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TABLE OF CONTENTS
I. Capital structure and capital structure decision: Definition, Objectives, Importance 1

II. Capital Structure Theory
A. MM theory
a. MM: No taxes; Propositions I and II 1
b. MM: With corporate taxes; Propositions I and II 2
c. MM: Effect of corporate and personal taxes 3
B. Trade-off theory 4
C. Signaling theory 4
D. Agency theory 4

III. EBIT-EPS Analysis 4

IV. Summary 6

V. Bibliography 7
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I. Capital Structure and Capital Structure Decision
Capital structure is the manner a firm finances its overall operations and growth by using different sources of funds.
It is also simply known as the combination of a companys debt and equity.
Capital structure decision, on the other hand, involves a firms choice of a target capital structure, the average
maturity of its debt, and the specific sources of financing it chooses at any particular time. Since capital structure
decision affects financial risk, it is safe to assume therefore that it could also affect the value of a particular firm.
A capital structure decisions main objective is to be able to come up with the right mixture of debt and equity which
would further maximize the shareholders wealth or the market price per share of a company. Thus, a capital
structure decision greatly involves a trade-off between risk and return in order to meet a particular companys goals.

II. Capital Structure Theories
Various capital structure theories exist to explain the relationship between a firms value and its capital structure.
These theories include the MM theory, Trade-off theory, Signaling theory and the Agency theory.
MM Theory
Franco Modigliani and Merton Miller (MM) developed a theory that helps us understand how taxes and financial
distress affect a companys capital structure decision.

The assumptions of their model are unrealistic, but they help us work through the effects of the capital structure
decision:

1. Investors have homogeneous expectations regarding future cash flows.
2. Bonds and stocks trade in perfect markets.
3. Investors can borrow and lend at the same rate.
4. There are no agency costs.
5. Investment and financing decisions are independent of one another.

MM Theory: No taxes
Proposition I -- Deals with Value of firm
Proposition II -- Deals with WACC of firm

1. M & M Proposition I: The Pie Model
The proposition that the value of the firm is independent of the firms capital structure.
Based on the assumptions that there are no taxes, costs of financial distress, or agency costs, so investors would
value firms with the same cash flows as the same, regardless of how the firms are financed.

2. M & M Proposition II: The Cost of Equity and Financial Leverage
Weighted Average Capital= Required return on firm s overall assets= (E/V) X Re + (D/V) X Rd
This is the famous M&M proposition II, a firms cost of equity capital is a positive linear function of its capital
structure, which tells us that the cost of equity depends on three things: the required rate of return on the firms
assets, R
A
, the firms cost of debt, R
D
, and the firms debt/equity ratio, D/E.

The no-tax case
a. Proposition I. The value of the firm levered (VL) is equal to the value of the firm unlevered. (VU)

VL=VU

Implications of Proposition I;
1. A firms capital structure is irrelevant
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2. A firms weighted average cost of capital (WACC) is the same no matter what mixture of debt and equity is used
to finance the firm.

b. Proposition II. The cost of equity, RE, is:

RE= RA + (RA-RD) x D/E

Where:
RA =is the WACC
RD =is the cost of debt
D/E = is the debt-equity ratio.

Implications of Proposition II:
1. The cost of equity rises as the firm increases its use of debt financing
2. The risk of the equity depends on two things: the riskiness of the firms operations (business risk) and the degree
of financial leverage (financial risk). Business risk determines Ra; financial risk determines D/E.

MM: With corporate taxes; Propositions I and II
In 1963, Modigliani and Miller published a follow-up paper wherein they relaxed the assumption that there are no
corporate taxes. To illustrate their assumption, we will have two firms, Firm UK which is the unlevered company
and Firm LA which is the levered company. These firms have identical assets and their operations are the same.
Lets assume that the EBIT is P3,500 every year for the both firms and the only difference between the firms is that
LA has issued P2,000 worth of perpetual bonds on which it pays 9% interest each year.

