Chapter IV

4.1. Theory of Capital Structure

4.1.1 Introduction to the Theory

Capital Structure
The proportion of short-term and long-term debt is considered in
analyzing a firm's capital structure. When people refer to capital
structure, they most likely are talking about a firm's debt/equity ratio,
which provides insight into how risky a company is. Usually a company
financed heavily by debt poses greater risks because it is highly
leveraged.

F Annual Interest Charges

ki =
= B Market Value of Debt

Earnings Available to Common

ke E = Stockholders
= S Market Value of Stock

Net Operating Earnings / Earnings

ko O = Before Tax
= V Total Market Value of the Firm

Where:

ki – is the yield on the company’s debt

ke – is the earnings/price ratio and is the required rate of return for
investors in a company whose earnings are not expected to grow and
whose dividend-payout ratio is 100 percent.

ko – is an overall capitalization rate for the firm. It is defined as the

weighted average cost of capital and may also be expressed as.

ko k k
B S
( B+ )+ ( B+ )
= i S e S

Net Operating Income Approach

To illustrate this approach, we assume that a firm has P1, 000 in
debt at 10 percent interest, that the expected value of annual net
 operating earnings is P1, 000 and that the overall capitalization rate(ko)
, is 15 percent. Given this information, we may calculate the value of
the firm as follows:

The earnings available to common stockholders, E, is simply net

operating income minus interest payments, or P1,000 – P100 = P900.
The implied required return on equity is
1,000.00 5,666.67
ko 0.1
0 ( 1,000 + )+ 0.158
82 (1,000 + ) .15 or
=
15%
= 5,666.67 5,666.67

F 100
ki = 1,0 =
.1 or
10.00%
= B 00
E 900
ke = 5,6 =
.1588 or
S 15.88%
= 67
Net Operating Income / Earnings Before 1,000.
O Interest and Taxes 00
ko Overall Capitalization Rate 0.15
6,666.
V Total Value of Firm 67
1,000.
B Market Value of Debt 00
5,666.
S Market Value of Stock 67

F Interest Charges 100

Earnings Available to Common 900.0
E Stockholders/EBT 0
ki Cost of Debt 0.1
k 0.158
e Required Return on Equity Rate 82

With this approach, net operating income or EBIT (O) is

capitalized at an overall capitalization rate (ko) to obtain the total value
of the firm (V). The market value of the debt (B) is then deducted from
the total value of the firm to obtain the market value of the stock (S).
Note that the ko and ki is stay the same regardless of the degree of
leverage although ke increases linearly with leverage.
 To illustrate, suppose the firm increases the amount of debt from
P1,000 to P3,000 and uses the proceeds of the debt issue to
repurchase stock. The valuation of the firm then is
Net Operating Income / Earnings Before 1,000.
O Interest and Taxes 00
ko Overall Capitalization Rate 0.15
6,666.
V Total Value of Firm 67
3,000.
B Market Value of Debt 00
3,666.
S Market Value of Stock 67

F Interest Charges 300

Earnings Available to Common 700.0
E Stockholders/EBT 0
ki Cost of Debt 0.1
k 0.190
e Required Return on Equity Rate 90

E 700
ke = 3,6 =
.1909 or
S 19.09%
= 67
ke increased
from 15.88% to 19.09% as the leverage increases

4.1.2 Modigliani – Miller Position

Simply put the Modigliani – Miller Position is based on the idea
that no matter how you divide up the capital structure of the firm
among debt, equity, and other claims, there is a conservation of
investment value. That is, because the total investment value of a
corporation depends on its underlying profitability and risk, it is
invariant with respect to relative changes in the firm’s financial
capitalization. Thus, the total pie does not change as it is divided into
debt, equity, and other securities. The sum of its parts must equal the
whole; so regardless of financing mix, the total value of the firm stays
the same, according to MM. The idea is illustrated with the two pies
below. Different mixes of debt and equity do not alter the size of pie –
total value stays the same.

The idea of this comparison is that regardless of the financial mix

of a firm the sum of its parts still must equal the whole. Different mixes
of debt and equity do not alter the size of the pie – total value stays
the same.

