# Capital Structure and Payout Concept Card: [Company, course or case] > A concept card for the capital structure and payout questions of the MBA core corporate finance course: does the mix > of debt and equity change firm value, how much debt a firm should carry, which source of funds it should use first, > how to value a project whose financing has side effects, and how much cash to return to shareholders. It covers > Modigliani and Miller (1958, 1963), the trade-off theory, the costs of financial distress, agency costs, the pecking > order (Myers 1984; Myers and Majluf 1984), adjusted present value (APV, Myers 1974) and payout policy (Miller and > Modigliani 1961; Lintner 1956), with computed examples and Excel formulas. It is for MBA students, finance interview > candidates and managers who sit on financing decisions. Worked example A is fully solved, B is half solved and > Exercise C is left to you; self-test answers sit in a separate key. > Source basis: the original papers cited in each section and standard corporate finance textbooks named as further > reading; all wording, notation and examples are original. Northfield Outdoor Co. and Corvane Robotics are fictional. > Replace every [bracketed] value and every row marked *Example*. This is a learning aid, not financial, tax or legal > advice. ## Document control | Field | Value | |---|---| | Document ID | [MBA-CF-CS-001] | | Course or project | [Core corporate finance / financing decision case / interview preparation] | | Learner | [Your name] | | Company or case | [Northfield Outdoor Co. (fictional) / your case] | | Tax assumption | [Corporate rate 25% (*Example*); personal taxes ignored unless stated] | | Currency and units | [USD m unless stated] | | Excel version used for checks | [Microsoft 365 / Excel 2021] | | Reviewed by | [Study group member, tutor or mentor] | | Last updated | YYYY-MM-DD | | Version | [0.1] | ## Contents 1. When to use it 2. The idea in plain language 3. Formulas and notation 4. Theories in order: MM, trade-off, agency, pecking order 5. Costs of financial distress 6. Adjusted present value 7. Payout policy 8. How managers use it in practice 9. Worked example A (fully solved) 10. Worked example B (half solved) 11. Exercise C (unsolved) 12. Connections to other cards 13. Common mistakes and misconceptions 14. Self-test questions 15. My notes and next steps ## When to use it | Decision you face | Main tool in this card | |---|---| | Should we take on more debt, or pay it down? | Trade-off theory, distress costs, ratings and coverage checks | | Debt or equity for this specific raise? | Pecking order, signalling, flexibility | | What is the value of a project or a buyout with changing debt? | Adjusted present value (APV) | | What discount rate should we use when leverage changes? | MM propositions with taxes, unlevering and relevering (mba/mba-capm-wacc-card) | | Dividend, buyback or keep the cash? | MM payout irrelevance, then taxes, signalling, agency and Lintner smoothing | **One-sentence rule:** financing creates value only through what it changes in the real world (taxes, the costs of distress, the incentives of managers, the information investors have, transaction costs); in a world without those, it is irrelevant (Modigliani and Miller 1958). ## The idea in plain language Think of a firm as a pizza: the operating assets produce the pizza, and debt and equity only decide how it is sliced. In a perfect market, slicing does not change the size of the pizza, so firm value does not depend on the debt ratio. That is Modigliani and Miller's first proposition. Equity becomes riskier as debt rises, so its required return rises just enough to keep the average cost of capital constant (proposition II). Real markets are not perfect, and each imperfection gives one theory: - **Taxes.** Interest is usually deductible, so debt shrinks the government's slice and raises the value left for investors (Modigliani and Miller 1963). - **Financial distress.** Too much debt raises the chance of costly distress: lawyers, lost customers and suppliers, fire sales, distorted decisions. Balancing tax benefits against these costs gives the **trade-off theory** (Kraus and Litzenberger 1973). - **Agency.** Debt disciplines managers who might waste free cash flow (Jensen 1986), but it also creates conflicts between shareholders and lenders, such as passing up good projects when most of the gain goes to lenders (Myers 1977; Jensen and Meckling 1976). - **Information.