SESSION 14

Corporate Finance
Term 3

Assistant Professor, Divya Aggarwal

Student 15 minutes later into the session
 Corporate Finance summarized

Maximize Business Value

Investment Operating Financing

Dividend Decision
Decision Decision Decision

Equity & Debt How much to

Hurdle Rate?
Working Capital mix? Return?
Management? Right kind of
Return Rate ?
debt? How to return?
 Session Objectives

• Understand the effect of financial leverage (i.e., capital structure) on

firm earnings.

• Understand capital structure theories with and without taxes.

• Debt/Equity trade off mix

 History of Finance
1960s --------------→ Theory of Capital Structure Relevance
 Modigliani Miller Theorem
The Modigliani-Miller theorem (M&M) states that the market value of a company is correctly
calculated as the present value of its future earnings and its underlying assets, and is
independent of its capital structure

Should one
borrow debt?
WHAT DO YOU THINK ?
 Rationale of Capital Structure Theorem
Think of the firm as a gigantic tub of whole milk. The farmer can sell the whole milk as is.
Or he can separate out the cream and sell it at a considerably higher price than the whole
milk would bring.
But, of course, what the farmer would be left with will be skim milk with low butterfat
content and that would sell for much less than whole milk.
 Lets revise your concepts : Capital Structure
The MM proposition says that if there were no costs of separation (and, of course, no
government dairy-support programs), the cream plus the skim milk would bring the same
price as the whole milk.
In a perfect market, investors can substitute their own leverage for a company’s leverage by
borrowing or lending appropriate amounts in addition to holding shares of the company.

Because this process is costless for investors, a company’s financial leverage should have no
impact on its value.

Hence, a company’s capital structure is irrelevant in perfect markets (?) (assuming no taxes)

Present value of future earnings and underlying assets impact firm

value
 Capital Structure : MM Theory

• What is a theory?
Though unrealistic assumptions, it provided a bases for thinking about capital structure and
the starting point for analysis

What are the assumptions:

• Homogenous expectations
• Perfect capital markets (no transaction costs, no taxes, information symmetry, no
bankruptcy costs)
• No agency costs : managers always act to maximize shareholder wealth
• Investors can borrow and lend at risk free rate
 Capital Structure theory
MM Theory Proposition I : (No taxes)
We can create a levered or unlevered position by adjusting the trading in our
own account.

This homemade leverage suggests that capital structure is irrelevant in

determining the value of the firm:
Refer to Appendix

VL = VU
slides if keen to
know about
homemade
leverage

Proposition I holds because shareholders can achieve any pattern of payouts they desire with
homemade leverage.
 Capital Structure theory
MM Theory Proposition II : (No taxes)
Leverage increases the risk and return to stockholders.
B
Rs = R0 +  ( R0 − RB )
RB is the interest rate (cost of debt).
S Rs is the return on (levered) equity (cost of equity).
B is the value of debt.
S is the value of levered equity. R0 is the return on unlevered equity (cost of capital).
 Capital Structure theory
MM Theory Proposition II : (No taxes) Derivation
B S
WACC = R0 =  RB +  RS
B+S B+S

B S B+S
 RB +  RS = R0 multiply both sides by
B+S B+S S

B+S B B+S S B+S

  RB   RS = R0
S B+S S B+S S

B B+S
 RB + RS = R0
S S
B
B B
 RB + RS = R0 + R0 RS = R0 + ( R0 − RB )
S S S
 Capital Structure theory
MM Theory (with taxes) : 1959
• Proposition I : Market value of a company is not affected by the capital structure of the
company
• Proposition II: The cost of equity is a linear function of the company’s debt/equity ratio
(assuming financial distress has no costs, as company takes more debt, cost of equity rises
in a manner to offset use of cheaper debt and maintain same WACC)
 Capital Structure

• Capital structure decision : It is simply about the decision on how to finance investments

• Depends upon the assumptions one makes about capital markets and the agents
operating in it
• Capital structure = Equity + Debt

• Goal of capital structure decision is to determine the financial leverage or capital

structure that maximizes the value of the company by minimizing the WACC

• Remember MM theory !!!!! : Capital structure is irrelevant

• Is the theory flawed then? Lets look at the link between theoretical relationship and
practical relationship
 Capital Structure : MM Theory
• Miller (1977): Caveat to the MM proposition II

• Whether or not financing with debt adds value to the company depends on the
corporate tax rate, the personal tax rate in interest income and the personal tax rate on
dividend income

• In practice, value of a levered company is affected by more than the tax issues
surrounding the use of debt.

