FNCE20005 · Corporate Financial Decision Making
Capital Structure
Capital structure is the mix of debt and equity that funds the firm, and the deep question is whether that mix changes firm value at all. Modigliani-Miller say no: in a frictionless world (no taxes, no distress, no transaction costs, symmetric information) firm value is independent of capital structure (VL = VU), because slicing the cash-flow pie into debt and equity wedges does not change the size of the pie; the cost of equity rises with leverage exactly enough to keep WACC flat. Add corporate tax and debt earns an interest tax shield, VL = VU + teD — taken literally this implies 100% debt. Add the threat of financial distress (small direct costs, large indirect ones) and the trade-off theory balances the shield against distress into an interior optimum, the D/E that minimises WACC. The pecking order abandons targets altogether: under asymmetric information firms follow a hierarchy — internal funds, then debt, then hybrids, then external equity as a last resort. Leverage also re-levers beta, βL = βu[1 + (1 − te)D/E]. The AU twist: imputation drives te toward zero, gutting the debt tax shield, so optimal leverage is lower in Australia.
What this chapter covers
- 011 Modigliani-Miller without tax — irrelevance and the pie theory
- 022 MM with corporate tax — VL = VU + teD and the imputation kill-switch
- 033 Levered beta — financial risk on top of business risk
- 044 Financial distress costs — direct vs indirect
- 055 Trade-off theory — the interior optimum and the U-shaped WACC
- 066 The three views side by side
- 077 Pecking-order theory — the financing hierarchy
- 088 Worked example — MM-tax value and re-levering beta
Worked example: MM-with-tax value and re-levering beta under imputation
- +1Levered firm value (MM with tax): VL = VU + teD = 500 + 0.12 × 200 = 500 + 24 = $524m. The shield adds just $24m — small, because imputation has shrunk te to 0.12.
- +1Split into debt and equity: E = VL − D = 524 − 200 = $324m, so D/E = 200/324 ≈ 0.617.
- +1Re-lever the beta: βL = βu[1 + (1 − te)D/E] = 0.80 × [1 + 0.88 × 0.617].
- +1Finish the arithmetic: 0.88 × 0.617 = 0.543; 1 + 0.543 = 1.543; βL = 0.80 × 1.543 = 1.23.
- +1Compare with classical tax: if te were 0.30, the shield would be 0.30 × 200 = $60m versus $24m — imputation more than halves the value debt adds.
Key terms
- Modigliani-Miller irrelevance (no tax)
- In a frictionless world firm value is independent of capital structure (VL = VU): dividing the cash-flow pie does not change its size. The cost of equity rises with leverage exactly enough to keep WACC flat. This is the benchmark, not a description of reality.
- MM with corporate tax
- Interest is tax-deductible, so debt adds the present value of its tax shields: for perpetual debt VL = VU + teD. Taken literally this implies 100% debt is optimal, which signals that distress costs are missing.
- Levered (equity) beta
- βL = βu[1 + (1 − te)D/E]. The unlevered (asset) beta carries business risk only; leverage piles financial risk onto shareholders, raising the equity beta. With no debt, βL = βu.
- Trade-off theory
- Firm value VL = VU + teD − PV(distress costs). The tax shield pulls value up, distress costs pull it down faster as leverage climbs, giving an interior optimal D/E that also minimises WACC (a U-shape).
- Pecking-order theory
- Under asymmetric information firms follow a financing hierarchy — internal funds, then debt, then hybrids, then external equity as a last resort — with no target ratio. It explains why profitable firms carry little debt and why equity issues draw a negative price reaction.
Capital Structure FAQ
Why is MM irrelevance the right starting point if it isn't realistic?
Because it is the benchmark. MM-no-tax tells you capital structure can only matter through a named market imperfection. Everything that follows — corporate tax, distress costs, asymmetric information — is a specific imperfection that breaks irrelevance in a known direction. Starting from irrelevance forces you to identify exactly which friction is driving any value effect.
How does Australian imputation affect the case for debt?
The whole tax advantage of debt is the interest tax shield, teD, but it uses the effective tax rate te = tc(1 − λ), not the statutory rate. Under pure imputation (λ = 1), franking refunds all the company tax, te = 0, and the debt tax shield vanishes — VL = VU again. This is why the textbook 'borrow for the tax break' logic is weak in Australia and optimal leverage tends to be lower. It is a favourite distractor.
What is the difference between trade-off and pecking-order theory?
Trade-off theory has a target D/E — the interior optimum where the marginal tax benefit of debt equals the marginal distress cost, which is also the minimum-WACC point. Pecking-order theory has no target at all: observed leverage just reflects the firm's cumulative need for external financing, following the hierarchy internal funds, debt, hybrids, equity. Keeping these two straight is essential — one targets a ratio, the other does not.
Who bears financial distress costs?
Shareholders, in advance. Distress costs come in two kinds: direct (legal, accounting, administration — usually small) and indirect (lost customers and suppliers, fire-sale asset prices, distracted management — usually the dominant cost). The expected distress cost is the probability of distress times the cost if it happens, and it rises with leverage. Debt-holders price it in by demanding a higher cost of debt, so shareholders bear it through that higher kd.
Exam move
Prepare for two question types. The compare-the-theories MCQ tests whether you can keep four conclusions straight without mixing them: MM-no-tax (irrelevance, flat WACC), MM-tax (debt always helps, falling WACC, implied 100% debt), trade-off (interior optimum, U-shaped WACC, a target ratio), and pecking order (hierarchy, no target). The plug-in tests two formulas: VL = VU + teD and the re-levering βL = βu[1 + (1 − te)D/E]. Drill the unlever-then-re-lever comparables routine, since it sets the discount rate for a project. Above all, carry the AU twist: imputation drives te toward zero, gutting the tax shield — use te, never the statutory rate, and expect the imputation kill-switch as a distractor.
