Study guide: Mastering Capital Structure and Modigliani-Miller Theory

Capital Structure & Modigliani-Miller Theorem Revision Sheet

1. 📌 Essentials

• Capital structure is the ratio of debt and equity financing used by a firm.
• WACC is the minimum return required, combining costs of debt and equity.
• Cost of debt = risk-free rate + credit spread, adjusted for taxes.
• Cost of equity is calculated via CAPM: $r_e = r_f + \beta (r_m - r_f)$.
• Modigliani-Miller (MM) Proposition 1 states in perfect markets, capital structure is irrelevant to firm value.
• Tax advantages of debt create a tax shield, increasing firm value (with taxes).
• Trade-off theory balances tax benefits against bankruptcy and distress costs.
• Pecking order theory favors internal funds, then debt, then equity.
• Agency costs stem from conflicts between managers, shareholders, and debt-holders affecting capital decisions.
• Market timing theory suggests firms issue equity when markets are overvalued and debt when interest rates are low.

2. 🧩 Key Structures & Components

• Debt — borrowed funds with fixed payments, senior claim, provides tax shield.
• Equity — shareholders’ residual claim, offers voting rights and dividends.
• WACC — average required rate considering capital mix.
• Tax Shield — reduction in taxable income due to interest expense.
• CAPM — model to estimate cost of equity: $r_e = r_f + \beta (r_m - r_f)$.
• Financial Distress Costs — costs arising from the risk of bankruptcy.
• Agency Costs — costs related to conflicts of interest among stakeholders.
• Market Timing — adjusting capital structure based on prevailing market conditions.

3. 🔬 Functions, Mechanisms & Relationships

• Hierarchy of financing: internal funds → debt → equity (pecking order).
• Leverage effect: increased debt raises firm risk, raising cost of debt and equity.
• Tax shield: interest deductibility reduces taxable income, increasing firm value.
• MM Proposition 1 (no taxes): firm value remains unchanged regardless of capital structure.
• MM with taxes: leverage adds value, $V_L = V_U + t_c \times D$.
• Trade-off: firm's optimal capital structure balances tax benefits against distress costs.
• Information asymmetry: leads firms to prefer internal and debt financing to avoid adverse selection.
• Agency conflicts: influence financing choices due to free cash flow and control issues.
• Market timing: firms issue equity overvalued or debt at low interest rates to optimize financing.

4. 📊 Comparative Table

5. 🗂️ Hierarchical Diagram (ASCII)

Capital Structure & Modigliani-Miller Theorem
 ├─ Components
 │   ├─ Debt
 │   │    ├─ Benefits: Tax shield, cheaper cost
 │   │    └─ Risks: Bankruptcy, distress
 │   ├─ Equity
 │   │    ├─ Benefits: Ownership, flexibility
 │   │    └─ Risks: Dilution, higher cost
 │   └─ WACC
 │        ├─ Combines costs based on capital mix
 │        └─ Lower WACC encourages debt up to a point
 ├─ Theories
 │   ├─ Trade-off
 │   │    ├─ Balances tax shields vs. distress costs
 │   │    └─ Finds optimal leverage
 │   ├─ Modigliani-Miller
 │   │    ├─ No taxes: value unchanged
 │   │    └─ With taxes: leverage adds value
 │   ├─ Pecking order
 │   │    ├─ Internal funds preferred
 │   │    └─ Debt before equity
 │   ├─ Market Timing
 │        ├─ Issue equity when overvalued
 │        └─ Issue debt at low interest rates

6. ⚠️ High-Yield Pitfalls & Confusions

• Confusing MM Proposition 1 with and without taxes.
• Overestimating the benefits of debt without considering bankruptcy risk.
• Assuming debt always reduces WACC; too much debt raises overall risk.
• Ignoring agency costs and their impacts on financing choices.
• Mistaking the pecking order for the optimal capital structure.
• Misapplying CAPM: forgetting beta or using incorrect assumptions.
• Overlooking market timing influences on capital structure.
• Confusing firm value with stock price—distinct concepts.

7. ✅ Final Exam Checklist

• Define capital structure and understand its components.
• Calculate WACC using $WACC = \frac{E}{V} r_e + \frac{D}{V} r_d (1 - T)$.
• Know how to derive the cost of debt and equity.
• Explain the assumptions and conclusions of Modigliani-Miller propositions.
• Understand tax shield benefits of debt.
• Describe the trade-off theory and how firms seek optimal leverage.
• Recognize the pecking order and the impact of information asymmetry.
• Identify sources and effects of agency costs.
• Explain market timing theory's influence on capital structure.
• Recognize how bankruptcy risk affects debt levels.
• Use the hierarchical structure and ASCII schema to organize ideas.
• Be aware of common pitfalls related to leverage, taxes, and market assumptions.
• Relate real-world examples like Seplat to theoretical models.

This revision sheet condenses core concepts for effective exam preparation on capital structure and the Modigliani-Miller theorem.