Chapter One

Capital Structure Policy and Leverage

Capital Structure Questions

Is there an easily identifiable debt-equity ratio that will maximize the value of a firm? Why or why not?
What determine the firm’s decision in choosing debt-equity ratio? As you have learned in the previous
course, one of the objectives of firm is wealth maximization that deals with maximizing the value of share
of its stock. What is the basic goal of financial management with regard to capital structure? What is the
ratio of debt to equity that maximizes the shareholders’ interests? Weighted Average Cost of Capital
(WACC) indicates the firm’s overall cost of capital that constitutes the cost of various components of
firm’s capital structure. In the process of determining WACC, the firm’s capital structure is considered as
given. One of the basic questions is what happens to the cost of capital when you vary the amount of debt
financing or debt equity ratio. A primary reason for studying WACC is that the value of the firm is
maximized when WACC is minimized.
CF 1 CF 2 CF 3
Value= + + …
(1+WACC ) (1+WACC ) (1+WACC )3
2

Therefore, since values and discount rate move in opposite directions, minimizing WACC mill maximize
firm value. Thus, you have to choose a firm’s capital structure that that minimizes WACC that leads to
increase firm’s value. Target Capital Structure is the mix of debt, preferred stock, and common equity
with which a firm plans to raise capital. Firms should, first, analyze a number of factors, and then
establish a target capital structure. This target may change over time as conditions change, but at any
given moment, management should have a specific capital structure in mind
Definition of Capital Structure
The concern of the financing decision is with the financing mix or capital structure, or leverage. The term
capital structure refers to the proportion of debt (fixed – interest source of financing) and equity capital
(variable – dividend securities/ source of funds). Capital structure is the combination of capitals from
different sources of finances. The capital of a company consists of equity share holders, preference share
and long term debts. Capital structure policy involves a trade-off between risk and return:

≈ Using more debt raises the riskiness of the firm’s earnings stream
≈ However, a higher debt ratio generally leads to a higher expected rate of return

Higher risk tends to lower a stock’s price, but higher expected rate of return raises it. Therefore, the
optimal capital structure strikes a balance between risk and return so as to maximize a firm’s stock price.

Types of capital structure

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 1. Equity Capital : is the money owned by the shareholders or owners. It consists of two
different types

a) Retained earnings: Retained earnings are part of the profit that has retained in organization
which will help in strengthening the business.

b) Contributed Capital: Contributed capital is the amount of money which the company owners
have invested at the time of opening

2.Debt Capital: is referred to as the borrowed money that is utilized in business. There are different
forms of debt capital.

 Long Term: Bonds

 Short Term: Commercial Paper

Difference between Debt and Equity

 The primary difference between Debt and Equity Financing is that debt financing is when the
company raises the capital by selling the debt instruments to the investors. In contrast, equity
financing is when the company raises capital by selling its shares to the public.

Base of Difference Debt Equity

Meaning Funds borrowed from Funds raised by the

financiers without giving company by giving the
them ownership rights; investor’s ownership rights;

What is for the company? Debt finance is a loan or a Equity finance is an asset of
liability of the company. the company, or the
companies own funds.

What does it reflect? Debt finance is an obligation Equity finance gives the
to the company. investor ownership rights.

Duration Debt finance is Equity is long term

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 comparatively short term finance for the company.
finance.

Status of the lender Debt financier is a lender to The shareholder of the

the company. company is the owner of the
company.

Risk Debt falls under low-risk Equity falls under high-risk

investments. investments.

Types of financing Debt financing can be Shares and Stocks can

categorized by Term Loan, categorize equity.
Debentures, Bonds, etc.

Nature of the return The interest payable to the Dividend paid to the
lenders is fixed and regular shareholders is variable,
and also mandatory. irregular as it completely
depends on the profit
earnings of the company.

