CHAPTER ONE

Capital structure policy and leverage

At the end of this chapter student is able to;
 Define capital structure and leverage
 Examine major capital structure questions
 Explain the factors that affects capital structure decision
 Explain and illustrate risks and leverage
 Determine the concept optimal capital structure
 Describe capital structure theories
 Examine usage of debt financing to constrain managers
1.1. Introduction to capital structure and leverage
Capital structure is concerned with how a firm finances its overall operation and growth by using
different sources of funds. Debt comes in the form of bond issues or long term note payable,
while equity is classified as common stock, preferred stock or retained earnings, short term debt
such as working capital requirements is also considered to be part of the capital structure. A firm
capital structure can be a mixture of long term debt, short term debt, common equity and
preferred equity. A company proportion of short and long term debt is considered when
analyzing capital structure. When analysts refer to capital structure they are most likely referring
to a firm’s debt to equity ratio, which provides insight into how risky a company is. Usually a
company that is heavily financed by debt has more aggressive capital structure and therefore
poses greater risk to investors. This risk however may be the primary sources of the firm’s
growth.
Capital structure is the mix of financial securities used to finance the firm. The value of a firm is
defined to be the sum of the value of the firm’s debt and the firm equity. If the goal of the
management of the firm is to make the firm as valuable as possible, the firm should pick the debt
to equity ratio that makes as possible. In general capital structure is the proportion of long term
finance to a firm value.

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The concept of leverage comes from physics lever refers something helps to lift objects by
magnification of forces. Leverage increases the power of operation.

In finance leverage is the use of fixed costs or fixed returns (fixed operating costs such as rent,
salary etc… inherent in the operation of the firm and financial costs interest cost for long term
debt instruments and dividend for preferred stocks). The higher the leverage the higher the risk
and the higher will be the expected return. The firm is also referred as levered firm, to much debt
in capital structure refers the firm is over levered firm similarly to much equity refers the firm is
under levered firm.
1.2. The capital structure question
Questions related to capital structure;

How a firm/project is financed? Does the firm financing affects the firm value?
Using debt and equity Yes
Firm value = Value of debt + Value of equity

What decision is required?

Financing decision especially capital structure
decision

What is the meaning of capital structure?

Capital structure is the mix/composition of long
term financing.

What is the appropriate debt- to- equity ratio?

Or optimal capital structure
The one that maximize wealth with minimum
cost (weighted average cost of capital-WACC)

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1.3. Factors that influence capital structure decisions
Four primary factors influence the capital structure decision risks (business & financial), the
firm’s tax position, financial flexibility or the ability to raise capital on reasonable terms under
adverse conditions and management policy. But, the following listed factors also affect the
firm’s capital structure.
Risk: - a risk includes both business or operating risk and financing risks. Business risk
represents the firm’s inability to meet operating costs. If a firms business risk is high, issue debt
if it is low issue equity. Whereas, financing risk represents the firm’s inability to meet fixed
financial charges (interest). If financial risk is high it is better to finance the firm using equity
instead of debt the reverse is true for debt financing.
Tax: - interest on debt finance is tax deductible expense. To avail the tax benefit a firm can use
more debt which helps in shareholders wealth maximization. When the tax rate is high firms
wants to avail tax benefit use more debt. More debt in high tax rate provides more tax benefit.
When the tax rate is low prefer equity than debt.
Flexibility: - The firm’s ability to adjust its capital structure to the needs of changing
environment. Whenever needed the company should be able to raise funds without undue delay
and cost to finance the profitable investment.
Management strategy:- if the management strategy is conservative managers focus is
minimizing risk by prioritizing stability and security over growth and expansion. In terms of
capital structure a company that relies more on equity than debt to finance its assets. This means
that the company has a lower leverage ratio and is less likely to default on its debt obligation. An
expansionary management strategy is a growth oriented approach that involves investing in new
projects, products, or markets to increase revenue and market share. An expansionary
management strategy can be supported by a leveraged capital structure, which involves financing
new projects through debt rather than equity.
Other factors that affect capital structure decision
Control right: - Whenever companies issues new share, it introduce new shareholders which
shares the ownership and control right with the existing shareholders. If existing equity
shareholders, does not want to dilute control right debt is more suitable for financing in such a
case. If they wants to share control right, use equity financing.
Seasonal variation: - if the firm’s business activity is seasonal in nature prefer less debt,
because debt financing requires regular benefits in the form of interest payment. If the business
activity is non-seasonal use debt financing.
Degree of competition: - when there is less competition use less equity or more debt in their
capital structure, since they can sell more products at a higher price. When there is more
competition use more equity or less debt because firm may not be able to sell more units and
cannot earn more profit.

