1. Overview

This chapter focuses on capital structure and the Modigliani-Miller theorem, core topics in corporate finance. It addresses how firms choose the mix of liabilities and equity (capital structure) to impact profitability, risk, and cost of capital. Key influences on capital structure include business and financial risk, tax benefits, financial distress costs, and agency costs. The chapter also covers capital cost concepts, calculation methods (including WACC), trade-off and pecking order theories, and market timing theory. The Modigliani-Miller theorem is presented for perfect and real markets, explaining capital structure irrelevance and tax shield benefits.

2. Core Concepts & Key Elements

• Course structure & focus

  • Chapter 3: Capital Structure and Modigliani-Miller Theorem
  • Capital structure definition: composition of liabilities and equity affecting firm value.

• Cost of Capital

  • Definition: minimum return rate to generate value.
  • Importance: guides investment justification, risk assessment, stock pricing.
  • Components: cost of debt, cost of equity, and weighted average cost of capital (WACC).

• Cost of Debt

  • Formula components: risk-free rate + credit spread, multiplied by (1 − tax rate).
  • Early-stage firms rely more on equity financing due to limited assets.

• Cost of Equity

  • Represents return rate to equity investors, assessed via CAPM.
  • CAPM components: risk-free rate, market risk premium, beta (stock risk).

• Weighted Average Cost of Capital (WACC)

  • Average cost across all sources of capital.
  • High WACC indicates risky sector, high debt risk, or startup status.

• Importance of Cost of Capital

  • Indicator of financial health.
  • Basis for evaluating project and financing decisions.

• Factors influencing capital structure decisions

  1. Business risk (operating profitability)
  2. Financial risk (debt-related risk)
  3. Tax benefits of debt (interest tax deductibility)
  4. Costs of financial distress (bankruptcy risk)

• Debt vs Equity Financing

  • Debt advantages: tax benefits, preserves ownership.
  • Debt disadvantages: mandatory payments, financial risk.
  • Equity advantages: no mandatory repayments, flexibility.
  • Equity disadvantages: ownership dilution, conflicts.

• Optimizing WACC

  • Debt is cheaper due to tax shields.
  • Excessive debt increases default risk and cost.
  • Increasing debt raises cost of equity due to risk premium.

• Trade-off Theory

  • Firms balance debt and equity costs and benefits.
  • Decisions consider debt cost, financial flexibility, growth, risk.

• Modigliani-Miller Theorem (Perfect Markets)

  • Assumptions: no taxes, no transaction/bankruptcy costs, perfect markets.
  • Proposition 1: Capital structure does not affect firm value ($V_U = V_L$).
  • Cost of equity rises with leverage due to increased default risk.

• Modigliani-Miller Theorem (Real World)

  • Taxes and costs exist; tax shield increases levered firm value ($V_L = V_U + t_c \times D$).
  • Cost of equity increases with leverage, less sensitively due to tax shields.

• Pecking Order Theory

  • Financing preference: internal funds → debt → equity.

• Information Asymmetry

  • Difference in information between insiders and outsiders.
  • Firms with more asymmetry prefer internal funds and debt.

• Agency Costs

  • Conflicts between shareholders and managers; shareholders and debtholders.
  • Influence capital structure choice.
  • Mitigated by governance and covenants.

• Market Timing Theory

  • Capital structure varies with market conditions.
  • Equity issued when market overvalued; debt preferred at low interest rates.
  • Long-term effects on capital structure.

• Practical Example: Seplat Petroleum

  • Step 1: Use retained earnings.
  • Step 2: Use debt financing.
  • Step 3: Equity financing as last resort.

• Conclusion

  • Interest reduces taxable income; increases total payment to investors.
  • Creates incentive to use debt financing.

3. High-Yield Facts

• Cost of capital: minimum return for value creation.
• WACC formula: $$ WACC = \frac{E}{V} r_e + \frac{D}{V} r_d (1 - T) $$
• Modigliani-Miller Proposition 1 (no taxes): capital structure irrelevant to value.
• Modigliani-Miller with taxes: $$ V_L = V_U + t_c \times D $$
• CAPM for cost of equity: $$ r_e = r_f + \beta (r_m - r_f) $$
• Debt tax shield reduces taxable income.
• Trade-off theory optimal debt/equity balances risk and tax benefits.
• Information asymmetry leads to financing hierarchy: internal → debt → equity.
• Agency costs reduce firm value and affect capital choices.
• Market timing affects financing costs and capital structure.
• Seplat Petroleum example illustrates pecking order financing steps.

4. Summary Table

5. Mini-Schema (ASCII)

Capital Structure & Modigliani-Miller Theorem
 ├─ Cost of Capital
 │   ├─ Cost of Debt
 │   ├─ Cost of Equity (CAPM)
 │   └─ Weighted Average Cost of Capital (WACC)
 ├─ Factors Influencing Capital Structure
 │   ├─ Business Risk
 │   ├─ Financial Risk
 │   ├─ Tax Benefits of Debt
 │   └─ Costs of Financial Distress
 ├─ Debt vs Equity Financing
 │   ├─ Advantages/Disadvantages of Debt
 │   └─ Advantages/Disadvantages of Equity
 ├─ Theories
 │   ├─ Trade-off Theory
 │   ├─ Modigliani-Miller Theorem
 │   │   ├─ Perfect Markets
 │   │   └─ Real World
 │   ├─ Pecking Order Theory
 │   ├─ Information Asymmetry
 │   ├─ Agency Costs
 │   └─ Market Timing Theory
 └─ Practical Application: Seplat Petroleum

6. Rapid-Review Bullets

• Capital structure = liabilities + equity.
• Cost of capital = minimum return rate.
• Debt claims > equity claims in seniority.
• Cost of debt includes risk-free rate + credit spread; tax deductible.
• Cost of equity computed via CAPM.
• WACC averages equity and debt costs.
• High WACC signals high risk or startup status.
• Tax shields create incentives for debt financing.
• Trade-off theory balances debt benefits and distress costs.
• MM theorem (no taxes): capital structure irrelevant.
• MM theorem (with taxes): leverage adds value via tax shields.
• Pecking order: internal financing preferred, then debt, lastly equity.
• Information asymmetry favors internal funds and debt.
• Agency costs arise from shareholder-manager and shareholder-debtholder conflicts.
• Market timing adjusts financing to market prices and interest rates.
• Seplat applies pecking order financing.
• Interest payments reduce taxable income.
• Equity dilution is a disadvantage of equity financing.
• Debt increases financial risk and default probability.
• Optimal capital structure minimizes WACC and balances risks.