Corporate Finance for Business
Administration
Lecture 1 Capital Structure (02-09)
Corporate finance is a specific area of finance that analyses corporate
decisions, such as:
- Capital structure
- Mergers and acquisitions
- Raising capital
- Payout policy
Abbreviations
- EBIT = earnings before interest and taxes (winst voor rente en
belastingen)
EBITDA = EBIT + depreciation
- ROE = Return on equity
- EPS = Earnings per share
Capital Structure
1. Why would a profitable company not issue debt?
A profitable company might avoid debt to maintain a conservative capital
structure, reducing financial risk and preserving flexibility.
2. Why would a company with a lot of cash use debt?
A cash-rich company might issue debt to optimize its capital structure
by adding leverage and benefiting from the tax shield on interest.
Example: Apple’s debt
- Much attention is paid to Apple’s cash reserves, because they are large
compared to e.g. Netflix and Tesla, but those are growing only because
Apple is raising debt to pay investors.
Today’s content
- Corporate claims: fundamental differences between debt and equity
- Measures of financial leverage
- The financial effects of leverage
- Brief recap: theories of capital structure (static trade-off theory and
pecking order theory)
Building blocks of the firm’s financial structure
Book: Chapter 13: Overview of corporate financing
- Liabilities (often called leverage) ≠ debt
o Liabilities: Obligations a company or individual owes to others,
including loans, accounts payable, and other debts.
o Debt: Money borrowed that must be repaid, usually with interest,
representing a specific type of liability.
- Equity (often called stock)
Financial vs Nonfinancial claims
- Financial claims: Debt (e.g., loans, bonds) and Equity
, - Nonfinancial claims: e.g., corporate income tax due, pension obligations,
and accounts payables
Debt vs. equity trade off
Conditions Debt Equity
A fixed claim A residual claim
Management NONE or little Voting rights (control)
influence
Repayment Debt has maturity date Stock has no maturity
date
Payment obligations Payment of interests Companies are not
legally liable to pay
dividends
(uncertainty for
shareholders)
Tax benefits Interest is tax deductible Dividends are not tax
(interest is paid from deductible (dividends are
before-tax income) paid from after-tax
income)
In case of default Priority (paid before Paid after lenders’ claims
shareholders) are satisfied
Measures of financial leverage
Capital / Assets = Liabilities + Equity
Liabilities = Debt (ST and LT) + other fixed-payment obligations
A company’s leverage measures how much debt it uses relative to equity or
assets to finance its operations. There are several common ways to measure
leverage:
Assessing company’s leverage
Debt-to-Equity Ratio (D/E) = Total Debt / Shareholder’s Equity
Total Liabilities / Total Capital (D/C) = Total liabilities / (Total liabilities +
Shareholders’ equity)
Total Debt / Equity = (Short-term debt + Long-term debt
+ other fixed-payment obligations) /
Shareholders’ equity
Long-term Debt / Equity = Long-term debt / Shareholders’
equity
Total Debt / Assets = (Short-term debt + Long-term debt
+ other fixed-payment obligations) /
Total assets
Interest coverage = EBIT ÷ Interest Expense
Total debt / EBITDA = Total debt / (EBIT + Depreciation)
Net debt / EBITDA = (Total debt − Cash & Cash
Equivalents) / (EBIT + Depreciation)
Research shows that most companies, both large and small, measure leverage
using…
= Debt / EBITDA, as it provides a clear indication of a company’s ability to repay
its debt from its operating cash flow.
Financial effects of leverage
Unlevered capital structure = A capital structure without debt. The company
is fully financed with equity, meaning there are no interest expenses or tax
benefits. Safe, lower returns, no debt (e.g. for startups).
,Levered capital structure = A capital structure with debt. The company is
financed with both equity and debt (loans, bonds), introducing leverage effects
and increased financial risk. Riskier, but potentially higher returns for
shareholders due to the leverage effect of debt (e.g. for bigger companies).
Link Harvard theory model
- The effect of leverage on measures of financial performance (ROE and
EPS).
