Chapter 17
Capital Structure
Determination
Chapter Objectives





Discuss the impact of financial leverage on a
firm’s capital structure.
Outline both MM Proposition I and MM
Proposition II.
Discuss the impact of corporate taxes on MM
Propositions I and II.
Explain the impact of bankruptcy costs on the
value of a firm.
Identify a firm’s optimal capital structure.
Copyright  2001 Prentice-Hall, Inc.
Fundamentals of Financial Management, 11/e by Van Horne and Wachowicz.
Slides prepared by Wu Xiaolan
1
Capital Structure
 Capital
Structure -- The mix (or proportion) of a
firm’s permanent long-term financing represented
by debt, preferred stock, and common stock
equity.
 Concerned with the effect of capital market
decisions on security prices.
 Assume: (1) investment and asset
management decisions are held constant and
(2) consider only debt-versus-equity
financing.
Copyright  2001 Prentice-Hall, Inc.
Fundamentals of Financial Management, 11/e by Van Horne and Wachowicz.
Slides prepared by Wu Xiaolan
2
A Conceptual Look --Relevant
Rates of Return
ki = the yield on the company’s debt
ki
=
I
B
=
Annual interest on debt
Market value of debt
Assumptions:
• Interest paid each and every year
• Bond life is infinite
• Results in the valuation of a perpetual bond
• No taxes (Note: allows us to focus on just
capital structure issues.)
Copyright  2001 Prentice-Hall, Inc.
Fundamentals of Financial Management, 11/e by Van Horne and Wachowicz.
Slides prepared by Wu Xiaolan
3
A Conceptual Look --Relevant
Rates of Return
ke = the expected return on the company’s equity
Earnings available to
E
E
common shareholders
=
=
ke
S
Market value of common
S
stock outstanding
Assumptions:
• Earnings are not expected to grow
• 100% dividend payout
• Results in the valuation of a perpetuity
• Appropriate in this case for illustrating the
theory of the firm
Copyright  2001 Prentice-Hall, Inc.
Fundamentals of Financial Management, 11/e by Van Horne and Wachowicz.
Slides prepared by Wu Xiaolan
4
A Conceptual Look --Relevant
Rates of Return
ko = an overall capitalization rate for the firm
O
O
ko= VV
=
Net operating income
Total market value of the firm
Assumptions:
• V = B + S = total market value of the firm
• O = I + E = net operating income = interest paid plus
earnings available to common shareholders
Copyright  2001 Prentice-Hall, Inc.
Fundamentals of Financial Management, 11/e by Van Horne and Wachowicz.
Slides prepared by Wu Xiaolan
5
Capitalization Rate
 Capitalization
Rate, ko -- The discount rate used to
determine the present value of a stream of expected
cash flows.
ko = ki
B
B+S
+
ke
S
B+S
Copyright  2001 Prentice-Hall, Inc.
Fundamentals of Financial Management, 11/e by Van Horne and Wachowicz.
Slides prepared by Wu Xiaolan
6
Net Income Approach

Net Income Approach -- A theory of capital
structure in which the weighted average cost of
capital will decrease and the total value of the
firm will increase as financial leverage is
becoming greater.
Assume:
 Both ki and ke are unrelated to the financial leverage.

Optimal Capital Structure -- The capital structure
that minimizes the firm’s cost of capital and
thereby maximizes the value of the firm.
Copyright  2001 Prentice-Hall, Inc.
Fundamentals of Financial Management, 11/e by Van Horne and Wachowicz.
Slides prepared by Wu Xiaolan
7
Net Income Approach
K
Ke
Ko
Ki
0
V
100% B/V
V
0
B/V
100%
Copyright  2001 Prentice-Hall, Inc.
Fundamentals of Financial Management, 11/e by Van Horne and Wachowicz.
Slides prepared by Wu Xiaolan
8
Summary of NI Approach

Critical assumption is both ki and ke remain
constant.
 As long as ki and ke are constant, ko is a
decreasing linear function of the debt-to-equity
ratio.
 Thus, there is a optimal capital structure when
B/V is 100%.
Copyright  2001 Prentice-Hall, Inc.
Fundamentals of Financial Management, 11/e by Van Horne and Wachowicz.
Slides prepared by Wu Xiaolan
9
Net Operating Income
Approach

