Corporate Finance Fundamentals
Module 7: Capital Structure
Module Overview
Welcome to Module 7! One of the most important strategic decisions a company makes is: How should we finance our operations—with debt, equity, or a mix of both?
This is the capital structure decision. It affects the company's risk, cost of capital, and ultimately its value. This module explores the trade-offs between debt and equity financing and helps you understand how companies optimize their capital structure.
Learning Objectives:
By the end of this module, you will be able to:
- Understand the components of capital structure
- Explain the Modigliani-Miller theorems and their implications
- Analyze the trade-off between the benefits and costs of debt
- Understand how taxes affect capital structure decisions
- Recognize the costs of financial distress
- Explain the pecking order theory
- Evaluate optimal capital structure
- Apply capital structure concepts to real business decisions
- Understand how capital structure varies across industries
Estimated Time: 5-6 hours
7.1 Introduction to Capital Structure
What is Capital Structure?
Capital structure is the mix of debt and equity a company uses to finance its operations and growth.
The Capital Structure Question:
- How much should we borrow?
- How much should we finance with equity?
- What's the optimal mix?
Components:
Debt (Liabilities):
- Bank loans
- Bonds
- Notes payable
- Leases
Equity (Ownership):
- Common stock
- Preferred stock
- Retained earnings
Measuring Capital Structure
Debt-to-Equity Ratio:
D/E = Total Debt / Total Equity
Debt Ratio:
Debt Ratio = Total Debt / Total Assets
Equity Ratio:
Equity Ratio = Total Equity / Total Assets
Examples:
Company A:
- Debt: $400M
- Equity: $600M
- Total Assets: $1,000M
D/E = $400M / $600M = 0.67
Debt Ratio = $400M / $1,000M = 40%
Equity Ratio = $600M / $1,000M = 60%
Company B:
- Debt: $800M
- Equity: $200M
- Total Assets: $1,000M
D/E = $800M / $200M = 4.0
Debt Ratio = $800M / $1,000M = 80%
Equity Ratio = $200M / $1,000M = 20%
Company B is much more leveraged (more debt).
Why Capital Structure Matters
1. Affects Cost of Capital
- Different capital structures → Different WACC
- Lower WACC → Higher firm value
2. Affects Risk
- More debt → More financial risk
- Risk affects required returns
3. Affects Flexibility
- High debt → Less flexibility
- Limits future financing options
4. Affects Control
- Debt: No dilution of ownership
- Equity: Dilutes existing shareholders
5. Tax Implications
- Interest is tax-deductible
- Dividends are not
- Tax shield affects optimal structure
Capital Structure Across Industries
High Debt Industries:
- Utilities: 50-60% debt
- Real Estate: 60-70% debt
- Telecommunications: 40-50% debt
Why? Stable, predictable cash flows can support debt.
Low Debt Industries:
- Technology: 10-20% debt
- Pharmaceuticals: 15-25% debt
- Biotechnology: 0-10% debt
Why? Uncertain cash flows, high growth, need flexibility.
Example Companies:
| Company | Industry | D/E Ratio |
|---|---|---|
| Verizon | Telecom | 1.8 |
| Duke Energy | Utility | 1.5 |
| Walmart | Retail | 0.6 |
| Microsoft | Technology | 0.3 |
| Tesla | Auto/Tech | 0.1 |
| Moderna | Biotech | 0.0 |
The Central Question
Does capital structure affect firm value?
Two Positions:
Capital Structure Irrelevance (Modigliani-Miller):
- In perfect markets, capital structure doesn't matter
- Firm value depends on assets, not how they're financed
Capital Structure Relevance (Traditional View):
- In real world with taxes and frictions, it matters
- Optimal capital structure maximizes firm value
We'll explore both perspectives.
7.2 Modigliani-Miller Theorem (No Taxes)
The M&M Proposition I (No Taxes)
Proposition: In a perfect market (no taxes, no transaction costs, no bankruptcy costs), capital structure is irrelevant to firm value.
In other words: Whether you finance with debt or equity doesn't matter—firm value is the same.
Formula:
V_L = V_U
Where:
- V_L = Value of levered firm (with debt)
- V_U = Value of unlevered firm (all equity)
The Intuition: The Pizza Analogy
Imagine a pizza worth $20.
