement)
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21.1 FINANCIAL LEVERAGE
• Advantages of financial leverage include:
– Magnification of profits to shareholders if the firm is profitable
– Lower cost of capital at low to moderate levels of financial leverage
because interest expense is tax-deductible
• Disadvantages of financial leverage include:
– Magnification of losses to shareholders if the firm loses money
– Higher break-even points
– At higher levels of financial leverage, the low after-tax cost of debt is
offset by other effects such as: potential bankruptcy costs and agency
costs
• Shareholders bear the added risks associated with the use of leverage
• Therefore, the higher the use of leverage, either operating or financial, the
higher the risk to the shareholder
• Higher leverage therefore causes an increased cost of capital because
shareholders require higher returns to compensate for the extra risk
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21.1 FINANCIAL LEVERAGE
Risk and Leverage
• All firms experience variability in sales and costs over time
• Some firms operate in highly volatile industries that are
sensitive to the business cycle, while others operate in more
stable industries that are largely unaffected by the business
cycle
• Business risk is the variability of a firm’s operating income
caused by operational risk and is measured as the standard
deviation of earnings before interest and taxes (EBIT)
• Shareholders bear the risks associated with business risk and
the added risks associated with the use of leverage because
they are residual claimants of the firm
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21.1 FINANCIAL LEVERAGE
• Return on equity is the return earned by equity holders on
their investment in a company, as shown in Equation 21-1:
( EBIT  RD B)(1  T )
ROE 
SE
• Return on investment is the return on all of the capital
provided investors, both shareholders’ equity and short and
long term debt; as shown in Equation 21-2:
EBIT (1  T )
ROI 
SE  B
• If a firm is financed only with equity, then ROE = ROI
• If a firm is financed with a mix of debt and equity, then ROE
can be smaller or larger than ROI as leverage magnifies both
positive and negative returns
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21.1 FINANCIAL LEVERAGE
• Using equations 21-2 and 21-2, we can derive Equation 21-3:
ROE  ROI  ( ROI  RD )(1  T )
B
SE
• Notice that ROI measures the return earned by a firm’s
operations, but it does not measure the impact of how a firm
is financed
• Equation 21-3 can be re-arranged as Equation 21-4:
B
B

ROI  ROI  1 
 RD (1  T )

SE
 SE 
• Notice that the second term in Equation 21-4 is fixed, but the
firm term depends on the firm’s ROI
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21.1 FINANCIAL LEVERAGE
The Rules of Financial Leverage
• Figure 21-1 graphs Equation 21-4: ROE as a function of ROI
• The intersection of the blue and orange lines is the indifference point,
where ROEs for financing strategies are equal
• The financial break-even point is the horizontal-axis intercepts for both
lines, or the points at which the firm’s ROE is zero
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21.1 FINANCIAL LEVERAGE
• For value maximizing firms, the use of debt increases the expected ROE,
so shareholders expect to be better off by using debt financing rather than
equity financing
• Financing with debt increases the variability of the firm’s ROE, which
usually increases the risk to common shareholders
• Financing with debt increases the likelihood of the firm running into
financial distress and possibly even bankruptcy
• Wider variation in ROI means magnified ROE
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21.1 FINANCIAL LEVERAGE
•
•
Figure 21-2 graphs the annual
returns from investing in the
S&P/TSX Composite Index using
three different financing strategies:
– 1) the first (TSX) is the annual
return generated from investing
in the S&P/TSX Composite Index
– 2) the second (Levered 1)
assumes that investors borrow
50 percent on margin;
– 3) the third (Levered 2) assumes
they borrow 80 percent on
margin
The added volatility of gains and
losses over time is evident, and the
principles of leverage apply to
corporations as well as households
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21.1 FINANCIAL LEVERAGE
Indifference Analysis
• Indifference analysis is a profit-planning technique used to forecast the
EPS-EBIT relationships under different financing scenarios, and is the point
where the EPS of two alternative financing strategies are equal
• Equation 21-5 shows the formula for EPS, given EBIT less interest on debt
after-tax. # is the number of common shares outstanding:
( EBIT  RD B)(1  T )
EPS 
#
• Equation 21-6 shows EBIT as a simple linear function of EBIT:
EBIT (1  T ) RD B(1  T )
EPS 

#
#
• Equation 21-6 is illustrated in Figure 21-3, a graph of the EPS-EBIT
