Capital Structure & Cost of

Capital

Prof. Sayantan Kundu

Indian Institute of Management Ranchi

 What is Capital Structure?

• The combination of debt and equity used to finance a firm’s

projects is referred to as its capital structure.
• The capital structure of a firm is some mix of debt, internally
generated equity, and new equity.
• What considerations determine the capital structure?
• What is the right mixture?
• Why do some industries tend to have firms with higher debt
ratios than other industries?
 Financial Leverage and Risk

• Equity owners can reap most of the rewards through financial

leverage when their firm does well.
• But they may suffer a downside when the firm does poorly.

• Example:
Consider an all equity firm having Assets worth 100 and
𝐸𝐵𝐼𝑇
𝑇𝑂𝑇𝐴𝐿 𝐴𝑆𝑆𝐸𝑇 = 𝑅𝑂𝑇𝐴 = 20%, given ROE=20%
Another firm in same business, having same Assets and ROTA
but having 50% debt (@10%) and 50% equity (ROE=?).
Compare the PAT and EPS if face value of each share is 1.
Assume debt is having 10% (cost of debt) and there are no
taxes.
 Capital Structure and Taxes
• Income taxes play an important role in a firm’s capital structure
decision because the payments to creditors and owners are
taxed differently.
• The basic framework for the analysis of capital structure and
how taxes affect it was developed by two Nobel Prize winning
economists, Franco Modigliani and Merton Miller (M&M).

• Example:
Consider an all equity firm having Assets worth 100 and
𝐸𝐵𝐼𝑇
𝑇𝑂𝑇𝐴𝐿 𝐴𝑆𝑆𝐸𝑇 = 𝑅𝑂𝑇𝐴 = 20%, given ROE=20%.
Another firm in same business, having same Assets and ROTA
but having 50% debt (@10%) and 50% equity (ROE=?)
Compare the PAT and EPS if face value of each share is 1.
Assume debt is having 10% (cost of debt) and tax rate is 30%.
 M&M Hypotheses
MM Proposition in a World without tax
• Proposition I: The proposition that the value of the firm is
independent of the firm’s capital structure.
• Proposition II: The proposition that a firm’s cost of equity capital is
a positive linear function of the firm’s capital structure.
• MM Proposition in a World with only Corporate Tax
• In presence of only taxes the value of levered firm in more than
the value of unlevered firm by the amount of present value of
interest tax shields.
• The proposition that a firm’s cost of equity capital is a positive
linear function of the firm’s capital structure.
• Proposition III (Miller, 1977): World with both personal and
corporate tax
• It depends upon the rate of personal tax vis-à-vis the
corporate tax.
 Value of the Firm In Absence of Taxes
Asset = 100, EBIT = 20, 100% dividend paid, Assume
Depreciation = 0 for simplicity, ROE = 20%, IntDebt = 10%

20
𝑉𝑈 = = 100
20%

15
𝑉𝐿 = 𝐸 + 𝐷 = + 50 = 100
𝑅𝑂𝐸
Thus, value of the firm is independent of capital structure, in
the absence of taxes. And one individual investor may just
create a portfolio of equity in the unlevered firm and bond
(debt) to synthetically create the same cash flow of the
levered firm.
Leverage and EBIT EPS Analysis
 Value of the Firm In Presence of Taxes
Asset = 100, EBIT = 20, Tax rate = 30%, 100% dividend
paid, Assume Depreciation = 0 for simplicity. ROE = 20%,
IntDebt = 10%
20(1 − 0.3)
𝑉𝑈 = = 70
20%

15(1 − 0.3)
𝑉𝐿 = 𝐸 + 𝐷 = + 50 = 85 = 𝑉𝑈 + 𝑇. 𝐷
𝑅𝑂𝐸

Thus, value of the firm increases with leverage in capital

structure, in the presence of taxes due to Present Value of
Interest Tax Shield (PVINTS). But it increases as long as
the firm remains profitable enough to pay back its debt
coverage and have some residual for equity holders.
 Personal Tax and Capital Structure
• If debt income (interest) and equity income (dividends and
capital appreciation) are taxed at the same rate, the interest tax
shield is still T.D and increasing leverage increases the value of
the firm.
• If debt income is taxed at rates higher than equity income,
some of the tax advantage to debt is offset by a tax
disadvantage to debt income. Whether the tax advantage from
the deductibility of interest expenses is more than or less than
the tax disadvantage of debt income depends on: the firm’s tax
rate; the investor’s tax rate on debt income; and the investor’s
tax rate on equity income. But since different investors are
subject to different tax rates (for example, pension funds are
not taxed), determining this is a problem.
• If investors can use the tax laws effectively to reduce to zero
their tax on equity income, firms will take on debt up to the
point where the tax advantage to debt is just offset by the tax
disadvantage to debt income.
Capital Structure and Distribution of Profit

