My Article
The Basics of Capital Structure
The value of a firm is defined to be the sum of the value of the firm’s debt and equity. We usually use B or D for the value of debt and S or E for the value of equity.
So V = B + S = D + E
Shareholders are interested in maximizing the value of the firm’s shares. A key question is: What is the ratio of debt to equity, if any, that maximizes the shareholder’s value?
As it turns out, changes in capital structure benefit shareholders if and only if the value of the firm increases. So we concern ourselves with the question of which proportion of debt versus equity maximizes the overall value of the firm.
We assume perfect capital markets in the following analysis:
· Perfect competition
· Equal access to information
· No transaction costs
· No taxes (later we drop this assumption)
We also assume that the individual can borrow at the same rate as the firm.
Example:
We will compare a firm whose capital structure is all equity, with a firm that is identical, except that it has some debt in its capital structure.
Suppose a firm has 1000 shares, a share price of $10, a market value of $10,000, and operating income as described in the table below. This income is a perpetuity, and all earnings are paid out as a dividend to investors. Expected income is $1500 and expected return is 15%.

Outcomes 

Operating Income 
500 
1000 
1500 
2000 
Earnings Per Share 
.50 
1.00 
1.50 
2.00 
Return On Equity 
5% 
10% 
15% 
20% 



Expected! 

Suppose the firm borrows $5,000 at 10% rate of interest and buys back 500 of its shares to create the following new situation: # shares 500, B = $5000, S = $5000, shares value: $10, annual interest: $500

Outcomes 

Operating Income 
500 
1000 
1500 
2000 
Interest 
500 
500 
500 
500 
Equity Earnings 
0 
500 
1000 
1500 
Earnings Per Share 
0 
1 
2 
3 
Return On equity 
0% 
10% 
20% 
30% 



Expected! 

Argument that value has increased: If operating income is greater than $1,000 then the expected Return On Equity increases. Since we expect operating income of $1,500, leverage must have added value. Shareholders expect 20% ROE with leverage.
Counterargument: Suppose an investor takes $10 of his/her own money and borrows $10 at 10% interest and invests the $20 to buy 2 shares of the unlevered firm.

Outcomes 

Operating Income 
500 
1000 
1500 
2000 
Earnings on 2 Shares 
1 
2 
3 
4 
Interest on $10 at 10% 
1 
1 
1 
1 
Net Earnings on 2 shares 
0 
1 
2 
3 
Return on $10 Investment 
0% 
10% 
20% 
30% 



Expected! 

Note: Investor gets the same result from borrowing personally as he/she gets from investing in the leveraged firm. Therefore, the firm is not doing anything by leveraging that the investor could not do on his/her own. This implies V_{L} = V_{U}. This is the famous ModiglianiMiller Proposition I.
So leverage increases the expected earnings per share, but not the share price. How can that be?
Leverage also increases the riskiness of the earnings. We must discount those higher expected earnings at a higher discount rate.
All equity: 1.50/.15 = $10
Leveraged: 2.00/.20 = $10
Recall: The value of a firm = the PV of the future cash flows.
If the firm is all equity financed, then V_{U} = C_{1}/(1+r_{0}) + C_{2}/(1+r_{0})^{2} + … where r_{0} is the cost of capital of an all equity financed firm.
If there is some debt in the capital structure, the cost of capital is given by:
r = [B/(B+S)]r_{B} + [S/(B+S)]r_{S} where r_{S} is the cost of equity capital of the now leveraged firm.
and V_{L} = C_{1}/(1+r) + C_{2}/(1+r)^{2} + ...
Since the value of the company doesn’t change with leverage, V_{L} = V_{U}, and so r must equal r_{0} – that is, r must be constant as debt is added to the capital structure (remember here we are assuming no taxes etc.). The idea is that as “expensive” equity is replaced with “cheap” debt, the risk to equity increases, as a result of the increased leverage, and so r_{S} increases. The increase in r_{S} just balances against the increased fraction of cheaper debt, so that r stays constant.
r_{0} = cost of capital for the all equity firm = r_{a} = required/expected return on the assets – reflects business risk – not financial leverage. If we solve:
r_{0} = [B/(B+S)]r_{B} + [S/(B+S)]r_{S} for r_{S}, we get r_{S} = r_{0} +[B/S](r_{0} – r_{B})
This is ModiglianiMiller Proposition II.
In our example above, r_{a} = 1500/10,000 = 15%. If B = S = 5000, then:
r_{S} = 15% + [5000/5000](15%  10%) = 20%
Initially the firm was all equity, had 1,000 shares at $10/share and equity worth $10,000
V = 1500/.15 = (CF/r_{S}) = $10,000
With $5,000 debt at 10% and $5,000 equity, now r_{S} = 20%, up from 15% and:
V = 500/.10 + 1000/.20 = interest payment/r_{B} + CF/r_{S} = 5,000 + 5,000 = 10,000
Essentially, we split a single cash flow of 1500/year, discounted at 15% into 2 cash flows of 500 and 1000, the former discounted at 10% and the latter discounted at 20%
====================
Let’s redo this example, assuming the 1500 expected cash flow was pre tax and taxes at 35%:

