16.1 The Capital Structure Question
A firm's capital structure is its mix of debt and equity financing. The goal of financial management in this context is to choose the capital structure that maximizes the value of the firm. This is equivalent to maximizing the value of a share of stock. A capital restructuring is any action that changes the firm's capital structure without altering its assets.
The optimal capital structure is the debt-equity ratio that results in the lowest possible Weighted Average Cost of Capital (WACC), thereby maximizing the firm's value.
16.2 The Effect of Financial Leverage
Financial leverage refers to the extent to which a firm relies on debt. We can see its impact by examining how it magnifies both the gains and losses to shareholders. For now, we will ignore taxes.
Table 16.3: Current and Proposed Capital Structures for the Trans Am Corporation
| 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 | 400,000 | 200,000 |
| Interest rate | 10% | 10% |
Table 16.4: Capital Structure Scenarios for the Trans Am Corporation
| Recession | Expected | Expansion | |
|---|---|---|---|
| Current Capital Structure: No Debt | |||
| EBIT | $500,000 | $1,000,000 | $1,500,000 |
| Interest | 0 | 0 | 0 |
| Net income | $500,000 | $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 | $500,000 | $1,000,000 | $1,500,000 |
| Interest | 400,000 | 400,000 | 400,000 |
| Net income | $100,000 | $600,000 | $1,100,000 |
| ROE | 2.50% | 15.00% | 27.50% |
| EPS | $.50 | $3.00 | $5.50 |
Figure 16.1: Financial Leverage: EPS and EBIT for the Trans Am Corporation
The 'With debt' line is steeper, showing that financial leverage magnifies the effect of changes in EBIT on EPS. The break-even point is where EPS is the same for both capital structures.
The break-even point (or indifference point) is the level of EBIT where the EPS is the same under both the levered and unlevered capital structures. Above this point, leverage is beneficial; below it, it is not.
Homemade Leverage
Investors can replicate a firm's capital structure by borrowing or lending on their own, a concept known as homemade leverage. This is a key reason why, in a perfect world (no taxes or other imperfections), a firm's capital structure is irrelevant to its value. A shareholder can 'unlever' or 'relever' their personal position to achieve their desired risk and return profile, regardless of the firm's choice.
16.3 Capital Structure and the Cost of Equity Capital
The irrelevance of capital structure in a perfect world is the basis of M&M Proposition I. This proposition states that the value of the firm is independent of its capital structure. We can think of this as a 'pie model' where the size of the pie (firm value) doesn't change, only how it is sliced between debt and equity.
However, changing the capital structure does affect the cost of equity. This relationship is described by M&M Proposition II (with no taxes):
\[ R_E = R_A + (R_A - R_D) \times \frac{D}{E} \]This formula shows that the cost of equity rises as the firm increases its use of debt. The total risk of a firm's equity has two parts: business risk (risk of the firm's operations) and financial risk (the extra risk from using debt).
Figure 16.3: The Cost of Equity and the WACC: M&M Propositions I and II with No Taxes
The WACC remains constant, while the cost of equity rises to offset the cheaper cost of debt, keeping the firm's overall cost of capital unchanged.
16.4 M&M Propositions I and II with Corporate Taxes
The existence of corporate taxes changes the irrelevance argument. The interest tax shield—the tax savings from interest payments—makes debt financing valuable. The value of a levered firm (\(V_L\)) is now greater than that of an unlevered firm (\(V_U\)).
\[ V_L = V_U + T_C \times D \]where \(T_C\) is the corporate tax rate and \(D\) is the amount of debt. This is M&M Proposition I with taxes. This implies that to maximize firm value, a firm should use as much debt as possible, as the value of the firm increases by the present value of the interest tax shield.
This also affects the WACC, which now declines as debt increases. The cost of equity is described by M&M Proposition II with corporate taxes:
\[ R_E = R_U + (R_U - R_D) \times (D/E) \times (1 - T_C) \]where \(R_U\) is the unlevered cost of capital. This shows that the cost of equity still rises with leverage, but at a slower rate than in the no-tax case because of the tax shield.
Figure 16.5: The Cost of Equity and the WACC: M&M Proposition II with Taxes
With taxes, the WACC decreases as the debt-equity ratio increases, implying that more debt is always better.
