1 Transparencies - Capital Structure

CAPITAL STRUCTURE AND THE FINANCING DECISION
The Basic Financing Choices: Equity and Debt

Common Equity
Ownership of the business and the right to manage and control the enterprise
Entitled to all residual income, i.e., profits after interest, taxes, and all other prior
claims. No guarantee of financial returns
Bears the residual risks of the business, but has limited liability
Debt
A contractual obligation on repayment of principal and compensation for the use
of the capital, which are not contingent on the financial performance of the
borrower
Senior to equity claims whether on the distribution of income, or the distribution
of assets in the event of the dissolution of the business
Generally fixed and predetermined return to lenders capital; interest payments
provide a tax shield for the borrower
Repayment of principal generally follows a predetermined schedule within a
specified period (the loan period)
Preferred Equity
A type of financing that lies between debt and common equity
Technically a form of equity, but typically do not have voting rights
Senior to common equity but subordinate to debt
Often has no definite maturity, but issuer sets either a redemption option,
conversion to common equity, or buyback in the secondary market
Investor cash income is in the form of dividends which are less binding than
interest payments but are senior to common dividends. Since preferred is a form
of equity, dividend payments dont have a tax shield.
R.C. Ybaez UP Cesar E.A. Virata School of Business
The Decision Criteria

The Financial Objective: Maximize shareholder value =
maximize market value of common stock
The Financing Criteria: The capital structure and financing policies that are
supportive of corporate strategies, and which
enhance shareholder value through a superior riskreturn payoff
The Use of Debt Finance to Enhance Shareholder Value

1. Financial Leverage
Use of fixed-rate debt, or financing with a limited rate of return, to fund
investments whose rate of return exceeds the cost of financing
Cost of debt is lower than the cost of equity because of the lower risk to
creditors
Positive leverage: when rate of return on invested capital1 (ROIC) >
after-tax cost of debt
Positive leverage enhances shareholder rate of return (ROE)
ROE is higher:
- the higher the ROIC
- the lower the interest rate or cost of debt
- the higher the debt-equity ratio
Leverage amplifies the impact of changes in operating rate of return on
ROE
Invested capital is total assets less non-interest bearing, spontaneous liabilities, e.g., accounts
payable. The peso return on invested capital is net operating profits after taxes (NOPAT);
percentage return is rate of return on invested capital (ROIC). For simplicity, we assume
throughout that there are no non-operating income and assets and hence, pre-tax operating profits
= EBIT. These measures are consistent with the WACC and valuation framework.
Table 1 Financial Leverage Without Tax Shield

No Debt
Debt:Equity Ratio
Debt at 8%
60:40
70:30
EBIT
Less: Tax (30%)
Net operating profit after tax
Less: Interest expense
Earnings available to common
shareholders
250,000
75,000
175,000
0
250,000
75,000
175,000
48,000
250,000
75,000
175,000
56,000
175,000
127,000
119,000
Return on Equity (ROE)

Payments to all suppliers
of capital
17.5 %
31.75 %
39.7 %
175,000
175,000
175,000
_______________________________________________________________________________
Assumed: operating assets or invested capital of P1 million, return on invested

capital (ROIC) of 17.5%, or 25% pre-tax
Table 2 ROE at Alternative EBIT and Financial Leverage

High EBIT1
No Debt
Debt:Equity Ratio
High EBIT1 High EBIT1

Moderate Debt Large Debt2
60:40
70:30
300,000
90,000
210,000
0
300,000
90,000
210,000
48,000
300,000
90,000
210,000
56,000

shareholders
210,000
162,000
154,000
21.0 %
40.5 %
51.3 %
210,000
210,000
210,000
EBIT
Less: Tax (30%)
NOPAT
Less: Interest expense (8%)
ROE
of capital
_____________________________________________
1
EBIT is 20% higher.

