17.4 Capital Structure Choices
4 min read•june 18, 2024
decisions shape a firm's financial foundation. rely solely on equity, while mix debt and equity. This balance impacts risk, returns, and firm value.
In perfect markets, doesn't affect firm value. But real-world factors like taxes make debt attractive. Firms weigh against costs to optimize their capital structure.
Capital Structure and Firm Value
Levered vs unlevered firms
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- Unlevered firms
- Financed entirely with equity capital (common stock, preferred stock, retained earnings)
- No debt financing in the capital structure such as bonds, loans, or credit lines
- Equity holders bear all the business risk and receive all the returns generated by the firm's assets
- Levered firms
- Financed with a combination of debt (bonds, loans) and equity capital (common stock, preferred stock)
- Capital structure includes both debt and equity financing in varying proportions
- Debt holders have a prior claim on the firm's assets and cash flows in the event of bankruptcy
- Equity holders bear more financial risk due to but have the potential for higher returns if the firm performs well
Capital structure in perfect markets
- - (MM) Proposition I states that in perfect capital markets, the value of a firm is independent of its capital structure ()
- Assumes no taxes, no transaction costs, no bankruptcy costs, and no information asymmetry between investors and managers
- Implies that the remains constant regardless of the chosen by the firm
- argument suggests that if two identical firms have different values due to capital structure, investors can exploit this difference and drive the values to equilibrium through buying and selling securities
- In perfect markets, the total value of a firm's securities (debt + equity) is equal to the value of its operating assets and not affected by the mix of debt and equity financing
Interest tax shield calculation
- represents the tax savings generated by the deductibility of interest payments on debt financing
- Calculated as: = Interest expense × Corporate tax rate
- Example: If a firm has 30,000 ($100,000 × 30%)
- Modigliani-Miller (MM) Proposition II with taxes states that the value of a levered firm is equal to the value of an unlevered firm plus the present value of the interest tax shield
- Formula:
- Implies that debt financing can increase firm value by providing tax benefits through the deductibility of interest payments
- suggests that firms balance the tax benefits of debt against the potential costs of (bankruptcy costs, ) when determining their optimal capital structure
Tax benefits for leverage decisions
- Higher corporate tax rates make debt financing more attractive due to the increased interest tax shield benefits
- Example: A firm in a country with a 40% corporate tax rate will have a greater incentive to use debt compared to a firm in a country with a 20% tax rate
- Firms with higher and more stable operating income can support more debt in their capital structure to take advantage of the tax benefits without increasing financial distress risk significantly
- such as depreciation and amortization expenses can reduce the relative advantage of debt financing by providing alternative means of reducing taxable income
- Personal taxes on interest income (for bondholders) and capital gains (for shareholders) can offset some of the corporate tax benefits of debt financing
- Firms may target a specific (e.g., 40% debt, 60% equity) or a certain credit rating (e.g., A+) to balance the tax benefits and costs of debt financing while maintaining
- This approach considers the firm's , which is the maximum amount of debt a company can borrow without significantly increasing its financial risk
Additional Capital Structure Theories
- suggests that firms prefer internal financing over external financing, and debt over equity when external financing is required
- proposes that firms issue equity when their stock prices are perceived to be overvalued and repurchase equity when prices are undervalued
- suggests that managers use capital structure decisions to convey information about the firm's prospects to investors
- Financial flexibility refers to a firm's ability to access and restructure its financing at a low cost, which can influence capital structure decisions
- occurs when high levels of existing debt discourage new investment, as the benefits would primarily accrue to existing debt holders rather than shareholders
Key Terms to Review (35)
Agency Costs: Agency costs refer to the expenses and potential losses that arise from the inherent conflict of interest between a company's management (the agent) and its shareholders (the principal). These costs stem from the separation of ownership and control, where managers may make decisions that prioritize their own interests over those of the shareholders they are meant to serve.
