Session 12 and 13.

Capital Structure
Decisions
PGP, IIM INDORE
Agenda

MM Trade-off Theory:
Benefit from Tax
Propositions: Bankruptcy Costs Pecking Order
Deductibility of
Capital Structure and Costs of Hypothesis
Interest
Irrelevance Financial Distress
Capital Structure
•Does Debt Policy Matter?
• What is the ratio of debt-to-equity (if any) that maximizes shareholder
value?
• Or are that other factors or motivations that can help determine (or
understand) a firm’s financial policy?
Financial Leverage and ROE
•Consider an all-equity firm that is contemplating raising debt (may be some existing
shareholders want to cash out)
•Assume – 0 taxes
Current Proposed
Assets Rs.20,000 Rs.20,000
Debt Rs.0 Rs.8,000
Equity Rs.20,000 Rs.12,000
Debt/Equity ratio 0 2/3
Interest rate n/a 8%
Shares outstanding 400 240
Share price Rs.50 Rs.50

The firm plans to borrow Rs.8,000 and buy back 160 shares at Rs.50 per share.
If EBIT is Rs. 2000, what is the current and new EPS and ROE?
Impact of Financial Leverage on Earnings
Current Proposed
Expected Expected
EBIT Rs.2,000 Rs.2,000
Interest 0 640
Net income Rs.2,000 Rs.1,360
EPS Rs.5.00 Rs.5.67
ROE 10% 11.30%

Current Shares Proposed Shares

Outstanding = 400 Outstanding = 240
shares shares

• Does that mean increase in financial leverage will ALWAYS increase EPS and ROE?
Earnings with Leverage: Different scenarios
Current Proposed
Recession Expected Recession Expected
EBIT Rs.1,000 Rs.2,000 Rs.1,000 Rs.2,000
Interest 0 0 640 640
Net income Rs.1,000 Rs.2,000 Rs.360 Rs.1,360
EPS Rs.2.50 Rs.5.00 Rs.1.50 Rs.5.67
ROE 5% 10% 3.00% 11.30%
Current Shares Outstanding Proposed Shares
= 400 shares Outstanding = 240 shares

If the earnings are lower than expected, than the EPS/ROE will be adversely affected – but more
adversely affected under the levered structure
Earnings with Leverage: Different scenarios
Current Proposed
Expected Expansion Expected Expansion
EBIT Rs.2,000 Rs.3,000 Rs.2,000 Rs.3,000
Interest 0 0 640 640
Net income Rs.2,000 Rs.3,000 Rs.1,360 Rs.2,360
EPS Rs.5.00 Rs.7.50 Rs.5.67 Rs.9.83
ROE 10% 15% 11.30% 19.70%
Current Shares Outstanding Proposed Shares
= 400 shares Outstanding = 240 shares

If the earnings are higher than expected, than the EPS/ROE under levered structure will be more than
under the all-equity structure
Earnings with Leverage: Summary
Current Proposed
Recession Expected Expansion Recession Expected Expansion
EBIT Rs.1,000 Rs.2,000 Rs.3,000 Rs.1,000 Rs.2,000 Rs.3,000
Interest 0 0 0 640 640 640
Net income Rs.1,000 Rs.2,000 Rs.3,000 Rs.360 Rs.1,360 Rs.2,360
EPS Rs.2.50 Rs.5.00 Rs.7.50 Rs.1.50 Rs.5.67 Rs.9.83
ROE 5% 10% 15% 3.00% 11.30% 19.70%
Current Shares Outstanding = 400 Proposed Shares Outstanding =
shares 240 shares

The use of debt, rather than equity funds to finance a given venture may well increase the expected
return to the owners, but only at the cost of increased dispersion of the outcomes - MM (1958)
Borrowing and EPS
•Borrowing increases EPS above a certain level of income (Effect of leverage depends on
company’s income), but does it increase share price or firm value?
• Does it affect the cash flows (say FCF)?

•Modigliani Miller theorems

•Trade-off Theory
Effect of Financial Leverage on
Competitive Tax-free Economy
•Modigliani & Miller: Capital structure is irrelevant in determining firm value
• Value is independent of the debt ratio

•Assumptions
• No taxes*, No bankruptcy costs*, Companies and investors can borrow/lend at the same rate, no
information asymmetry, EBIT not affected by the use of debt, Frictionless markets – no transaction
costs, and others

•When firm pays no taxes and capital markets function well, no difference if firm borrows or
individual shareholders borrow
• Investor can create a levered or unlevered position by adjusting the trading in their own account –
Homemade leverage
*Capital structure, therefore, does not affect cash flows.
Recall the earlier example
An all-equity firm, with no debt:

Current Proposed
Assets Rs.20,000 Rs.20,000
Debt Rs.0 Rs.8,000
Equity Rs.20,000 Rs.12,000
Debt/Equity ratio 0 2/3
Interest rate n/a 8%
Shares outstanding 400 240
Share price Rs.50 Rs.50

