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Capital Structure
Managerial Finance, 2008
Konan Chan
Capital Structure and the Pie
• The value of a firm is defined to be the sum of the
value of the firm’s debt and the firm’s equity.
V = B + S
• If the goal of the firm’s
management is to make the firm
as valuable as possible, then the
firm should pick the debt-equity
ratio that makes the pie as big as
possible.
S B
Value of the Firm
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Leverage Effect Example
Current Proposed
Assets $5,000,000 $5,000,000
Debt $0 $2,500,000
Equity $5,000,000 $2,500,000
Debt/Equity Ratio 0 1
Share Price $10 $10
Shares Outstanding 500,000 250,000
Interest rate 10% 10%
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Example
Current Capital Structure: No Debt
Recession Expected Expansion
EBIT $300,000 $650,000 $1,000,000
Interest 0 0 0
Net Income $300,000 $650,000 $1,000,000
ROE 6.00% 13.00% 20.00%
EPS $0.60 $1.30 $2.00
Proposed Capital Structure: Debt = $2.5 million
EBIT $300,000 $650,000 $1,000,000
Interest 250,000 250,000 250,000
Net Income $50,000 $400,000 $750,000
ROE 2.00% 16.00% 30.00%
EPS $0.20 $1.60 $3.00
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Leverage Effect
EPS and EBIT
• When increase financial leverage by more debt
– Let’s ignore tax here for simplicity
– In good year, we have more left-over after paying interests;
in bad year, we have less left-over
– ROE changes from 6%-20% to 2%-30% range
– EPS changes from $.6-$2 to $.2-$3 range
• The variability in both ROE and EPS increases when
financial leverage is increased
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$3.5
$3.0
$2.5
$2.0
$1.5
EPS
$1.0
Break-even Point:
EPS = $1; EBIT = $500,000
$0.5
Current
Proposed
$0.0
$300,000 $650,000 $1,000,000
EBIT
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1

Capital Structure Theory
• Modigliani & Miller Propositions
– No tax (MM,1958)
– With corporate tax (MM, 1963)
– With both corporate and personal tax (Miller, 1977)
• Trade-off theory
• Pecking order theory (Myers and Majluf, 1984)
• Free cash flow theory (Jensen, 1986)
• Market timing (Baker and Wurgler, 2002)
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Homemade Leverage
Current Capital Structure
• Investor borrows $500 and
uses $500 of her own to buy
100 shares of stock
• Payoffs:
– Recession: 100(0.60) -
.1(500) = $10
– Expected: 100(1.30) - .1(500)
= $80
– Expansion: 100(2.00) -
.1(500) = $150
• Mirrors the payoffs from
purchasing 50 shares from the
firm under the proposed
capital structure
Proposed Capital Structure
• Investor buys $250 worth of
stock (25 shares) and $250
worth of bonds paying 10%.
• Payoffs:
– Recession: 25(.20) + .1(250) =
$30
– Expected: 25(1.60) + .1(250) =
$65
– Expansion: 25(3.00) + .1(250) =
$100
• Mirrors the payoffs from
purchasing 50 shares under the
current capital structure
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MM Propositions (no tax)
• MM proposition I
– Capital structure does affect not firm value or WACC
– WACC keeps the same for any debt ratio
• MM proposition II
– Given proposition I, WACC keeps the same
– WACC = R B (B/V) + R S (S/V) = R 0 where V=B+S
– R S = R 0 + (B/S)(R 0 - R B )
– the expected return on equity increases with the debt-equity
ratio
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Cost of capital: R (%)
MM Proposition II (No Taxes)
B
RS
= R 0
+ × ( R 0
− R B
)
S
R B
R 0 R
WACC
B S
= × RB
+ × RS
B + S B + S
R B
Debt-to-equity Ratio
B
S
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L
Example: MM w/o Tax
• Suppose required return on assets = 16%, cost of debt
= 10%, debt/assets = 45%
• What is the cost of equity
– R S = 16% + (16% - 10%)(.45/.55) = 20.91%
• Suppose the cost of equity is 25%, what is the debtto-equity
ratio What is equity/assets
– 25% = 16% + (16% - 10%)(B/S)
– B/S = (25% - 16%) / (16% - 10%) = 1.5
– S/V = 1 / 2.5 = 40%
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Tax Shield
• Compare unlevered (U) with levered firm (L: 4 million debt,
r B
= 10% )
U L
EBIT 1,000,000 1,000,000
Interests (r B * B) 0 -400,000
EBT 1,000,000 600,000
Taxes (T C = 0.35) -350,000 -210,000
Earnings 650,000 390,000 (EBIT - r B B)(1-T C )
Total cash flows 650,000 790,000
• The difference between 790,000 and 650,000 is 140,000
(T C
r B
B = 0.35 * 0.1 * 4,000,000)
• T C
r B
B: tax shield from debt - the advantage of using debt
(disadvantage of equity financing)
EBIT(1-T C ) + T C r B B
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2

