TO BORROW OR NOT TO BORROW?

THE CAPITAL STRUCTURE DECISION

Key Concepts/Questions
• What is Capital Structure?

• Do managers create value by leveraging?

• Understand capital structure theories with and without

taxes

• Estimate value of a(n) levered/unlevered firm

• Relevant Text Book Chapter – “Capital Structure: Basic

Concepts”
 Scenario 1: The Manager
You are currently a board member of Vodafone-Idea Pvt.
Ltd. You know the business is struggling and you’re losing
money each quarter. You have an important decision to
make in the coming weeks. Assume you decide to give the
business one last push and in order to do that you need
capital to invest in capital expenditure. How will you raise
the capital? Debt? Equity? Combination – if so, what
proportion would be debt?
 Scenario 2: The Stockholder
Suppose you’re a marginal investor of Vodafone-Idea

1. In the current scenario of the firm, what is your primary

objective? Maximize the firm’s value or maximize returns for the
₹ you invested?

2. Suppose the board comes to a conclusion that borrowing would

add value to you, the stockholder. Is there an ideal debt to value
ratio that maximizes your value?
Firm Value vs Stockholder Interest
Current Proposed
I II III
Debt 0 500 500 500
Equity 1000 250 500 750
Value 1000 750 1000 1250

Suppose, the firm borrowed ₹ 500 to pay the entire cash as dividends to the
stockholders. In all the three proposed scenarios, what is the value of the
stock holder i.e. the total payoff (dividend + capital gain)? Assume no taxes.
Restructured Payoffs
Payoffs to Shareholders
I II III
Capital Gains -750 -500 -250
Dividends 500 500 500
Net Gain/Loss -250 0 250

Moral of the story: As it turns out, changes in capital structure only benefit the
stockholders if the value of the firm increases.
 Let’s go back to earlier scenario
• Firms (managers and board) often make capital structure
decisions by borrowing (adding leverage or leveraging) or
retiring debt (unlevering).

• When they do that, they brandish that “we create value for
our investors” as a common mantra.

• If you’re a marginal investor, how do you know whether

this is true?
 Let’s go back to Utopia!
• To answer the earlier question, we go back to the drawing
board.

• We begin by assuming the world is perfect i.e. utopia.

• What if…………
• There were no income taxes
• There were no transaction costs
• There were no bankruptcy costs
• An individual and a corporation can borrow at same rate
 The impact of financial leverage
Assume you’re a marginal stockholder of a firm that is completely
unlevered i.e. it has zero debt (all equity firm). Your board suggests that by
adding debt, your shareholder worth will go up. So, the firm borrows
money and buys back some outstanding shares in the market.

Current Proposed
Assets $ 20000 $ 20000
Debt $0 $ 8000
Equity $ 20000 $ 12000
D/E Ratio 0 0.67
Interest Rate 8% 8%
Shares Outstanding 400 240
Share Price $ 50 $ 50
 Task 1
• There are three market scenarios for the firm

Scenario Recession Expected Expansion

EBIT $ 1000 $ 2000 $ 3000

• If the firm is in its current state of all-equity (unlevered),

estimate the EPS and RoE – two important metrics for a
marginal investor.
 EPS and RoE: Current Structure
Recession Expected Expansion
EBIT $ 1000 $ 2000 $ 3000
Interest 0 0 0
Net Income $ 1000 $ 2000 $ 3000
EPS $ 2.5 $5 $ 7.5
RoA 5% 10% 15%
RoE 5% 10% 15%
Shares
400
Outstanding
 Task 2
• Assume the board goes ahead with the restructuring of its
finances, and borrows money.

• Estimate the EPS and RoE with the new capital structure
which has financial leverage (the firm is now a levered
firm).
 EPS and RoE: Proposed Structure
Recession Expected Expansion
EBIT $ 1000 $ 2000 $ 3000
Interest $ 640 $ 640 $ 640
Net Income $ 360 $ 1360 $ 2360
EPS $ 1.5 $ 5.67 $ 9.83
RoA 1.8% 6.8% 11.8%
RoE 3% 11.3% 19.7%
Shares
240
Outstanding
 Task 3
• Draw two axes, x-axis is EBIT in $, y-axis is EPS in $.

• Plot two graphs now, one for the unlevered firm, one for
the levered firm from your earlier computations.

• If you’re the manager of the firm, do you choose to borrow

or not to borrow?

• If you choose to borrow, what is the condition at which

you borrow?
Financial Leverage and EPS
12.00

10.00 Debt

8.00 No Debt

6.00 Break-even Advantage

EPS

point to debt
4.00

2.00

0.00
1,000 2,000 3,000
(2.00) Disadvantage EBIT in dollars, no taxes
to debt
 What does this mean?

1. The impact of financial leverage depends upon EBIT.

2. Financial leverage increases RoE and EPS when EBIT is

greater than the cross-over point.