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Industry life cycle: - The industry life cycle consists of introduction stage, growth stage,
maturity stage and decline stage. In introduction stage use less debt or more equity, since the
profit earning capacity is less due to less sales. In growth stage have more profits use more debt
or less equity swill helps to maximize the share holders wealth.
Agency cost: - In practice, there may exists conflict of interest among shareholders, debt holders
and management. These conflicts give rise to agency problem, which involves agency cost.
Share holders and managers conflict; managers may transfer shareholders wealth to the
advantage by increasing their compensation and perquisites. Whereas, shareholders and debt
holders conflict arises because of possibility of shareholders transferring the wealth of debt
holders to their own favor. So, the financial strategies of the firm seek to minimize agency cost,
management should use the debt to the extent that maximizes the shareholders wealth.
Size of the firm: - Small firms have to depend on owners fund for financing activities as
compared to large firms. On the other hand large firms are forced to make use of different
sources of funds, because no single source is sufficient to their needs.
Period of finance /maturity period/: - when the firm needs finance for unlimited period equity
share capital is best source. When the firm needs finance for limited period redeemable
debentures or preference share is the best source.
Purpose of finance: - when the finance is needed for productive purpose like purchase of real
assets debt is suitable. When the finance is needed for unproductive purpose, like for social
responsibility of general development, equity share capital is the best source.
Credit rating: - measures the firm’s ability to met financial obligations. Firm enjoying high
credit rating may get funds easily from the capital market as compared to firms having low credit
rating. Because investor and creditor prefer to invest and grant loans to high credit rating firms,
since the risk is less.
Requirement of investors: - Some investors are ready to take risk /bold investor/ who prefer
capital gain and control equity shares are preferable by them. Investors who are interested in
safety of their investment and stable returns /conservative investors/ prefer to invest in
debentures. Investors who are less cautious who prefer stable return and shares in profit
preference share more suitable to them.
Legal requirement: - There are some guidelines on shares and debentures issued by the
government that are very important for the construction of capital structure. If there is high
restriction on equity investment by government use debt financing the reverse is true for equity
financing.
Cash flow position: - if the firms have enough cash flow uses more debt or less equity.
Whereas, if the firm have shortage of cash flow, use more equity or less debt.
Interest coverage ratio (ICR): - measures the number of times the company earnings before
interest and tax covers the interest payment obligation. When ICR is high prefer debt, when ICR
is low prefer equity financing.
Return of investment: - if the rate of investment is greater than rate of interest for debt prefer
debt. Whereas, if the return of investment is less than rate of interest for debt, prefer equity
financing.
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Flotation costs: - generally flotation cost of debenture is less than the cost of equity this may
influence financial manager to use the cheapest source of finance i.e debt.
State of stock market: - when the state of stock market is on boom/pick/ market price of
securities is high, heavy demand for share in case issue equity. When the state of stock market is
on recession or depression the market price of securities is low, no demand for share incase issue
debt.
1.4. Risks and leverage
The total systematic risk of the firm’s equity thus has two parts:
 Business and
 Financial Risk
The business risk it is also called operating risk. It depends on the firm’s assets and operations
and is not affected by capital structure. The risk inherent in a firm’s operations is called the
business risk of the firm’s equity. Business risk is the equity risk that comes from the nature of
the firm’s operating activities or the risk that the firm is unable to cover its operating cost. With
business risk, the concern is that the company will be unable to function as a profitable
enterprise. Business risk relates to whether a company can make enough in sales and revenue to
cover its expenses and turn a profit.
Financial risk is completely determined by financial policy. It is the risk that the firm will be
unable to cover the required financial obligations such as interest, lease payment, preference
share dividends etc. With financial risk, there is a concern that a company may default on its debt
payments. This extra risk that arises from the use of debt financing is called the financial risk of
the firm’s equity.
The term leverage refers to a relationship between two interrelated variables. With reference to a
business firm, these variables may be costs, output, sales, revenue, EBIT, Earning per share etc.
In financial analysis, the leverage reflects the responsiveness or influence of one variable over
some other financial variables. It helps in understanding the relationship between any two
variables. In the leverage analysis, the emphasis is on the measurement of the relationship of two
variables rather than on measuring these variables. The leverage may be defined as the % change
in one variable divided by the % change in some other variable. Impliedly, the numerator is the
dependent variable say X and the Y is the independent variable. The leverage analysis reflects as
to how responsiveness is the dependent variable to a change in the independent variable.
1.4.1. Business risk and operating leverage
Operating Leverage measures the relationship between outputs and earnings before interest and
tax (EBIT), specifically; it measures the effect of changing levels of output on EBIT. The
functional relationship between these two variables is:
y = f (Q),
Where, y = earnings before interest and tax
Q = number of units of output produced and sold
Earnings before interest and tax = Total revenue – Total variable cost – fixed cost.
y = QP – QV – F
Or y = Q (P – V) – F

