Lectures 7 & 8

Capital Structure in a Perfect Market

(Chap. 14)

Riccardo Zago

ESCP Business School

2024 / 2025
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Introduction

Should you finance new projects with debt or equity?

What is the optimal capital structure for a company?

We will begin by assuming that there are no taxes and no

transaction costs (and that markets are perfect).

⇒ According to the law of one price, the choice between debt

and equity has no effect on the value of the company, the stock
price or the cost of capital!

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Outline

A. Equity versus debt financing (Chap. 14.1)

B. Modigliani-Miller I: leverage, arbitrage, and firm value (Chap.
14.2)
C. Modigliani-Miller II: leverage, risk, and the cost of capital (Chap
14.3)
D. Capital structure fallacies (Chap 14.4)
E. Summary: the theorems of Modigliani and Miller (Chap. 14.5)

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A. Equity versus debt financing

Reminder: WACC, cost of debt, cost of equity:

The cost of debt is lower than the cost of equity, but leverage
increases risk for stockholders and thus the cost of equity.

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Debt vs. equity financing: example

Financing a risky project (perfect markets, no tax)

⇒ Company U
Year 0 Year 1: Cash-Flow
Investment Expansion Recession
(Prob = 0.5) (Prob= 0.5)
-800 EUR 1400 EUR 900 EUR
Expected future cash flow: 0.5 × 1400 + 0.5 × 900 = 1150.

NPV of the project with a discount rate of 15%:

NPV = −800 + 1150
1.15
= 200.
1150
Value of the project after financing: PV = 1.15
= 1000.

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Debt vs. equity financing: example (con’t)

Returns for unlevered equity (equity in a firm with no debt)

Year 0 Year 1: Returns
Initial value Expansion Recession
(Prob= 0.5) (Prob= 0.5)
1000 EUR 40% -10%
Expected return on unlevered equity:
0.5 × 40% + 0.5 × (−10%) = 15%.

Because the risk of unlevered equity equals the risk of the

project, shareholders are earning an appropriate return for the
risk they are taking.

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Financing with equity and 500 EUR debt with
interest of 5% ⇒ Firm L (leveraged)
Cash flows
Initial value Expansion Recession
(Prob= 0.5) (Prob= 0.5)
Debt 500 EUR 525 EUR 525 EUR
Levered equity 300 EUR 875 EUR 375 EUR
Firm 800 EUR 1400 EUR 900 EUR
Market values
Initial value Expansion Recession
(Prob= 0.5) (Prob= 0.5)
Debt 500 EUR 525 EUR 525 EUR
Levered equity ? 875 EUR 375 EUR
Firm ? 1400 EUR 900 EUR

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Financing with equity and 500 EUR debt
Questions:
▶ What price should the levered equity sell for, and what is the best
capital structure choice?

Response of Modigliani and Miller (perfect markets, no tax):

▶ If you buy the debt and equity of the levered firm, you obtain the
same cash flows as if you bought the unlevered firm.
▶ Therefore, the law of one price implies that the value of the firm is
always 1000, hence the value of the equity has to be
1000-500=500.

Remark: equity holders realize the same capital gain as previously,

i.e., 200 (a value of 500 for an investment of 300).

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Common fallacy

Cash flow for equity holders of the levered firm =

0.5 × 875 + 0.5 × 375 = 625.
PV of these cash flows with 15%: 625/1.15 = 543 > 500 ?!
Problem: risk for equity holders and thus the discount rate
increases!
Year 0 Year 1: Returns
Initial value Expansion Recession
(Prob= 0.5) (Prob= 0.5)
Debt 500 EUR 5% 5%
Levered equity 500 EUR 75% -25%
Firm 1000 EUR 40% -10%

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To summarize

In perfect capital markets, the NPV for the entrepreneur will not
change with the financing of the project.

Debt financing is less costly than equity financing but leverage

increases the risk of equity and thus the cost of equity financing.

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Leverage and cost of capital: Modigliani-Miller
theorems
Franco Modigliani (Nobel prize in 1985) and Merton Miller
(Nobel prize in 1990)
▶ “The Cost of Capital, Corporation Finance and the Theory of
Investment,” 1958, American Economic Review
▶ Formalisation of the previous example.