** Managers know more than investors. Issuing equity can signal that shares are overvalued, so firms prefer internal funds, then debt, then equity: the **pecking order** (Myers 1984; Myers and Majluf 1984). Payout policy follows the same logic: in a perfect market, how cash is returned does not change value (Miller and Modigliani 1961); in practice, taxes, signals and agency costs matter, and managers smooth dividends (Lintner 1956). ## Formulas and notation **MM proposition I, no taxes:** $V_L = V_U$. **MM proposition II, no taxes:** $$ r_E = r_U + \frac{D}{E}\,(r_U - r_D) $$ **MM with corporate taxes and permanent debt (1963):** $$ V_L = V_U + t_c D, \qquad r_E = r_U + \frac{D}{E}\,(1 - t_c)(r_U - r_D) $$ **WACC:** $$ WACC = \frac{E}{V}\,r_E + \frac{D}{V}\,r_D\,(1 - t_c) $$ **Trade-off value:** $$ V_L = V_U + PV(\text{tax shields}) - PV(\text{expected distress costs}) - PV(\text{agency costs of debt}) $$ **Adjusted present value** (Myers 1974): $$ APV = NPV_{\text{base, at } r_U} + PV(\text{interest tax shields}) - PV(\text{issue costs}) + PV(\text{other financing side effects}) $$ **Lintner partial adjustment** (Lintner 1956): $$ D_t - D_{t-1} = c\,(p\,EPS_t - D_{t-1}) $$ | Symbol | Meaning | |---|---| | $V_U$, $V_L$ | Value of the unlevered firm and of the levered firm | | $D$, $E$, $V$ | Market values of debt, equity and the firm ($V = D + E$) | | $r_U$ | Cost of capital of the unlevered firm (asset return) | | $r_E$, $r_D$ | Cost of equity and cost of debt | | $t_c$ | Marginal corporate tax rate on the interest deduction | | $p$ | Target payout ratio | | $c$ | Speed of adjustment towards the target dividend ($0 < c \le 1$) | | $D_t$, $EPS_t$ | Dividend per share and earnings per share in year $t$ (context separates dividend $D_t$ from debt $D$) | ## Theories in order: MM, trade-off, agency, pecking order **Modigliani and Miller (1958).** In a market with no taxes, no transaction or distress costs and equal access to information, investors can create or undo leverage on their own account ("homemade leverage"), so they will not pay a premium for a firm that does it for them. The cost of equity rises linearly with $D/E$; WACC stays at $r_U$. The value of MM is not that it describes the world but that it tells you where to look: if financing creates value, it must be because one of the assumptions fails. **Modigliani and Miller (1963), the tax correction.** With deductible interest and permanent debt $D$, the annual tax saving is $t_c r_D D$; discounted at $r_D$ (the risk of the debt), its present value is $t_c D$. Taken literally, firms should be financed almost entirely with debt. They are not, which motivates the next theories. Miller (1977) showed that personal taxes on interest income can offset part or all of the corporate advantage, so the net tax gain depends on both tax systems. Many tax systems also limit net interest deductions, often relative to EBITDA; check the current rules in your jurisdiction before you value a tax shield (dated caution, October 2026). **Trade-off theory** (Kraus and Litzenberger 1973). Value rises with debt while the marginal tax benefit exceeds the marginal expected cost of distress, then falls. The optimum is where they are equal. The theory predicts that firms with safe, tangible assets and taxable profits borrow more, and that firms with intangible assets, volatile cash flows or large growth opportunities borrow less. It struggles to explain why the most profitable firms in an industry often borrow the least. **Agency theory** (Jensen and Meckling 1976; Myers 1977; Jensen 1986). Debt has agency benefits (fixed payments reduce free cash flow that managers could waste) and agency costs (risk shifting towards gambles that hurt lenders, underinvestment because lenders capture part of the gain from new projects, the problem Myers 1977 described and now usually called debt overhang). Covenants, short maturities and convertible features are ways to manage these costs. **Pecking order** (Myers 1984; Myers and Majluf 1984). When managers know more than investors, a decision to issue equity tells investors that managers think the shares are overvalued, so the price falls on announcement. Firms therefore use internal cash first, then safe debt, then riskier debt, and equity last. The theory explains why profitable firms borrow less (they have internal funds) and why equity issues are rare for mature firms. It struggles to explain equity issues by young growth firms with debt capacity left. Worked example A, part A5, shows the mechanism with numbers: a firm with good private news may pass up a positive-NPV project rather than sell underpriced shares. **Evidence from practice.