Financial Management

Capital Structure and Cost of Capital

Dr. M.Thiripalraju

Indian Institute of Capital Markets

Capital Structure
WACC Rw (1 z ) Rs zRb
Where z = B / (S+B) is the proportion of debt finance and
(1-z) = S / (S+B) is the proportion of equity finance. Rw is
known as the weighted average cost of capital, WACC.

Capital Structure
The WACC is a weighted average of the cost of equity /
share finance and the cost of debt/bond finance
The value of the firm is:

$Y
V
WACC

Capital Structure

Minimising the WACC will also maximise the value of the

firm

Capital Structure
The capital structure question merely asks whether it makes any
difference to the market value of the firm V if the firm is financed
by all equity (z = 0), all debt (z = 1) or a mixture of equity and debt
(0<z<1).
The crucial question is whether an increase in leverage z leads to
a fall in Rw and hence an increase in the value of the firm.

Traditional View: Cost of Capital

Cost of capital

Equity, Rs
WACC
Debt, Rb

(B/S)*

Debt-to-equity ratio (B/S)

Capital Structure
Franco Modigliani and Merton Miller, in a landmark 1958 paper,
argued against the traditional view They stated that (under
certain conditions) the value of the firm is independent of the mix
of debt-to-equity finance).

WACC and Leverage

Let us see how the WACC varies as we alter the level of leverage
z. Suppose Rb = 10% p.a. To start the ball rolling, if leverage z =
20%, let us assume shareholders require Rs = 15% p.a. Hence:
Rw = (1 z) Rs + zRb = 0.8 (15%) + 0.2 (10%) = 14%
If we increase leverage to z = 50% and Rs remains unchanged at
15% then:
WACC Rw = 0.5 (15%) + 0.5 (10%) 12.5%
The value of the firm V = Y / WACC will increase as the debt level
initially increases.

WACC and Leverage

The Modigliani-Miller assumption is that as leverage z increases
from z0 = 0.2 to z1 = 0.5 then Rs will rise, but it rises just enough
so that Rw remains constant. For example, in a Modigliani Miller
world the required return by shareholders Rs would rise to 18%
p.a. as leverage increased to 50%, so that Rw remains unchanged
at 14%.
Rw = 0.5 (18%) + 0.5 (10%) = 14%

Leverage and the Return on Equity

Capital raised = $10m = S + B = shares + debt (bonds)
Cost of debt = 10%

1. Poor

Earnings before interest Yi (equal probability) 0.5

2. Average

3. Good

A. 100% equity (0% leverage)

(S = $10m equity)
Debt interest rB

Earnings/dividends for shareholders

$0.5

$200

$4

Return on shares Ri = Div / S

0.5/10 = 5%

2/10 = 20%

4/10 = 40%

Expected return (standard deviation)

21.7% (14.3)

B. 20% levered (z = B/V = 2/10)

(B = $2m debt, S = $8m equity)
Debt interest rB

$0.2

$0.2

$0.2

Earnings/dividends for shareholders

$0.3

$1.8

$3.8

Return on shares R = Div / S

0.3/8 = 3.75%, 1.8/8 = 22.5%, 3.8/8 = 47.5%

Leverage and the Return on Equity

1. Poor

2. Average

3. Good

Earnings before interest Yi (equal probability)

C. 50% levered (z = 5/10)
(B = $5m debt, S =$5m equity)
Debt interest rB

$0.5

$0.5

$0.5

Earnings/dividends for shareholders

$0.0

$1.5

$3.5

Return on shares Ri = Div / S

0.5 = 0%

1.5/5 = 30% 3.5/5 = 70%

Expected return (standard deviation)

33.3% (21.2)

How Leverage Affects Equity Returns

Equity return, Rs

50% equity
(50% debt)

70%

100% equity
(0% debt)
B

40%
30%
20%
10%

A
0.5 1m

4m

Earnings, Yi

As earnings Yi change from 1m to 4m, the equity return Rs for the all equity financed
firm moves from 10% to 40% (A to B) but for the 50% levered firm the equity return
changes much more, from 10% to 70% (A to C).

