1

Capital
Structure
MGMT-6030
2
Outline
Modigliani-Miller and Optimal capital
structure
No Taxes
With Taxes
WACC, APV and FTE methods
Agency costs
3
What we know
Investment decisions should follow the
positive NPV rule:
Invest into projects that have non-negative
NPV for a given cost of capital
Normally, the higher the cost of capital, the
lower the NPV
Ergo, company would like to have the cost
of capital as low as possible
4
?
BIG QUESTION
Shareholders and debt-holders require
different return on their investment,
because of the different risk involved
Is there some optimal combination of debt
and equity (we call it capital structure),
that would minimized the weighted-average
cost of capital (WACC) and thus maximize
the value of the firm?
Related question: why should shareholders
care about the value of the firm, rather than
the equity value?
5
Main results of MM
In the perfect world (no taxes, no
asymmetric information, no transaction
costs) the capital structure does not matter.
Level of debt is irrelevant
Once we introduce taxes, high leverage
increases firm value to its shareholders
Therefore, there exists an optimal leverage,
which would maximize the firm value
6
Modigliani-Miller Assumptions
No asymmetric information
No frictions (no transaction costs)
Individuals and companies can borrow and
lend at the same rate
7
Proof of MM1 by no arbitrage. Example
Ulevered firm:
Average EBIT
10,000
k
RF
=4%; Ak
m
=6%;
|
U
=1
1,000 shares
Value of the firm?
Share price?
Levered firm:
Average EBIT 10,000
1,000 shares
Risk-free debt D=
40,000
Value of equity?
Share price?
Value of the firm?
8
Example (2)
Unlevered firm:
Net Income = EBIT x (1-T) = 10,000
k
U
= k
RF
+ |
U
Ak
m
= 4% + 6% = 10%
Value of the firm, V
U
= 10,000 / 10% = 100,000
P
U
= 100
9
Example (3)
Levered firm
Interest = D x k
RF
= 40,000 x 4% = 1,600
Net Income = (EBIT - Interest) x (1-T) = 8,400
Since the cash flow from the levered firm is exactly the
same, its total value should be the same. V
L
=V
U
, value
of equity E
L
= V
L
- D
Value of the firm V
L
= V
U
= 100,000
Value of equity E
L
= V
L
- D = 100,000 - 40,000 = 60,000
P
L
= 60,000/1,000 = 60
Return to shareholders k
E
U
= 8.4 / 60 = 14 %
10
Example (4)
Proof: by arbitrage. For simplicity assume that all net
income is paid as dividends
Suppose that V
L
>V
U
(P
L
> 60)
You can sell short 1 share of the levered company,
borrow 40 and buy 1 share of the unlevered company
Your Cash Flow:
Item Now Every year in the future
Sell short P
L
+P
L
-8.4
Borrow @ 4% +40 -1.6
Buy P
U
-100 10
_______________________________________________
Total P
L
- 60 > 0 0
Arbitrage!!!
11
(No) Arbitrage Principle
What is an arbitrage?
Making a guaranteed (non-speculative) profit by taking
advantage of some mispricing, e.g., differences in interest
rates, exchange rates, commodities pricing etc.
The law of one price: Two securities with the same cash
flows should have the same price
The same cash flow means the same in every state of the
world
The same expected payoff is not enough!
To price a security, we can create a replicating portfolio of
other securities, which prices are known
The price of this security should be equal to the price of this
replicating portfolio
Commonly used in to price bonds and derivatives
12
Note on arbitrage pricing
To price security using the arbitrage argument:
1. Correctly identify all the cash flow until maturity
2. Choose the replicating portfolio
2.1. With derivative securities, the mostly likely candidates
are the underlying security and a riskless bond
2.2. With bond pricing the candidates are other bonds of
the same risk, but with different maturities and coupon
rates
3. Check that the cash flow for the replicating portfolio is
exactly the same as for the security of interest (no dividends
at intermediate dates, no extra costs)
4. Find the current value of the replicating portfolio. This is the
price of our security of interest
13
Example
What is the price of financial asset ABM, if it will pay to
its holder $ 1,000 in one year under all circumstances
and $ 2,000 in two years if the Dow Jones index will
be below 9,000 at that time?
Asset ABM:
$ 1,000 In 1 year
$ 2,000 In 2 years, iff DJ < 9,000
Two assets are traded on the market
CL (current price = $ 98)
$ 100 In one Year
Asset BND ( current price = $ 600)
$ 1,000 In 2 years, iff DJ < 9,000
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( )
D
U
E
U
E
L
E
E D
k k
E
D
k k
const k
V
E
k
V
D
WACC
+ =
= + =
Modigliani-Miller without taxes
In a tax-free world the capital structure
does not matter (it does not matter how you
slice the pizza)
MM1: Value of the firm remains the same
V
L
=V
U