MM Theory with Taxes
• If tax shield is perpetual,
PV of tax shield = B * R B * T C / R B = T C * B
• Value of levered firm (V L )
= unlevered firm value (V U ) + PV of tax shield
= EBIT(1- T C ) / R 0 + T C * D
• More debt is better, because the interest deduction
generates extra value (save tax)
• R WACC = (S/V)R S + (B/V)(R B )(1-T C )
• R S = R 0 + (R 0 – R B )(B/S)(1-T C )
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MM Propositions (with corp. tax)
• MM proposition I (with tax)
– Capital structure does matter
EBIT (1 −TC
) TC
RBB
– VL =
+ = VU
+ TC
B
R0
RB
• MM proposition II
– The cost of equity is positively related to leverage
– R
S
B
= R0 + ( 1−TC
)( r0
− RB
)
S
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Cost of capital: R
(%)
The Effect of Financial Leverage
B
RS
= R 0
+ × ( R 0
− R B
)
S
B
RS
= R0 + × ( 1−TC
) × ( R0
− RB
)
SL
R 0
R B
B
L
R
WACC
=
B + S
L
× RB
× (1 −TC
) + ×
B + SL
L
S
R
S
Example - MM with Tax
• Suppose EBIT is 25 million, tax rate 35%, debt $75
million, cost of debt 9%, unlevered cost of capital 12%
• V U = 25(1-.35) / .12 = $135.42 million
• V L = 135.42 + 75(.35) = $161.67 million
• S = 161.67 – 75 = $86.67 million
• R S = 12% + (12%-9%)(75/86.67)(1-.35) = 13.69%
• R WACC = (86.67/161.67)(13.69%) +
(75/161.67)(9%)(1-.35) = 10.05%
Debt-to-equity
ratio (B/S)
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Example - MM with Tax
• Suppose that the firm changes its capital structure so
that the debt-to-equity ratio becomes 1.
• What will happen to the cost of equity under the new
capital structure
– R S = 12% + (12% - 9%)(1)(1-.35) = 13.95%
• What will happen to the weighted average cost of
capital
– R WACC = .5(13.95%) + .5(9%)(1-.35) = 9.9%
Miller Theory
• Allow both corporate and personal tax to exist
⎛ (1 − TC
)(1 − TS
) ⎞
V
⎜
⎟
L
= VU
+ B 1−
⎝ (1 − TB
) ⎠
• The cost of equity is positively related to leverage
B ⎛ (1 − TC
)(1 − TS
) ⎞
rS
= r0 +
( r0
rB
)
S
⎜
(1 TB
)
⎟ −
⎝ − ⎠
• In some cases, capital structure will not matter; i.e.,
back to original MM propositions w/o tax
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3