relationship on the following slide
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21.1 FINANCIAL LEVERAGE
• The slopes of the lines in Figure 21-3 are a function of the number of
common shares outstanding (i.e., the dilution of EPS), so the all-equity
(orange) line has a lower slope because every dollar of net income is
divided by more common shares
• The horizontal-axis intercept is greater for the debt-financing scenario
because the firm must cover its interest expense before earnings begin to
accrue to the benefit of shareholders
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21.2 DETERMINING CAPITAL STRUCTURE
• Table 21-4 shows the results of a 1990 survey of 119 U.S. companies
• External sources of information include: (#2) consultations with advisors
and (#5) examining other firms in the same or similar industries
• The three primary sources of information are: (#4) the impact on profits,
(#3) risk considerations and (#1) an analysis of cash flows
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21.2 DETERMINING CAPITAL STRUCTURE
• Ratio analysis is useful in capital structure analysis
• Helpful stock ratios, which use balance sheet information, include:
– Total debt to total assets
– Debt to equity
• Flow ratios, which use income statement information, can be
combined with balance sheet data to determine the ability of a firm
to service its debt
• Equation 21-7 shows the fixed burden coverage ratio, which is an
expanded interest coverage ratio that looks at a broader measure of
both income and any expenditures associated with debt:
EBITDA
Fixed burden coverage 
I  ( Pref. Div.  SF) /(1  T)
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21.2 DETERMINING CAPITAL STRUCTURE
• Equation 21-8 shows the cash flow to debt ratio, which is a
direct measure of the cash flow over a period that is available
to cover a firm’s stock of outstanding debt:
Cash Flow to Debt(CFTD) 
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EBITDA
Debt
16
21.2 DETERMINING CAPITAL STRUCTURE
Financial Ratios and Credit Ratings
• Equation 21-9 shows Altman’s Z-score, which is a method of
predicting the bankruptcy of a firm using five variables:
Z  1.2 X 1  1.4 X 2  3.3 X 3  0.6 X 4  0.999 X 5
where
X1 = working capital divided by total assets
X2 = retained earnings divided by total assets
X3 = EBIT divided by total assets
X4 = market values of total equity divided by non-equity
book liabilities
X5 = sales divided by total assets
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21.2 DETERMINING CAPITAL STRUCTURE
• Table 21-5 illustrates the application of these measures using information
from Moody’s. IG represents investment grade companies which have at
least a BBB long-term bond rating. Non-IG represents companies which
do not have an investment-grade rating.
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21.3 THE MODIGLIANI AND MILLER
(M&M) IRRELEVANCE THEOREM
• The Modigliani and Miller (M&M)Irrelevance Theorem concludes,
under some simplifying assumptions, that the value of a firm should
not be affected by the manner in which it is financed
• That is, capital structure is irrelevant if certain assumptions hold;
these assumptions are:
– Markets are perfect, which means that there are no transaction
costs or information asymmetries
– There are no taxes
– There is no risk of a costly bankruptcy or associated financial
distress
– Two firms in the same “risk class” can therefore have different
levels of debt and the earnings of these firms are perpetuities
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21.3 THE MODIGLIANI AND MILLER
(M&M) IRRELEVANCE THEOREM
• Arbitrage is a powerful force in capital markets, because it ensures that
where two identical assets trade at different prices, market trades will
spot the opportunity to earn riskless profits and trade until the prices are
equivalent
• Traders sell the overvalued assets and buy the undervalued asset
• These trading activities cause the price of the overvalued asset to fall and
the price of the undervalued asset to rise until both assets are
equivalently priced
• Traders earn abnormal profits from these trades until the prices of the two
securities move into equilibrium
• Market participants who find levered investments trading for a greater
value can, therefore, undo the leverage and earn abnormal profits
• Arbitrage will therefore force assets with equal payoffs to trade for the
same price
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21.3 THE MODIGLIANI AND MILLER
(M&M) IRRELEVANCE THEOREM
M&M and Firm Value
• Equation 21-10 shows that, where payoffs are identical for two different
assets (a levered firm and an unlevered firm ), both should be priced
equivalently: V  S  D  V
U
L
L
• The value of the levered firm VL is equal to the value of its debt plus the
value of its equity (SL + D), which also equals the value of the unlevered
firm VU