Net Operating Income Approach -- A theory of
capital structure in which the weighted average
cost of capital and the total value of the firm
remain constant as financial leverage is
changed.
Assume:
 Both ki and ko remain constant.
Copyright  2001 Prentice-Hall, Inc.
Fundamentals of Financial Management, 11/e by Van Horne and Wachowicz.
Slides prepared by Wu Xiaolan
10
Required Rate of Return on
Equity
 Capital
costs and the NOI approach in a graphical
representation.
Capital Costs (%)
.25
ke = 16.25% and
17.5% respectively
.20
ke (Required return on equity)
.15
ko (Capitalization rate)
.10
ki (Yield on debt)
.05
0
0
.25
.50
.75
1.0 1.25 1.50
Financial Leverage (B / S)
Copyright  2001 Prentice-Hall, Inc.
Fundamentals of Financial Management, 11/e by Van Horne and Wachowicz.
Slides prepared by Wu Xiaolan
1.75
2.0
11
Summary of NOI Approach

Critical assumption is ko remains constant.
 An increase in cheaper debt funds is exactly
offset by an increase in the required rate of
return on equity.
 As long as ki is constant, ke is a linear function
of the debt-to-equity ratio.
 Thus, there is no one optimal capital structure.
Copyright  2001 Prentice-Hall, Inc.
Fundamentals of Financial Management, 11/e by Van Horne and Wachowicz.
Slides prepared by Wu Xiaolan
12
Traditional Approach
 Traditional Approach
-- A theory of capital
structure in which there exists an optimal capital
structure and where management can increase the
total value of the firm through the judicious use
of financial leverage.
Copyright  2001 Prentice-Hall, Inc.
Fundamentals of Financial Management, 11/e by Van Horne and Wachowicz.
Slides prepared by Wu Xiaolan
13
Optimal Capital Structure:
Traditional Approach
Traditional Approach
ke
Capital Costs (%)
.25
ko
.20
.15
ki
.10
Optimal Capital Structure
.05
0
Financial Leverage (B / S)
Copyright  2001 Prentice-Hall, Inc.
Fundamentals of Financial Management, 11/e by Van Horne and Wachowicz.
Slides prepared by Wu Xiaolan
14
Summary of the Traditional
Approach
 The
cost of capital is dependent on the capital
structure of the firm.
Initially, low-cost debt is not rising and replaces more
expensive equity financing and ko declines.
Then, increasing financial leverage and the associated
increase in ke and ki more than offsets the benefits of lower
cost debt financing.
 Thus,
there is one optimal capital structure where ko
is at its lowest point.
 This is also the point where the firm’s total value
will be the largest (discounting at ko).
Copyright  2001 Prentice-Hall, Inc.
Fundamentals of Financial Management, 11/e by Van Horne and Wachowicz.
Slides prepared by Wu Xiaolan
15
The Modigliani-Miller Theorem
(intuition)
It is after the ball game and the pizza man is
delivering a pizza to Yogi .
“Should I cut it into four slices as usual, Yogi?”
asks the pizza man.
“No,” replies Yogi, “Cut it into eight;
I’m hungry tonight.”
Copyright  2001 Prentice-Hall, Inc.
Fundamentals of Financial Management, 11/e by Van Horne and Wachowicz.
Slides prepared by Wu Xiaolan
16
The Modigliani-Miller
Theorem

Intuition: the way that a pie is sliced does not effect its size.
Equivocally, it is the size of the firm's cash flows and not how
these cash flows are diced up that drives firm value.
Debt
Equity
Copyright  2001 Prentice-Hall, Inc.
Fundamentals of Financial Management, 11/e by Van Horne and Wachowicz.
Slides prepared by Wu Xiaolan
17
MM Proposition I
Value of firm
Value of firm
Shares
40%
Debt
60%
Debt
40%
Shares
60%
The size of the pie does not depend on how it is sliced.
The value of the firm is unaffected by its capital structure.
Copyright  2001 Prentice-Hall, Inc.
Fundamentals of Financial Management, 11/e by Van Horne and Wachowicz.
Slides prepared by Wu Xiaolan
18
The Modigliani-Miller
Theorem (Cont.)