MM2:
15
Self-made replication of the capital
structure
What about higher return to the shareholders of
the levered firm?
First, high risk - high return
Second, shareholders of the unlevered firm can
enjoy the same return!
Instead of buying 1 share of the unlevered firm by
using $ 100 of personal wealth, the shareholder can
personally borrow $ 40 @ 4% interest and invest only
$ 60 of his own money
Investment: 60 $
Payoff: 10 - 1.6 = 8.4
Return: 14%
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Example:
Firms U and L without taxes
EBIT= $ 10 M; V
U
= $ 100 M, E= $ 100 M
EBIT= $ 10 M; V
L
= $ 100 M, D = $ 40 M;
E = $ 60 M
WACC=10%, k
D
= 8%
k
E
U
= ? k
E
U
= 10%
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Example:
Firms U and L without taxes
EBIT= $ 10 M; V
U
= $ 100 M, E= $ 100 M
EBIT= $ 10 M; V
L
= $ 100 M, D = $ 40 M;
E = $ 60 M
WACC=10%, k
D
= 8%
k
E
L
= |
.
|

\
|

D
k
V
D
WACC
E
V
% 33 . 11 % 8
100
40
% 10
60
100
=
|
.
|

\
|
=
|
.
|

\
|

D
k
V
D
WACC
E
V
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Introducing taxes. Example
Once we introduce taxes, the cash flows to two
firms become different
Suppose that T = 40%
Unlevered firm:
Net Income = EBIT x (1-T) = 10,000 x 0.6 = 6,000
k
U
= k
RF
+ |
U
Ak
m
= 4% + 6% = 10%
V
U
= 6,000 / 10% = 60,000
P
U
= 60
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Example (2)
Levered firm
Interest = D x k
RF
= 40,000 x 4% = 1,600
Net Income = (EBIT - Interest) x (1-T) = 8,400 x .6
= 5,040
Total Cash Flow to stakeholders (shareholders +
debtholders):
1,600 + 5,040 =6,640
Every year the levered firm enjoys increased cash
flow of 640
This is due to the interest rate tax shield:
Interest x T = 1,600 x 0.4 =640
How much value does the tax shield add?
20
Example (3)
How much value does the tax shield add?
Let us assume that the company will keep
this debt forever, repaying only the interest
Then we have (T
C
denotes corporate tax
rate):
( )
000 , 16 000 , 40 4 . 0 ) (
) (
= = =
=

=
D T TaxShield PV
TD
k
D k T
k
Interest T
TaxShield PV
C
D
D
D
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Modigliani-Miller with taxes
In the world with tax the capital structure does
matter, because interest is tax deducted
The value of a levered firm is (MM1)
V
L
=V
U
+T
c
D
And its WACC and k
E
L
are, respectively (MM2)
( )( )
D
U
E C
U
E
L
E
L
E c D
k k T
E
D
k k
const k
V
E
T k
V
D
WACC
+ =
= + =
1
) 1 (
22
Example
An all finance equity firm has EBIT=20 M $ and
E=100 M $. The tax rate is T
C
= 35%. It has 10 M
shares outstanding
What is the value of this firm, if it issues D = 40 M $
to buy back some equity? Assume k
D
= 8%? What
is the new WACC?
Solution:
FCF=20x0.65 = 13
k
U
= 13/100 = 13%
V
L
= V
U
+ T
C
D = 100 + .35 x 40 = 114;
D/E = 40 / 74 = .54; D/V = 40/114 = .35
k
L
= 13% + .54 x 0.65 x (.13 - .08) = 14.76%
WACC = 11.4%
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Debt issued
Price per share
Shares bought =
Changing Capital Structure (example)
Company ABC announces the
recapitalization
New debt is issued
Proceeds are used to repurchase stock
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Calculating share price after share repurchase
A Company raises debt D buy back shares. Old
equity value is E
old
. New equity value after the
buyback is E
new
. What is the new share price
P
new
? How many shares A are bought?
old
new
new
new
old
new
new
new old new new new new
old new new
N
D E
E
N
N
D E
P
P N P N P E
N N P D
+
=
+
=
A = =
A = A =
;
;
25
51 . 3 49 . 6 10
49 . 6 10
114
74 ) 1 (
4 . 11
10
14 100
74 40 ) 35 . 0 1 ( 100 ) 1 (
= = A
= =
+