** In a survey of chief financial officers, Graham and Harvey (2001) found that financial flexibility and the credit rating were the factors managers ranked most important in debt policy, with tax benefits moderately important; the information-cost argument behind the pecking order received weaker direct support than its predictions would suggest. ```mermaid flowchart TD A["Financing need identified"] --> B{"Enough internal cash beyond the liquidity buffer?"} B -->|"Yes"| C["Use internal funds"] B -->|"No"| D{"Debt capacity left at the target rating and coverage?"} D -->|"Yes"| E{"Taxable profits to use the interest deduction?"} E -->|"Yes"| F["Issue debt: check covenants, maturity, distress risk"] E -->|"No"| G["Consider leases, hybrids or equity"] D -->|"No"| H{"Large growth options or volatile cash flows?"} H -->|"Yes"| I["Issue equity: plan the signal and the use of funds"] H -->|"No"| J["Restructure: cut payout, sell non-core assets, then reassess"] ``` ## Costs of financial distress | Type | Examples | What drives the size | |---|---|---| | Direct | Legal, advisory and court fees in restructuring or bankruptcy | Complexity of the capital structure, number of creditor classes, jurisdiction | | Indirect, customers | Customers stop buying products that need service, warranties or spare parts | Product durability, after-sales needs, switching costs | | Indirect, suppliers and employees | Tighter trade credit, loss of key staff | Dependence on specialised suppliers and talent | | Indirect, operations | Fire sales of assets, cuts to R&D, marketing and maintenance | Asset specificity, investment needs | | Agency in distress | Risk shifting, underinvestment, delayed liquidation | Distance from default, ownership of the debt | Evidence: Warner (1977) found direct bankruptcy costs of railroads to be small, a few percent of firm value just before filing and smaller when measured years earlier. Andrade and Kaplan (1998) estimated total costs of financial distress for highly leveraged transactions that became distressed at about 10 to 20 percent of firm value. The expected cost today is the probability of distress multiplied by these costs, discounted; it rises steeply as leverage approaches the level where cash flows can no longer cover interest in a bad year. ## Adjusted present value APV splits value into the project as if all-equity financed plus each financing side effect valued separately (Myers 1974). It has three advantages over a single WACC: it handles debt that changes over time, it shows managers where value comes from (operations or financing), and it adds side effects such as subsidised loans or issue costs transparently. Rules of thumb for discount rates: discount the unlevered cash flows at $r_U$. Discount tax shields at $r_D$ when the amount of debt is fixed in advance (the shields are about as risky as the debt), or at $r_U$ when debt is rebalanced to a target ratio (the shields move with firm value). Value issue costs at the time they are paid, and subsidised financing as the present value of the interest saved. When a firm keeps a constant debt-to-value ratio, APV and WACC give the same answer if the inputs are consistent; Exercise C lets you prove it in one line of numbers. ## Payout policy **Irrelevance** (Miller and Modigliani 1961). With fixed investment policy and perfect markets, a shareholder who wants cash can sell shares and one who does not can reinvest dividends, so payout policy does not change wealth. A dividend lowers the share price by the amount paid; a buyback at a fair price leaves the price unchanged and reduces the number of shares. **Why payout matters in practice:** - **Taxes.** Dividends and capital gains may be taxed differently, and gains are taxed only when realised. Check the current rules for your investors; tax facts are not given here. - **Signalling.** Managers raise dividends only when they expect to sustain them, so increases are read as good news and cuts as bad news. - **Agency.** Paying out free cash flow removes it from managers who might invest it below the cost of capital (Jensen 1986). - **Flexibility.