CORPORATE FINANCIAL DECISION
MAKING (FNCE 20005)
Dr Chander Shekhar
University of Melbourne
Faculty of Business and Economics
Department of Finance
1
LECTURE 4
ISSUES WITH WACC
AND CAPITAL STRUCTURE POLICY
Textbook Chapter 16
2
Big Picture of Corporate Finance Again
3
Shareholders’
equity
Current assets
Fixed assets
1. Tangible assets
(assets in place)
2. Intangible
assets (growth
assets)
Long-term debt
Short-term debt
Assets
generate
cash flow
Investors
provide capital
Investors get return on their capital
Table of Contents
1. Weighted Average Cost of Capital (WACC)
2. Optimal Debt Ratio – Cost of Capital Approach
3. Modigliani-Miller “Irrelevance” Theorem
4. Capital Structure Theory I: Trade-off Theory
5. Capital Structure Theory II: Pecking Order
Perspective
6. An Integrative Approach
4
1. Weighted Average Cost of
Capital (WACC)
5
Cost of Capital
• Projects have to earn at least a benchmark rate of return
(minimum acceptable hurdle rate) to be accepted
• The benchmark return should be higher for riskier projects
than for safer ones
• How to find this benchmark rate of return?
• Different terminology reflects different viewpoints of the
same thing
• From investors’ viewpoint: required rate of return or
market-determined opportunity cost
• From the firm (issuer)’s viewpoint: cost of capital
6
WACC Formula
• WACC puts weights on cost of debt and cost of equity
where - cost of debt, - cost of equity, - effective company
tax rate, , – debt & equity market values, firm value = +
• Interpretations
• The overall return the firm must earn on its existing assets to
maintain the value of its securities or
• The required return on any investments by the firm that
essentially have the same risks as existing operations
7
( )1d e e
D E
WACC k k t k
V V
   
= = − +   
   
Each Component in WACC -
• Market interest rate that the firm has to pay on its long term
borrowing today
• = risk-free rate + default spread
• If the firm is rated, use the rating and a typical default
spread on bonds with that rating
• If not rated, use the interest rate on a bank loan or estimate
a proper default spread based on a synthetic rating (how?
next slide!)
8
Company S&P Rating Risk-Free Rate Default Spread Cost of Debt
Disney A 2.75% (US $) 1.00% 3.75%
Deutsche Bank A 1.75% (Euros) 1.00% 2.75%
Vale A- 2.75% (US $) 1.30% 4.05%

Each Component in WACC -
• Estimating a synthetic rating
• Can be estimated by using one or a collection of financial ratios
• A simple, common ratio that seems to work best is
Interest coverage ratio = EBIT/Interest Expenses
9Source: Corporate Finance (2nd edition) by Aswath Damodaran
Each Component in WACC -
• (1 − ) reflects tax savings associated with debt
• Under a imputation tax system in Canada, Australia and NZ,
corporate tax is reimbursed to resident shareholders as tax
credits attached to dividends (so-called franking credits)
• Thus, the effective corporate tax rate can be lower than the
statutory corporate tax rate ( = 30%):
= 1 −
where λ is the proportion of corporate tax claimed by shareholders
• λ=0, a classical tax system; λ=1, a pure imputation tax system
• λ depends on a proportion of overseas operations/shareholders and
on the decision to distribute profits as fully franked dividends or not
10
Quick recap: Basic Present Value Formula
• Perpetuity (a coupon payment every period forever; gSo,
11
∞ =
1
(1+)1
+
1(1+)
(1+)2
+
1(1+)
2
(1+)3
⋯ ← the sum of infinite geometric
series: + + 2 +⋯
=

