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 TCH422
MARKETS AND FINANCIAL MANAGEMENT
Nguyen Manh Hiep
2021

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 CHAPTER 4
CAPITAL STRUCTURE AND FINANCIAL INSTRUMENTS
Nguyen Manh Hiep

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 In this chapter:
I.
• INTRODUCTION

II.
• MM THEORY

III.
• TRADE-OFF THEORY

IV
• PECKING –ORDER THEORY

V
• MARKET TIMING THEORY

VI
• EQUITY ISSUE

VII
• DEBT FINANCING

VIIII
• DIVIDEND POLICY

IX
• HOMEWORK 4
 I. INTRODUCTION
 Capital structure is the combination of equity and
debt and other securities issued by the company to
finance its activities.
 Do capital structure and financing decisions affect
shareholders’ value?
o In a perfect market: No effects.
o In reality: Yes.
 How do financing decisions affect shareholders’
value?
o Various theories and empirical evidence exist.
 I. INTRODUCTION
Internal vs External Funding
 External funding is used more in developed
financial system.
 Large firms use more external funding.
Internal Funding External Funding
Vietnamese firms Source: WB
Large 73.7 26.3

Medium 79.3 20.7

Small 92.6 7.4

Average 82.3 17.7

 I. INTRODUCTION
Internal vs External Funding
 I. INTRODUCTION
Source of External Funding
Vietnamese Firms’ External Funding for Investment (%)
Bank Finance Equity Issue Other

Large 17.6 6.6 2.1

Medium 14.7 5.4 0.6

Small 6.5 0.6

0.3

Average 12.7 4.1 0.9

 I. INTRODUCTION
ROE and capital structure
Example:
 Mai Linh Company has đ1000 billion in debt and
đ2000 billion in equity. Debt interest rate is 10%.
Tax is 20%. EBIT is đ400 billion. Calculate Mai
Linh’s return on equity.
 Tuan Bach Company has đ2000 billion in debt and
đ1000 billion in equity. Debt interest rate is 10%.
Tax is 20%. EBIT is đ400 billion. Calculate Tuan
Bach’s return on equity.
• ML: ROE= (EBIT-iD)x(1-t) /E
• ML: ROE = (400-0.1x1000)x(1-0.2)/2000=0.12
• TB: ROE = (400-0.1x2000)x(1-0.2)/1000= 0.16
• ML D/E = 0.5, TB D/E = 2
• TB has higher D/E and ROE
• D/E của Tuấn Bách cao hơn; D/E càng cao thì Leverage càng cao; phân tích
Dupont => ROE càng cao
• CTY nào càng sử dụng nhiều nợ vay thì ROE càng cao

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 I. INTRODUCTION
ROE and capital structure
Example:
 Mai Linh Company has đ1000 billion in debt and
đ2000 billion in equity. Debt interest rate is 10%.
Tax is 20%. EBIT is đ200 billion. Calculate Mai
Linh’s return on equity.
 Tuan Bach Company has đ2000 billion in debt and
đ1000 billion in equity. Debt interest rate is 10%.
Tax is 20%. EBIT is đ200 billion. Calculate Tuan
Bach’s return on equity.
• ML: ROE= (EBIT-iD)x(1-t) /E
• ML: ROE = (200-0.1x1000)x(1-0.2)/2000=0.04
• TB: ROE = (200-0.1x2000)x(1-0.2)/1000= 0
• ML D/E = 0.5, TB D/E = 2
• TB has higher D/E but lower ROE

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 I. INTRODUCTION
ROE and capital structure

ROIC > chi phí lãi vay sau thuế (i’) thì D/E cao làm ROE cao & ngược lại
 I. INTRODUCTION
ROE and capital structure

Source: Robert Higgins

 I. INTRODUCTION
Degree of Financial Leverage (DFL)
Example:
 Mai Linh Company has đ1000 billion in debt and đ2000
billion in equity. Tuan Bach Company has đ2000 billion in
debt and đ1000 billion in equity. Debt interest rate is 10%.
Tax is 20%. EBIT is đ300 billion. Calculate their return on
equity. Mai Linh and Tuan Bach has 200 million shares and
100 million shares outstanding.
 What is the percentage change in EPS when EBIT of both
companies increases / decreases to đ400/200 billion?
 Draw a graph showing the relationship between EBIT and
EPS of both firms in the same coordinate system.
 • ROE
• ML ROE= (300-0.1x1000)x(1-0.2)/2000=0.08
• TB ROE= (300-0.1x2000)x(1-0.2)/1000=0.08 
• EPS: 
• ML= 300/ 200= 1.5
• TB= 300/ 100= 3

