Capital structure Study Guide

📖 Core Concepts Capital Structure – The mix of shareholders’ equity, debt, and preferred stock a firm uses to finance its assets. Financial Leverage – Using debt to amplify EPS because interest is tax‑deductible; creates a tax shield but also bankruptcy risk. Optimal Capital Structure – The debt‑equity mix that minimizes the firm’s overall cost of capital while preserving financial flexibility and credit standing. Debt Seniority – Order of claim in bankruptcy: senior debt → subordinated debt → preferred stock → common equity; senior debt is often secured by collateral. Key Ratios – Debt‑to‑Capital, Capital Gearing, Debt‑to‑Equity – quantitative gauges of leverage. Modigliani‑Miller (MM) Theorem – In a perfect market, capital structure does not affect firm value (Prop 1) and the cost of equity rises with leverage (Prop 2). Trade‑off Theory – Firms balance tax benefits of debt against bankruptcy/distress costs; optimal point where marginal benefit = marginal cost. Pecking Order Theory – Financing hierarchy: internal cash → debt → equity; equity issuance signals possible overvaluation. Agency Cost Theories – Leverage can cause asset substitution, debt overhang, and free‑cash‑flow problems, influencing firm value. --- 📌 Must Remember Debt‑to‑Capital Ratio = $\dfrac{\text{Debt}}{\text{Debt} + \text{Equity} + \text{Preferred Stock}}$ Capital Gearing Ratio = $\dfrac{\text{Risk‑bearing Capital (debt + preferred)}}{\text{Non‑risk‑bearing Capital (equity)}}$ Debt‑to‑Equity Ratio = $\dfrac{\text{Total Debt}}{\text{Shareholders’ Equity}}$ MM Prop 1: In a no‑tax, no‑bankruptcy world, Firm value = Value of assets (independent of financing). MM Prop 2: $r{E}^{L}= r{E}^{U} + (r{E}^{U} - r{D})\times \dfrac{D}{E}$ (levered equity cost = unlevered cost + risk premium). Tax Shield Value: $V{L}=V{U}+Tc D$ where $Tc$ = corporate tax rate, $D$ = debt amount. Trade‑off optimality condition: Marginal Tax Benefit = Marginal Bankruptcy Cost. Pecking Order: Use retained earnings first; issue debt only if needed; issue equity as a last resort. Agency Effects: High debt → risk‑shifting (asset substitution) & possible under‑investment (debt overhang). --- 🔄 Key Processes Assessing Leverage Ratio Compute each ratio (Debt‑to‑Capital, Gearing, Debt‑to‑Equity). Compare to industry averages → flag “high” vs “low” leverage. Determining Optimal Debt Level (Trade‑off) Estimate tax benefit per additional $1 of debt: $Tc \times rD$. Estimate expected bankruptcy cost per $1 of debt (often a rising function). Increase debt incrementally until marginal benefit = marginal cost. Applying MM with Taxes Start with unlevered firm value $VU$. Add present value of tax shield: $Tc D$. Adjust cost of capital: $WACC = rD (1 - Tc)\frac{D}{VL} + rE \frac{E}{VL}$. Financing Decision (Pecking Order) Check available internal cash → fund projects. If insufficient, evaluate debt capacity (ratio thresholds, credit rating). Issue equity only if debt capacity exhausted or signaling concerns are minimal. --- 🔍 Key Comparisons Debt vs. Preferred Stock Interest vs. Fixed dividend; debt interest = tax‑deductible, preferred dividend is not. Seniority: Debt senior to preferred in bankruptcy. MM Proposition 1 vs. Real‑World Assumptions: No taxes, no bankruptcy → value independence. Reality: Taxes, distress costs → capital structure matters. Trade‑off Theory vs. Pecking Order Theory Trade‑off: Focuses on balancing tax shields vs. distress costs; predicts a target leverage. Pecking Order: Emphasizes information asymmetry; predicts a financing hierarchy, not a target ratio. Senior Debt vs. Subordinated Debt Claim priority: Senior paid first, often secured. Risk/return: Subordinated carries higher yield due to lower claim rank. --- ⚠️ Common Misunderstandings “More debt always lowers WACC.” – True only when tax shield outweighs incremental bankruptcy costs; beyond a point, WACC rises. “MM means leverage never matters.” – MM’s conclusions hold only under perfect market assumptions; real markets have taxes, costs, and asymmetric information. “Preferred stock is the same as debt.” – Preferred dividends are not tax‑deductible and have lower claim priority than debt. “A high Debt‑to‑Equity ratio always signals risk.” – Context matters; capital‑intensive industries may naturally carry higher ratios without excessive risk. --- 🧠 Mental Models / Intuition Tax Shield = “Free Money” – Every dollar of interest saves $Tc$ dollars in taxes → think of debt as a cash‑flow enhancer until the cost of possible default outweighs the saving. Balance Beam Analogy – Imagine leverage as a seesaw: left side = tax benefit (rises linearly with debt); right side = distress cost (convex upward). Optimal point is where the seesaw balances. Information Asymmetry Funnel – Internal funds are “known” to all, debt is “partially known”, equity issuance reveals “possible trouble”, hence the pecking order funnel. --- 🚩 Exceptions & Edge Cases Zero‑Tax Jurisdictions – Tax shield disappears → debt provides no advantage, making MM Proposition 1 more realistic. Highly Regulated Industries – May have debt covenants limiting leverage regardless of tax benefits. Distressed Firms with High Cash Reserves – Free‑cash‑flow problem can still exist; excess cash can fund value‑destructive projects despite low leverage. Emerging‑Market Firms – Higher bankruptcy costs and limited debt markets → optimal structure leans toward equity. --- 📍 When to Use Which Use MM (no‑tax version) when analyzing theoretical value or when taxes are truly negligible (e.g., tax‑exempt entities). Apply Trade‑off Model for firms with substantial debt and observable tax rates; useful for estimating target debt ratios. Employ Pecking Order for growth firms with abundant internal cash but limited access to cheap debt. Choose Capital Gearing Ratio over Debt‑to‑Equity when you need to distinguish risk‑bearing vs. non‑risk‑bearing capital (e.g., comparing firms with large preferred issues). --- 👀 Patterns to Recognize Rising Leverage Ratios + Declining Credit Rating → imminent distress risk (watch for WACC increase). Sudden Equity Issuance after a profit drop → possible negative signaling (pecking order violation). High Preferred Stock proportion + Low Debt → firm may be avoiding tax shield or facing covenant restrictions. Consistently high Debt‑to‑Capital across years → persistence; likely driven by firm‑specific characteristics rather than market timing. --- 🗂️ Exam Traps Choosing “Debt always lowers cost of capital” – Ignoring the rising marginal bankruptcy cost leads to over‑optimistic answer. Confusing MM Prop 2 with the CAPM – Prop 2 adds a leverage premium to the unlevered equity cost; it is not the same as the market risk premium. Selecting “Preferred stock = debt” – Overlooks tax non‑deductibility and lower claim priority. Assuming “Higher gearing = higher risk” without industry context – Some capital‑intensive sectors (utilities) operate safely with high gearing. Mix‑up between “senior debt” and “subordinated debt” – Remember senior debt is paid first and often secured; subordinated is riskier and yields more. ---