Importance of Capital structure

A firm having a sound capital structure has a higher chance of increasing the market price
of the shares and securities that it possesses.
Ensures that the available funds are used effectively. It prevents over or under
capitalization.
It helps the company in increasing its profits in the form of higher returns to stakeholders.
helps in maximizing shareholder’s capital while minimizing the overall cost of the capital
provides firms with the flexibility of increasing or decreasing the debt capital as per the
situation.

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 Factors that influence capital structure decisions.

Trading on Equity: means taking advantage of equity share capital to borrowed funds
on reasonable basis. It refers to additional profits that equity shareholders earn because of
issuance of debentures and preference shares
Degree of control-: The equity shareholders have more rights in a company than the
preference shareholders or the debenture shareholders. The capital structure of a firm will
be determined by the type of shareholders and the limit of their voting rights. Preference
shareholders have reasonably less voting rights while debenture holders have no voting
rights
Flexibility of financial plan- Debentures and loans can be refunded back as the time
requires. While equity capital cannot be refunded at any point which provides rigidity to
plans
Choice of investors: The Company’s policy generally is to have different categories of
investors for securities. Therefore, a capital structure should give enough choice to all
kind of investors to investor for securities
Capital market condition- In the life time of the company, the market price of the
shares has got an important influence.
 During the depression period, the company’s capital structure generally consists
of debentures and loans while in period of boons and inflation, the company’s
capital should consist of share capital generally equity shares.

Business and Financial Risks

a. Business risk
Business risk is the riskiness inherent in the firm’s operations if it uses no debt. It is in a stand-alone sense
is a function of the uncertainty inherent in projections of a firm’s return on invested capital (ROIC).
ROIC = net operating profit after taxes/Capital
NB: In this case capital is the sum of the firm’s debt and common equity.
If a firm uses no debt, then its interest payments will be zero, its capital will be all equity, and its ROIC
will equal its return on equity, ROE:
ROIC (No debt) or ROE = Net income to common stockholders/Common Equity
The uncertainty regarding future ROE, assuming the firm uses no debt financing, is defined as the
company’s business risk.

Business risk depends on a number of factors, the more important of which are listed
below:

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a. Demand variability. The more stable the demand for a firm’s products, other things held constant,
the lower its business risk.
b. Sales price variability. Firms whose products are sold in highly volatile markets are exposed to more
business risk than similar firms whose output prices are more stable.
c. Input cost variability. Firms whose input costs are highly uncertain are exposed to a high degree of
business risk.
d. Ability to adjust output prices for changes in input costs. Some firms are better able than others to
raise their own output prices when input costs rise. The greater the ability to adjust output prices to
reflect cost conditions, the lower the degree of business risk.
e. Ability to develop new products in a timely, cost-effective manner. Firms in such high-tech
industries as drugs and computers depend on a constant stream of new products. The faster its
products become obsolete, the greater a firm’s business risks.
f. Foreign risk exposure. Firms that generate a high percentage of their earnings overseas are subject
to earnings declines due to exchange rate fluctuations. Also, if a firm operates in a politically unstable
area, it may be subject to political risks.
g. The extent to which costs are fixed: operating leverage. If a high percentage of costs are fixed,
hence do not decline when demand falls, then the firm is exposed to a relatively high degree of
business risk.
Business Risk and Operating Leverage

Operating Leverage measures the relationship between outputs and earnings before interest and tax
(EBIT). Specifically; it measures the effect of changing levels of output on EBIT. It measures the extent
to which fixed costs are used in a firm’s operations. As noted above, business risk depends in part on the
extent to which a firm builds fixed costs into its operations. If fixed costs are high, even a small decline in
sales can lead to a large decline in ROE. So, other things held constant, the higher a firm’s fixed costs, the
greater its business risk. If a high percentage of total costs are fixed, then the firm is said to have a high
degree of operating leverage. High degree of operating leverage, other factors held constant, implies
that a relatively small change in sales results in a large change in ROE. In general, holding other factors
constant, the higher the degree of operating leverage, the greater the firm’s business risk.
Degree of operating leverage (DOL)

DOL: measures the resulting percentage change in EBIT as a result of the percentage change in output.