3. The variability of EPS and RoE increases with leverage.

 The marginal investor conundrum
• Now if you’re a marginal investor, are you satisfied with
the answers your manager has given you?

• Has leverage really created value for you?

• Recall the assumptions of utopia, now if the utopian

conditions are true, has your manager really created
value for you by leveraging?

• Can you ask a different question?

 Homemade Leverage
• Let’s revisit the earlier example.

• You are a marginal investor now, and you need to know

whether leverage has created value for you.

• Recall the estimates of EPS in the two capital structures.

Capital
Recession Expected Expansion
Structure
Current 2.5 5 7.5
Proposed 1.5 5.67 9.83
 Homemade Leverage
• You want to understand whether the company is really
creating value for you by leveraging.

• Assume you have $ 50 with you right now, your own

money, and remember, this is equity (refer class 1).

• $ 50 will fetch you one share of the proposed firm, and

your earnings are as follows:

EPS 1.5 5.67 9.83

Income from 1 1.5 5.67 9.83
share
 Homemade Leverage
• The only way you know whether this is a value add is to
check whether you can by your own means replicate this
earning using the existing all equity position.

• Remember the condition – individual and firm can borrow

at the same rate.

• So, logically you must borrow enough money so that, in

your personal balance sheet, your debt to equity ratio
matches that of what the firm proposes to do.
 Homemade Leverage
• Alternative to investing your $ 50 (remember again, equity) in
the levered firm, you can use this and a combination of
personal debt to invest in all equity (unlevered) firm.

• As a first step, you need to now borrow, therefore along with

the $ 50 you have, you need to personally borrow $ x that
matches the capital structure of the new firm.

• As the D/E of new firm is 2/3, currently you have 50 as your

own investment, you need to borrow $ 33.33 (at 8%) so that
overall your personal portfolio has a borrowing of 33.33 and
own money (equity) of 50 matching the D/E of firm.
 Homemade Leverage
• Now, you choose to invest all the proceeds i.e. your own $
50 and $ 33.33 borrowed, a total of $ 83.33 into the
unlevered (current) firm’s equity (approx. 1.67 shares)

• For borrowing 33.33, you pay interest of $ 2.67 at 8%.

EPSunlevered 2.5 5 7.5

Earning for
4.167 8.33 12.50
1.67 shares
Interest paid (2.67) (2.67) (2.67)
Overall
1.5 5.67 9.83
gain/loss
 Moral of the story
• Without taking any risk, the individual investor on his own
can replicate the dollar return that the firm promises to
provide through change of capital structure.

• If the investor can do on his own (without taking risks)

what the management promise by their capital
restructuring decision, what is the point of such
restructuring?

• In other words, is the firm adding any value to the investor

(in this case shareholder)?
 Welcome to MM Theory: Assumptions

• Homogeneous Expectations
• Homogeneous Business Risk Classes
• Perpetual Cash Flows
• Perfect Capital Markets:
• Perfect competition
• Firms and investors can borrow/lend at the same rate
• Equal access to all relevant information
• No transaction costs
• No taxes
 MM Theory Proposition 1 (no taxes)
• An individual can create his/her own levered/unlevered
position by adjusting trading in his/her own account.

• This homemade leverage suggests that capital structure

is irrelevant in determining the value of the firm:

• VL = VU
 Alternative Example
• Assume there are two companies, U and L, both in the
same industry, having same assets worth ₹ 10,000 and
both earning the same earnings of ₹ 1,000.

• The only difference is, U is an unlevered company while

30% of L’s assets are funded by debt (at 20% interest).

• Assume both companies pay out all the earnings to

shareholders after a year and immediately get liquidated.

• What is the value of both firms?

 The balance sheets of U and L
• The balance sheet of U:

Assets 10000 Equity 10000

• The balance sheet of L:

Assets 10,000 Debt 3000

Equity 7000
 Value created by U and L
• As both firms earn ₹ 1,000 and immediately distribute the entire earnings to
the shareholders, the Net Income for both firms are as follows:
U L
Earnings 1000 1000
Interest 0 600
Net Income 1000 400
• Recall the value of a firm is V = D+E, implying the firm creates value for
bondholders/debt providers as coupon/interest payments and to equity
holders as dividends/capital gains.

• In this example, value of U is 1,000 as it has only equity and all earnings are
disbursed as dividends.

• Firm L, on the other hand provides a value of 600 as interest to debt

providers and 400 as dividends to equity holders, a total value of 1000.