- Return on equity (ROE) = Net income (annual) / Shareholder’s Equity
- Earnings per share (EPS) = Net Income / Number of shares outstanding
Effects of Debt and EBIT
- Increasing debt means the company borrows more money. If EBIT is
positive, it can earn more on the borrowed money than it pays in interest.
This makes ROE higher because the company is using less equity to
finance its assets. EPS can increase as well, showing that leverage can
boost shareholder returns.
o Conclusion Slides: Leverage increases ROE and EPS. It is why even
cash rich companies issue debts
- When EBIT becomes negative, the company is making an operating loss.
ROE turns negative because net income is negative, even though equity
remains the same. EPS also becomes negative since losses reduce the
earnings available to shareholders. High debt amplifies both the losses and
the impact on ROE and EPS because interest still has to be paid on the
borrowed money.
o Conclusion Slides: Leverage amplifies both the highs and the lows
of a company’s performance, and the higher the leverage, the
greater the amplification
Who bears the company’s business risk?
- Unlevered company = the shareholders
- Debt-financed company = the shareholders (as residuals claimants), but
risk per dollar of equity increases as leverage rises.
- Conclusion: the levered equity is riskier. Shareholders get a compensation
(higher ROE and EPS)
o N.B. At some point, the debt starts getting risky, because too much
leverage can lead to financial problems or even default.
Brief recap: theories of capital structure
- Keeping in mind those financial effects of leverage, we might ask:
o Which capital structure maximizes the value of the firm?
Which theories of capital structures do you know?
- Modigliani and Miller (M&M) propositions I and II (no taxes)
- Modigliani and Miller (M&M) propositions I and II (with taxes) this
lecture
- The (static) trade-off theory
- Pecking order theory
- Agency cost theory
- Market timing theory
- Life-cycle theory
, Modigliani-Miller Theorem – Proposition I (No Tax)
- View: Capital structure is irrelevant for firm value and cost of capital
- Under certain conditions, the market value of a company does not depend
on its capital structure.
o The total value of the firm remains the same, regardless of the mix
of equity (shares) and debt (bonds).
Administration
Lecture 1 Capital Structure (02-09)
Corporate finance is a specific area of finance that analyses corporate
decisions, such as:
- Capital structure
- Mergers and acquisitions
- Raising capital
- Payout policy
Abbreviations
- EBIT = earnings before interest and taxes (winst voor rente en
belastingen)
EBITDA = EBIT + depreciation
- ROE = Return on equity
- EPS = Earnings per share
Capital Structure
1. Why would a profitable company not issue debt?
A profitable company might avoid debt to maintain a conservative capital
structure, reducing financial risk and preserving flexibility.
2. Why would a company with a lot of cash use debt?
A cash-rich company might issue debt to optimize its capital structure
by adding leverage and benefiting from the tax shield on interest.
Example: Apple’s debt
- Much attention is paid to Apple’s cash reserves, because they are large
compared to e.g. Netflix and Tesla, but those are growing only because
Apple is raising debt to pay investors.
Today’s content
- Corporate claims: fundamental differences between debt and equity
- Measures of financial leverage
- The financial effects of leverage
- Brief recap: theories of capital structure (static trade-off theory and
pecking order theory)
Building blocks of the firm’s financial structure
Book: Chapter 13: Overview of corporate financing
- Liabilities (often called leverage) ≠ debt
o Liabilities: Obligations a company or individual owes to others,
including loans, accounts payable, and other debts.
o Debt: Money borrowed that must be repaid, usually with interest,
representing a specific type of liability.