 It is defined as the percentage change in the earnings before interest and taxes relative to a given
percentage change in sales.
 Degree of operating Leverage= %change in EBIT
%change in Sales
%change in EBIT = Change in EBIT/EBIT
% change in sales = change sales /sales

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 DOL = OR

 Where Q is the units of output, s is the unit selling price, v is the unit variable cost and F is the
total fixed costs

% ∆ EBIT FC
DOL= OR 1+ where, EBIT = Q (P-V) – FC
%∆ Q EBIT

Example: Assume that the price per unit of output (P) is Br. 10, and variable cost per unit of output (y) is
Br. 4, and fixed cost (F) is Br. 30,000, and the level of output (T) is 8000 units. By using the formula
EBIT is computed as follows:
EBIT = Total revenue – Total variable cost – fixed cost
EBIT = TP – TV – F
or EBIT = T (P – V) – F
EBIT= 8000 (Br. 10 – Br. 4) – Br. 30,000
= Br. 18,000
Now assume that the level of output increases from 8000 to 10,000 units. The resulting EBIT is computed
as:
EBIT = 10,000 (Br. 10 – Br. 4) – Br. 30,000
= Br. 30,000
≈ % ∆ EBIT , 30,000-18,000/18,000 = 66.67%
≈ % ∆ Q , 10,000-8000/8000 = 25%
% ∆ EBIT FC 30,000
DOL= , 66.67%/25% = 2.67% or 1+ , 1+ = 2.67%
%∆ Q EBIT 18,000

The coefficient of operating leverage of 2.67 is interpreted as follows. A 1 percent change in output
(sales) from an initial value of 8000 units produces a 2.67 percent change in EBIT.

b. Financial Risk

Financial risk is the additional risk placed on the common stockholders as a result of the
decision to finance with debt. Conceptually, stockholders face a certain amount of risk that is
inherent in a firm’s operations; this is its business risk, which is defined as the uncertainty
inherent in projections of future operating income. The use of debt, or financial leverage,
concentrates the firm’s business risk on its stockholders. This concentration of business risk occurs
because debt holders, who receive fixed interest payments, bear none of the business risk. To illustrate the
concentration of business risk, we can extend the Belay Electronics example. To date, the company has
never used debt, but the financial manager is now considering a possible change in the capital structure.
Changes in the use of debt will cause changes in earnings per share (EPS) as well as changes in risk—
both of which will affect the company’s stock price.

Financial Leverage

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Financial leverage is the extent to which fixed-income securities (debt and preferred stock) are used in
a firm’s capital structure. It measures the relationship between EBIT and earning per share (EPS).

% ∆ EPS EBIT
DOFL= OR
% ∆ EBIT EBIT−I −L−(D /1−T )

I = Interest payment, L = Lease payment, D = Dividend

( EBIT−I ) ( 1−T )−D

EPS ¿ , N = Number of common stock outstanding shares
N

Assume that I = Br. 100,000, T = 0.4, D = Br. 80,000

N = 60,000, and EBIT = Br. 500,000.
The EPS at this level of EBIT iscomputed as:
EPS = (Br. 500,000 – Br. 100,000) (1 – 0.4) – Br. 80,000
60,000
= Br. 2.67
 If EBIT increases from Br. 500,000 to Br. 600,000, the resulting EPS is:
EPS = (Br. 600,000 – Br. 100,000) (1 – 0.4) – Br. 80,000
60,000
= Br. 3.67
The financial leverage is computed as:
 Percentage change in EBIT = Br. 100,000/Br. 500,000 = 20%
 Percentage change in EPS = Br. 1/Br. 2.67 = 37.45%
% ∆ EPS
DOFL=
% ∆ EBIT
= 37.45%/20%
= 1.87
Combine Leverage
It is the combination of both operating and financial leverage. It measures the relationship between output
(sales) and EPS. It is the potential use of FC, both operating and financial to magnify the effect of
changes in sales on the firms EPS.
% ∆ EBIT
Degree of Combined Leverage (DCL) = OR DOL X DOFL
%∆Q
DCL = DOL X DOFL
Q(P−V ) EBIT
= X
Q ( P−V )−F EBIT−I −L−D/(1−T )