Merton H. Miller, 1923-2000 Franco Modigliani, 1918-2003

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Leverage and cost of capital: Modigliani-Miller
theorems (con’t)

The theorems of Modigliani and Miller (MM) identify the effect

of leverage on
▶ the value of the firm,
▶ the cost of equity,
▶ the cost of capital.

We will use MM to
▶ optimize the capital structure,
▶ take investment decisions,
▶ understand how financing decisions can change the value of the
firm.

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C. MM I: leverage, arbitrage, and firm value
Hypotheses in Modigliani and Miller (1958; henceforth MM1)
⇒ perfect capital markets
▶ No taxes, transaction costs, or issuance costs associated with
security trading.
▶ No bankruptcy costs.
▶ All investors can borrow and invest without restrictions at the
risk-free rate.
▶ Law of one price holds.
▶ Firm’s financing decisions do not change the cash flows generated
by its investments.

Proposition
In a perfect capital market, the total value of a firm’s securities is equal
to the market value of the total cash flows generated by its assets and is
not affected by its choice of capital structure.

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MM1: intuition and discussion

The capital structure can be understood as a distribution of the

cash flows generated by the assets of a firm:
▶ These cash flows have different characteristics in terms of risk
and return.
▶ However, the sum of all cash flows received by the different
types of investors is always equal to the cash flows generated by
the assets.

Miller has illustrated this idea with a pizza: if you cut the pizza
into more slices, you will not have more pizza.

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Arbitrage according to MM
Consider two firms, U and L, which differ only by their capital
structure: U is financed only with E (equity), L is financed with
both E and D (debt) (at the risk-free rate r )
▶ Remark: the two firms generate the same operating income,
denoted by Π

Assume that V U > V L .

Consider an investor who holds bE U , where b ∈]0, 1].

▶ Cash flow = bΠ.

This investor sells his shares in U . . .

▶ Cash flow = bE U .

. . . and buys equity for bE L and debt for bD L

▶ Value of the investment = b(E L + D L ).
▶ Remark: bE U − b(E L + D L ) > 0 (because we assumed that
V U > V L ).
Riccardo Zago Lectures 7 & 8: Capital Structure in a Perfect Market 16 / 37
Arbitrage according to MM (con’t)
The cash flow received by the investor is then:

b(Π − rD L ) + b(rD L ) = bΠ.

Investing directly in U (A) generates the same profit than

investing in L and replicate its capital structure (B).
▶ AND the two strategies have the same risk!

But the strategy (B) requires a lower investment

IMPOSSIBLE in perfect capital markets ⇒ Arbitrage

The absence of arbitrage opportunities implies that V U = V L .

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Homemade leverage
The MM arbitrage is possible because investors can choose the
leverage they wish.
▶ They can change the risk and return of their investments
themselves.
▶ Example: preference for risky cash flows ⇒ hold firm U +
personal leverage, which replaces the leverage of the firm.
Example:
Year 0 Year 1
Initial cost Expansion Recession
Firm U 1000 EUR 1400 EUR 900 EUR
Margin loan - 500 EUR -525 EUR -525 EUR
Portfolio total 500 EUR 875 EUR 375 EUR
▶ Which is equivalent to holding the stocks of L!

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Market value balance sheet of the firm
According to MM1, the market value of the firm’s assets is equal to
the market value of the securities issued by the firm.

Hence, we can construct a balance sheet with market values

ATTENTION: it is often hard, or even impossible, to define the

market value of an item of the assets!
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D. MM II: leverage, risk, and the cost of capital

(Almost immediate) consequence of Proposition 1 of MM1:

▶ The return of a portfolio of the securities of the levered firm is
equal to the return of the asset of an equivalent unlevered firm:
D E
rLWACC = rD + r L = rU U
WACC = rE .
D+E D+E E
This return can be used as a discount rate for investments with
a similar risk than the assets in place.
▶ For any capital structure!