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When the level of output changes from its initial value, the initial value of EBIT also changes.
Thus, operating leverage is defined as the resulting percentage change in EBIT divided by the
percentage change in output, symbolically, operating leverage is expressed as:
L ( y) y / y %  EBIT
 
L (Q ) Q / Q %  output
T (P  V )
Short cut formula for operating leverages (OL/Q) = T ( P  V )  F
Example:- Assume that the price per unit of output (p) is Br. 10, and variable cost per unit of
output (y) is Br. 4, and fixed cost (F) is Br. 30,000, and the level of output (T) is 8000 units. By
using the formula EBIT is computed as follows:
y = Total revenue – Total variable cost – fixed cost
y = QP – QV – F
Or y = Q (P – V) – F
y = 8000 (Br. 10 – Br. 4) – Br. 30,000
= Br. 18,000
Now assume that the level of output increases from 8000 to 10,000 units. The resulting EBIT is
computed as:
y = 10,000 (Br. 10 – Br. 4) – Br. 30,000
= Br. 30,000
The coefficient of operating leverage is computed as follows:
Percentage change in output = 2000/8000 = 25%
Percentage change in EBIT = Br. 12000/Br. 18000 = 66.7%
L( y ) y / y

L (Q ) Q / Q
L ( y ) .667

L (Q ) .25 = 2.67
By using Short cut formula for operating leverage
8000 ( Br.10  Br.4)
 2.67
(OL/Q) = 8000 ( Br.10  Br.4)  30,000
Interpretation:- 1 percent change in output from an initial value of 8000 units produces a 2.67
percent change in EBIT. Since output increased by 25 percent from its initial value of 8000 units,
EBIT increases by (2.67) (.25) = .667 or 66.7 percent.
1.4.2. Financial risk and Financial Leverage
Financial leverage refers to the extent to which a firm relies on debt. It is defined as the potential
use of fixed financial costs to magnify the effect of change in EBIT on the firms EPS. It
measures the relationship between the effects of changing levels of EBIT on EPS. The functional
relationship between these two variables is:
EPS = f (EBIT)
Let EBIT = Y

