What Is Capital Structure?

Capital Structure
• Capital Structure refers to the mix of financing instruments (e.g.
shares, preferred stock, bonds, etc.) a firm uses to fund its
investments (assets).

• We can think of a firm’s capital structure as broadly being composed

of debt and equity.
• Can be summarised by the Debt (or Leverage) Ratio:

Debt
Debt Ratio =
Debt + Equity
• Or the Debt-to-Equity Ratio:

Debt
Debt-Equity Ratio =
Equity
The End
MM Capital Structure Irrelevance
MM Capital Structure Irrelevance

In perfect capital markets, the choice of capital structure is irrelevant for the value
of a firm (or a project).

This result is known as the Modigliani-Miller (MM) Theorem. What exactly is a perfect
capital market?
• No taxes
• No transaction costs
• No asymmetric information or differences of opinion
• No costs of financial distress
• Individuals and firms can borrow and lend at the same interest rate
• Investment cash flows are independent of financing choices
The Firm As a Pie

Equity

Equity

Debt

In perfect capital markets, changing the capital structure changes how the stream of cash
flows generated by a firm’s assets is divided amongst debt and equity holders but does not
change the total cash flow going to all investors.
Homemade Leverage

• Homemade leverage: when investors use leverage in their own

portfolios to adjust the leverage choice made by the firm.
• MM demonstrated that if investor prefer an alternative capital
structure to the one the firm has chosen, investors can borrow or
lend on their own and achieve the same result.
• Homemade leverage is a perfect substitute for firm leverage in
perfect capital markets.
The End
The Cost of Capital Fallacy
The Cost of Capital Fallacy

Return to our example of firm ABC.

• Its (unlevered) cost of equity was 12%.
• Its cost of debt was 6%.

• Because 6% < 12%, debt is a “cheaper” source of financing than

equity. Thus, ABC should finance itself with debt instead of equity.
• ABC would be valued more if 100% debt financed!

What is wrong with this argument?

The Cost of Capital Fallacy

The aforementioned argument ignores the “hidden” cost of debt:

Raising more debt makes existing equity (and debt) more risky.

Milk analogy: Whole milk = Cream + Skimmed milk.

• Debt gets the firm’s first (and safest) X dollars – the “cream”.
• Equity gets whatever is left over – the lower-quality “skim milk”.
Understanding the Fallacy

• In a frictionless world, the company cost of capital is

independent of leverage and always equal to the unlevered cost
of capital: ! !
D E
rd + re = ra
D+E D+E
• Because ra is fixed, re and/or rd must change as the values of equity
(E) and debt (D) change!
Levered Cost of Equity: Example

• In ABC’s case with leverage, ra = 12%, rd = 6%, D = 5m, E = 45m

(because VL = D + E = VU = 50m).
!
45 5
 
0.12 = re + × 0.06 → re = 12.67%
50 50

• That is, the cost of levered equity is 12.67% > cost of unlevered
equity, which is 12%.
MM Proposition II

Re-arranging the WACC expression to make the expected return on

levered equity, re , the subject of the formula, we get:

D
re = ra + (ra − rd )
E

MM Proposition II: The expected rate of return on the common stock of a

levered firm increases in proportion to the debt-equity ratio (D/E).
MM Proposition II: Risk-free Debt
r
rd
WACC
re

re

WACC

ra = WACC

rd

rd

D/E
MM Proposition II: Risky Debt

1
Source: Brealey, Myers, and Allen
The End
Is EPS a Useful Performance Metric?
The EPS Fallacy

Net Income
EPS =
Shares Outstanding

Claim: “Debt is desirable when it increases earnings per share (EPS)”

• EPS can go up (or down) when a company increases its leverage. (True)
• Companies should choose their financial policy to maximise their EPS. (False)
Cash Flows

Suppose that:
• The firm pays no taxes
• The firm makes no new investments (in working capital and fixed
assets)
• There is no (accounting) depreciation and amortisation.

Because of these simplifying assumptions, the firm’s cash flows are

identical to its earnings before interest and tax (EBIT).
MM and the EPS Fallacy
Consider a firm with the following expected cash flows (in $millions):

Time 0 1 2 3 ···
Expected Cash Flow 0 20 20 20 · · ·

The actual cash flows (EBIT) can be higher or lower than the expected
cash flows. Suppose that the distribution of cash flows is:

State of the world: Low Medium High

EBIT ($m): 10 20 30
Probability: 1/3 1/3 1/3
From EBIT to EPS

Suppose initially that the firm is fully financed with equity (ie, no debt).
There are 10m shares outstanding.