2
Assume no change in interest rate. Debt is 70% of invested capital.
3
2. Tax Benefits
Financing options that produce net tax benefits enhance value
Interest payments are deductible from taxable income; on the other
hand, payments to shareholders (cash dividends) do not provide a tax
shield
REMEMBER: principal payment is not an expense!
Table 3 Financial Leverage With Tax Shield

No Debt
Debt:Equity Ratio
Debt at 8%
60:40
70:30
EBIT
Less: Interest Expense
EBT
Less: Tax (30%)
shareholders
250,000
0
250,000
75,000
250,000
48,000
202,000
60,600
250,000
56,000
194,000
58,200
175,000
141,400
135,800
Return on Equity (ROE)

of capital
17.5 %
35.4 %
45.3 %
175,000
189,400
191,800
ROE = r +
D
[ r kd (1 tc)]
E
where r = ROIC
[ in illustration, 17.5% = 25% (1 0.3) ]
kd = interest rate on debt

tc = corporate income tax rate
Note: In using this formula, if there are other non-equity financing, e.g.,
preferred stock, include these under the category debt
4
Table 4 ROE at Alternative EBIT and Financial Leverage

with Tax Shield
High EBIT
No Debt
Debt:Equity Ratio
High EBIT
High EBIT
Moderate Debt Large Debt
60:40
70:30
300,000
0
300,000
90,000
300,000
48,000
252,000
75,600
300,000
56,000
244,000
73,200

shareholders
210,000
176,400
170,800
21.0 %
44.1 %
56.9 %
210,000
224,400
226,800
EBIT
Less: Interest expense
EBT
Less: Tax (30%)
ROE
of capital
Qualification 1: Increased ROE Volatility

Higher risk to shareholders due to increased ROE volatility
Negative Leverage: ROIC < after-tax cost of debt
ROE of debt option < ROE of equity option
ROE volatility for levered firm is higher:
- the higher the operating risks (the more risky the business)
- the more volatile the interest rate environment
- the greater the mismatch between operating and financing cash flows (in
terms of currency, interest rate basis, etc.)
Table 5 Financial Leverage and Volatility of ROE

ROE at pre-tax
ROIC = 25 %
ROE at pre-tax
% Decrease
ROIC = 15 %
Unlevered (0:100)
17.5 %
10.5 %
40.0 %
Moderate Debt (60:40)
35.4 %
17.9 %
49.4%
Large Debt (70:30)
45.3 %
21.9 %
51.6 %
Table 6 Sensitivity Analysis of Moderate Debt Case

(% Change Relative to Base Case)
% Decrease in pre-tax ROIC
% Decrease in ROE
20 %
24.8 %
40 %
49.5 %
60 %
74.3 %
80 %
99.0 %
Table 7 Sensitivity Analysis of Large Debt Case

(% Change Relative to Base Case)
% Decrease in pre-tax ROIC
% Decrease in ROE
20 %
25.8 %
40 %
51.5 %
60 %
77.3 %
80 %
103.1 %
EBIT-EPS Chart: analyzing the interaction between operating and

risks
financing
EPS
0.57
0.5
0.4
0.3 0.28
0.2
0.1 0.09
0
48
80
100
150
200
250 EBIT
Levered firm has steeper slope: EPS fluctuations will be larger

Break-even EBIT: EBIT level where EPSe = EPSd
EPSe for all-equity
EBIT(1 t c )
625,000
EPSd for levered equity
(EBIT 48,000)(1 t c )
250,000
Break-even EBIT = 80,000 and EPS = 0.09 for both schemes

The risk of negative leverage: what is the likelihood that EBIT will fall below
the break-even level of P80,000?
Note: include other non-equity cost of financing, e.g., dividends of preferred stocks, if
present
7
Modigliani-Miller (M-M) Arbitrage: Does Debt Matter?

(assuming perfect capital markets and zero taxes)
Company A (Unlevered) Company B (Levered)
(P600,000 debt at 8%)
Operating income
Interest Expenses
Earnings to Common
P 175,000
0
175,000
P175,000
48,000
127,000
Cost of Equity (ke)

Value of Equity (Ve)
Value of Debt (Vd)
Value of Firm (V=Ve + Vd)
15.75%
1,111,111
0
1,111,111
20.0%
635,000
600,000
1,235,000
15.75%
0
14.17%
150%
Cost of capital (WACC)

