11/26/2021

Capital Structure
L Ramprasath

Capital Structure – What is good?

What is the objective?

Maximizing the value of the firm
We should also consider the possibility that no combination is
more optimal than the others
May be the more important decisions concern the firm’s assets
and the cap structure is just a minor detail
One advantage with this outcome: separation of investment and
financing decisions
We can analyze all capital expenditure related decisions using
all equity financing

Consider this simple case first

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The value of the firm may remain unaffected; but the

shareholders might be affected even under these idealistic
conditions

Capital Structure – What is good?

Consider this: MSR is reviewing its capital structure

Currently no leverage; 100% payout

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The CEO’s argument

Nature of leverage: Amplifies both +ve and –ve returns

If the CEO is visualizing higher returns under an alternate capital
structure, it is coming with higher risks (let’s not forget the basic
principle of risk-return tradeoff)

After the table is presented, the following observations are

made
Effect of leverage depends on company’s EBIT (beneficial when
EBIT is high)
Under expected scenario, leverage increases RoE and EPS
Shareholders are exposed to more risk
Because of all the above, capital structure is important

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So if MSR shareholders can borrow at 10%, then the firm

does not have to adjust its capital structure (can remain with
100% equity)

Upshot: investors can adjust their financial leverage to create

a different payoff pattern; it doesn’t matter whether MSR
borrows or not!
Essence of MM Proposition1: If levered firms are priced too
high, then rational investors will simply borrow on their
personal accounts to buy shares in unlevered firms
Homemade Leverage
How did we know to borrow $10 to match the payoffs?

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Cost of debt and cost of equity - which is usually higher?

Why?

Value maximizing firms often target a lower WACC ?

“Shareholders demand (and deserve) higher expected rates

of return than bondholders do. Thus debt is the cheaper
source of capital. So we can reduce WACC by borrowing
more.” (True / False)

Is there a link between return per share and leverage?

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MM Proposition II (No Taxes)

Cost of capital: R

B
RS  R0   ( R0  RB )
(%)

SL

B S
R0 RW ACC   RB   RS
BS BS

RB RB

Debt-to-equity B
Ratio S
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Summarizing so far, (with no taxes) higher leverage increases

both equity returns and equity risk, but the company’s overall
cost of capital does not change.

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Implications of Modigliani-Miller’s results: “The true role of a

firm’s financial policy is to deal with financial market
imperfections such as taxes and transaction costs and see
how this can be used to enhance value”

Can taxes create value?

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PVTS

The tax deductibility increases the total income that can be

paid out to bondholders and stockholders
Who benefits?

One way of discounting the tax shield: If the debt is fixed,

then the riskiness of tax shields is similar to that of the
interest payments generating them

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How does leverage affect your EPS?

For a certain level of EBIT, which will give you higher EPS – debt
financing or equity financing?

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The House of Toast Inc. is considering a new investment that

will cost $50,000 and that will increase the firm’s annual
operating earnings (EBIT) by $10,000 per year from the
current level of $20,000 to $30,000.
The firm can raise the $50,000 by (1) selling 500 shares of
common stock at $100 each, or (2) selling bonds that will net
the firm $50,000 and carry an interest rate of 8.5%.
What is the EPS for the expected level of EBIT equal to
$30,000 under these two choices?
The firm currently has equity worth $150,000 (with 1500 shares
outstanding) and long term debt worth $50,000 (carrying an
interest of 8%) in its balance sheet. And it lies in the 35% tax
bracket.
What is the effect of the financing alternatives on the level
and volatility of the firm’s EPS, if the firm anticipates that its
EBIT will fall within the range of $20,000 to $40,000 per
year?

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With taxes, do we still have a split between business and

financial risk?

What happens in the simple case of perpetual debt?

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The Effect of Capital structure

(Spl case: Fixed and perpetual debt)

Cost of capital: R B
(%)
RS  R0   ( R0  RB )
SL

B
RS  R0   (1  TC )  ( R0  RB )
SL

R0

B SL
RW ACC   RB  (1  TC )   RS
BSL B  SL
RB

Debt-to-equity
ratio (B/S)
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What does this tell us about optimal capital structure?

Need to relax another of the MM conditions
Costs of financial distress

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Why too much debt may not be good?

