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Unit 8: Capital Structure Decision

arbitrage. This increases the demand for securities of the firm U and will lead to increase in its Notes
price. At the same time, the price of the security of the firm L will decline due to the selling
pressure. This will continue till the prices of the securities of the firms become identical.
Taxes: If the corporate taxes are taken into consideration. MM argues that the value of the firm
will increase and cost of capital will decrease with leverage. Interest paid on the debt is tax
deductible and therefore, effective cost of debt is less than the coupon rate of interest. Therefore,
levered firm would have a greater market value than the unlevered firm (cost capital of levered
firm would be lower).
Symbolically:
VL = VU + BT
where, VL = Value of levered firm

VU = Value of unlevered firm
B = Amount of debt
T = Tax rate

8.9 The Trade-off Theory: Cost of Financial Distress and Agency Costs

As the debt-equity ratio (i.e. leverage) increases, there is a trade-off between the interest tax
shield and bankruptcy, causing an optimum capital structure, D/E*
The trade-off theory of capital structure is a theory in the realm of Financial Economics about the
corporate finance choices of corporations. Its purpose is to explain the fact that firms or
corporations usually are financed partly with debt and partly with equity. It states that there is
an advantage to financing with debt, the tax benefit of debt and there is a cost of financing with
debt, the costs of financial distress including bankruptcy costs of debt and non-bankruptcy costs
(e.g. staff leaving, suppliers demanding disadvantageous payment terms, bondholder/
stockholder infighting, etc.). The marginal benefit of further increases in debt declines as debt
increases, while the marginal cost increases, so that a firm that is optimizing its overall value
will focus on this trade-off when choosing how much debt and equity to use for financing.
Although the empirical success of the alternative theories is often dismal, the relevance of this
theory has often been questioned. For example, Miller’s (1977) metaphor speaks of the balance
between those two as equivalent to the balance between horse and rabbit content in a stew of
one horse and one rabbit. Other critics have suggested it is the mechanical change in asset prices
that makes up for most of the variation in capital structure.

Recognize that costs of financial distress and agency costs are real.
8.9.1 Trade-off Model

Financial distress costs (includes bankruptcy)
1. Direct costs: Lawyer’s fees, court costs, administrative expenses, assets disappear or become
obsolete.
2. Indirect costs: Managers make short-run decisions; customers and suppliers may impose
costs.

8.9.2 Agency Costs

More debt is likely to be experienced. Distress stockholders (thus management) want risk, while
bondholders do not.

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