Capital Structure

Capital Structure
Session 13 &14
Capital Structure Choices
• Capital structure
– The collection of securities a firm
issues to raise capital from
investors.
– Mixture of Debt and Equity.
– Blend of Debt and Equity is known as
Financial Leverage.
Capital Structure Choices
• A firm’s debt-to-value ratio is the fraction of

the firm’s total value that corresponds to
debt
V= D / (E+D)
• Capital structure choices often vary across
industries and within industry as many
factors affect the choice .
• We will explore such factors towards the
end of the session.
ASAHI INDIA GLASS
FY Debt Equity Ratio
Mar '23 0.62
Mar '22 0.65
Mar '21 0.82
Mar '20 1.02
Mar '19 1.13
Mar '18 1.14
Mar '17 1.09
Mar '16 2.67
Mar '15 3.62
Mar '14 4.21
Capital Structure in Perfect Capital
Markets
• A perfect capital market is a market in
which:
– Securities are fairly priced
– No tax consequences or transactions
costs
– Investment cash flows are independent
of financing choices.
Markets
• Application: Financing a coffee shop that
costs $24,000 to open
– Expected cash flow is $34,500 at the end of one
year
– Given the risk, coffee shop should earn 15%
– What will be value of the coffee
shop.
• NPV of the project is
- $24,000+$34,500/1.15 = $6,000
Levered Financing – Debt +Equity
• Suppose Cash flow are certain up to $

16000,
• so we can borrow $15000 at Risk free
rate = 5%
• Debt after 1 year = $15750
• How much equity (levered equity)
we can raise ?
• After the debt is paid Equity holder can
expect to receive = $34500-$15750=
$18750.
• So we can raise 18750/1.15= $16304
• If this correct, we can raise additional
$1304 (15000+16304 = 31304-30000)
more in case of leverage.
Markets
Unlevered Versus Levered Cash Flows
with Perfect Capital Markets
Markets
Unlevered Versus Levered Returns with
Perfect Capital Market
The Risk and Return of Levered
Equity
Equity
Solution:
Plan:
• The value of the firm’s total cash flows does not change:
it is still $30,000. Thus, if you borrow $6000, your firm’s
equity will be worth $24,000. ‘
• To determine its expected return, we will compute the
cash flows to equity under the two scenarios .
• The cash flows to equity are the cash flows of the firm
net of the cash flows to debt (repayment of principal
plus interest).
Equity
Equity
Class Exercise-1
Problem:
• Suppose you borrow $50,000 when financing a
coffee shop which is valued at $75,000. You expect
to generate a cash flow of $75,000 at the end of
the year if demand is weak, $84,000 if demand
is as expected and $93,000 if demand is strong.
Each scenario is equally likely.
• The current risk-free interest rate is 4%, and
there’s an 8% risk premium for the risk of the
assets.
• According to Modigliani and Miller, what
should the value of the equity be? What is
the expected return?
Solution:
Plan:
• The value of the firm’s total cash flows does not
change: it is still $75,000 (expected cash flow of
$84,000 discounted at 12%).
• Thus, if you borrow $50,000, your firm’s equity will
be worth $25,000.
• To determine its expected return, we will compute
the cash flows to equity under the two scenarios.
The cash flows to equity are the cash flows of
the firm net of the cash flows to debt
(repayment of principal plus interest).
Execute:
• The firm will owe debt holders
$50,000  1.04 = $52,000 in one year.
• Thus, the expected payoff to equity holders is
$84,000 – $52,000 = $32,000,
for a return of
$32,000 / $25,000 – 1 = 28%.
Evaluate:
• While the total value of the firm is unchanged, the firm’s equity
in this case is more risky than it would be without debt.
• To illustrate, if demand is weak, the equity holders will receive
$75,000 – $52,000 = $23,000, for a return of $23,000-$25,000
=-2000/25000= – 8%.
• If demand is strong, the equity holders will receive $93,000 –
$52,000 = $41,000, for a return of $41,000-$25,000 =
16000/25000 = 64%.
• Without debt, equity holders expect to receive $84,000-
75,000 = 9000/75000 = 12%.
Markets
• Leverage and the Cost of Capital
– Weighted average cost of capital (pretax)
D E
rU  rD  rE
DE DE
Markets
D
rE rU  (rU  rD )
E
WACC and Leverage with Perfect Capital Markets
WACC and Leverage with Perfect Capital
Markets (cont’d)
Computing the Equity Cost of Capital
Solution:
Plan:
• Because your firm’s assets have a market value of
$30,000, by MM Proposition I, the equity will have a
market value of $24,000 = $30,000 – $6,000.
• We know the unlevered cost of equity is ru = 15%.
We also know that rD is 5%.
Execute:
6000
rE 15%  (15%  5%) 17.5%
24, 000
Debt and Taxes
Debt and Taxes
Safeway’s Income with and without
Leverage, 2012 ($ millions)
Total amount available to all investors is:

Debt and Taxes
• Interest Tax Shield

– The gain to investors from the tax deductibility
of interest payments
Interest Tax Shield = Corporate Tax Rate  Interest Payments

Computing the Interest Tax Shield
Example 16.3 Computing the
Interest Tax Shield
Problem (cont’d):
Computing the Interest Tax Shield
Execute:
($ million) 2010 2011 2012 2013

Interest expense 50 80 100 100
Interest tax shield (35% X interest
expense) 17.5 28 35 35
The Cash Flows of the Unlevered and
Levered Firm
Debt and Taxes
Debt and Taxes
• Interest Tax Shield with Permanent Debt

