1. INTRODUCTION TO CAPITAL STRUCTURE
Corporate Finance
Lecture 16
INTRODUCTION TO CAPITAL STRUCTURE
Ronald F. Singer
FINA 4330
Fall, 2010

2. THE FIRM'S CAPITAL STRUCTURE IS DEFINED AS:
THE MIX OF THE DIFFERENT SECURITIES ISSUED BY THE FIRM
THE PROBLEM:
WHAT IS THE MIX WHICH MAXIMIZES STOCKHOLDERS' WEALTH

3. THE TYPICAL CAPITAL STRUCTURE OF A LARGE CORPORATION:
Common Equity
Preferred Equity
Sinking Fund
Non-sinking Fund
Senior Debt
Secured
Unsecured
Callable
Non-callable
Sinking fund
Convertible
Etc
Junior Debt

4. WE ASSUME THAT THE FIRM HAS ONLY COMMON EQUITY AND A SINGLE DEBT ISSUE IN ITS CAPITAL STRUCTURE.
THE SAME PRINCIPLES FOLLOW WITH A MORE COMPLEX CAPITAL STRUCTURE.
THE CAPITAL STRUCTURE DECISION SHOULD BE THOUGHT OF AS A DECISION WHICH ASKS HOW IS THE OPERATING CASH FLOW OF THE FIRM GOING TO BE SPLIT AMONG THE DIFFERENT SECURITY HOLDERS:
THAT IS: The firm as a whole generates (after tax) operating cash flow. How is this cash flow distributed? That will be in accordance with the firm’s capital structure decisions

5. FIRM Operating Cash Flow Cash Flow Cash Flow To To Bondholders
Stockholders

6. SOME DEFINITIONS AND NOTATION: LET:
B be the market value of the debt issued by the firm
S be the market value of the equity issued by the firm
rB be the required return to the debt
rs be the required return to the firm's equity
ro be the discount rate applied to the business risk of the firm
By Definition:

7. V = B + S
where,
V is the "market value" of the securities issued by the firm.
T _
B = S yB(t)
t=1(1 +rB)t
is the market value of the debt. _
S = S yS(t)
t=1 (1 + rS )t
is the market value of equity.
YB(t) is the cash flow to bondholders,
yS(t) is the cash flow to stockholders

8. Where, y(t) is the firm’s operating cash flow at time (t)
MODIGLIANI AND MILLER
PROPOSITION I:
Given A frictionless world (Perfect Capital Markets
No taxes
No flotation, brokerage, bankruptcy cost Costless information _
V = VA = S E[y(t)] = B + S
t=1(1 + ro)t
Where, y(t) is the firm’s operating cash flow at time (t)
THAT IS, THE MARKET VALUE OF ALL THE SECURITIES OF THE FIRM IS EQUAL TO THE PRESENT VALUE OF THE OPERATING CASH FLOWS GENERATED BY THE FIRM.

9. The Weighted Average Cost of Capital is
By Definition:
r0= WACC = rS S + rB B,
V V
IT IS BY DEFINITION:
The Capitalization rate of the firm's total Operating Cash Flow
That is:
WACC = r0 = "cost of capital":
where r0 is the solution to:
V = S y(t) = B + S
t=1 (1+r0)t

10. In a frictionless environment:
r0= WACC =
= rS S + rB B
V V
Proposition II:
Rearranging (1) that means that:
rS = ro + (ro - rB) B S

11. BUSINESS RISK
THE RISK IMPOSED ON STOCKHOLDERS AS A RESULT OF THE RISK OF THE FIRM'S OPERATING CASH FLOWS
FINANCIAL RISK
FINANCIAL RISK IS THE ADDITIONAL RISK IMPOSED ON THE STOCKHOLDERS BY HAVING DEBT IN THE FIRM'S CAPITAL STRUCTURE

12. Graphically: % rS = r0 + (r0 – rB) (B/S) Financial Risk
Weighted Average Cost of Capital r0
Cost of Debt
Business Risk rB
DEBT

13. IN SUMMARY: GIVEN PERFECT CAPITAL MARKETS,
THE COST (REQUIRED RETURN) OF EACH SECURITY ISSUED BY THE FIRM MUST BE SUCH THAT:
THE WEIGHTED AVERAGE OF THE REQUIRED RETURN OF EACH OF THE SECURITIES MUST BE EQUAL TO THE REQUIRED RETURN ASSOCIATED WITH THE RISK OF THE OPERATING CASH FLOWS OF THE FIRM. THE WEIGHTS ARE THE RELATIVE MARKET VALUES OF EACH OF THE SECURITIES.

14. So why do firms worry about capital structure?
If capital structure matters then we have to look toward other factors
Taxes
“transaction” costs, here is what some call “contracting” costs especially the costs associated with financial distress
Costly information
Self interest of managers