** Buybacks can be varied from year to year without the signal of a dividend cut. Survey evidence (Brav, Graham, Harvey and Michaely 2005) shows managers treat the dividend level as close to a commitment and use repurchases for the residual. - **Smoothing** (Lintner 1956). From interviews with managers of 28 US companies, Lintner found that firms have a long-run target payout ratio and move only part of the way towards it each year, so dividends change slowly and less than earnings. Worked example A, part A7, computes the pattern. **EPS is not value.** A buyback raises EPS when the earnings yield on the shares exceeds the after-tax return on the cash used, but the higher EPS comes with higher leverage and risk; under MM the share price does not change. ## How managers use it in practice | Check | Question | Typical evidence | |---|---|---| | CS-01 *(Example)* | Target credit rating and the leverage it allows | Net debt / EBITDA, interest coverage, peer ratings | | CS-02 *(Example)* | Tax position | Taxable profits, losses carried forward, interest limitation rules | | CS-03 *(Example)* | Business risk and asset tangibility | Cash flow volatility, collateral value, cyclicality | | CS-04 *(Example)* | Growth options and investment needs | Capex plan, R&D, acquisition pipeline | | CS-05 *(Example)* | Liquidity buffer | Cash plus committed facilities against a stress case (finance/liquidity-funding-plan) | | CS-06 *(Example)* | Market conditions and signals | Spreads, share price relative to fundamentals, announcement effects | | CS-07 *(Example)* | Payout commitment | Dividend coverage, buyback capacity, shareholder base | In practice, firms set a target range rather than a point, borrow below the theoretical optimum to keep flexibility, and move towards the target slowly. A banker's "debt capacity" is the trade-off theory expressed in rating metrics. ## Worked example A (fully solved) **Setting (*Example*, fictional).** Northfield Outdoor Co., a mature outdoor-gear retailer, earns perpetual EBIT of USD 120m with no growth and reinvests only depreciation. Its unlevered cost of capital is 10 percent and it can borrow at 6 percent. Figures in USD m. **A1. MM without taxes (1958).** Debt 400. | Item | Value | Excel | |---|---|---| | $V_U$ = 120 / 0.10 | 1,200.00 | `=120/0.10` | | $V_L$ = $V_U$ | 1,200.00 | | | $E$ = 1,200 - 400 | 800.00 | `=1200-400` | | $r_E$ = 0.10 + (400/800)(0.10 - 0.06) | 12.00% | `=0.10+400/800*(0.10-0.06)` | | WACC = (800/1,200)(12%) + (400/1,200)(6%) | 10.00% | `=800/1200*0.12+400/1200*0.06` | **A2. MM with corporate tax of 25 percent (1963).** Debt 300, permanent. | Item | Value | Excel | |---|---|---| | $V_U$ = 120 × 0.75 / 0.10 | 900.00 | `=120*(1-0.25)/0.10` | | Annual tax shield = 0.25 × 0.06 × 300 | 4.50 | `=0.25*0.06*300` | | PV of tax shield = 0.25 × 300 | 75.00 | `=4.5/0.06` | | $V_L$ | 975.00 | `=900+75` | | $E$ | 675.00 | `=975-300` | | $r_E$ = 0.10 + (300/675)(0.75)(0.04) | 11.33% | `=0.10+300/675*(1-0.25)*(0.10-0.06)` | | Check: equity cash flow (120 - 18) × 0.75 = 76.50; 76.50 / 675 | 11.33% | `=(120-0.06*300)*(1-0.25)/675` | | WACC = (675/975)(11.33%) + (300/975)(6%)(0.75) | 9.23% | `=675/975*rE+300/975*0.06*(1-0.25)` | | Check: $V_L$ = 90 / WACC | 975.00 | `=120*(1-0.25)/WACC` | The three ways of valuing the levered firm (APV-style $V_U + t_c D$, equity cash flow at $r_E$ plus debt, free cash flow at WACC) agree, which is the point of the exercise. **A3. Trade-off with expected distress costs.** Assume (illustration only) that the present-value-weighted probability of distress is $p(D) = 0.02 + 0.6\,(D/900)^3$ and that distress would cost 25 percent of $V_U$ (USD 225m). | Debt | $p(D)$ | PV of tax shields | PV of expected distress costs | $V_L$ | |---|---|---|---|---| | 0 | 2.00% | 0.00 | 4.50 | 895.50 | | 100 | 2.08% | 25.00 | 4.69 | 920.31 | | 200 | 2.66% | 50.00 | 5.98 | 944.02 | | 300 | 4.22% | 75.00 | 9.50 | 965.50 | | 400 | 7.27% | 100.00 | 16.35 | 983.65 | | 500 | 12.29% | 125.00 | 27.65 | 997.35 | | 600 | 19.78% | 150.00 | 44.50 | 1,005.50 | | 700 | 30.23% | 175.00 | 68.02 | 1,006.98 | Excel for one row (debt in A2): `=900+0.25*A2-(0.02+0.6*(A2/900)^3)*0.25*900`. The value peaks at debt of about USD 671m (Solver: maximise the value cell by changing debt), with $V_L$ = 1,007.30, where the marginal tax benefit of 0.25 per dollar of debt equals the marginal expected distress cost. The curve is flat near the top: moving from 600 to 700 changes value by under 0.2 percent, which is why firms choose a range and stay below the