=
=
+
=
+
=
= = =
old
c old
c old
new
old
c old
new
c old new
N
D T E
D T E
N
N
D T E
P
D T E E
Example (contd.)
D=$ 40 M, V
new
=$ 114 M; T
c
=35%, N
old
=10 M
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D/V D/E Bond
ratio ratio rating k
d

0 0 -- --
0.125 0.1429 AA 8%
0.250 0.3333 A 9%
0.375 0.6000 BBB 11.5%
0.500 1.0000 BB 14%
Example: ABCs cost of debt at different
debt levels after recapitalization
27
Why does the bond rating and cost of debt
depend upon the amount borrowed?
As the firm borrows more money, the firm increases
its risk causing the firms bond rating to decrease,
and its cost of debt to increase
Since V
L
=V
U
+T
c
D, why would the credit rating
matter?
Because of the cost of financial distress!
Financial distress occurs when promises to creditors
are broken or honored with difficulty (often leads to
bankruptcy). Therefore
V
L
=V
U
+PV(tax shield) - PV(cost of financial distress)
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Recap: Benefits of debt
Tax advantage
According to MM, the company should have as
much debt as possible
Disciplining device
If a company has a lot of cash, its managers
become complacent. They might start making
wrong investment decisions and divert cash flows
to their own benefits
Should companies have near 100% of debt?
Of course NO!
Debt has its own costs! These costs depend on the
amount of debt
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Costs of debt
Direct Costs
Legal and administrative costs (tend to be a
small percentage of firm value)
Indirect Costs
Impaired ability to conduct business (e.g., lost
sales)
Agency Costs
Selfish strategy 1: Incentive to take large risks
Selfish strategy 2: Incentive toward
underinvestment
Selfish Strategy 3: Milking the property
30
Agency theory
An agency relationship exists whenever a
principal hires an agent to act on their
behalf
Within a corporation, agency relationships
exist between:
Shareholders and managers
Shareholders and creditors
31
Shareholders versus managers
Managers are naturally inclined to act in
their own best interests
But the following factors affect managerial
behavior:
Managerial compensation plans
Direct intervention by shareholders
The threat of firing
The threat of takeover
As a managers disciplining device debt is
good!
32
Shareholders versus creditors
Shareholders (through managers) could
take actions to maximize stock price that
are detrimental to creditors
Creditors take this into account, when
lending money
Therefore, In the long run, such actions will
raise the cost of debt and ultimately lower
stock price
33
Capital structure and agency costs
Distortions in investment strategies due to
shareholders/debtholders conflict
Debt overhang problem:
Pre-existing debt distorts the payoff from a new
project to shareholders
Results in underinvestment, because existing debt
precludes from undertaking a good project)
Example
Asset substitution problem
Results in investment into too risky projects
Example
Shortsighted investment
Reluctance to liquidate when liquidation is optimal
34
Example: Foregoing a good project
(debt overhang)
Company ongoing operations generate 50 M
at T=1 and T=2 (after taxes and interest)
Outstanding debt D = 100 (payable at T=2)
Investment project I=50 at T=1, payoff V=70
at T=2
WACC=20% (k
d
= 8 % ). Cost of equity is not
known, but we know that it is higher than
WACC
Should the company undertake the project?
Will it undertake the project?
35
Debt overhang example (2)
NPV
70/1.2 - 50 = 58.33 - 50 = 8.33 > 0
Distribution to the Stakeholders
With the project:
Debtholders get 100. PV(100) = 92.59
Shareholders get 50+70-100 = 20. PV(20) <
16.67
Without the project
Debtholders get 50 at T=2. PV(50)=46.29
Shareholders get 50 at T=1. PV=50
36
Debt overhang example (3)
Should the firm undertake the project?
YES!
Will the firm undertake the project if
managers act in the interests of
shareholders and only shareholders?
NO!
Who will suffer?
Shareholders!!!
Possible remedy - no-dividend covenant
37
Asset substitution example
Same as Example 1, BUT, no dividends
covenant! (remedy to Example 1)
Suppose that the company has a
competing project 2
Investment of 50 at T=1
Payoff of 200 with probability 1/4
Payoff of 0 with probability 3/4
Which project the firm will undertake?
38
Asset substitution example (2)
NPV:
Project 1 NPV = 8.33 > 0
Project 2. Expected payoff is
200 1/4 + 0 3/4 = 50
Project 2 NPV is
50/1.2 - 50 = -8.33 < 0
39
Asset substitution example (3)
With project 1:
Debtholders get 100, PV(100) = 92.59
Shareholders get 20, PV(20) < 16.67
With project 2:
Debtholders get 100 with probability 1/4 and
50 with probability 3/4. PV(72.5)=67.13
Shareholders get 150 with probability 1/4.
PV(37.5) > PV(20)
40
Agency cost of debt
