Fundamentals of Finance

Capital Structure
Dr. Md. Rostam Ali
Associate Professor
Department of Accounting
Mawlana Bhashani Science and Technology University
Santosh, Tangail-1902, Bangladesh

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The Firm’s Capital Structure

• Capital structure can be defined as the mix of owned

capital (equity, reserves & surplus) and borrowed capital
(debentures, loans from banks, financial institutions)
• Maximization of shareholders’ wealth is prime objective
of a financial manager. The same may be achieved if an
optimal capital structure is designed for the company.
• Planning a capital structure is a highly psychological,
complex and qualitative process.
• It involves balancing the shareholders’ expectations
• (risk & returns) and capital requirements of the firm.
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Types of Capital

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 Planning the Capital Structure
Important Considerations –
• Return: ability to generate maximum returns to the
shareholders, i.e. maximize EPS and market price per share.
• Cost: minimizes the cost of capital (WACC). Debt is cheaper
than equity due to tax shield on interest & no benefit on
dividends.
• Risk: insolvency risk associated with high debt component.
• Control: avoid dilution of management control, hence debt
preferred to new equity shares.
• Flexible: altering capital structure without much costs & delays,
to raise funds whenever required.
• Capacity: ability to generate profits to pay interest and
principal 4
Value of a Firm – directly co-related with the
maximization of shareholders’ wealth.

• Value of a firm depends upon earnings of a firm and its cost of

capital (i.e. WACC).
• Earnings are a function of investment decisions, operating
efficiencies, & WACC is a function of its capital structure.
• Value of firm is derived by capitalizing the earnings by its cost
of capital (WACC).
Value of Firm = Earnings / WACC
• Thus, value of a firm varies due to changes in the earnings of a
company or its cost of capital, or both.
• Capital structure cannot affect the total earnings of a firm
(EBIT), but it can affect the residual shareholders’ earnings. 5
Capital Structure Theory

• According to finance theory, firms possess a target

capital structure that will minimize its cost of capital.
• Unfortunately, theory can not yet provide financial
mangers with a specific methodology to help them
determine what their firm’s optimal capital structure
might be.
• Theoretically, however, a firm’s optimal capital
structure will just balance the benefits of debt financing
against its costs.

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Capital Structure Theory (cont.)

• The major benefit of debt financing is the tax shield

provided by the federal government regarding interest
payments.
• The costs of debt financing result from:
– the increased probability of bankruptcy caused by debt
obligations,
– the agency costs resulting from lenders monitoring the firm’s
actions, and
– the costs associated with the firm’s managers having more
information about the firm’s prospects than do investors
(asymmetric information).

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Capital Structure Theory:
Probability of Bankruptcy (cont.)

• Financial Risk

Let us assume that (1) the firm has no current liabilities,

(2) its capital structure currently contains all equity, and
(3) the total amount of capital remains constant at
$500,000, the mix of debt and equity associated with
various debt ratios would be as shown in Table 12.10.
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Capital Structure Theory:
Probability of Bankruptcy (cont.)

• Financial Risk
Table 12.10
Capital Structures
Associated with
Alternative Debt
Ratios for Cooke
Company

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Capital Structure Theory:
Probability of Bankruptcy (cont.)

• Financial Risk
Table 12.11
Level of Debt,
Interest Rate, and
Dollar Amount of
Annual Interest
Associated with
Cooke
Company’s
Alternative
Capital Structures

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 Capital Structure Theory:
Probability of Bankruptcy (cont.)

• Financial Risk

Table 12.12
Calculation of
EPS for
Selected Debt
Ratios ($000)
for Cooke
Company (cont.)

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Capital Structure Theory:
Probability of Bankruptcy (cont.)

• Financial Risk
Table 12.12
Calculation of
EPS for
Selected Debt
Ratios ($000)
for Cooke
Company (cont.)

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 Capital Structure Theory:
Probability of Bankruptcy (cont.)

• Financial Risk

Table 12.12
Calculation of
EPS for
Selected Debt
Ratios ($000)
for Cooke
Company

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Capital Structure Theory:
Probability of Bankruptcy (cont.)

• Financial Risk
Table 12.13
Expected EPS,
Standard
Deviation, and
Coefficient of
Variation for
Alternative Capital
Structures for
Cooke Company

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Capital Structure Theory:
Probability of Bankruptcy (cont.)

• Financial Risk
Figure 12.3
Probability
Distributions

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Capital Structure Theory:
Probability of Bankruptcy (cont.)

• Financial Risk
Figure 12.4 Expected EPS and Coefficient of Variation
of EPS

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Capital Structure Theory: Agency Costs
Imposed by Lenders (cont.)

• To avoid this, lenders impose various

monitoring costs on the firm.
• Examples would of these monitoring
costs would:
– include raising the rate on future debt issues,
– denying future loan requests,
– imposing restrictive bond provisions.

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Capital Structure Theory: Agency Costs
Imposed by Lenders

• When a firm borrows funds by issuing debt, the interest

rate charged by lenders is based on the lender’s
assessment of the risk of the firm’s investments.
• After obtaining the loan, the firm’s stockholders and/or
managers could use the funds to invest in riskier assets.
• If these high risk investments pay off, the stockholders
benefit but the firm’s bondholders are locked in and are
unable to share in this success.

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Capital Structure Theory:
Asymmetric Information

• Asymmetric information results when managers of a

firm have more information about operations and future
prospects than do investors.
• Asymmetric information can impact the firm’s capital
structure as follows:

Suppose management has identified an extremely lucrative

investment opportunity and needs to raise capital. Based on
this opportunity, management believes its stock is
undervalued since the investors have no information about
the investment.
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Capital Structure Theory:
Asymmetric Information (cont.)