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 EBT = Y – I
Taxes= (Y – I) (t)
Net income = (Y – I) (1 – t)
Earnings available to common shareholders
Net income– preferred stock dividends
(Y – I) (1 – t) – E
Earnings per share to common stock holders:
Earnings available to common shareholders
Number of common shares
EPS = (Y – I) (1 – t) – E
N
The algebraic equivalent of the complete income statement is obtained by substituting the
symbolic form of EBIT as follows:
[Q( P  V )  F  I ] (1  t )  E
EPS = N
When the level of EBIT changes from its initial value, the initial value of EPS also changes.
Financial leverage is thus defined as the resulting percentage change in EPS divided by the
percentage change in EBIT. Symbolically, financial leverage is expressed as:
L ( EPS ) EPS / EPS % EPS
 
L ( EBIT ) EBIT / EBIT % EBIT = EBIT/ EBIT - INTEREST
Y
E
Y I 
Short cut formula for financial leverage (FL/Y) = 1 t
Example Assume that I = Br. 100,000, t = 0.4, E = Br. 80,000
N = 60,000, and EBIT = Br. 500,000. The EPS at this level of EBIT is
Computed as:
EPS = (Br. 500,000 – Br. 100,000) (1 – 0.4) – Br. 80,000
60,000
= Br. 2.67
If EBIT increases from Br. 500,000 to Br. 600,000, the resulting EPS is:
EPS = (Br. 60,000 – Br. 100,000) (1 – 0.4) – Br. 80,000
60,000
= Br. 3.67
The financial leverage is computed as:
Percentage change in EBIT = Br. 100,000/Br. 500,000 = 20%
Percentage change in EPS = Br. 1/Br. 2.67 = 37.45%
L ( EPS ) 0.3745
  1.87
L ( EBIT ) 0.2

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 Y
E
Y I 
By using Short cut formula of financial leverage (FL/Y) = 1 t
500,000
 1.87
Br.80,000
Br.500,000  Br.100,000 
(FL/Y) = 1  0 .4
Interpretation:-1 percent change in EBIT from an initial value of Br. 500,000 produces a 1.87
percent change in EPS. Since EBIT increased by 20 percent from its initial value, EPS increased
by 1.87 (0.20) = 0.374 or 37.4 percent.
Note that EBIT is the independent variable when measuring financial leverage, but the dependent
variable when measuring operating leverage. As a result, EBIT, is sometimes called the linking
pin variable with respect to leverage application in finance.
Degree of total leverage = degree of operating leverage * degree of financial leverage
Shareholders can adjust the amount of financial leverage by borrowing and lending on their own.
This use of personal borrowing to alter the degree of financial leverage is called homemade
leverage.
1.5. Optimal Capital Structure
The optimal capital structure of a firm is the best mix of debt and equity financing that
maximizes a company’s market value or maximizing the shareholders benefit while minimizing
its cost of capital. In theory, debt financing offers the lowest cost of capital due to its tax
deductibility. However, too much debt increases the financial risk to shareholders and the return
on equity that they require. Thus, companies have to find the optimal point at which the marginal
benefit of debt equals the marginal cost.