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MM1 - leverage and cost of capital

Reminder (from 10 seconds ago)

D EL
rUAssets = rEU = L
rD + L
rEL .
D+E D+E

Proposition
The cost of capital of levered equity increases with the firm’s
debt-to-equity ratio:
D  U 
rEL = rEU + r E − r D .
EL

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Levered and unlevered betas

The effect of leverage on the risk of a firm’s securities can also

be expressed in terms of beta:

▶ Unlevered beta: measures risk of a firm as if it did not have

leverage, which is equivalent to the beta of the firm’s assets.

▶ Levered betas (or stock betas): reflect the economic risk of the
firm and the risk due to leverage.

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Beta and leverage
A portfolio of the debt and stocks of a leveraged firm has the
same beta than a portfolio of stocks of an unlevered firm:
D E
βEUnlevered = βD+E
Portfolio
= βD + β Levered .
D+E D+E E
We obtain for the beta of the levered stock (levered beta) and
the beta of the unlevered firm (unlevered beta)

(D + E ) βEUnlevered − DβD
βELevered = .
E
If the debt is risk-free:
D+E U
βD = 0 ⇒ βELevered = βE .
E

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Example: beta and leverage

The stock of a firm with a debt-to-equity ratio of 2 has a beta

of 1.7. What would the beta of the firm be if the firm was debt
free? (The debt is risk-free.)

What would the beta of a firm’s stock in the same industry but
with a debt ratio (D/(E+D)) of = 0.5 be?

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Financing cost of an industry
The average betas of industries are often used either because a
given firm is not listed or because the average beta of a sample
is a better estimate.
Attention: to take the average you need to first calculate the
“unlevered betas.”
Steps:
▶ Identify a sample.
▶ Find the cost of equity, debt ratio and if possible the cost of
debt for each of these firms.
▶ Compute the “unlevered betas” for these firms.
▶ Compute the average.
▶ Determine the “levered beta” corresponding to the “unlevered
beta.”

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Beta of an industry: example

Consider the following firms, all belonging to the same industry

(Remark: debt is risk-free)
Firm Beta E D/E Beta assets
A 1.1 23.31% 0.892
B 1.3 44.35% 0.901
C 1.3 2.15% 1.273
D 0.8 3.03% 0.776
Average 0.960
What is the equity beta of firm P, not listed, operating in the
same industry considering that its D/E ratio is 0.2?

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Beta and leverage: summary

In the MM1 framework, it can be shown that :

D U
βEL = βAsset
U
+ β ,
E L Asset
where, if debt is considered risky:
D  U 
βEL = βAsset
U
+ β − βD .
E L Asset
See Hamada, “Portfolio analysis, market equilibrium and
corporate finance” Journal of Finance, 1969

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E. Capital structure fallacies

MM1 framework: the capital structure does not affect the value
of the firm.

But, even in this framework, wrong arguments are used to argue

in favor of using leverage
1 Leverage and Earnings per Share
2 Equity issuance and dilution

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Leverage and EPS

Leverage can increase expected Earnings per Share (EPS).

▶ Some stockholders therefore conclude that leverage should
increase the stock price.

However, the risk of earnings also changes and the average

increase of EPS is necessary to compensate shareholders.
In perfect capital markets, the price should not change!

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Equity issuance and dilution
Dilution: an increase in the total of shares that will divide a
fixed amount of earnings.
An increase in capital usually dilutes the EPS.
It is sometimes (incorrectly) argued that issuing equity will dilute
existing shareholders’ ownership, so debt financing should be
used instead.
In fact: no dilution of value if the stocks are sold at their market
value.
▶ Any gain or loss associated with the transaction will result from
the NPV of the investments the firm makes with the funds
raised.
▶ The decrease in stock price which is often observed at the
announcement of an increase in capital corresponds to an
information effect (thus: it is related to market frictions)

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F. Summary: Modigliani-Miller theorems
Perfect capital markets ⇒ Conservation of value
▶ Financial transactions neither add nor destroy value, but instead
represent a repackaging of risk (and therefore return).
▶ The cost of capital depends on the assets of the firm and
their risk.

Modigliani-Miller for dummies:

▶ The total amount of pizza does not change if you slice it up
differently!