MM in Reality and Trade-off
• In reality, no firm takes the extreme step of using
100% debt financing as implied by MM with tax
• MM ignored the costs of bankruptcy in their analysis
of MM with taxes
• By including the cost of bankruptcy, there is a tradeoff
between the benefits of debt financing (tax
shields) against costs of debt financing (increased
risk of bankruptcy)
• Firm value = unlevered firm value + PV tax shield -
PV of financial distress costs
Costs of Financial Distress
• Direct costs
– Legal and administrative costs (lawyers, accountants,
professional witness, …etc.)
– About 3% of market value (Warner, 1977)
• Indirect costs
– Impaired ability to conduct business (lost sales)
– Agency costs of debt (over-investment (Jensen and
Meckling, 1976), under-investment (Myers and Majluf,
1984))
– Costly managerial efforts
– Employee’s unwillingness to work (wage reduction, search
new jobs)
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Trade-off Theory
• Trade-off between the benefits (tax shields) and costs
(financial distress) of using debt
• There exists an optimal level of debt which maximizes the
firm value
Firm Value
V U
PV(costs of financial distress)
B*
V L = V U + T C B
PV(tax shields)
Debt
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Factors Affect Trade-off
• Growth
– high growth firms should use less debt
– because their growth potential will be easily destroyed by
financial distress
• Types of assets
– firms with more intangible assets should have less debt
(high-tech. vs. airlines) because firms with tangible assets
can sell assets to recover from financial distress
• Uncertainty of operating income
– firms with more uncertain operating income should have
less debt (software vs. utilities) because these firms have a
high probability of experiencing financial distress
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Pecking Order Theory
• Theory
– Firms heavily rely on internally generated funds
– When needs external financing is necessary, debt is the
primary way to get financing
– Equity is the last resort to finance projects
• Rationale
– Information asymmetry causes difficulty in pricing equity
– Firm will issue over-valued shares only and thus investors
discount shares
– Firms prefer to use internally generated funds
– Bonds are safer than equity because valuation of bonds is
less affected by information asymmetry
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Implications from Pecking Order
• Theory
– No defined target (optimal) capital structure
– Most profitable firms generally borrow less is not because they have
low target debt ratios but because they don’t need outside money
– Less profitable firms issue debt because debt financing is first on the
pecking order of external financing
– Firms will avoid external financing, if with enough internal funds
• Financial slack
– Cash buildup, low debt level, and ready access to debt financing
– Financial slack is valuable because it avoids the costs of financial
distress and external financing during bad times
– It’s more valuable if firms with more positive NPV projects
– Explains why growth firms have low debt ratios
– Time the issues in good times to reserve financial slack
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4

Agency Costs
• What is the agency relationship
– The relationship between the principal and agent
– The agent is hired by the principal to act on behalf of the
principal
– Examples: stockholders and the manager, investors and
fund manager, landlord and tenant
• Is there any problem
– Will the agent always act in the interests of the principal
Why
– Conflict of interests ⇒ agency costs
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Types of Agency Problems
• Agency problem between stockholders and the manager
(agency costs of equity)
– Shirking
– Perquisites
– Over-investment
– Wasting free cash flows (free cash flows are cash flows in excess of
that required to fund all positive NPV projects)
• Agency problem between stockholders and bondholders
(agency costs of debt)
– Over-investment (risk-shifting/asset substitution)
– Under-investment (pass out positive NPV projects)
– Milking the property (cash in and run)
– Bait and switch (promise to do safe project,but invest in risky project)
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Over-Investment Problem
• When a firm is in financial distress, and there is a
risky project (high payoff with very small chance)
• What will the shareholders do
Over-Investment (Risk-Shifting)
• Stockholders have only limited liabilities
• Given financial distress, shareholders will be
forced to give up the ownership
• If head I win, if tail you lose:
– Stockholders shift the project risks to bondholders. So,
stockholders gain at the expense of bondholders
• Financial distress leads stockholders to take high
risks
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Under-Investment Problem
• The firm is in financial distress and has a safe
positive project, but it is short of cash
• What will shareholders do Raise money to take the
project or not
Under-Investments
• Stockholders and bondholders share the benefits of
positive NPV projects
• So, shareholders will pass up the positive NPV
project
• Financial distress destroys the investment policy
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5