1 −
< 1
∞ =
1
(1 + )
×
1
1 − (1 + )/(1 + )
=
1
−
Each Component in WACC -
• Two methods to calculate
(1) Capital asset pricing model (CAPM)
(2) DCF approach (Gordon Growth model)
where 0= current period dividend per share and
g = growth rate
12
0 =
1
−
⇒
= + [ − ]
=
0(1 + )
0
+
Using CAPM to Estimate
• CAPM formula
• Beta reflects how the underlying stock moves with the
market (correlation or diversification measure)
• Stocks with higher risk (high beta) require a higher
expected rate of return for an investor
13
= + [ − ]
Using CAPM to Estimate - Disney
• Inputs to CAPM
• Disney’s Beta = 1.25 (right-hand side)
• Risk-free Rate = 2.75% (current U.S.
ten-year T Bond rate)
• Market Risk Premium = 5.76%
(current)
• Calculation of
Expected Return = Risk-free Rate +
Beta×(Market Risk Premium)
= 2.75% + 1.25 (5.76%) = 9.95%
14
Estimating Beta
Return on Disney = .0071
+ 1.2517 Return on Market
Period used: past 5 years
Return Interval = Monthly
Market Index: S&P 500 Index
Source: Corporate Finance (2nd edition) by Aswath Damodaran
Each Component in WACC - Weights
• Weights should be calculated using market values rather
than book values
• Ideally, use the firm’s target (or optimal) capital structure
• The firm’s current capital structure can be used if it’s
optimally chosen and will not change following the
acceptance of the project
15
( )1d e e
D E
WACC k k t k
V V
   
= = − +   
   
• Interest rate kd 0.10
• Statutory company tax rate tc 0.30
• Proportion of tc claimed by shareholders (λ) 0.60
• Market value of debt D $10,000,000
• Cost of equity capital ke 0.20
• Market value of equity E $10,000.000
Note that te = tc (1 – λ) = 0.30 (1-0.60) = 0.12
Using the WACC formula:
= kd (1 – te) (D /V ) + ke (E /V )
= 0.10 (1–0.12) (10/20) + 0.20 (10/20)
= 0.044 + 0.10
= 0.144 or 14.4% per annum
Weighted Average Cost of Capital: Example
Using WACC for companies with subsidiaries –
Wesfarmers (see pg. 161-163, Annual report 2021)
17
Wesfarmers Brands
(see pg. 181, Wesfarmers Annual report 2021)
18
WACC for a Diversified Firm
• Assume that Wesfarmers has a WACC of 17% p.a. The annual meeting
is being held to decide capital expenditure for the following year.
• Head of the resources division proposes a mining project with expected return of
24%
• Head of the retail division proposes a project opening a new Coles store in growth
region with expected return of 12%
• Using company wide WACC to accept/reject projects will bias towards
mining (and riskier) projects, and bias away from retail projects!
• Wesfarmers needs to find publicly-traded companies in the same
industry (mining/retail) as the project, obtain information about their
expected returns, and then use it to make the accept/reject decision!
• The company cost of capital should only be used as a benchmark rate of
return for a new project if the project has the same basic risk as the rest
of the company
19
2. Optimal Debt Ratio – Cost of
Capital Approach
20
Optimal Capital Structure
• Common measure of a firm’s capital structure
Debt to Capital Ratio (or leverage ratio)
= Debt / (Debt + Equity)
• Is there an “optimal” (or “target”) capital structure, i.e., an
optimal mix between debt and equity that maximizes firm
value?
• If then, how to find it for a given firm?
• = σ=1
∞
(1+)
(DCF method)
• Firm value will be maximized when the cost of capital is
minimized! – “cost of capital approach”
21
Cost of Capital Approach
• Then how to get the minimum cost of capital?
• Let’s see what will happen to the WACC as debt ratio
increases
• What will happen to the cost of debt ()?
• Will increase with leverage because default risk will go up and
bond ratings will go down, requiring a higher default spread
22
( )1d e e
D E
WACC k k t k
V V
   
= = − +   
   
?
?
?
?
Cost of Capital Approach – Cont’d
• What will happen to the cost of equity ()?
• Will also increase with leverage. Why?
• Shareholders of a leveraged firm need to bear two types of
risk: Business risk and Financial risk
• Stock beta (and so, ) captures both types of risks
: levered beta (stock beta of a firm with leverage)
: unlevered beta (or asset beta) only reflects business risk
= 1 + 1 −


• Levered beta is a function of unlevered beta and D/E ratio
23
Cost of Capital Approach – Cont’d
24
= 1 + 1 −