- Equity (often called stock)
Financial vs Nonfinancial claims
- Financial claims: Debt (e.g., loans, bonds) and Equity
, - Nonfinancial claims: e.g., corporate income tax due, pension obligations,
and accounts payables
Debt vs. equity trade off
Conditions Debt Equity
A fixed claim A residual claim
Management NONE or little Voting rights (control)
influence
Repayment Debt has maturity date Stock has no maturity
date
Payment obligations Payment of interests Companies are not
legally liable to pay
dividends
(uncertainty for
shareholders)
Tax benefits Interest is tax deductible Dividends are not tax
(interest is paid from deductible (dividends are
before-tax income) paid from after-tax
income)
In case of default Priority (paid before Paid after lenders’ claims
shareholders) are satisfied
Measures of financial leverage
Capital / Assets = Liabilities + Equity
Liabilities = Debt (ST and LT) + other fixed-payment obligations
A company’s leverage measures how much debt it uses relative to equity or
assets to finance its operations. There are several common ways to measure
leverage:
Assessing company’s leverage
Debt-to-Equity Ratio (D/E) = Total Debt / Shareholder’s Equity
Total Liabilities / Total Capital (D/C) = Total liabilities / (Total liabilities +
Shareholders’ equity)
Total Debt / Equity = (Short-term debt + Long-term debt
+ other fixed-payment obligations) /
Shareholders’ equity
Long-term Debt / Equity = Long-term debt / Shareholders’
equity
Total Debt / Assets = (Short-term debt + Long-term debt
+ other fixed-payment obligations) /
Total assets
Interest coverage = EBIT ÷ Interest Expense
Total debt / EBITDA = Total debt / (EBIT + Depreciation)
Net debt / EBITDA = (Total debt − Cash & Cash
Equivalents) / (EBIT + Depreciation)
Research shows that most companies, both large and small, measure leverage
using…
= Debt / EBITDA, as it provides a clear indication of a company’s ability to repay
its debt from its operating cash flow.
Financial effects of leverage
Unlevered capital structure = A capital structure without debt. The company
is fully financed with equity, meaning there are no interest expenses or tax
benefits. Safe, lower returns, no debt (e.g. for startups).
,Levered capital structure = A capital structure with debt. The company is
financed with both equity and debt (loans, bonds), introducing leverage effects
and increased financial risk. Riskier, but potentially higher returns for
shareholders due to the leverage effect of debt (e.g. for bigger companies).
Link Harvard theory model
- The effect of leverage on measures of financial performance (ROE and
EPS).
- Return on equity (ROE) = Net income (annual) / Shareholder’s Equity
- Earnings per share (EPS) = Net Income / Number of shares outstanding
Effects of Debt and EBIT
- Increasing debt means the company borrows more money. If EBIT is
positive, it can earn more on the borrowed money than it pays in interest.
This makes ROE higher because the company is using less equity to
finance its assets. EPS can increase as well, showing that leverage can
boost shareholder returns.
o Conclusion Slides: Leverage increases ROE and EPS. It is why even
cash rich companies issue debts
- When EBIT becomes negative, the company is making an operating loss.
ROE turns negative because net income is negative, even though equity
remains the same. EPS also becomes negative since losses reduce the
earnings available to shareholders. High debt amplifies both the losses and
the impact on ROE and EPS because interest still has to be paid on the
borrowed money.
o Conclusion Slides: Leverage amplifies both the highs and the lows
of a company’s performance, and the higher the leverage, the
greater the amplification
Who bears the company’s business risk?
- Unlevered company = the shareholders
- Debt-financed company = the shareholders (as residuals claimants), but
risk per dollar of equity increases as leverage rises.
- Conclusion: the levered equity is riskier. Shareholders get a compensation
(higher ROE and EPS)
o N.B. At some point, the debt starts getting risky, because too much
leverage can lead to financial problems or even default.
Brief recap: theories of capital structure
- Keeping in mind those financial effects of leverage, we might ask:
o Which capital structure maximizes the value of the firm?
Which theories of capital structures do you know?
- Modigliani and Miller (M&M) propositions I and II (no taxes)
- Modigliani and Miller (M&M) propositions I and II (with taxes) this
lecture
- The (static) trade-off theory
- Pecking order theory
- Agency cost theory
- Market timing theory
- Life-cycle theory
, Modigliani-Miller Theorem – Proposition I (No Tax)
- View: Capital structure is irrelevant for firm value and cost of capital
- Under certain conditions, the market value of a company does not depend
on its capital structure.
o The total value of the firm remains the same, regardless of the mix
of equity (shares) and debt (bonds).
