Capital Structure: Internal vs. External Financing

Capital Structure Overview

• Capital structure is a fundamental aspect of corporate finance.

• It can be defined by internal vs. external financing, and different sources of external financing.

• It can be investigated as to whether there is an optional financial structure

• CFO survey evidence shows capital structure is among the finance functions that add the most value to a firm.

Market Value Balance Sheet

• Equity can be generated through internal self-financing methods, or by external shares.
• External shares include IPO and SEO (initial and secondary equity offering).
• Debt can be sourced from markets, banks or operating activities.

Internal vs. External Financing

• Internal financing represents a large part of investments in France

Sources of External Financing

• The two main sources of external financing are equity and debt.
• The sources of equity vary depending on the size of the company from personal resources for small businesses, risky capital for SMEs and financial markets for the largest.
• Debt can come from banks or bond markets, but also inter-company credit leasing, and money market.

Financing Sources and Lifecycle

• Venture capital and bank loans are typically the first sources of funding for a company.
• IPO (Initial Public Offering) is next, then bonds and finally SEO (Seasoned Equity Offering) and LBO (Leveraged Buyout).

External Financing

• External financing comes from financial markets
• Debt markets include bank loans, bonds commercial papers and leasing
• Stock markets include common stock, preferred stock, and warrants

Debt to Equity Ratio

• The D/E (Debt to Equity) ratio can be contrasted between GE (grande enterprise), ETI (enterprise de taille intermédiaire), and PME (petites et moyennes enterprises)

Bank Loans to Non-Financial Corporations

• Year-on-year variation data can be tracked for bank loans to non-financial corporations across investments, treasury, and total Euro Zone.

Bonds and Financial Debt

• Trends in bonds/debt can be tracked for GE (grande enterprise), ETI (enterprise de taille intermédiaire), and PME (petites et moyennes enterprises)

External vs. Internal Financing Flows

• Total vs. External financing for non-financial companies in Europe became negative in 2023 due to share buybacks
• Net external financing flow broken down for euro area NFCs (Non-Financial Companies)

Composite Bank Lending Rates

• Interest rates have increased in Europe
• This is especially true with smaller companies

Nominal Cost of External Financing

• The nominal cost of external financing for euro area NFCs is broken down by component
• Components are financing overall, cost of equity, cost of market-based debt, short-term cost of bank borrowing, and long term costs of bank borrowing

Optimal Capital Structure

• The optimal capital structure maximizes the value of the firm or minimizes the cost of capital.
• If this exists the question is what are the determinants?
• If it does not exist the question is why?

Traditional vs. Modigliani-Miller

• The "traditional position" is that an optimal capital structure does exist
• The Modigliani-Miller theory states that capital structure does not matter

Modigliani and Miller Theorems

• MMI is based off when there are no taxes
• MM2 arises when there are taxes

MMI and a Perfect World

• Franco Modigliani (MIT) and Merton Miller (Chicago) were both Nobel laureates.
• They developed key propositions and conclusions on MMI, intuition, and provided summaries and further questions.

MMI Hypothesis

• Several key assumptions to the MMI hypothesis are there are no taxes, no transaction costs, perfect capital markets, no bankruptcy costs, and all firms and individuals borrow at a risk-free rate
• Firms are assessed to be in the same risk class
• Core premises: the value of the firm does not depend on its capital structure (VL = VU), and the cost of capital does not depend on the capital structure

MM1 and a perfect world – arbitrage

• (1) Firm's total value is independent of its capital structure => VU = VL (arbitrage)
• (2) Leverage effect (Cost of equity increases with its debt-to-equity ratio)
• (3) MMI with WACC

The Cost of Equity

• Assumes the return from capital depends on risk
• U's shareholders bear only economic risk, whereas L's shareholders bear also financial risk

MM2: Introducing Corporate Taxes

• The premise is F. Modgliani and M. Miller "Corporate income taxes and the cost of capital: a correction", American Economic Review, 1963
• If there are taxes on profits, the value of the firm is an increasing function of its debt: VL = VU + DT.
• There is a further relationship where The WACC is a decreasing function of the debt ratio
• This leads to a results in MM correction and can lead to generalization

Example with Corporate Taxes

• Under MM2, if you consider a baseline Unlevered Firm and add Levered Firms, you will get changes based on taxes and other attributes

MM2

• Tax income rate T helps shield DT which leads to the following expression
• VL = VU + DT

MM2 Proof

• It is based off Unlevered firm (no debt) where cash flows (EBIT) and revenue for shareholders follows a certain expression
• VU = 𝑋(1−𝑇) / 𝑊𝐴𝐶𝐶𝑈 = 𝑋(1 – 𝑇) / kEU

In turn the Levered Firm can be assessed with the addition of debt where:

• Total CF = (X – rD)(1 - T) + rD = X(1 - T) + rDT
• This produces a value with tax savings where VL = 𝑋(1−T)+rDT / WACCU +rDT/r

MM2 Breakdown

• A key point to remember is firm should be assumed to be leveraged forever and to pay taxes at a constant rate.
• This suggests debt tax shields are discounted at the risk-free rate, and they are considered as a perpetuity

Carryforward in France (2024)

Loss incurred during a financial year is considered as an expense deductible from the profit of the following financial years without limitation This year the loss can only be carried to is capped it is limited to € 1 million per year, increased by 50% of the fraction of the profit above this limit.

Carryback in France (2024)

• Loss incurred during a financial year is considered as an expense deductible from the profit of the previous financial year.
• Note that Carryback is only allowed for the previous financial year but not in future years

MM2: Non-Perpetual Debt

• Can be evaluated with certain expression, including years, interest rate etc

MM2: Discounting at a rate different from the risk-free rate

• Can be expressed relative to debt maturity [years]

Corporate Tax Rates

• Rates can fluctuate in Europe and over time
• There is also an agreement across 140 countries for a the minimum tax level as well

Section 3: MM and CAPM

• Can be used to assess asset beta and economic risk for MM and more

MM to Risk Assets

• In general, the expected return on a firm's assets (WACC) should reflect the riskiness of the investment and the mix of debt and equity used to finance it.
• Risk is measured by the variance in returns.

Total Risk

• Risk = σ i = total risk of an asset
• = diversifiable risk + non-diversifiable risk.

Diversifiable vs. Non-Diversifiable Risk

• Diversifiable risk is the aspect which can come from a number of elements

CAPM

• The CAPM (Capital Asset Pricing Model) has a number of key Assumptions
• Investors are well diversified (bear no specific risk), there are No transaction costs, All assets are traded and infinitely divisible, there is No information asymmetry, and Investors can lend and borrow at the risk-free rate
• One assumption is Investor risk aversion is reflected in investing more or less in the riskless asset.

Risk/Return Tradeoff

• Can be summarized with the following expression
• E(R i) = rf + (E(R M) – rf) × β i

CAPM and Asset Beta

• The risk-return factor can be illustrated by a graph where a steeper slope corresponds to the market risk premium

MM and Risk

• They have a hypothesis for the conditions to be analyzed

MM with Taxes

• They have a hypothesis for the conditions to be analyzed

Asset Beta

• Can be illustrated by breaking down risk into components

Assets and Levereage

• Both depend on the circumstances

MM2 Generalization

• Involves Hamada and other factors

Additional Considerations

• Profitability ratio and operating income also play a role

Corporate Tax in France

• They have different rules based on size

Deductibility

• Many factor impact this.

  Is the directive really binding?

• It depends on the situation.