Modigliani and Miller Capital Structure Irrelevance
Proposition I
 The value of a company derives from the operations of the
company.
 Changes in capital structure only affect the way in which the
distribution of the cash flows between stockholders and
bondholders is achieved.

Firm value is dependent not on how it is financed, but on
its operations.
Copyright  2001 Prentice-Hall, Inc.
Fundamentals of Financial Management, 11/e by Van Horne and Wachowicz.
Slides prepared by Wu Xiaolan
19
M&M Irrelevance
Proposition II

True or false:
 Firms can lower their cost of capital by substituting debt for
equity, since debt is much cheaper than equity


How can you support your argument?
Definition of M&M II
 The expected return on a levered firm’s equity is a linear
function of firm’s debt to equity ratio.
Copyright  2001 Prentice-Hall, Inc.
Fundamentals of Financial Management, 11/e by Van Horne and Wachowicz.
Slides prepared by Wu Xiaolan
20
The MM Propositions I & II
(No Taxes)

Proposition I
 Firm value is not affected by leverage
VL = VU

Proposition II
 Leverage increases the risk and return to stockholders
rs = r0 + (B/S) (r0 - rB)
rB is the interest rate (cost of debt)
rs is the return on (levered) equity (cost of equity)
r0 is the return on unlevered equity (cost of capital)
B is the value of debt
S is the value of levered equity
Copyright  2001 Prentice-Hall, Inc.
Fundamentals of Financial Management, 11/e by Van Horne and Wachowicz.
Slides prepared by Wu Xiaolan
21
The MM Propositions I & II (with
Corporate Taxes)

Proposition I (with Corporate Taxes)
 Firm value increases with leverage
VL = VU + TC B

Proposition II (with Corporate Taxes)
 The increase in equity risk and return is partly offset by
tax shield of the debt
rS = r0 + (B/S)×(1-TC)×(r0 - rB)
rB is the interest rate (cost of debt)
rS is the return on equity (cost of equity)
r0 is the return on unlevered equity (cost of capital)
B is the value of debt
S is the value of levered equity
Copyright  2001 Prentice-Hall, Inc.
Fundamentals of Financial Management, 11/e by Van Horne and Wachowicz.
Slides prepared by Wu Xiaolan
22
Discussion of the assumptions
of the Modigliani-Miller Theorem:

No change in investment policy.
 Perfect capital market






No transaction costs
No taxes
No bankruptcy costs
Competitive market
Individuals can borrow at the same rate as the corporations.
Symmetric information

All cash flows are perpetuities, meaning a zero growth
rate.
 Homogeneous expectation
Copyright  2001 Prentice-Hall, Inc.
Fundamentals of Financial Management, 11/e by Van Horne and Wachowicz.
Slides prepared by Wu Xiaolan
23
Graphical representation of M&M
with corporate tax
Total Firm Value
VL  VU  DTC
VU
M&M: =
VL  VU
Debt as % of capital
Copyright  2001 Prentice-Hall, Inc.
Fundamentals of Financial Management, 11/e by Van Horne and Wachowicz.
Slides prepared by Wu Xiaolan
24
Absolute priority rule


Absolute priority rule states that debt holders must be
paid in full before equity holders receive any proceeds of
the bankruptcy, secured debt holders be paid before
unsecured debt holder, and senior debt holders be paid
before junior debt holder.
Who gets paid first?










Secured claims
Administrative claims
Gap claims: post-filing/pre-trustee expenses
Wages & salaries ($2,000 limit per person)
Benefit plan claims
Consumer claims and deposits.
Taxes and rents.
Unsecured creditors.
Preferred stockholders.
Common stockholders.
Copyright  2001 Prentice-Hall, Inc.
Fundamentals of Financial Management, 11/e by Van Horne and Wachowicz.
Slides prepared by Wu Xiaolan
25
Bankruptcy

Technical Insolvency
 Insolvency in Bankruptcy
 Legal Bankruptcy
Copyright  2001 Prentice-Hall, Inc.
Fundamentals of Financial Management, 11/e by Van Horne and Wachowicz.
Slides prepared by Wu Xiaolan
26
Bankruptcy Costs
-- Direct bankruptcy costs

Direct costs of financial distress are the legal
and administrative charges that occur during
bankruptcy proceedings and that are taken from
the cash flows that otherwise would go to the
bondholders and stockholders.
Copyright  2001 Prentice-Hall, Inc.
Fundamentals of Financial Management, 11/e by Van Horne and Wachowicz.
Slides prepared by Wu Xiaolan
27
Direct bankruptcy costs
(cont.)