Q( P−V )
=
Q ( P−V )−F−I −L−D /(1−T )

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Example: A firm has a sales level of 15,000 units and increased to 16,500 units. Sales price is br.
50 and variable cost per units is br. 30. Total annual operating FC is br. 150,000 and annual
interest expense is br. 40,000. The firm paid br. 20,000 for preferred stock holders and has
10,000 outstanding shares of common stock. The firm tax rate is 40%.
Required:
a. What is the firm’s EPS at output level of 15,000 and 16,500 units?
b. What is the firm’s EBIT, DOL AND DOFL at output level of 15,000 units.
c. What is the firm’s degree of combined leverage DCL?
Solution
EBIT = 15,000(50-30)-150,000 = Br. 150,000

( EBIT −I )( 1−T )− D
EPS=
N
( 150,000−40,000 ) ( 1−0.4 )−20,000
EPS= = 4.6
10,000

 If output increased to 16,500 units, EPS increased to:

EBIT = 16,500(50-30)-150,000 = Br.180,000
( 180,000−40,000 ) ( 1−0.4 )−20,000
EPS= = 6.4
10,000
% ∆ EPS
DCL= , 6.4-4.6/4.6/16,500-15,000/15,000 = 3.91OR
%Q
FC 150,000
DOL=1+ , 1+ =2
EBIT 150,000
EBIT 150,000
DOFL= , = 1.956
EBIT −I −L−D/(1−T ) 150,000−40,000−20,000 /(0.6)
DCL=DOL X DOFL , 2 X 1.956 = 3.91

Optimum Capital Structure

The optimum capital structure of the firm is the best mix of debt and equity financing that
maximizes a company’s market value while minimizing its cost of capital.

EBIT/EPS analysis
The effect of Financial Leverage on EPS
EBIT‐EPS analysis gives a scientific basis for comparison among various financial plans and
shows ways to maximize EPS. EBIT/EPS analysis examines the effect of financial leverage on
the EPS with varying levels of EBIT or under alternative financial plans. It helps a firm in
determining optimum financial planning having highest EPS. EBIT‐EPS analysis is
advantageous in selecting the optimum mix of debt and equity emphasizing on the relative value
of EPS.

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Example: Suppose ABC co. is now considering financial plans. The firm needs Br. 100,000 long
term capital to begin operation. There are two alternatives to raise the required finance:
Alternative 1: Selling 1000 shares of common stock at Br.100 per share
Alternative 2: Selling 500 shares of common stock at Br.100 and borrow br.50,000 from the
bank at 5% interest

Question: what is the effect of these plans on ABC EPS?

Suppose there are three economic conditions (Weak, Average and Strong) corresponding with respective
EBIT. EBIT at each economic condition is br.4,000, 6,000 and 8,000 respectively.
Alternative 1:
Weak Average Strong
EBIT Br.4,000 6,000 8,000
Interest - - -
EBT 4,000 6,000 8,000
Tax(50%) 2,000 3,000 4,000
NI 2,000 3,000 4,000
No of common shares 1,000 1,000 1,000
EPS 2 3 4

Alternative 2:

Weak Average Strong

EBIT Br.4,000 6,000 8,000
Interest 2,500 2,500 2,500
EBT 1,500 3,500 5,500
Tax(50%) 750 1,750 2,750
NI 750 1,750 2,750
No of common shares 5,00 500 500
EPS 1.5 3.5 5.5
Therefore, from the above analysis we can conclude that alternative 2 will result the highest
EPS.