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1.5.1. EBIT/EPS analysis
EBIT/EPS analysis is an important tool used to optimize the capital structure for highest earning
for shareholders. It helps in understanding the sensitivity of EPS at a given level of earnings
before interest and tax under different sources of financing. It helps in analyzing how capital
structure decision is important to raise the value of firm. An optimal financing structure
minimizes the cost of capital and maximizes the earnings. “No debt,” represents the case of no
leverage and EPS would be zero if EBIT were zero. EPS is negative if EBIT is zero. Because
there is debt and interest must be paid regardless of the firm’s profits.
See the following format of EBIT
Sales…………………………………………..xxx
Less: Variable cost……………………………xxx
Contribution margin…………………………..xxx Operating
Less: Fixed cost……………………………….xxx
EBIT ------------------------------------------xxx
Less: Interest on debt-------------------------------xxx
EBT--------------------------------------------xxx
Less: Tax---------------------------------------------xxx Financing
EAT--------------------------------------------xxx
Less: preferred dividend---------------------------xxx
Profit available to equity shareholders---xxx
EPS = Earnings available to equity shareholder
Number of equity shares
Capital structure is a composition of equity shares, debt instruments (bonds, debentures, notes
etc…) and preferred shares. Therefore earning per share is calculated as follows;
Earnings per share
Plan 1 (Only equity shares)
EPS = EBIT (1- tax rate)
Number of outstanding shares
Plan 2 (Equity share and debt)
EPS = (EBIT-interest) (1- tax rate)
Number of outstanding shares
Plan 3 (Equity, debt and preference shares)
EPS = (EBIT-interest) (1- tax rate)-preferred dividend
Number of outstanding shares
Plan 4 (Equity shares and preference shares)
EPS = EBIT(1- tax rate) - preferred dividend
Number of outstanding shares
Problem 1:- ABC ltd has existing equity share capital of $300,000 (face value 100 each). It has
decided to expand its business for each there is an additional capital requirement of $100,000.
Now, it has the following four alternative sources to raise capital:-
Plan 1- To raise full $100,000 through equity financing
Plan 2- To raise 50,000 (face value of 100) through equity and $50,000 through debt at interest
rate of 10%.
Plan 3- To raise full $100,000 through debt financing @ interest rate of 10%
Plan 1:-To raise $50,000 through equity and $50,000 through 5% preference shares.
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The expected level of EBIT IS $75,000, Tax rate is 30%, which plan do you think it should go
for considering the one which would provide maximum EPS?
Solution
Plan 1:- To raise full $100,000 from issue of 1000 equity shares at face value 100
Existing share capital = $300,000
At face value = 100
Number of shares = $300,000/100 = 3000
Expected EBIT = 75,000
Tax rate = 30%
EPS = EBIT (1- tax rate)
Number of outstanding shares
EPS = 75,000 (1- 0.3)
3000+1000
= 13.12/share
Plan 2:- To raise $50,000 through equity at face value 100 and $50,000 through debt at
10% interest rate.
Existing share capital = $300,000
At face value = 100
Number of shares = $300,000/100 = 3000
Expected EBIT = $75,000
Tax rate = 30%
New equity shares = $50,000 @100 face value
Number of shares = $50,000/100 = 500
Interest on debt = 10% of 50,000 = 5000
EPS = (EBIT-interest) (1- tax rate)
Number of outstanding shares
EPS = ($75,000-5000) (1- 0.3)
3000+500
=14/share
Plan 3:- To raise full $100,000 through debt financing at interest rate 10%
Existing share capital = $300,000
At face value = 100
Number of shares = $300,000/10 =3000
Expected EBIT = 75,000
Tax rate = 30%
Interest on debt = 10% of $100,000=10,000
EPS = (EBIT-interest) (1- tax rate)
Number of outstanding shares
EPS = (75,000-10,000) (1- 0.3)
3000
= 15.16/share
Plan 4:- To raise 50,000 through equity shares at face value of 100 and 50,000 through 5%
preference shares.
Existing shares capital =300,000
At face value = 100
Number of shares = 300,000/100 = 3000