Homemade Leverage
According to Modigliani and Miller, companies cannot do
something for its stockholders (leverage). There is the idea that
investors are able to substitute personal for corporate leverage. Capital
changes are not a thing of value in the perfect capital market world.
Therefore, two firms with alike in every aspect except capital structure
must have the same total value. If not then arbitrage is possible, and
its occurrence will cause the two firms to sell in the market at the
same total value. To illustrate it we consider two firms identical in
every respect except that company A is not levered, while company B
has P30,000 of 12 percent bonds outstanding. According to the
traditional position, company B may have a higher total value and
lower average cost of capital than company A. The valuation of the two
firms assumed to be the following:
Company Company
A B
10,000 10,000
O Net Opertating Income / EBIT .00 .00
3,600
F Interest Charges .00
E Earnings Available to Common 10,000 6,400
 Stockholders .00 .00
0 0
ke Required Return on Equity Rate .15 .16
66,666 40,000
S Market Value of Stock .67 .00
30,000
B Market Value of Debt .00
66,666 70,000
V Total Value of Firm .67 .00
ko Overall Capitalization Rate 15.0% 14.3%
B/ 0
S Debt-to-Equity Ratio - .75

4.1.3 Taxes and Capital Structure

The irrelevance of capital structure rests on an absence of
market imperfections. No matter how one slices the corporate pie
between debt and equity, there is a conservation of value, so that the
sum of the parts is always the same. That is to say, the firm’s valuation
and cost of capital may change with changes in its capital structure.
One is the most important imperfections is the presence of taxes.

Corporate Taxes
The advantage of debt in a world of corporate taxes is that
interest payments are deductible as an expense. They elude taxation
at the corporate level, whereas dividends or retained earnings
associated with stock are not deductible by the corporation for tax
purposes. Consequently, the total amount of payments available for
both debt holders and stockholders is greater if debt is employed.
To illustrate, suppose the earnings before interest and taxes
(EBIT) are P2,000 for companies X and Y, and they are alike in every
respect except in leverage. Company X Y has P5,000 in debt at 12
percent interest, whereas company X has no debt. If the tax rat3 is 40
percent for each company we have
Company Company
X Y
Earnings Before Interest and Taxes
(EBIT) 2000 2000
Interest Income to Debt Holders 0 600
Earnings Before Taxes 2000 1400
Taxes 800 560
Income Available To Stockholders 1200 840
Income to debt holders plus income to
stockholders 1200 1440
 So as illustrated above the total income to debt holders and
stockholders for the levered firm is larger than of the unlevered firm.
This is so because debt holders receive payments even before tax
payments are made and income to stockholders is paid after taxes are
paid. In this essence, government pays a subsidy to the levered
company for use of debt. In our example, this amounts to P600 x .40 =
P240. This is a tax shield provided by the government to levered firms
like Company B. If the debt is permanent, the present value of the tax
shield using the perpetuity formula is
te r
Present value of tax te
B =
shield = B
r

.
Present value of tax 40(500 200
shield = 0) = 0

Where te is the corporate tax rate, r is the interest tax rate on

the debt and B is the market value of debt.

Components of Overall Value. Tax shield is a thing of value and that

the overall value of the company will be P2,000 more if debt is
employed than if the company has no debt. This increased valuation
occurs because the stream of income to all investors is P240 (12% of
P2,000) per year greater. Implied is that the risk associated with the
tax shield is that of the stream of interest payments, so the
appropriate discount is the interest rate on the debt. Thus, the value of
the firm is
Value of Value if Value of tax
Firm = Unlevered + shield
For our example, assuming the required equity return for Company X,
which has no debt is 16 percent. Therefore the value of the firm if it
were unlevered would be P1,200/.16 = P7,500.Plus tax shield of 2000,
so the total value of Company Y is then P9,500.
We see in the equation of the Present value of the tax shield that
the greater the amount of debt, the greater the tax shield and the
greater the value of the firm, all other things are the same. Thus, the
original MM proposition as subsequently adjusted for corporate taxes
suggest that an optimal strategy is to tale on a maximum amount of
leverage. Clearly this is not consistent with the behavior of
corporations, and alternative explanations must be sought.

Uncertainty of Tax Shield

The tax savings associated with the use of debt are not certain. If
repeated is consistently low or negative, the tax shield on debt is
reduced or even eliminated. As a result, the near full or full cash-flow
 burden of interest payments would be felt payments. So if the firm
would go bankrupt and liquidate, the potential future tax savings
associated with debt would stop together. So the greater the possibility
of going out of business, the greater the probability the tax shield will
not be effectively utilized.

