MONASH

BUSINESS
SCHOOL

BFF5954
BUSINESS FINANCE

JOHN R. WATSON
 MONASH
BUSINESS
SCHOOL

Teaching Week Eleven

Capital Structure

Readings
Chapter 14 (Sections 14.1-14.5 pages 527-549)
 MONASH
BUSINESS
SCHOOL

Learning Objectives

(1) Understand the different ways available firms to finance their

assets;
(2) Understand the relationship between leverage and risk;
(3) Understand capital structure theories through MM
propositions;
(4) Understand how costs associated with bankruptcy may affect
the value of the firm;.
1. LEVERAGE

 Results from use of fixed-cost assets or funds to magnify

returns to the firm’s owners.

 The extent of leverage in a firm is positively associated with

risk and potential return.

 Capital restructuring involves changing the amount of

leverage (L) without changing the amount of assets (A).

↑LEVERAGE by issuing debt and repurchasing shares (↓E)

↓LEVERAGE by issuing new shares (↑E) and retiring debt
LEVERED AND UNLEVERED FIRMS

 Value of the firm = value of debt + value of equity

 BUT not all firms have both debt AND equity

Some firms are 100% equity firms
 These are called unlevered firms.

Most firms have a mix of debt AND

equity
 These are called levered firms.

 The term “levered” is thus given to a firm that has

some debt → we will now see that by adding debt
we increase the financial leverage (or risk) of a
firm.
BUSINESS RISK

 Business Risk stems from uncertainty about future operating

income (EBIT).
 It depends on how accurately operating income is predicted.

• Business risk is affected mainly by business operations:

- Uncertainty about demand (sales)
- Uncertainty about output prices
- Uncertainty about costs
- Product & other types of liability

• Operating Leverage stems from the use of fixed rather than variables
costs. When demand falls (and thus production) the fixed costs do not
decrease. A firm with a large % of fixed costs is therefore said to have
HIGH operating leverage.
FINANCIAL RISK

 In the case of bankruptcy debt holders have a prior claim on

the cash flows of the firm. Equity holders have a residual
claim.

 The more debt in the firm’s capital structure, the higher the
financial leverage of the firm.

 Financial risk is the additional risk concentrated on ordinary

shareholders as a result of financial leverage.

 Financial Risk depends only on the capital structure mix

• the more debt is issued: the greater the financial risk.
THE CAPITAL-STRUCTURE QUESTION
AND THE PIE THEORY
Value of Firm (VCompany) = Value of Assets (VAssets)
Value of Firm = Value of Debt (D) + Value of Equity (E)
V = Debt + Equity = D + E
 To maximise the value of the firm we need to pick the
combination of debt (D) and equity (E) that maximises
the size of the pie (the value of the firm).

S D
E The question is therefore: “What ratio
of debt to equity maximises the size
of the pie (and thus maximises
shareholder value)?”
 EFFECT OF LEVERAGE ON
ROA, ROE & EPS
ROA = Return on Assets; ROE = Return on Equity; EPS = Earnings Per Share

Consider an unlevered firm that is considering

introducing debt in its capital structure.
Current Proposed

Assets $20,000 $20,000

Debt $0 $8,000
Equity $20,000 $12,000
Debt/Equity ratio 0 2/3
Interest rate n/a 8%
Shares outstanding 400 240
Share price $50 $50
Scenario: The firm borrows $8,000 and buys back 160 shares at $50 per share
EPS & ROE UNDER BOTH
CAPITAL STRUCTURES
UNLEVERED
Recession Expected Expansion
EBIT $1,000 $2,000 $3,000
Interest 0 0 0
Net income $1,000 $2,000 $3,000
EPS = earnings per share $2.50 $5.00 $7.50
ROA = return on assets 5% 10% 15%
ROE = return on equity 5% 10% 15%
Current Shares Outstanding = 400 shares

LEVERED Recession Expected Expansion

EBIT $1,000 $2,000 $3,000
Interest (8% * $8000) $640 $640 $640
Net income $360 $1,360 $2,360
EPS $1.50 $5.67 $9.83
ROA 5% 10% 15%
ROE 3% 11% 20%
Proposed Shares Outstanding = 240 shares

The effect of economic conditions on ROE & EPS is exacerbated by leverage.

