CP

486 CHAPTER 13 Capital Structure Decisions

Capital Structure Theory

In the previous section, we showed how capital structure choices affect a firm’s ROE

and its risk. For a number of reasons, we would expect capital structures to vary con-

siderably across industries. For example, pharmaceutical companies generally have

very different capital structures than airline companies. Moreover, capital structures

vary among firms within a given industry. What factors explain these differences? In

an attempt to answer this question, academics and practitioners have developed a

number of theories, and the theories have been subjected to many empirical tests. The

following sections examine several of these theories.

Modigliani and Miller: No Taxes

Modern capital structure theory began in 1958, when Professors Franco Modigliani

and Merton Miller (hereafter MM) published what has been called the most

influential finance article ever written.^8 MM’s study was based on some strong as-

sumptions, including the following:

1 .There are no brokerage costs.

2 .There are no taxes.

3 .There are no bankruptcy costs.

4 .Investors can borrow at the same rate as corporations.

TABLE 13-1 Effects of Financial Leverage: Strasburg Electronics Financed

with Zero Debt or with $100,000 of Debt

(^8) Franco Modigliani and Merton H. Miller, “The Cost of Capital, Corporation Finance, and the Theory of
Investment,” American Economic Review,June 1958. Modigliani and Miller both won Nobel Prizes for their
work.
SECTIONI. ZERODEBT
Debt 0
Book equity $200,000
Demand for Pre-Tax Taxes Net
Product Probability EBIT Interest Income (40%) Income ROE
(1) (2) (3) (4) (5) (6) (7) (8)
Terrible 0.05 ($ 60,000) $0 ($ 60,000) ($24,000) ($36,000) 18.0 %
Poor 0.20 (20,000) 0 (20,000) (8,000) (12,000) 6.0
Normal 0.50 40,000 0 40,000 16,000 24,000 12.0
Good 0.20 100,000 0 100,000 40,000 60,000 30.0
Wonderful 0.05 $140,000 $ 0 $140,000 $56,000 $84,000 42.0
Expected value: $ 40,000 $0 $ 40,000 $16,000 $24,000 12.0 %
Standard deviation: 14.8 %
Coefficient of variation: 1.23
Assumptions: 1. In terms of its operating leverage, Strasburg has chosen Plan B. The probability distribution and EBITs are obtained from Figure 13-2.

2. Sales and operating costs, hence EBIT, are not affected by the financing decision. Therefore, EBIT under both financing plans is
   identical, and it is taken from the EBIT column for Plan B in Figure 13-2.


3. All losses can be carried back to offset income in the prior year.

482 Capital Structure Decisions