Debt/Equity Ratio
Consider now an investor who owns 1% of Company B:

he has an equity of P6,350 on which he earns annually P1,270
this corporate equity is leveraged up to 1.5x of equity at a cost of 8%
Suppose he now:
sells his shares in Company B (gets P6,350 cash, loses P1,270 income)
borrows P6,000 at 8%, i.e., assumes personal leverage equivalent to 1% of B's
debt and hence is leveraged to the same degree as B.
buys 1% of Company A's equity for P11,111.11 - hence, releasing P1,238.89 of
his personal funds
Net returns to the investor:
Investment income (P11,111.11 x 15.75%)
Less interest (P6,000 x 8%)
Net income
P 1,750
(480)
P1,270
Investor is obviously better off selling the levered stock and substituting personal
leverage and investing in the unlevered stock. This arbitrage operation will drive B
prices down and/or A prices up. The process must stop at a point where the market
value (and cost of capital) of both firms will be equal.
The Combined Effect of Corporate and Personal Taxes

Operating Income (P 1)
Paid out as interest
Corporate Tax
None
tc
Income after corporate

tax
1 tc
Personal Tax
td
te(1 tc)
(1 td)
(1 te)(1 tc)
Income after all taxes

tc
td
te
or paid out as dividend
= corporate tax rate

= personal tax rate on lenders interest income
= personal tax rate on shareholders dividend income
Corporations benefit from the corporate tax shield, but the interest income may be taxed at
the personal level. Investors presumably decide on the basis of after-tax returns. A higher
tax on interest income means investors will avoid lending unless interest rates increase to
compensate for the higher tax. Thus, taxes on interest income reduce the advantage of
corporate debt. Taxes on equity income on the other hand increase the advantage of
corporate debt.
Debt will have a net tax advantage if :
(1 td) > (1 tc) (1 te) or T = 1
(1 t c )(1 t e )
>0
(1 t d )
It can be shown that the value contribution of debt is TVd. Note that if personal taxes are
disregarded, the value contribution of debt is tcVd.
Other qualifications to the tax benefit from debt: taxes on secondary trading of
securities, alternative tax shelters of the enterprise, etc.
Qualification 2: Risk of Default and Financial Distress

Operating, Investment and Financing Cash Flow, Year 1
Average EBIT
No
Debt
Earnings after Tax
Moderate
Debt
Low EBIT1
No
Debt
Moderate
Debt
175,000
141,400
105,000
71,400
50,000
50,000
50,000
50,000
Investment (Capex and

working capital)
( 50,000)
( 50,000)
( 30,000)
( 30,000)
Operating & invest. CF
175,000
141,400
125,000
91,400
Depreciation
Payment of Principal2
Cash Surplus (Deficit)
(120,000)
175,000
21,400
(120,000)
125,000
( 28,600)
____________________
1
Pre-tax ROIC of 15%, or 40% lower than average pre-tax ROIC
Assuming equal principal payments over a 5-year term, 8% interest rate
Risk of default and financial distress is higher

- the higher the operating risks (the more risky the business)
- the greater the mismatch between operating and financing cash flows (i.e.,
mismatch in maturity, currency, etc.)
- the less liquid are assets; the lower the proportion of tangible assets
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Long-term liquidity needs to be managed

- match assets and liabilities: match operating cash flow with debt service
(short-term financing is cheaper but increases default risk)
- matching cash flows may require lengthening maturities, grace periods,
bullet repayments, etc.
- use financing instruments with flexible cash flow requirements, e.g.,
preferred stocks, convertibles, etc.
- maintain liquidity reserves in cash and near-cash assets, excess borrowing
capacity, etc. (dont run out of cash)
Qualification 3: Direct and Indirect Costs of financial distress
Direct Costs: Administrative costs, cost of lawyers, auditors, financial advisers,
etc., as the two parties attempt to resolve a conflict situation2
Indirect Costs
loss of market share and increased business risk. If safety, health, quality
and/or after-market relationships are important concerns, customers may
take their business elsewhere
loss of key employees who are concerned about job security
loss of suppliers: particularly those who need to invest long-term, e.g., who
invest in specialized equipment, or must hire specialized skills or spend on
specialized training to do business with borrower
(these ideas are often referred to as the stakeholder theory)
Weak regulatory structure and poor enforcement of bankruptcy laws impact on these costs. In
February 2010, 10 years after the bill was first filed, the Financial Rehabilitation and Insolvency
Act was finally passed.
11
reduced flexibility to address operating problems. Creditors will want to

conserve and secure assets. Their actions could restrict the ability of the
borrower firm to manage and redeploy assets, or dispose of assets
valuable management time is diverted to dealing with creditors and
receivers
dynamics of competition may become less predictable. Competitors, smelling
blood, may launch predatory attacks (e.g., price war). Or the distressed firm
may itself initiate a price war to grab market share and raise cash in the
short run
12
Qualification 4: Agency Costs and Loan Covenants

