Capital Structure

Main Topics:
Capital structure: Simply put, a mix of debt and
equity.

Do capital structure decisions influence firm

value?

MM Proposition I & II (assume no taxes)

MM Proposition I & II (with corporate tax)

The role of corporate tax in corporate structure

decisions
Static trade-off theory & Optimal capital structure
What did we learn in the previous class?
How Can Firms Raise Funds?
Plowing back profits (i.e., retained earnings)

Seeking external financing

Debt financing
Equity financing

Some detailed issues:

IPO, SEO, and Rights Offering
Callable Bond and its valuation
 Question: which financing source is relatively more
important? Please see the data from U.S. firms:

Debt financing vs. Equity financing: The total amount of bank

loan and public bond issuances were about $1,500 billion and
$700 billion in 2005, respectively. The corresponding figure
was only $115 billion for equity.
What did we learn in the previous class?
The observation from real-world data seems to be
consistent with the Pecking Order Hypothesis.
Rule #1: Use the internal financing first
Rule #2: Issue the securities with less
asymmetric information first. (Namely, we issue
debt first, then issue equity.)

Perhaps the most significant challenge to the

pecking order hypothesis is the large number of
firms who behave in a manner that is inconsistent
with the basic predictions of the pecking order
theory.
Challenges to Pecking Order Hypothesis
Recall that under the pecking order theory, firms issue
equity only as a last resort. In practice, however, a
strikingly large number of firms show a strong
preference for equity financing over debt financing.

Many firms use equity financing when they appear to

have available debt capacity. For example, Microsoft
company that has high debt capacity did not issue any
long-term debt until year 2009.

In addition, pecking order hypothesis implies that an

optimal capital structure (e.g., an optimal mix of
debt and equity financing) does not exist.
What is the meaning of optimal?
 A quick review
Weighted-Average Cost of Capital (WACC)
Definition: Cost of Capital
From investors perspective, they are returns.
Weighted Average Cost of Capital (WACC)
WACC = [ VD (1 Tc ) rdebt ] + ( VE requity )
Measuring Capital Structure Using Market Value
Calculating Required Rates of Return for Debt (
pre-tax cost of debt = YTM), Preferred stocks (if
any), and Common Stocks
Calculate and interpret WACC
Just like interest rate is inversely related to bond price.
The lower the Cost of Capital, the greater the firm value.
 What should be an optimal capital
structure?
What should be an optimal capital structure?
What is the goal of the corporations?

Optimal capital structure:

(i) The capital structure is the debt-equity ratio that
minimizes the WACC (Weighted Cost of Capital)
(ii) The capital structure is the debt-equity ratio that
maximizes firm value.

Does an optimal capital structure for a firm exist? Or

can capital structure decisions influence firm value?
This is a big question!
Around 50 years ago, Modigliani and Miller (MM)
tried to answer this question in their studies.
 A detour: financial
leverage and its effects

What is Financial Leverage?

Financial Leverage:
In physics, the lever (leverage) makes it easier to
move objects because it takes less force to move it.
[Archimedes and the Law of the Lever. "Give me a
place to stand on, and I will move the earth."]
In general, financial leverage means the use of debt
in business, investment, etc.
From a corporations perspective, financial leverage
means the degree to which a company issues debt
securities (i.e., how much debt borrowed).
A detour: financial leverage and its effects
Assume that you can trade using a margin account.
That is, you can borrow brokers money to purchase
stocks, and the interest rate of the debt is 10%.
Assume that the margin requirement on a stock
purchase is 50%. That is, you can use 50% of your
own money and 50% of debt to purchase a stock.
Assume that you decide to purchase 100 shares of
VMware, Inc.(NYSE:VMW) and the price per share is
$100. This stock does not pay cash dividends.
Assume there is no taxes.
(i) After one year, if the price increases to $130, how
much is your percentage return?
(ii) After one year, if the price decreases to $80, how
much is your percentage return?
A detour: financial leverage and its effects
Equations: [NOTER0 equation also shows the return when we
buy stock use 100% of our own money (i.e., all-equity case). ]
HPR (holding period return) of the stock
= R0 = [ Dividend + (P1 P0) ] / P0

Return of your investment using leverage (i.e., buy on margin):