Traditional View
Consider an initial all equity financed company. The traditional view is that
as the firm acquires increasing amounts of debt, then the WACC first falls
but eventually rises, thus leading to an optimal debt-to-equity ratio at (B/S)*.
The reason for the initial fall in the overall cost of capital is:
The cost of debt Rb is less than the cost of equity Rs
The cost of equity initially remains constant.
Hence, as you increase the proportion of debt, R w falls. However, as more
debt is added the cost of equity capital Rs begins to rise because:
The variability of future earnings (after deduction of interest payments)
increases with leverage (as interest must be paid to bondholders regardless
of the gross earnings of the company);
The risk of bankruptcy increases (and bondholders are paid before equity

Traditional View
TRADITIONAL VIEW
There is a debt-to-equity mix which minimises the WACC and
hence maximises the firms market value

Modigliani Miller No Corporate Taxes

Merton Miller put forward the following analogy to explain the MM
Proposition I. Suppose the firm is a giant tub of whole milk. You
could sell the whole milk. Alternatively you could separate out
the cream and the remainder would be skimmed milk. The cream
would sell at a high price but the skimmed milk would sell at a low
price.
More formally, the MM view is also based on the idea that the
value of a company is ultimately determined by the capitalised
value (i.e. PV) of the future income stream from its activities in
production, sales marketing and investment in plant and
machinery.

Modigliani Miller No Corporate Taxes

Suppose firm A and firm B both have a PV of future (net) income
of $100m. Firm A has 80% debt finance and 20% equity finance,
while for firm B the proportions are 20% debt and 80% equity.
The MM view implies that the market value should be the same
for both firms (and equal to $100m). Basically the idea is this. If
two firms X and Y are identical except for their capital structure,
yet you can purchase the securities of X for less than the
securities of Y, then an arbitrageur should short sell the securities
of Y and buy the securities of X, thus making an immediate cash
profit. Since the future cash flows from the identical firms X and Y
are the same (in PV terms) then there are zero net cash flows in
future periods, from the long and short positions in X and Y.

The value of the firm. MM Proposition I (no taxes)

Value of firm, V

Debt-to equity ratio (B/S)

V is independent of B/S

Modigliani Miller No Corporate Taxes

MODIGLIANI MILLER PROPOSITION I

The WACC and the value of the firm are both independent
of the debt-to-equity mix used in financing the firms
activities

Modigliani Miller No Corporate Taxes

ASSUMPTIONS: MODIGLIANI MILLER APPROACH
Perfect capital markets with borrowing and lending rates
equal and the same for companies and persons.
No corporate or personal taxes or transactions costs.
Other firms exist with the same business (systematic) risk
but different leverage.
Net cash flows from physical investment projects can be
regarded as perpetuities and are independent of the debt-toequity mix

Modigliani Miller No Corporate Taxes

V=S+B
Value of levered firm VL = value of unlevered firm VU
Capital Structure
Unlevered
Levered
VU = $1000
VL = ?
BU = $0

BL= $200
SL = ?
RB= 0.05

Note: Future cash flow from both firms is Y = $800

Modigliani Miller No Corporate Taxes

Levered and unlevered company

Transaction

$ Investment

$ Return

(a) Case U: buy 10% of unlevered company

Buy 0.10 of VU

$100 = 0.10 VU

0.10 Y

(b) Case L: buy 10% of levered company

Buy 0.10 of VL

0.10SL = 0.10 (VL BL) 0.10 [Y - 0.05 x 200]

= 0.10 (Y Rb BL)

Modigliani Miller No Corporate Taxes

Cost of L = Cost of SL
0.10 (VL BL) = 0.10 (VU BL)
Hence:
VL = VU
We can now fill in the gaps in the preceding table.
VL = VU = $1000 and SL = VL BL=$1000 - $200 = $800

Profitable Arbitrage
To show that home-made leverage and arbitrage ensures that
VL = VU, consider starting with SL*= $1300 so that we are in
equilibrium:

VL* = SL* + BL = $1500 > VU = $1000

Synthetic Leveraged Company

Transaction

$ Investment

$ Return

Case SL: synthetic leverage = borrow and invest in levered company

Borrow 0.10 of BL

-0.10 BL

Buy 0.10 of VU

+0.10 VU
Net inv. = 0.10 (VU BL)

-0.10 Rb BL + 0.10 Y

Return = 0.10 (Y RbBL)

Direct Investment in Levered Company

Transaction

$ Investment

$ Return

Case L*: buy 10% of levered company

Buy 0.10 of SL*

(0.10) SL*=(0.10)$1300

0.10 (Y RbBL)

=$130

=0.10 ($800 0.05 ($200))

=$79

Cost of home-made leverage

Transaction

$ Investment

$ Return

Case SL*: borrow and invest in unlevered company

Borrow 0.10 of BL -0.10 BL= 0.10 ($200) = 20

-0.10 Rb BL = -1

Buy 0.10 of VU

+0.10 VU = 0.10 ($1000) = 100

+0.10 Y = 80

Net inv. = $80

Net return = $79

=0.10 (VU BL)

=0.10 (Y Rb BL)

Leverage and the Required Rate of Return on

Equity
We have noted that the MM proposition implies that the overall cost
of capital Rw is independent of the degree of leverage. One
implication of this is that the WACC formula can be rearranged to
show that the equilibrium expected return on equity (shares) Rs is
positively related to leverage.
In equation WACC = Rw = (1-z) Rs + zRb, substitute z = B/V = B/
(S+B) and rearrange to give:

B
Rs Rw ( Rw Rb )
S

Leverage and the Required Rate of Return on

Equity

MODIGLIANI MILLER PROPOSITION II

Since the WACC is independent of the debt-to-equity ratio,
this implies that the cost of equity capital Rs rises with the
debt-to-equity ratio B/S

Modigliani Miller with Corporate Taxes

The cost of equity finance. MM proposition II (no taxes)
Rs= Rw + (Rw Rb) (B/S)

Cost of capital

Debtholders share some

of the business risk

WACC, Rw
Rb

(B/S)*

Debt-to-equity ratio (B/S)

Cost of equity rises with rising debt-to-equity ratio

Modigliani Miller with Corporate Taxes

For two firms with the same business risk, then with
corporate taxes the optimal debt ratio that maximises the
value of the firm involves 100% leverage (i.e. all debt
financed)!
To develop this argument a little further note that, with corporate
taxes, the value of an unlevered firm VU (i.e. 100% equity
financed) equals the constant after-tax earnings Y(1 t)
discounted at the riskuadjusted discount rate for an unlevered
(i.e. all equity firm s :

Y (1 t )
VU
su

The Value of an Unlevered and Levered Firm

For an unlevered (i.e. 100% equity financed) firm, after-tax
earnings are Y(1-t) and the value of the firm is:
Y (1 t )
VU
su

Where su = risk adjusted discount rate for an all equity financed

firm. For the levered firm, corporate taxes are calculated after
deduction of interest payments. Hence, interest income paid to
bondholders and the earnings available to shareholders are:
Interest income of bondholders = RbBL
Shareholder earnings = (Y RbBL) (1 t)

The Value of an Unlevered and Levered Firm

Therefore, the total income accruing to both stakeholders in a
levered firm is:
Total income of levered firm = (Y RbBL)(1 t) + RbBL=Y(1 t) + t(RbBL)
= income of unlevered firm + tax shield

The Value of an Unlevered and Levered Firm

Note that Y(1 - t) equals the income accuring to an equivalent
unlevered firm and hence should be discounted at su the risk
adjusted discount rate for an all equity firm. The income from the
tax shield arises because the firm holds debt of BL. If the tax
shield is riskless it should be discounted at the rate Rb.
Therefore, from equation the value of the levered firm VL is:
Y (1 t ) Rb tBL
VL

VU tBL
u
s
Rb

The Value of an Unlevered and Levered Firm

MM PROPOSITION I (WITH CORPORATE TAXES)
Value of levered firm = value of unlevered firm + value of tax
shield

WACC ( BL / VL )T (1 ) /(1 Rb )
*

u
s

u
s

Modigliani Miller with Corporate Taxes

MM PROPOSITION I (WITH CORPORATE TAXES)

Value of a levered firm VL = value of an unlevered firm VU
value of the tax shield, tB
VL = VU + tB

Modigliani Miller with Corporate Taxes

It follows from the above equation that as the amount of debt B
increases then the value of the levered firm increases and is
maximised at 100% debt finance.