2. Capital Structure

 Capital Structure refers to the way in which the companies

assets are financed (excluding current liabilities).

 Debt capital generally requires a lower return than equity

capital since debt-holders have the first claim in bankruptcy
and can exert greater legal pressure against the company.

 It is important since it influences cost of capital and as such

the NPV of potential projects.
3. Capital Structure Theory

 Miller and Modigliani wrote a paper in 1958 entitled “The cost

of capital, corporate finance and the theory of investment”.

 They make 3 propositions in regards to capital structure and its

effect on the value of the firm.

 In 1963 they published a second paper which relaxes a number

of the assumptions made in their first paper. They reassess their
propositions from 1958 with these relaxed assumptions.

 They use the concept of homemade leverage to prove their

propositions.
HOMEMADE LEVERAGE

Consider two Firms: They generate the same operating income

and only differ via their capital structure.

One Levered (Firm L) One unlevered (Firm U)

 Recall EL = VL – DL
HOMEMADE LEVERAGE

Assumption One:
You do not want to expose yourself to much risk
HOMEMADE LEVERAGE:
EXAMPLE
Option One: Buy 1% of Firm U’s shares

Option Two: Buy 1% of both debt and equity in Firm L

Both Strategies offer the same payoff

HOMEMADE LEVERAGE:
EXAMPLE (Continued)
make use of information about firms U and L in slide 9 onwards
Additionally: Assume EBIT = Profit (used below) = $2000.00

Option One: Buy 1% of Firm U’s shares

Option Two: Buy 1% of both debt and equity in Firm L

Both Strategies offer the same payoff

HOMEMADE LEVERAGE:
EXAMPLE (Continued)

o Consider two Firms: They generate the same operating income

and only differ via their capital structure

o One Levered (Firm L) One unlevered (Firm U)

o Recall EL = VL – DL
HOMEMADE LEVERAGE:
EXAMPLE (Continued)

Assumption Two:
You are now willing to take a little more risk
HOMEMADE LEVERAGE:
EXAMPLE (Continued)
Option One: Buy 1% of Firm L’s shares

Option Two: Borrow 1% on your own account and

purchase 1% of stock in Firm U

Both Strategies offer the same payoff

HOMEMADE LEVERAGE:
EXAMPLE (Continued)
Option One: Buy 1% of Firm L’s shares

Option Two: Borrow 1% on your own account and

purchase 1% of stock in Firm U

Both Strategies offer the same payoff

HOMEMADE LEVERAGE

With homemade leverage we can make the risk of the

investment in the levered firm the same as the risk of the investment of
the unlevered firm.
- To do this we need to remove financial risk (lend money)

This is the fundamental insight of M&M

 MM 1958 - ASSUMPTIONS

1. No taxes

2. Homogenous expectations of the firm’s future EBIT

3. Homogenous business risk classes exist across firms

4. All cash flows are perpetual and all earnings are paid out as dividends

5.Perfect capital markets

- i.e. perfect competition, no transaction costs, investors &
corporations can borrow & lend at the same rate
 PROPOSITION I - 1958

The value of the firm is independent of its capital

structure.
VL = VU

VL = Value of levered firm

VU = Value of unlevered firm

Implication:
 Changing the mix of debt and equity financing (capital
structure) does not affect the value of the firm.
 PROPOSITION II - 1958

The cost of equity of a levered firm is equal to:

(a) the cost of equity of the unlevered firm in the same risk class plus
(b) a risk premium
rE = rU + (D / E) (rU - rd)

rE is the return on (levered) equity (cost of equity)

rU is the return on unlevered equity (cost of capital)
D is the value of debt
E is the value of levered equity
rd is the interest rate (cost of debt)
 PROPOSITION II - 1958

Implication:
 Leverage increases the risk and return to shareholders

How does capital structure affect the cost of equity capital

for a levered firm?