– As we know that, the market value of debt must
equal the present value of its future interest
payments:
Market value of Debt = D = PV(Future Interest Payments)

Debt and Taxes
• Interest Tax Shield with Permanent Debt

– If the firm’s marginal tax rate (TC) is constant, we
have the following general formula:
Value of the Interest Tax Shield of Permanent Debt
PV(Interest Tax Shield)=PV(TC X Future Interest Payments)

=TC X PV(Future Interest Payments)
=TC X D
Debt and Taxes
• Weighted Average Cost of Capital with Taxes

– Another way to incorporate the benefit of the
firm’s future interest tax shield
– Weighted Average Cost of Capital with Taxes
Debt and Taxes
• The reduction in the WACC increases with

the amount of debt financing
• The higher the firm’s leverage, the more the
firm exploits the tax advantage of debt, and
the lower its WACC
The WACC with and without Corporate
Taxes
• With more debt, there is a greater chance
that the firm will default on its debt
obligations
• A firm that has trouble meeting its debt
obligations is in financial distress
Direct and Indirect Cost of
Bankruptcy
• Outside professionals , accounting experts,
consultants, auctioneers and other with
experience of selling distressed assets.
• Creditors may incur cost during bankruptcy
cost
• Loss of customers
• Loss of suppliers
• Cost to employees
• Fire Sale of assets
• Tradeoff Theory:
– Total value of a levered firm equals the
value of the firm without leverage plus
the present value of the tax savings from
debt, less the present value of financial
distress costs:
Optimal Capital Structure: The
Tradeoff Theory
• Key qualitative factors determine the
present value of financial distress costs:
– The probability of financial distress
• Depends on the likelihood that a firm will
default
• Increases with the amount of a firm’s
liabilities (relative to its assets)
• It increases with the volatility of a firm’s cash
flows and asset values
Tradeoff Theory
Optimal Leverage with Taxes and
Financial Distress Costs
Tradeoff Theory
Additional Consequences of Leverage:
Agency Costs and Information
• Agency costs:
– costs that arise when there are conflicts of
interest between stakeholders
• Separation of ownership and control:
– Managers may make decisions that:
• Benefit themselves at investors’ expense
• Reduce their effort
• Spend excessively on perks
• Engage in “empire building” – focusing on expansion
rather than more NPV creating projects
Optimal Leverage with Taxes, Financial
Distress, and Agency Costs
Pecking Order Theory
• The pecking order hypothesis states:

– Managers have a preference to fund investment
using retained earnings, followed by debt,
and will only choose to issue equity as a
last resort.
• Retained Earning
• Private Debt
• Public Debt
• Equity
• The pecking order theory states that
companies prioritize their sources of
financing (from internal financing to equity)
and consider equity financing as a last
resort.
• Internal funds are used first, and when they
are depleted, debt is issued.
• When it is not prudent to issue more debt,
equity is issued
Capital Structure: Putting It
All Together
• Use the interest tax shield if firm has
consistent taxable income
• Balance tax benefits of debt against costs of
financial distress
• Consider short-term debt for external
financing when agency costs are
significant.
• Increase leverage to signal confidence in the
firm’s ability to meet its debt obligations
Capital Structure: Putting It
All Together
• Rely first on retained earnings, then
debt, and finally equity
• Do not change the firm’s capital structure
unless it departs significantly from the
optimal level.
Determinants of CS - Factors
• Profitability
• growth,
• cash flow,
• Size of firm,
• industry characteristics
• Interests rate
• Tax structure
• Assets tangibility- lower financing cost
Rising burden of Debt in Indian Cos.
Does Size Matters?
Sector FY22 FY23
Agriculture and allied 0.47 0.4
Auto and ancillaries 0.22 0.21
Capital goods 0.23 0.2
Chemicals 0.2 0.21
Construction and real estate 0.46 0.39
Consumer durables 0.16 0.14
FMCG 0.13 0.11
Hospitality 0.51 0.46
Infra and engineering 0.59 0.55
IT and ITeS 0.08 0.07
Media and entertainment 0.29 0.3
Metals and mining 0.37 0.46
Oil and gas 0.44 0.48
Pharma and healthcare 0.18 0.19
Power 1.19 1.16
Textiles 0.8 0.81
Industry
wise trend
last two
years
Profitability Data of Sample
Companies
Year Total income Operating profit Net profit
FY11 20.9 13.9 12.8
FY12 21.1 9.3 -0.2
FY13 7.6 5.1 1.5
FY14 7.3 9.4 10.1
FY15 0.4 3 -2.5
FY16 -5.2 4.7 2.6
FY17 6.5 13.1 16.4
FY18 10.3 6 -0.4
FY19 18 13.5 19.1
FY20 -5.4 -21.8 -50.7
FY21 -7.2 32.6 96.5
FY22 35.8 29.9 62.3
FY23 23.3 0.2 -6.9

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Capital Structure

• A firm’s debt-to-value ratio is the fraction of

• Suppose Cash flow are certain up to $

Total amount available to all investors is:

• Interest Tax Shield

Interest Tax Shield = Corporate Tax Rate  Interest Payments

($ million) 2010 2011 2012 2013

• Interest Tax Shield with Permanent Debt

Market value of Debt = D = PV(Future Interest Payments)

• Interest Tax Shield with Permanent Debt

Value of the Interest Tax Shield of Permanent Debt

PV(Interest Tax Shield)=PV(TC X Future Interest Payments)

• Weighted Average Cost of Capital with Taxes

• The reduction in the WACC increases with

• The pecking order hypothesis states:

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