Low Medium (expected) High

EBIT ($m) 10 20 30
Interest Payments 0 0 0
Net Income ($m) 10 20 30
EPS ($) 1 2 3
Firm Value and the Share Price

• Suppose that we know the asset cost of capital: ra = 10%.

• What is the value of this firm?
Expected CF 20
Firm Value = = = $200m
ra 0.1

• What is the share price?

Market value of equity 200

Share price = = = $20
Number of shares 10
Changing the Capital Structure

• Suppose the firm wants to repurchase (i.e. buy back) 5m shares at

the current market price ($20).

• To pay for these shares, the company issues a $100m bond, with the
following characteristics:
• Issued at par (market value = face value)
• Perpetual
• Promised coupon (interest) rate: 7%
Net Income and EPS After Levering Up

Low Medium High

(expected)
EBIT ($m) 10 20 30
Interest Payments ($m) 7 7 7
Net Income ($m) 3 13 23
EPS ($) 0.6 2.6 4.6

Note that debt is risk free: even in the low state, there is enough cash flow
to pay bondholders.

To calculate EPS, divide net income by the new number of shares (5m).
What Is the Value of the Levered Firm?

• The value of the firm is the present value of its expected cash flows,
regardless of who receives them.
• Does debt change the expected total cash flows? Does debt change
the riskiness of total cash flows?
• Since debt has no effect on either expected cash flows or cash flow
risk, firm value must be unchanged!
• That is, Vfirm = $200m, both before and after levering up.
Decomposing Firm Value

Changes in capital structure affect how the ‘pie’ is sliced.

Let D denote the value that accrue to debtholders and E denote the value
that accrue to equity holders. Then,

VL = D + E
The Market Value of Debt

What is D?
• If the debt is fairly priced (ie, if our firm is not being ripped off), the
market value of debt is equal to the amount borrowed ($100m).
• To see this, note that bondholders receive $7m in perpetuity.
Because the coupon is risk-free, the discount rate must be the
risk-free rate: rd = rf .
• Remembering that the bond is issued at par, if the bond is fairly
priced, the promised interest rate must also be rf . Thus,
D = 7m/0.07 = $100m.
The Market Value of Equity

What is E?
• Using our formula, E = VL − D = 200 − 100 = $100m
• What about the share price?

100m
Pafter = = $20
5m

• After the recapitalisation, the market value of equity falls, but the
share price does not change.
EPS Changes With Leverage
How is it possible that (expected) EPS rises, but the share price does not?

Unlevered
Levered
4
EPS

0
10 20 30 EBIT

Notice that both the expected (average) EPS and EPS risk go up.
The Levered Cost of Equity

The share price is

E(EPS)
P=
re

• With no leverage, re = ra , so P = 2/0.1 = $20

• With leverage, we know that E(EPS) = 2.6, P = $20. But what is re ?

2.6
re = = 13%
20
EPS Fallacy: Summary

It is true that leverage may increase EPS. But higher EPS doesn’t imply
higher prices.

Why?
• EBIT is unaffected by a change in capital structure.
• Creditors receive the safe (or the safest) part of EBIT.
• Expected EPS might increase, but EPS has become riskier!
• The cost of equity (re ) increases with leverage, and perfectly offsets
the increase in expected EPS.
Takeaways
• The Modigliani-Miller Theorem: In a world without frictions, the
value of a firm is independent of its capital structure (ie, its mix of
debt and equity).
• In such a world, firm value is created only by the asset side of the
balance sheet.
• Firms can change EPS by changing capital structure, even when
capital structure is irrelevant for value. Thus, EPS is not a useful
performance metric.
• MM is not a literal statement about the real world. It obviously leaves
important things out. But it gets you to ask the right question: How is
this financing move going to change the size of the pie?
The End
Modeling 1: MM Irrelevance
Consider an all-equity financed firm with only one asset: a project
that will generate an uncertain cash flow of $60 or $100 (equally likely)
in one period’s time, and no cash flows thereafter. The firm’s
unlevered cost of capital is ra = 15% and the risk-free rate is rf = 6.6%.