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Expected EBIT = 75,000
Tax rate = 30%
New equity shares = 50,000@ 100 face value
Number of shares = 50,000/100 = 500
Dividend on preferred shares = 5% of 50,000 = 2500
EPS = EBIT(1- tax rate) - preferred dividend
Number of outstanding shares
EPS = 75,000(1- 0.3) - 2500
3000+500
= 14.28/share
EPS under different capital structure financing plans
Plan Earnings per share in each plans Earnings per share
1 EPS- PLAN 1 13.12
2 EPS- PLAN 2 14
3 EPS- PLAN 3 15.16 Highest EPS
4 EPS- PLAN 4 14.28
1.5.2. The effect of capital structure on stock price and the cost of capital
The relationship between capital structure and stock prices is a complex one, and there is no
clear consensus on the exact nature of relationship. However, some studies suggest that a
company capital structure can have an impact on its stock prices. For example, a company with
high level of debt in its capital structure may be viewed as riskier by investors, which could lead
to a decline in its stock price. On the other hand, a company with a constrictive capital structure
that relies more on equity than debt may viewed as less risky and more stable, which could lead
to an increase in its stock price.
The cost of capital is the minimum rate of return that a company must earn on its investments to
satisfy its investors. The cost of capital is affected by the company’s capital structure, which is
the mix of debt and equity financing used to fund its operations. The cost of capital is generally
lower when a company has a higher proportion of debt in its capital structure, as debt is less
expensive than equity financing. However, too much debt can increase the risk of bankruptcy
and lead to higher borrowing costs. The cost of capital is also influenced by the company’s
capital structure, which determines the relative weight of debt and equity financing in the
company’s funding mix.
The effect of capital structure on the cost of capital is a subject of much debate among
economists. Some argue that the cost of capital is independent of the company’s capital structure,
while others contend that the cost of capital is lower when a company has a higher proportion of
debt in its capital structure. The relationship between capital structure and the cost of capital is
complex and depends on a variety of factors, including the company’s industry, its size, and its
growth prospects.
In summary, the effect of capital structure on the cost of capital is a complex issue that depends
on a variety of factors. While some economists argue that the cost of capital is independent of the
company’s capital structure, others contend that the cost of capital is lower when a company has
a higher proportion of debt in its capital structure. Ultimately, the optimal capital structure for a
company depends on its specific circumstances and goals.

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1.6. Introduction to the theory of capital structure
1.6.1. Modigliani-Miller (MM) Theory
The Modigliani-Miller (M&M) theory is a capital structure approach named after Franco
Modigliani and Merton Miller. Modigliani and Miller were two economics professors who
studied capital structure theory and collaborated to develop the capital structure irrelevance
proposition in 1958. They proposed the relationship between capital structure, firm value and
WACC.
This proposition states that in perfect markets the capital structure a company uses doesn't matter
because the market value of a firm is determined by its earning power and the risk of its
underlying assets. According to Modigliani and Miller, value is independent of the method of
financing used and a company's investments. The M&M theorem made the two following
propositions:
 Modigliani and Miller (M&M) Propositions I and II with no taxes
 Modigliani and Miller (M&M) Propositions I and II with taxes
Debt has two distinguishing features that we have not taken into proper account.
 First, as we have mentioned in a number of places, interest paid on debt is tax deductible.
This is good for the firm, and it may be an added benefit of debt financing.
 Second, failure to meet debt obligations can result in bankruptcy. This is not good for the
firm, and it may be an added cost of debt financing.
We can start by considering what happens to M&M Propositions I and II when we consider the
effect of corporate taxes. To do this, we will examine two firms: Firm U (unlevered) and Firm L
(levered). These two firms are identical on the left side of the balance sheet, so their assets and
operations are the same.
Proposition I
This proposition says that the capital structure is irrelevant to the value of a firm. The value of
two identical firms would remain the same and value would not be affected by the choice of
financing adopted to finance the assets. The value of a firm is dependent on the expected future
earnings. It is when there are no taxes.
MM proposition I with no tax
 The value of a firm is independent of its capital structure. The value of the firm do not
change due to the change in capital structure
 The value of unlevered firm equals to the value of levered firm.
 Unlevered firm is a firm that has no debt.
 Share price is constant
Example: assume an all equity firm has a market value of Br. 300,000 and 50,000 shares
outstanding. It is thinking of changing its capital structure by borrowing Br. 120,000 in debt and
repurchasing shares. Ignore tax.
A. Proposition I: The value of the firm levered (V L) is equal to the value of the firm unlevered
(VU): VL = VU