Practical implications:
▶ Investment decisions are more important than financing decisions.
▶ It is easier to create or destroy value with investment decisions than
with financing decisions.

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Exercise: cost of capital and leverage
Amalgamated Products (Am.Pr.) owns three activities:
▶ Food 40% of the value of the firm.
▶ Electronics 30% of the value of the firm.
▶ Chemicals 30% of the value of the firm.
Amalgamated Products doesn’t pay tax. To estimate its cost of
capital Amalgamated has identified three competitors:
Beta of the stock Debt/(Debt+Equity)
United Foods 0.8 0.4
General Electronics 1.6 0.2
Associated Chemicals 1.2 0.3
We assume that the debt of the firm is risk-free.
(a) What are the asset betas of each division of Amalgamated?
(b) The debt ratio of Amalgamated is D/(D+E)=0.4. What is the beta
of the stock of Amalgamated?
(c) With rf = 7% and rM = 15%, what is the cost of capital of each
division?
(d) What is the WACC of Amalgamated?
Riccardo Zago Lectures 7 & 8: Capital Structure in a Perfect Market 32 / 37
Exercise: reducing leverage

Infonian AG is a very leveraged firm with a debt to equity ratio

of 150%. The bank does not consider the debt as risky and asks
for an interest rate of 5% (≈ rf ). The equity holders require a
return of 20%. The company does not pay tax.
▶ What is the WACC of the firm?
▶ What is the cost of equity if Infonian issues equity and reduces
its debt to achieve a debt to equity ratio of 50%?

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Exercise: increasing leverage
Mr. Goodman the CFO of Perkscom comes back thoughtful from
the shareholder meeting of his firm. The investment fund who owns
10% of the capital of Perkscom has announced to the CFO Mr.
Goodman at the annual shareholder meeting that it expects an
earnings yield of at least 20% for the current year, otherwise it would
take away the stock options for the managers of the firm. Because
Mr. Goodman counts on his stock options to repay the mortgage for
his villa, he is a bit worried and thinks about what he can do.
The cash flow of Perkscom is equal to the EBIT of 10 million for
this year with annual growth rate of 10% per year. The firm has no
leverage. The accounting value of its equity is 80 million and its
stock market capitalisation is 100 million.
The firm could easily raise debt at an interest rate of 5%. Perkscom
does not pay tax (tax rate = 0) and distributes all its cash flows as
dividends to shareholders.

Riccardo Zago Lectures 7 & 8: Capital Structure in a Perfect Market 34 / 37

Exercise: increasing leverage (con’t)
1 If the market anticipates the perpetual growth rate of the EBIT of
10%, what should be the cost of capital of Perkscom?
2 Suppose that with a more efficient reorganisation of its production,
Perkscom can increase its cash flows by 50% from 10 million to 15
million at the end of the year with the same perpetual growth rate
as previously. What is now the value of the firm and the return on
equity and earnings yield?
3 Mr. Goodman understands that with operational measures, he
cannot achieve the earnings yield required by the investment fund.
He decides to increase the leverage to the debt-to-equity ratio of 3:1
without changing the assets of the company (e.g., we are in the
initial setting and not the one of 2.) and without increasing the
cashflows of the company. Compute the amount of debt to be
raised and describe briefly the necessary transactions.

Riccardo Zago Lectures 7 & 8: Capital Structure in a Perfect Market 35 / 37

Exercise: increasing leverage (con’t 2)

4 What will be the WACC after the transaction and what will be
the cost of equity?
5 What will the earnings yield and return on equity be?
6 What is the lowest level of leverage that can achieve the
earnings yield required by the investment fund?
7 Has the investment fund chosen a good performance measure?
Should it be satisfied by the measures taken by Mr. Goodman?

Riccardo Zago Lectures 7 & 8: Capital Structure in a Perfect Market 36 / 37

Quiz

Why is debt cheaper than equity?

Why is the WACC without taxes not decreasing in the amount
of leverage used?
A firm without debt has a beta 1. What is the equity beta of the
firm if the firm takes on debt for a total of 50% of the value of
its assets? (Assume that the beta of the firm’s debt is zero.)

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