V R0 B RB ( S + B) R0 B RB
RS =
S S
S R0 + B R0 B RB B
= =
R0 + ( R0 RB )
S S
Rs = the return from your levered investment.
V = the total value of investment
S = the investment amount from own money (i.e., equity)
B = the amount of investment from borrowing debt
RB = the cost of debt ; R0 = unlevered cost of equity.
 Capital Structure and the Pie
The value of a firm is defined to be the sum of
the value of the firms debt (B=bond) and the
firms equity (S=stock).
V=B+S

If the goal of the firms

management is to make the S B
firm as valuable as possible,
then the firm should pick the
debt-equity ratio that makes
the pie as big as possible.
Can they? Value of the Firm
MM Proposition I & II (without taxes)
Assumption:
No tax
No transaction cost, agency cost, bankruptcy, etc.
Individual and corporations borrow at same rate.

MM Proposition I: VL = VU (Value of levered

firm equals value of unlevered firm.)
B
RS =
R0 + ( R0 RB )
MM Proposition II: S
(The cost of equity increases with leverage
because of the risk to equity rises with leverage.)
MM Proposition: Intuition (page 1)
EBIT EBIT
= VL = ?= VU =
MM Proposition I: RWACC R0
(Value of levered firm equals value of unlevered firm.)

Why did they obtain this counter-intuitive result?

If a firm only changes capital structure, then EBIT is
unchanged (because firms operation is unchanged).
Thus, EBIT will be the same for a firm that changes
from all-equity (unlevered) firms to a levered firm.
By definition, the firm value (the market value of
asset) is equal to the present value of all future cash
flow to firms. For simplicity, if we assume that EBIT
is a perpetuity, the firm value can be described as V
= EBIT / R. (Now, Is
R equal )to R ? )
WACC 0
MM Proposition I: Intuition (page 2)
Is
RWACC equal to R0 ?
Recall the Weighted Average Cost of Capital (WACC)
formula. (Note: MM Proposition I assumes no
taxes) S B
RWACC = RS + RB
V V

Based on our discussion on Financial Leverage

earlier, we know V R0 B RB B
RS = =
R0 + ( R0 RB )
S S

Now, Is
RWACC equal to R0 ?
MM Proposition: Intuition (page 3)
Cost of capital: R

RS = R0 + RB WACC
( R R=R
) 0
(%)

0 B
SL

B S
R0 RW ACC = RB + RS
B+S B+S

RB RB

Debt-to-equity B
Ratio S
MM Proposition I: Intuition (page 4)
If a firm only changes capital structure, then EBIT is
unchanged. Thus, EBIT will be the same.
MM further argue that the firms overall cost of capital
cannot be reduced by using more debt. That
is, RWACC = R0 . Because even though debt appears to
be cheaper than equity, the remaining equity become
more risky and has greater cost of equity that offsets
the effect of reduced cost of debt (using more debt that
has comparatively lower cost of capital). [That is the
intuition behind MM II.] MM mathematically prove the
2 effects (reduced cost of debt vs. increased cost of
equity) exactly offset each other ( thus RWACC = R0 ),
so the firm value is invariant to the use of debt (i.e.,
capital structure). EBIT EBIT
= V=
L V=
U
RWACC R0
 Nobel Prize

Prof. Franco Prof. Merton

Modigliani H. Miller

Modigliani, Franco, and Merton Miller, 1958, The cost of

capital, corporation finance and the theory of
investment, American Economic Review 48, 261-297.
 Final Comments on
MM Propositions I & II (without taxes)
I have a simple explanation [for the first Modigliani-Miller
proposition]. It's after the ball game, and the pizza man
comes up to Yogi Berra and he says, 'Yogi, how do you want
me to cut this pizza, into quarters?' Yogi says, 'No, cut it into
eight pieces, I'm feeling hungry tonight.' Now when I tell that
story the usual reaction is, 'And you mean to say that they
gave you a [Nobel] prize for that? -Merton H. Miller (1997)

What is the bottom-line idea behind MM Proposition I?

Given that firm value and cash flow are largely determined
by the firms business operation, how we divide the firm
value among shareholders and debtholders wont affect the
total amount of the firm value.
Just like how we cut the pizza wont affect the total size of
the pizza.
 Final Comments on
MM Propositions I & II (without taxes)
The counter-intuitive MM Proposition I & II (assume
no taxes) is largely driven by their strict assumptions.