Scenario 1: Cut into 8 slices (all equity)
- 8 equity slices × $2.50 = $20
Scenario 2: Cut into 4 debt slices + 4 equity slices
- 4 debt slices × $2.50 = $10
- 4 equity slices × $2.50 = $10
- Total: $20
The pizza is still worth $20!
How you slice it doesn't change the total value. Similarly, M&M argues that how you split firm cash flows between debt and equity doesn't change total value.
The M&M Proposition II (No Taxes)
Proposition: As leverage increases, cost of equity increases linearly to keep WACC constant.
Formula:
r_e = r_0 + (r_0 - r_d) × (D/E)
Where:
- r_e = Cost of equity
- r_0 = Cost of capital for unlevered firm
- r_d = Cost of debt
- D/E = Debt-to-equity ratio
Intuition: More debt makes equity riskier, so equity holders demand higher returns. This exactly offsets the benefit of cheaper debt financing.
Example:
Unlevered firm:
- r_0 = 12%
- r_d = 6%
At D/E = 0 (All equity):
r_e = 12% + (12% - 6%) × 0 = 12%
WACC = 12%
At D/E = 0.5:
r_e = 12% + (12% - 6%) × 0.5 = 15%
WACC = (1/3) × 6% + (2/3) × 15% = 12%
At D/E = 1.0:
r_e = 12% + (12% - 6%) × 1.0 = 18%
WACC = (1/2) × 6% + (1/2) × 18% = 12%
WACC stays at 12% regardless of leverage!
Why M&M Matters (Even Though It's "Wrong")
M&M is based on unrealistic assumptions:
- No taxes
- No bankruptcy costs
- No transaction costs
- Perfect information
- No agency costs
But it's still important because:
- Benchmark: Shows what matters are the deviations from perfect markets
- Focus: Tells us where to look for capital structure effects (taxes, bankruptcy, etc.)
- Perspective: Challenges naive views about debt being "cheaper"
Key Insight: If capital structure matters, it's because of market imperfections. Let's examine those imperfections.
7.3 Capital Structure with Corporate Taxes
The Tax Advantage of Debt
Key Fact: Interest payments are tax-deductible, dividends are not.
This creates an advantage for debt financing.
The Interest Tax Shield
Interest tax shield is the reduction in taxes due to interest deductibility.
Formula:
Annual Tax Shield = Interest Payment × Tax Rate
Example:
Company borrows $1,000,000 at 8% interest. Tax rate: 30%
Annual interest = $1,000,000 × 8% = $80,000
Tax shield = $80,000 × 30% = $24,000
The company saves $24,000 per year in taxes!
Alternative View:
- Without debt: Pay $80,000 to investors, no tax benefit
- With debt: Pay $80,000 to investors, save $24,000 in taxes
- Net cost: $56,000
After-tax cost of debt = 8% × (1 - 0.30) = 5.6%
Present Value of Tax Shield
For perpetual debt:
PV(Tax Shield) = D × r_d × T / r_d = D × T
Simplified:
PV(Tax Shield) = D × T
Where:
- D = Amount of debt
- T = Corporate tax rate
Example:
Debt: $500 million Tax rate: 25%
PV(Tax Shield) = $500M × 0.25 = $125M
By using $500M of debt, the company creates $125M of value from tax shields!
M&M Proposition I (With Taxes)
With corporate taxes:
V_L = V_U + PV(Tax Shield)
V_L = V_U + (D × T)
Now leverage DOES affect value!
Example:
Unlevered firm value: $800M Debt: $300M Tax rate: 30%
PV(Tax Shield) = $300M × 0.30 = $90M
V_L = $800M + $90M = $890M
Using debt increases firm value by $90M.
Implication: More debt is better! Use 100% debt!
But wait... This ignores costs of debt. In reality, there are limits to debt.
M&M Proposition II (With Taxes)
Cost of equity with taxes:
r_e = r_0 + (r_0 - r_d) × (1 - T) × (D/E)
Example:
- r_0 = 12%
- r_d = 6%
- T = 30%
- D/E = 1.0
r_e = 12% + (12% - 6%) × (1 - 0.30) × 1.0
r_e = 12% + 6% × 0.70
r_e = 12% + 4.2%
r_e = 16.2%
WACC with debt:
WACC = (0.5) × 6% × (1 - 0.30) + (0.5) × 16.2%
WACC = (0.5) × 4.2% + (0.5) × 16.2%
WACC = 2.1% + 8.1%
WACC = 10.2%
Compared to all-equity WACC of 12%, using debt reduces WACC to 10.2%!