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Implications of Proposition I:
1. A firm’s capital structure is irrelevant.
2. A firm’s weighted average cost of capital (WACC) is the same no matter what mixture of debt
and equity is used to finance the fi rm.
MM proposition I with tax
 The value of unlevered firm different from the value of levered firm
 More debt = larger interest tax shield = less taxes = larger firm value
 The value of unlevered firm + present value of interest tax shield = value of levered firm
 Interest tax shields are the tax saving attained by a firm from interest expense.
A. Proposition I with taxes: The value of the firm levered (V L) is equal to the value of the firm
unlevered (VU) plus the present value of the interest tax shield:
VL = V U + TC * D
Where TC is the corporate tax rate and D is the amount of debt.
Implications of Proposition I:
1. Debt financing is highly advantageous, and, in the extreme, a firm’s optimal capital structure
is 100 percent debt.
2. A firm’s weighted average cost of capital (WACC) decreases as the firm relies more heavily
on debt financing.
MM proposition II with no tax
The WACC do not change due to the change in capital structure
 Share price is constant
 WACC is constant:
 Cost of equity raises as the firm increases its debt financing
WACC = (E/V) * Re + (D/V) * Rd
RA = (E/V) * Re + (D/V) * Rd
RE = RA + (RA- RD) * (D/E)
Where, WACC is weighted average cost of capital
E/V is rate of equity
Re is cost of equity
D/V is rate of debt
Rd is cost of debt
RA is required rate of return
D/E is debt equity ratio
Example:- XYZ CO. has a required rate of return of 12%. It can borrow at 8%. Assuming that,the
firm has a target capital structure of 80% equity and 20% debt. Calculate cost of equity and
WACC?
Solution
RE = RA + (RA- RD) * (D/E)
= 0.12 + (0.12 – 0.08) * (0.2)
= 0.13 or 13%

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WACC = (E/V) * Re + (D/V) * Rd
= 0.8 *0.13 + 0.2 *0.08
= 0.12 or 12%
What is the cost of equity and WACC if the firm’s capital structure is 50% debt and 50% equity?
MM proposition II with tax
 Cost of equity raises as the firm increases its debt financing and it is similar withMM
proposition II without tax.
 WACC decreases with increase in debt.
 VL> VU i.e. Value of a firm increases with increase in debt.
 VL = VU + D * tax rate
Here cost of equity is calculated as follows:
RE = RU+ (RU – RD) * (D/E) * (1-T)
WACC = (E/V) * Re + (D/V) * Rd* (1 –T)
Example: given RD= 8%
RU = 10%
Debt = 1,000
Leveraged firm value = 7,300
Tax rate = 30%
Calculate cost of equity and WACC?
Solution
VL = VU + D * tax rate
RE = RU+ (RU – RD) * (D/E) * (1-T)
= 0.1 + (0.1 – 0.08) * 1000/6300 * (1- 0.3)
= 0.1022 or 10.22%
WACC = (E/V) * Re + (D/V) * Rd* (1 –T)
= (6,300/7,300) * 0.1022 + (1,000/7,300) * 0.08(1-0.3)
= 0.96 or 9.6%
Increase in debt increases the value of the firm and decreases WACC
Example: VU = 500
Debt = 500
RU (cost of Unleveraged firm) = 20%
Cost of debt = 10%
Tax rate = 34%
Calculate cost equity and WACC?
Solution:
E = VL –D
VL= VU + D * tax rate
RE = RU+ (RU – RD) * (D/E) * (1-T)
= 0.2 + (0.2 -0.1) * (500/170) * (1 – 0.34)
= 0.39 or 39%