Arbitrage: Arbitrage is the practice of taking advantage of a price difference between two or more markets, striking a combination of matching deals to capitalize on the imbalance and generate a risk-free profit. It is a fundamental concept in finance that is closely tied to the notion of market efficiency.
Capital structure: Capital structure is the mix of debt and equity that a firm uses to finance its operations and growth. It directly impacts the company's risk, cost of capital, and overall financial strategy.
Capital Structure: Capital structure refers to the mix of debt and equity financing that a company uses to fund its operations and investments. It represents the relative proportions of different sources of capital, such as short-term debt, long-term debt, and equity, that a company employs to finance its assets and activities. The capital structure of a company is a crucial aspect of corporate finance, as it directly impacts the company's financial risk, cost of capital, and ultimately, its overall value and performance.
Capital Structure Irrelevance: Capital structure irrelevance is a principle in finance which states that a firm's value is unaffected by how that firm is financed, be it through debt, equity, or a combination of the two. This concept is a cornerstone of modern corporate finance theory and has significant implications for how companies make financing decisions.
Debt Capacity: Debt capacity refers to the maximum amount of debt a company or individual can take on while maintaining a healthy financial position and meeting its financial obligations. It is a critical consideration in capital structure choices, as it helps determine the optimal mix of debt and equity financing for a business.
Debt Overhang: Debt overhang refers to a situation where a company or country has accumulated so much debt that the burden of servicing and repaying that debt becomes a significant obstacle to future investment and economic growth. This occurs when the expected future cash flows of the entity are not sufficient to cover the existing debt obligations, making it difficult to raise additional funds for new projects or investments.
Debt-to-equity ratio: The debt-to-equity ratio is a solvency ratio that measures the proportion of a company's debt to its shareholders' equity. It indicates how much debt a company is using to finance its assets relative to the value represented in shareholders’ equity.
Debt-to-Equity Ratio: The debt-to-equity ratio is a financial metric that measures a company's financial leverage by dividing its total liabilities by its total shareholders' equity. This ratio provides insight into a company's capital structure and its ability to meet its financial obligations.
Financial distress: Financial distress occurs when a firm struggles to meet its financial obligations, leading to potential insolvency or bankruptcy. It often results in increased borrowing costs and operational disruptions.
Financial Distress: Financial distress refers to a situation where a company or individual is struggling to meet their financial obligations and is at risk of defaulting on debt payments or even bankruptcy. It is a critical concept in the context of capital structure, the costs of debt and equity capital, capital structure choices, and optimal capital structure.
Financial Flexibility: Financial flexibility refers to a company's ability to adapt and respond to changing financial circumstances, allowing it to access additional funds or reallocate resources as needed. This concept is crucial in the context of cash flow management, capital structure decisions, and a firm's overall financial resilience.
Financial leverage: Financial leverage is the use of borrowed funds to increase the potential return on investment. It involves amplifying both potential gains and potential losses by using debt financing.
Interest tax shield: The interest tax shield is the reduction in taxable income that results from claiming interest payments as a tax-deductible expense. This benefit lowers the overall cost of debt for firms and can influence their capital structure decisions.
Interest Tax Shield: The interest tax shield refers to the reduction in a company's tax liability due to the deductibility of interest expenses on debt financing. This concept is particularly relevant in the context of analyzing the costs of debt and equity capital, as well as making capital structure choices.
Leverage: Leverage refers to the use of debt or other financial instruments to increase the potential return on an investment. It involves using borrowed funds or financial derivatives to magnify the impact of market movements, allowing investors to potentially generate higher returns but also exposing them to greater risk.
Levered equity: Levered equity is the portion of a company's equity that has been financed using debt. It reflects the increased risk and potential return associated with borrowing funds to invest in business operations.
Levered Firms: Levered firms are companies that have taken on debt financing, such as loans or bonds, to fund their operations and investments. The use of debt, or leverage, can amplify a firm's returns but also increases its financial risk.
