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:

1. Benchmark: Shows what matters are the deviations from perfect markets
2. Focus: Tells us where to look for capital structure effects (taxes, bankruptcy, etc.)
3. 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:

1. Company borrows money
2. Shareholders invest in very risky projects
3. If project succeeds: Shareholders get all upside
4. 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:

1. No debt: Miss out on tax shields
2. Moderate debt: Tax benefits > distress costs
3. Optimal point: Maximize firm value
4. 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:

1. Financial flexibility (59%)

   • Maintain spare borrowing capacity
   • Be ready for opportunities

2. Credit rating (57%)

   • Maintain investment-grade rating
   • Access to debt markets

3. Tax advantage of debt (45%)

   • Use tax shields

4. Comparable firm leverage (37%)

   • Industry norms

5. 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:

1. Find comparable companies in target industry
2. Get their levered betas
3. Unlever their betas (remove their leverage)
4. Average the unlevered betas = Project business risk
5. Relever using your company's target capital structure
6. 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

1. 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

2. Compare Companies:

   Company X:

   • Debt: $300M
   • Equity: $900M

   Company Y:

   • Debt: $600M
   • Equity: $400M

   Which company is more leveraged?

Problem Set 2: Modigliani-Miller

3. M&M Proposition II (No Taxes):

   • Unlevered cost of capital: 14%
   • Cost of debt: 7%
   • D/E ratio: 0.8

   Calculate cost of equity.

4. 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

5. Value of Tax Shield: Company borrows $800M. Tax rate: 30%

   Calculate PV of interest tax shield.

6. Firm Value with Leverage:

   • Unlevered firm value: $1,000M
   • Debt: $400M
   • Tax rate: 25%

   Calculate levered firm value.

7. 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

8. 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?

9. 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

10. Unlever Beta: Company has:

    • Levered beta: 1.6
    • D/E: 0.8
    • Tax rate: 30%

    Calculate unlevered beta.

11. Relever Beta: Unlevered beta: 1.0 New D/E target: 1.2 Tax rate: 25%

    Calculate new levered beta.

12. 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

13. 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!