Capital Structures & Limits to the Use of Debt
Capital Structure – the proportion of debt and equity financing which a firm chooses to optimize
-The optimal capital structure is one that minimizes a firm’s cost of capital
Risk and Capital Structure
-Determining a firm’s financial structure means answering two basic questions:
-How should the firm’s total sources of funds be divided among long-term and short-term
-What proportion of funds should be financed by debt and what proportion by equity?
-Long term sources of a firm’s capital structure include:
-Preferred stock -Common stock
-Internally generated funds
The Pie Analogy
-Max firm value = max shareholder value
-When there is a significant probability of bankruptcy:
Max firm value ≠ max shareholder value
-Can be measured by standard deviation of EBIT
-Created by fixed costs
-Variability of EPS
-Probability of bankruptcy
-Increases as debt-equity ratio increases
-May increase or decrease firm value
-Created by debt!
Operating and Financial Leverage
-Operating leverage – arises from fixed cost associated with production
-Financial leverage – arises from the amount of debt in a firm
-Degree of Operating Leverage (DOL) – measures impact of change in sales on EBIT
-Degree of Financial Leverage (DFL) – measures impact of change in operating income on
earnings available to common shareholders
DFL = % change in Operating leverage = % change in ROE = Net
EPS_ EBIT income____
% change in % change in Book value of equity
Financial leverage = % change in EPS = Net
% change in EBIT Number of shares
Ex. A new business Net Income = (EBIT – Interest) x (1 – Tax requires a $100,000
investment. The rate) project can either be
entirely equity financed, or ½ of the investment can be funded by a 10 year bank loan at 8%.
The corporate tax rate is 43%. EBIT is expected to be $25,000, but it could be as low as $5,000
or as high as $45,000. Calculate ROE for all 6 scenarios. Comment. How Much Debt Should a Firm Have?
-Tools to assess optimal debt levels:
-“In making the capital structure decision, focus first and foremost on taxes, risk and financial
-Debt reduces taxes to be paid, increases risk of bankruptcy and volatility of EPS,
disciplines managers, and reduces managerial flexibility
Indifferent of EPS – EBIT Analysis
-Assess the impact of leverage:
-Based on EBIT of firm
-Rank desirability of alternative capital structures
-Ignores market reaction to increased debt levels
-Expected EPS and ROE rise as more debt is added, but also becomes more volatile
-At low levels of EBIT, ROE/EPS lower for leveraged firm than all equity firm
-At high levels of EBIT, ROE/EPS higher for leveraged firm than all equity firm
-EBIT – EPS Analysis
-Graphical depiction of the amount of EPS for different levels of EBIT
-Allows us to visualize the impact of leverage
Ex. Emco, an all equity firm has 250,000 shares outstanding, which currently trade at $14. It
wishes to raise $5 million, and it has 2 options available:
a. Raise the entire amount by issuing equity that will net the firm $12.50 a share
b. Raise the entire amount through an issue of 10% debentures
What should the firm do, if its tax rate is 46%?
Capital Structure – M&M Approach
1. M&M without tax = MM under perfect market (No tax, no bankruptcy cost)
2. M&M with tax = Have tax, no bankruptcy cost
3. Have tax and bankruptcy cost
1. Will capital structure affect firm value? Yes
2. Will capital structure affect cost of capital? Yes Perfect Capital Markets Assumptions
-Assume firms are financed by long term debt and common stock only
-Assume that firm is not expected to grow in the future and all earnings are paid out as cash
-Homogeneous business risk class: Business risk is measured by σ EBIT Firms with the same
business risk belong to the same class
-There are no brokerage costs
-Ignore any costs of bankruptcy
-All investors borrow and lend at the same riskless rate of interest, r = b f
-There are no corporate taxes
M&M Propositions I and II in Words
-A firm’s value is determined by the operating side of the company and not how the
-As a firm becomes more levered, equity holders require a higher rate of return to offset
*Even though debt is cheaper than equity, firms cannot reduce their cost of capital by issuing
-The law of one price and no arbitrage argument implies that the market value of any firm is
independent of its capital structure.
-We have economic arguments why this must be the case too:
-Firm value is determined by the left-hand of the Balance Sheet, the firm's assets, and
the EBIT generated by them.
-A firm cannot change its market value by splitting its cash flows into different streams:
i.e., interest or dividends.
-M&M irrelevance argument: In a world with no taxes and no bankruptcy, a firm’s value does not
depend on its capital structure. Consumers will not value either firm more.
-This leads to some relationships between WACC and the return required by the equity holders
and debt holders of a firm.
-VU= value of the unlevered firm
-VL= value of the levered firm
-rb= the cost of debt (the risk free rate)
-rs= the return on (levered) equity (cost of equity)
-r0= the return on assets or the cost of capital/cost of equity in an all equity firm
-B = the value of debt
-SL= the value of levered equity
Proposition I and II Revisited
V = Cash Flow to shareholders and debt VU= EBIT VL= EBIT
holders PV tax shieldsc R o rWACC
S = EBIT - B
Interest = B x r b
Interest M&M Proposition II (No
V = EBIT (1 – T ) V = (EBIT – B x r ) (1 – T ) +
U C L b C
Bo B B V L V +uT x c taxes)
-In the absence of taxes, any savings from debt financing are offset by a higher return required
by common shareholders
-The firm’s WACC is not altered by issuing either common stock or debt
Ex. National Glass Co. has EBIT of $150 million, outstanding equity with a market value of $800
million and 10% coupon perpetual debt worth $200 million.
a. Suppose an MM world existed without taxes. What is the cosst of equity capital? What is the
b. The firm decides to issue an additional $100 million in debt (at 10%) and repurchase $100
million in common stock. What is the firm’s cost of equity capital? What is the firm’s WACC?
Criticisms of M&M
-The M&M hypothesis implies that personal and corporate leverage are perfect substitutes.
-Brokerage costs impede the arbitrage process.
-Many institutional investors are prohibited in 'home-made' leverage, thus impeding the
-M&M assume that all investors can borrow and lend at the same rate.
-M&M assume that the cost of debt does not rise as leverage increases.
-M&M ignore effect of capital structure on incentives of managers and therefore on cash flows.
-M&M ignore corporate and personal taxes.
Interest Tax Shield
-B= Value of debt
-rb= Cost of debt
rbx B = interest payments
Tc= Corporate tax rate
Tcx r b B = Annual tax shield generated by debt
-If the tax shields are received in perpetuity, then:
Value of the Firm
-The value is created by the tax deductibility of debt
-This effective subsidy changes the situation from being a zero-sum game between two parties
(debt holders and equity holders) to a three party game, where the value created is at the
expense of the government
M&M Propositions I & II(With Taxes)
-The value of the levered firm is -Proposition II:
-The return required by shareholders increases as leverage increases
-Since firm value rises with debt, rWACC must fall with debt
WACC > UACC L
M&M Proposition II with Taxes
Ex. Rollins International is an all equity firm that generates EBIT of $3 million per year. The cost
of equity capit