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WACC = (E/V) * Re + (D/V) * Rd* (1 –T)
= (170/670) * 0.39 + (500/670) *0.1(1-0.34)
= 14.92%
1.6.2. The static (tradeoff) theory of capital structure
It is also called tradeoff theory. 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. The static theory assumes that the firm is
fixed in terms of its assets and operations and it considers only possible changes in the debt-
equity ratio. According to static theory, the gain from tax shield on debt is offset by financial
distress costs. An optimal capital structure exists that just balances the additional gain from
leverage against the added financial distress cost (bankruptcy cost). According to static theory,
the WACC falls initially because of the tax advantage of debt. Beyond the point D/E; it begins to
rise because of financial distress cost.
1.6.3. The Pecking-Order Theory
The pecking order theory focuses on asymmetrical information costs. Flotation costs and
asymmetric information leads to use this theory. This approach assumes that companies
prioritize their financing strategy based on the path of least resistance. Internal financing is the
first preferred method, followed by debt and external equity financing as a last resort.
The pecking-order theory is an alternative to the static theory. A key element in the pecking-
order theory is that firms prefer to use internal financing whenever possible. A simple reason is
that selling securities to raise cash can be expensive, so it makes sense to avoid doing so if
possible. If a firm is very profitable, it might never need external financing; so it would end up
with little or no debt. This is because internal funds are less costly than external funds, and debt
is less costly than equity. Therefore, companies will only issue new equity as a last resort.
Implications of the pecking order
The pecking-order theory has several significant implications, a couple of which are at odds with
our static theory:
No target capital structure: under the pecking-order theory, there is any target or optimal debt-
equity ratio. Instead, a firm’s capital structure is determined by its need for external financing,
which dictates the amount of debt the firm will have.
Profitable firms use less debt: Because profitable firms have greater internal cash flow, they
will need less external financing and will therefore have less debt.
Companies will want financial slack: To avoid selling new equity, companies will want to
stockpile internally generated cash. Such a cash reserve is known as financial slack. It gives
management the ability to finance projects as they appear and to move quickly if necessary.
1.6.4. Signaling theory
The signaling theory suggests that companies use their capital structure to signal information to
investors about their future prospects. For example, a company that issues new equity may be
signaling to investors that it has profitable investment opportunities that require additional
funding. Similarly, a company that issues new debt may be signaling that it is confident in its
ability to generate future cash flows to service its debt obligations.
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While both theories provide insights into how companies choose their capital structure, they have
different implications for the cost of capital and the value of the firm. The pecking order theory
suggests that companies with a conservative capital structure may have a lower cost of capital
and a higher firm value, while the signaling theory suggests that companies with a leveraged
capital structure may have a lower cost of capital and a higher firm value.
1.7. Using debt financing to constrain managers
Agency problems may arise if managers and shareholders have different objectives. Such
conflicts are particularly likely when the firm's managers have too much cash at their disposal.
Managers often use excess cash to finance luxurious tasks (acquisition of luxuries assts) all of
which may do little to maximize stock prices. Even worse, managers might be tempted to pay too
much for an acquisition, something that could cost shareholders hundreds of millions.
By contrast, managers with limited "excess cash flow" are less able to make wasteful
expenditures. Firms can reduce excess cash flow in a variety of ways. One way is to funnel some
of it back to shareholders through higher dividends or stock repurchases. Another alternative is
to shift the capital structure toward more debt in the hope that higher debt service requirements
will force managers to be more disciplined.
If debt is not serviced as required, the firm will be forced into bankruptcy, in which case its
managers would likely lose their jobs. Therefore, a manager is less likely to buy an expensive
new corporate assets if the firm has large debt service requirements that could cost the manager
his or her job. In short, high levels of debt bond the cash flow, since much of it is pre-committed
to servicing the debt. One professor has argued that adding debt to a firm's capital structure is
like putting a dagger into the steering wheel of a car. The dagger— which points toward your
stomach—motivates you to drive more carefully, but you may get stabbed if someone runs into
you, even if you are being careful.
The analogy applies to corporations in the following sense: Higher debt forces managers to be
more careful with shareholders' money, but even well-run firms could face bankruptcy (get
stabbed) if some event beyond their control such as a war, an earthquake, a strike, or a recession
occurs. To complete the analogy, the capital structure decision comes down to deciding how big
a dagger stockholders should use to keep managers in line.
Finally, too much debt may over constrain managers. A large portion of a manager's personal
wealth and reputation are tied to a single company, so managers are not well diversified. When
faced with a positive NPV project that is risky, a manager may decide that it's not worth taking
on the risk, even when well-diversified stockholders would find the risk acceptable. This is
called the underinvestment problem. The more debt the firm has, the greater the likelihood of
financial distress, and thus the greater the likelihood that managers will forego risky projects
even if they have positive NPVs.

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