Unleveraged 
Leveraged 
EBIT (expected) 
1500 
1500 
Interest 

500 
Pretax income 
1500 
1000 
Taxes 
525 
350 
Net Income to shareholders 
975 
650 
Total income to debt and equity investors 
975 
1150 
Interest tax shield 

175 
So, case I: UNLevered:
CF = 1500
525 is taxes
975 to equity
and V_{U} = 975/.15 = $6,500
Case II: Levered:
CF = 1500
Interest: 500
Taxes: 350
650 to equity
and V_{L} = 500/.10 + 650/.20 = $5,000 +$3,250 = $6,500 + $1,750 = $8,250
Note that in Case II, more cash flows to the “good guys” – the investors in the firm (both creditors and shareholders), and less cash flows to the “bad guys” – the government, via taxes.
Note that the value of the firm has increased by $1,750 – which is $175/.10 – the present value of the annual cash flow shielded from taxes – that is, PV(ITS). (How do we justify discounting at 10%?)
Note that: V_{L} = $6,500 + $1,750 = V_{U} + PV(ITS)
In general, the annual tax shield is r_{B}BT_{c}, and the PV of the tax shield is (r_{B}BT_{c})/r_{B} = BT_{c.}
So, we can conclude, in the presence of taxes that: V_{L} = V_{U} + PV(Interest Tax Shield). If the debt is fixed and permanent, V_{L} = V_{U} + BT_{c}.
Brief digression:
In fact, if we also include the expected cost of financial distress as a result of the increased debt, we get: V_{L} = V_{U} + PV(ITS) – PV (costs of financial distress).
This analysis leads to a theory called the trade off theory of capital structure. The optimal capital structure reflects a tradeoff between the tax benefits of debt due to the deductibility of interest expense, versus the increased risks of financial distress due to the high(er) debt levels.
Anyway, let’s continue with our example:
MM Proposition II – in the presence of taxes, can be shown to be:
r_{s} = r_{0} +[B/S](1T_{c})(r_{0} – r_{B})
We are still assuming B = $5,000 at 10% interest, and since V_{L} = $8,250, therefore S = $3,250.
In the presence of taxes and leverage, r_{s} = .15 + [5000/3250](1.35)(.15.10) = .20
To verify: S = (EBIT – r_{B}B)(1T_{c})/r_{s} = (1500 – 500)(1.35)/.20 = 3250
What is the after tax, weighted average cost of capital – WACC?
WACC = [B/V_{L}]r_{B}(1T_{c}) + [S/V_{L}]r_{s} = [5000/8250](.10)(1.35) + [3250/8250](.20) = .1182
So the cost of capital reduces from 15% with no debt to 11.82% with debt, and it is NOT because debt is cheaper than equity, but rather because of the tax deductibility of debt!
Note that V_{L} = EBIT(1T_{c})/r_{WACC} = 1500(1.35)/.1182 = 8250 as before. It is standard practice to discount the after tax operating cash flows of the unleveraged firm by the WACC. The tax benefit of debt is embedded in the WACC formula.
Let’s think about this some more!
Suppose the firm was initially all equity, and moved to $5,000 of debt.
The all equity firm was worth $6,500 = 1500(1.35)/.15
Suppose there were 1,000 shares worth $6.50/share.
When the firm announced that it would borrow $5,000 at 10% interest and use the debt to buy back some of its shares (that is, its equity), the value of the firm increased immediately (in efficient capital markets) by $1750, = PV(ITS).
Since there were still 1,000 shares outstanding, the shares increased in value by 1750/1,000 = $1.75, so the share price jumped to $6.50 + $1.75 = $8.25.
Shortly thereafter, the $5,000 was actually borrowed. How many shares were bought back?
$5,000/$8.25 = 606 shares, leaving 394 shares remaining.
The 394 shares are worth 394 x $8.25 = $3250 and B = $5,000
Note: Shareholders holding shares at the time of the announcement of the leveraged recapitalization capture the benefit – the tax benefit of debt, whether or not they choose to tender their shares.