OVERVIEW OF CAPITAL

STRUCTURE
 SOURCES OF FINANCE
SOLE PROPRIETORSHIP:
Own Capital
Bank Borrowing
Crowd Funding
Venture Capitalist
Business Angels
Leasing
Mortgage
Hire Purchasing
 SOURCES OF FINANCE
PARTNERSHIP:
Joint Capital
Bank Borrowing
Crowd Funding
Venture Capitalist
Business Angels
Leasing
Mortgage
Hire Purchasing
 SOURCES OF FINANCE
CORPORATION:
Bank Borrowing
Crowd Funding
Leasing
Mortgage
Hire Purchasing
Share
Bonds/Debentures
BUSINESS ANGELS

Rich individuals
- Contribute Capital
- Does not get involve in running the
business
- Returns
VENTURE CAPITALISTS

Rich individuals/Organizations
- Contribute Capital/Equity
-Get involve in running the business
-Sharing Returns
-Acquisitions
 Key Concepts and Skills
• Understand the effect of financial
leverage on cash flows and the cost
of equity
• Understand the impact of taxes and
bankruptcy on capital structure
choice
• Understand the basic components of
the bankruptcy process

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 Chapter Outline
• The Capital Structure Question
• The Effect of Financial Leverage
• Capital Structure and the Cost of Equity Capital
• M&M Propositions I and II with Corporate Taxes
• Bankruptcy Costs
• Optimal Capital Structure
• The Pie Again
• The Pecking-Order Theory
• Observed Capital Structures
• A Quick Look at the Bankruptcy Process

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 Capital Restructuring
• We are going to look at how changes in capital
structure affect the value of the firm, all else equal
• Capital restructuring involves changing the amount
of leverage a firm has without changing the firm’s
assets
• The firm can increase leverage by issuing debt
and repurchasing outstanding shares
• The firm can decrease leverage by issuing new
shares and retiring outstanding debt

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 Choosing a Capital
Structure
• What is the primary goal of financial
managers?
– Maximize stockholder wealth
• We want to choose the capital structure that
will maximize stockholder wealth
• We can maximize stockholder wealth by
maximizing the value of the firm or
minimizing the WACC

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 The Effect of Leverage
• How does leverage affect the EPS and ROE of a
firm?
• When we increase the amount of debt financing,
we increase the fixed interest expense
• If we have a really good year, then we pay our
fixed cost and we have more left over for our
stockholders
• If we have a really bad year, we still have to pay
our fixed costs and we have less left over for our
stockholders
• Leverage amplifies the variation in both EPS and
ROE

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 Capital Structure Theory
• Modigliani and Miller (M&M)Theory of
Capital Structure
– Proposition I – firm value
– Proposition II – WACC
• The value of the firm is determined by the
cash flows to the firm and the risk of the
assets
• Changing firm value
– Change the risk of the cash flows
– Change the cash flows

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Capital Structure Theory Under
Three Special Cases
• Case I – Assumptions
– No corporate or personal taxes
– No bankruptcy costs
• Case II – Assumptions
– Corporate taxes, but no personal taxes
– No bankruptcy costs
• Case III – Assumptions
– Corporate taxes, but no personal taxes
– Bankruptcy costs

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Case I – Propositions I and II
• Proposition I
– The value of the firm is NOT affected by
changes in the capital structure
– The cash flows of the firm do not
change; therefore, value doesn’t
change
• Proposition II
– The WACC of the firm is NOT affected
by capital structure

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 Case II – Cash Flow
• Interest is tax deductible
• Therefore, when a firm adds debt, it
reduces taxes, all else equal
• The reduction in taxes increases the
cash flow of the firm
• How should an increase in cash
flows affect the value of the firm?

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 Case III
• Now we add bankruptcy costs
• As the D/E ratio increases, the probability of
bankruptcy increases
• This increased probability will increase the
expected bankruptcy costs
• At some point, the additional value of the interest
tax shield will be offset by the increase in expected
bankruptcy cost
• At this point, the value of the firm will start to
decrease, and the WACC will start to increase as
more debt is added

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 Bankruptcy Costs
• Direct costs
– Legal and administrative costs
– Ultimately cause bondholders to incur
additional losses
– Disincentive to debt financing
• Financial distress
– Significant problems in meeting debt obligations
– Firms that experience financial distress do not
necessarily file for bankruptcy

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 More Bankruptcy Costs
• Indirect bankruptcy costs
– Larger than direct costs, but more difficult to measure
and estimate
– Stockholders want to avoid a formal bankruptcy filing
– Bondholders want to keep existing assets intact so they
can at least receive that money
– Assets lose value as management spends time worrying
about avoiding bankruptcy instead of running the
business
– The firm may also lose sales, experience interrupted
operations and lose valuable employees

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 Conclusions
• Case I – no taxes or bankruptcy costs
– No optimal capital structure
• Case II – corporate taxes but no bankruptcy costs
– Optimal capital structure is almost 100% debt
– Each additional dollar of debt increases the cash
flow of the firm
• Case III – corporate taxes and bankruptcy costs
– Optimal capital structure is part debt and part equity
– Occurs where the benefit from an additional dollar of
debt is just offset by the increase in expected
bankruptcy costs

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 Managerial
Recommendations
• The tax benefit is only important if the firm
has a large tax liability
• Risk of financial distress
– The greater the risk of financial distress, the
less debt will be optimal for the firm
– The cost of financial distress varies across
firms and industries, and as a manager you
need to understand the cost for your industry

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Figure 16.9

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 The Value of the Firm
• Value of the firm = marketed claims +
nonmarketed claims
– Marketed claims are the claims of stockholders and
bondholders
– Nonmarketed claims are the claims of the government
and other potential stakeholders
• The overall value of the firm is unaffected by
changes in capital structure
• The division of value between marketed claims
and nonmarketed claims may be impacted by
capital structure decisions

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 The Pecking-Order Theory
• Theory stating that firms prefer to issue debt rather
than equity if internal financing is insufficient.
– Rule 1
• Use internal financing first
– Rule 2
• Issue debt next, new equity last
• The pecking-order theory is at odds with the
tradeoff theory:
– There is no target D/E ratio
– Profitable firms use less debt
– Companies like financial slack

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Observed Capital Structure
• Capital structure does differ by industry
• Differences according to Cost of Capital
2008 Yearbook by Ibbotson Associates,
Inc.
– Lowest levels of debt
• Computers with 5.61% debt
• Drugs with 7.25% debt
– Highest levels of debt
• Cable television with 162.03% debt
• Airlines with 129.40% debt

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 Quick Quiz
• Explain the effect of leverage on EPS and ROE
• What is the break-even EBIT, and how do we
compute it?
• How do we determine the optimal capital
structure?
• What is the optimal capital structure in the three
cases that were discussed in this chapter?
• What is the difference between liquidation and
reorganization?

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 Ethics Issues
• Suppose managers of a firm know that the
company is approaching financial distress.
– Should the managers borrow from creditors and issue a
large one-time dividend to shareholders?
– How might creditors control this potential transfer of
wealth?

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 Comprehensive Problem
• Assuming perpetual cash flows in
Case II - Proposition I, what is the
value of the equity for a firm with
EBIT = $50 million, Tax rate = 40%,
Debt = $100 million, cost of debt =
9%, and unlevered cost of capital =
12%?

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End of Chapter

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