Option and agency theories suggest that levered firms may attempt to
maximize shareholder value at the expense of creditors
Some ways that borrowing firms can do this:
- owner-borrower will resist liquidation: playing for time
- underinvestment in positive NPV projects
- asset substitution that increases the riskiness of the business (e.g., investing
in high risk, negative NPV projects)
- bias for short-term investments
- the dilution of the claims of existing creditors through the issuance of
additional debt of higher or equal priority: bait and switch
- excessive withdrawals by shareholders: take the money and run via cash
dividends, share repurchases, DOSRI loans, excessive compensation for
owner-managers, sweetheart deals with subsidiaries/affiliates
Loan covenants: the fine print of loan agreements that guard against such
types of borrower misbehavior and the resulting dilution in the value of
creditor claims
To the borrowing firm, covenants are an added burden/cost:
- reduce flexibility and dilute control, e.g., restrictions on investments
- ultimately costly as creditors may pass on their monitoring and
enforcement cost to the borrower by way of higher interest rates
If lenders are not convinced that the borrower will comply, or if
enforcement cost is too high, lenders will simply not provide funding
13
The Case of the Financially Distressed Company
Capital
Periodic Cash Flow

2
3
4
Book value
1,000,000
175,000
Debt (8%, 5
years)
600,000
Equity
400,000
(168,000)
65,000
65,000
65,000
(158,400) (148,800)
(139,200) (129,600)
The firms cost of capital is 15.75%

PV of firm = PV of future cash flows =
175,000
65,000
+
= 507,731
1.1575 0.1575(1.1575)
So,
1. Firm is not yet in default on its debt, but it will default by year 2 if there is no significant
improvement in operating cash flows.
2. In fact, the value of the firm is less than its liabilities in essence, the firm is bankrupt!
The value of the equity in theory is zero; in PV terms, only creditors capital has any
significant value. (Option theory however says that the market value will not be zero for
as long as shareholders remain the legal owners. Equity value in this case is purely option
value)
Now, it is often the case that a financially distressed company may still have profitable
investment opportunities (i.e., NPV > 0), or maybe even a plan to restructure operations.
But this will now require external financing.
Suppose one such investment opportunity has the following cash flow:
Period
Cash flow
0
(85,000)
35,000
35,000
35,000
35,000
35,000
At the current cost of capital, PV of future CF is P115,272 for an NPV of P30,272

Questions:
1. Will existing shareholders be willing to infuse the additional financing? Would other
investors be willing to? Would creditors? Under what general terms?
2. What feasible options are there to manage the debt overhang and service the debt? Under
what general terms?
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The Shortsighted Investment Problem

Cash Flows of Textronics
Debt Due
From Existing
Assets
From ShortTerm Project
From LongTerm Project
Year 1 P100 million
P 50 million
P 50 million
P 20 million
Year 2
60 million in
favorable state
0 million
40 million
40 million
10 million in
unfavorable state
To simplify the illustration, assume that the risk-free rate is zero, both cash flows are certain, and
the long-term project has a higher PV than the short-term project.
The cash flow from existing assets on the other hand is certain for year 1, but uncertain for year 2.
The probability of favorable vs. unfavorable state in year 2 is 50:50.
If Textronics chooses the long-term project:
NPV will be higher, but

company will not be able to service debt in year 1 from operating cash flow (P100 million vs.
P70 million); it will need to borrow P 30 million in subordinated debt
If the new debt is subordinated to existing debt, the firm must promise to pay P50 million in
year 2. This ensures an expected value of P30 million: (50% x P50 m) + (50% x P10 m).
Notice that in the unfavorable state, existing debt can still be paid (P10 m + P40 m vs. P40 m)
but only P10 m will be available for subordinated debt.
If Textronics chooses the short-term project:
NPV will be lower