Ways to Reduce Agency Costs:
• Align interests of the manager and stockholders
– The threat of firing
– (Hostile) Takeover
– Managerial compensation
– Leveraged buyouts (LBOs): pro and con
• Align interests of the stockholders and bondholders
– Protective covenants
– Consolidation of debt
– Strip financing
RJR Nabisco LBOs:
Stock price Bond value
• Oct. 27, 1988 (before ann.) $56 $5.0 billion
• Oct. 28, 1988 (after ann.) $75 $4.4 billion
• Nov. 30, 1988 (final bid) $109
• KKR won the bid (25 billion in total), even though
the management bid $3 more
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Free Cash Flow Theory
• Managers have incentives to not distribute free cash
flows and cause their firms to grow beyond the
optimal size
• The use of debt and corporate market control
(takeovers, LBOs) can help to reduce the agency
costs of free cash flows
– benefits of using debt
– ways to reduce the agency cost of equity
• Example: Oil industry in 80’s
Agency Cost of Equity
• An individual will work harder for a firm if he is one of the
owners than if he is one of the “hired help.”
• While managers may have motive to partake in perquisites,
they also need opportunity. Free cash flow provides this
opportunity.
• The free cash flow hypothesis says that an increase in
dividends should benefit the stockholders by reducing the
ability of managers to pursue wasteful activities.
• The free cash flow hypothesis also argues that an increase in
debt will reduce the ability of managers to pursue wasteful
activities more effectively than dividend increases.
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Market Timing Theory
Market Value Debt Ratios, 2002
• Managers “time” the market and issue equity when
the market price is high
– Loughran and Ritter (1995) find issuers underperform after
equity issuance
• The market timing has long and persistent effect on
capital structure
– Capital structure is the outcome of managers’ past attempt
to issue equity opportunistically
Company
Microsoft
Intel
ExxonMobil
Merck
Procter & Gamble
Boeing
Walt Disney
Debt/Assets
0
0
0.04
0.08
0.12
0.27
0.27
LT debt/capital
0
0
0.03
0.04
0.07
0.24
0.25
M/B
5.54
4.03
3.72
7.18
10.13
3.65
1.92
American Electric Power
0.54
0.36
1.62
Delta Air Lines
0.77
0.75
0.82
General Motors
0.84
0.83
4.12
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6

Country
Leverage Ratios
Total debt to
total asset
(Book value %)
LT debt to total
assets
(Book value %)
LT debt to total
capital
(Market value %)
United States 58% 37% 28%
Japan 69 53 29
Germany 73 38 23
France 71 48 41
Italy 70 47 46
UK 54 28 35
Canada 56 39 35
India 67 34 35
South Korea 73 49 64
Capital Structure Patterns Worldwide
• Capital structures have strong industry patterns
– High: utilities, transport, and capital-intensive manufacture
– Low: service, mining, most rapidly growing or high-tech
– The industry's asset mix and variability affect capital structure
• Capital structures vary across countries
– US, UK, Canadian firms have lower book debt ratios than firms
in Japan, France, and Italy
– US & German firms have lower market value debt ratios
– Leverage in developing countries is less than developed ones
– Historical, institutional, & cultural factors may play a part
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Capital Structure Patterns Worldwide
• Leverage ratios are inversely related to the perceived costs of
financial distress.
– Both across industries & across countries, the more costly is financial
distress, the less debt will be used.
– Companies rich in collateralizeable assets have higher leverage than
firms rich in growth options.
• Within industries, leverage is inversely related to profitability
– In all industries, the most profitable firms typically borrow the least
• Taxes influence capital structures, but they cannot explain the
differences in leverage across industries and countries
– Increased corporate tax rates yield increased debt usage
– It’s not clear firms in US use more debt now
Capital Structure Patterns Worldwide
• Existing shareholders consider leverage-increasing events
"good news" and leverage-decreasing events "bad news"
– Stock prices rise when leverage-increasing events announced, but fall
for leverage-decreasing events.
• Corporations that are forced away from a preferred capital
structure tend to return to that structure over time
– Has occurred frequently, particularly for US firms that have taken on
large amounts of new debt to finance takeovers.
– More generally, corporations like to operate within target leverage
zones, and will issue new equity when debt ratios get too high and
will issue debt if they fall too low.
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Negative news for Equity offerings
Positive news for leverage-increasing
Security type
Common stock
Preferred stock
Convertible preferred stock
Straight bonds
Convertible bonds
Two-day announcementperiod
abnormal return
-3.14%
-0.19%
-1.44%
-0.26%
-2.07%
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7

Rajan and Zingales (1995)
US Financing Pattern
90
Historical US financing patterns
60
30
0
-30
79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02
Internal Debt Equity
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Junk Bonds
• Low-grade bonds, with high default risks, but offer high
yield.
• Prior to 1970, most junk bonds are “Fallen Angels”.
• From late 1970, Michael Milken of Drexel Burnham Lambert
changed the market by creating the demand and supply of the
junk bonds.
• Junk bonds grew rapidly from 1984 to 1989, changing the
corporate finance in 80s.
• Small firms can get a huge amount of financing through junk
bonds, where they were not allowed to do so in the past
• Threat of hostile takeover, wave of mergers and acquisitions,
popularity of share repurchases
LBOs
• The acquisition by a small group of investors
financed primarily with debt.
• Going private transaction, usually with very high
debt ratio after LBOs.
• Top ten LBOs happened in 1986-1989.
• Too much money was chasing too few good deals
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The Development
• The increasing defaulted events in late 80s increased
the burden of DBL.
• Milken was charged for securities fraud, and DBL
filed bankruptcy in 1990.
• Junk bond market collapsed in 1990, so as the
decline of LBOs.
Junk Bonds and M&A
Amount
Junk Bonds Issues
160000
80%
140000
70%
120000
60%
100000
50%
80000
40%
60000
30%
40000
20%
20000
10%
0
0%
80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99
Amount M&A%
Year
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8