Lower WACC → Higher firm value
The Tax Shield Benefit: Complete Example
Company ABC is considering capital structure change:
Current (All Equity):
- Assets: $1,000M
- EBIT: $150M
- Tax rate: 25%
- Cost of equity: 15%
Value = EBIT(1-T) / r_e
Value = $150M × 0.75 / 0.15
Value = $112.5M / 0.15
Value = $750M
Proposed (50% Debt):
- Debt: $400M at 7% interest
- Interest: $28M
- Tax shield: $28M × 25% = $7M
PV(Tax Shield) = $400M × 0.25 = $100M
New Value = $750M + $100M = $850M
Adding debt increases value by $100M (13.3%)!
7.4 Costs of Financial Distress
Why Not 100% Debt?
If debt creates tax shields, why don't companies use 100% debt?
Answer: Debt creates costs as well as benefits.
Financial Distress
Financial distress occurs when a company has difficulty meeting debt obligations.
Two Types:
1. Bankruptcy (Legal Process)
- Company legally defaults
- Court-supervised reorganization or liquidation
- Chapter 11 (reorganization) or Chapter 7 (liquidation)
2. Financial Distress (Economic)
- Struggling but not legally bankrupt
- May lead to bankruptcy
Direct Costs of Financial Distress
Legal and Administrative Costs:
- Lawyers
- Accountants
- Court costs
- Bankruptcy trustees
- Reorganization advisors
Magnitude:
- Small companies: 20-25% of firm value
- Large companies: 2-5% of firm value
- Average: ~3-5% of firm value
Example:
Large company worth $1 billion files bankruptcy:
- Direct costs: ~$30-50 million
Indirect Costs of Financial Distress
Much larger than direct costs!
1. Lost Sales
- Customers worry about warranties
- Customers switch to competitors
- Example: Who buys a car from a bankrupt automaker?
2. Supplier Problems
- Suppliers demand cash payment
- Refuse credit
- Raise prices
3. Employee Issues
- Best employees leave
- Difficulty recruiting
- Lower morale and productivity
4. Lost Investment Opportunities
- Can't finance profitable projects
- Competitors take market share
5. Fire Sales
- Forced to sell assets below value
- To raise cash
6. Management Distraction
- Time spent dealing with creditors
- Not running the business
Example: Airlines in Distress
When airlines enter bankruptcy:
- Business travelers avoid them (afraid of losing miles, schedule changes)
- Sales drop 20-30%
- Best pilots and staff leave
- Can't lease new planes
Total indirect costs can be 10-20% of firm value.
Agency Costs of Debt
Agency problems arise between debt holders and equity holders.
Conflict: What's good for equity holders may hurt debt holders.
Problem 1: Asset Substitution (Risk Shifting)
The Game:
- Company borrows money
- Shareholders invest in very risky projects
- If project succeeds: Shareholders get all upside
- If project fails: Debt holders bear losses
Example:
Company with $100M debt borrows another $50M.
Conservative Project:
- Investment: $50M
- 50% chance of $60M
- 50% chance of $55M
- Expected: $57.5M
Risky Project:
- Investment: $50M
- 50% chance of $150M
- 50% chance of $0
- Expected: $75M
From equity holders' perspective:
Conservative:
- Success: $60M - $100M debt = $0 (debt paid), equity keeps $60M
- Failure: $55M - $100M debt = $0 (can't pay all), equity gets $0
- Expected equity value: ~$7.5M
Risky:
- Success: $150M - $100M debt = $50M to equity
- Failure: $0 - $100M debt = bankruptcy, equity gets $0
- Expected equity value: $25M
Equity holders prefer risky project even though it has lower total value!
Debt holders anticipate this and demand higher rates.
Problem 2: Underinvestment
The Setup:
- Company in distress
- Has profitable investment opportunity
- Benefits mostly go to debt holders
Equity holders may refuse to invest!
Example:
Distressed company:
- Existing debt: $100M
- Firm value: $80M
- Investment opportunity: Cost $10M, worth $12M (NPV = $2M)
If equity holders invest $10M:
- New firm value: $80M + $12M = $92M
- Debt still $100M
- Equity gets: $0 (all goes to debt holders)
Equity holders reject positive NPV project!