FIRMS
UK LA
EBIT P 3,500 P 3,500
Interest - 180
Taxable Income 3,500 3,320
Tax (30%) (1,050) (996)
Net Income P 2,450 P2,324
Table 2. 1
So as you can see on the illustration the interest is P180 which is computed by multiplying P2,000 to 9%.
Assuming that the corporate tax is 30% and there is no depreciation and that capital spending is zero and that there
are no changes in working capital, we can now compute the cash flow from assets of UK and LA. We can
immediately see that capital structure is now having some effect because the cash flows from UK and LA are not the
same even though the two firms have identical assets.

FIRMS
Cash Flow from
Assets
UK LA
EBIT P 3,500 P 3,500
Tax (1,050) (996)
TOTAL P 3,500 P 3,320
Table 2. 2
We can also compute the cash flow to stockholders and bondholders.
Cash Flow to UK LA
Stockholders P 3,500 P 3,500
Bondholders (1,050) (996)
TOTAL P 3,500 P 3,320
Table 2. 3
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We can see that the total cash flow to LA is P54 more because its tax is P54 less than UK. The fact that interest is
deductible for tax purposes has generated a tax saving which is equal to the interest payment multiplied by the tax
rate. This is called the interest tax shield.


MM: Effect of corporate and personal taxes

Continuing the illustration stated above, we have now come up with the result that the value of the levered firm is
greater than the unlevered firm. Therefore, weve come up with an equation wherein the value of the levered firm is
equal to the sum of the value of unlevered firm and the present value of the interest tax shield.

VL = VU + (TC x D)
The result of the analysis is the realization that once we include taxes, capital structure definitely matters. However,
the optimal capital structure is 100% debt was also concluded. And this conclusion can be reached by examining the
Weighted Average Cost of Capital. To calculate the WACC, we need to know the cost of equity. And the Cost of
Equity in the M&M Proposition II with corporate taxes is

RE= RU + (RU-RD) x (D/E) x (1-TC)

where:
RU=cost of capital of u levered
RD=cost of debt
D/E=debt-equity ratio
Tc=tax rate

MM Theory: Effect of personal and corporate taxes
The tax case
a. Proposition I with taxes
Continuing the illustration stated above, we have now come up with the result that the value of the levered firm is
greater than the unlevered firm. Therefore, weve come up with an equation wherein the value of the levered firm is
equal to the sum of the value of unlevered firm and the present value of the interest tax shield.

VL = VU + (TC x D)

Implications of Proposition I with taxes
1. Debt Financing is highly advantageous and the firms optimal capital structure is 100% debt.
2. A Firms Weighted Average cost of capital (WACC) decreases as the firm relies more heavily on debt financing.

b. Proposition II with taxes
The result of the analysis is the realization that once we include taxes, capital structure definitely matters. However,
the optimal capital structure is 100% debt was also concluded. And this conclusion can be reached by examining the
Weighted Average Cost of Capital.

To calculate the WACC, we need to know the cost of equity. And the Cost of Equity in the M&M Proposition II
with corporate taxes is

RE= RU + (RU-RD) x (D/E) x (1-TC)

where:
RU=cost of capital of unlevered
RD=cost of debt
D/E=debt-equity ratio
TC=tax rate

