Capital Structure

Taxes
Dividends

Andrs Sotomayor Aspiazu

Summary
The choices: types of financing
Equity
Debt

Capital structure and the cost of capital

Capital structure and the cost of equity capital

The Miller and Modigliani proposition I (M&M)
The Miller and Modigliani proposition II (M&M)
M&M with taxes
Tax shield
Taxes and M&M Proposition I

Taxes, WACC and M&M Proposition II

Bankruptcy costs

Optimal capital structure

The choices: types of financing
There are only two ways in which any business
can raise money: debt (bonds) or equity (stocks).
Debt financing involves borrowing money from
investors or lenders

Debt financing allows companies to retain full

ownership of the business
Financing

Companies that opt for debt financing have only

Debt to repay the money due on loans or bonds issued

Debt MUST be paid, whether the cash flows are

Equity high or low
Companies that use debt financing maintain any
profits made within the company
In some countries, interest expenses (debt) are
tax deductible, and create tax savings
 The choices: types of financing
There are only two ways in which any business
can raise money: debt (bonds) or equity (stocks).
Equity financing requires a company to sell a
percentage of its interests to investors

Companies sell shares on the stock market or through

a private offering
Financing

Equity financing distributes ownership or equity

Debt
among stockholders
With equity financing, companies have no repayment
Equity obligation, so the risks fall on the investors or
shareholders
Companies may distribute a portion of any profits
made to stockholders

Dividend payments (equity) have to be made out of

after-tax cash flows
But, the more shareholders a company has
Companies that use the equity financing approach
the less decision-making power
mustowners andtheir profits to shareholders
distribute
management have over a business
The choices: types of financing

Debt is any financing vehicle that is a contractual claim on the firm (and not a
function of its operating performance), creates tax-deductible payments, has a
fixed life, and has a priority claim on cash flows in both operating periods and
in bankruptcy.

Equity is any financing vehicle that is a residual claim on the firm, does not
create a tax advantage from its payments, has an infinite life, does not have
priority in bankruptcy, and provides management control to the owner.
The choices: types of financing (equity)
1. Owners Equity
Brought in by the owners of the company and provide the basis for the growth and
success of the business.

2. Venture capital and private equity:

Usually equity capital provided to a private firm by an investor or investors, in
exchange for a share of the ownership of the firm.

3. Common Stock
The conventional way for a publicly traded firm to raise equity is to issue common
stock at a price the market is willing to pay. If the company goes bankrupt, the
common stockholders will not receive their money until the creditors and preferred
shareholders have received their respective share of the leftover assets.

4. Warrants
When the holders received the right to buy shares in the company at a fixed price in
return for paying for the warrants up front.

5. Contingent value rights

A type of right given to shareholders of an acquired company (or a company facing major
restructuring) that ensures they receive additional benefit if a specified event occurs.
The choices: types of financing (debt)
1. Bank Debt

2. Bonds
The indebted entity (issuer) issues a bond that states the interest rate
(coupon) that will be paid and when the loaned funds (bond principal)
are to be returned (maturity date). Interest on bonds is usually paid
every six months (semi-annually). The main categories of bonds are
corporate bonds, municipal bonds, and U.S. Treasury bonds, notes and
bills, which are collectively referred to as simply "Treasuries.

3. Leases
A legal document outlining the terms under which one party
agrees to rent property from another party. A lease guarantees
the lessee (the renter) use of an asset and guarantees the lessor
(the property owner) regular payments from the lessee for a
specified number of months or years.For example, if you want to
rent an apartment, the lease will describe how much the monthly
rent is, when it is due, what will happen if you don't pay.
CAPITAL STRUCTURE AND THE COST OF CAPITAL

The WACC tells us that the firms overall cost of capital is a weighted
average of the costs of the various components of the firms capital
structure.

What happens to the cost of capital when we vary the amount of debt
financing, or the debtequity ratio?

Minimizing the WACC will maximize the value of the firms cash flows.

We will want to choose the firms capital structure so that the WACC is
minimized.

One capital structure is better than another if it results in a lower WACC.

A particular debtequity ratio represents the optimal capital structure if it

results in the lowest possible WACC.

This optimal capital structure is sometimes called the firms target capital
structure.
The effect of financial leverage
In this section, we examine the impact of financial leverage
on the payoffs to stockholders.

Financial leverage refers to the extent to which a firm relies

on debt. The more debt financing a firm uses in its capital
structure, the more financial leverage it employs.

We start by illustrating how financial leverage works.

For now, we ignore the impact of taxes.

Also, for ease of presentation, we describe the impact of

leverage in terms of its effects on earnings per share, EPS
and return on equity, ROE.
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The effect of financial leverage
1. The effect of financial leverage
depends on the companys EBIT.
When EBIT is relatively high,
leverage is beneficial.

2. Under the expected scenario,

leverage increases the returns to
shareholders, as measured by
both ROE and EPS.

3. Shareholders are exposed to

more risk under the proposed
capital structure because the EPS
and ROE are much more sensitive
to changes in EBIT in this case.
It actually makes no difference
whether or not Jean Carlos adopts
the proposed capital structure,
because any stockholder who
prefers the proposed capital
structure can simply create it using
This use of personal leverage.
homemade borrowing to alter the
degree of financial leverage is called
homemade leverage (there are levered and
Capital structure and the cost of equity capital
What we illustrated for the Jean Carlos Corporation is a special
case of M&M Proposition I. M&M Proposition I states that it
is completely irrelevant how a firm chooses to arrange its
finances.