Hệ số góc đường này là độ

đòn bẩy tài chính => cty
TB có độ đòn bẩy tài
chính lớn hơn ML
EBIT thay đổi thì EPS thay
đổi nhiều hơn
DN lỗ thì ML an toàn hơn

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• ML EPS= (300-0.1x1000)x(1-0.2)/200=0.8
• TB EPS= (300-0.1x2000)x(1-0.2)/100=0.8
• ML EPS= (400-0.1x1000)x(1-0.2)/200=1.2
• TB EPS= (400-0.1x2000)x(1-0.2)/100=1.6
Increase EBIT to 400 bil
• ML : 1.2/0.8 = 1.5 = 150%
• TB : 1.6/0.8 = 200%

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• ML EPS= (300-0.1x1000)x(1-0.2)/200=0.8
• TB EPS= (300-0.1x2000)x(1-0.2)/100=0.8
• ML EPS= (200-0.1x1000)x(1-0.2)/200=0.4
• TB EPS= (200-0.1x2000)x(1-0.2)/100=0
Decrease EBIT to 200 bil
• ML : 0.4/0.8 = 50%
• TB : 0/0.8 = 0%

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 II. MM THEORY
Assumptions
 Perfect capital market (no transaction costs, no
information asymmetry, REM investors,
homogenous expectations).
 Individuals and corporations lend and borrow at
risk-free interest rate.
 II. MM THEORY
 Mai Linh has the following project. rf = 5%,
required rate of return 15%.
Year 0 Year 1
Good (50%) Bad (50%)
-$800 $1400 $900
• PV=(1400 x 0,5 + 900 x 0,5)/(1 + 0,15) = 1000
• ML sells her own equity to do the project
Sell at 1150: (1150-1100)/1100 = 4.5% < 15% -> not buy
Sell at 900: (1000x(1+0,15)-900)/900 = 27.8% > 15% => buy

• 1000 là điểm cung cầu gặp nhau

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 II. MM THEORY
 Mai Linh raises 100% equity to invest. She can sell
equity at $1000.Sell at 900: (1400*0,5+900*0,5-900)/900=27,8% > 15% -> buy
Sell at 1100: (1400*0,5+900*0,5-1100)/1100=4,54% -> not buy
Sell at 1000: (1400*0.5+900*0.5-1000)/1000=15%

Year 0 Year 1
Good Bad
Unlevered Equity $1000 $1400 $900
rE = rA = 15% (r = 40%) (r=-10%)
0.4x0.5-0.1x0.5

 Equity risk: 40%-(-10%) = 50%

 Equity risk premium: 15% - 5% = 10%
> cứ 5 đơn vị rủi ro thì có 1 đơn vị phần bù rủi ro cho PX để đền bù cho mức rủi ro PX chịu
5% là lãi suất phi rủi ro
 II. MM THEORY
 Mai Linh raises 50% equity and 50% debt.
Year 0 Year 1
Good Bad
Firm assets $1000 $1400 $900
rA = 15%
500x1.05. Tốt hay xấu thì cũng phải trả như nhau

Debt $500 $525 $525

rD = rf = 5% (r = 5%) (r = 5%)

Levered Equity $500 1400-525

$875 $375
rE = 25% > rA (r = 75%) (r=-25%)
supposed that required rate of return on
equity remains at 15%
 Equity risk: 75% - (-25%) = 100% Þ value of equity = (875*0.5 +
375*0.5)/1.15 = 543,478
shareholders' value increases by (543.47-
 Equity risk premium: 25% - 5% = 20% 500)/500
 II. MM THEORY
MM proposition 1: Firm value (and thus
shareholders’ value) is not affected by the choice of
capital structure. When the firm increases the use of
debt, cost of equity increases accordingly.
 See more: Modigliani, Franco và Merton H. Miller (1968), “The Cost of
Capital, Corporate Finance, and the Theory of Investment”, American
Economic Review 48.

 VL = VU = EBIT / rU
 rE = rU + (rU – rD) * D/E
 WACC = E/V * rE +D/V * rD
 WACC = rU = rA
 II. MM THEORY
 Cash (and so does other risk-free securities)
reduces investor’s required rate of return on the
firm and is considered as “negative debt”.
 Net debt = Debt – Cash.
 II. MM THEORY
Taxes
 Cash flows to investors with leverage = cash flows
to investors without leverage + interest tax shield.