• The analysis gets more complicated once factors such as cost of financial distress,
agency costs and asymmetric information are taken into account
 Bankruptcy costs
Bankruptcy risk versus bankruptcy cost
• The possibility of bankruptcy has a negative effect on the value of the firm.
• However, it is not the risk of bankruptcy itself that lowers value.
• Rather, it is the costs associated with bankruptcy.
• It is the stockholders who bear these costs.

What about others costs related to use of debt:

• Expected Cost of Financial distress =
• Cost of financial distress and bankruptcy in the event that happen i.e. legal and administrative
costs (Direct costs)
• Probability that financial distress and bankruptcy happen i.e. impaired ability to conduct
business (Indirect costs)

There is a trade-off between the tax advantage of debt and the costs of financial distress.
It is difficult to express this with a precise and rigorous formula.
 Signaling
The firm’s capital structure is optimized where the marginal subsidy to debt equals the
marginal cost.

Investors view debt as a signal of firm value

• Firms with low anticipated profits will take on a low level of debt.
• Firms with high anticipated profits will take on a high level of debt.

A manager that takes on more debt than is optimal in order to fool investors will pay the cost
in the long run.
 Agency Costs

• Agency costs = Monitoring costs + Bonding costs + Residual costs

• Better a company is governed, lower are the agency costs

• Michael Jensen’s free cash flow hypothesis (1996): more financially leverage a
company is, the less freedom managers have to either take on more debt or
unwisely spend cash. Management may create an overinvestment agency cost
which can be avoided by paying dividends as well
 Cost of Asymmetric Information

Cost of asymmetric information

• Pecking order theory (Myers & Majluf 1984) : managers choose methods of financing
according to a hierarchy that gives first preference to methods with the least potential
information content (retained earnings) and lowest preference to the form with the
greatest potential information content (public equity offerings)

Theory stating that firms prefer to issue debt rather than equity if internal financing is
insufficient.
Rule 1 : Use internal financing first.
Rule 2: Issue debt next, new equity last
 Investor Preferences : Personal Taxes

Individuals, in addition to the corporation, must pay taxes. Thus, personal taxes must be
considered in determining the optimal capital structure.

Dividends face double taxation (firm and shareholder), which suggests a stockholder receives
the net amount: (1 − TC )  (1 − TS )

Interest payments are only taxed at the individual level since they are tax deductible by the
corporation, so the bondholder receives: (1 − TB )

If TS = TB , then the firm should be financed primarily by debt (avoid double tax)

The firm is indifferent between debt and equity when: (1 − TC )  (1 − TS ) = (1 − TB )

 Capital Structure : MM Theory
• All the theories put together show that their exists an optimal capital
structure

• The theory is based on balancing the expected costs from financial

distress against the tax benefits of debt service payments

• Level of debt which maximizes shareholder value is determined by the

trade-off between the benefits and costs of financial leverage
• Primary benefit : Debt tax shield
• Primary cost: Expected costs of financial distress

• Hence, knowing the capital structure and assumptions around the capital
structure forms a crucial part of the financial model
 Capital Structure : Practical Issues in Capital Structure Policy
• Factors influencing capital structure:

• Company specific factors : probability of bankruptcy, profitability, quality and

structure of assets, growth opportunities

• Industry specific factors:

• Country specific factors: general environment in which the company operates

• Institutional and legal environment
• Financial markets and banking sector
• Macroeconomic environment
 Capital Structure : Practical Issues in Capital Structure Policy

• Companies' optimal capital structure may differ simply as a consequence of many

country specific differences

• With respect to international financial and credit analysis, these international

differences in debt ratios present some challenges in developing debt policies for
the foreign subsidiaries of multinational companies

• Theory provides little guidance and corporate practices in this area seem to vary
widely.

• These are learnings and insights you develop OVER TIME

 Capital Structure : Practical Issues in Capital Structure Policy
• Evaluating capital structure policy

• What happens to the cost of capital as the debt ratio is changed?

• At what debt ratio is the cost of capital minimized and company value
maximized?

• To what extent are stock price and company value affected when market
conditions make it difficult or impossible for a company to maintain its capital
structure?

Lets work upon a small

class exercise !
 Capital Structure : Practical Issues in Capital Structure Policy

Lets work upon a

• Problem 1 : Value of debt small class
exercise !
• Problem 2 : Value of Equity

• Problem 3 : Value of unlevered firm + Value of debt tax shields

 Answer the below questions in your group
• Do you shareholders are better or worse off with more leverage ?

• In this set of problems, is leverage good for shareholders? Why? In what sense
should shareholders pay a premium for shares of levered companies

• From a macroeconomic point of view, is society better off if firms use more than
zero debt (up to some prudent limit)?