• An increase in leverage increases the cost of equity of the firm

• Cost of equity capital for a levered firm (rE) equals:
 business risk or the underlying risk of the asset (rU) PLUS
additional risk due to leverage (D / E) (rU - rd)
 PROPOSITION III - 1958

Discount rate for NPV will be completely unaffected by the capital

structure of the firm

WACCU = WACCL

Implication:
 An increase in leverage does not affect the discount rate used for a
project.
The Cost of Equity, the Cost of Debt, and the Weighted Average Cost of Capital:
MM Proposition II with No Corporate Taxes
Cost of capital: r (%)

rE = rU + (D / E) (rU - rd)

D E
rE rWACC   rD   rE
V V

rd

D
Debt-to-equity Ratio
E
MM 1963 - ASSUMPTIONS

New assumptions:
1. There are corporate taxes and
2. Debt interest is tax deductible

Note: personal tax is ignored and all other assumptions

from 1958 hold.
 MM 1963 – PROPOSITION I

 Firm value increases with leverage

VL = VU + TD

Implication:
The value of the levered firm is equal to:
(a) The value of an unlevered firm in the same risk class
PLUS
(b) The gain from leverage (this is the value of the tax saving and
is calculated as tax rate (T) times debt (D) also known as tax
shield =TD)
LEVERED VS UNLEVERED FIRM

 The value of the levered firm is higher because a smaller

piece of the pie is “lost” to tax.
 Tax saving associated with debt is realised as long as interest
is paid on the firms debt.

Unlevered firm Levered firm

Tax
CF - Debt
Tax
30%

CF -
Equity
70%
CF - Equity
MM (1963) – Proposition I

Value of firm (V) Value of firm under

MM with corporate
Present value of tax taxes and debt
shield on debt
VL = VU + TD

VU = Value of firm with no debt

0 Debt – Equity Ratio

(D/S)
 MM 1963 - PROPOSITION II

 Some of the increase in equity risk and return is offset

by the interest tax shield
rE = rU + (D / E) (rU - rd)(1-T)

Implication:
The cost of equity of a levered firm is equal to
(a) the cost of equity of an unlevered firm in the same risk class PLUS
(b) a risk premium to compensate financial risk: The risk premium is
less in a tax world due to tax savings than in a no tax world.
 MM 1963 - PROPOSITION III
 With the introduction of tax, there is now an additional
advantage to gearing-up: the tax relief obtained on the debt
interest.
 Thus weighted average cost of capital (rWACC) becomes

rWACC  ( D / V )(rD )(1  T )  ( E / V ) rE

Implication:
o The more highly geared the company becomes, the more tax relief
it obtains and the smaller its tax liability.
o In a world with tax relief on debt interest we would expect a
company’s after tax WACC to be progressively lowered as it
increases its gearing.
MM 1963 – PROPOSITION II & III

Cost of capital: rE (%) rE = rU + (D / E) (rU – rd)

rE = rU + (D / E) (rsU - rd)(1-T)

rE

rWACC  ( D / V )(rD )(1  T )  ( E / V )rE

Debt-to-equity ratio (D/E)

CASH FLOW TO INVESTORS UNDER
EACH CAPITAL STRUCTURE
UNLEVERED
Recession Expected Expansion
EBIT $1,000 $2,000 $3,000
Interest 0 0 0
EBT $1,000 $2,000 $3,000
Taxes (Tc = 30%) $300 $600 $900

Total Cash Flow to S/H $700 $1,400 $2,100

LEVERED Recession Expected Expansion

EBIT $1,000 $2,000 $3,000
Interest ($8000 @ 8% ) $640 $640 $640
EBT $360 $1,360 $2,360
Taxes (T = 30%) $108 $408 $708
Total Cash Flow $252+640 $952+$640 $1,652+$640
(to both S/H & B/H): $892 $1,592 $2,292
EBIT(1-T)+TKDd $700+$192 (=640 x 30%) $1,400+$192 $2,100+$192
$892 $1,592 $2,292
 CASH FLOW TO INVESTORS UNDER
EACH CAPITAL STRUCTURE

Unlevered firm Levered firm

equity tax equity tax

debt

 The sum of the debt plus the equity of the levered firm is
greater than the equity of the unlevered firm.
 This is how cutting the pie differently can make the pie larger:
the government takes a smaller slice of the pie!
CASH FLOW TO INVESTORS UNDER
EACH CAPITAL STRUCTURE

 M&M suggest financial leverage does not matter, or imply

that taxes cause the optimal financial structure to be 100%
debt.

