BFF5520 Chap.8 Financing and Capital Structure I
Financing and Capital Structure I
Capital structure divides operating cash flow between debt and equity claims. Modigliani and Miller provide the frictionless benchmark: with fixed investment policy, no taxes and perfect markets, repackaging the same asset cash flows cannot change total value because investors can create or offset leverage personally. Debt makes equity riskier and raises required equity return.
Corporate tax can add an interest tax shield when deductions are usable. Financing actions may also transfer value between debtholders and shareholders without changing total firm value, so claimant values and total value must be reconciled separately.
What this chapter covers
- 01
Operating assets and claims
- 02
MM irrelevance benchmark
- 03
Homemade leverage
- 04
Leverage and equity risk
- 05
Debt tax shield
- 06
Fixed-debt assumptions
- 07
Share repurchases
- 08
Claimant wealth transfers
Worked example · free
Construct homemade leverage
- +2A 3% claim on common operating assets requires 3% × $800,000 = $24,000 of Firm U shares.
- +2Borrow personally 3% × $200,000 = $6,000 to reproduce the proportional debt priority.
- +1Net wealth invested is $24,000 - $6,000 = $18,000.
- +1A 3% stake in Firm L equity also costs 3% × $600,000 = $18,000, and state cash flows match under the assumptions.
Key terms
- Capital structure
- Capital structure is the mix and priority of financing claims used to fund operating assets.
- Homemade leverage
- Homemade leverage is personal borrowing used with unlevered equity to reproduce levered equity exposure.
- MM proposition
- The MM proposition is the frictionless benchmark that financing mix alone does not change total operating value.
- Interest tax shield
- An interest tax shield is the corporate tax saving created when interest expense is deductible.
- Levered equity
- Levered equity is the residual claim after promised debt payments and therefore has amplified operating sensitivity.
- Wealth transfer
- A wealth transfer is a gain to one claimant offset by a loss to another without a change in total firm value.
Financing and Capital Structure I FAQ
Why can investors undo corporate leverage?
Under the benchmark, investors can borrow or lend on the same terms and combine that position with equity. They can therefore reproduce or offset the firm's financing exposure, preventing claim repackaging alone from carrying a value premium.
Why does required equity return rise with debt?
Debt receives priority, leaving equity with a more variable residual claim on the same operating cash flow. Greater leverage magnifies equity gains and losses, so shareholders require a higher expected return for that added risk.
How does the corporate tax shield add value?
Deductible interest reduces corporate tax and increases after-tax cash available to claimholders. With fixed permanent debt and usable deductions, the standard shortcut values the shield as the tax rate multiplied by debt.
When is the permanent-debt shortcut unsafe?
The shortcut can fail when debt changes with firm value, the shield is risky, the firm lacks taxable income, or debt policy varies over time. The timing and risk of tax savings then require explicit valuation.
How can shareholders gain without firm value increasing?
A financing action can weaken existing debt or alter priority, causing debtholders to lose exactly what equity gains. Recalculate debt, equity and total value. If claimant changes offset, the event is a transfer rather than value creation.
Exam move
Begin every problem with operating asset value and show how debt and equity divide it. Recreate a levered equity stake using an unlevered company plus personal borrowing, and recreate an unlevered position by adding personal lending to levered equity. State the assumptions that make replication possible. Then add corporate tax as a separate cash-flow effect and write when the fixed-debt shield shortcut applies.
In recapitalisation questions, keep a three-column ledger for debt value, equity value and total firm value so transfers cannot be mistaken for new wealth. Draw a claim stack for every state of the world: operating cash flow enters once, debt receives its contractual amount subject to limited liability, and equity receives the residual.
Use that same state table to test homemade leverage, matching both the cash amount and risk in each state rather than matching only an expected payoff. List the benchmark assumptions beside the replication: identical borrowing terms, no taxes or transaction costs, divisible claims and unchanged investment policy. Add one friction at a time so its value channel remains visible.
For a tax shield, identify the interest deduction, applicable tax rate and debt policy before choosing a shortcut; fixed permanent debt and debt rebalanced with firm value do not support the same valuation step. Reconcile any recapitalisation through pre-transaction firm value, financing proceeds, cash distributed and post-transaction claims.
If total operating cash flow has not changed, a higher promised payment to one claimant must be offset by risk or value borne elsewhere unless a genuine frictional benefit is introduced.
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