Capital Structure Decision

Financial leverage and Capital Structure Policy
Capital structure decision refers to the decision about the firms debt
Equity ratio. The firm may choose any capital structure it wants. If
management desires it could issue stock and use the money to pay off som
Of its debt , there by reducing the debt-equity ratio. Activities such as this
which alters the firms existing capital structure, are called capital
restructuring.
In general such restructuring take place when ever the firm substitutes one
capital structure for another wile leaving the firm’s assets unchanged.
The Capital Structure Question:

How a firm will choose its debt equity ratio. As a guiding principle we
will choose that course of action that maximizes the value of the share
of the firm.
The effect of financial leverage:
Financial leverage refers to the extent to which a firm
Relies on debt. The more debt financing a firm uses in its
Capital structure , the more financial leverage it employs.
Te basics of financial leverage:

The following table is an illustration of how financial leverag
works. We ignore the impact of taxes.
Current and proposed capital structure for Trans AM
Current Proposed
Assets 8 ,000,000 8,000,000
Debt 0 4,000,000
Equity 8,000,000 4,000,000
Debt-equity ratio 0 1
Share price 20 20
Shares outstanding 4,00,000 2,00,000
Interest rates 10% 10%
Current capital structure: No debt
Recession Expected Expansion
EBIT 5,00,000 1,000,000 1,500,000
Interest 0 0 0
Net Income 5,00,000 1,000,000 1,500,000
ROE 6.25% 12.50% 18.75%
EPS 1.25 2.50 3.75
Proposed Capital Structure: Debt-4 million
EBIT 5,00,000 1000,000 1,500,000
Interest 4,00,000 4,00,000 4,00,000

Net Income 1,00,000 6,00,000 1,100,000
ROE 2.50% 15% 27.50%
EPS .50 3.00 5.50
EPS Vs EBIT
5 With debt
4
Disadvantage to debt NoNdebt
3
o
d
EPS
2 e
Break even point bAdvantage to debt
t
1
0
4 lac 8 lac 12 lac
-1
EBIT
-2
Proposed Capital structure:
EPS 0.5 3 5.5
Earnings 50 300 550

for 100
shares
Net cost: 100 shares*20=2,000

Original capital structure and homemade leverage:
EPS 1.25 2.50 3.75
Earnings for 250 500 750

200 shares
Interest on 200 200 200
2000 @10%
Net earnings 50 300 550
Net cost 200*20- 4000-2000 2000

amount
borrowed
Home made leverage: The use of personal borrowing

to change the overall amount of financial leverage to which
the individual is exposed.
Capital structure and the Cost of equity Capital:
The M&M proposition I (without taxes)

Assumptions:
•No taxes
•No transaction cost
•Individual and corporations borrow at the same rate
Proposition I: The value of the levered firm (VL) is equal to the value
Of the unlevered (VU) firm.
VL=VU
Implication of Proposition I:
1.A firm’s capital structure is irrelevant
2. A firms weighted average cost of capital is same no matter mixture of
Debt equity is used to finance the firm
B. The M&M Proposition II (without taxes)
The cost of equity ,RE is RE=RA+(RA-RD)*D/E
Where RA is WACC ,RD is the cost of debt and D/E is the debt equity
Ratio.
Implication of Proposition II
1. The cost of equity rises as the firm increases its use of debt financing.
2. The risk of equity depends on two things : The riskiness of the firm’s
Operation (business risk) and the degree of financial leverage
(financial risk). The business risk is determined by RA and financial risk
is by D/E.
Business and Financial Risk:
M&M proposition shows that a firm’s cost of equity can be broken
down into two component. The first component ,RA is the required
return on the firm’s assets, and it depends on the nature of the firm’s
operating activities. The risk inherent in a firm operation is called the
business risk. Business risk depends on the systematic risk of the firm’s
assets.
The second component in the cost of equity (RA-RD)*D/E is
determined by the firm’s financial structure. For an all equity firm this
component is zero. As the firm begins to rely on debt , the required return
on equity rises. This occurs because the debt financing increases the
risk borne by the stock holders. The extra risk that arises from the use
of debt is known as financial risk.
The total systematic risk of the firm’s equity thus has two parts: business
risk and financial risk .The first part ( the business risk) depends on the
firm’s assets and is not affected by capital structure. The second part is
determined by financial policy .
The Interest tax shield:
Debt has two distinguishing features. First interest paid
On debt is tax deductible. This is good for the firm.
Second ,failure to meet debt obligation can result in
Bankruptcy.
M&M Proposition I and II when we consider