Source: Berk, DeMarzo

 II. MM THEORY
 Tax 30%. $10 per share
No debt Year 0 Year 1
Good Bad
$1400 $900
Tax $126 $-24
Unlevered Equity $980 $1274 $924
(12.15%) (30%) (-5.7%)
 Equity risk: 30%-(-5.7%)=35.71%
 Equity risk premium: 12.15%-5%=7.15%
 EPS good=$3 EPS bad=-$0.57
• Tốt: (1400-980)*30%= 126
• Xấu: (900-980)*30%= - 24
• VCSH: 
• Tốt: 1400-126= 1274….
• Xấu: 90-(-24)=924
• Lợi suất đầu tư:
• Tốt: (1274-980)/980=0.3
• Xấu: -0.057
• Rủi ro VCSH: 30%-5.7%= 35.7%
• Lợi suất kì vọng của VCSH: 30%*0,5+(-5,7%)*0,5=12,15% 
• Phần bù rủi ro: 12.15%-5%=7.5%  
• 35.7/7.15=5 => không đổi
• EPS: 
• Tốt: (1274-980)/(980/10)=3
• Xấu: (924-980)/98=-0.57
• Giả sử ML không tài trợ bằng nợ vay, còn 50% nợ vay, 50% VCSH (490:490)
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 II. MM THEORY
With 50% debt Year 0 Year 1
Good Bad
$1400 $900
Interest expense $24.5 $24.5
Tax (30%) $118.65 -$31.35
Debt (principal) $490 $490 $490
Equity $490 $766.85 $416.85
(20.8%) (56.5%) (-14.9%)
Risk-adjusted return 19.3% $759.5 (r=55%) $409.5 (r=-16.4%)
Tax shield 1.5% $7.35 (=$24.5×0.3) $7.35 (=$24.5×0.3)
 Equity risk: 56.5%-(-14.93%)=71.43%
 Equity risk premium: 19.3%-5%=14.3%
 Equity value = ($766.85×0.5+$416×85*0.5)/1.193 = $496.1619.3%)
 EPSgood=$25.65 EPSbad=$18.5
• Lãi vay: 490. 0,05= 24,5
• Thuế: (1400-24.5-980)*0.3= 118.65
• Debt: 1400 - 24.5 - 118.65 - 490 = 766.85
• Tốt: (766.85-490)/490 = 0.565
• Xấu: (416.85-490)/490=-14.9%
• Lợi suất kì vọng của VCSH: 0,5*(56,5%-14,9%) = 20,8%
• Khoảng rủi ro của VCSH:  56.5%--14.9%=71.4%
• Phần bù rủi ro: 71.4/5=14.3%
• Lợi suất điều chỉnh rủi ro: 14.3%+5%=19.3%
• Mà nhận được 20.8% => cao hơn. Phần cao hơn là giá trị của phần bù rủi ro
• Lá chắn thuế: 20.8-19.3=1.5%
• Giá trị VCSH: chiết khấu các dòng tiền của VCSH theo chi phí VCSH (=19.3%)=
(766.85*0.5 + 416.85*0.5) / 1.193 = 496.102 
• GT VCSH không còn là 490 mà tăng lên 496.102; 6.102 là giá trị hiện giá của lá chắn
thuế
• Khi thay đổi cơ cấu nợ vay, gt VCSH tăng lên nhờ sự gia tăng giá trị lá chắn thuế 
• EPS tốt = (1400-24,5-980-118,65)/49=5,65 (lãi sau thuế)
• EPS xấu= (900-980-24.5- -31.35)/(49)=-1.493
30
• Sử dụng nợ vay thì EPS cao hơn
 II. MM THEORY
MM Proposition 2: Firm value and thus
shareholders’ value increases with the use of debt.
 VL = VU + PV(Interest Tax Shield)
 PV(Int. Tax Shield) = τC * D
 VU = EBIT*(1- τC) / rU
 rE = rU + (rU – rD) * D/E * (1- τC)
 rWACC = E/V * rE +D/V * rD* (1- τC)
 What is the optimal level of debt?
Cơ cấu có hiện giá tax shield cao nhất- cao nhất khi chi phí lãi vay cao nhất (tax shield=chi phí lãi vay*tax).  
Nếu cơ cấu 100% nợ vay: chủ nợ thành csh => đ được ☺)))
Với giả định hệ thống thuế đối xứng (lỗ thì được nhà nước trợ cấp)
Nếu bỏ giả định không đối xứng thì cơ cấu vốn tối ưu nhất khi lãi vay= EBIT
 III. TRADE-OFF THEORY
 Financial distress costs damage shareholders’ and
debtholders’ value. They are 10-20% of firm value.
o Direct costs from 3%-10% of a firm’s assets.
Indirect costs are substantial.
o Even the high probability of financial distress may
impose indirect costs.
o Lenders ex ante require higher interest.
 Bradley, M. và G. A. Jarrell và E. H. Kim (1984). “On the Existence of an
Optimal Capital Structure: Theory and Evidence”. Journal of Finance 39.
 Andrade, G. & Kaplan, S. (1998). “How Costly Is Financial (Not Economic)
Distress? Evidence from Highly Leveraged Transactions That Became
Distressed, Journal of Finance 53.
 III. TRADE-OFF THEORY
Financial distress cost components
 Expected bankruptcy costs equal probability times
costs incurred if bankruptcy happens.
 Which company loses more value in a bankruptcy, a value company with
mostly physical assets or a growth company whose value comes mostly
from growth potential?
 Implicit costs.
 Predict how creditors, customers and suppliers react if they realize that a
company is near financial distress.
 Predict ex ante action of the managers with regard to cash holding.
 Distorted investment decisions due to conflicts of
interest (see the examples in Chapter 1).
 III. TRADE-OFF THEORY
Example
 Tuan Bach Inc. and Mai Linh Co. are two leading
competitors who provide highly substitutable
products, each occupies 40% market share.
 Due to excessive growth and heavy debt burden,
Mai Linh is on the brink of bankruptcy with cash
flows barely enough to pay its debt.
 Tuan Bach has abundant of cash reserve, healthy
cash flows and little debt.
 What should Tuan Bach do?
 III. TRADE-OFF THEORY