For example, by assuming there is no taxes, MM

Propositions I & II (without taxes) ignore the effect of
corporate tax.

Why are MM Propositions I & II (without taxes) so

influential, even helping both scholars win Nobel Prize?
It provides a clean benchmark case.
By relaxing the assumptions one-by-one, later
studies gain many fruitful insight (on why capital
structure decisions matter in real world).
From next slide, lets assume there is corporate tax.
MM Propositions I & II (With Taxes)
Key question: If we assume firms do pay corporate
tax, can capital structure decisions influence firm
value?
A short answer: YES! But, why?
Recall: V = B + S. If tax decreases, then V increases.
MM Propositions I & II (With Taxes)
WPC firm has a corporate tax rate (tc) 35% and expected
EBIT of $1 million each year. This firm is considering 2
alternative capital structures: (i) all-equity (use zero
debt); (ii) borrow $4,000,000 debt with 10% interest rate
( Interest payment = $400,000 each year).

Annual tax shield benefit

Lets use real-world data to do a preliminary
calculation on the size of tax-shield benefit
AAPL adjusted its capital structure since Summer
2013 by increasing long-term debt & buying back
shares.
http://online.wsj.com/news/articles/SB100014241278
87324482504578454691936382274
[WSJ, April 30, 2013] Apple Inc. AAPL sold the
largest corporate-bond deal in history Tuesday, a
$17 billion offering
On this date, the AAPL stock went up by around 2%.
It indicates that stock investors felt that using more
debt will increase the firm value of Apple Inc.
Lets use real-
world data to
do a
preliminary
calculation on
the size of tax-
shield benefit AAPL started to use debt

AAPL adjusted
its capital
structure since
Summer 2013
by increasing
long-term debt
& buying back
shares.
Lets use real-world data to do a preliminary
calculation on the size of tax-shield benefit
Apple Inc. (AAPL) adjusted its capital structure since
April 2013 by increasing long-term debt & buying
back shares. According to its balance sheet, the
long-term debt of AAPL in pre-2013 period is 0,
while the long-term debt of AAPL at the end of year
2013 is $16.96 billion. According to
Morningstar.com, the coupon rate of a AAPLs long-
term debt is 3.85%. According to csimarket.com, the
effective tax rate of AAPL is around 26%.
Based on these data about AAPL, what is the
amount of annual interest tax shield?
 AAPL
example
Since
Summer
2013, AAPL
stock stopped
the prolonged
decline of its
share prices
and went up
from around
$400 to more
than $500.
 Total Cash Flow to Investors
- A brief summary
All-equity firm Levered firm

S G S G

- The levered firm pays less in taxes than does the all-equity
firm. Thus, the sum of the debt plus the equity of the levered
firm is greater than the equity of the unlevered firm.
-This is how cutting the pie differently can make the pie
larger, i.e., the government takes a smaller slice of the pie!
- Therefore, MM Proposition I (with tax) should be
 MM Proposition I (with taxes)
Assumption:
Assume there is corporate tax.
No transaction cost, agency cost, bankruptcy, etc.
Individual and corporations borrow at same rate.

MM Proposition I (with tax): VL > VU (Value of

levered firm is greater than value of unlevered firm.)

Specifically, tC RB B
V=
L VU + tax
shield benefit = VU + ( for perpetuity case)
RB
Conclusion: Owing to the tax-shield benefit, firms
can increase firm value by using greater debt.
 MM Proposition II (with taxes)
MM Proposition II (with tax): The cost of equity
increases with leverage because of the risk to equity
rises with leverage. B
Specifically, RS =R0 + (1 tC )( R0 RB )
S
is RWACC < R0 when there is
Why corporate tax ?
S B S B B
= RS) + RB tC = R0 + (1 tC )( R0
RWACC (1 (1RB ) ) + RB tC
V V V S V
S S B B S B B
= R0 + ( R0 RB ) (1 tC ) + RB (1 tC ) = R0 + ( R0 RB ) (1 tC ) + RB (1 tC )
V V S V V V V
S B B B
= R0 + R0 (1 tC ) RB (1 tC ) + RB (1 tC ) The derivation is
V V V V
NOT required.
S B S B S+B B
= R0 + R0 (1 tC ) = R0 R0 tC = R0 R0 tC
V V V V V V
V B B
= R0 R0= tC R0 R0 tC < R0 RWACC < R0 , when B > 0 (i.e., use debt.)
V V V
 How corporate tax affects WACC?
[1] If we assume there is no tax, MM propositions
(without tax) suggest that WACC is invariant to the use
of debt. S B
[2] If we assume there is tax: RWACC =V RS + V RB (1 tC )
L L