Problem 3: Milking the Property
The Game:
- Company in distress
- Equity holders extract value before bankruptcy
- Pay large dividends
- Sell assets cheap to insiders
- Reduce maintenance
Debt holders get less in bankruptcy.
All these agency costs reduce the value of debt financing.
7.5 The Trade-Off Theory
Balancing Benefits and Costs
Trade-off theory says optimal capital structure balances:
Benefits of Debt:
- Tax shields (increase value)
- Discipline on management
Costs of Debt:
- Financial distress costs
- Agency costs
- Reduced flexibility
The Optimal Capital Structure
Optimal Debt = Level where Marginal Benefit = Marginal Cost
Graphically:
Firm Value
↑
| _______________ Optimal
| / \
| / Tax \ Financial
| / Shield \ Distress
| / Benefits \ Costs
|____/________________________\________
|
└─────────────────────────────────────→
Debt Level
Key Points:
- No debt: Miss out on tax shields
- Moderate debt: Tax benefits > distress costs
- Optimal point: Maximize firm value
- Excessive debt: Distress costs > tax benefits
Factors Affecting Optimal Capital Structure
1. Tax Rate
- Higher tax rate → More tax benefit → More debt optimal
- Zero tax rate → No tax benefit → Less debt
2. Business Risk
- Stable cash flows → Can support more debt
- Volatile cash flows → Less debt optimal
- Example: Utilities vs. Tech startups
3. Asset Type
- Tangible assets → Easier to borrow against
- Intangible assets → Harder to borrow
- Example: Manufacturing vs. Consulting
4. Growth Opportunities
- High growth → Need flexibility → Less debt
- Low growth → Less need for flexibility → More debt
5. Profitability
- High profits → Generate internal funds → Less need for debt
- Low profits → May need external financing
Example: Determining Optimal Leverage
Company considering different debt levels:
| Debt Ratio | Tax Shield PV | Distress Cost PV | Net Benefit | Firm Value |
|---|---|---|---|---|
| 0% | $0 | $0 | $0 | $800M |
| 20% | $40M | -$5M | $35M | $835M |
| 40% | $80M | -$15M | $65M | $865M |
| 60% | $120M | -$40M | $80M | $880M |
| 80% | $160M | -$100M | $60M | $860M |
Optimal debt ratio: 60% (maximizes firm value at $880M)
Beyond 60%, distress costs rise faster than tax benefits.
7.6 Pecking Order Theory
An Alternative View
Pecking order theory says companies prefer financing sources in this order:
1st Choice: Internal Financing (Retained Earnings)
- No issuance costs
- No dilution
- No outside scrutiny
2nd Choice: Debt
- Lower cost than equity
- Less information asymmetry
- No dilution
3rd Choice: Equity
- Most expensive
- Maximum dilution
- Negative signal to market
The Information Asymmetry Problem
Key Idea: Managers know more about the firm than outside investors.
Problem with Equity Issuance:
Scenario:
- Managers know firm is undervalued
- Should they issue equity? No! (Would benefit new shareholders at expense of existing)
- Managers know firm is overvalued
- Should they issue equity? Yes! (Good deal for existing shareholders)
Investors know this logic!
Result: Equity issuance signals overvaluation. Stock price drops when equity is announced.
Example:
Studies show stock prices drop 2-3% on average when companies announce new equity offerings.
Debt issuance: Much less information problem, smaller price impact.
Implications of Pecking Order
Capital structure is result of past financing decisions:
- Profitable companies: Use retained earnings → Low debt
- Unprofitable/growing companies: Need external funds → Higher debt
No target debt ratio!
- Companies don't actively manage toward optimal leverage
- Leverage changes passively based on profitability
Example:
Apple:
- Highly profitable
- Generates massive cash flow
- Low debt (even though it could borrow more cheaply)
- Consistent with pecking order
Tesla (historically):
- Low profitability, high growth
- Needed external financing
- Issued equity (reluctantly)
- Debt capacity limited
Trade-Off vs. Pecking Order
Trade-Off Theory:
- Companies have target debt ratio
- Actively manage toward it
- Balance tax benefits and distress costs
Pecking Order Theory:
- No target debt ratio
- Passive leverage changes
- Driven by information asymmetry
Evidence: Both theories have some support. Most companies seem to have target ranges but don't adjust quickly.
