Lecture 1: Relevance and Irrelevance of Financing
Capital Structure: Basic Questions
What determines firms’ financing decisions?
• Some people have money, others have great ideas. You want to match those people! You want them
to put their money in the bank, and the bank then chooses the people the money goes to.
• The good companies should get easy financing. This leads, in the end, to economic growth and
innovation.
Debt Equity
• Examples: loan, bond • Example: common share
• Cash flow: interest • Cash flow: dividends, capital gains (share
• Right to cash flows: yes (in case of price goes up)
bankruptcy) • Right to cash flows: no
• Voting power: no • Voting power: yes (ownership)
Is a firm’s value affected by its capital structure?
• The value of the firm is the discounted value of the future cash flows.
• The discount rate that is used by the firm is the cost of capital.
• Goal: minimize the cost of capital. Minimize the cost of firms to get financing.
• Re = expected return equity holders
Rd = expected return debtholders
• Each year, you need ReE + RdD
o In terms of return: (ReE + RdD)/D+E)
o Re(E/(D+E)) + Rd(D/(D+E))
Optimal Capital Structure: Remember The WACC?
= Optimize capital structure to reduce the weighted average cost of capital.
If no taxes:
𝐸 𝐷
𝑊𝐴𝐶𝐶 = 𝑟𝑒 ∙ ( ) + 𝑟𝑑 ∙ ( )
𝐷+𝐸 𝐷+𝐸
The return debtholders demand is typically lower than the return equity holders demand. This is because
equity holders invest in a firm, and so take on more risk.
Interest rate on debt is generally lower than the required return on shares.
• So, why not only finance with debt?
Capital Structure: Does It Matter?
A firm currently has no debt in its capital structure. The firm is considering issuing debt to buy back some of its
equity.
• The firm’s assets are $8000.
• There are 400 shares of the all-equity firm.
• The proposed debt issue is $4000, with an interest rate of 10%.
• There are no taxes.
Return on assets (ROA) are expected to be either 5%, 15%, or 25%.
See the summary in the table on the next page.
, Earnings in the current state (no debt) Earnings in the proposed state
= How much do we make as a shareholder? = The situation with debt financing.
Earnings and EPS: Which Line Is Better?
The red line is the levered firm. The blue line is the unlevered firm.
→ Being involved in the levered firm is riskier.
Which Is Better?
Strategy A
Buy 100 shares of levered firm.
Initial cost: 100 * $20 = $2000
Capital Structure: Basic Questions
What determines firms’ financing decisions?
• Some people have money, others have great ideas. You want to match those people! You want them
to put their money in the bank, and the bank then chooses the people the money goes to.
• The good companies should get easy financing. This leads, in the end, to economic growth and
innovation.
Debt Equity
• Examples: loan, bond • Example: common share
• Cash flow: interest • Cash flow: dividends, capital gains (share
• Right to cash flows: yes (in case of price goes up)
bankruptcy) • Right to cash flows: no
• Voting power: no • Voting power: yes (ownership)
Is a firm’s value affected by its capital structure?
• The value of the firm is the discounted value of the future cash flows.
• The discount rate that is used by the firm is the cost of capital.
• Goal: minimize the cost of capital. Minimize the cost of firms to get financing.
• Re = expected return equity holders
Rd = expected return debtholders
• Each year, you need ReE + RdD
o In terms of return: (ReE + RdD)/D+E)
o Re(E/(D+E)) + Rd(D/(D+E))
Optimal Capital Structure: Remember The WACC?
= Optimize capital structure to reduce the weighted average cost of capital.
If no taxes:
𝐸 𝐷
𝑊𝐴𝐶𝐶 = 𝑟𝑒 ∙ ( ) + 𝑟𝑑 ∙ ( )
𝐷+𝐸 𝐷+𝐸
The return debtholders demand is typically lower than the return equity holders demand. This is because
equity holders invest in a firm, and so take on more risk.
Interest rate on debt is generally lower than the required return on shares.
• So, why not only finance with debt?
Capital Structure: Does It Matter?
A firm currently has no debt in its capital structure. The firm is considering issuing debt to buy back some of its
equity.
• The firm’s assets are $8000.
• There are 400 shares of the all-equity firm.
• The proposed debt issue is $4000, with an interest rate of 10%.
• There are no taxes.
Return on assets (ROA) are expected to be either 5%, 15%, or 25%.
See the summary in the table on the next page.
, Earnings in the current state (no debt) Earnings in the proposed state
= How much do we make as a shareholder? = The situation with debt financing.
Earnings and EPS: Which Line Is Better?
The red line is the levered firm. The blue line is the unlevered firm.
→ Being involved in the levered firm is riskier.
Which Is Better?
Strategy A
Buy 100 shares of levered firm.
Initial cost: 100 * $20 = $2000