Refer to EBIT EPS Analysis simulation

 Benefit of Leverage in Presence of Taxes
Value 𝑉𝐿 = 𝑉𝑈 + 𝑇. 𝐷
of
Levered
Firm

PVINTS
VL

VU

Debt / Equity

But in a real world scenario can value of firm increase in an

unabated way only due to leverage?
 Trade-off Theory of Capital Structure

• A firm’s debt equity decision is a trade-off between

interest tax shields and the cost of financial distress.
• It recognizes that target debt ratios may vary from firm to
firm.
• Unlike M&M theory, it avoids extreme predictions and
rationalizes moderate debt ratios.
• Higher profits imply more debt servicing capacity and
more taxable income to shield and so should give a higher
target debt ratio.
• Forms part of static theories of capital structure that states
that firms capital structure remains static, based on MM
assumptions.
 Capital Structure and Financial Distress
• Costs of Financial Distress:
• Cost of forgoing a long term profitable project
• Cost of lost sales
• Costs associated with suppliers.
• Legal costs

• Value of the firm = Value of the firm if all-equity financed

+ Present value of the interest tax shield
– Present value of financial distress
Optimal Capital Structure (Static trade-off theory)
𝑉𝐿 = 𝑉𝑈 + 𝑇. 𝐷
Value
of
Levered
Firm

DISTRESS

PVINTS
COST of
VL

VL Max

VU

Optimal Capital Structure Debt / Equity

 Pecking Order Theory
• Firms prefer using internally generated capital (retained
earnings) to externally raised funds (issuing equity or debt).
• Firms try to avoid sudden changes in dividends.
• When internally generated funds are greater than needed for
investment opportunities, firms pay off debt or invest in
marketable securities.
• When internally generated funds are less than needed for
investment opportunities, firms use existing cash balances or
sell off marketable securities.
• If firms need to raise capital externally, they issue the safest
security first; for example, debt is issued before preferred stock,
which is issued before common equity.
• Dynamic theory
 Signaling Theory
• MM assumed that investors have the same information
about a firm’s prospects as its managers- this is called
symmetric information.
• Signaling theory says that by capital structure decisions, the
management (agents) of a firm signals to the investors (D &
E both) about their future profitability and ability to repay
the loans.

• Dynamic theory
 Optimal Capital Structure
• The mix of debt and equity that maximizes the value of the firm
is referred to as the optimal capital structure.
• So what good is this analysis of the tradeoff between the value
of the interest tax shields and the costs of distress if we cannot
apply it to a specific firm?
• While we cannot specify a firm’s optimal capital structure, we
do know the factors that affect the optimum.
 Capital Structure: Different Industries

• The greater the marginal tax rate, the greater the benefit from
the interest deductibility and, hence, the more likely a firm is to
use debt in its capital structure.
• The greater the business risk of a firm, the greater the present
value of financial distress and, therefore, the less likely the firm
is to use debt in its capital structure.
• The greater extent that the value of the firm depends on
intangible assets, the less likely it is to use debt in its capital
structure.
 Final Words on Capital Structure
• We cannot figure out the best capital structure for a firm. We can provide
a checklist of factors to consider in the capital structure decision:
• There are several factors to consider in making the capital structure
decision:
• Taxes. The tax deductibility of interest makes debt financing attractive.
However, the benefit from debt financing is reduced if the firm cannot
use the tax shields.
• Risk. Because financial distress is costly, even without legal
bankruptcy, the likelihood of financial distress depends on the
business risk of the firm, in addition to any risk from financial
leverage.
• Type of asset. The cost of financial distress is likely to be more for
firms whose value depends on intangible assets and growth
opportunities.
• Financial slack. The availability of funds to take advantage of
profitable investment opportunities is valuable. Therefore, having a
store of cash, marketable securities, and unused debt capacity is
valuable.
 What should be the discount rate?
• So far we have assumed some discount rate to find out the NPV.
But in real life what is the discount rate?

• For pure debt instruments like bonds the discount rate is bond
yield
• For equity valuation, dividends are discounted at Return on
Equity.