7.7 Other Capital Structure Considerations
Market Timing Theory
Idea: Companies issue equity when stock prices are high, debt when interest rates are low.
Example:
Tech Bubble (1999-2000):
- Many tech companies issued equity at inflated prices
- Rational: Sell overvalued equity
Financial Crisis (2009-2012):
- Many companies issued debt at historically low rates
- Rational: Lock in cheap financing
Result: Capital structure reflects historical market conditions, not just optimal structure.
Signaling Theory
Capital structure decisions send signals to market:
Issuing Debt:
- Positive signal: Management confident in cash flows
- Willing to commit to fixed payments
Issuing Equity:
- Negative signal: Maybe stock is overvalued?
- Or company can't support more debt?
Stock Repurchase:
- Positive signal: Stock is undervalued
- Company has excess cash
Example:
Company announces $10B debt issuance for stock buyback:
- Stock price typically rises
- Signal: Management bullish on future
- Confident they can handle debt
Managerial Entrenchment
Agency Problem: Managers may prefer low debt to protect themselves.
Low Debt:
- Less pressure
- Lower bankruptcy risk
- More job security
- More freedom to pursue pet projects
High Debt:
- Discipline on managers
- Must generate cash to service debt
- Less free cash flow to waste
Example:
In leveraged buyouts (LBOs):
- Private equity firms load target with debt
- Forces management efficiency
- Often improves performance
Industry Norms and Peer Effects
Companies look at competitors:
- What's the industry average?
- Follow industry leaders
- Don't want to be too different
Example Industries:
Utilities:
- Average D/E: ~1.2
- Most utilities cluster around this
- Deviation signals something unusual
Technology:
- Average D/E: ~0.3
- Most tech companies have low debt
- High debt would be concerning
Pressure to conform to industry norms.
7.8 Real-World Capital Structure Decisions
How Companies Actually Decide
Survey Evidence: CFOs Say They Consider:
-
Financial flexibility (59%)
- Maintain spare borrowing capacity
- Be ready for opportunities
-
Credit rating (57%)
- Maintain investment-grade rating
- Access to debt markets
-
Tax advantage of debt (45%)
- Use tax shields
-
Comparable firm leverage (37%)
- Industry norms
-
Earnings volatility (35%)
- Stable earnings → More debt
Interestingly, "optimal capital structure" is rarely the top consideration!
Case Study: Microsoft's Capital Structure Evolution
1980s-2000s:
- Zero debt
- Massive cash hoard
- Highly profitable
- Didn't need external financing
Critics asked: Why not use debt?
- Could save billions in taxes
- Equity is more expensive
2009: First Bond Issue
- Issued $3.75 billion in bonds
- Used proceeds for working capital, acquisitions
- Beginning of capital structure shift
2010s-Present:
- Increased debt steadily
- Still has large cash balance
- Moved toward more "normal" structure
Why the change?
- Recognition of tax benefits
- Maturation of business
- Pressure from activist investors
- Repatriation tax issues
Case Study: General Electric's Deleveraging
Pre-2008:
- GE Capital (finance arm) heavily leveraged
- Total debt: ~$500 billion
- D/E ratio: ~7:1
Financial Crisis Impact:
- Credit markets froze
- GE couldn't roll over debt
- Stock price collapsed
- Near-death experience
2009-2020: Dramatic Deleveraging
- Sold assets
- Reduced GE Capital
- Cut debt by 70%
- Focus on industrial businesses
Lesson: Excessive leverage can be fatal when markets freeze.
Practical Guidelines
For Young/Growing Companies:
- Keep debt low (flexibility important)
- Preserve borrowing capacity
- Accept higher WACC
- Use equity (especially if valued richly)
For Mature Companies:
- Can handle more debt
- Stable cash flows
- Use tax shields
- Return cash to shareholders
For Cyclical Companies:
- Conservative leverage
- Need cushion for downturns
- Can't support high fixed payments
For Stable Companies (Utilities):
- High leverage sustainable
- Predictable cash flows
- Maximize tax benefits
7.9 Adjusting for Leverage: Unlevering and Relevering Beta
The Problem
Question: How do we compare companies with different capital structures?
Example:
- Company A: D/E = 0.5, β = 1.2
- Company B: D/E = 1.0, β = 1.5
Is Company B riskier? Or just more leveraged?
Solution: Unlever betas to see business risk, then relever to desired capital structure.
