pages 1-5

Capital Structure: How to Fund the Firm's Assets

  • Definition: Capital structure refers to how a firm finances its overall operations and growth by using different sources of funds, primarily debt and equity.

Key Concepts

  • Leverage: The use of debt in a firm's capital structure to amplify returns to shareholders.

  • Capital Restructuring: Changing the financial leverage of a firm without altering the underlying assets held by the firm.

  • Manager's Objective: To maximize stockholder wealth through strategic funding decisions.

Capital Markets

  • Separation of Decisions: According to Fisher, capital markets separate operating decisions from financing decisions.

  • Financing Objective: To choose a capital structure that minimizes the Weighted Average Cost of Capital (WACC).

Modigliani-Miller (MM) Theorem Under Assumptions

  • Proposition I: The capital structure is irrelevant in a perfect market.

    • Leverage does not impact total firm value or WACC.

    • Cost of Equity: While leveraging increases the cost of equity, it does not affect the WACC.

  • Optimal Capital Structure: Achieved through a balance between the benefits and costs of leverage.

    • Benefits: Corporate taxes subsidize debt financing, enhancing value.

    • Costs: High levels of debt can lead to financial distress which destroys firm value.

  • Tradeoff Theory: Suggests an optimal level of leverage exists where the marginal benefit of debt equals its marginal cost.

Financial Impacts of Debt

  • Effects of Interest: Interest expense reduces net income and taxable income but does not affect Earnings Before Interest and Taxes (EBIT).

  • Debt Financing: Decreases reliance on equity capital.

  • Leverage Outcomes:

    • Leverage increases expected Earnings Per Share (EPS) and Return on Equity (ROE).

    • Increased risk due to leverage results in a higher cost of equity.

MM Proposition II: Leverage and Cost of Equity

  • Prop II Explanation: Leveraging affects the cost of equity:

    • re = rA + (rA - rD) rac{D}{E}

    • This compensates equity holders for the additional business and financial risks associated with increased leverage.

Benefits of Debt

  • Tax Advantages: Debt financing reduces corporate tax liabilities, thereby increasing the overall value of the firm.

    • Present Value of Debt Tax Shields: PV(Debt ext{ Tax Shields}) = T_C imes Debt

    • Leveraged Firm Value: VL = VU + T_C imes D where:

      • V_L = Value of the levered firm

      • V_U = Value of the unlevered firm

      • D = Debt

    • Equity Gains: E = V_L - D

  • Impact on WACC: WACC decreases due to the after-tax cost of debt.

    • WACC = rac{D(1-T_C)}{D + E}

    • After-tax debt reduces agency problems which can drive operational efficiencies.

  • Management Signals: Taking on debt signals that management expects to meet obligations, hence potentially enhancing firm credibility.

Costs of Debt

  • Bankruptcy Costs: High levels of debt may lead to significant financial distress costs, including:

    • Direct bankruptcy costs: Legal fees, administrative expenses.

    • Operational Costs: Managers’ focus shifts from business operations to financing.

    • Business Disruptions: Under distress, firms face interruptions in sales, employee morale issues, and loss of key employees.

    • Additional issues: Inability to purchase goods on credit, potential fire sales of assets below their true value.

Tradeoff Between Benefits and Costs of Debt

  • Graphical Analysis: A graph may depict the relationship between the value of the firm ($V_L$), the optimal debt level (denoted as $D^$), and the weighted average cost of capital (WACC) across different cases of Modigliani-Miller propositions (with and without taxes).

  • Cases:

    • Case I: MM Proposition without taxes

    • Case II: MM Proposition with taxes

    • Case III: Static theory of capital structure.

    • Optimal debt-equity ratio identified as rac{D}{E} .