Intuition: Because of the tax-shield benefit (B * tc), firms

using greater debt (i.e., B increases) have lower true cost
of debt. Thus, the more debt we use, the lower the WACC.
 Example Question:
Tax-shield and Firm Valuation
A firm expects its EBIT to be $1,000,000 every year
forever. The firm can borrow at 10%. This firm has
no debt currently, and its cost of equity is 20%.
Assume the tax rate is 40%. EBIT (1 tC )
VU =
(i) What is the value of the firm? R0
(ii) What will the value be if this firm borrows
$1,500,000 and uses the proceeds to retire part of
its equity? Assume the debt will mature after
many years (i.e., assume the interest payment of
the debt is a perpetuity).
(iii) What is the cost of equity after this capital
structure change? What is the WACC?
 What is the policy implication of MM
Proposition I (with tax)?
Policy Implication: Firms should use as much debt as
possible to maximize the tax shield benefit and to
increase firm value.

A peek at the
real-world data:

Around the world,

the average book
value of debt to
market value of a
firm is only
around 25%.
Incorporate Bankruptcy Cost into
the Analysis
The expected bankruptcy cost is a function of
two variables
the cost of going bankrupt
(i) direct costs: Legal and other Deadweight Costs
(ii) indirect costs: Costs arising because people
perceive a firm to be in financial trouble (e.g., lost
sale)
the probability of bankruptcy, which will depend
upon how uncertain a firms future cash flows are.

As a firm borrows more, the probability of

bankruptcy increases and hence the expected
bankruptcy cost increases.
 Incorporate Bankruptcy Cost into
the Analysis
Lets revisit the Pie.
The bankruptcy cost
represents of a slice
of Pie, and certainly
reduce the overall
size of the Pie.
If a firm borrows
more debt, the
expected bankruptcy
cost could increase Let G and L stand for payments to
and thus reduce the government and bankruptcy
lawyers, respectively.
overall firm value. VT = S + B + G + L
Static Trade-
off Theory
We realize that
excessive use of
debt will decrease
firm value. It is
mainly because of
the greater
expected
bankruptcy cost
associated with
higher debt.
It suggests that
an optimal
capital structure
should exist.
Are CFOs targeting an optimal
capital structure?
Graham and Harvey (2002) conduct a survey on 392
CFOs (from Fortune 500 firms). They asked CFOs
whether their companies have an optimal or target
debt-equity ratio.
54% had very strict or somewhat tight targets or
ranges; another 37% said they had flexible targets or
ranges. Only 9% firms has no target ratio or range.

Conclusion: Capital structure decision is a

type of financing decisions.
But, just like investment decisions, financing
decisions (e.g., capital structure decisions)
could also affect firm value.
Managers might choose some target/optimal
capital structure to maximize firm value.
Investment and Financing Decisions:
 A minor issue - Beta and Leverage:
No Corporate Taxes
In a world without corporate taxes, and with risky
corporate debt (i.e., beta of debt is not 0), it can be
shown that the relationship between the beta of the
unlevered firm and the beta of levered equity is:
Debt Equity Basically, it is the
Asset = Debt + Equity
Asset Asset Portfolio Beta equation.

In a world without corporate taxes, and with

riskless corporate debt (Debt = 0), it can be
shown that the relationship between the beta of
the unlevered firm and the beta of levered equity
is: Equity
Asset
= Equity
Asset
 A minor issue - Beta and Leverage:
With Corporate Taxes
In a world with corporate taxes, and riskless
debt, it can be shown that the relationship
between the beta of the unlevered firm and the
beta of levered equity is:
Debt
Equity ( of Levered firm ) = 1 + (1 TC ) Unlevered
Equity

Since 1 + Debt (1 T ) must be more than 1 for a

C
Equity
levered firm, it follows that Equity > Unlevered firm
 Review: Capital Structure
The Main Topics:
Do capital structure decisions influence firm value?

MM Proposition I & II (assume no taxes)

MM Proposition I & II (with corporate tax)

The role of corporate tax in corporate structure

decisions
Static trade-off theory
Optimal capital structure