Some estimates the tax advantages of debt (TcD)
are maybe 20 cents on the dollar. Thus, they
argue the costs in terms of expected financial
distress are small compared to its advantages.
 Because most of the direct costs of bankruptcy
are the same for both small and large firms, the
bankruptcy costs of small firms as a proportion
of the value of their assets, are much larger. For
small firms, these costs may be fairly large,
perhaps 20-25% of a firm’s value.
Copyright  2001 Prentice-Hall, Inc.
Fundamentals of Financial Management, 11/e by Van Horne and Wachowicz.
Slides prepared by Wu Xiaolan
28
Bankruptcy Costs
-- Indirect bankruptcy costs

Indirect bankruptcy costs: potential costs due to
firm’s liquidation. Also known as financial
distress costs.
 Types of indirect bankruptcy costs:
 Loss of valuable trademark, brand, etc.
 Impaired ability to conduct business
 Loss of potential business deals, partners,
 Assets sold in fire-sale
 Employees
 Agency costs
Copyright  2001 Prentice-Hall, Inc.
Fundamentals of Financial Management, 11/e by Van Horne and Wachowicz.
Slides prepared by Wu Xiaolan
29
Example

In the late 1970s, a financially distressed
Chrysler would have defaulted on its debt had
the government not intervened. In 1979,
Chrysler offered rebates on its cars and trucks to
attract customers who might have avoided
Chrysler vehicles because of the company’s
financial distress.
 Assuming a $300 rebate on each vehicle and if
Chrysler sold 1,438,000 cars and trucks in 1979,
then how much financial costs come from this
rebate incentive?
Copyright  2001 Prentice-Hall, Inc.
Fundamentals of Financial Management, 11/e by Van Horne and Wachowicz.
Slides prepared by Wu Xiaolan
30
Agency Costs

Agency costs: conflict between debt holders and
equity holders, old bondholders and new
bondholders
 The incentives of equity holders to maximize
the value of their shares are not necessarily
consistent with the incentive to maximize the
total value of the firm’s debt and equity.
Total assets of firm = total debt + total equity
Copyright  2001 Prentice-Hall, Inc.
Fundamentals of Financial Management, 11/e by Van Horne and Wachowicz.
Slides prepared by Wu Xiaolan
31
Who bears the bankruptcy costs?
(Direct costs)

Under the absolute priority rule, most of a firm’s
value in the event of bankruptcy is transferred to
its debt holders. Since the direct costs of
bankruptcy diminish the value of the firm, most
direct costs are thus ultimately borne by the
firm’s debt holder.
Copyright  2001 Prentice-Hall, Inc.
Fundamentals of Financial Management, 11/e by Van Horne and Wachowicz.
Slides prepared by Wu Xiaolan
32
Who bears the bankruptcy costs?
(Cont.)

Since lenders realize they will be bearing costs
in the event of bankruptcy, they change a higher
interest rate, default premium, on the firms that
are in financial distress.
 Default premium: the differences between the
promised yield to the bond’s lenders and the yield on
a bond with no default.

Thus, equity holders are, in effect, paying the
expected bankruptcy costs whenever they issue
risky debt.
Copyright  2001 Prentice-Hall, Inc.
Fundamentals of Financial Management, 11/e by Van Horne and Wachowicz.
Slides prepared by Wu Xiaolan
33
Optimal Capital Structure:

Optimal capital structure is achieved by finding
the point at which the tax benefit of an extra dollar
of debt = potential cost of financial distress. This
is the point of:
 Optimal amount of debt
 Maximum value of the firm
 Optimal debt to equity ratio
 Minimal cost of WACC

This will obviously vary from firm to firm and
takes some effort to evaluate. No single equation
can guarantee profitability or even survival
Copyright  2001 Prentice-Hall, Inc.
Fundamentals of Financial Management, 11/e by Van Horne and Wachowicz.
Slides prepared by Wu Xiaolan
34
Concluding remarks on capital
structure
Where do we stand?
Do we have an optimal capital structure?