it will be able to meet its debt obligations in year 1 (P100 million outflow vs. P100 million
inflow)
What project will Textronics pursue? If year 2 results in an unfavorable state, Textronics will
default regardless of the project it pursues and the value of equity will be zero. If year 2 results in
a favorable state, the value of the firms equity is:
P 10 m if the long-term project is taken: (P60 m + P40 m) (P40 + P50)
P 20 m if the short-term project is taken: P60 m P40 m
Textronics will therefore choose the short-term project. Shareholders gain at the expense of
existing creditors who are better off if the long-term project is chosen.
15
Bankruptcy and Liquidation Decisions of Firms

with More Than One Class of Debt
Mayer Inc. has no cash flow in the current period, but will have cash flows of P1.5 million next
year if the economy is favorable and P0.5 million if the economy is unfavorable (with equal
probabilities for the two states). Assuming risk neutrality and a zero discount rate, the operating
value of the firm is therefore P1 million.
Also assume that if the firm were liquidated immediately, it would generate P1.2 million in
proceeds. Hence, if the firm were financed entirely with equity, shareholders would choose to
have the firm liquidated immediately.
The firms debt obligations are listed below. The venture capitalist is subordinated to the other
creditors.
Debt Obligations
Debt Holders
Venture Capitalist
Immediate
Next Year
P 150,000
P 1,000,000
200,000
Mayer will be forced into bankruptcy if it cannot meet its P150,000 current obligation. If this
happens, all of its debt obligations become due immediately and the debt holders will take control
of the firm. The payoffs shows clearly that debt holders will want to liquidate because they can
still be paid in full. Note that the junior debt held by the venture capitalist will only get back
P50,000 of the P200,000 debt owed them by Mayer (P1.2 million liquidation value less senior
debt of P1.15 million). Shareholders get nothing.
Payoff in the Event of Liquidation
Debt Holders
Venture Capitalist
Stockholders
16
P 1,150,000
50,000
0
The table below suggests that both shareholders and the venture capitalist have an incentive to
avoid liquidation - even though the firms value is maximized if the firm is liquidated. For
example, the venture capitalist might be persuaded to infuse an additional P150,000 cash to pay
off the immediate claim of debt holders. Shareholders would be willing to pay very high interest say P100,000, or an effective rate of 67%.
The venture capitalist would effectively invest P200,000 (cash infusion of P150,000 plus
foregone liquidation proceeds of P50,000) for a 50% chance to earn P450,000. He would receive
zero otherwise, for an expected value of P225,000.
Shareholders have a 50% chance of receiving P50,000 which is better than a zero value if the firm
is liquidated immediately.
Note that debt holders are worse off since they effectively forego P1 million today (P1.15 million
from liquidation, minus P150,000 immediate payment they would have received anyway) in
exchange for a payoff with an expected value of P750,000.
Payoffs in the Event of a Cash Infusion
Next Year States of the Economy

Immediate
Favorable
Unfavorable
Debt Holders
P 150,000
P 1,000,000
P 500,000
Venture Capitalist
150,000
450,000
50,000
Stockholders
Can the shareholders of Mayer be persuaded to infuse additional equity of P150,000? Not likely,
there is no incremental gain for them - the payoff from an infusion is P300,000 in a favorable
state, and zero in an unfavorable state, or an expected value of P150,000.
17
Examples of Loan Covenants

Standard Covenants
1. Monitoring disclosures and furnishing of regular financial reports.
Undertaken by credit rating agencies in the case of bonds
2. Financial ratio requirements liquidity, debt ratios, etc.
3. Conservation and maintenance of assets property taxes, insurance,
equipment maintenance, etc.
4. Collateral secures claim of senior creditors, especially in the event of
liquidation. Mitigates other possible borrower misbehavior
Covenants intended to deter asset substitution
1. Collateral requirement prevents sale of asset wherein cash proceeds may
then be reinvested elsewhere, or its use to acquire more debt
2. Restrictions on investments in unrelated businesses, mergers, acquisitions
Covenants to deter attempts to take the money and run
1. Restrictions on cash dividends and the repurchase of stocks, on
compensation to owner-managers, DOSRI advances, etc.
2. Restrictions on transactions with subsidiaries and affiliates
Protective covenants need to be monitored and enforced, which can be costly.
Also, covenants alone cannot solve all possible borrower-creditor conflicts.
Alternative approaches include:
Security design
Short term debt vs long term debt
Bank and privately placed debt vs bonds
18
The Trade-Off Theory of Capital Structure
There is an optimal capital structure that results from balancing tax

