MM is the Benchmark
In perfect markets, VU = VL. Any deviation from this requires
a market imperfection (taxes, distress, agency, asymmetric info).
Capital Structure Explorer
Class 8: Capital Structure & Corporate Governance
📚 Week 8 Overview: Capital Structure & Corporate Governance
The bridge from MM's perfect-market benchmark to real-world capital structure optimization
🎯 The Central Question
Does financing choice change the size of the pie (firm value)?
We start with MM's irrelevance proposition, then "cancel" perfect-market assumptions
one by one (taxes, distress costs, agency problems, asymmetric information) to find the optimal capital structure.
Main Concepts Covered
📐
MM Propositions
In perfect markets, capital structure is irrelevant — financing only
splits the pie, doesn't change its size. Debt appears cheap but
equity risk rises to offset it.
VU = VL (no taxes)
💰
Interest Tax Shield
Interest is tax-deductible, creating real value. With taxes, levered
firms are worth more than unlevered firms by the present value of
tax savings.
VL = VU + PV(Tax Shield)
⚠️
Financial Distress Costs
High leverage increases bankruptcy risk. Direct costs (legal fees)
and indirect costs (lost customers, supplier issues) destroy value.
VL = VU + PV(TS) − PV(DC)
⚖️
Trade-off Theory
Optimal leverage balances tax benefits against distress costs. The
optimum is where marginal tax benefit equals marginal distress cost
— the "hump" peak.
Optimal: min WACC = max VL
🎯
Pecking Order Theory
Due to asymmetric information, firms prefer internal funds first,
then debt, then equity (last resort). Equity signals potential
overvaluation.
Internal → Debt → Equity
👔
Agency Problems
Managers may not act in shareholders' interests (shirking, empire
building). Debt disciplines managers but excessive leverage creates
conflicts with creditors.
Agency costs ↓ Firm value
🧠 Key Exam Framework
For any capital structure question, use this checklist:
Taxes (tax shield value), Distress costs
(probability × magnitude), Transaction costs (equity
issuance fees), Agency problems (manager vs shareholder
vs creditor conflicts), and Information problems
(signaling effects of financing choices).
Key Takeaways for the Final
1
2
Debt is NOT "Cheaper" in MM World
Common exam trap! Equity cost rises with leverage to offset cheaper debt.
rE = rA + (D/E)(rA − rD). WACC stays constant.
3
Trade-off Creates "Hump-Shaped" Value Curve
Value rises with leverage (tax shield) then falls (distress costs).
Optimal leverage is at the peak. Use the simulator to visualize this!
4
Pecking Order ≠ Target Leverage
Leverage is the outcome of cumulative choices, not a target. Profitable
firms often have low debt because they fund internally.
5
Debt Has Agency Benefits AND Costs
Benefits: disciplines managers (commits cash flows). Costs: risk shifting,
underinvestment, claim dilution. Covenants mitigate agency costs of debt.
💡 Exam Strategy: When analyzing any news/case about leverage,
structure your answer as: (1) Name the theory, (2) Explain the mechanism,
(3) State the prediction, (4) Discuss implications for value/WACC/stakeholders.
🎮 Interactive Trade-off Theory Simulator
Visualize how debt ratio, tax rate, and distress risk affect firm value
Higher leverage increases tax benefits but increases
distress risk.
Higher corporate taxes increase the value of the interest
tax shield.
Higher distress risk increases the expected costs of
financial distress.
Base firm value without any debt financing.
Unlevered Value (VU)
$1000
Current Firm Value (VL)
$0
Optimal Leverage
0%
Trade-off Formula:
VL = VU +
PV(Tax Shield)
−
PV(Distress Costs)
💡 Notice how firm value increases with leverage (tax
benefits) but then decreases as distress costs dominate.
Cost of Capital at Current Leverage
Cost of Equity (rE)
0.0%
Cost of Debt (rD)
5%
WACC (with tax)
0.0%
⚠️ Key Insight: As leverage increases,
rE rises. In MM world (no taxes), WACC stays
constant. With taxes, WACC can initially fall but may rise
again due to distress risk.