Debtholders know about shareholders
opportunistic behavior
They require higher interest rate
Positive NPV projects are not undertaken -
this is called the agency cost of debt
Possible remedy - convertible debt
Convertible debt gives creditors the right to
convert debt into shares to reap the benefits
from a good outcome
41
Recap: Mitigating incentive problems
Covenants
Issuing more short-term than long-term
debt
Potential problem - higher exposure to
interest rate risk
Use of convertible bonds
Giving right incentives to the managers
42
Value of Stock
0 D
1
D
2
D/V
MM result
Actual
No leverage
43
%
15
0 .25 .75 .50
D/V
k
s
WACC
k
d
(1 T)
$
D/V
.25 .50
P
0
EPS
Cost of capital and EPS
44
Possible levels of debt
Which capital structure is better?
Is it ideal?
time
Value
Debt,
Face value
time
Value
Debt,
Face value
V
L
V
L
45
Signaling
Signal is a message credibly conveying
information from informed to uninformed
players
It is credible
if it is in the players interest to tell the truth
it is too costly to mimic (to lie) by others
46
Capital structure and signaling
Assumptions:
Managers have better information about a
firms long-run value than outside investors
Managers act in the best interests of current
stockholders
Managers can be expected to:
Issue stock if they think stock is overvalued
Issue debt if they think stock is undervalued
As a result, investors view a common stock
offering as a negative signal -- managers
think stock is overvalued
47
Capital structure and signaling (2)
Signaling theory, suggests firms should
use less debt than MM suggest
This unused debt capacity helps avoid
stock sales, which depress P
0
because of
signaling effects
48
The Pecking-Order Theory
Theory stating that firms prefer to issue
debt rather than equity if internal finance is
insufficient
Rule 1: Use internal financing first
Rule 2: Issue debt next, equity last
According to the pecking-order theory:
There is no target D/E ratio
Profitable firms use less debt (they use self-
financing instead)
Companies like financial slack
49
How Firms Establish Capital Structure?
Most corporations have low D/V Ratios
Changes in leverage affect firm Value
Stock price increases with increases in leverage
and vice-versa; this is consistent with M&M with
taxes
Another interpretation is that firms signal good
news when they lever up
Capital structure varies across Industries
There is some evidence that firms behave as if
they had a target D/E ratio
50
Factors in Target D/E Ratio
Taxes
If corporate tax rates are higher than bondholder
tax rates, there is an advantage to debt
Types of assets
The costs of financial distress depend on the types
of assets the firm has
Uncertainty of operating Income
Even without debt, firms with uncertain operating
income have high probability of experiencing
financial distress
Pecking order and financial slack
Theory stating that firms prefer to issue debt rather
than equity if internal finance is insufficient
51
Industry Book Market
Pharmaceuticals 27.4% 7.34%
Computers 24.75% 7.46%
Steel 32.88% 14.61%
Aerospace 46.32% 23.25%
Airlines 71.88% 32.86%
Electr. Utilities 61.74% 47.71%
Auto & Truck 81.52% 65.51%
Internet 18.57% 2.18%
Educational services 12.97% 2.24%
Source: Bloomberg, January 2005 (collected
by Aswath Damodaran (NYU))
Long-term debt ratios (D/V) for
selected industries
52
Summary and Conclusions
Costs of financial distress cause firms to restrain their issuance
of debt
Direct costs
Lawyers and accountants fees
Indirect Costs
Impaired ability to conduct business
Incentives to take on risky projects
Incentives to underinvest
Incentive to milk the property
Three techniques to reduce these costs are:
Protective covenants
Repurchase of debt prior to bankruptcy
Consolidation of debt
53
Summary and Conclusions
Because costs of financial distress can be
reduced but not eliminated, firms will not
finance entirely with debt
Debt (B)
Value of firm (V)
0
Present value of tax
shield on debt
Present value of
financial distress costs
Value of firm under
MM with corporate
taxes and debt
V
L
= V
U
+ T
C
B
V = Actual value of firm
V
U
= Value of firm with no debt
B*
Maximum
firm value
Optimal amount of debt
54
Summary and Conclusions
If distributions to equity holders are taxed at a lower
effective personal tax rate than interest, the tax
advantage to debt at the corporate level is partially
offset. In fact, the corporate advantage to debt is
eliminated if (1-T
C
) (1-T
S
) = (1-T
B
)
Debt (B)
Value of firm (V)
0
Present value of tax
shield on debt
Present value of
financial distress costs
Value of firm under
MM with corporate
taxes and debt
V
L
= V
U
+ T
C
B
V = Actual value of firm
V
U
= Value of firm with no debt
B*
Maximum
firm value
Optimal amount of debt
V
L
< V
U
+ T
C
B when T
S
< T
B