Introduction to the theory of capital structure

Modigliani and Miller (M&M) Propositions I and II with no taxes

In attempt to answer the questions like why capital structure is different among companies across and
within the same industry, scholars developed various theories. One of the modern theories is Modigliani
and Miller (M&M). Modern capital structure theory began in 1958, when Professors Franco Modigliani

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 and Merton Miller (hereafter MM) published what has been called the most influential finance article ever
written.MM proved, under a very restrictive set of assumptions, that a firm’s value is unaffected by its
capital structure. Put another way, MM’s results suggest that it does not matter how a firm finances its
operations, hence capital structure is irrelevant. However, MM’s study was based on some unrealistic
assumptions, including the following:
1. There are no brokerage costs.
2. There are no taxes.
3. There are no bankruptcy costs.
4. Investors can borrow at the same rate as corporations.
5. Capital markets are perfect. All information is available and there is no transaction costs
6. EBIT is not affected by the use of debt.
Based on the above assumptions, M&M derived the following two propositions:
i. Total market value of a firm is equal to its expected net operating income divide by the discount rate
appropriate to its risk class decided by the market (WACC).
Accordingly:- Value of levered firm = Value of unlevered firm
Value of firm = Net Operating Income/WACC
ii. A firm having debt in capital structure has higher cost of equity than unlevered firm. The cost of equity
include risk premium for the financial risk. In addition, according to proposition II, changing capital
structure of the firm may not change the firm’s value. It does not cause important changes in the firm’s
debt and equity. The structure of the capita (Financial Leverage), does not affect the overall cost of
capital. Cost of capital is only affected by business risk.
WACC = (E/V x Ke ) + (D/V x Kd)
E = Equity, D = Debt, Ke = Cost of equity, Kd = Cost of debt, V = E + D
The cost of equity in a levered firm is determined as:
Ke = WACC + (WACC – Kd ) debt/equity
Example: To proof that the cost of equity is higher to the firm that uses debt in its capital structure, use
the following example. Suppose RRR Co. has a WACC (unadjusted) 12%. It can borrow @8%. Assume
that RRR has a target capital structure of 80% equity & 20% debt
Required:
A. What is the cost of equity?
B. What is the cost of equity if the target capital structure is 50% equity and 50% debt
C. Calculate unadjusted WACC
Solution:
A. Cost of Equity (Ke)

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Ke = WACC + (WACC – Kd ) debt/equity
12% + (12% -8%) (0.2/0.8) = 13%
B. Cost of equity of new capital structure
Ke = WACC + (WACC – Kd ) debt/equity
12% + (12% - 8%)(0.5/0.5) = 16%
C. Unadjusted WACC assuming that %tage of equity financing is 80% and Ke =13%
WACC = (E/V x Ke ) + (D/V x Kd)
0.8 x 13% + 0.2 x 8% = 12% Therefore, WACC is 12% in both cases.

The Shortcoming of this approach is the assumptions that the theory used is unrealistic (i.e. perfect
market, no taxes, no brokerage costs….) are making the approach unrealistic. Despite the fact that some
of these assumptions are obviously unrealistic, MM’s irrelevance result is extremely important. By
indicating the conditions under which capital structure is irrelevant, MM also provided us with clues
about what is required for capital structure to be relevant and hence to affect a firm’s value. MM’s work
marked the beginning of modern capital structure research, and subsequent research has focused on
relaxing the MM assumptions in order to develop a more realistic theory of capital structure.

Modigliani and Miller (M&M) Propositions I and II with taxes

MM published a follow-up paper in 1963 in which they relaxed the assumption that there are no corporate
taxes. They amended their theory by incorporating tax through recognized that the value of the firm will
increase or cost of capital will decrease where corporate taxes exist.Tax Laws allow separate-legal entities
to deduct interest payments as an expense, but dividend payments to stockholders are not deductible. This
differential treatment encourages these entities to use debt in their capital structures. As a result, there will
be some difference in the earnings of equity and debt holders in levered and unlevered firm and value of
levered firm will be greater than the value of unlevered firm by an amount equal to amount of debt
multiplied by corporate tax rate.Accordingly, M&M has developed the formula for computation of cost of
capital (WACC), and cost of equity (Ke ) for levered firm.