M&M PROPOSITION I: THE PIE MODEL

M&M Proposition I states: The size of the pie doesnt depend on how
it is sliced.
The cost of equity and financial leverage:
M&M Proposition II
Changing the capital structure of the firm does not change the
firms total value, it does cause important changes in the firms
debt and equity ocurre.

We now examine what happens to a firm financed with debt and

equity when the debtequity ratio is changed.

We will continue to ignore taxes.

If we ignore taxes, the weighted average cost of capital, WACC, is:
Where V = E + D

If we call the WACC RA instead (required return on the firms

overall assets):

If we rearrange this to solve for the cost of equity capital, we see

that:
The cost of equity and financial leverage:
At this point we are looking a firm
M&M Proposition II with a debtequity ratio of zero, so RA
= RE in that case (WACC = all equity,
no debt).
This is the famous M&M
Proposition II which tells us that
the cost of equity depends on
three things:
1) The required rate of return on the
firms assets, RA (or WACC),
2) The firms cost of debt, RD and
3) The firms debtequity ratio, D/E.

As the firm raises its debt

The WACC doesnt depend on the debt
equity ratio; its the same no matter what
the debtequity ratio is. This is another
way of stating M&M Proposition I: The
firms overall cost of capital (WACC) is
unaffected by its capital structure (how
equity ratio, the increase in
leverage raises the risk of
the equity and therefore
the required return or cost
of equity (RE).
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much debt or equity it has).

M&M Propositions I and II with corporate taxes
In the U.S. and in some other countries DEBT IS TAX
DEDUCTIBLE:
interest paid on debt is tax deductible (it may be an added benefit
of debt financing).

Failure to meet debt obligations can result in BANKRUPTCY:

may be an added cost of debt financing.

We We
can consider taxes in this section andto bankruptcy in theI next
start by considering what happens M&M Propositions and II
one.
when we consider the effect of corporate taxes. To do this, we will
examine two firms: Firm U (unlevered) and Firm L (levered).

We assume that EBIT is expected to be $1,000

every year forever for both firms. The difference
between the firms is that Firm L has issued $1,000
worth of perpetual bonds on which it pays 8
percent interest each year. The interest bill is thus
.08 X $1,000 = $80 every year forever. Also, we
assume that the corporate tax rate is 30 percent.
M&M Propositions I and II with corporate taxes

THE INTEREST TAX SHIELD

We will assume that depreciation is zero. We will also assume that capital
spending is zero and that there are no changes in NWC (net working
capital).

In this case, cash flow from assets is simply equal to EBIT - Taxes. For Firms
U and L, we thus have:

What we are seeing is that the total cash flow to L is $24 more. This occurs
because Ls tax bill (which is a cash outflow) is $24 less. The fact that
interest is deductible for tax purposes has generated a tax saving equal to
the interest payment ($80) multiplied by the corporate tax rate (30
percent): $80 X .30 = $24 We call this tax saving the interest tax shield.
Taxes and M&M Proposition I
Because the debt is perpetual, the same $24 shield will be generated
every year forever. The aftertax cash flow to L will thus be the same
$700 that U earns plus the $24 tax shield.
Because Ls cash flow is always $24 greater, Firm L is worth more
than Firm U, the difference being the value of this $24 perpetuity.
Since it is a perpetuity, we can calculate the present value of this
tax shield.
We use 8% because the
tax shield is generated
by debt.

M&M Proposition I with corporate taxes: we have seen that the

value of Firm L (VL) exceeds the value of Firm U (VU) by the
present value of the interest tax shield, TC x D.

M&M Proposition I with taxes therefore

states that:
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Taxes, the WACC and M&M Proposition II
Once we consider taxes, the WACC is:

To calculate this WACC, we need to know the cost of

equity. M&M Proposition II with corporate taxes states
that the cost of equity is:

To illustrate, recall that we saw a moment ago that Firm L

is worth $7,300 total. Because the debt is worth $1,000,
the equity must be worth $7,300 - 1,000 = $6,300. For
Firm L, the cost of equity is thus:
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The weighted average cost of capital is:

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Without debt, the WACC is over 10 percent; with
debt, it is 9.6 percent. Therefore, the firm is
better off with debt.
Bankruptcy costs
If debt is so good, what is the factor that put a limit to it?

One limiting factor affecting the amount of debt a firm might use
comes in the form of bankruptcy costs.

As the debtequity ratio rises, so too does the probability that the firm
will be unable to pay its bondholders what was promised to them.

When this happens, ownership of the firms assets is ultimately

transferred from the stockholders to the bondholders.

In principle, a firm becomes bankrupt when the value of its assets

equals the value of its debt. When this occurs, the value of equity is
zero, and the stockholders turn over control of the firm to the
bondholders.

It is expensive to go bankrupt (there are direct and indirect

bankruptcy costs).
Optimal capital structure
Basically, a firm should borrow money (debt) as long as
the tax shield generated by it is convenient.
At very high debt levels, the possibility of financial
distress is a problem for the firm.

THE STATIC THEORY OF CAPITAL STRUCTURE

The static theory of capital structure says that firms
borrow up to the point where the tax benefit from an
extra dollar in debt is exactly equal to the cost that
comes from the increased probability of financial
distress.

Its called static because it assumes that the firm is fixed

in terms of its assets and operations and it considers only
possible changes in the debtequity ratio.
Optimal capital structure
THE STATIC THEORY OF CAPITAL
STRUCTURE
Optimal capital structure and the cost of
capital
The capital structure that maximizes the value of the firm is
also the one that minimizes the cost of capital
Optimal capital structure: a recap

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