BL
R s (1 t )( Rb )
SL
L

u
s

u
s

Modigliani Miller with Corporate Taxes

MM PROPOSITION II (WITH CORPORATE TAXES)

There is a positive relationship between the required
return on equity in a levered firm RsL and the debt-toequity ratio BL / SL

Return on Equity of a Levered Firm, RsL and the

Debt-to-Equity Ratio, BL/ SL
The relationship between the cost of equity in a levered firm RsL
and the debt-to-equity ratio BL/SL is a little involved. First,
consider the balance sheet of the levered firm (paying corporate
taxes):
Assets
Value unlevered firm
Value tax shield
Total

VU

Liabilities
Debt (bonds)

BL

tBL

Equity

SL

VU + tBL

BL + SL

Return on Equity of a Levered Firm, RsL and the

Debt-to-Equity Ratio, BL/ SL
The expected cash flow (perpetuity) per annum from VU and the
tax shield tBL is:
Expected cash flow from assets = su VU + Rb (tBL)
The expected cash flow to equity and bondholders is:
RsL SL + Rb BL
Since there are no retained earnings, the two cash flows in
u which gives after rearrangement:
equations and must be equal,

RsL VU

SL

(1 t )

SL

Rb

Return on Equity of a Levered Firm, RsL and the

Debt-to-Equity Ratio, BL/ SL
But from equation and the fact that in an efficient market the value
of the firm VL is equal to the market value of equity plus debt:
VL=VU + tBL =SL + BL
Hence:
VU = SL (1 t) BL_
Substituting equation
in equation for VU:
u
s
L

BL
Rb
Rs
[ S L (1 t ) BL ] (1 t )
SL
SL

Return on Equity of a Levered Firm, RsL and the

Debt-to-Equity Ratio, BL/ SL
Note that for each unit increase in BL/SL the required return on
equity RsL increases by (1 - t)(su Rb), which is less than under the
no tax case (I.e. t = 0). This concludes our proof of MM Proposition
II.

BL
R (1 t )( Rb )
SL
L
s

u
s

u
s

where su Rb

MM PROPOSITION II (WITH CORPORATE TAXES)

The required return on equity in a levered firm RsL increases
with the debt-to-equity ratio BL/SL

Cost of Equity
ERs r s ( ERm r ) 3 8 s
The APT requires estimates of the factor loadings bij and the price
of risk I for each of these factors. It is then straightforward to
calculate the cost of equity for firm i:
Ers = 1bs1 + 2bs2 +
Either of these measures can be used as a measure of the cost of
equity finance.

Cost of Debt
Rb* (1 t ) Rb

Retained Earnings

Weighted Average Cost of Capital

C Rs S Rb (1 t ) B

V SB
total cos t S
B
Rw (WACC )

Rs
Rb (1 t )
total value S B
S B

(1 z ) Rs zRb (1 t )
Where z = B / (B + S) is the degree of leverage. With no
corporate taxes we simply set t = 0 in the above equation. The
WACC should be used as the discount rate in the NPV formula to
discount after-tax earnings Y(1-t) for the marginal capital
investment project as long as the following conditions hold.