• Therefore, debt cannot destroy value
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21.3 THE MODIGLIANI AND MILLER
(M&M) IRRELEVANCE THEOREM
• Homemade leverage is the creation of the same effect of a firm’s financial
leverage through the use of personal leverage
• Individual investors can buy an unlevered firm and use personal debt to
replicate corporate leverage, or buy a levered firm and undo its effects
• M&M made a modelling assumption to simplify the analysis that the firm’s
earnings represent a perpetuity, therefore we can show that the value of a
levered firm’s equity is given by Equation 21-11:
EBIT  K D
SL 
and the cost of equity capital by Equation 21-12:
Ke 
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D
Ke
EBIT  K D D
SL
22
21.3 THE MODIGLIANI AND MILLER
(M&M) IRRELEVANCE THEOREM
M&M and the Cost of Capital
• Since the value of the firm is unchanged by leverage, we can define the
unlevered value by discounting the firm’s expected EBIT by its unlevered
cost of equity, as in Equation 21-13:
VU 
EBIT
 S L  D  VL
KU
• Equation 21-14 shows that if a firm has no debt, the equity investor
requires the cost of unlevered equity (KU):
K e  KU  (KU  K D )
D
SL
• The unlevered cost of equity depends on the firm’s business risk
• As the firm increases the amount of debt it uses for financing, the equity
cost increases due to the financial leverage risk premium
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21.3 THE MODIGLIANI AND MILLER
(M&M) IRRELEVANCE THEOREM
• Equation 21-15 shows that, in a world without taxes, the WACC (KU) is
simply the weighted average of the cost of debt and the cost of equity:
KU  K E
S
D
 KD
V
V
• Figure 21-4 illustrates M&M without corporate taxes where the cost of
equity rises to offset the lower cost of debt producing a WACC that
remains unchanged by the use of financial leverage
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21.3 THE MODIGLIANI AND MILLER
(M&M) IRRELEVANCE THEOREM
• If WACC remains the same regardless of the financial strategy
used by the firm, VL = VU
• As the use of debt financing increases, the cost of equity rises
so that, even if EPS increases through the use of debt
financing, that benefit is offset by a higher discount rate
• From a shareholder wealth perspective, under the M&M
assumptions, financing strategy is irrelevant
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21.4 THE IMPACT OF TAXES
• If we introduce corporate taxes into the M&M model, the value of
the firm drops
• Equation 21-16 shows that the higher the tax rate, the lower the
value of the firm:
EBIT (1  T )
VU 
KU
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21.4 THE IMPACT OF TAXES
• Equation 21-17 gives the value of the levered firm as the value of a
firm without leverage plus the corporate debt tax shield from debt
financing: V  V  DT
L
U
• The total claims of corporate taxes, debt holders and equity holders
are borne by the pre-tax cash flow produced by the firm
• If the firm uses more debt, and interest on that debt is taxdeductible, this produces a greater tax shield, reducing the
government share of the value of the private enterprise so the
WACC must decrease
• Equation 21-18 shows that both interest cost and the financial
leverage risk premium on the equity cost are reduced by (1 – T)
D
K e  K U  ( K U  K D )(1  T )
SL
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21.4 THE IMPACT OF TAXES
• Figure 21-6 shows that as the use of debt increases, WACC
decreases monotonously and so the value of the firm in a
world with corporate taxes should increase
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21.4 THE IMPACT OF TAXES
• Equation 21-19 gives the WACC equation adjusted for the taxdeductibility of interest expenses on debt:
WACC  K e
S
D
 K D (1  T )
V
V
• Equation 21-20 uses beta to adjust for the systematic risk of a firm,
assuming 100% debt financing is optimal (a controversial
assumption):
D
K e  RF  MRP   U 1  (1  T )
SL
• Equity cost without any debt is therefore the risk-free rate plus the
market risk premium plus multiplied by the unlevered beta
coefficient
• Equation 21-20 can be used to unlever betas to obtain the cost of
unlevered equity
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21.5 FINANCIAL DISTRESS, BANKRUPTCY
AND AGENCY COSTS
• Bankruptcy is a state of insolvency that occurs when a firm
commits an act of bankruptcy, such as non-payment of interest, and
creditors enforce their legal rights to recoup money, or when a firm
voluntarily declares bankruptcy in order to be protected while
reorganizing to become solvent again
• There are two acts under which firms can reorganize:
– The Companies Creditors Arrangements Act (CCAA) is used by larger,
more complex firms. It is flexible, allowing the firm to pursue
agreements with creditors and/or employees to raise new financing. A
trustee is appointed by the court and there is a stay-of-proceedings.
