Introduction

Corporate Financing Foundations: Capital Formation and Corporate Governance

Capital Structure vs Financial Structure

Capital Structure: The permanent long-term financing mix of a firm comprising Long-Term Debt, Preferred Stock, and Common Equity (excluding short-term liabilities).
Financial Structure: The entire right-hand side of the Balance Sheet (Total Liabilities + Shareholders’ Equity), including all short-term current liabilities.

Static Trade-Off Theory (Modigliani-Miller with Taxes)

Firms balance the tax shield benefits of debt financing against the rising present value of financial distress and bankruptcy costs:

V_L = V_U + T_c D - \text{PV of Financial Distress Costs}

Pecking Order Theory (Myers-Majluf)

Firms prioritize financing sources based on asymmetric information: 1st Internal Cash/Retained Earnings $\implies$ 2nd Safe Debt $\implies$ 3rd Risky Equity as a last resort.

Modigliani-Miller Theorems and Capital Structure Irrelevance vs Trade-Off Theory

Modigliani-Miller (MM) Propositions Synthesis

Proposition I (No Taxes):
$V_L = V_U$
Firm value is independent of capital structure in frictionless markets.
Proposition I (With Corporate Taxes):
$V_L = V_U + T_c D$
Firm value increases linearly with debt due to the interest tax shield.
Proposition II (Cost of Equity):
$r_e = r_0 + \frac{D}{E}(r_0 - r_d)(1 - T_c)$
Cost of equity increases linearly with the debt-to-equity ratio ( $D/E$ ) to compensate equity holders for higher financial risk.

Comparative Capital Structures: Equity Dominance vs Debt-Leveraged Firms

Theory	Modigliani-Miller (With Tax)	Trade-off Theory	Pecking Order Theory
Optimal Debt Ratio	100% Debt (Maximum tax shield)	Target balance where marginal tax shield = marginal distress cost	No target; determined by internal cash deficits
Driver of Choice	Corporate tax deductibility of interest	Tax shield vs Bankruptcy / Agency costs	Asymmetric information & signaling

Financial Leverage, EPS Volatility, and EBIT-EPS Indifference Computations

Applied Problem: Modigliani-Miller with Corporate Taxes

Unlevered Firm U has EBIT = Rs. 10,000,000 in perpetuity. Its cost of equity is $r_0 = 12.5\%$ and the corporate tax rate is $T_c = 25\%$ . Levered Firm L is identical to Firm U except that it has issued Rs. 30,000,000 of perpetual bonds at an interest rate of $r_d = 8.0\%$ .

Compute the value of Unlevered Firm U ( $V_U$ ).
Compute the value of Levered Firm L ( $V_L$ ) under MM with taxes.
Determine the market value of equity ( $E_L$ ) and the required return on equity ( $r_{eL}$ ) for Firm L.

Solution:

Value of Unlevered Firm U:
$V_U = \frac{\text{EBIT}(1 - T_c)}{r_0} = \frac{10,000,000 \times (1 - 0.25)}{0.125} = \frac{7,500,000}{0.125} = \text{Rs. } 60,000,000$
Value of Levered Firm L:
$V_L = V_U + T_c D = 60,000,000 + (0.25 \times 30,000,000) = 60,000,000 + 7,500,000 = \text{Rs. } 67,500,000$
Market Value of Equity and Cost of Equity ( $r_{eL}$ ):
$E_L = V_L - D = 67,500,000 - 30,000,000 = \text{Rs. } 37,500,000$

$\frac{D}{E} = \frac{30,000,000}{37,500,000} = 0.80$

$r_{eL} = r_0 + \left(\frac{D}{E}\right)(r_0 - r_d)(1 - T_c) = 12.5\% + (0.80)(12.5\% - 8.0\%)(1 - 0.25)$

$r_{eL} = 12.5\% + (0.80)(4.5\%)(0.75) = 12.5\% + 2.70\% = 15.20\%$

Key analytical nuance: they equate capital structure with financial structure, forgetting to exclude short-term current liabilities from capital structure.

Corporate Financing Decision

Chapter notes

Unit 1: Introduction· 5 LHs· ~6 marks