Incentives and Economic Value Added

EVA (or residual income) = earnings after tax, EAT capital used
= EAT (WACC x KC)
Return on capital ROC = EAT / KC = $100m / $1000m = 10%
The investment decision is then:
Invest in project if ROC > WACC
Economic profit EP = (ROC WACC) x KC = (0.10 0.09) x $1000m = $10m

Incentives and Economic Value Added

Economists will recognise this average value as being the annuity
value of the PV of the future earnings, sometimes called permanent
earnings/income. The PV of the annuity flow EAT is, PV = EAT /
WACC and the NPV criterion is:
Invest in the project if

PV (earnings) > KC

Or

EAT WACC x KC > 0

where PV = EAT/WACC

Incentives and Economic Value Added

Fortune magazine (of 10th November 1997) provided figures for
the EVA ($m) of companies, from which the following have been
extracted:

General Electric

EVA
2515

Capital
51017

ROC
17.7

WACC
12.7

General Motors

-3527

94268

5.9

9.7

Johnson & Johnson

1327

15603

21.8

13.3

Incentives and Economic Value Added

Capital at risk = loan exposure x LGD x ( L x percentile level)

RISK ADJUSTED RETURN ON CAPITAL: RAROC

RAROC = earnings / capital at risk

EVA = earnings capital at risk x WACC > 0

Leverage and the Return on Equity (No

Corporate Taxes)
Y = earnings (cash flow, profits) before interest, tax and depreciation for
either a levered L or unlevered U firm
SL = $-value of equity in a levered firm
BL = $-value of debt (bonds) in a levered firm
Vi = $-value of the firm ( i = U or L)
Rb = interest cost of debt
Rs = return on equity in levered firm
RsL = return on equity in levered firm
Z BL / VL = degree of leverage (and 1 z SL / VL)

Leverage and the Return on Equity (No

Corporate Taxes)
The return on equity is defined as:
RsL = (Div) / SL
Using SL (1 z) VL and Div = Y Rb BL = Y Rb (zBL) then:
Y Rb ( zVL )
Y
z
R

Rb
(1 z )VL
VL (1 z )
(1 z )
L
s

Clearly, RsL depends on Y and leverage z.

Leverage and the Return on Equity (No Corporate Taxes)

Rs = Y / V L
Where we have dropped the L in the notation. The value of Y for which the
all equity and a levered firm give an equal value for R s is given from which
we obtain:
Y* = RbV
Y* = 0.1 ($10m) = $1m which can be seen as the cross-over point. You
might also note that equation can also be obtained by rearranging V L = Y /
WACC to solve for RsL where WACC = (1 z)RsL + zRb. This is perfectly
consistent as long as we realise that VL is held constant and only the
proportions of S and B are being altered (I.e. leverage), which then has a
direct effect on RsL. The overall result and equation is that the expected
return on equity and the volatility of equity returns, are both higher the
greater the degree of leverage z.

Modigliani Miller with Corporate Taxes

We show how Modigliani Miller Proposition I is altered in the
presence of corporate taxes. The relationship between the value
of a levered firm and an unlevered firm is:
VL = VU + tBL
The value of the levered firm increases with the amount of
debt BL
Therefore our original no tax MM Proposition I that VL is
independent of debt BL does not hold in the presence of
corporate taxes

Modigliani Miller with Corporate Taxes

We demonstrate that the cost of equity capital RsL in a levered
firm is given by:
BL
L
u
u
Rs s (1 t )( s Rb )
SL
Where su is the cost of equity capital in an unlevered firm (I.e.
100% equity financed), hence:
Our original MM Proposition II that RsL rises with the degree
of leverage (BL / SL) still holds in the presence of corporate
taxes

The Return on Equity in an Unlevered Firm and

Adjusted Present Value
We derive an expression for the return on equity in an unlevered
firm su in terms of the return on equity in a levered firm RsL and
the bond return Rb. This enables us to calculate su in terms of
the observables RsL and Rb.
We can then use our calculated su as the discount rate in
the adjusted NPV technique
To apply the APV technique of project appraisal, we need a
measure of the discount rate on an unlevered firm su . This can
be obtained from the CAPM/SML:

r ( ERm r )
u
s

The Return on Equity in an Unlevered Firm and

Adjusted Present Value
However, we now require u, the beta of an unlevered firm.
Unfortunately, (nearly) all firms are levered, so what we observe
in the data is the beta of a levered firm L. Can we link Uyp L?
the answer is yes. But the method is rather involved. We
therefore consider the no tax case, before moving on to the case
where we have corporate taxes.