peak. ```vega-lite { "$schema": "https://vega.github.io/schema/vega-lite/v5.json", "description": "Northfield Outdoor Co. (fictional): firm value against debt under MM with taxes and under the trade-off theory", "width": 380, "height": 220, "data": {"values": [ {"Debt": 0, "Line": "MM with taxes (VU + tD)", "Value": 900.0}, {"Debt": 0, "Line": "Trade-off", "Value": 895.5}, {"Debt": 100, "Line": "MM with taxes (VU + tD)", "Value": 925.0}, {"Debt": 100, "Line": "Trade-off", "Value": 920.31}, {"Debt": 200, "Line": "MM with taxes (VU + tD)", "Value": 950.0}, {"Debt": 200, "Line": "Trade-off", "Value": 944.02}, {"Debt": 300, "Line": "MM with taxes (VU + tD)", "Value": 975.0}, {"Debt": 300, "Line": "Trade-off", "Value": 965.5}, {"Debt": 400, "Line": "MM with taxes (VU + tD)", "Value": 1000.0}, {"Debt": 400, "Line": "Trade-off", "Value": 983.65}, {"Debt": 500, "Line": "MM with taxes (VU + tD)", "Value": 1025.0}, {"Debt": 500, "Line": "Trade-off", "Value": 997.35}, {"Debt": 600, "Line": "MM with taxes (VU + tD)", "Value": 1050.0}, {"Debt": 600, "Line": "Trade-off", "Value": 1005.5}, {"Debt": 650, "Line": "MM with taxes (VU + tD)", "Value": 1062.5}, {"Debt": 650, "Line": "Trade-off", "Value": 1007.14}, {"Debt": 700, "Line": "MM with taxes (VU + tD)", "Value": 1075.0}, {"Debt": 700, "Line": "Trade-off", "Value": 1006.98} ]}, "mark": {"type": "line", "point": true}, "encoding": { "x": {"field": "Debt", "type": "quantitative", "title": "Debt (USD m)"}, "y": {"field": "Value", "type": "quantitative", "title": "Firm value (USD m)", "scale": {"zero": false}}, "color": {"field": "Line", "type": "nominal", "title": null} } } ``` **A4. APV for a Corvane Robotics facility (*Example*).** Investment 400 today; unlevered after-tax free cash flows of 60, 80, 100, 110 and 110 in years 1 to 5, plus an after-tax salvage value of 120 in year 5; $r_U$ = 12 percent. The project supports a loan of 200 at 7 percent, repaid 40 a year (interest on the opening balance); tax rate 25 percent; issue costs 2 percent of the loan, paid today (treated as not deductible, for simplicity). | Item | Value | Excel | |---|---|---| | Base-case NPV at 12% | -11.06 | `=NPV(0.12,60,80,100,110,230)-400` | | Interest tax shields years 1 to 5 | 3.50, 2.80, 2.10, 1.40, 0.70 | `=0.25*0.07*OpeningBalance` | | PV of tax shields at 7% | 9.00 | `=NPV(0.07,3.5,2.8,2.1,1.4,0.7)` | | Issue costs | -4.00 | `=-0.02*200` | | **APV** | **-6.06** | `=-11.06+9.00-4.00` | Financing side effects add 5.00 but do not rescue a project that destroys value on its operations. Reject it, or find operating improvements, not cheaper debt. **A5. Pecking order mechanism (*Example*, after Myers and Majluf 1984).** A firm's assets in place are worth 250 if managers' private news is good and 50 if it is bad; investors think each is equally likely, so they value the shares at 150. A new project costs 20 and has NPV 10. If the firm must sell equity: | Item | Value | Excel | |---|---|---| | Pooled value after the project = 150 + 20 + 10 | 180.00 | `=150+20+10` | | Fraction sold to raise 20 | 11.11% | `=20/180` | | Old shareholders, good news, issue: 88.89% × 280 | 248.89 | `=(1-20/180)*280` | | Old shareholders, good news, do not issue | 250.00 | | | Old shareholders, bad news, issue: 88.89% × 80 | 71.11 | `=(1-20/180)*80` | | Old shareholders, bad news, do not issue | 50.00 | | With good news, old shareholders lose by issuing (248.89 < 250.00), so the firm skips a positive-NPV project. With bad news it issues. Investors anticipate this, treat an issue as bad news and price the shares at 80 (fraction sold 25 percent; old shareholders keep 60.00 = 50 + 10). Expected value lost: half the time the NPV of 10 is forgone, 5.00. If the firm could fund the project with safe debt or cash, no mispricing arises and both types invest: that is the pecking order. **A6. Payout irrelevance.** Equity worth 1,000 (including 100 of excess cash), 100m shares, net income 80. | Item | Value | Excel | |---|---|---| | Price before payout | 10.00 | `=1000/100` | | Dividend of 1.00 per share: ex-dividend price | 9.00 | `=(1000-100)/100` | | Shareholder wealth per share (9.00 + 1.00) | 10.00 | | | Buyback at 10.00: shares bought | 10.0m | `=100/10` | | Price after buyback | 10.00 | `=(1000-100)/(100-10)` | | EPS before | 0.80 | `=80/100` | | EPS after, ignoring interest lost on the cash | 0.89 | `=80/90` | | EPS after, with 4% pre-tax interest lost on the cash | 0.86 | `=(80-0.04*(1-0.25)*100)/90` | Wealth per share is 10.00 in every case; only its form changes. EPS rises after the buyback, but the share price does not, because equity is now more levered (less cash) and riskier. **A7. Lintner smoothing.