• But the big question is what should be the discount rate for a
firm that has both debt and equity in its balance sheet?
• The answers is weighted average cost of capital, that is he
weighted (fraction of asset) average of cost of debt and cost of
equity.
 Weighted Average Cost of Capital (WACC)
• Suppose, market value based Balance Sheet of a company looks like:

• Company’s weighted average cost of capital without tax:

= RD*(D/V) + RE*(E/V)
= 7.5% * 0.30 + 15% * 0.70 = 12.75%
• But in presence of tax, since on the debt payment the company
enjoys tax shield, the lost of debt is actually lower.
• Hence the Company’s weighted average cost of capital in presence of
35% tax rate (T): = RD*(1-T)*(D/V) + RE*(E/V)
= 7.5% * (1 - 0.35) * 0.30 + 15% * 0.70
= 12.00%
 Leverage and Cost of Equity (without Tax)
Because of MM-I proposition without taxes, WACC of a Levered firm
and a unlevered firm should be the same in a tax free world.
If we define the required rate of return of unlevered firm as RA, it will
be same as ROE of unlevered firm.
𝐸 𝐷
𝑊𝐴𝐶𝐶 = 𝑅𝐴 = 𝑅𝐸 + 𝑅𝐷
𝐷+𝐸 𝐷+𝐸
Solving for RE, we get
𝐷+𝐸 𝐷
𝑅𝐸 = 𝑅𝐴 − 𝑅𝐷
𝐸 𝐸

𝑫
𝐨𝐫, 𝑹𝑬 = 𝑹𝑨 + (𝑹𝑨 − 𝑹𝑫 )
𝑬
ROE (RE) or cost of Equity has two parts
• RA or the business risk
• D/E or the financial leverage risk
Thus, ROE of a firm increase with leverage (MM-II) (intuitively why?)
Leverage and Cost of Equity (without Tax)
 Leverage and Cost of Equity (with Tax)
In a world with only corporate taxes, value of unlevered firm is
𝐸𝐵𝐼𝑇(1 − 𝑇)
𝑉𝑈 = , 𝑜𝑟, 𝐸𝐵𝐼𝑇 1 − 𝑇 = 𝑉𝑈 𝑅𝑈 … … … (1)
𝑅𝑈
Since, value of firm increases with leverage due to PVINTS, hence the value of
levered firm is: 𝑉𝐿 = 𝐷 + 𝐸 = 𝑉𝑈 + 𝑇. 𝐷 … … … (2)
Since, EBIT(1-T) is the amount distributed between bond holders and
shareholders,
𝐸 𝐷
𝐸𝐵𝐼𝑇 1 − 𝑇 = 𝑉𝐿 . 𝑊𝐴𝐶𝐶 = 𝐷 + 𝐸 .𝑅 + 𝑅 1 − 𝑇 … (3)
𝐷+𝐸 𝐸 𝐷+𝐸 𝐷
Equating (1) and (3) and substituting 𝑉𝑈 = 𝐷 + 𝐸 − 𝑇𝐷 from (2)

𝐷 + 𝐸 − 𝑇𝐷 𝐷
𝑅𝐸 = 𝑅𝑈 − 𝑅𝐷 (1 − 𝑇)
𝐸 𝐸
𝑫
𝒐𝒓, 𝑹𝑬 = 𝑹𝑼 + (𝑹𝑼 − 𝑹𝑫 )(𝟏 − 𝑻)
𝑬
Which is the relation between Cost of Equity of levered firm and the Cost of
Equity of identical unlevered firm in presence of corporate taxes.
Leverage and Cost of Equity (with Tax)
Optimal WACC (with Tax)
 Where to get the RD and RE from?
• Return on Debt is easily obtained from the actual debt of the
firm. If there are several typed of debt the weighed average of
all of them is taken.
• Return on equity is a bit tricky. It can be obtained from a firm
that is being traded in the market, by using the CAPM (CAPITAL
ASSET PRICING MODEL)

• Example:
• A firm having 1:1 debt equity ratio, has secured debt of
20mn at 8% and un-secured debt of 50mn at 10%. The
company has a equity beta of 1.2. The expected market
return is 15% and the risk free rate is 5%. What is the cost of
capital of the company if tax rate is 30%?
 Where to get the RD and RE from?
• Example:
• A firm having 1:1 debt equity ratio, has secured debt of 20mn at
8% and un-secured debt of 50mn at 10%. The company has a
equity beta of 1.2. The expected market return is 15% and the risk
free rate is 5%. What is the cost of capital of the company if tax
rate is 30%?

Cost of debt:
20 50
𝑅𝐷 = ∗ 8% + ∗ 10% = 9.4286%
20 + 50 20 + 50
Cost of Equity:
𝑅𝐸 = 𝑅𝑓 + 𝛽 𝑅𝑀 − 𝑅𝑓 = 5% + 1.2 ∗ 15% − 5% = 17%

1 1
WACC = ∗ 1 − 𝑇 ∗ 𝑅𝐷 + ∗ 𝑅𝐸 = 0.5 ∗ 0.7 ∗ 9.4286% + 0.5 ∗ 17%
2 2
or WACC = 11.8%
Thank You