(a) What is the (unlevered) value of the firm?

The firm raises $30 by issuing a one-period zero coupon bond and
immediately distributes the entire proceeds as a dividend to
shareholders. The CAPM beta of the firm’s debt is zero.

(b) What is the value of the firm’s (levered) equity and its cost of
equity?
Instead of $30, assume that the firm borrows $60, which is
immediately distributed as dividends. Assume the beta of the debt is
still zero. Note that the firm will now default in the bad state.

(c) Determine the promised payment to debt holders (ie, the bond’s
face value) and the bond’s yield (to maturity).
(d) What is the value of the firm, its equity, and the expected return
of the firm’s equity? Does MM Irrelevance still hold? Why/why
not?
Solution (a)

Unlevered firm value:

0.5 × 100 + 0.5 × 60 80

VU = = ≈ 69.57
1 + 0.15 1.15
Solution (b)

• The beta of debt is 0. The risk-free interest rate is 6.6%.

• Therefore rd = rf + βd (rm − rf ) = rf = 6.6%
• So repayment of bonds requires

30(1 + rf ) = 30 × 1.066 ≈ 32
Solution (b)
Remember, the firm distributes the $30 debt issuance proceeds as
dividends. Therefore, the assets of the firm are unchanged.

Today Next Year

Bad State Good State Expected Cashflow

Total Free Cash 0 60 100 80

Flows
Free Cash flow -30 32 32 32
to Debt
Free Cash Flows 30 28 68 48
to equity
Solution (b)
Approach 1: MM Proposition 1
• By MM Proposition 1: the assets of the firm are unaffected, therefore
the value of the firm is unchanged.
VL = VU = 69.57

• Value of debt: D = 30. Therefore,

EL = VL − D = 69.57 − 30 = 39.57

• The expected cash flow to equity next period is 48. Therefore, to find
the cost of equity (ie, expected return on equity), we solve:
39.57 (1 + re ) = 48

• re = (48/39.57) − 1 ≈ 21.4%
Solution (b)
Approach 2: MM Proposition 2
• We know that expected cash flow to equity has to be discounted at
the appropriate discount rate (levered firm), so:
48
EL = (1)
(1 + re )
• From MM Proposition II, we know that:
D 30
re = ra + (ra − rd ) = 0.15 + (0.15 − 0.066) (2)
EL EL
• Two equations, two unknowns. Solving for EL and re :
EL = 39.57
re = 21.4%
• Again, VL = EL + D = 39.57 + 30 = 69.57
Solution (c)
• If the debt is fairly priced, D = 60. Therefore,

E (CF to Debt)
D= = 60
1 + rd

• Since rd = rf = 6.6% (zero beta), we know that:

E (CF to Debt) = D (1 + rd ) = 60 × 1.066 ≈ 64

• Debt holders will only receive 60 in the bad state, so the face value F
must satisfy:
F × 0.5 + 60 × 0.5 = 64
• So, F = 68
Solution (c)

• The yield on the debt (ytm) solves:

Promised CF to Debt
D= = 60
1 + ytm

• There is only one promised cash flow, the face value, F = 68, so:

68
60 = ⇒ ytm ≈ 13.33% ̸= rd
1 + ytm
Solution (d)

Today Next Year

Bad Good Expected
State State
Total Free Cash 0 60 100 80
Flow
Bond Cash -60 60 68 64
Flows
Free Cash 60 0 32 16
Flows to Equity
Solution (d)
MM Proposition II approach:

• Simultaneously solve the following system of equations for EL and re :

D 60
re = ra + (ra − rd ) = 0.15 + (0.15 − 0.066)
EL EL
E (CF to Equity) 16
EL = =
1 + re 1 + re

• re = 67.88% and EL = 9.57, so VL = 60 + 9.57 = 69.57 = VU

Some Takeaways

• MM holds, even when debt is risky (ie, when there is default risk).
• Firm value has not changed (VL = VU = $69.57)

• Shareholders’ wealth has not changed:

• Scenario 1 (D = 0): They have an equity stake worth $69.57.
• Scenario 2 (D = 30): They have a $30 dividend, plus an equity stake worth
$39.57. In total, $69.57.
• Scenario 3 (D = 60): They have a $60 dividend, plus an equity stake worth
$9.57. In total, $69.57.

• The yield to maturity and expected return on debt are not the same
when debt is risky.
The End