Case A: No Corporate Taxes

We begin with the fact that the beta of a levered firm is a weighted
average of the debt bL and equity sL betas (and the weights
sum to unity):

L L SL L
b
s

VL
VL
L

bL and sL are observable/measurable from the SML, using data

on returns on debt and equity for levered firms. MM Proposition
I implies that the beta of an unlevered firm u (with equal business
risk) equals that of a levered firm, hence:

Case A: No Corporate Taxes

L
u
VL

SL

VL
L
b

sL z bL (1 z ) sL

Where z = BL / VL. Equation allows us to calculate u from the

observed bL and sL. Now bL < sL because debt is less risky than
equity, so equation implies:
u < sL
Hence, the beta of an all equity firm is less than the equity beta of a
levered company. This also fits with MM-II where we found that the
equity of a levered firm has higher risk than an equivalent unlevered
(100% equity) firm. If bL 0 then equation becomes:
SL L
u
s

VL

Case B: With Corporate Taxes

Again we want to obtain an expression for the unobservable in
u terms of the observable/measurable values bL and sL. The
derivation is a little involved so we immediately present the
equation we are looking for, which is:

L
BL (1 t ) L
SL
u
b
s
BL (1 t ) S L
(1 t ) BL S L

Case B: With Corporate Taxes

This is very similar to equation since in both equation and equation
u is a weighted average of bL and sL with the weights summing
to unity. In equation the weights contain the tax rate t, as we
might expect. Of course, if you set t = 0 in equation it collapses to
equation, the no tax form of the equation. To prove equation we
begin with the value of a levered firm, given by MM-I (with taxes):
VL=VU + tBL

Case B: With Corporate Taxes

By definition, the value of the levered firm is equal to the market
value of its debt and equity:
VL=BL + SL

From equations:
VU= (1- t) BL + SL

The definition of the beta of a levered firm is:

BL L S L L

b
s
VL
VL
L

Case B: With Corporate Taxes

The next point holds the key to the derivation. From MM-I with
taxes we have VL = VU + tBL. Hence, the beta of a levered firm
can also be viewed as a weighted average of the beta of an
unlevered (100% equity financed) firm and the beta of the tax
shield (tB). Hence:
VU u tBL L
L


b
VL

VL

The beta of the cash flow from the tax shield is the debt beta,
since here we assume the tax shield is riskless. We are now
nearly there. Equating and rearranging:
BL (1 t ) L S L L

b
s
VU

VU
u

Case B: With Corporate Taxes

Substituting for VU from equation ( )gives the expression
required:

L
BL (1 t ) L
SL

b
s
(1 t ) BL S L
(1 t ) BL S L
u

Case B: With Corporate Taxes

The unobservable beta of an unlevered firm is equal to a

weighted average of the observable betas on debt and
equity of the levered firm

Case B: With Corporate Taxes

The weights on bL and sL in equation sum to unity. Again,
note that since bL < sL then from equation the beta of the equity
of an unlevered (100% equity financed) firm is less than the beta
of the equity of a levered firm:
u < sL
This again fits with our MM-II (with taxes), which implies that
levered equity is more risky than unlevered equity. If we set bL =
0 in equation then it is easy to see that in this case u < sL.

Assumptions when Using WACC

BL
Dollar amount of debt =
VL

= BL
V
L

KC

KC and

Dollar amount of equity

The total dollar cost per annum of the debt and equity is:
BL
Total dollar cost of finance p.a. = (1 t) Rb V
L

B
KC + R L L KC
s

VL

Assumptions when Using WACC

A variable investment project requires perpetual earnings Y p.a.
from the project to exceed the dollar cost p.a., that is:

or

BL
Y (1 t ) Rb
VL

SL
KC R

VL
L
s

KC

BL
Y
L SL
Rs
WACC
(1 t ) Rb
KC
VL
VL

Note that the Y / KC is the projects annual rate of return. Hence,

a viable project exceeds the WACC, where the latter assumes the
debt ratio BL / VL for the project, is the same as for the firm as a
whole.

Thank You