** Target payout 40 percent, adjustment speed 0.3, last dividend 1.80. | Year | EPS | Target dividend | Dividend paid | Payout | Excel (D in column D, previous in D1) | |---|---|---|---|---|---| | 1 | 5.00 | 2.00 | 1.86 | 37.2% | `=D1+0.3*(0.4*B2-D1)` | | 2 | 5.50 | 2.20 | 1.96 | 35.7% | same, filled down | | 3 | 4.20 | 1.68 | 1.88 | 44.7% | same | | 4 | 6.00 | 2.40 | 2.03 | 33.9% | same | | 5 | 6.30 | 2.52 | 2.18 | 34.6% | same | EPS falls 24 percent in year 3 but the dividend falls only 4 percent; the payout ratio absorbs the shock. ## Worked example B (half solved) **Setting (*Example*, fictional).** A Northfield Outdoor Co. division earns perpetual EBIT of USD 80m, $r_U$ = 11 percent, tax rate 25 percent. Management proposes permanent debt of USD 150m at 5.5 percent. | Step | Item | Value | Excel | |---|---|---|---| | 1 | $V_U$ = 80 × 0.75 / 0.11 | 545.45 | `=80*(1-0.25)/0.11` | | 2 | PV of tax shield | [ ] | `=0.25*150` | | 3 | $V_L$ | [ ] | `=V_U+PVTS` | | 4 | $E$ | 432.95 | `=V_L-150` | | 5 | $r_E$ | [ ] | `=0.11+150/E*(1-0.25)*(0.11-0.055)` | | 6 | WACC | [ ] | `=E/V_L*rE+150/V_L*0.055*(1-0.25)` | | 7 | Check: $V_L$ = 60 / WACC | [ ] | `=60/WACC` | | 8 | Name two costs that MM with taxes ignores and that could make 150 too much debt for this division | [ ] | | ## Exercise C (unsolved) Corvane Robotics considers a service platform that costs USD 250m and produces perpetual unlevered free cash flow of USD 30m a year; $r_U$ = 11 percent. It will carry permanent debt of USD 100m at 6 percent; tax rate 25 percent; ignore issue costs and distress costs. 1. Compute the base-case NPV. 2. Compute the PV of the tax shield and the APV. 3. Compute the equity value of the platform with debt, its cost of equity and its WACC. 4. Compute the NPV by discounting the free cash flow at that WACC and compare with step 2. 5. In two sentences, explain to a board member why the financing adds value here and what could make it disappear. ## Connections to other cards | Card or template | Connection | |---|---| | mba/mba-capm-wacc-card | Beta unlevering and relevering use MM proposition II with the CAPM | | mba/mba-dcf-valuation-card | WACC assumes a constant target capital structure; switch to APV when it changes | | mba/mba-options-real-options-card | Equity as a call option on the firm's assets (Merton 1974) explains risk shifting and debt overhang | | mba/mba-paper-lbo | A leveraged buyout is an APV problem with a debt schedule | | mba/mba-venture-finance-cap-table-card | Early-stage firms rely on equity: the pecking order and trade-off in reverse | | mba/mba-ratio-analysis-card | Coverage and leverage ratios behind credit ratings | | finance/capital-structure-dividend-policy | Turns the analysis into a board-approved policy | | finance/treasury-policy and finance/credit-memo | Lender and treasury views of the same decision | ## Common mistakes and misconceptions - **"Debt is cheaper than equity, so more debt lowers WACC forever."** Each extra unit of debt raises the cost of equity (MM II) and, beyond some point, the cost of debt and the expected cost of distress. - **Using the statutory tax rate for every firm.** A firm with losses carried forward, or one hitting an interest limitation rule, gains little or nothing from extra interest deductions this year. - **Valuing the tax shield twice.** Discounting FCFF at an after-tax WACC already includes the tax shield; adding $t_c D$ on top double counts it. In APV, the base case must be all-equity. - **Discounting tax shields at the wrong rate.** Fixed debt schedules: at $r_D$. Debt rebalanced to a target ratio: at $r_U$. Mixing them changes the answer. - **Book values in WACC weights.** Use market values (or target weights), not balance-sheet book equity. - **Treating the pecking order as a rule that firms never issue equity.** It predicts an ordering of preferences when information costs dominate; firms with no debt capacity left or large growth options do issue equity. - **"A buyback creates value because EPS rises."** EPS rises mechanically when the earnings yield exceeds the after-tax yield on cash; value changes only through taxes, signals, agency effects or buying shares below value. - **"Dividend cuts are always bad."