Market Timing Theory: The market timing theory suggests that investors can outperform the market by timing their investments, buying when the market is low and selling when the market is high. This theory is particularly relevant in the context of capital structure choices and the pursuit of an optimal capital structure.
Miller: Miller, in the context of finance, refers to the Miller Modigliani theorem, a proposition about capital structure. It states that, under certain conditions, the value of a firm is unaffected by how it is financed, whether through debt or equity.
MM Proposition I: MM Proposition I states that in a perfect market, the value of a firm is unaffected by its capital structure. It implies that the firm's financing decisions do not influence its overall value.
Modigliani: Modigliani refers to Franco Modigliani, an economist who co-developed the Modigliani-Miller theorem. This theorem is foundational in understanding capital structure in corporate finance.
Modigliani-Miller Theorem: The Modigliani-Miller theorem is a fundamental principle in corporate finance that states the value of a firm is independent of its capital structure, meaning the way a firm finances its operations through debt or equity has no effect on its overall value. This theorem is a crucial concept in understanding capital structure choices and the optimal capital structure for a firm.
Non-Debt Tax Shields: Non-debt tax shields refer to tax-deductible expenses or allowances that can reduce a company's taxable income, similar to the way interest payments on debt can reduce taxable income. These non-debt tax shields provide a financial benefit to the firm without the associated costs and risks of debt financing.
Pecking Order Theory: Pecking order theory is a concept in corporate finance that describes the order in which a company will prefer to use sources of financing for new investments. It suggests that companies prioritize internal financing over external financing, and if external financing is required, they will prefer debt over equity.
Signaling Theory: Signaling theory is a concept in finance that explains how companies can convey information about their financial health and future prospects to investors through various signals, such as the choice of capital structure. It suggests that a firm's financing decisions can act as a signal to the market, providing insights into the company's underlying quality and future performance.
Target Capital Structure: The target capital structure refers to the optimal mix of debt and equity financing that a company aims to maintain in order to minimize its weighted average cost of capital and maximize firm value. It represents the company's long-term financing strategy and guides its financing decisions.
Tax Benefits: Tax benefits refer to the various advantages and incentives provided by the tax system that can reduce an individual's or organization's tax liability. These benefits are designed to encourage certain behaviors, investments, or activities that are deemed socially or economically beneficial.
Trade-off theory: Trade-off theory suggests that firms seek to balance the benefits of debt, such as tax shields, against the costs, including financial distress and bankruptcy risk. This results in an optimal capital structure where the marginal benefit of debt equals its marginal cost.
Trade-Off Theory: The trade-off theory is a financial concept that suggests companies should balance the benefits and costs of debt financing to determine their optimal capital structure. It proposes that there is an ideal mix of debt and equity that maximizes firm value by weighing the tax advantages of debt against the potential costs of financial distress and bankruptcy.
Unlevered equity: Unlevered equity is the value of a company's equity without any debt financing. It represents the firm's equity value purely from its operational performance, free from interest obligations.
Unlevered Firms: Unlevered firms are companies that do not use debt financing in their capital structure. They rely solely on equity financing, without any borrowed capital or financial leverage. The absence of debt is a key characteristic of unlevered firms, which impacts their financial profile and decision-making processes.
Weighted Average Cost of Capital: The weighted average cost of capital (WACC) is the average cost of a company's different capital sources, such as common stock, preferred stock, and debt. It represents the minimum rate of return a company must earn on its existing asset base to satisfy its creditors, owners, and other providers of capital.
Weighted average cost of capital (WACC): Weighted average cost of capital (WACC) is the average rate of return a company is expected to pay its security holders to finance its assets. It reflects the overall cost of raising new capital, considering both debt and equity.
Weighted Average Cost of Capital (WACC): The Weighted Average Cost of Capital (WACC) is a financial metric that represents the blended cost of a company's various sources of capital, including debt and equity. It is a crucial concept in corporate finance that is used to evaluate the overall cost of financing a project or investment, and to determine the minimum required rate of return for a company's operations.