Applied Corporate Finance: Capital Structure

Gregory Weitzner

January 9, 2023

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The Key Questions of Corporate Finance

1 Valuation: how do we distinguish between good investment projects

and bad ones?

2 Financing: how should we finance the investment projects we choose

to undertake?

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Investment Policy

1 Which projects should a firm undertake?

Open a new plant?
Increase R&D?
Launch a new product?
Acquire another company?

2 Real investments can create “value” if they are NPV positive

When is a project NPV positive?
This is the key question of the second half of the course
We will come back to this later

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Financing Policy

Assuming we have an NPV positive project, investment requires

funding...

But what is the best source of funds?

Internal funds (i.e., cash)?
Debt (i.e., borrowing)?
Equity (i.e., issuing stock)?

Moreover, different kinds of ...

Internal funds (e.g., cash reserves vs. cutting dividends)
Debt (e.g., bank debt vs. bonds)
Equity (e.g., VC/PE vs. IPO)

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Roadmap

Need to understand when financing doesn't matter at all -> M&M

1. Modigliani-Miller
1.1 M&M and the Irrelevance of Capital Structure
1.2 M&M and the Cost of Capital

2. Taxes and Financial Policy

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 Modigliani-Miller

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Key Questions in this Topic

How does leverage (the amount of debt relative to equity) affect the
value of the firm?
Is there an “optimal” capital structure?

Can a firm add value through its choice of financial policy?

If yes, how does this depend on the firm’s operations?

These are the key questions in the first part of the course

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The Irrelevance of Financial Decisions

The Modigliani-Miller (M&M) propositions tell us when financial

decisions are irrelevant
By examining conditions that make financial decisions irrelevant, we
can learn when they will be relevant!
M&M provides an incredibly useful benchmark

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 M&M and the Irrelevance of Capital Structure

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M&M Theorem (Proposition 1)

If:
1 The sum of all future cash flows is unaffected by capital structure
2 No transaction costs
3 No arbitrage

Then: the market value of the firm is independent of how it is

financed -> Financing does not matter

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Remarks on the Conditions of M&M

Condition 1 (cash flows are unaffected by capital structure)

Key condition!
If there are not transaction costs or arbitrage, then capital structure is
irrelevant if it does not affect of the firm’s cash flows

Opposite reading:
Capital structure matters only if it affects the total cash flows
generated by the firm

How might capital structure affect cash flows?

1 Taxes debt has a tax advantage over equity
2 Bankruptcy costs and agency problems debt will increase bankruptcy cost
3 Informational asymmetries

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Remarks on the Conditions of M&M

Condition 2 (no transaction costs)

Fairly reasonable assumption investors can freely trade securities without incurring any costs

Are the securities issued by the firm “special”?

Can a firm offer packages of cash flows that investors cannot get
themselves? a firm cannot offer packages of cash flows that investors cannot replicate themselves
Remember that a security is just a claim on cash flows!

Condition 3 (absence of arbitrage)

Very reasonable assumption
If it were not true, investors could easily earn excess profits (as we will
soon see)

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M&M Intuition

Three ways to understand M&M intuitively

1 Pie intuition
2 NPV intuition
3 Homemade leverage intuition

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M&M Pie Intuition

Equity Equity
60% 40%

Debt Debt
40% 60%

The value of the pie is that of the cash flows generated by its
operating assets

The firm’s financial policy divides up the “pie” among different

claimants (e.g., debt holders and equity holders)
But the size of the pie stays the same

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M&M NPV Intuition

Question: what activities create value for firms?

Answer: NPV positive investments!

Fixing the balance sheet, operations in capital markets have zero NPV
and therefore should not increase the value of the firm
I.e., they do not increase the size of the pie

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M&M Homemade Leverage Intuition

In perfect capital markets investors can replicate the leverage choice

themselves and do not need to pay the firm to do it

If an investors holds equity in a firm and. . .

1 . . . the firm increases its leverage, the investor can unlever her position
by selling part of her equity and investing the proceeds in the risk-free
asset (e.g., government bonds)
2 . . . the firm decreases its leverage, the investor can lever up her position
by borrowing money (e.g., shorting the risk-free asset) and buying more
equity

Conclusion: If investors can reverse a firm’s financial decisions, these

decisions are irrelevant

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Notation

V
|{z} = D
|{z} + E
|{z}
Total Firm Value Debt Value Equity Value

Let’s take a look at an example

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M&M Example

Firms U (unlevered) and L (levered) produce the following cash flows

Recession Normal Expansion

Probability 1/3 1/3 1/3
Cash Flow 800 1800 2800

Suppose that:
1 Value of unlevered firm: VU = $1500 (100 shares at $15) Investors are risk
averse
Question: what does VU imply about the market’s risk preferences?
2 Levered firm has DL = $600 of risk free debt at rD = 10%, with
principal and interest repayable next period
1500 - 600 = 900

What is the value of the levered firm’s equity EL ?