shield benefits vs bankruptcy and agency costs
In theory, capital structure is optimal at the minimum WACC. In
practice, firms likely aim for a credit rating corresponding to the
target capital structure, rather than target WACC
In general, higher debt-ratios for firms with:
stable businesses, mature businesses (lower operating risk). This
implies that firms in the same industry will have comparable capital
structures
high profitability (more taxable income to shield)
more tangible assets (collateral, lower risk of asset substitution)
more liquid assets
regulated firms (regulatory oversight lowers risk for creditors,
transparency)
Other Financing Sources of Value

1. Regulatory Constraints and Regulatory Costs
Avoidance of regulatory constraints/costs
2. Transactions Cost, Liquidity and Trading Costs
Transactions costs of external finance, particularly capital market (nonbank) transactions. Internally generated funds, i.e., retained earnings, do
not have transactions costs
Liquidity investors value liquidity, e.g., via a secondary market,
especially liquidity of long-term securities
Taxes and fees on secondary trades can reduce liquidity
19
3. Information Asymmetry and Financial Signaling

Information asymmetry: insiders (managers and major shareholders)
know more than outsiders (creditors/investing public)
Disclosure laws, financial reporting rules and third-party evaluation, e.g.,
credit rating agencies, mitigate the information asymmetry
The lemon problem: investors/lenders worry that the firm will take
advantage of their superior information. Market could react by
underpricing debts/equity issues of the firm
The information value of business decisions: what firms do (more than
what they say) can signal to capital markets the financial health and
prospects of the firm
4. Financial Engineering and Financial Innovation

As in any business, product innovations can be important sources of
value. Financing instruments that address an unmet demand for certain
return or risk characteristics can create value for the firm. Or products
that match the riskiness of the product with the risk management
capabilities of the investor
Financial innovations can mitigate information asymmetry (e.g.,
convertibles), reduce transactions cost (e.g., shelf registration), enhance
liquidity (e.g., ETFs), mitigate specific types of risks (e.g., reinvestment
risk is avoided via zero coupon bonds), permit specific risks to be traded
(e.g., credit default swaps that trade credit risks), etc.
Caveat for issuers of innovative securities: financial products generally
dont have patent protection, so issuers should cash in quickly on their
innovations
Caveat for investors: the complexity of a financial product is not
necessarily an indication of a well-crafted product. Maybe the products
complexity is deliberate to mask the true value, or risk, of the product
(examples are the subprime securities like CDOs and CDO-squared)
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5. Corporate Control
Capital structure choices impact on corporate control
Corporate control is the power to direct and manage the business. Its
value derives mainly from the value of management.
For example, hostile takeovers often lead to changes in management and
to asset restructuring, disposal of poorly performing assets changes
whose aim is to increase cash flow and/or reduce risk
Via a pyramid structure, control rights are partially delinked from cash
flow rights. This can be a financing advantage: minority equity, like debt
capital, can be tapped without unduly diluting controlling shareholders
control rights (see chart)
The dark side of corporate control: pyramiding provides opportunities
for controlling shareholders to expropriate value from minority
shareholders (an agency conflict similar to that faced by creditors)
9 diversion of resources to companies owned by the controlling shareholders
9 transfer of resources at terms/price disadvantageous to the target company
9 acquisition of additional cash-flow rights, e.g., warrants at below fair value
issued directly to the controlling shareholders or indirectly through
companies owned by controlling shareholders
9 access to firms technology, management systems, business intelligence, etc.
that are beneficial to the controlling shareholders business interests.
9 above-normal compensation and perks for controlling shareholders who
serve as officers/directors
These can be mitigated by regulations that protect the rights of minority

shareholders
One international study has half of its Philippine sample operating
through the pyramid structure. Another study shows that the greater the
difference between control rights and cash flow rights, the lower is
shareholder value
21
Illustration of Pyramiding: Leveraging Control

Base Structure
Pyramid Structure
Assume P100 equity
Holding company
Minority
Founders
25%
75%
P20
P60
Minority
Founders
Minority
Holding co.
40%
60%
20%
80%
P40
P60
P20
P80
Alternatively,
Holding company
Minority
Minority
22
Founders
30%
70%
P15
P35
Holding co. Founders
25%
50%
25%
P25
P50
P25
Scenario: Additional minority equity of P20; total dividends of P10