• Asymmetric information results when managers of a

firm have more information about operations and future
prospects than do investors.
• Asymmetric information can impact the firm’s capital
structure as follows:

In this case, management will raise the funds using debt

since they believe/know the stock is undervalued
(underpriced) given this information. In this case, the use of
debt is viewed as a positive signal to investors regarding the
firm’s prospects.
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Capital Structure Theory:
Asymmetric Information (cont.)

• Asymmetric information results when managers of a

firm have more information about operations and future
prospects than do investors.
• Asymmetric information can impact the firm’s capital
structure as follows:

On the other hand, if the outlook for the firm is poor,

management will issue equity instead since they
believe/know that the price of the firm’s stock is overvalued
(overpriced). Issuing equity is therefore generally thought of
as a “negative” signal.
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The Optimal Capital Structure

• In general, it is believed that the market value of a company is

maximized when the cost of capital (the firm’s discount rate) is
minimized.
• The value of the firm can be defined algebraically as follows:
• Value of Firm = Earnings / WACC

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The Optimal Capital Structure

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The Optimal Capital Structure

Figure 12.5
Cost Functions
and Value

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EPS-EBIT Approach
to Capital Structure

• The EPS-EBIT approach to capital structure involves selecting

the capital structure that maximizes EPS over the expected range
of EBIT.
• Using this approach, the emphasis is on maximizing the owners
returns (EPS).
• A major shortcoming of this approach is the fact that earnings
are only one of the determinants of shareholder wealth
maximization.
• This method does not explicitly consider the impact of risk.

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EPS-EBIT Approach
to Capital Structure (cont.)

Example

EBIT-EPS coordinates can be found by assuming specific

EBIT values and calculating the EPS associated with them.
Such calculations for three capital structures—debt ratios of
0%, 30%, and 60%—for Cooke Company were presented
earlier in Table 12.2. For EBIT values of $100,000 and
$200,000, the associated EPS values calculated are
summarized in the table with Figure 12.6.

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EPS-EBIT Approach
to Capital Structure (cont.)

Figure 12.6
EBIT–EPS
Approach

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EPS-EBIT Approach
to Capital Structure (cont.)

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Basic Shortcoming
of EPS-EBIT Analysis

• Although EPS maximization is generally good for the

firm’s shareholders, the basic shortcoming of this
method is that it does not necessary maximize
shareholder wealth because it fails to consider risk.
• If shareholders did not require risk premiums
(additional return) as the firm increased its use of debt,
a strategy focusing on EPS maximization would work.
• Unfortunately, this is not the case.

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Traditional View of Optimal Capital Structure
Capital = $50,000, Share Available at 50 cents each, Debt available at 8%.

Actions No Debt 20,000 Debt 25,000 Debt

NOI 10,000 10,000 10,000
Less Interest 00 1,600 2,000
Equals Income Available to the 10,000 8,400 8,000
Ordinary Shareholders
Divided by Cost of Equity Capital .13 .14 .25
(Ke)
Equals Market Value of Share (E) 76,923 60,000 32,000
Plus Market Value of Debt (D) 00 20,000 25,000
Equals Total Market Value (V) 76,923 80,000 57,000
13% 12.5% 17.54%
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Traditional View of Optimal Capital Structure

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 MM View of Optimal Capital Structure
(With No Corporate Tax)

 Modigliani and Miller (MM) Approach suggests that the

valuation of a firm is irrelevant to the capital structure of a
company.
 Whether a firm is highly leveraged or has a lower debt
component has no bearing on its market value.
 Therefore, market value of a company is calculated using
its earning power and the risk of its underlying assets.

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MM View of Optimal Capital Structure
(With No Corporate Tax)

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MM View of Optimal Capital Structure

𝑵𝑶𝑰
V=
(𝐾0)
* * 𝑫
Ke =K + (K - Kd)
(𝐸)
(Required rate of return on
Ke = + (Risk premium)
equity of unlevered company)

Therefore, as a company increases the portion of debt in its

capital structure, the cost of equity increases so as to exactly
offset any advantage from using debt
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MM View of Optimal Capital Structure

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MM View of Optimal Capital Structure

Capital = $50,000, Share Available at 50 cents each, Debt available at 8%.

Actions No Debt 20,000 Debt

NOI 10,000 10,000
Less Interest 00 1,600
Equals Income Available to the 10,000 8,400
Ordinary Shareholders
Divided by Cost of Equity Capital (Ke) .13 .14
Equals Market Value of Share (E) 76,923 60,000
Plus Market Value of Debt (D) 00 20,000
Equals Total Market Value (V) 76,923 80,000
13% 12.5%

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MM View of Optimal Capital Structure

Arbitrage Process

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Choosing the Optimal
Capital Structure (cont.)

Table 12.14 Required Returns for Cooke Company’s

Alternative Capital Structures

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Choosing the Optimal
Capital Structure (cont.)

By substituting the level of EPS and the associated

required return into Equation 12.12, we can
estimate the per share value of the firm, P0.

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Choosing the Optimal
Capital Structure (cont.)

Table 12.15 Calculation of Share Value Estimates

Associated with Alternative Capital Structures for Cooke
Company

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Choosing the Optimal
Capital Structure (cont.)

Figure 12.7
Estimating Value

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Table 12.16 Important Factors to Consider
in Making Capital Structure Decisions

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