EL = $900 - let’s show this

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Payoffs of unlevered firm (VU = EU = $1500):
Recession Normal Expansion
Probability 1/3 1/3 1/3
Cash Flow 800 1800 2800
Return on Equity −46.7% 20.0% 86.7%
(800-1500) / 1500 = -46.7%

Expected return on equity:

= 1/3(−46.7%) + 1/3(20%) + 1/3(86.7%) = 20%
Return on equity gets higher as we add debt

Payoffs of levered firm (DL = $600, EL = $900):

Recession Normal Expansion
Probability 1/3 1/3 1/3
Cash Flow to Debt 660 660 660
Cash Flow to Equity 140 1140 2140
Return on Equity −84.4% 26.7% 137.8%
(140 - 900) 900 = -84.4%
Expected return on equity:
= 1/3(−84.4%) + 1/3(26.7%) + 1/3(137.8%) = 26.7%
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An investor who owns α = 1% in each firm obtains:

Recession Normal Expansion

Probability 1/3 1/3 1/3
Buy αL To Debt 6.60 6.60 6.60
To Equity 1.40 11.40 21.40
Total 8.00 18.00 28.00
Buy αU Total 8.00 18.00 28.00

If there is no arbitrage, the value of 1% of each firm must be the

same!
=⇒ VL = VU = 1500 and EL = VL − DL = 1500 − 600 = 900

To make arbitrage profits:

If EL > 900 then investors would buy EU and short DL and EL
If EL < 900 then investors would short EU and buy DL and EL

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 M&M and the Cost of Capital

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M&M and the Cost of Capital

Can a firm reduce its cost of capital by altering its capital structure?

WACC formula reminder:

D E
   
WACC = rU = rD + rE
V V

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Answer: M&M Proposition 2

No!! Under the same conditions as Proposition 1 WACC is

independent of a firm’s capital structure
D E
   
rU = rD + rE = constant
V V

M&M Proposition 2 also says the expected return on equity increases

with the leverage ratio (as we just saw)
Note this requires that rU > rD . Why would this usually be the case?

D
rE = rU + (rU − rD )
E

Using more debt makes equity riskier, raising the cost of equity

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M&M Proposition 2 Without Taxes

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M&M Proposition 2: Intuition

Q: Why does the firm’s cost of capital remains constant when we

increase the firm’s leverage?
A: Because the combined risk of all the securities issued by the firm is
entirely determined by the risk of its assets, which under the M&M
assumptions, do not change with leverage

Q: Why does the cost of the levered equity increases when we

increase the firm’s leverage?
A: Because the safer cash flows goes to the debt holders (debt has
priority over equity) and hence the equity becomes riskier

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M&M Proposition 2: Business vs. Financial Risk

D
rE = rU + (rU − rD ) ×
|{z} |{z} E}
Risk of Equity Business Risk
| {z
Financial Risk

Business Risk: The equity risk that comes from the nature of the
firm’s operating activities

Financial Risk: The equity risk that comes from the financial policy
of the firm. using leverage

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How is the Risk of a Firm’s Securities Affected by
Leverage?

The unlevered beta (or “asset beta”) of firm

D E
βU = βD + βE
V V

Solve for βE
D
βE = βU + (βU − βD )
E

Hence, leverage increases the risk (and expected return) of equity

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Example: Leveraged Recapitalization - No Taxes

Dot.com is an all equity firm worth $200 million that has 50 million
shares outstanding. On April 20th Dot.com announces a leveraged
recapitalization with the following schedule:
1 on April 25th Dot.com will issue $80 million worth of debt
2 on April 29th it will use the proceeds to buy back shares

Calculate the value of the equity, the value of the firm, and the price
per share on April 21st, April 26th, and April 30th

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Solution

April 21st (day after announcement of recapitalization):

E = $200mm, D = 0, V = D + E = $200mm
Shares Outstanding = 50mm
Price Per Share = 200
50 = $4

April 26th (day after issuing debt):

E = $200mm, D = $80mm, V = D + E = $280mm
Shares Outstanding = 50mm
Price Per Share = 200
50 = $4

Notice that after issuing debt but before buying back the shares the
value of the firm increases by the amount raised, i.e., $80 million
This is not “creating value” because both the balance sheet and
liabilities increase by $80mm

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Solution

April 30th (day after completing recapitalization):

E = 200 − 80 = $120mm, D = $80mm, V = D + E = $200mm
Number of Shares Repurchased = 80
4 = 20mm
Number of Shares Remaining = 50 − 20 = 30mm
Price Per Share = 120
30 = $4

Notice that:
1 The value of the firm remains constant before and after the leveraged
recapitalization
2 The price per share remains constant because the leveraged
capitalization does not create or destroy value

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M&M Applies to All Securities and Financial Policies

Securities
1 Debt vs. Equity
2 Preferred vs. Common Stock
3 Long Term vs. Short Term Debt
4 Secured vs. Unsecured Debt
5 Senior vs. Subordinated Debt
6 Convertible vs. Nonconvertible Debt
7 Floating vs. Fixed Rate Debt

Other Financial Policies

1 Dividends are irrelevant
2 Risk management is irrelevant

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Using M&M

M&M is not a literal statement about the world

assumptions are not true

But it forces us to ask the right question:

How is the financing decision affecting the size of the pie?