= + 1 −


• What is intuition here?
• Consider a firm whose cash flows (subject to business risk) can
be decomposed into safe cash-flows and risky cash-flows
• Suppose that it is an all-equity firm. Then, both cash flows go to
shareholders
• Now suppose that it has outstanding debt.
• then a large part of the safe cash-flows goes to debtholders
• residual cash-flows left for shareholders are mostly from risky cash
flows, thereby placing an additional risk on shareholders (financial
risk)
business risk
financial risk
Cost of Capital Approach – Cont’d
• Steps for cost of capital approach
1. Estimate the cost of equity () at different levels of debt
• D/E increases → Beta will increase → will increase
• Estimation requires levered beta calculation
2. Estimate the cost of debt () at different levels of debt
• Default risk will go up and bond ratings will go down as debt goes up
→ will increase
• Estimation requires estimation of bond ratings
3. Calculate the cost of capital at different levels of debt and
choose the optimal level
4. Calculate the effect on firm value and stock price
25
Cost of Capital Approach – Cont’d
Here’s an example: Don’t worry about the exact numbers!
Just understand the trends here and choose optimal ratio!
26
Source: Professor Aswath Damodaran, NYU Stern School of Business
More weight
(D/(D+E))
on cheaper ;
so, CoC is
decreasing
Both &
increase more
sharply at high
debt ratio; so,
CoC is increasing
Cost of Capital Approach – Cont’d
Assume the firm has an annual cash flow of $200 million,
expected to grow 3% a year forever regardless of D/(D+E):
=
ℎ
−
=
200 × 1.03
− 0.03
27Source: Professor Aswath Damodaran, NYU Stern School of Business
What is Our Plan Now?
• Modigliani-Miller Irrelevance Theorem (Benchmark):
• Capital Structure is irrelevant
• What’s missing from the M-M view?
• Taxes
• Costs of financial distress
• Other market imperfections…
• Two main theories of capital structure
• “Trade-Off” theory (Benefits and Costs of Debt)
• “Pecking Order” perspective
• An integrative approach
28
Source: The following part of lecture notes is adapted from MIT open lecture by Professor Katharina Lewellen, 2003
3. Modigliani-Miller “Irrelevance”
Theorem
29
M-M’s “Irrelevance” Theorem
• Assume “perfect” markets*:
• No transaction or bankruptcy costs; no agency costs
• No taxes and no asymmetric information
• Market efficiency and perfect market competition (no arbitrage
opportunity)
• Then
• The value of the firm is independent of its capital structure
( = )
• : the value of an unlevered firm (with no debt);
• : the value of a levered firm
• Financing decisions do not matter!
*Note that MM did not mean that markets really look like this!
30
M-M’s “Irrelevance” Theorem – Cont’d
• MM Theorem: Proof (pie theory)
• The value a firm is that of the cash flows generated by its
operating assets (e.g., plant and inventories)
• The firm’s financial policy divides up this cash flow “pie”
among different claimants (debtholders and shareholders)
• But the size (i.e., value) of the pie is independent of how
the pie is divided up
31
M-M’s “Irrelevance” Theorem – Cont’d
• M-M Theorem was initially meant for capital structure
• But it applies to all aspects of financial policy under perfect
markets assumptions
• capital structure is irrelevant
• long-term vs. short-term debt is irrelevant
• dividend policy is irrelevant
• risk management is irrelevant
• …
32
4. Capital Structure Theory I:
Trade-off Theory
33
Trade-Off Theory
• The optimal target capital structure is determined by
balancing taxes and expected costs of financial distress
• These two ingredients can change the size of the pie that
goes to the firm’s claimholders (firm value) in the opposite
directions
• Trading off the two provides an “optimal” capital structure
(but, this theory does not aim at providing a precise target
but rather a range)
34
Debt Tax Shields
• Debt increases firm value by reducing the tax burden
• Now the pie is divided like
• Government gets a slice too
• Because interest payments are tax-deductible, the PV of the
government’ slice can be reduced by using debt rather than
equity
35
Debt Tax Shields: Value Implications
• With corporate taxes (but no other imperfections), the value
of a levered firm equals:
= + ( ℎ)
• If the firm is a going concern and debt is a perpetuity,
• Annual interest payment:
• Tax shield on interest payment: ×
• PV of interest tax shields = PV of a perpetuity
=
×