 In practice, most executives do not like a capital structure of

100% debt because that is a state known as “bankruptcy”.
 MM EXAM QUESTION

• CBI has $200,000 in debt due to financing

their business at a cost of 8%. The EBIT of an
otherwise identical but unlevered firm is
$30,000 and cost of equity 10%. Assume that
the tax rate is 30%.

• Calculate the weighted average cost of capital.

 Suggested Solution

= =$210,000

h𝑒𝑛𝑐𝑒 , = 2.85

rE = rU + (D / E) (rsU - rd)(1-T) = 0.10+2.85(0.02)(1-0.3)=13.99%

rWACC  ( D / V )(rD )(1  T )  ( E / V )rE

200 70
 0.08(1  0.3)  0.1399
270 270
 7.77%
4. BANKRUPTCY COSTS
 Debt provides tax benefits but puts pressure on the firm - Why?
 Interest and Principal payments are obligations & if not met, might
result in bankruptcy
 Bankruptcy costs thus tend to offset the advantages of having debt

Example:

Firms A and B plan to be in business for one more year. They

forecast a cashflow of either $100,000 or $50,000 in the coming
year, each occurring with 50% probability. The firms have no other
assets. Previously issued debt requires payments of $49,000 of
interest and principal in Firm A. Previously issued debt requires
payments of $60,000 of interest and principal in Firm B. Assume
that stockholders and bondholders are risk neutral and expect 10%
return. Show the impact of bankruptcy costs.
BANKRUPTCY COSTS

Example:
Firm A

Boom Recession
Cash Flow $100,000
$50,000
Probability of event. 0.5
0.5
Debt (Int. + Principal) $49,000 $49,000

Firm B
 BANKRUPTCY COSTS

 If the cash flow is only $50,000 bondholders will be informed

that they will not be paid in full.

 These bondholders are likely to hire lawyers to negotiate or even

sue the company.

 The firm is likely to hire lawyers to defend itself.

 BANKRUPTCY COSTS

Consider Firm B (Assume legal costs = $10,000)

BANKRUPTCY COSTS

 The possibility of bankruptcy has a negative effect on the

value of the firm.
 It is not the risk of bankruptcy itself that lowers the value
but the cost associated with bankruptcy.

WHO BEARS THE FUTURE BANKRUPTCY COSTS? –

Shareholders, recall Financial risk is the additional risk

concentrated on ordinary shareholders as a result of financial
leverage
5. Optimal Capital Structure

Bankruptcy

Tax Bondholders

Shareholders

 There is a trade-off between the tax advantage of debt and the

costs of financial distress.
 This is often called the static trade-off theory of capital
structure.
 Integration of Tax Effects and Financial
Distress Costs

Value of firm (V) Value of firm under

MM with corporate
Present value of tax taxes and debt
shield on debt
VL = VU + TD

Maximum Present value of

firm value financial distress costs
V = Actual value of firm
VU = Value of firm with no debt

0 Debt (D)
D*
Optimal amount of debt
It is difficult to express the optimal level of debt with a precise and rigorous formula.
 The Pie Model Revisited

 Taxes and bankruptcy costs can be viewed as just another claim

on the cash flows of the firm.
 Let G and L stand for payments to the government (as taxes)
and bankruptcy lawyers, respectively.

E
V = E+ D + G + L D

L G

 The essence of the M&M intuition is that V depends on the

cash flow of the firm; capital structure just slices the pie.
 MONASH
BUSINESS
SCHOOL

Today we have been talking about company capital

structure and the impact of getting this wrong,
Bankruptcy. Next week in our final seminar we
focus on the redistribution of wealth question
“Dividend Policy” before we run through a quick
recap of content and discuss the final exam in
more detail.
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