Table 16.6: Modigliani and Miller Summary
| I. The No-Tax Case | |
|---|---|
| Proposition I | The value of the firm levered (\(V_L\)) is equal to the value of the firm unlevered (\(V_U\)): \(V_L = V_U\). |
| Implications | 1. A firm's capital structure is irrelevant. 2. A firm's WACC is the same no matter what mixture of debt and equity is used. |
| Proposition II | The cost of equity, \(R_E\): \(R_E = R_A + (R_A - R_D) \times (D/E)\). |
| Implications | 1. The cost of equity rises as the firm increases its use of debt. 2. The risk of the equity depends on business risk (\(R_A\)) and financial risk (\(D/E\)). |
| II. The Tax Case | |
| Proposition I with taxes | \(V_L = V_U + T_C \times D\). |
| Implications | 1. Debt financing is highly advantageous; optimal capital structure is 100% debt. 2. A firm's WACC decreases as the firm relies more heavily on debt. |
| Proposition II with taxes | \(R_E = R_U + (R_U - R_D) \times (D/E) \times (1 - T_C)\). |
| Implications | The general implications are the same as in the no-tax case. \(R_E\) rises with leverage. |
16.5 Bankruptcy Costs
The M&M theory with taxes leads to the unrealistic conclusion that a firm should be 100% debt-financed. In reality, a firm's ability to borrow is limited by the risk of financial distress and bankruptcy. These costs can be categorized as:
- Direct bankruptcy costs: These are the legal and administrative expenses of the bankruptcy process, such as lawyer and accountant fees. They represent a direct loss of firm value.
- Indirect bankruptcy costs: These are the costs incurred by a firm in financial distress even if it avoids formal bankruptcy. They include lost sales, loss of key employees, and the disruption of normal business operations as management focuses on survival.
The total value of the firm is reduced by the present value of these expected costs. This creates a trade-off: The tax benefits of debt versus the costs of financial distress.
16.6 Optimal Capital Structure
The static theory of capital structure posits that a firm's optimal capital structure exists at the point where the tax benefit from an extra dollar of debt is exactly offset by the cost of the increased probability of financial distress. The value of the firm rises with debt, hits a maximum, and then declines as bankruptcy costs outweigh the tax shield.
Figure 16.6: The Static Theory of Capital Structure
The value of the firm reaches a maximum at the optimal amount of debt (\(D^*\)) where the benefit of the tax shield is balanced against the costs of financial distress.
This trade-off is also reflected in the WACC. The WACC initially falls with leverage due to the tax shield but eventually rises as financial distress costs become significant. The minimum WACC corresponds to the optimal capital structure.
16.7 The Pie Again
The extended pie model provides a more complete view of M&M's intuition. It recognizes that the firm's cash flows pay off not just stockholders and bondholders, but also the government (taxes) and other claimants (bankruptcy costs, potential lawsuits, etc.). The total value of all claims is constant, but the size of the individual slices can change. An optimal capital structure is one that minimizes the value of nonmarketed claims (like taxes and bankruptcy costs) to maximize the value of marketed claims (equity and debt).
The Extended Pie Model
Lower Financial Leverage
Higher Financial Leverage
The extended pie model shows that the total value of all claims remains the same, but the relative size of the slices changes with financial leverage. As debt increases, the stockholder claim shrinks, while the bondholder claim and bankruptcy/tax claims may grow.
16.8 The Pecking-Order Theory
The pecking-order theory is an alternative to the static trade-off theory. It suggests that a firm's capital structure is determined by its need for external financing, following a clear hierarchy:
- Internal financing (retained earnings) first.
- Debt financing next, as it avoids the negative signaling of an equity issue.
- Equity financing is a last resort, as managers may believe their stock is undervalued and selling it would be costly for existing shareholders.
This theory explains why profitable firms often use less debt and why companies desire financial slack (a stockpile of cash) to avoid external financing altogether.
16.10 A Quick Look at the Bankruptcy Process
When a firm cannot meet its debt obligations, it may enter legal bankruptcy. There are two main forms of bankruptcy proceedings:
- Liquidation (Chapter 7): The firm is terminated, its assets are sold, and the proceeds are distributed to creditors according to the absolute priority rule (APR).
- Reorganization (Chapter 11): The firm continues as a going concern, with a plan to restructure debt and other obligations. It often involves issuing new securities to replace old ones.
Some bankruptcy filings are strategic actions, used by firms to gain a competitive advantage by renegotiating contracts or managing litigation costs. Prepackaged bankruptcies allow firms to quickly move through the legal process by securing creditor approval beforehand.