** A cut that funds positive-NPV projects can add value; the market reaction reflects what the cut signals about cash flows, not the cut itself. - **Ignoring indirect distress costs.** Legal fees are small; lost customers, suppliers and investment opportunities are not. - **Believing theory gives an exact optimal ratio.** The value curve is flat near its peak, and its inputs (distress probabilities, costs) are uncertain; work with ranges and rating metrics. ## Self-test questions 1. State MM proposition I and II without taxes. What does "homemade leverage" mean? 2. In A2, why is the PV of the tax shield $t_c D$ and not $t_c r_D D$? 3. A firm with $r_U$ = 10%, $r_D$ = 5% and no taxes moves from $D/E$ = 0.5 to $D/E$ = 1.0. What happens to $r_E$ and to WACC? 4. Name two predictions of the trade-off theory and one fact it struggles to explain. 5. Explain in three sentences why announcing an equity issue can lower the share price. 6. When is APV better than discounting at a single WACC? Give two cases. 7. Why does a firm with large growth options typically use less debt? Use the idea of debt overhang. 8. In A6, why does EPS rise after the buyback while the share price does not? 9. A firm's EPS jumps 30 percent this year. Using Lintner's model, describe how its dividend will change this year and next. 10. Name three direct and three indirect costs of financial distress for a hospital such as Tallow Creek Medical Center (fictional). ## My notes and next steps | Item | My entry | |---|---| | Confidence with capital structure (1 = lost, 5 = could teach it) | [ ] | | Theory I find hardest to apply | [ ] | | Questions for my professor, tutor or study group | [ ] | | Mistakes logged in mba/mba-error-log | [Date and short description] | | Flashcards made in mba/mba-concept-flashcards | [Card IDs] | | Next review date (spacing: +2 days, +1 week, +1 month) | YYYY-MM-DD | | Next card to study | [mba/mba-options-real-options-card / mba/mba-dcf-valuation-card] | ## Sources and further reading - Lintner, J. (1956). Distribution of incomes of corporations among dividends, retained earnings, and taxes. *American Economic Review*, 46(2), 97–113. - Modigliani, F., and Miller, M. H. (1958). The cost of capital, corporation finance and the theory of investment. *American Economic Review*, 48(3), 261–297. - Miller, M. H., and Modigliani, F. (1961). Dividend policy, growth, and the valuation of shares. *Journal of Business*, 34(4), 411–433. - Modigliani, F., and Miller, M. H. (1963). Corporate income taxes and the cost of capital: a correction. *American Economic Review*, 53(3), 433–443. - Kraus, A., and Litzenberger, R. H. (1973). A state-preference model of optimal financial leverage. *Journal of Finance*, 28(4), 911–922. - Myers, S. C. (1974). Interactions of corporate financing and investment decisions: implications for capital budgeting. *Journal of Finance*, 29(1), 1–25. - Merton, R. C. (1974). On the pricing of corporate debt: the risk structure of interest rates. *Journal of Finance*, 29(2), 449–470. - Jensen, M. C., and Meckling, W. H. (1976). Theory of the firm: managerial behavior, agency costs and ownership structure. *Journal of Financial Economics*, 3(4), 305–360. - Miller, M. H. (1977). Debt and taxes. *Journal of Finance*, 32(2), 261–275. - Myers, S. C. (1977). Determinants of corporate borrowing. *Journal of Financial Economics*, 5(2), 147–175. - Warner, J. B. (1977). Bankruptcy costs: some evidence. *Journal of Finance*, 32(2), 337–347. - Myers, S. C. (1984). The capital structure puzzle. *Journal of Finance*, 39(3), 575–592. - Myers, S. C., and Majluf, N. S. (1984). Corporate financing and investment decisions when firms have information that investors do not have. *Journal of Financial Economics*, 13(2), 187–221. - Jensen, M. C. (1986). Agency costs of free cash flow, corporate finance, and takeovers. *American Economic Review*, 76(2), 323–329. - Andrade, G., and Kaplan, S. N. (1998). How costly is financial (not economic) distress? Evidence from highly leveraged transactions that became distressed. *Journal of Finance*, 53(5), 1443–1493. - Graham, J. R., and Harvey, C. R. (2001). The theory and practice of corporate finance: evidence from the field. *Journal of Financial Economics*, 60(2–3), 187–243. - Brav, A., Graham, J. R., Harvey, C. R., and Michaely, R. (2005). Payout policy in the 21st century. *Journal of Financial Economics*, 77(3), 483–527. - Textbooks (further reading, by name only): Berk and DeMarzo, *Corporate Finance*; Brealey, Myers and Allen, *Principles of Corporate Finance*; Ross, Westerfield and Jaffe, *Corporate Finance*; Tirole, *The Theory of Corporate Finance* (advanced). - Open resource: OpenStax, *Principles of Finance* (2022), free online at https://openstax.org (check the licence on the book page). ## Answer key **Worked example B.