– The Bankruptcy Insolvency Act (BIA) is limited in scope to prevent
creditors from seizing assets. There are no provisions for DIP financing
nor to impose a settlement on all creditors
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21.5 FINANCIAL DISTRESS, BANKRUPTCY
AND AGENCY COSTS
• Figure 21-7 illustrates the value of a firm as a call option for
shareholders
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21.5 FINANCIAL DISTRESS, BANKRUPTCY
AND AGENCY COSTS
• Direct costs of bankruptcy are incurred as a direct result of
bankruptcy:
– Liquidation of assets
– Loss of tax losses (which are potential tax shield benefits)
– Legal and accounting costs
• Indirect costs of bankruptcy are financial distress costs, or losses to a
firm prior to the declaration of bankruptcy:
– Agency costs
– Increasing costs of doing business, including: creditors tightening trade
credit terms, lenders increasing risk premiums and monitoring, loss of
key staff and increases in recruitment and retention costs, and distracted
management focused on financing and not on the management of
business operations
– Potentially reduced sales revenue
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21.5 FINANCIAL DISTRESS, BANKRUPTCY
AND AGENCY COSTS
• Figure 21-8 illustrates the rising value of distress costs with
increasing debt:
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21.5 FINANCIAL DISTRESS, BANKRUPTCY
AND AGENCY COSTS
• Agency costs are important in the “real world”
• It is possible for shareholders to act in their own best interests, at
the expense of debt holders
• For example, when a firm is under financial distress:
– Shareholders can favour some creditors over others
– Assets may be dissipated to related, but solvent companies
– Moral hazard can result in asymmetric payoffs
• Being aware of these risks, lenders take action to protect their
interests, including:
–
–
–
–
Demanding moratoriums on additional debt
Increasing the rate on adjustable-rate debt
Demanding additional surveillance of financial performance
Taking the firm to court to enforce rights
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21.5 FINANCIAL DISTRESS, BANKRUPTCY
AND AGENCY COSTS
• The static trade-off model is illustrated by Figure 21-9:
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21.5 FINANCIAL DISTRESS, BANKRUPTCY
AND AGENCY COSTS
• In the static trade-off model, the impact of bankruptcy and
financial distress costs on M&M with corporate taxes is:
– The cost of equity rises throughout as more debt is added
– The cost of debt rises at higher debt levels
– WACC falls initially, because the benefits of the taxdeductibility of interest expense outweigh the marginal
increases in component costs
– But, at higher levels of debt, the tax advantage of debt is
offset and the value of the firm falls as WACC starts to rise
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21.6 OTHER FACTORS AFFECTING CAPITAL
STRUCTURE
• The static trade-off model ignores two important issues:
1.
2.
Information asymmetry problems
Agency problems
• These factors are likely responsible for what Myers and
Donaldson call the pecking order
• The pecking order is the order in which firms generally prefer
to raise financing:
1.
2.
3.
Start with internal cash flow or retained earnings
Add debt
Then lastly issue more common equity to raise new funds
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21.6 OTHER FACTORS AFFECTING CAPITAL
STRUCTURE
• Factors that favour corporate ability and willingness to issue
debt include:
– Profitability
– Unencumbered tangible assets to be used as collateral for
secured debt
– Stable business operations over time
– Corporate size
– Growth rate of the firm
– Capital market conditions
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21.7 CAPITAL STRUCTURE IN PRACTICE
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21.7 CAPITAL STRUCTURE IN PRACTICE
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APPENDIX 21A PERSONAL TAXES AND
CAPTIAL STRUCTURE
• Merton miller argued that firms should strive to minimize all taxes, both
corporate and personal, paid on corporate income
• By doing so, the firm maximizes total cash flows available to security
holders after corporate and personal taxes
• Equation 21-A1 shows the value of a levered firm accounting for personal
and corporate tax rates
 (1  TC )(1  TD ) 
VL  VU  D 1 

1

T
P


where:
TC = corporate tax rate
TP = individual’s personal tax rate on ordinary income (including interest
income)
TD = individual’s tax rate on dividend income
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APPENDIX 21A PERSONAL TAXES AND
CAPTIAL STRUCTURE
• If (1 – TP) = (1 – TC) (1 – TD), then VL = VU
– This is M&M’s irrelevance proposition and is referred to as an integrated
tax system which has historically be used in Western Europe where
individuals get a tax credit for corporate taxes paid on their behalf
– There are no tax advantages for firms if they use debt
• If (1 – TP) < (1 – TC) (1 – TD), then VL < VU
– Firms lose value by issuing debt, so there is an incentive for individuals
to borrow money rather than firms
• If (1 – TP) > (1 – TC) (1 – TD), then VL > VU
– Firms add value by issuing debt
– This is a partially integrated tax system and is the system we have in
Canada
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APPENDIX 21A PERSONAL TAXES AND
CAPTIAL STRUCTURE
• If TP = TD, the personal tax rate on dividends equals the tax
rate on ordinary and interest income:
– We have a classic tax system in which all personal income
is taxed at the same rate which, historically, is the system
in place in the United States
– Here the corporate tax shield holds even with personal
taxes, so the value of a levered firm equals the value of an
unlevered firm plus the tax shield created by paying
interest expenses
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