Capital Structure Decisions: The Basics
Capital structure theory Overview of capital structure effects Business versus financial risk The effect of debt on returns

Basic Definitions
• • • • • V = value of business FCF = free cash flow WACC = weighted average cost of capital rs and rd are costs of stock and debt re and wd are percentages of the business that are financed with stock and debt. • VU = value of unleveraged business • VL = value of leveraged business

Capital Structure Theory
• MM theory
– Zero taxes – Corporate taxes – Corporate and personal taxes

• Trade-off theory • Signaling theory • Debt financing as a managerial constraint

MM Theory: Zero Taxes
• MM prove, under a very restrictive set of assumptions, that a business’s value is unaffected by its financing mix: VL = VU • Therefore, capital structure is irrelevant. • Any increase in ROE resulting from financial leverage is exactly offset by the increase in risk (i.e., rs), so WACC is constant.

MM Theory: Corporate Taxes
• Corporate tax laws favor debt financing over equity financing. • With corporate taxes, the benefits of financial leverage exceed the risks: More EBIT goes to investors and less to taxes when leverage is used. • MM show that: VL = VU + TD. • If T=40%, then every dollar of debt adds 40 cents of extra value to business.

MM relationship between value and debt when corporate taxes are considered.
Value of business, V VL TD VU Debt

0

Under MM with corporate taxes, the business’s value increases continuously as more and more debt is used.

MM relationship between capital costs and leverage when corporate taxes are considered. Cost of Capital (%)

rs

WACC rd(1 - T) 0 20 40 60 80 100 Debt/Value Ratio (%)

Miller’s Theory: Corporate and Personal Taxes
• Personal taxes lessen the advantage of corporate debt:
– Corporate taxes favor debt financing