Base Structure
Pyramid Structure
Holding company
Minority
Founders
25%
75%
P20
P60
1.67
Addl.
Minority Founders
Minority
50%
P20
P40
5.00
P10
5.00
Minority
5.00
Holding co.
50%
33%
67%
P60
P40
P80
3.33
6.67
P10
1. The new equity reduces founders ownership to a fragile 50% in the base
case; in the pyramid structure, they retain effective control
2. Founders get exactly the same dividends in both structures (note: typically,
dividends to corporate shareholders are exempt from taxes)
23
A Recap of Trade-Off Theory

Implies an optimal capital structure (debt-to-equity ratio):
a tradeoff between tax benefits from leverage versus financial distress costs
Some Implications of Trade-Off Theory
The optimal debt ratio is higher:
1. the less risky the business. This suggests firms in the same business (hence,
of comparable business risk) will tend to have similar debt ratios
2. the more profitable is the business (need for tax shield)
3. the greater the proportion of tangible assets (collateral) in total resources
Debt ratios will be lower for firms with significant growth opportunities. (asset
substitution problems for creditors).
Trade-off theory suggests that capital structure will adjust to changes in tax
rates and the tax structure
Stakeholder Theory: businesses that require long-term relationships with
customers and other stakeholders will avoid risky debt, e.g., firms with high
value employees with specialized skills/knowledge; firms where safety/health,
after-market service, replacements parts are crucial to buyer choice; firms who
rely heavily on long-term suppliers and subcontractors, etc.
Firm Size and Leverage: high debt-ratios for large firms?
economies of scale; capital market transactions have significant fixed costs
large firms more likely to have diversified cash sources, have market power,
etc. which are good attributes to the lender
larger firms also tend to be listed companies; disclosure rules mitigate
information asymmetry problem
24
The Free Cash Flow Problem

An agency problem: managers (the agent) self-interest may run counter to
the best interest of shareholders (the principal)
Example: managers may overinvest. Their compensation/perks tend to be
higher, the greater the resources and the larger the organization they
control
Debt can mitigate this - debt service requirements reduce free cash and the
opportunities for managers to use the cash on unprofitable projects and on
perks; while loan covenants restrict managers ability to use the cash
The Empirical Evidence:
Is Trade-Off Theory Supported by Actual Practice?
1. Trade-off theory would suggest that more profitable firms will have higher
debt ratios since debt can be used to shield profits from taxes. Data however
show that debt ratios are lower for the more profitable firms (US and Phils).
2. Data also show that debt ratios vary widely among firms in the same
business or industry (US)
3. There is a general reluctance among firms to tap the equity market (US)
4. Empirical research show that share prices react negatively to corporate
announcements to tap the capital market (e.g., via bond issues and new
shares). Price reaction is greater for equity issues than for bond issues (US)
5. Firms with significant growth opportunities have higher debt ratios (US and
Phils). Recall that trade-off theory suggest the reverse on the premise that
lenders are wary of asset substitution risks when a firm has significant
growth options
25
An Alternative Theory: The Pecking Order Hypothesis

Information asymmetry (managers and insiders know more than other
stakeholders) is a much more important consideration than tax benefits. The
key consequence of information asymmetry is the potential underpricing of
securities when the firm raises external financing.
Rather than aim for an optimal debt ratio, firms follow a pecking order: (1)
internal finance (2) debt (bank loans first, then bonds) (3) quasi-equity such as
preferred stocks (4) new issues of common shares
Implications of Pecking Order Hypothesis
1. Not all firms will have a target capital structure, i.e., an optimal debt ratio
2. The firms debt ratio will simply be the byproduct of the firms ability to
generate internal finance (from profits) and its demand for funds
(investments and dividends). Thus, firms in the same industry can have very
different debt-ratios
3. The more profitable the firm, the lower its debt ratio since firms will prefer
to tap internally generated funds rather than external sources
4. If a firm has to tap external funding, go for the safer options first, i.e.,
lower risk of underpricing: debt before equity, bank loans before bonds.
Hence, when firms resort to financing choices that are near the bottom of the
pecking order, e.g., new equity issues, this sends negative signals to investors
5. Financial slack (liquid assets and borrowing capacity) is important: it
minimizes the need to issue new equity (the choice at the bottom of the
pecking order). The maintenance of financial slack generally leads to
conservative financing policies
6. Firms with significant growth opportunities will tend to have higher debt
ratios. Firms which are very profitable but have limited growth
opportunities will tend to pay off debt first
26
Where is Capital Structure Theory Today?