Source: Berk, DeMarzo

 III. TRADE-OFF THEORY
Benefits of high leverage
 Concentration of ownership.
 Reduction of wasteful investments and activities.
 Higher pressure on and commitments by
management.
 Restrictions by debt covenants and additional
monitoring from lenders.
 III. TRADE-OFF THEORY
 VL = VU + PV(tax shield) - PV(financial distress
costs) - PV(agency costs of debt) + PV(agency
benefits of debt)
 III. TRADE-OFF THEORY

Source: Berk, DeMarzo

 III. TRADE-OFF THEORY
Example: Which of the following is likely to use more
debt?
 A firm with high intangible assets, R&D-intensive,
human-capital-intensive, high-growth, unstable
cash flows.
 A firm with high tangible assets, low-growth, stable
cash-flows.

• Mai Linh: nên dùng ít nợ vay hơn, do chi phí phá sản lớn
• Tuấn Bách: ngược lại
 IV. PECKING ORDER
THEORY
 Equity issuance conveys a negative signal (why?),
leading to a significant loss in shareholder value.
 Asquith, P., & Mullins, D. W. (1986). Equity issues and offering dilution.
Journal of Financial Economics, 15(1-2), 61–89.
 Retain earnings first, debt second, equity last.
 Myers, S. C. (1984). “The Capital Structure Puzzle”. Journal of Finance 39.

Example: For firms unwilling to sell equity (small

firms, family firms, firms of strategic importance to
owner, undervalued firms…), what determine their
growth? DN tốt: phát hành nợ vay; xấu: cổ phiếu
Phát hành cổ phiếu thì giá trị cổ phiếu giảm; mức trung bình là 30% khối lượng cp cty phát hành  
Muốn vay nợ vay thì vcsh lớn, lợi nhuận giữ lại lớn => không trả cổ tức
Luôn ưu tiên giữ lại lợi nhuận -> đi vay nợ -> phát hành vcsh 
DN nhỏ, gia đình không muốn bán csh vì founder không muốn người khác can thiệp vào 
Tài trợ phụ thuộc giá trị đòn bẩy và tỷ lệ lợi nhuận giữ lại
Tỷ lệ tăng trưởng bền vững sustainable growth rate: g= ROE* retain rate (tỉ lệ lợi nhuận giữ lại)
 IV. PECKING ORDER
THEORY

