Capital Structure

SUGATH ALWIS, CFA

How should a firm choose its debt–
equity ratio?
Value of the firm is to be a sum of V = B+ S
Where B is the market value of debt and S is the market value of equity

▪ If the goal of the management of the firm is to make the firm as valuable as possible, then
the firm should pick the debt–equity ratio that makes the pie—the total value—as big as
possible.
▪ This discussion begs two important questions:
1. Why should the stockholders in the firm care about maximizing the value of the entire firm?
2. What ratio of debt to equity maximizes the shareholders’ interests?
Maximizing Firm Value versus Maximizing
Stockholder Interests
Suppose the market value of the J. J. Sprint Company is $1,000. The company currently has no
debt, and each of J. J. Sprint’s 100 shares of stock sells for $10. A company such as J. J. Sprint
with no debt is called an unlevered company. Further suppose that J. J. Sprint plans to borrow
$500 and pay the $500 proceeds to shareholders as an extra cash dividend of $5 per share. After
the issuance of debt, the firm becomes levered. The investments of the firm will not change as a
result of this transaction.
Management recognizes that, by definition, only one of three outcomes can occur from
restructuring. Firm value after restructuring can be (1) greater than the original firm value of
$1,000, (2) equal to $1,000, or (3) less than $1,000. After consulting with investment bankers,
management believes that restructuring will not change firm value more than $250 in either
direction. Thus it views firm values of $1,250, $1,000, and $750 as the relevant range.
What will the value of the firm be after the proposed restructuring?
Maximizing Firm Value versus Maximizing
Stockholder Interests
Maximizing Firm Value versus Maximizing
Stockholder Interests
Maximizing Firm Value versus Maximizing
Stockholder Interests
Managers should choose the capital structure that they believe will have the highest firm
value because this capital structure will be most beneficial to the firm’s stockholders

Clearly, J. J. Sprint should borrow $500 if it expects Outcome I. The crucial question in
determining a firm’s capital structure is, of course, which outcome is likely to occur. However,
this example does not tell us which of the three outcomes is most likely to occur. Thus it does
not tell us whether debt should be added to J. J. Sprint’s capital structure. In other words, it does
not answer question (2) in slide 2.
Financial Leverage and Firm Value:
Trans Am Corporation currently has no debt in its capital structure. The firm is considering
issuing debt to buy back some of its equity. Both its current and proposed capital structures are
presented in Table 16.1 . The firm’s assets are $8,000. There are 400 shares of the all-equity
firm, implying a market value per share of $20. The proposed debt issue is for $4,000, leaving
$4,000 in equity. The interest rate is 10 percent.
Financial Leverage and Firm Value:
The effect of economic conditions on earnings per share is shown in Table 16.2 for the current
capital structure (all equity). Consider first the middle column where earnings are expected to
be $1,200. Because assets are $8,000, the return on assets (ROA) is 15 percent
(=$1,200/$8,000). Assets equal equity for this all-equity firm, so return on equity (ROE) is also 15
percent. Earnings per share (EPS) is $3.00 (=$1,200/400). Similar calculations yield EPS of $1.00
and $5.00 in the cases of recession and expansion, respectively.
Financial Leverage and Firm Value:
The case of leverage is presented in Table 16.3 . ROA in the three economic states is identical in
Tables 16.2 and 16.3 because this ratio is calculated before interest is considered. Debt is $4,000
here, so interest is $400 (=.10 * $4,000). Thus earnings after interest are $800 (=$1,200 - $400)
in the middle (expected) case. Because equity is $4,000, ROE is 20 percent (=$800/$4,000).
Earnings per share are $4.00 (=$800/200). Similar calculations yield earnings of $0 and $8.00 for
recession and expansion, respectively.
Financial Leverage and Firm Value:
THE CHOICE BETWEEN DEBT AND EQUITY
Modigliani and Miller (MM or M & M) have a convincing argument that a firm cannot change
the total value of its outstanding securities by changing the proportions of its capital structure.
In other words, the value of the firm is always the same under different capital structures. In still
other words, no capital structure is any better or worse than any other capital structure for the
firm’s stockholders. This rather pessimistic result is the famous MM Proposition I.
Their argument compares a simple strategy, which we call Strategy A, with a two part strategy,
which we call Strategy B.
Financial Leverage and Firm Value:
MM Proposition I (no taxes):
This example illustrates the basic result of Modigliani–Miller (MM) and is, as we have noted,
commonly called their Proposition I. We restate this proposition as follows:
MM Proposition I (no taxes): The value of the levered firm is the same as the value of the
unlevered firm.
Modigliani and Miller: Proposition II (No
Taxes)
Modigliani and Miller: Proposition II (No
Taxes)
Modigliani and Miller: Proposition II (No
Taxes)
Modigliani and Miller: Proposition II (No
Taxes)
Modigliani and Miller: Proposition II (No
Taxes)
MM: AN INTERPRETATION
Taxes
The Water Products Company has a corporate tax rate, t , of 35 percent and expected earnings
before interest and taxes (EBIT) of $1 million each year. Its entire earnings after taxes are paid
out as dividends.
The firm is considering two alternative capital structures. Under Plan I, Water Products would
have no debt in its capital structure. Under Plan II, the company would have $4,000,000 of debt,
B. The cost of debt, R B , is 10 percent.
Calculate the total cashflow to both stockholders and bondholders under two plans
Taxes
PRESENT VALUE OF THE TAX SHIELD
VALUE OF THE LEVERED FIRM
VALUE OF THE LEVERED FIRM
MM with Corporate Taxes
Divided Airlines is currently an unlevered firm. The company expects to generate $153.85 in
earnings before interest and taxes (EBIT) in perpetuity. The corporate tax rate is 35 percent,
implying aftertax earnings of $100. All earnings after tax are paid out as dividends.
The firm is considering a capital restructuring to allow $200 of debt. Its cost of debt capital is 10
percent. Unlevered firms in the same industry have a cost of equity capital of 20 percent. What
will the new value of Divided Airlines be?
EXPECTED RETURN AND LEVERAGE
UNDER CORPORATE TAXES
MM Proposition II under no taxes posits a positive relationship between the expected return on
equity and leverage. This result occurs because the risk of equity increases with leverage. The
same intuition also holds in a world of corporate taxes. The exact formula in a world of corporate
taxes is this
EXPECTED RETURN AND LEVERAGE
UNDER CORPORATE TAXES
THE WEIGHTED AVERAGE COST OF CAPITAL, R
WACC , AND CORPORATE TAXES
Can Costs of Debt Be Reduced?
PROTECTIVE COVENANTS
Negative covenants
Positive covenants
Protective covenants
Q&A