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Corporate Finance
Lecture 06
INTRODUCTION TO CAPITAL
STRUCTURE
Ronald F. Singer
FINA 7330
Fall, 2010
Summary
• Capital Structure Defined
• The Modigliani and Miller Irrelevance
Theorem
• Role of Imperfections on the Capital
Structure Decision
THE FIRM'S CAPITAL STRUCTURE IS DEFINED AS:
THE MIX OF THE DIFFERENT SECURITIES ISSUED BY THE FIRM
THE PROBLEM:
WHAT IS THE MIX WHICH MAXIMIZES STOCKHOLDERS' WEALTH
THE TYPICAL CAPITAL STRUCTURE OF A LARGE
CORPORATION:
Capital Structure
Common Equity
Preferred Equity
Sinking Fund
Non-sinking Fund
Senior Debt
Secured
Unsecured
Callable
Non-callable
Sinking fund
Convertible
Etc
Junior Debt
WE ASSUME THAT THE FIRM HAS ONLY COMMON EQUITY
AND A SINGLE DEBT ISSUE IN ITS CAPITAL STRUCTURE.
THE SAME PRINCIPLES FOLLOW WITH A MORE COMPLEX
CAPITAL STRUCTURE.
THE CAPITAL STRUCTURE DECISION SHOULD BE
THOUGHT OF AS A DECISION WHICH ASKS HOW IS THE
OPERATING CASH FLOW OF THE FIRM GOING TO BE
SPLIT AMONG THE DIFFERENT SECURITY HOLDERS:
THAT IS:
FIRM
Operating Cash Flow
Cash Flow
To
Stockholders
Cash Flow
To
Bondholders
SOME DEFINITIONS AND NOTATION:
LET:
B be the market value of the debt issued by the firm
S be the market value of the equity issued by the firm
rB be the required return to the debt
rs be the required return to the firm's equity
ro be the discount rate applied to the business risk of the
firm
By Definition:
V = B + S,
where;
V is the "market value" of the securities issued by the
firm.
T
B 
y B( t )
t 1(1  rB )
t
is the market value of the debt.
T
S 
ys ( t )
t 1(1  rs )
t
is the market value of equity.
yB(t) is the cash flow to bondholders,
yS(t) is the cash flow to stockholders
Frictionless World
•
•
•
•
No taxes
No transaction costs
Small (atomistic) participants
No information costs
MODIGLIANI AND MILLER
PROPOSITION I:
Given A frictionless world (Perfect Capital Markets
No taxes
No flotation, brokerage, bankruptcy cost
Costless information
T
V=
V(A) =
E[ y(t )]
= B+S

t
t 1 (1  ro )
Where, y(t) is the operating cash flow at time t
r o is the firm’s “cost of capital”
THAT IS, THE MARKET VALUE OF ALL THE SECURITIES OF
THE FIRM IS EQUAL TO THE PRESENT VALUE OF THE
OPERATING CASH FLOWS GENERATED BY THE FIRM.
The Weighted Average Cost of Capital is
By Definition:
r0= WACC = rS S + rB B,
V
V
IT IS BY DEFINITION:
The Capitalization rate of the firm's total Operating Cash Flow
That is:
WACC = r0 = "cost of capital":
where r0 is the solution to:
V=
S
t=1
y(t)
(1+r0)t
.
In a frictionless environment:
r0= WACC =
= rS S + rB B
V
V
Proposition II:
Rearranging (1) that means that:
rS = ro + (ro - rB) B
S
BUSINESS RISK
THE RISK IMPOSED ON STOCKHOLDERS AS A RESULT OF
THE RISK OF THE FIRM'S OPERATING CASH FLOWS
FINANCIAL RISK
FINANCIAL RISK IS THE ADDITIONAL RISK IMPOSED ON THE
STOCKHOLDERS BY HAVING DEBT IN THE FIRM'S CAPITAL
STRUCTURE
Graphically:
%
Financial Risk
rB
Business Risk
r0
Weighted Average Cost of Capital
Cost of Debt
DEBT
IN SUMMARY: GIVEN PERFECT CAPITAL MARKETS,
THE COST (REQUIRED RETURN) OF EACH SECURITY
ISSUED BY THE FIRM MUST BE SUCH THAT:
THE WEIGHTED AVERAGE OF THE REQUIRED RETURN OF
EACH OF THE SECURITIES MUST BE EQUAL TO THE
REQUIRED RETURN ASSOCIATED WITH THE RISK OF THE
OPERATING CASH FLOWS OF THE FIRM. THE WEIGHTS ARE
THE RELATIVE MARKET VALUES OF EACH OF THE
SECURITIES.
So why do firms worry about capital
structure?
• If capital structure matters then we have to
look toward other factors
– Taxes
– “transaction” costs, here is what some call
“contracting” costs especially the costs
associated with financial distress
– Costly information
– Self interest of managers