Source: Berk, DeMarzo

 V. MARKET TIMING
THEORY
 The choice of debt and equity depends on market
condition.
 Baker, M và J. Wurgler (2002), Market Timing and Capital Structure,
Journal of Finance 57.
 Debondt, W. F. M. và R. Thaler (1985), Does the Stock Market Overreact?,
Journal of Finance 40.
Example:
2002-2007: Vietnamese listed companies raises
around 40% external funding from share issues.
2008-2011: Only 20% of external funding is from
share issues.
 *SUM UP THE THEORY
Rapidly growing firms
 Low or high leverage?
 Low or high dividend payout?
 How to finance if investment needs exceed
internal funds?
 What to do if external funding is exhausted?
 McConnell, J. J., & Servaes, H. (1995). Equity ownership and the two faces
of debt. Journal of financial economics, 39(1), 131-157.
• DN tăng trưởng mạnh: giá trị đến từ tiềm năng tăng trưởng, khi kiệt quệ tài chính thì không còn tăng trưởng nữa => chi phí kiệt
quả tài chính lớn; đầu tư vào vốn cố định và vốn lưu động => dòng tiền thường bị âm thì vay nợ nhiều xs kiệt quệ tài chính cao,
xs kiệt quệ tài chính cao => không nên vay nợ nhiều. 
• Ưu tiên hang đầu là tái đầu tư -> trả cổ tức ít 
• Nguồn vốn cạn kiệt: phát hành vốn cổ phần
• Hạn chế tăng trưởng: giảm quy mô, tăng giá bán để nhu cầu thấp, 
• DN ít tăng trưởng, bão hòa -> sử dụng nợ vay, lợi ích: lá chắn thuế, áp lực quản trị DN, chi phí vay nợ thấp
 *SUM UP THE THEORY
Low growth, matured firms
 Use more leverage. Buy back shares or pay more
dividend.
 McConnell, J. J., & Servaes, H. (1995). Equity ownership and the two faces
of debt. Journal of financial economics, 39(1), 131-157.
 VI. EQUITY FUNDING
Seed stage
 “Angel” investors (Ex: Shark tanks)
Private equity
 “Angel” investors.
 Venture capital.
 Private equity funds.
Going public
 IPO.
 SEO.
 Private placement.
 VI. EQUITY FUNDING
Raising equity
 Common shares vs preferred shares. (ref. Luật Doanh
nghiệp 2020; Luật chứng khoán 2019)
 Primary equity market: right offering, private
placement, public offering.
 Secondary equity market: OTC market, exchange
market, and other trading systems.
 VI. EQUITY FUNDING
Share issue: An example prospectus.
 VI. EQUITY FUNDING
Stock valuation: A simple example of DDM
TBC has just paid $1 dividend each share. In the
annual shareholder meeting, the CEO promises
that dividend with remain $1 each year forever.
Investors’ required rate of return is 12%. What is
the intrinsic value of a TBC share?
Assume that the CEO promises that dividend with
increase 5% each year permanently. What is the
value of TBC share?
 VII. DEBT FUNDING
 Bank loans
 Bonds
 Pros and cos?
 VII. DEBT FUNDING
Example:
 What are the typical maturity structure of debt?
 Should debt maturity match asset maturity or
should it be longer/shorter? Pros and cos of each
choice?
 VII. DEBT FUNDING
Bank credit decision
Why don’t firm apply for bank loans?

Source: Cole, Sokolyk (2016)

 VII. DEBT FUNDING
Raising debt
 Short-term: commercial paper, bank loans, non-
bank loans, etc. (is trade credit a debt?)
 Long-term: bank loans, bond offerings.
 Primary bond market: offering through auctions,
underwriting, agents, or direct sale. (ref. 163/2018/NĐ-CP,
81/2020/NĐ-CP, 153/2020/NĐ-CP)
 Secondary bond market: OTC market exchange
market, and other trading systems.
 VII. DEBT FUNDING
Bond issue: An example of bond indenture
 VII. DEBT FUNDING
Bond valuation: A simple example
Bond TB01 has three years until maturity, par value 100,
annual coupon rate 10%. YTM 9%. Calculate bond price.
What happens to bond price if YTM decreases from 9%
to 8%?
What happens to bond price if YTM increases from 9%
to 10%?
 VII. DEBT FUNDING
Example
Tuan Bach is a large corporation with a long history and well-
established reputation. Tuan Bach is raising capital to invest in
a long-term project. The interest rate is however currently high
and is expected to decline in the coming years. Which of the
following is least likely a good way to raise the capital needed?
A. Issue 10-year bonds with fixed interest rate.
B. Issue 10-year bonds with floating interest rate.
C. Issue commercial papers and refinance when they mature.
D. Issue callable bonds.
E. Apply for floating-rate bank loans.
VII. DEBT FUNDING
VII. DEBT FUNDING

Moody’s S&P
P-1 A-1
Increasing default risk

P-2 A-2
P-3 A-3
NP B
C
D