Redundancy. Another argument is by De Angelo and Masulis and it

has to do with tax shelter redundancy. The notion here is that
companies ways other than interest on debt to shelter income –
leasing, foreign tax shelters, and investments in tangible assets and
the use option and future contracts, to name a few. De Angelo and
Masulis reason that as a company takes on more debt, it increases the
probability that earnings in some years will not be sufficient to offset
all the tax deductions. Some of them may be redundant, including the
tax deductibility if interest.

The New Value Equation. The uncertain nature of the interest tax
shield, together with the possibility of at least some tax shelter
redundancy, may cause firm to raise less with leverage than the
corporate tax advantage alone would suggest. This will be illustrated
below, where the corporate tax effect is shown by the top line. As
leverage increases, the uncertainty associated with the interest tax
shield come to play. At first, the diminution in value is slight. AS more
leverage occurs, tax shield uncertainty causes value to increase at an
ever-decreasing rate and perhaps eventually to turn down. Thus, the
more uncertain the corporate tax shield the less attractive debt
becomes. The value of the firm now can be expressed as
Value of Value if Pure value of Value lost through tax
Firm = unlevered + corporate tax shield - shield uncertainty

The last two factors combined give the present value of the corporate
tax shield. The greater the uncertainty associated with the shield, the
less important it becomes.
 Corporate Plus Personal Taxes
Apart from tax shield uncertainty, the presence of taxes on
personal income may reduce or possibly eliminate the corporate tax
advantage associated with debt. If returns on debt and on stock are
taxed at the same personal tax rate, however, the corporate tax
advantage remains. This can be seen by taking our earlier example
and applying a 30 percent personal tax rate to the debt and stock
returns:

Company Company
X Y
Debt Income 0 600
Less: Personal Taxes of 30% 0 -180
Debt Income after Personal Taxes 0 420

Income available lto stockholders 1200 840

Less: Personal Taxes of 30% -360 -252
Stockholders' Income after Personal Taxes 840 588
Income to Debt Holders and Stockholders after
Personal Taxes 840 1008
Although the total after-tax income to debt holders and stockholders is
less than before, the tax advantage with debt remains.
Looking at the matter as we did in our earlier discussion, we
discover that the present value of the corporate tax shield would be
the following when personal taxes are present:
(1-te)(1-
Present Value of Tax
Shield = (1 - tps)
1-tpd
)B

Where te is the corporate tax rate, r is the interest tax rate on the debt
and B is the market value of debt, tps is the personal income tax
applicable to common stock income and tpd is the personal tax rate
applicable to debt income. If the return on debt is taxed at the same
personal tax rate as that of the stock we have tps=tpd. As a result,
these two terms cancel out and the present value is the same as:
(1-te)(1-
Present Value of Tax
Shield = (1 - tps)
1-tpd
)B

Present value of tax (te)

shield = B
Therefore, the corporate tax advantage stays the same if tps=tpd.

Dividends versus Bankruptcy Cost. We know that stock income is

composed both of dividends and capital gains, however. Dividend
income by and large is taxed at the same personal tax rate as interest
income. Capital gains often are taxed at a lower rate. Sometimes the
differential is explicit in that the tax rate is less. To illustrate, we begin
with an extreme assumption. All stock income is realized as capital
gains and the tax rate on such gains is zero; therefore tps is equal to
zero. Assume, however, that the personal tax rate applicable to debt
income tpd is positive. In this situation, a company will need to decide
whether to finance with debt or with stock. If a dollar of operating
earnings is paid out as interest to debt holders, the company pays no
corporate tax on it ecause interest is deductible as an expense.
Therefore, the income to the investor after personal taxes are paid is
After tax income for debt P1(1-
holders = tpd)

If the dollar of operating earnings is directed instead to stockholders,

the company pays a tax on those earnings at the corporate tax rate.
The residual would be income to stockholders; and because we assume
that the personal tax rate on stock income s zero, it would go directly
to them. Therefore
After tax income for P1(1-
stockholders = te)
 If the company is concerned with only after-tax income to the investor,
it would finance either with debt or with stock, depending on the
relative values of tpd and te. If the personal tax rate on debt income
exceeds the corporate tax rate, the company would finance with stock,
because the after-tax income to the investor would be higher. If tpd is
less than te however, it would finance with debt, because after-tax
income to the investor would be greater here. If tpd is equals te, it
would be a matter of indifference whether debt or stock were
employed.

4.1.4 Effect of Bankruptcy Cost

Another imperfection affectin