Modigliani–Miller Propositions
The foundation of modern capital structure theory
🎯 Perfect Market Assumptions
✓
No taxes
✓
No transaction costs
✓
No bankruptcy costs
✓
No asymmetric information
✓
Efficient markets
📌 Proposition I: Capital Structure Irrelevance
VU = VL
The Pie Analogy: Financing decisions determine how the "pie" (firm value) is split between debt and equity, but do not change the size of the pie. Value is created by investments (LHS of the balance sheet), not financing (RHS).
🎓 Exam Trap: Do not claim "debt increases value because it is
cheaper" in MM's no-tax perfect market world.
📌 Proposition II: Leverage & Risk
rE = rA +
(D/E) ×
(rA − rD)
As leverage increases, equity becomes riskier and shareholders require higher expected returns. In the no-tax MM setting, the cheaper debt is offset by a higher cost of equity, keeping WACC constant.
💰 With Taxes: Debt Creates Value
VL = VU +
PV(Tax Shield)
Interest is tax-deductible, so each dollar of interest reduces taxes by t × Interest. This is the Interest Tax Shield.
🎯 Pecking Order Theory
How asymmetric information shapes financing choices
💡 The Core Insight
Managers typically know more about the firm than outside investors (asymmetric information). Equity issuance can be interpreted as a negative signal (possible overvaluation), which can pressure the stock price.
The Financing Hierarchy:
1
Internal Funds (Retained Earnings)
🟢 Most preferred — no signal, low friction, no outside scrutiny
2
Debt Financing
🟡 Second choice — generally weaker negative signal than equity
3
Equity Issuance
🔴 Last resort — stronger adverse selection concerns
📊 Key Implications
-
→Leverage is not a target — it is an outcome of cumulative financing decisions
-
→Profitable firms can have low debt — internal funds reduce external financing needs
-
→Financial slack is valuable — it preserves flexibility and avoids costly issuance
⚖️ Agency Theory & Governance
Conflicts between managers, shareholders, and creditors
👔 The Principal–Agent Problem
Managers (agents) may not act in shareholders' (principals') best interests. These agency costs reduce firm value.
😴
Shirking
Not working hard enough
🏰
Empire Building
Growing beyond optimal scale
✈️
Perks
Excessive compensation / benefits
🛡️
Risk Avoidance
Playing too safe
🛠️ Governance Mechanisms (Reduce Agency Costs)
💰 Incentive Alignment
Stock options, restricted stock, pay-for-performance
👁️ Board Monitoring
Independent directors, audit committees
🐋 Large Blockholders
Active investors monitoring management
🎯 Market for Control
Takeover threat disciplines managers
💪 Debt as a Governance Tool
Free Cash Flow Problem: Managers may waste excess cash on negative-NPV projects or empire building.
Solution: Debt commits cash flows to creditors. Interest is enforceable (unlike discretionary payouts), disciplining managers and reducing wasteful spending → Agency benefit of debt.
⚠️ But Too Much Debt Creates New Problems
Agency costs of debt (conflicts with creditors):
Risk Shifting
Taking excessive risk — upside to shareholders, downside to
creditors
Claim Dilution
Issuing more debt, harming existing creditors
Underinvestment
Rejecting good projects because benefits go to creditors
Asset Stripping
Paying out value before bankruptcy (looting)
💡 Covenants in debt contracts can mitigate many of
these problems.
✏️ Test Your Understanding
8 questions covering the key concepts from Class 8
📋 Quick Formula Reference
Compact reminders for exams and problem sets
MM I (no tax)
VU = VL
MM II (no tax)
rE = rA + (D/E)(rA − rD)
Trade-off
VL = VU + PV(TS) − PV(DC)
WACC (with tax)
rE×(E/V) + rD×(1−t)×(D/V)