At present, there is no single theory that can explain all the variations we
observe about firms capital structures. The two main theories disagree on
whats more important to firms. Some factors are more important to some
types of firms and less so for others, which can lead to highly divergent choices
of financing.
Modiglian and Miller remind us that figuring out the optimal capital structure
shouldnt matter that much. Brealey and Myers argue that value derives
largely from good investment choices, less so on the financing choices firms
make. A firm should therefore choose a financing structure that best supports
its investment program and business strategy, while ensuring that its financing
choices dont lead to financial distress and the failure of an otherwise
profitable enterprise.
27

1 Transparencies - Capital Structure

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CAPITAL STRUCTURE AND THE FINANCING DECISION

The Basic Financing Choices: Equity and Debt

R.C. Ybaez UP Cesar E.A. Virata School of Business

The Decision Criteria

The Use of Debt Finance to Enhance Shareholder Value

Table 1 Financial Leverage Without Tax Shield

Return on Equity (ROE)

Assumed: operating assets or invested capital of P1 million, return on invested

Table 2 ROE at Alternative EBIT and Financial Leverage

High EBIT1 High EBIT1

Earnings available to common

EBIT is 20% higher.

R.C. Ybaez UP Cesar E.A. Virata School of Business

Table 3 Financial Leverage With Tax Shield

Return on Equity (ROE)

[ in illustration, 17.5% = 25% (1 0.3) ]

kd = interest rate on debt

R.C. Ybaez UP Cesar E.A. Virata School of Business

Table 4 ROE at Alternative EBIT and Financial Leverage

Earnings available to common

Qualification 1: Increased ROE Volatility

R.C. Ybaez UP Cesar E.A. Virata School of Business

Table 5 Financial Leverage and Volatility of ROE

Moderate Debt (60:40)

Large Debt (70:30)

Table 6 Sensitivity Analysis of Moderate Debt Case

Table 7 Sensitivity Analysis of Large Debt Case

% Decrease in pre-tax ROIC

R.C. Ybaez UP Cesar E.A. Virata School of Business

EBIT-EPS Chart: analyzing the interaction between operating and

Levered firm has steeper slope: EPS fluctuations will be larger

EPSd for levered equity

Break-even EBIT = 80,000 and EPS = 0.09 for both schemes

R.C. Ybaez UP Cesar E.A. Virata School of Business

Modigliani-Miller (M-M) Arbitrage: Does Debt Matter?

Cost of Equity (ke)

Cost of capital (WACC)

Consider now an investor who owns 1% of Company B:

R.C. Ybaez UP Cesar E.A. Virata School of Business

The Combined Effect of Corporate and Personal Taxes

Income after corporate

Income after all taxes

or paid out as dividend

= corporate tax rate

(1 td) > (1 tc) (1 te) or T = 1

R.C. Ybaez UP Cesar E.A. Virata School of Business

Qualification 2: Risk of Default and Financial Distress

Investment (Capex and

Operating & invest. CF

Pre-tax ROIC of 15%, or 40% lower than average pre-tax ROIC

Assuming equal principal payments over a 5-year term, 8% interest rate

Risk of default and financial distress is higher

R.C. Ybaez UP Cesar E.A. Virata School of Business

Long-term liquidity needs to be managed

R.C. Ybaez UP Cesar E.A. Virata School of Business

reduced flexibility to address operating problems. Creditors will want to

R.C. Ybaez UP Cesar E.A. Virata School of Business

Qualification 4: Agency Costs and Loan Covenants

R.C. Ybaez UP Cesar E.A. Virata School of Business

The Case of the Financially Distressed Company

Periodic Cash Flow

The firms cost of capital is 15.75%

At the current cost of capital, PV of future CF is P115,272 for an NPV of P30,272

R.C. Ybaez UP Cesar E.A. Virata School of Business