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However, these assumptions by Modigliani and Miller were contradicted by various scholars. Here are the reasons
why:
1. Income taxes are existent.
2. Legal and administrative expenses of bankruptcy are quite great and assets sold under duress usually bring a
fraction of their original value. In reality, these costs actually take up most of whats left in a bankrupt
company.
3. Individuals usually pay higher interest rates than what firms pay, and anyones rates generally go up as more
money is borrowed.
Despite these arguments against the MM theory, Modigliani and Miller still has provided a great starting point for
the various succeeding studies with regards to the capital structure.
Trade-off Theory
Tradeoff theory refers to the capital structure where a firm chooses how much debt and equity finance to use by
putting the costs and benefits into balance. This theory assumes that there are benefits to leverage within a capital
structure up until the optimal capital structure is reached. However, studies show that most companies have less
leverage than this theory would suggest is normal. Its difference with the MM theoryis the potential benefit a
company gets from debt in a capital structure, which comes from the tax benefit of the interest payments.
Signaling Theory
Signaling theory states that financial decisions by the managers serve as signals to investors as a way of
compensating the information asymmetry. These signals are often regarded as the core of financial relationships.
When a company issues new stock, stockholders assume that it is overvalued. When bonds are issued, the stock is
undervalued. Stock issuances are generally taken as an indicator of a lower expected FCF (free cash flow).
Agency Theory
Agency theory suggests that the optimal capital structure of a firm results from a compromise between various
funding options which reconciles the conflict of interest among the shareholders, creditors, and managers. The better
the corporate governance a company has, the lower the agency costs it incurs. These agency costs matter as they
tend to increase the cost of equity and reduce the value of the firm. As it suggests, if theres a higher use of debt in
relation to the firms equity, the greater the monitoring of the firm, and therefore, the lower the cost of equity and
the higher the value of the firm.
III. EBIT-EPS Analysis
EBIT/EPS analysis allows managers to see how different capital structures affect the earnings and risk levels of their
firms. Specifically, it shows the graphical relationship between a firm's operating earnings, or earnings before
interest and taxes (EBIT) and its earnings per share (EPS). Scenario analysis with different levels of EBIT can help
analysts to see the effects of different capital structures on the firm's earnings per share.
EBIT/EPS analysis is an older tool that was first developed when accounting concepts dominated financial analysis.
Also, most managers are familiar with the concept of earnings and are more comfortable discussing the impact of
leverage on earnings rather than on cash flow.











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Comparison of different economic situations relative to EBIT-EPS


Figure 3. 1

An accurate method of determining when to offer equity or debt (breakeven EBIT-EPS analysis):

Formula:
(EBIT-1)(1-t)
EPS = ---------------------------------------
# of common shares outstanding


where;

I - interest
t - tax rate

Sample Problem:
Angels Corporation has decided in favor of a capital restructuring. Currently, Angels uses no debt financing.
Following the restructuring, however, debt will be P1million. The interest rate on the debt will be 9%. Angels
currently has 200,000 shares outstanding, and the price per share is P20. If the restructuring is expected to increase
EPS, what is the minimum level for EBIT that Angels management must be expecting? Ignore taxes in answering.








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Solution:

Figure 3. 2
Verify that, in either case, EPS is P1.80 when EBIT is P360,000. Management at Angels is apparently of the opinion
that EPS will exceed P1.80.

RFM Corporation

Figure 3. 3

IV. Summary
In evaluating which capital structure is best for a particular company, the following factors are being considered by
the firm or its financial analyst:
- A companys capital structure overtime and the capital structure it uses compared with its competitors with
similar business risk
- A firms capital structure considering the firms corporate governance
- The industry where the company belongs
- The companys need for financial flexibility
- The extent to which the company has tangible assets
- The degree of information asymmetry (the condition in which at least some relevant information is known
to some but not all parties involved)
- The regulatory environment
The goal of the capital structure decision is to determine the financial leverage that maximizes the value of the
company (or minimizes the weighted average cost of capital). In the Modigliani and Miller theory developed
without taxes, capital structure is irrelevant and has no effect on company value. The deductibility of interest lowers
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the cost of debt and the cost of capital for the company as a whole. Adding the tax shield provided by debt to the
Modigliani and Miller framework suggests that the optimal capital structure is all debt. In the Modigliani and Miller
propositions with and without taxes, increasing a companys relative use of debt in the capital structure increases the
risk for equity providers and, hence, the cost of equity capital. However, the MM theory was contradicted by some
various scholars which lead to other theories such as trade-off theory, signaling theory and agency theory.
EBIT/EPS analysis allows managers to see how different capital structures affect the earnings and risk levels of their
firms.


























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BIBLIOGRAPHY:

Lasher, W. (2005). Practical Financial Management. New York: Cengage Learning

Ross, S. Jaffe, J. & Westerfield, R. (2007) Modern Financial Management. New York: McGraw Hill Higher
Education

Brigham, E & Ehrdhart, M. (2010) Financial Management: Theory and Practice. South Western

Shareholder Information. Retrieved February 22, 2014, from http://www.rfmfoods.com/investor-relations