** (2) 37.50. (3) $V_L$ = 582.95. (5) $r_E$ = 0.11 + (150/432.95)(0.75)(0.055) = 12.43%. (6) WACC = 10.29%. (7) 60 / 0.1029 = 582.95 (exactly, with unrounded WACC). (8) Expected costs of financial distress (lost customers and suppliers, fire sales) and agency costs of debt (underinvestment, risk shifting); also limits on interest deductibility and personal taxes that reduce the net tax gain. **Exercise C.** (1) Base NPV = -250 + 30/0.11 = 22.73. (2) PV of tax shield = 0.25 × 100 = 25.00; APV = 47.73. (3) Levered value = 272.73 + 25.00 = 297.73; equity = 197.73; $r_E$ = 0.11 + (100/197.73)(0.75)(0.05) = 12.90%; WACC = 10.08% (10.076% unrounded). (4) NPV = -250 + 30/0.10076 = 47.73, the same as APV, because permanent debt in a no-growth perpetuity keeps the debt ratio constant. (5) The interest deduction saves tax every year, worth 25.00 today if the debt is permanent and the platform stays profitable. It disappears if the firm cannot use the deduction (losses or interest limits) or if the debt raises the risk of distress. **Self-test.** 1. I: firm value does not depend on capital structure. II: the cost of equity rises linearly with $D/E$ so that WACC stays constant. Homemade leverage: investors can borrow or lend on their own account to recreate any leverage, so they will not pay extra for corporate leverage. 2. Because $t_c r_D D$ is the annual saving; for permanent debt it is a perpetuity discounted at $r_D$: $t_c r_D D / r_D = t_c D$. 3. $r_E$ rises from 10% + 0.5 × 5% = 12.5% to 10% + 1.0 × 5% = 15.0%. WACC stays at 10%. 4. Predictions: firms with tangible assets and taxable profits borrow more; firms with high distress costs or growth options borrow less. Struggles with: the most profitable firms often borrow least. 5. Managers know more about value than investors. They prefer to issue equity when they think it is overvalued. Investors know this, so they read an issue as a signal of overvaluation and lower the price. 6. When the amount of debt follows a fixed schedule (buyouts, project finance) and when there are financing side effects such as subsidised loans or issue costs to show separately. 7. Lenders would capture part of the value of future investments when debt is risky, so shareholders may refuse to fund positive-NPV projects (debt overhang, Myers 1977); firms whose value is mostly growth options lose most from this, so they keep debt low. 8. EPS rises because the earnings yield (0.80/10 = 8%) exceeds the after-tax yield lost on the cash; the price does not rise because the remaining equity is riskier and its required return is higher. 9. The dividend rises only by the fraction $c$ of the gap between the new target ($p \times EPS$) and the old dividend, and continues to move towards the target next year if earnings stay high. 10. Direct: legal fees, advisory fees, court and administration costs. Indirect: patients and referring doctors move to other providers, key clinicians leave, suppliers demand cash, maintenance and investment in equipment are delayed. ## Revision history | Version | Date | Author | Change summary | |---|---|---|---| | 0.1 | YYYY-MM-DD | [Your name] | First version from the template | | 0.2 | YYYY-MM-DD | [Your name] | *Example:* Added case company's rating metrics and replaced the illustrative distress function | ## Standard and licence note Based on the capital structure and payout theories in the original works cited above (Modigliani and Miller 1958, 1963; Miller and Modigliani 1961; Lintner 1956; Myers 1974, 1977, 1984; Myers and Majluf 1984) as taught across MBA core corporate finance courses; no single standard governs these methods. The explanations, notation, worked examples and layout are original; no textbook text, published case or exam question is reproduced. Every number was computed in Python and is shown with the matching Excel formula. Tax rules change and differ by jurisdiction: check the current rules before applying any tax assumption. The template is not affiliated with or endorsed by any business school or publisher, and it is not financial, tax or legal advice. Template licence: MIT.