M&M exposes several fallacies

WACC Fallacy

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WACC Fallacy

Q: Should cost of debt be lower than cost of equity?

If so, should firms simply finance themselves with all debt because it’s
cheaper?
What is wrong with this argument?

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WACC Fallacy

safe cash flows are going to debt holders

This argument ignores the “hidden” cost of debt

Increasing leverage raises the cost of equity by making it riskier!
Q: Is it still true when the probability of default is zero?

People get confused between “low cost” and a “good deal”

Something can cost less but not be a better deal
We will talk more about this in the second half of the course

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Practical Implications of M&M

When evaluating a decision (e.g., the effect of a merger):

Separate financial (RHS) and real (LHS) parts of the move
M&M says value is created on LHS

When evaluating an argument in favor of a financial decision:

Understand that it is wrong under M&M assumptions
What departures from M&M assumptions does it rely upon?
If none, then this is a dubious argument

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Main Takeways Regarding M&M

Value is only created by operating assets

Financing decisions merely divide up the pie of a firm’s assets

M&M is clearly not true in reality (otherwise I would not have a job)
...but it it provides a really strong benchmark
It tells us things that do not cause financial policies to matter
It also tells us things that can cause financial policies to matter

Throughout this course I want you to ask “what is breaking M&M in

this particular situation?”

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Reasons Why Financial Policies Have to Matter

1 Executives spend substantial time thinking about financial decisions

2 Stock prices react dramatically to financing decisions

On average stock prices react positively to announcements of
1 Cash distributions, i.e. dividends
2 Debt issuance. i.e. increasing leverage
On average stock prices react negatively to announcements of
1 Raising cash, i.e. cutting dividends
2 Equity issuance, i.e. reducing leverage

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 Taxes and Financial Policy

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Taxes and Capital Structure

Taxes have a clear effect on cash flows

Three important dimensions

1 Corporate taxes
2 Tax deductible interest expenses
3 Personal taxes

For investors, relevant cash flows are cash flows after taxes

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Corporate Taxes and Capital Structure

Q: Why are corporate taxes important for capital structure?

A:Because interest payments are tax-deductible while dividends are
not. This implies that debt has a tax advantage over equity.

The interest tax shield is the tax saving for investors from the tax
deductibility of interest payments

Interest Tax Shield = Corporate Tax Rate × Interest Payments

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Example

Comanche Industries has marginal corporate tax rate of 39% and the
following projections for the next four years. If the cost of debt is 5%
what is the present value (in 2006) of Comanche’s interest tax shields
from years 2007 through 2010? (Assume that the interest tax shields
have the same risk as Comanche’s debt.)

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Solution

Tax rate: 39%

2007 2008 2009 2010
Interest $27 $29 $32 $35
Interest Tax Shield $10.53 $11.31 $12.48 $13.65

10.53 11.31 12.48 13.65

PV(Tax Shields) = + + + = $42.3
1.05 1.052 1.053 1.054

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Some Observations on Taxes and Financing Decisions

Corporate and personal taxes both can affect optimal capital structure

Key feature of the corporate tax code: corporate cash flow paid to
equity investors is after tax money, cash paid to debt investors is
pre-tax money

Key feature of personal tax code: investors have varying personal tax
rates and income on different types of investments is taxed differently

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M&M Propositions with Corporate Taxes

M&M Proposition 1 with taxes:

V(Equity with Debt) = V(All Equity) + PV(Tax Shield)

M&M Proposition 2 with taxes:

D E
rU = rD (1 − TC ) + rE
V  V
D
rE = rU + (rU − rD ) (1 − TC )
E

Where TC is the corporate tax rate

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M&M Proposition 2 with Taxes

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M&M Pie with Taxes

Equity
50%

Taxes
Debt 10%
40%

Cash flows of firm now devoted to equity, debt and taxes

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Personal Taxes

Personal taxes will not be a focus of the class.. but

For corporate taxes debt dominates equity

For personal taxes equity dominates debt

If held long enough, equity taxed at capital gains which is less than
ordinary income tax

Net effect: taxes usually favor debt for companies

In practice we will ignore personal taxation

This is ok most of the time

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Marginal Tax Rate

In most situations we care about the marginal tax rate (MTR)

MTR: The present value tax obligation resulting from earning an extra
dollar of income today
Usually any decisions we make are marginal, i.e., invest more, issue
more debt, etc

Steps to calculate the MTR:

1 Calculate tax liability for all years as “base case”
2 Add $1 to year t = 0 income and recalculate tax liability
3 Subtract tax liability in 1) from tax liability in 2). This is the change in
taxes that occurs solely because you earned an extra $1 in t = 0
4 Calculate the PV of the change in tax liabilities calculated in (3). This
PV is the economic MTR

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Why Care about Tax Rates?

The marginal corporate tax rate is important for many corporate

decisions
1 Choice of equity vs. debt financing
2 Tax incentive to hedge
3 Tax benefits of reorganizations

We will discuss some of these in more detail later

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Concluding Thoughts on Taxes

Corporate taxes give debt an advantage over equity

But firms do not simply just lever up as much as possible

Next we will talk about costs of debt that can explain this

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