Chapter Review and Critical Thinking Questions
Solution: Business risk is the inherent risk of a firm's operations and is unaffected by its capital structure. It depends on the systematic risk of the firm's assets. Financial risk is the extra risk borne by stockholders as a result of using debt financing. A firm with greater business risk (Firm A) will not necessarily have a higher cost of equity capital than another (Firm B). The cost of equity also depends on the firm's financial risk. If Firm B uses significantly more debt than Firm A, its financial risk could be higher, potentially leading to a higher cost of equity even if its business risk is lower.
Solution: The debater's conclusion is a common misconception. The error lies in assuming that an increase in the risk of both debt and equity must lead to an increase in the overall risk of the firm. M&M Proposition I (with no taxes) states that the total value and overall risk of the firm's assets are independent of its capital structure. While the individual claims (debt and equity) may become riskier, the total pie of the firm's cash flows and risk remains unchanged. The debater is missing the point that while the risk of the individual claims increases, the proportion of the cheaper, less risky debt financing also increases, which perfectly offsets the increase in the riskiness of the equity, keeping the overall WACC constant.
Solution: No, there is no easily identifiable optimal debt-equity ratio. The static theory of capital structure provides a conceptual framework, suggesting that the optimal capital structure balances the tax shield benefits of debt against the costs of financial distress. However, quantifying the precise costs of financial distress and the point at which they outweigh the tax benefits is extremely difficult and varies significantly across firms and industries.
Solution: The table shows that certain industries are more highly leveraged than others. For example, industries with tangible, easily-collateralized assets (like utilities and airlines) tend to have higher debt ratios. In contrast, industries with a high degree of intangible assets and R&D (like computer and drug companies) use less debt. This is because the costs of financial distress are higher for firms with intangible assets that would lose significant value in a bankruptcy. Operating results and tax history are also important, as the interest tax shield is only valuable to tax-paying firms. Future earnings prospects also play a role, as volatile earnings increase the risk of financial distress.
Solution: The use of debt financing is referred to as financial leverage because it magnifies the returns to shareholders. A small change in the firm's operating income can lead to a much larger percentage change in the earnings per share (EPS) and return on equity (ROE) for stockholders. However, this is a double-edged sword: leverage also magnifies losses in a poor economic environment.
Solution: After the Tax Cuts and Jobs Act of 2017, the net interest deduction is limited to a maximum of 30% of EBITDA (or EBIT after 2021). The Times Interest Earned (TIE) ratio, which is calculated as EBIT/Interest, must be greater than or equal to a certain threshold for interest to be fully deductible. Specifically, the TIE must be greater than or equal to \(1/0.3\), or 3.33, to ensure that the interest expense does not exceed 30% of EBIT, allowing for full deductibility. The actual calculation is based on EBITDA, but the principle is the same.
Solution: This is a highly debated ethical question. Proponents would argue that it is a proper use of bankruptcy as it allows the firm to manage a catastrophic financial event in an organized way, preserving the value of the firm's other assets for other stakeholders. Critics would argue that it is a misuse of the process to avoid legal obligations and harm those with legitimate claims against the firm.
Solution: This is also a highly debated topic. From an ethical standpoint, it is questionable. A firm is using the law to gain an advantage over its creditors, who entered into a contract in good faith. However, from a financial management perspective, it could be argued that management's primary duty is to maximize shareholder wealth, and renegotiating debt can be a value-creating activity. The line between using a threat as a negotiating tool and a genuine attempt to restructure is often blurry.
Solution: On one hand, critics argue that using bankruptcy to break labor contracts is unethical. It harms employees who had valid contracts and often leaves them with reduced wages, benefits, and job security. It is seen as an abuse of the bankruptcy process. On the other hand, proponents argue that if a firm's labor costs are so high that they make it uncompetitive, and it can only survive by reducing those costs, then using bankruptcy to achieve this goal is a proper, albeit painful, way to save the firm and the remaining jobs. This is a classic example of a decision that is legally permissible but ethically questionable.
Solution: The basic goal of financial management with regard to capital structure is to choose the mix of debt and equity that maximizes the value of the firm. This is equivalent to choosing the capital structure that results in the lowest possible weighted average cost of capital (WACC). A lower WACC means a lower hurdle rate for new projects, which in turn leads to a higher value for the firm's cash flows.