• Google leveraged recapitalization and then look at Problem 7 to work and comment
on what is being done in this sheet?
 Group 4: Case on M&M Pizza
Case Objective

• M&M irrelevance propositions for capital structure

• Build intuition on the conservation of value and risk across financial policies in a
perfect market
• Examine the trade-off model of capital structure in which firms trade off the gains
and costs of tax shields and financial distress
 Group 5: Case on Hill Country
Case Objective

• Examine impact of alternative capital structures on financial performance

• Value benefits created by debt finance
• Examine capital structure theory and how to select a target debt-to-capital ratio
• Consider effect of corporate culture and managerial philosophy on the capital
structure decision
 Group 6: Case on Singapore Airlines
Case Objective

• Examine alternative sources of funding in a pandemic

• Evaluate pandemic’s impact on a firm’s capital structure along with conducting a

valuation exercise
 Lets discuss Group Project 2 and 3

Submission Deadline Date : 18th Session EOD

Appendix: HOME-MADE LEVERAGE
CONCEPT DERIVATION
 Homemade Leverage
Consider an all-equity firm that is contemplating going into debt. (Maybe some of the original
shareholders want to cash out.)

Current Proposed
Assets $20,000 $20,000
Debt $0 $8,000
Equity $20,000 $12,000
Debt ∕ Equity ratio 0.00 2/3
Interest rate n/a 8%
Shares outstanding 400 240
Share price (assume) $50 $50
 Unlevered and Levered Firm : EPS and ROE

Unlevered Firm Recession Expected Expansion

EBIT $1,000 $2,000 $3,000
Interest 0 0 0
Current outstanding shares = 400 shares
Net income $1,000 $2,000 $3,000
E PS $2.50 $5.00 $7.50
ROA 5% 10% 15%
ROE 5% 10% 15%

Levered Firm Recession Expected Expansion

EBIT $1,000 $2,000 $3,000
Interest 640 640 640
Current outstanding shares = 240 shares
Net income $360 $1,360 $2,360
E PS $1.50 $5.67 $9.83
ROA 1.8% 6.8% 11.8%
ROE 3.0% 11.3% 19.7%
 EPS and ROE under Homemade Leverage
Own Portfolio Recession Expected Expansion We are buying 40 shares of a $50
EPS of Unlevered firm $2.50 $5.00 $7.50 stock, using $800 in margin and
Earnings for 40 shares $100 $200 $300 1200 own fund.
Less interest on $800 (8%) $64 $64 $64
Net Profits $36 $136 $236 We get the same personal ROE as
if we bought into a levered firm.
ROA (Net Profits ∕ $1,200) 3.0% 11.3% 19.7%

B $800 2
Our personal debt-equity ratio is: = =
S $1, 200 3
Levered Firm Recession Expected Expansion
EBIT $1,000 $2,000 $3,000
Interest 640 640 640
Proposed shares outstanding = 240 shares
Net income $360 $1,360 $2,360
E PS $1.50 $5.67 $9.83
ROA 1.8% 6.8% 11.8%
ROE 3.0% 11.3% 19.7%
 EPS and ROE under Homemade (Un)Leverage
Recession Expected Expansion Buying 24 shares of an
EPS of Levered firm $1.50 $5.67 $9.83 otherwise identical levered firm
Earnings for 24 shares $36 $136 $236 along with some of the firm’s
Plus interest $64 $64 $64 debt gets us to the ROE of the
Net Profits $100 $200 $300
unlevered firm.
This is the fundamental insight
ROA (Net Profits ∕ $2,000) 5% 10% 15%
of M&M.

Recession Expected Expansion

EBIT $1,000 $2,000 $3,000
Interest 0 0 0
Net income $1,000 $2,000 $3,000
E PS $2.50 $5.00 $7.50
ROA 5% 10% 15%
ROE 5% 10% 15%
 MM Proposition I (With taxes) ----------- Derivation
The total cash flow to all stakeholders is ( EBIT − RB B )  (1 − TC ) + RB B

The present value of this stream of cash flows is VL .

Clearly ( EBIT − RB B )  (1 − TC ) + RB B =
= EBIT  (1 − TC ) − RB B  (1 − TC ) + RB B

= EBIT  (1 − TC ) − RB B + RB BTC + RB B
• The present value of the first term is VU .

• The present value of the second term is TC B.

VL = VU + TC B
 MM Proposition II (With taxes) ----------- Derivation

Start with M&M Proposition I with taxes: VL = VU + TC B

• Since VL = S + B  S + B = VU + TC B
VU = S + B (1 − TC )

• The cash flows from each side of the balance sheet must equal:
SRS + BRB = VU R0 + TC BRB

SRS + BRB =  S + B (1 − TC )  R0 + TC RB B
• Divide both sides by S
B  B  B
RS + RB = 1 + (1 − TC )  R0 + TC RB
S  S  S
B
• Which quickly reduces to: RS = R0 +  (1 − TC )  ( R0 − RB )
S