Junk Bonds and Default
Amount
Junk Bonds Issues
800
12%
700
10%
600
8%
500
400
6%
300
4%
200
2%
100
0
0%
80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99
New issues Default
Year
Testing Trade-off
• Supportive
– Significant negative relationship between R&D and debt
– Leverage is positively related to tangibility of assets, but
negatively related to growth opportunity. Leverage is also
positively related to sales (firm size)
• Against
– Profitability is negatively related to leverage
– Stock prices increase for leverage-increasing
announcements, and stock prices decrease for leveragedecreasing
announcements
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Testing Pecking Order
• Supportive
– Inverse relationship between profitability and financial
leverage within industries
– Stock prices increase for leverage-increasing
announcements, and stock prices decrease for leveragedecreasing
announcements
– Leverage is positively related to firm size
• Against
– Cannot explain the inter-industry differences in debt ratios
– Leverage is positively related to tangibility of assets
Testing Free Cash Flow
• Supportive
– Stock prices increase for leverage-increasing
announcements, and stock prices decrease for leveragedecreasing
announcements
• Against
– Leverage is positively related to tangibility of assets
– Profitability is negatively related to leverage
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Testing Market Timing
• (M/B) efwa is the weighted average of historical
market-to-book ratios, giving more weight when
firms issue more equity
Graham and Harvey (2001)
• Survey on 392 corporate managers (CFOs) to see if
theories match practice
• For each question, managers rate their answers from
0~4
– 0 means they never care about it
– 4 means it’s important
– Summarized by percentage of CFOs answer 3 or 4
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9

Survey on Debt Issue Decision
Trade-Off in Practice
• CFOs think that the corporate tax advantage of debt
is moderately important (rating: 2.07, 45%)
– It’s more important for large, higher levered, dividendpaying,
manufacturing, regulated, public firms
• Distress is not very important (rating: 1.24, 21%)
• Almost 60% CFOs think flexibility and credit rating
are important factors in raising debt, an evidence
saying that they want to avoid distress
• Earnings volatility is important when making debt
decisions (rating: 2.32, 48%)
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Target Debt Ratio
Trade-Off in Practice
• Targets that are tight or somewhat strict are more
common for
– large firms (55%) than for small firms (36%)
– investment-grade (64%) than speculative firms (41%)
– regulated (67%) than unregulated firms (43%)
• Given large investment-grade firms represent the big
portion of the economy, the evidence fairly strongly
supports the trade-off theory
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Pecking Order in Practice
• Financial flexibility is the most important item about
corporate debt decisions (rating: 2.59, 59%)
• Insufficient internal funds is important in debt
issuance decisions (rating: 2.13, 47%)
• Flexibility is more important for dividend-paying
firms, which are thought to have less information
asymmetry
• No strong evidence that firms issue equity because
recent profits are insufficient to fund activities, or
because the ability to obtain funds from debt is
diminished
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Pecking Order in Practice
• The importance of financial flexibility (financial
slack) and insufficient internal fund to security
issuance decisions is generally consistent with the
pecking-order model
• But, the desire for flexibility and the claim of
insufficient funds are not driven by information
asymmetry, the factors behind the pecking order
theory
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10

Survey on Equity Issue Decision
Pecking Order and Equity Issue
• Undervaluation is important when firms avoid to
issue equity, consistent with pecking order
• But, large, dividend-paying firms are more likely to
think this is important than small, nondividendpaying
firms
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Agency Cost in Practice
• Jensen (1986) argue that when a firm has ample free
cash flow, its managers tend to waste
• Firms can use debt to commit to pay out free cash
flow and discipline management to work efficiently
• Little evidence that firms discipline managers in this
way. It is important to note, that
– managers might be unwilling to admit to using debt in this
manner
– perhaps a low rating on this question reflects an
unwillingness of firms to adopt Jensen’s solution more
than a weakness in Jensen’s argument
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