Corporate Finance Week 8 — Capital Structure (MM → Real-World Optimization)
1) What Week 8 is really testing
- Start in a perfect-market world (MM as the benchmark).
- Then relax assumptions one by one (taxes, distress costs, transaction costs, agency, asymmetric information).
- Key question: does the financing choice change the size of the pie (firm value), or only split it?
2) MM baseline (perfect markets): what you must be able to state and use
MM irrelevance conditions (logic, not just list)
- Complete/efficient markets
- No asymmetric information
- No taxes
- No transaction or bankruptcy costs
- Investment policy held constant
- Financing does not create value; it only allocates cash flows between claimholders
Proposition I: capital structure irrelevance
VU = VL (= EL + DL)
Intuition: financing splits the cash-flow “pie” but does not change its size; arbitrage enforces the equality.
Proposition II: leverage raises equity risk/return; WACC constant in MM world
rE = rA + (D/E) * (rA - rD)
- Debt appears cheaper because equity becomes riskier as leverage rises.
- Weighted return on debt + equity equals asset return (rA).
Exam trap: “More debt lowers WACC because debt is cheaper.” In MM, that is false: rE rises to offset, so WACC stays constant.
3) Relaxing assumptions → an optimal capital structure exists
Week 8 sets up a checklist for any leverage/capital-structure question:
- Taxes
- Financial distress costs
- Transaction costs
- Agency problems
- Information problems (asymmetric information)
A) Taxes: why debt can add value
- Debt creates an interest tax shield (interest is deductible).
- Adding debt can increase firm value relative to all-equity.
VL = VU + PV(Tax Shield)
Common simplification (when debt is treated as roughly constant): PV(TS) is approximately tax rate × debt value,
but this is an approximation and not fully realistic for long horizons.
Exam trap: inconsistent tax treatment (e.g., mixing after-tax WACC adjustments incorrectly). The course logic: start with MM, then add the tax wedge explicitly.
B) Financial distress costs: why 100% debt is not optimal
- With distress costs, value is hump-shaped in leverage: value rises with tax benefits, then falls when expected distress costs dominate.
- Optimal leverage is the top of the hump; equivalently, where WACC is lowest.
Static trade-off structure to write in exams:
VL = VU + PV(Interest Tax Shield) − PV(Expected Distress Costs)
Distress checklist (what to discuss)
- Probability of distress: cash-flow volatility and business risk
- Costs of distress: customer sensitivity, asset redeployability, competitive threats if cash-pinched, managerial behavior in distress
C) Transaction costs
- Equity issuance can be costly (fees + internal time/capacity).
- This friction pushes firms away from equity unless it is necessary.
4) Agency costs + corporate governance (Week 8 “Part 2”)
The core agency problem
- Managers (agents) may not act in shareholders’ (principals’) interests.
- Agency costs show up as lower share price / value loss.
Typical agency behaviors to cite
- Shirking
- Empire building
- Perks
- Risk avoidance
How governance reduces agency costs (mechanisms to name)
- Incentives / compensation alignment
- Restricted stock/options
- Pay-for-performance
- Monitoring
- Independent directors on the board
- Large blockholders
- Market for corporate control (takeovers)
Transcript reinforces that board oversight can fail (high-salience example used to illustrate weak diligence/monitoring).
Debt as a governance tool (agency benefit of leverage)
- Free cash flow problem: managers may prefer to keep excess cash and spend it on negative-NPV projects.
- Debt disciplines by committing future cash flows to creditors and reducing managerial slack.
- Dividends are discretionary; debt service is enforceable.
But excessive leverage creates agency conflicts with creditors (agency costs of debt)
- Looting / liquidating dividends (if not prevented by covenants)
- Delayed liquidation
- Claim dilution (borrowing more surprises existing creditors)
- Risk shifting / asset substitution (creditors demand higher rates ex ante)
Takeaway: leverage can reduce some agency problems, but too much leverage creates new ones; covenants mitigate many.
5) Asymmetric information: pecking order and market reactions
- Equity issuance conveys negative information (investors infer managers do not believe the stock is undervalued).
- Outside finance is costly under asymmetric information; internal finance is best.
- Project value can depend on financing because funding constraints change what can be undertaken.
Pecking order rule (write cleanly in exams)
- Retained earnings
- Debt (unless already highly leveraged)
- Equity as last resort
Pecking order implications
- Leverage is often an outcome of incremental financing choices, not a fixed target.
- Profitable firms may reduce leverage to build financial slack and avoid future equity issuance.
6) “So what’s the number?” — answering practical leverage questions
No one-size-fits-all: you must state trade-offs and justify a range.
- Main tension: maximize tax advantage vs minimize distress costs.
- Use business judgment; leverage moves with profitability and financing needs.
- Apply the checklist: taxes, expected distress costs, transaction costs, agency, information effects.
Fast-growth vs mature firms (exam-friendly classification)
- Fast growth / high R&D / risky strategy: typically lower debt; may drift above “target” if avoiding equity, increasing distress risk.
- Mature / stable cash flows / tangible assets: often higher debt; may drift below “target” if reluctant to repurchase equity or increase dividends.
7) How this shows up on the final: marking-friendly structure
- Name the theory (MM / trade-off / agency / pecking order / governance).
- Mechanism (tax shield vs distress; debt discipline vs risk shifting; equity-issuance signal).
- Prediction (move toward/away from leverage; price reaction; covenant/monitoring changes).
- Implication (direction for firm value/WACC; stakeholder impact; governance risk).