The company is proposing a new capital structure such Debt is 40% in total capital and equity is
60%.
An investor can create the same leverage, substitute personal leverage for company’s leverage
The investor can buy 10% of company (unlevered) – can buy 40 shares of a Rs.50 stock
Of the total funds required, Rs. 2000, he borrows 40%, that is – he takes Rs.800 loan
 Homemade Leverage
Expected
EPS of Unlevered Firm Rs.5.00
Earnings for 40 shares Rs.200
Less interest on Rs.800 (8%) Rs.64
Net Profits Rs.136
ROE (Net Profits / Rs.1,200) 11.30%

Investor can buy 40 shares of a Rs.50 stock, using Rs.800 in loan.

She gets the same ROE as if she bought into a levered firm.
Investor’s personal debt-equity ratio is: 800/1200 = 2/3
MM Propositions I & II (Without Taxes)

Proposition I (without Corporate Taxes)

◦ Value of a levered firm is equal to the value of an unlevered firm
VL = VU
Proposition II (without Corporate Taxes)
◦ Ka (WACC) is constant, cost of equity (Ke ) increases with the increase in financial leverage.
Capital Structure Decisions

Static Trade-off
MM
Benefit from Tax Theory:
Propositions: Pecking Order
Deductibility of Bankruptcy Costs
Capital Structure Hypothesis
Interest and Costs of
Irrelevance
Financial Distress
Tax-Deductible Interest
•The tax deductibility of interest increases the total income that can be paid
out to bondholders and stockholders.
Current Proposed
Expected Expected
EBIT Rs.2,000 Rs.2,000
Interest 0 640
Earnings Before Taxes Rs.2,000 Rs.1,360
Taxes (if Tax rate is 25%) 500 340
Net Income 1500 1020
Tax Saved under Proposed Structure 160
Interest 0 + Net Interest 640 + Net
Total Earnings for Debt and Equity Investors
Income 1500 = 1500 Income 1020 = 1660

Interest Tax Saving = Interest Exps * Tax rate = 640 * 25% = 160
Note: Interest Tax Savings are also called ‘Interest Tax Shields’
Advantage of tax savings
Current Proposed
Expected Expected
EBIT Rs.2,000 Rs.2,000
Interest 0 640
Earnings Before Taxes Rs.2,000 Rs.1,360
Taxes (if Tax rate is 25%) 500 340
Net Income 1500 1020
Tax Saved under Proposed Structure 160
Interest Tax Saving = Interest Exps * Tax rate = 640 * 25% = 160
Note: Interest Tax Savings are also called ‘Interest Tax Shields’

So what if the tax is saved? After all, the interest expense also reduces the Net Income!!
But you must then ask: What is the total earning available for debt and equity investors put together?
Tax-Deductible Interest
•The tax deductibility of interest increases the total income that can be paid
out to bondholders and stockholders.
Current Proposed
Expected Expected
EBIT Rs.2,000 Rs.2,000
Interest 0 640
Earnings Before Taxes Rs.2,000 Rs.1,360
Taxes (if Tax rate is 25%) 500 340
Net Income 1500 1020
Tax Saved under Proposed Structure 160
Interest 0 + Net Interest 640 + Net
Total Earnings for Debt and Equity Investors
Income 1500 = 1500 Income 1020 = 1660

Interest Tax Saving = Interest Exps * Tax rate = 640 * 25% = 160
Note: Interest Tax Savings are also called ‘Interest Tax Shields’
Corporate Taxes
Special Case of Constant Level of Debt (i.e. Rupee or Dollar Value of
Debt is Constant)
◦ If we assume – Debt Level is permanent, then Present value of Tax shields
is:
!"#$"#%&' )%* +%&' ∗-.&'#'/& 0%12'.& 4 ∗67 ∗&
◦ 𝑃𝑉 𝑡𝑎𝑥 𝑠ℎ𝑖𝑒𝑙𝑑 = !"/& "3 4'5&
= 67 =𝐷 ∗ 𝑡
The value of a levered firm increases by the present value of interest
tax shields (i.e., interest tax savings)
MM Propositions I & II (With Taxes)

Proposition I (with Corporate Taxes)

◦ Firm value increases with leverage
VL = VU + Present value of tax shields

• To note: if debt level (dollar value) is constant then, VL = VU + D*t

Tax Effects
Value of firm (V) Value of firm under
MM with corporate
Present value of tax taxes and debt
shield on debt
VL = VU + PV ITS

Maximum
firm value
V = Actual value of firm
VU = Value of firm with no debt

0 Debt (B)

Optimal amount of debt

The Effect of Financial Leverage
Cost of capital: R
(%)