Value of a levered company = Value of an unlevered company + tax benefit

Value = Vu + Tax Benefits
 The following are two propositions
i. Cost of equity in a levered company = Cost of equity in an unlevered company + (Cost of equity
Unlevered firm – cost of debt) (Debt/debt +Equity)
ii. WACC in a levered company = Cost of equity in an unlevered company (1-t Debt/Debt + Equity)
Example: Suppose that EBIT is expected to be br1,000 every year for both firms. The difference between
them is that Firm L has issued 8% interest Br. 1,000 perpetual bonds. Assume tax rate is 30%.

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 Firm U Firm L
EBIT Br. 1,000 Br. 1,000
Interest (8%*1000) 0 80
EBT 1,000 920
Tax (30%) 300 276
NI 700 644
To understand the effect of tax, assume that depreciation, additional capital expenditures and networking
capital is zero. So, cash flow from assets is equal to EBIT – taxes. Therefore, cash from assets of Firm U
& L would be Br. 700 (1000- 300) & Br.724 (1000-276) respectively. From this you can see that capital
structure has effect on the cash flow of firms because of the existence of taxes. The total cash flow of
Firm L is br.24 more than that of U. This is because interest I tax deductible which generate tax saving
(i.e. 0.3*80 = 24).
Proposition I: Value of a levered company = Value of an unlevered company + tax benefit
Given the above example, since debt is perpetual, the same br.24 tax shield will be generated every year
forever. After tax cash flow to L will thus 700 plus tax saving (br.24). Since Firm L’s cash flow is always
br.24 greater than Firm U, Firm L is worth more than Firm U by the value of br.24 perpetuity. Because
tax shield is generated by paying interest, it has the same risk as the debt and 8% cost of debt is therefore,
the appropriate discount rate.
PV of interest tax shield is = T x Kd x D/ Kd
Where, T = tax, Kd = cost of debt, D = debt
PV = 24/0.08OR PV = 0.3 x 0.08 x 1000/0.08
= Br.300 =Br.300
From this we can drive the formula for value of levered firm as:
VL = VU + T x D, 700 + 300 =1000 OR 700 + (0.3*1000) = 1000
VL
VL = VU + T x D
T

VL =7, 300 TxD

VU = 7000 VU

VU

Total Debt(D)
1,000

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According to M & M proposition I with taxes, the value of the firm increases as total debt increases
because of the interest tax shield.
Suppose that the cost of capital for the firm U is 10% (Unlevered cost of capital K U = 10%). Br. 700 cash
flow forever to firm U (the value of firm U) is calculated as:
VU = EBIT x (1-T)/KU
=1000 X (1-0.3)/0.1
= Br.7000
From this we can calculate the value of levered firm (VL) as:
VL = VU + tax*debt
= 7000 + 03*1000
= 7,300
As indicated in figure above, the value of the firm goes up by br.0.3 for every Br.1 in debt. It is difficult
to imagine why any corporation would not borrow to absolute maximum under these circumstances. The
result of analysis in this section is that, if tax is included capital structure definitely matters. However, we
reach illogical conclusion that optimum structure is 100%.
Proposition II: Taxes, and WACC
WACC = E/V x Ke + D/V x Kd(1-T), V=E+D
Ke = KeU+ (Ke U -Kd)(D/E)(1-T)
Example; Recall that Firm L worth br.7,300 total assets of the firm. Since debt is worth br. 1,000, equity
must worth br.6,300(7,300-1,000). Firm L cost of equity is:
Ke = KeU + (Ke U -Kd)(D/E)(1-T)
10%+ (10% - 8%)(1,000/6,300)(1-0.3)
= 10.22%
Therefore, WACC is:
WACC = 6,300/7,300 x 10.22% + 1,000/7,300x 8%(1-0.3)
= 9.6%
Thus, without debt WACC is 10%, while with debt it becomes 9.6%. Therefore, the firm is better-off with
debt. As WACC decrease value of the firm increase.
Example: Given about FAF Corp., EBIT = Br. 151.52, T= 34%, D = Br. 500, Ke U = 20%, Kd = 10%
Required;
1. What is the value of FAF’s equity
2. Compute the cost of equity
3. Compute WACC
Solution
Remember that all cash flows are perpetuities and Value of unlevered firm (V U) is calculated as:
VU = EBIT x (1-T)/Ke U
151.52 x (1-0.34)/0.2 = Br.500