• Therefore, we see M&M’s proposition in the absence of taxes, VU = VL

 M&M Proposition II (no taxes)
• Proposition II
• Leverage increases the risk and return to stockholders
RE = RA + (D/ EL) (RA - RD)
RD is the interest rate (cost of debt)
RE is the return on (levered) equity (cost of equity)
RA is the return on unlevered equity (cost of capital)
D is the value of debt (in $)
EL is the value of levered equity (in $)

• Essentially, once the firm borrows, the equity holders bear

more risk due to the residual nature of equity and demand
more returns to compensate for the risk.
 MM Proposition II (No Taxes)
Cost of capital: R (%)

𝐷
𝑅𝐸 = 𝑅A + × (𝑅A − 𝑅𝐷 )
𝐸𝐿

𝐷 𝐸
R0 𝑅𝑊𝐴𝐶𝐶 = × 𝑅𝐷 + × 𝑅𝐸
𝐷+𝐸 𝐷+𝐸

RD RD

Debt-to-equity Ratio
𝐷
𝐸
 Revisiting U and L with taxes
• In the previous example of U and L, assume the tax rate is 30%.
How does the value of both firms change?
U L
EBIT 1000 1000
Interest 0 600
EAI 1000 400
Taxes (30%) 300 120
EAT 700 280
Value of firm
700 880
(D+E)

• We see that value of L is slightly more than U. This is called the tax
shield effect.

• Effectively, Value of L = 700 + 30%×600 = 880. Due to interest

payment, the tax portion of interest payment is money not paid as
taxes, thus increasing the value of the levered firm.
 M&M Propositions I & II with taxes
• Proposition I (with Corporate Taxes)
• Firm value increases with leverage
VL = VU + Net benefits of debt
• Proposition II (with Corporate Taxes)
• Some of the increase in equity risk and return is offset by the interest tax
shield
RE = RA + (D/EL)×(1-tax rate)×(RA - RD)
RD is the interest rate (cost of debt)
RE is the return on equity (cost of equity)
RA is the return on unlevered equity (cost of capital)
D is the value of debt ($)
EL is the value of levered equity ($)
 The Effect of Financial Leverage
Cost of capital: R 𝐷
𝑅𝐸 = 𝑅𝐴 + × (𝑅𝐴 − 𝑅𝐷 )
(%) 𝐸𝐿

𝐷
𝑅𝐸 = 𝑅𝐴 + × (𝑅𝐴 − 𝑅𝐷 ) ×(1-tax rate)
𝐸𝐿

R0

𝐷 𝐸𝐿
𝑅𝑊𝐴𝐶𝐶 = × 𝑅𝐷 × (1 − 𝑡𝑎𝑥 𝑟𝑎𝑡𝑒) + × 𝑅𝐸
𝐷 + 𝐸𝐿 𝐷 + 𝐸𝐿

RD

Debt-to-equity
ratio (D/E)
 Total Cash Flow to Investors
Recession Expected Expansion
EBIT $1,000 $2,000 $3,000
Interest 0 0 0
All Equity

EBT $1,000 $2,000 $3,000

Taxes (Tc = 35%) $350 $700 $1,050

Total Cash Flow to S/H $650 $1,300 $1,950

Recession Expected Expansion

EBIT $1,000 $2,000 $3,000
Interest ($800 @ 8% ) 640 640 640
Levered

EBT $360 $1,360 $2,360

Taxes (Tc = 35%) $126 $476 $826
Total Cash Flow $234+640 $884+$640 $1,534+$640
(to both S/H & B/H): $874 $1,524 $2,174
EBIT(1-Tc)+TC RBB $650+$224 $1,300+$224 $1,950+$224
$874 $1,524 $2,174
 Total Cash Flow to Investors
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.”
-the government takes a smaller slice of the pie!
 Summary: No Taxes
• In a world of no taxes, the value of the firm is unaffected by
capital structure.
• This is M&M Proposition I:
VL = VU
• Proposition I holds because shareholders can achieve any
pattern of payouts they desire with homemade leverage.
• In a world of no taxes, M&M Proposition II states that leverage
increases the risk and return to stockholders.

RE = RA + (D / EL) × (RA - RD)

 Summary: Taxes
• In a world of taxes, but no bankruptcy costs, the value of the
firm increases with leverage.
• This is M&M Proposition I:
VL = VU + Net benefit of leverage
• Proposition I holds because shareholders can achieve any
pattern of payouts they desire with homemade leverage.
• In a world of taxes, M&M Proposition II states that leverage
increases the risk and return to stockholders.

RE = RA + (D / EL) ×(RA - RD)×(1-tax rate)

Which discounting rate to use where?
Name of investor Description Discounting Rate
Equity holder of an
Unlevered Equity Holder
unlevered firm i.e. a firm
(Unlevered Equity) RA
that has no
debt/leverage
RE
RE = RA + (D/EL)×(RA - RD) ×(1-tax rate )

Equity holder of a
Note: In computation of
Levered Equity Holder levered firm i.e. a firm
D/EL here, the equity must
(Levered Equity) that has some
be levered equity (in $) i.e.
debt/leverage
equity of a firm with
leverage.

Valuing cash flows of the

Firm WACC
entire firm
THANK YOU