Unlevering Beta
Remove the effect of financial leverage:
β_U = β_L / [1 + (1 - T) × (D/E)]
Where:
- β_U = Unlevered beta (business risk only)
- β_L = Levered beta (observed)
- T = Tax rate
- D/E = Debt-to-equity ratio
Example:
Company has:
- Levered beta: 1.5
- D/E: 1.0
- Tax rate: 25%
β_U = 1.5 / [1 + (1 - 0.25) × 1.0]
β_U = 1.5 / [1 + 0.75]
β_U = 1.5 / 1.75
β_U = 0.857
Business risk beta: 0.857 Additional risk from leverage: 1.5 - 0.857 = 0.643
Relevering Beta
Apply a different capital structure:
β_L = β_U × [1 + (1 - T) × (D/E)]
Example:
Starting with β_U = 0.857 (from above), what if D/E = 0.5?
β_L = 0.857 × [1 + (1 - 0.25) × 0.5]
β_L = 0.857 × [1 + 0.375]
β_L = 0.857 × 1.375
β_L = 1.178
With lower leverage (D/E = 0.5), beta is 1.178 instead of 1.5.
Application: Pure Play Method
Use when evaluating project in different industry:
Steps:
- Find comparable companies in target industry
- Get their levered betas
- Unlever their betas (remove their leverage)
- Average the unlevered betas = Project business risk
- Relever using your company's target capital structure
- Use this beta to calculate cost of equity
Example:
Your company (manufacturing, D/E = 0.6, T = 30%) considering software project.
Find software comparables:
| Company | β_L | D/E |
|---|---|---|
| Soft A | 1.4 | 0.2 |
| Soft B | 1.6 | 0.4 |
| Soft C | 1.3 | 0.1 |
Step 1: Unlever each beta (T = 30%)
β_U(A) = 1.4 / [1 + 0.7 × 0.2] = 1.4 / 1.14 = 1.228
β_U(B) = 1.6 / [1 + 0.7 × 0.4] = 1.6 / 1.28 = 1.250
β_U(C) = 1.3 / [1 + 0.7 × 0.1] = 1.3 / 1.07 = 1.215
Step 2: Average unlevered beta
β_U(project) = (1.228 + 1.250 + 1.215) / 3 = 1.231
Step 3: Relever using your company's D/E = 0.6
β_L(project) = 1.231 × [1 + 0.7 × 0.6]
β_L(project) = 1.231 × 1.42
β_L(project) = 1.748
Step 4: Calculate cost of equity
Risk-free rate: 4%, Market premium: 8%
r_e = 4% + 1.748 × 8% = 17.98%
Use ~18% as cost of equity for software project.
Module 7 Practice Problems
Problem Set 1: Capital Structure Metrics
-
Calculate Ratios: Company has:
- Total debt: $500M
- Total equity: $700M
- Total assets: $1,200M
Calculate: a. Debt-to-equity ratio b. Debt ratio c. Equity ratio
-
Compare Companies:
Company X:
- Debt: $300M
- Equity: $900M
Company Y:
- Debt: $600M
- Equity: $400M
Which company is more leveraged?
Problem Set 2: Modigliani-Miller
-
M&M Proposition II (No Taxes):
- Unlevered cost of capital: 14%
- Cost of debt: 7%
- D/E ratio: 0.8
Calculate cost of equity.
-
M&M Proposition II (With Taxes):
- Unlevered cost of capital: 13%
- Cost of debt: 6%
- Tax rate: 25%
- D/E ratio: 1.0
Calculate: a. Cost of equity b. WACC
Problem Set 3: Tax Shields
-
Value of Tax Shield: Company borrows $800M. Tax rate: 30%
Calculate PV of interest tax shield.
-
Firm Value with Leverage:
- Unlevered firm value: $1,000M
- Debt: $400M
- Tax rate: 25%
Calculate levered firm value.
-
Complete Tax Shield Analysis: Company considering capital structure change:
Current (All Equity):
- EBIT: $200M
- Tax rate: 28%
- Cost of equity: 16%
Proposed (Add $500M Debt at 8%):
- Same EBIT
- Same tax rate
a. Calculate value under current structure b. Calculate value with debt c. What is the increase in firm value?
