Capital Structure, Debt, and Value: Financial Accounting Study Notes

Value and Capital Structure

Definition and Components

Capital structure refers to the mix of long-term debt and equity financing used by a firm. The value of a firm is determined by the market value of its assets, which is financed by a combination of debt and equity.

• Capital Structure: The proportion of debt and equity in a firm's financing.

• Restructuring: Changing the firm's capital structure without altering its real assets.

Assets	Liabilities and Stockholders' Equity
Value of cash flows from firm's real assets and operations	Market value of debt
Value of Firm	Market value of equity
	Value of Firm

Average Book Debt Ratios

Industry Comparisons

Debt ratios vary across industries, reflecting different capital structure strategies and risk profiles.

Industry	Debt Ratio	Industry	Debt Ratio
Pharmaceuticals	0.07	Paper	0.40
Semiconductors	0.24	Aerospace	0.40
Computer software	0.26	Chemicals	0.41
Food	0.32	Clothing	0.46
Oil	0.35	Autos	0.46
Machinery	0.35	Utilities	0.49
Construction	0.39	Retail	0.53
Transportation	0.40	Telecoms	0.55

Note: Debt to total capital ratio is $D/(D+E)$, where $D$ and $E$ are the book values of long-term debt and equity.

Modigliani and Miller (MM) Theory: Debt Policy Doesn't Matter

Core Proposition

Modigliani and Miller (MM) propose that in a world without taxes and with perfect capital markets, a firm's value is unaffected by its capital structure. This means that the mix of debt and equity does not influence the total market value of the firm.

• Assumptions: No taxes, no bankruptcy costs, no effect on management incentives, and sufficient alternative securities for investors.

• Implication: Financial managers cannot increase firm value by changing the mix of securities used for financing.

MM Example: All Equity vs. 50% Debt

Data	All Equity	50% Debt
Number of shares	100,000	50,000
Price per share	$10	$10
Market value of shares	$1,000,000	$500,000
Market value of debt	-	$500,000

Outcome	Slump	Expected	Boom
Operating income	$75,000	$125,000	$175,000
Earnings per share (all equity)	$0.75	$1.25	$1.75
Return on shares (all equity)	7.5%	12.5%	17.5%
Interest (50% debt)	$50,000	$50,000	$50,000
Equity earnings (50% debt)	$25,000	$75,000	$125,000
Earnings per share (50% debt)	$0.50	$1.50	$2.50
Return on shares (50% debt)	5%	15%	25%

Key Point: Borrowing increases earnings per share (EPS) but does not affect total firm value under MM assumptions.

How Borrowing Affects Risk and Return

Types of Risk

• Operating Risk (Business Risk): Risk inherent in the firm's operating income due to business activities.

• Financial Risk: Additional risk to shareholders resulting from the use of debt financing.

• Financial Leverage: Use of debt to amplify the effects of changes in operating income on returns to stockholders.

• Interest Tax Shield: Tax savings from the deductibility of interest payments.

MM's Proposition II

Relationship Between Debt and Cost of Equity

MM's Proposition II states that as a firm increases its debt, the expected return on equity rises due to increased financial risk, while the expected return on assets remains constant.

• With Fixed Interest Rate: $r_{equity} = r_{assets} + (D/E) (r_{assets} - r_{debt})$

• With Risky Debt: The cost of debt increases with risk, and bankruptcy risk is included.

Graphical Representation: The rate of return on equity increases with the debt-equity ratio, while the return on assets remains unchanged.

Capital Structure and Corporate Taxes

Tax Shield and Firm Value

In the presence of corporate taxes, debt financing creates value by providing a tax shield. The interest paid on debt is tax-deductible, reducing taxable income and increasing cash flows to both equity and bondholders.

• Present Value of Tax Shield: $PV_{tax ext{ shield}} = D \times T_C$ (assuming perpetuity)

• Example Calculation: For $500,000$ debt at $10 ext{%}$ interest and $21 ext{%}$ tax rate, tax benefit is $500,000 \times 0.10 \times 0.21 = $10,500$.

• PV of $10,500$ perpetuity at $10 ext{%}$ rate: $\frac{10,500}{0.10} = $105,000$

Example: Debt vs. Equity Financing

	All Equity	½ Debt
EBIT	$10,000	$10,000
Interest payment	0	$3,000
Pretax income	$10,000	$7,000
Taxes at 21%	$2,100	$1,470
Net cash flow	$7,900	$5,530

Total Cash Flow: All Equity = ½5,530 + 8,530

Financial Distress

Costs and Impact on Firm Value

Financial distress refers to the costs arising from bankruptcy or suboptimal business decisions made before bankruptcy. These costs reduce the value created by the tax shield from debt financing.

• Market Value of Firm: $= \text{Value if all Equity Financed} + PV_{tax ext{ shield}} - PV_{costs ext{ of financial distress}}$

• Optimal Debt Level: The point where the marginal benefit of the tax shield equals the marginal cost of financial distress.

Financing Games

Shareholder-Debtholder Conflicts

Financing games illustrate conflicts between shareholders and debtholders, especially when firms are threatened with default.

• Risk Shifting: Firms may take riskier investments to benefit shareholders at the expense of debtholders.

• Debt Overhang: Firms may avoid positive-NPV projects if bondholders capture part of the value added.

• Loan Covenant: Agreements that require firms to meet certain conditions to protect lenders.

Financial Choices

Theories and Practical Considerations

• Trade-off Theory: Firms balance the tax benefits of debt against the costs of financial distress to determine optimal debt levels.

• Pecking Order Theory: Firms prefer internal financing, then debt, and lastly equity issuance.

• Financial Slack: Maintaining access to cash or debt financing for flexibility.

Costs of Financial Distress: These include bankruptcy costs and distorted business decisions before bankruptcy.

Summary Table: Key Theories of Capital Structure

Theory	Main Idea
MM Theory	Capital structure does not affect firm value in perfect markets without taxes.
Trade-off Theory	Optimal debt balances tax shield and financial distress costs.
Pecking Order Theory	Firms prefer internal funds, then debt, then equity.

Additional info: These notes expand on the original slides by providing definitions, formulas, and context for each concept, ensuring a self-contained study guide for Financial Accounting students.