but (1-T
B
) > (1-T
C
)(1-T
S
)
Agency Cost of Equity Agency Cost of Debt
55
Calculating NPV of a Project in a Levered
Firm
WACC approach
Adjusted present value (APV) approach
Flow-to-equity (FTE) approach
56
WACC approach
Estimate FCF ignoring financing effects
Calculate cost of equity for each type of
capital used
Calculate WACC
Make sure that you are using the correct
D/E ratios for each year!
Find NPV
57
Adjusted present value (APV) approach
Calculate NPV for an all-equity financed
project
Adjust for the debt effects such as the
value of the tax shield and bankruptcy
costs
If the absolute amount of debt remains the
same over time, then the value of the tax
shield is T
c
D
58
Flow-to-equity (FTE) approach
Calculate the levered cash flow
Make sure that you calculate the interest
payment correctly
Calculate the levered cost of equity
Make sure that you use the right D/E ratio
Calculate the NPV
59
Which approach to use?
If D/E ratio is constant over time, WACC is
simpler to use
If the absolute value of debt is constant,
APV is simpler to use
60
Example
An all-equity company (the current value $
2 M, cost of capital k
U
=12%, k
RF
=6%) is
planning to undertake a new project, which
requires investment of $ 500 K and will
generate free cash flow with CF=100
growing in perpetuity at g=2%. The
company wants to finance the project by
issuing $ 500 K of console bonds at the
rate 8%. The tax rate is 40%.
What is the new value of the company
(total value and equity value)?
61
Example (2)
Solution: since the D = const, we use the APV
approach
The PV of the project is 100/(.12-.02)=1,000 K
Therefore, if all equity financed, the new value
of the firm would be $ 3 M
The PV of the tax shield is 500 x .4 = 200
The value of the levered firm is $ 3.2 M. The
value of debt is $ 500 K and the value of
equity is $ 2.7 M
Why is using WACC approach more difficult?
62
Appendix: Capital structure and option
theory
63
Stocks and Bonds as Options
Levered Equity is a Call Option
The underlying asset comprise the assets of the
firm
The strike price is the payoff of the bond
If at the maturity of debt, the value of the firm
assets is greater than the face value of debt,
the shareholders will pay the bondholders and
call in the assets of the firm
Otherwise, the shareholders will declare
bankruptcy and let the call expire
64
Stocks and Bonds as Options
Levered Equity is a Put Option
The underlying asset comprise the assets of the firm
The strike price is the payoff of the bond
If at maturity, the assets of the firm are
less in value than the debt
Shareholders have an in-the-money put
They will put the firm to the bondholders
If at maturity the assets are more valuable
than the face value of debt
The shareholders will not exercise the option
(i.e. NOT declare bankruptcy) and let the put
expire
65
Capital-Structure Policy and Options
Recall some of the agency costs of
debt: they can all be seen in terms
of options
For example, recall the incentive
shareholders in a levered firm have
to take large risks
They do that because high risk
projects increase the value of the
option
66
Value of debt and equity as options
Example
Biotech start-up develops a new drug. They finance
their investment with debt maturing in 3 years
(repayment of 600 M). By that time either the drug is
successful (with different degrees of success) and
company sells itself to a big pharmaceutical company,
or it fails. 4 possible states with equal probability
State: Success Moderate Mediocre Failure
Payoff: 1000 700 500 100
Debt: 600 600 500 100
Equity: 400 100 0 0
67
Value of debt and equity as options (2)
600
CF to firm
Equity
0
600
CF to firm
Debt
0
600
68
Value of debt and equity as options (3)
In option valuation language:
Underlying asset: the firm itself
Maturity - 3 years (maturity of debt)
Exercise price X = 600 M
Two similar interpretations:
Equity holders buy a call option from the debt-
holders (a right to buy the firm from the
bondholders at maturity). Debt-holders
(Bondholders) effectively own the firm and sell the
call option
Alternatively: Equity-holders own the firm, they
borrow 600 M and they buy a put option to sell the
firm to the bondholders at X=600 M