Problem Set 4: Optimal Capital Structure
-
Trade-off Analysis:
Firm evaluating debt levels:
Debt Tax Shield Distress Cost Net $0 $0 $0 ? $200M $50M $8M ? $400M $100M $25M ? $600M $150M $60M ? $800M $200M $140M ? Base firm value (unlevered): $900M
a. Calculate net benefit for each level b. Calculate firm value for each level c. What is the optimal debt level?
-
Factors Analysis: For each company, recommend high or low debt:
a. Utility company with stable cash flows b. Biotech startup with no revenue c. Mature manufacturing firm with tangible assets d. Software company with high growth potential
Problem Set 5: Beta Adjustments
-
Unlever Beta: Company has:
- Levered beta: 1.6
- D/E: 0.8
- Tax rate: 30%
Calculate unlevered beta.
-
Relever Beta: Unlevered beta: 1.0 New D/E target: 1.2 Tax rate: 25%
Calculate new levered beta.
-
Pure Play Method: Your company (D/E = 0.5, T = 30%) evaluating hotel project.
Hotel industry comparables:
Hotel β_L D/E A 1.3 0.8 B 1.4 1.0 C 1.2 0.6 Risk-free rate: 4% Market premium: 8%
a. Unlever each comparable's beta b. Average the unlevered betas c. Relever using your company's capital structure d. Calculate appropriate cost of equity for hotel project
Problem Set 6: Real-World Application
-
Comprehensive Capital Structure Decision:
ABC Corp currently all-equity financed:
- Market value: $1,200M
- EBIT: $180M
- Tax rate: 25%
- Cost of equity: 15%
- Shares outstanding: 100M
Considering recapitalization:
- Issue $400M debt at 7%
- Use proceeds to repurchase shares
- Assume market is perfect except for taxes
a. Calculate current WACC b. Calculate current EPS c. Calculate firm value after recapitalization d. Calculate new cost of equity (use M&M Prop II) e. Calculate new WACC f. Calculate new EPS g. Should they recapitalize? Why?
Additional Resources
Excel Templates
Download templates for:
- Capital structure analysis
- Tax shield calculations
- Beta levering/unlevering
- Optimal capital structure modeling
Further Reading
Books:
- "Capital Structure and Corporate Financing Decisions" by H. Kent Baker
- "Theory and Practice of Corporate Finance" by Pascal Quiry
Papers:
- Modigliani & Miller (1958, 1963) - Original papers
- Myers (1984) - Pecking Order Theory
- Graham & Harvey (2001) - Survey of CFO practices
Real-World Data
- Damodaran Online: Industry leverage ratios
- Company 10-K filings: Capital structure details
- Credit rating agency reports
Looking Ahead to Module 8
You now understand how companies choose their financing mix and how leverage affects risk, cost of capital, and value. This completes the core trilogy:
- Module 5: Risk and Return
- Module 6: Cost of Capital
- Module 7: Capital Structure
These three modules together show how financing decisions affect firm value.
In Module 8, we'll explore Working Capital Management—the day-to-day financial management:
- Managing cash
- Managing inventory
- Managing receivables and payables
- The cash conversion cycle
- Short-term financing
This is where corporate finance meets operations.
Prepare for Module 8 by:
- Reviewing current assets and liabilities (Module 2)
- Understanding that working capital ties up cash
- Recognizing the trade-off between efficiency and risk
Summary
Congratulations on completing Module 7! You now understand:
✓ What capital structure is and how to measure it ✓ The Modigliani-Miller theorems and their implications ✓ How taxes create value through interest tax shields ✓ The costs of financial distress (direct and indirect) ✓ Agency costs associated with debt ✓ The trade-off theory of optimal capital structure ✓ The pecking order theory of financing choices ✓ How to unlever and relever betas ✓ Real-world considerations in capital structure decisions ✓ How capital structure varies across industries
Capital structure is one of the most important strategic decisions a company makes. The right balance of debt and equity can create value; the wrong balance can destroy it. While there's no single "optimal" capital structure for all firms, understanding the trade-offs helps you make better financing decisions.
Ready for the practical side of finance? Proceed to Module 8: Working Capital Management to learn about day-to-day financial operations.
"Capital structure is complex, but the principle is simple: Use as much debt as you can handle, but not more." — Anonymous CFO
"Our leverage is very low. We could borrow a lot more money, but we don't need it." — Warren Buffett on Berkshire Hathaway's capital structure
You now understand what these statements mean and the reasoning behind them.
See you in Module 8!