What do we mean by optimal capital structure?
 There are two main theories of capital structure
choice: trade-off theory and pecking order
theory.
Copyright  2001 Prentice-Hall, Inc.
Fundamentals of Financial Management, 11/e by Van Horne and Wachowicz.
Slides prepared by Wu Xiaolan
35
Trade-off theory

The trade-off theory says that companies have
optimal debt-equity ratios, by trading off the
benefits of debt against its costs
 What are some advantages and disadvantages of
debt that you can think of?
 The good news: interest payments are deductible and
create a debt tax shield (TCD).
 The bad news: all else equal, borrowing more money
increases the probability (and therefore the expected
value) of direct and indirect bankruptcy costs.
Copyright  2001 Prentice-Hall, Inc.
Fundamentals of Financial Management, 11/e by Van Horne and Wachowicz.
Slides prepared by Wu Xiaolan
36
Trade-off theory (Cont.)
Value of firm under
MM with corporate
taxes and debt
Value of firm (V)
Present value of tax
shield on debt
VL = VU + TCB
Present value of
financial distress costs
Maximum
firm value
V = Actual value of firm
VU = Value of firm with no debt
0
Debt (B)
B*
Optimal amount of debt
Copyright  2001 Prentice-Hall, Inc.
Fundamentals of Financial Management, 11/e by Van Horne and Wachowicz.
Slides prepared by Wu Xiaolan
37
Trade-off theory (Cont.)

What does this trade-off formula tells us?

Based on the trade-off theory, what prediction
can we make?
Copyright  2001 Prentice-Hall, Inc.
Fundamentals of Financial Management, 11/e by Van Horne and Wachowicz.
Slides prepared by Wu Xiaolan
38
Pecking-order theory



Pecking-order theory is the main contender to the tradeoff theory.
It bases its argument on information asymmetry.
It argues that actual corporate leverage ratios typically
do not reflect capital structure targets. Instead, the
widely observed corporate practice is financing new
investment with internal financing when possible and
issuing debt rather than equity if external financing is
needed.
Copyright  2001 Prentice-Hall, Inc.
Fundamentals of Financial Management, 11/e by Van Horne and Wachowicz.
Slides prepared by Wu Xiaolan
39
Pecking-order theory (Cont.)

According to the theory, management is
reluctant to issue underpriced equity (though
often willing to issue fairly priced or overpriced
equity).
 Investors thus interpret management decisions
to raise equity as a sign that the firm is
overvalued and devalue the firm’s stock.
Copyright  2001 Prentice-Hall, Inc.
Fundamentals of Financial Management, 11/e by Van Horne and Wachowicz.
Slides prepared by Wu Xiaolan
40
Critical considerations:





Firms with greater risk of financial distress must borrow
less
The greater volatility in EBIT, the less a firm should
borrow (magnify risk of losses)
Costs of financial distress can be minimized the more
easily firm assets can be liquidated to cover obligations
A firm with more liquid assets may therefore have less
financial risk in borrowing
A firm with more proprietary assets (unique to the firm,
hard to liquidate) should minimize borrowing
Copyright  2001 Prentice-Hall, Inc.
Fundamentals of Financial Management, 11/e by Van Horne and Wachowicz.
Slides prepared by Wu Xiaolan
41
The Extended Pie Model
Lower financial leverage
Bondholder
claim
Shareholder
claim
Bankruptcy
claim
Tax
claim
Higher financial leverage
Bondholder
claim
Shareholder
claim
Bankruptcy
claim
Tax
claim
Copyright  2001 Prentice-Hall, Inc.
Fundamentals of Financial Management, 11/e by Van Horne and Wachowicz.
Slides prepared by Wu Xiaolan
42