=
36
Debt Tax Shield: Value Implications
• Leverage and firm value: = +
• This suggests that having enough debt financing is optimal so as to reduce the
tax bill
• Imputation tax neutralises tax benefit of debt (e.g., the PV of tax-shields, D, is
zero in pure imputation system), implying lower leverage
37
A note about imputation system of
taxation
• The imputation system implies that firm income distributed as dividends is
effectively taxed at the shareholder’s marginal rate – just like interest income!
• But capital gains may be tax-advantaged for some investors. Therefore,
• So, there may be a tax-induced reason to issue equity rather than debt where
shareholders generate their returns via capital gains
Gains CapitalInterest
Gains CapitalDividendsDividendsInterest
tthence, and
t tbut, tt


Expected Costs of Financial Distress
• If taxes were the only issue, companies would be 100%
debt financed
• Common sense suggests otherwise
• If the debt burden is too high, the company is likely to run
into trouble
• The result: “financial distress” ⇒ bankruptcy (court
supervision) in some cases
• Now, the pie is divided like
39
Probability of Financial Distress
Expected costs of financial distress= (Probability of distress) * (Costs if actually in distress)
• Probability of distress
• “Cash flow volatility” (or business risk)
• Is industry risky? Is the firm’s strategy risky?
• Are there uncertainties induced by competition? By regulatory
changes?
• Is there a risk of technological change?
• Sensitive to macroeconomic shocks or seasonal fluctuations?
• As debt increases, the probability of financial distress also
increases
40
Costs of Financial Distress
• Direct costs (tend to be small)
• Legal expenses, court costs, advisory fees…
• Indirect costs (tend to be larger, but hard to measure)
• Opportunity costs (e.g., management distraction and effort)
• Scare off customers and suppliers (damage to reputation)
• Debtholders bear realised bankruptcy costs, but
• Shareholders bear expected bankruptcy costs in the form of more expensive
debt.
• Debtholders will increase interest rate to reflect the probability of default and
costs incurred in case of default.
• The greater the risk of a firm’s core activities (business risk), the greater the
probability of default.
• Greater default probability → higher interest rate charged.
• Higher interest rate charged → lower leverage.
41
Expected Costs of Distress
• Expected costs of financial distress increases sharply with
leverage (both probability and actual costs increase)
• Shareholders bear expected distress costs in the form of
more expensive debt (higher interest rates, more covenants)
• Companies with high expected distress costs should be more
conservative in using debt
42
Trade-off Theory: Optimal Leverage
• The value of a levered firm is now
= + − (. )
• The optimal capital structure maximises firm value
43
To summarise so far:
Modigliani
and Miller
(no taxes)
Introduce
taxes
Introduce
costs of
financial
distress
Survey Evidence
• Do firms have optimal or target debt-equity ratios?
(responses of 392 CFOs)
45
Source: Graham and Harvey, “The theory and practice of corporate finance: Evidence from the field”, JFE 2001
5. Capital Structure Theory II:
Pecking Order Perspective
46
Trade-off Theory: Implications
• Firms should:
• Issue equity when leverage rises above the target level
• Buy back stock when leverage falls below the target
capital structure
• Stock market should:
• React positively (or neutrally) to announcements of
securities issues
What really happens?
47
What Really Happens?
• Stock prices drop (on average) at the announcements of
equity issues
• Companies are reluctant to issue equity
• They follow a “pecking order” in which they finance
investments as follows:
• first with internally generated funds
• then with debt
• then with hybrids, and finally with equity
• Willingness to issue equity fluctuates over time
So, the “target-leverage” view seems incomplete!
48
How to Incorporate These Concerns?
• So far, we’ve assumed
• No distinction between existing and new shareholders
• No conflicts between managers and shareholders
• No costs of financial transactions
• Departing from these can explain a pecking-order preference
(1) Asymmetric information: managers have more information than
outside investors (Myers and Majluf, 1984)