effect of Corporate tax.
For ease of understanding we take the example of

two firms : firm U and firm L . These two firms are
identical on the asset side .
Assume that EBIT is expected to be 1,000 every year. The
Difference is that firm L has issued 1,000 worth of
Perpetual bond on which it pays 8% interest rate. The
Interest bill is thus .08*1,000=80 every year. Also assume
That corporate tax rate is 30%.
Cash flow Firm U Firm L
To stock holders 700 644
To bondholders 0 80
Total[(EBIT-RD*D)*(1-Tc)+Tc*D*RD] 700 724
Total cash flow to L is 24 more. This occurs because L’s tax bill is
24 less. The fact is that interest is deductible for tax purposes has
generated a tax savings equal to the interest payment (80)multiplied b
the corporate tax rate(30%):80*0.30=24.We call this interest tax shiel
Algebraically the reduction in corporate tax is Tc*D*RD.Because the tax
shield is generated by paying interest .It has the same as risk on the
debt and interest rate is the appropriate discount rate. Tc value of the
tax shield is thus PV of the tax shield (Tc*RD*D)/RD=Tc*D
(.30*1000*.08)/.08=300
Taxes and MM Proposition:

The annual after tax cash flow of an unlevered firm is
EBIT*(1-Tc).So the present value of an unlevered firm is
Vu=EBIT(1-Tc)/ru
Calculation of net income:
Firm U Firm L
EBIT 1,000 1,000
Interest(RD*D) 0 80
Taxable income(EBIT-RD*D) 1000 920
Taxes(30%)(Tc) 300 276
Net income[(EBIT-RD*D)*(1-Tc) 700 644
To simplify things lets assume that depreciation is zero. We assume

That there is no changes in NWC and capital spending is zero.
So the cash flow from assets are
Cash flow from assets Firm U Firm L

EBIT 1000 1000
Taxes 300 276
Total 700 724
We can now observe that capital structure is now having some

Effect on because the cash flows from U and L are not the same
Though the firms have identical assets.
Where
Vu=present value of an unlevered firm
EBIT(1-Tc)=firm cash flow after corporate tax
Tc=corporate tax rate
ru=The cost of capital to an all equity firm.
Leverage increases the value of the firm by the tax shield

Which is TcD for perpetual debt. So we can write that
VL=EBIT(1-Tc)/Ru+TcD
=VU+TcD
The MM Proposition II without taxes holds that risk of the

Equity rises with the leverage.
The same intuition holds for MM proposition II with taxes

MM Proposition II with corporate tax says that
RE=Ru+(Ru-RD)*D/E*(1-Tc)
Where
RE=Cost of equity
RU=Cost of capital of an unlevered firm
RD=Cost of debt
D=Amount of debt
E=Amount of equity
Tc=Corporate tax rate
So the weighted average cost of capital is
WACC= (E/V)*RE+(D/V)RD*(1-Tc)
Problems:
1.The market value of the firm with 5,00,000 of debt is 17,00,000.EBIT

Is a perpetuity. The interest rate on debt is 10%. The company is on
34% tax bracket. If the company were 100% equity financed,
the equity holders would require a 20% return.
a) What would be the value of the firm if it was entirely financed

with equity.
b) What is net income to the stockholders of this levered firm.
2.Olbet Inc is a no growth company in the 35% tax bracket.Olbet’s

EBIT is 1.2m per annum. The firm’s pre tax cost of debt is 8% and its
Interest is per year 2,00,000. Analyst’s estimate Olbet’s unlevered
cost of equity capital is 12%.
a) What is value of the firm?