When a firm cannot meet its obligations, someone will get

less than what they were promised
Stakeholders start getting defensive

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As B/S increases, something else also rises – likelihood of

default
When firm value = value of debt
ownership gets transferred from the stockholders to the
debtholders
Debtholders liquidate the assets and get their dues back
Closer to reality, transfer of ownership is a legal process
“Anything related to courts and lawyers cannot be free of cost”

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Bankruptcy

Bondholders don’t get everything that is remaining from a

bankrupt firm
A fraction of the firm’s assets disappears during the legal process

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Is costs of financial distress just the legal costs surrounding

restructurings?
These are the Direct Costs - Legal and administrative costs
There is another type of costs
Indirect Costs
Impaired ability to conduct business (e.g. valuable employees
leave, forced to liquidate assets at throwaway prices, loss of sales,
loss of trust)

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Tradeoffs

And sometimes, a firm in distress goes for value-eroding

decisions.

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A firm in distress

Consider a levered firm looking at two mutually exclusive +ve

NPV projects, P1 and P2. Assuming there are two equally
likely outcomes – good times (expansion, boom) and bad
times (recession). The firm has debt obligations amounting to
$100mn.

Under P1
Future value of firm: 90 mn (recession) or 200 mn (boom)
Under P2
Future value of firm: 50 mn (recession) or 240 mn (boom)

Which is a better project?

Which project will the firm choose?

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Another situation

Consider another firm in distress below, with $4 mn of

outstanding debt payments

Boom Recession
Future Firm Value 5,000 2400
(figures in thousands)

The firm must decide to accept or reject a new project, which

will generate cash flows of 1.5mn one year from now,
independent of a boom or recession and which costs 1mn$ right
now. Also the firm does not have access to additional debt.
Assuming the Boom and Recession scenarios are equally likely,

What will an unlevered firm do?

What will this distressed firm do?
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Ultimately who pays for these distortions (from value

maximizing actions)?
Bondholders know that they cannot expect help from
stockholders during distress; so they try to protect themselves
by raising the int rates
Stockholders, who pay these high rates (or faces credit
rationing), ultimately bear the costs of selfish strategies

A bigger model (with personal taxes)?

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Financial distress is generally associated with negative

consequences
But the threat of financial distress can provide a source of
discipline that restrains managers in a positive way.

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Debt adds discipline to management

“If you are managing a firm with no debt, and you generate
high income and cash flows each year, you tend to become
complacent. The complacency can lead to inefficiency and
investing in poor projects. There is little or no cost borne by
the managers”

“Forcing such a firm to borrow money can be an antidote to

the complacency. The managers now have to ensure that the
investments they make will earn at least enough return to
cover the interest expenses. The cost of not doing so is
bankruptcy and the loss of such a job.”
(Bennett Stewart)

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Future financing flexibility

As the firm’s borrowings increases, it loses the flexibility of

financing future projects with debt.
The more uncertain a firm is about its future financing
requirements and projects, or the more difficult it is for the
firm to access markets quickly, the less debt the firm will use
for financing current projects.

Financial slack: keeping larger cash reserves

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One last point

Researchers have also looked into the role of information

asymmetry between managers and shareholders.
A seller knows more about the asset that he is selling than the
buyer (this asymmetry is the highest, for example in the
secondary markets for automobiles)
What happens when the company goes for additional equity
capital?

This is the reason, there is often a pecking order in raising

new capital and equity comes last in this order.

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Debt or Equity?: Summarizing the Trade Off

Advantages of Borrowing Disadvantages of Borrowing

1. Tax Benefit: 1. Bankruptcy Cost:
Higher tax rates --> Higher tax benefit Higher business risk --> Higher Cost
2. Added Discipline: 2. Agency Cost:
Greater the separation between managers Greater the separation between stock-
and stockholders --> Greater the benefit holders & lenders --> Higher Cost
3. Loss of Future Financing Flexibility:
Greater the uncertainty about future
financing needs --> Higher Cost

Summary contd…

Don’t underestimate the costs of higher levels of debt

A healthy unlevered firm can increase firm value by going for
leverage
“The precise obligation to repay is another mechanism to
squeeze operating inefficiencies”

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