Topic outline

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  • 1. Introduction

    Welcome to "Capital Structure Decisions!"  The module investigates how to use financial decision making to improve (or protect) firm value. This introductory section provides an overview of the structure of the module.


    financing policy word cloud


    The main learning goals of this module are:
    • Learn how to use financial decision making to improve firm value.
    • Understand how and why the firm's capital structure (debt-equity mix) matters.
    • Learn how a firm can adjust its capital structure.
    • Understand the implication for debt and equity valuation.
    • Know the key considerations behind an optimal capital structure.
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  • 2. Capital Structure: Overview

    This section starts with a general overview of the internal and external sources of financing that are available to firms. We then focus on the two most important sources of capital: debt and equity. The two instruments have strikingly different characteristics, in particular with respect to their property rights and their cash flow rights. These differences can have far-reaching implications for many important dimensions, including the firm's tax bill, the willingness to take risks, and the way we measure performance.  The section concludes with an overview of the most important finanacial ratios to assess the capital structure of a company.

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  • 3. Does Debt Policy Matter? A Perfect World

    Does it matter whether firms use debt or equity to finance their activities? We start the discussion of this important question in a very stylized world. We learn that, in principle, the value of a company is unrelated to its financing policy and that, ultimately, the financing policy simply defines how a given firm value is split among the various providers of capital.

    We also learn, however, that financing decision change the risk characteristics of the various sources of capital, in particular the firm's equity. Because debtholders are entitled to preferred returns whereas shareholders only have a residual claim, the risk of the equity increases as leverage goes up. Shareholders require a compensation for this additional risk, which is why there is a positive relation between the firm's leverage and the expected return on equity.

    These findings and discussions have imortant implications for dimensions such as the banking regulation and executive compensation. We briefly discuss these implications at the end of the section.

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  • 4. Tax Implications of Debt Financing

    This section drops one of the key assumptions from the preceding section and studies in detail the tax implications of financing decisions. Debt receives favorable tax treatment compared to equity. By moving from equity financing to debt financing, firms can therefore save taxes, which provides them with an additional source of value on top of the value generated with the operating activities. 


    We discuss the value implications of debt financing and show in detail how to compute the cost of capital of firms that pursue a financing policy with a target debt ratio (e.g., debt corresponds to 40% of firm value) or target debt levels (e.g., a fixed amount of debt outstanding). We then discuss a two-step valuation approach that allows us to adjust a company valuation to correctly reflect the tax implications of financing decisions. This is the so-called Adjusted Present Value (APV) approach


    Ultimately, taxes lower the firm's borrowing cost. Instead of modelling the value implications of debt financing separately, we can also include the tax effect in the computation of the cost of capital. This is what the so-called Weighted Average Cost of Capital (WACC) does. We introduce this measure of the firm's cost of capital and show how to apply it in firm valuations.

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  • 5. Adjusting the Capital Structure

    In the previous section, we have seen that different financing policies can have different value implications. The purpose of this section is to understand how firms can actually adjust their capital structure and which step in the process is responsible for the value effect. To be able to study the financing effect in isolation, we maintain the assumption that the firm in question does not adjust its operating activities and merely rearranges how these activities are financed.

    We start by looking at the announcement effects of leveraged recapitalizations: How does the market react if the firm announces a change in its financing policy? We learn how to assess the change in the debt tax shield (DTS) at the time of the announcement and how this affects the firm's valuation.

    Next, we investigate whether it matters how the firm distributes cash to its shareholders. We consider dividend payments and share repurchases and see that the distribution decision itself has no effect on the overall shareholder value.

    Many mature firms hold considerable amounts of excess cash on their balance sheets. We discuss how to adjust the preceding approach to understand the tax penalty of excess cash and how and why distributing excess cash could increase firm value.

    Finally, we look into the relevance of Earnings per Share (EPS) as a performance metric and valuation input. Many practitioners look at EPS when assessing the attractiveness of a firm as an investment target. We show that EPS is not a value indicator and that it is in fact easy to create a simple corporate transaction that improves EPS but destroys value.

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  • 6. Understanding and Valuing Debt and Equity

    The preceding sections have looked in great detail at the tax implications of financing decisions. In what follows, we focus on other "side-effects" of financing decisions and show that these other side-effects might often be at least as relevant than the direct tax implications. The purpose of this section is to take a closer look at the incentive and valuation implications of debt financing.

    To better understand how debt financing affects the incentives of the involved parties, it makes sense to compare the key characteristics of the payoffs to debt and equity. This is how we start. One of the most direct implications is that debtholders are risk averse whereas (high) leverage gives shareholders an incentive to increase the riskiness of the firm. In the extreme, shareholders are better off when the firm pursues a high-risk project that distroys value, on average. This is the so-called asset substitution problem. We consider other typical incentive problems that (too much) debt can bring about, including the reluctance to invest (underinvestment problem) or the preference for short-term projects, and we discuss how debt contracts typically try to address these problems.

    Understanding the payoffs to debt and equity is also helpful for the valuation of these claim. In the second part of this section, we introduce the so-called Merton model, which decomposes the overall value of the firm into a debt value and an equity value using option pricing. A valuable side effect of this model is that it allows us to estimate the market-implied probability of default as well as the expected loss in default, among other things.

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  • 7. Towards an Optimal Capital Structure

    In this last section of the module, we conclude the discussion of the debt-equity trade-off. We start by discussing possible additional costs and benefits of debt financing, namely: 


    debt-equity trade-off


    Then we turn to the question of how these considerations shape the optimal financing policy. To this end, we discuss the two most important theories of capital structure, namely the Pecking-Order Theory as well as the Trade-off Theory. We conclude the section with an illustration of how we can use Monte Carlo Simulation to determine a firm's optimal leverage range.

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