(2) Agency costs of equity (or free cash flow problem): managers may
not act in the interest of shareholders (Jensen, 1986)
(3) Different flotation costs: issuing equity is more expensive than issuing
debt (direct underwriting fees and legal/registration fees)
49
Pecking-order theory is primarily based on the notion of asymmetric
information
• Pecking order theory does not lead to optimal capital structure.
• Rather capital structure is reflection of the firm‘s need for external finance.
• Insight: firms in same industry may have different debt levels due to their different
profitability
Internal equity
Debt
Hybrids
External equity
Pecking Order and Capital Structure
• If Pecking Order holds, a company’s leverage ratio reflects:
• Not an attempt to approach a target ratio;
• But its cumulative requirements for external finance
• High cash-flow ⇒ no need to raise debt & can repay debt ⇒
leverage ratio decreases
• Low cash-flow ⇒ need to raise capital (but prefer issuing
debt rather than equity) ⇒ leverage ratio increases
51
Hybrids
Hybrid Securities are securities that display characteristics of both debt
and equity
Two main types of hybrids in Australia are:
• Convertible notes (short-term) or bonds (long-term)
• A debt security (bond) with an option to convert to equity at maturity
• Debt security with promised interest payments over life
• An option to convert if the value of equity is greater than the face value of the
debt at maturity
• Preference shares
• Equity that has “preferred” status over ordinary equity with respect to dividend
payments and return of capital
• Different characteristics make it more/less equity/debt-like
Many different “flavours” of convertibles and preference shares
(also refer to the relevant slides in Lecture 3)
52
Survey Evidence
53
Many surveys conducted around the world have asked CFOs: “What
factors affect how you choose the appropriate amount of debt for your
firm?”
Non-tax impacts on capital structure: Asset
type
General use vs Firm specific
• The value of general-use assets is easier to realise than the value
of firm-specific assets
• Debtholder's risk is lower if the company’s value is largely
attributable to its general-use assets.
• Companies with a high proportion of general-use assets are able
to borrow more than companies with a high proportion of firm-
specific assets.
Tangible v Intangible
• In case of default, the value of tangible assets is easier to realise
than the value of intangible assets
• Debtholder's risk is lower if the company’s value is largely
attributable to its tangible assets.
• Companies with a high proportion of tangible assets are able to
borrow more than companies with a intangible assets.
54
Non-tax impacts on capital structure: Free
Cash Flow
• Free Cash Flow (FCF) (Jensen, 1986)
• Cash flow in excess of that needed to fund all positive NPV projects
• Managers may be reluctant to pay out FCF to shareholders
• Prefer “empire building” through unprofitable acquisitions
• Invest in pet projects, consume perks etc.
• This problem is more severe for “cash cows”
• Firms with lots of cash (i.e., profitable firms)
• And few good investment opportunities
• Can leverage reduce FCF problem?
• Debt = commitment to distribute cash flows in the future
• Thus, debt reduces FCF available to managers
• This may also explain why cash cow firms have higher leverage
55
Non-tax impacts on capital structure: Agency
Costs
1) Debt overhang (underinvestment)
• When a firm is in financial distress, shareholders may prefer to
pay out cash to shareholders than fund projects (even positive
NPV projects) because most of the benefits would go to the
firm’s existing creditors
2) Excessive risk-taking (asset substitution)
• Shareholders have unlimited upside potential but bounded
losses
• When a firm faces financial distress, shareholders are tempted
to gain by gambling (negative NPV projects) at the expense of
debt holders
56
Firm age, characteristics and capital structure
• Young, R&D intensive firms have low leverage because:
• Risky cash flows – high probability of financial distress
• High human capital – large loss in case of financial distress
• Have few tangible assets
• Low-growth, mature, capital intensive firms have high
leverage because:
• Stable cash flows – low probability of financial distress