Bankruptcy cost:
Debt provides tax benefit to the firm. But debt also puts
pressure on firm. because interest and principal payments
are obligation. If these obligations are not met, the firm
may run risk of financial distress. The ultimate
distress is bankruptcy, where the ownership of the firms
assets is legally transferred from the stockholders to the
bondholders. These debt obligations are fundamentally
different stock obligations. While stockholders like and
expect dividend , they are not legally entitled to dividends
in the way bondholders are legally entitled to interest
and principal payments.
There are two types of bankruptcy costs:
• Direct bankruptcy cost
• Indirect bankruptcy cost
Direct bankruptcy cost

a)Legal and administration cost of bankruptcy:
When the value of the firm’s assets is equal to the value

Of its liability, then the firm is economically bankrupt in the
sense that the equity has no value. However the formal
turning over of the assets to the bondholders is a legal
process. there are legal and administrative costs to
bankruptcy. because of the expenses associated with
bankruptcy bondholders wont get all that they are owed.
These direct bankruptcy costs are disincentive to debt
financing. if a firm goes bankrupt ,then, suddenly a piece
Of the firm disappears.
Indirect cost of bankruptcy:
a) Impaired ability to conduct business: Bankruptcy
Hampers conduct with customers and suppliers. Sales are
frequently lost Because of both fear of impaired service
and loss of trust.
Loss of Customers. Because bankruptcy may enable or

encourage firms to walk away from commitments to their
customers, customers may be unwilling to purchase
products whose value depends on future support or
service from the firm.
Loss of Suppliers Customers are not the only ones who

retreat from a firm in financial distress. Suppliers may also
be unwilling to provide a firm with inventory if they fear
they will not be paid.
Loss of Employees. Because firms in distress cannot
offer job security with long-term employment
contracts, they may have difficulty hiring new
employees, and existing employees may quit or be
hired away. Retaining key employees may be costly.
Loss of Receivables. Firms in financial distress tend

to have difficulty collecting money that is owed to
them.
Fire Sales of Assets. In an effort to avoid

bankruptcy and its associated costs, companies in
distress may attempt to sell assets quickly to raise
cash. To do so, the firm may accept a lower price than
would be optimal if it were financially healthy.
The distribution of the proceeds occurs according
to the priority list.
1. Administrative expenses associated with bankruptcy.

2. Other expenses arising after filling of an involuntary
petition but before appointment of a trustee
3. Wages, salaries and commission of the stakeholders

4. Contribution to employee benefit plan
5. Consumer claims
6. Government tax claims
7. Payment to secured creditors.
8. Payment to unsecured creditors
9. Payment to preferred stockholders
9. Payment to common stockholders

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Financial leverage and Capital Structure Policy

The Capital Structure Question:

Te basics of financial leverage:

Proposed Capital Structure: Debt-4 million

EBIT 5,00,000 1000,000 1,500,000

Interest 4,00,000 4,00,000 4,00,000

Recession Expected Expansion

EPS 0.5 3 5.5

Earnings 50 300 550

Net cost: 100 shares*20=2,000

Recession Expected Expansion

EPS 1.25 2.50 3.75

Earnings for 250 500 750

Net cost 200*20- 4000-2000 2000

Home made leverage: The use of personal borrowing

The M&M proposition I (without taxes)

M&M Proposition I and II when we consider

For ease of understanding we take the example of

Taxes and MM Proposition:

To simplify things lets assume that depreciation is zero. We assume

Cash flow from assets Firm U Firm L

We can now observe that capital structure is now having some

Leverage increases the value of the firm by the tax shield

The MM Proposition II without taxes holds that risk of the

The same intuition holds for MM proposition II with taxes

So the weighted average cost of capital is

1.The market value of the firm with 5,00,000 of debt is 17,00,000.EBIT

a) What would be the value of the firm if it was entirely financed

2.Olbet Inc is a no growth company in the 35% tax bracket.Olbet’s

a) What is value of the firm?

Direct bankruptcy cost

When the value of the firm’s assets is equal to the value

Loss of Customers. Because bankruptcy may enable or

Loss of Suppliers Customers are not the only ones who

Loss of Receivables. Firms in financial distress tend

Fire Sales of Assets. In an effort to avoid

1. Administrative expenses associated with bankruptcy.

3. Wages, salaries and commission of the stakeholders

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