WACC = Kd × (D/V) ×(1-TC) + Ke × (E/V)

Kd

Debt-to-equity
ratio (B/S)
Implications of Benefits associated with Taxes
•WACC reduces as more debt is used
•As WACC reduces, firm value increases (if all other factors are
held constant) G

B
•Does this mean the optimal capital structure is 99.99% debt?
Capital Structure Decisions

MM Trade-off Theory:
Benefit from Tax
Propositions: Bankruptcy Costs Pecking Order
Deductibility of
Capital Structure and Costs of Hypothesis
Interest
Irrelevance Financial Distress
Costs of Financial Distress and Bankruptcy
Financial Distress and Bankruptcy Costs

Financial distress includes failure to pay interest or principal or both

◦ Occurs when promises to creditors are broken or honored with difficulty.

Cost of Financial Distress

◦ Costs arising from bankruptcy or distorted business decisions before bankruptcy

Direct Costs of Bankruptcy - Legal and administrative costs

Indirect Costs of Bankruptcy - Impaired ability to conduct business
◦ Example: lost sales, inability to negotiate long-term supply contracts, loss of credibility
Tax Effects and Financial Distress
•Trade-off Theory of Capital Structure
• There is a trade-off between the tax advantage of debt and the costs of financial distress.
Value of the Firm when Costs of Financial
Distress are considered
•Value of firm = value if all-equity financed + PV(tax shield) - PV(costs of financial
distress)
•The trade-off between the tax benefits and the costs of distress determines optimal
capital structure.
• PV(tax shield) initially increases as a firm borrows more. P
• V(cost of financial distress) is small and the value of the firm increases with more
borrowing.
• At higher levels of debt, PV(cost of financial distress) dominates (i.e., outweighs) and the
firm value diminishes.
Capital Structure Decisions

Static Trade-off
MM
Benefit from Tax Theory:
Propositions: Pecking Order
Deductibility of Bankruptcy Costs
Capital Structure Hypothesis
Interest and Costs of
Irrelevance
Financial Distress
Equity and Debt Issues with Information Asymmetries
•Information asymmetries
•Managers know more about their firm’s prospects, risks and values, than outside investors
• That is, there are information asymmetries between managers and outside investors

•Managers are less likely to issue equity when it is undervalued.

•In fact, managers are more likely to issue equity when it is overvalued
— Investors anticipate this, and they watch corporate action to interpret the value of equity
— Equity issuance often signals overvaluation
— Therefore, as a step 1: Use internal financing first
— Step 2: Issue debt next.
— Step 3: If you have exhausted your debt capacity – issue new equity as the last resort
The Pecking-Order Hypothesis
—The pecking-order hypothesis (Myer, 1984) implies:
— Firms prefer internal finance
— If external finance is required, firms issue debt first, then hybrid security (possibly),
then equity as a last resort.
— There is no target D/E ratio (contrary to Trade-off theory)
— There are two kinds of equity: one (internal) at the top of the pecking order and one
(external) at the bottom
—The theory also implies
— Profitable firms use less debt
— They may not need external funding
— Companies prefer to have financial slack
The Pecking-Order Hypothesis
—Financial Slack (cash, near cash, easily saleable real assets, spare debt
capacity)
—Positives of having financial slack: It is valuable.
— If positive NPV opportunities arise, you use internal funding or easily access debt
markets
—Negatives of financial slack: Lead to agency problems – misuse of cash
Is there a unifying theory that explains debt policy of
corporations?
Is there a unifying theory that explains debt policy of
corporations?
•There is no ONE theory that captures everything about the Debt-equity
choice
•Profitable firms:
• Have lower debt ratio, because they can rely on internally generated profits for
funding investments (pecking order hypothesis)
• This is contrary to the prediction of Trade-off theory that more profitable firms
could use tax shields, and thus should lever up.
•Tangible assets: Firms with higher fixed assets (as % of Total assets)
• They tend to borrow more
• Assets can serve as collateral and reduce financial distress
Is there a unifying theory that explains debt policy of
corporations?
•Smaller growth company:
• Less need for interest tax shields
• Preserving debt capacity / financial slack is more important
• Costs of financial distress are high
• They are most likely to use equity financing (confirms to Trade-off theory)
•Mature public corporation:
• Often follow pecking order
• Information asymmetries deter large equity issues
Other Factors in Debt policy choice
•Debt brings more financial discipline
• Thus, mitigates free cash flow problem (Jensen, 1986)
•Firm Life cycle and Loan spreads
• Loans spreads higher in intro, fall in growth and mature stages, rise up in
the decline stages
•FRICTO Analysis
Reference
Brealey, R. A., Myers, S. C., Allen, F., & Mohanty, P. (2015). Principles of corporate finance. Tata
McGraw-Hill Education. Referred to as BM hereafter.
◦ BM: Ch 17 & 18