• Tangible assets – lower costs of financial distress
• Few investment opportunities – debt overhang problem is unlikely
57
6. An Integrative Approach
58
What Should We Do with These Theories?
• Each theory makes a statement about what is of
primary importance:
• Trade Off: Tax shield and Distress costs
• Pecking Order: Information (market response), managerial
agency costs, issuing costs
• These theories need not be incompatible:
• Use each when you think they emphasize the right issues
• When getting far away from target, TO type issues dominate
• When reasonably close to target, PO type issues dominate
59
Capital Structure: Checklist
• Taxes
• Does the company benefit from debt tax shield?
• Expected distress costs
• What is the probability of distress? (Cash flow volatility; business risk)
• What are the costs of distress?
• Competitive threat if pinched for cash, customers care about distress,
assets difficult to redeploy?, agency costs of debt
• Information problems
• Do outside investors understand the funding needs of the firm?
• Would an equity issue be perceived as bad news by the market?
• Managerial agency problems
• Does the firm have a free cash flow problem?
• Issuing Costs
60
An Integrative Approach
• Establish long-run “target” capital structure
• Evaluate the true economic costs of issuing equity rather
than debt
• Real cost of price decrease and issuance costs vs. foregone
investment or increase in expected cost of distress
• If still reluctant to issue equity:
• Are there ways to reduce the cost? (e.g., give more information to the
market)
• Will the cost be lower if you issue later?
• Can you use hybrid securities?
61
http://pages.stern.nyu.edu/~adamodar/
• Data for capital structure (and lots of other corporate
finance variables)
• Snapshot of leverage ratios of US industries, January
2022
62
Industry Name Number of firms Book Debt to Capital
Market Debt to Capital
(Unadjusted) Market D/E (unadjusted)
Market Debt to Capital (adjusted for
leases)
Market D/E (adjusted for
leases) Effective tax rate
Advertising 49 67.39% 33.52% 50.41% 33.98% 51.47% 5.76%
Aerospace/Defense 73 57.03% 22.38% 28.83% 22.75% 29.45% 6.83%
Air Transport 21 84.92% 60.25% 151.60% 60.53% 153.33% 5.32%
Apparel 39 53.72% 23.27% 30.32% 24.01% 31.60% 12.06%
Auto & Truck 26 66.27% 16.58% 19.88% 16.57% 19.86% 3.88%
Auto Parts 38 48.06% 23.90% 31.41% 24.06% 31.68% 13.62%
Bank (Money Center) 7 67.41% 62.99% 170.21% 63.02% 170.39% 14.69%
Banks (Regional) 563 31.86% 25.16% 33.61% 25.69% 34.57% 19.29%
Beverage (Alcoholic) 21 40.72% 17.17% 20.73% 17.64% 21.42% 7.93%
Beverage (Soft) 32 57.53% 13.85% 16.08% 14.27% 16.65% 4.53%
Broadcasting 28 60.38% 53.39% 114.53% 53.88% 116.82% 11.54%
Summary of Lecture
63
Does Capital
Structure Matter?
Cost of
Capital
(WACC)
Cost of
Debt
Cost of
Equity
Optimal
Debt
Ratio
Cost of
Capital
Approach
Capital
Structure
Theories
MM
Irrelevance
Theorem
Trade-off
Theory
Pecking-
order
Perspective
After Today’s Class
You should be able to answer the following questions:
• What is a firm’s WACC? What is the intuition behind it? How to estimate it?
• What is the intuition behind the CAPM for cost of equity?
• When can we use a single company WACC for project evaluation and what are the likely
consequences if a multidivisional company uses its company WACC to evaluate all proposed
investments?
• What is the relationship between the WACC and the value of the firm?
• How can we find an optimal debt ratio for a given firm using the cost of capital approach?
• What is the equation for the levered beta and what is the intuition behind it?
• How can we use the levered beta equation to evaluate a firm’s new projects that have different
business risks from those of its existing projects?
• Explain MM’s irrelevance theorem
• How can you explain the trade-off theory and what practical implications does this theory
provide?
• How can you describe debt overhang and asset substitution problems?
• Why is the trade-off theory not enough? What is missing from the trade-off theory?
• What is the pecking-order perspective?
• Why do high growth, R&D intensive firms use less debt? Why do low growth, mature, and
capital-intensive firms use more debt?
• What would be your general financing policy to fund the firm’s real investments if you were the
CFO of a firm?
64