Course Progress
Part of 10 Chapters
The Art of Leverage: Capital Structure and Enterprise Value
Chapter 7. The Art of Leverage: Capital Structure and Enterprise Value
How much should a company borrow? Is there a “perfect” mix of debt and equity that makes a company most valuable? Today, we enter the core of corporate strategy: Capital Structure.
Using debt (leverage) is like a double-edged sword. It can magnify returns for shareholders, but it also increases the risk of the “ship” sinking. Let’s explore how financial engineering crafts the optimal balance.
1. Modigliani-Miller (MM): The Foundation
In 1958, Franco Modigliani and Merton Miller shook the financial world by proving that in a “perfect market” (no taxes, no bankruptcy costs), ==“The value of a firm is independent of its capital structure.”==
The MM Proposition Comparison
| Scenario | Value of the Firm | Conclusion |
|---|---|---|
| **Case 1: No Taxes** | Constant regardless of Debt | Pie size doesn't change how you cut it |
| **Case 2: With Taxes** | Increases as Debt increases | **Interest Tax Shield** creates value |
2. The Power of the Tax Shield
Why do companies love debt in the real world? Governments allow companies to deduct interest expenses from their taxable income.
Company generates Earnings Before Interest and Taxes (EBIT)
Interest is paid out of EBIT *before* the taxman takes his share
Company pays less tax compared to an all-equity firm
The present value of these tax savings adds directly to Firm Value
==Enterprise Value (Levered) = Value (Unlevered) + PV(Tax Shield)==
3. The Trade-off: Benefits vs. Risks
If debt is so good for taxes, why not borrow 100%? Because of Financial Distress Costs.
The Optimal Point (Static Trade-off)
Balance the Tax Shield against the risk of bankruptcy.
- The Trade-off: As you borrow more, the tax benefit grows, but the probability of going bankrupt also rises. Optimal Capital Structure is the point where the marginal benefit of debt equals the marginal cost of potential bankruptcy.
4. Financial Leverage: The Magnifier
Leverage magnifies ROE (Return on Equity).
| Performance | All Equity (ROE) | Levered (ROE) |
|---|---|---|
| Good Year | 10% | 15% (Magnified) |
| Bad Year | 2% | -5% (Hurts) |
The Leverage Trap: Leverage is great when things are going well, but it turns a slight downturn into a catastrophe. Only companies with stable cash flows should dare to carry heavy debt.
5. Conclusion: Designing the Future
Choosing a capital structure is about ==“Optimizing the Cost of Capital to Maximize Firm Value.”== A great manager knows exactly how much pressure (debt) the company can withstand to achieve the highest possible growth.
📚 Prof. Sean’s Selected Library
- [The Theory of Corporate Finance] - Jean Tirole: A rigorous look at the incentives and structures of firm financing.
- [Capital Structure and Corporate Financing Decisions] - H. Kent Baker: A practical guide to how real-world CFOs make borrowing decisions.
- [A Random Walk Down Wall Street] - Burton Malkiel: Context on how market perceptions of debt affect stock prices.
Next time, we will explore ‘Dividend Policy’—how a company decides how much of its hard-earned cash to return to shareholders.