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  From MM Proposition I with taxes, we know that the value firm with debt (VL) is:
VL = V U + T x D
500 + (0.34 x 500) = Br. 670
 Since the firm is worth Br.670 as a total and debt is Br.500, equity is Br.170 calculated as:
Equity (E) = VL – D, 670- 500 = Br. 170
 Thus from MM proposition II with taxes, cost of equity is:
Ke = KeU + (Ke U -Kd)(D/E)(1-T)
= 0.2 + (0.2 – 0.1) (500/170)(1-0.34)= 39.4%
Then, WACC is:
WACC = E/V x Ke + D/V x Kd(1-T)
= 170/670 x 0.394 + 500/670 x 0.1(1-0.34)
= 14.92%
Trade-Off Theory (Static Trade-Off Hypothesis)

Suggests as an optimal capital structure, that mix of equity and debt where present value of tax
advantages equals to the present value of costs related to debt. The preceding arguments led to the
development of what is called “the tradeoff theory of leverage,” in which firms’ tradeoff the benefits of
debt financing (favorable corporate tax treatment) against the higher interest rates and bankruptcy costs.
The trade-off theory of capital structure is the idea that a company chooses how much debt finance and
how much equity finance to use by balancing the costs and benefits. Trade - off theory suggests as an
optimal capital structure, that mix of equity and debt where present value of tax advantages equals to the
present value of costs related to debt.
According to the static theory the gain from the tax shield on debt is offset by financial distress costs. An
optimal capital structure exists that just balances the additional gain from leverage against the added
financial distress costs. The optimum capital structure is the point at which WACC is minimum, and debt
to equity ratio is optimal.
Signaling theory
It was assumed by MM that investors have the same information about a firm’s prospects as its managers,
this is called symmetric information. However, managers in fact often have better information than
outside investors. This is called asymmetric information, and it has an important effect on the optimal capital
structure. To see why, consider two situations, one in which the company’s managers know that its
prospects are extremely positive (Firm P) and one in which the managers know that the future looks
negative (Firm N).

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Case I: we should expect a firm with very positive prospects (Firm P) avoid selling stock and instead to
raise required new capital by other means, including debt usage beyond the normal target capital
structure. This is because; they would not have had to share the benefits of the new product with the new
stockholders.
Case II: A firm with negative prospects would want to sell stock, which would mean bringing in new
investors to share the losses.
The conclusion from all this is that firms with extremely bright prospects prefer not to finance through
new stock offerings, whereas firms with poor prospects like to finance with outside equity. In a nutshell:
The announcement of a stock offering is generally taken as a signal that the firm’s prospects as seen by its
own management are not good; conversely, a debt offering is taken as a positive signal.

Using Debt Financing to Constrain Managers

Agency problems may arise if managers and shareholders have different objectives. Such conflicts are
particularly likely when the firm’s managers have too much cash at their disposal. Managers often use
excess cash to finance pet projects or for perquisites such as nicer offices, corporate jets, and sky boxes at
sports arenas none of which have much to do with maximizing stock prices. Even worse, managers might
be tempted to pay too much for an acquisition, something that could cost shareholders hundreds of
millions of dollars. By contrast, managers with limited “excess cash flow” are less able to make wasteful
expenditures. Firms can reduce excess cash flow in a variety of ways. One way is to funnel some of it
back to shareholders through higher dividends or stock repurchases. Another alternative is to shift the
capital structure toward more debt in the hope that higher debt service requirements will force managers
to be more disciplined. If debt is not serviced as required then the firm will be forced into bankruptcy, in
which case its managers would likely lose their jobs.

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