Chapter 12 Capital Structure Concepts

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Chapter 12Capital Structure Concepts

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Capital StructureVs Financial Structure

• Capital Structure
• Permanent s-t debt
• L-T debt
• P/S
• C/S

• Financial Structure
• Total current liabilities
• L-T debt
• P/S
• C/S
• Right-Hand side of the balance sheet

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Capital Structure Terminology

• Optimal capital structure
• Minimizes a firms weighted cost of capital
• Maximizes the value of the firm
• Target capital structure
• Capital structure at which the firm plans to
  operate
• Debt capacity
• Amount of debt in the firms optimal capital
  structure

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What Determines the Optimal Capital Structure
?Debt Capacity ?

• Business risk of the firm
• Tax structure
• Bankruptcy potential
• Agency costs
• Signaling effects
• Trend towards deleveraging

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Capital Structure Assumptions

• Firms investment policy is held constant
• Capital structure changes the distribution of the
  firms EBIT among the firms claimants
• Debtholders Preferred stockholders Common
  stockholders
• Constant investment policy leaving the debt
  capacity of the firm unchanged

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Factors Influencing a Firms Business Risk

• Variability of sales volume
• Variability of selling price
• Variability of cost
• Amount of market power and competition
• Extent of product diversification

• Firms growth rate
• Degree of operating leverage ( DOL )
• (a 1 change in sales or output has a what
  change in EBIT)
• Both systematic and unsystematic risk

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Financial Leverage

• OPM
• (Other peoples money)
• Increase returns to common stockholders
• Whenever a firm finances a portion of its assets
  with any type of fixed-charge financing, such as
  debt, leasing, and preferred stock, the firm is
  said to be using Financial Leverage.
• Typically, the greater the firms business risk,
  the less the amount of financial leverage that
  will be used.

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Financial Risk

• Variability of EPS and increased probability of
  bankruptcy
• Factors indicating financial risk
• Debt-to asset ratio
• Debt-to-equity ratio
• Fixed charge coverage ratio
• DFL (a 1 change in EBIT causes a what change
  in EPS)
• Probability distribution of profits
• Times interest earned ratio
• EBIT-EPS analysis

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Capital Structure Theory

• Studies the relationship between
• Capital Structure Cost of capital
• debt/assets
  value of the firm
• Capital Structure Models
• Shows the role of
• Taxes Bankruptcy costs
  Agency costs
• on the determination of an optimal capital
  structure

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Modigliani and Miller ( MM )On Capital Structure

• Assumed perfect capital markets including
• No taxes (1958)
• No bankruptcy ( B ) costs
• No agency ( A ) costs
• If leverage increases, the cost of equity ( ke ),
  increases to exactly offset the benefits of more
  debt financing ( kd ), leaving the cost of
  capital ( ka ) constant Please see Model 1.

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Model 1
Cost of Capital

• The overall cost of capital is independent of the
  capital structure. The firms value is
  independent of the capital structure.

ke
ka
kd
Debt
Total Assets

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MM Arbitrage Proof

• D Dividends
• Value of U D/ke
• Value of L D/ke I/kd
• D paid to Ls stockholders are reduced by the
  amount of I paid on the debt
• ke is higher for L because of the additional
  leverage-induced risk
• The values of U and L are identical due to
  arbitrage (No Tax Model)

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Assumptions of Modigliani and Miller (1958)

• No Taxes
• No Transactions Costs for buying and selling
  securities
• All investors can borrow or lend at the same rate
• Relevant information is costless and readily
  available to all investors
• Investors are rational and have homogeneous
  expectations of firm earnings.

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What Happens with Taxes ?

• Same two equations
• VU D/ke VL D/ke I/kd
• D distributed to Us stockholders are reduced by
  the taxes paid on operating income and the value
  of U drops (1963 Model)
• Since I is tax deductible, L realizes a tax
  savings
• PV of tax shield value of debt ( B ) x tax rate
  ( T )
• Please note next slide.

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VL VU Value of Tax Shield
Mkt Value of Firm
VL
PV of Tax Shield
VU
Debt

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Model 2
Cost of Capital
ke
ka
ki kd ( 1 - T )
Debt
Total assets
The cost of capital decreases with the amount of
debt Firm maximizes its value by choosing a
capital structure that is theoretically all debt.

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What Happens With Taxes, Bankruptcy, Agency
Costs ?

• B A costs increase with the amount of leverage
• Eventually offset the marginal benefits from the
  value of the tax shield
• Market value of levered firm
• Market value of unlevered firm
• PV of tax shield
• - PV of bankruptcy costs
• - PV of agency costs See optimal
  debt ratio slide

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Bankruptcy (Financial Distress) Costs

• Lenders may demand higher interest rates
• Lenders may decline to lend at all
• Customers may shift their business to other firms
• Distress incurs extra accounting legal costs
• If forced to liquidate, assets may have to be
  sold for less than market value

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Agency CostsStockholder-Bondholder Relationship

• Agency costs are incurred by the owners when the
  firm is managed by others (e.g. monitoring costs)
• Investing in projects with high risk and possible
  low returns can shift wealth from bondholders to
  stockholders
• Stockholders may forgo some profitable
  investments in the presence of debt
• Stockholders might issue high quantities of new
  debt and diminish the protection afforded to
  earlier bondholders
• Bondholders will shift monitoring and bonding
  costs back to the stockholders by charging higher
  interest rates

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Optimal Debt Ratio
Mkt Value of the Firm with taxes
VL
PV B A Costs
PV of Tax Shield
Mkt value of levered firm
VL
Vu
Debt Ratio
Optimal Debt Ratio
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Model 3Least Cost Capital Structure is Optimal
Cost of Capital
ke
ka
ki
B
B E
Static Tradeoff Theory
0
Optimal Capital Structure
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Static Tradeoff Theory

• In the presence of corporate taxes, financial
  distress costs and agency costs, it can be shown
  that the Cost of Capital will be U shaped.
• The Cost of Capital will be minimized and the
  value of the firm will be maximized.
• The precise relationship between the cost of debt
  and the debt ratio is difficult to determine.

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Static Tradeoff Theory - Continued

• The greater the proportion of debt used, the
  greater the risk of bankruptcy and the higher the
  interest costs.
• The greater the proportion of debt used, the
  greater the variability of earnings per share and
  the higher the risk premium required
• ka weke wiki wpkp
• ki

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Other Impacts on the Optimal Capital Structure

• Personal tax effects
• Could reverse some tax benefits
• Industry effects
• Profitability and bankruptcy patterns
• Signaling effects
• Asymmetric information
• Managerial preferences
• Pecking order theory

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Capital Structure Implications for Managers

• A centrally important management decision
• Benefits of the tax shield from debt provide an
  incentive to use debt financing
• To the point that increasing A B costs offset
  the debt advantage
• Optimal capital structure is heavily influenced
  by business risk
• Changes in capital structure signal important
  information to investors
• Pecking order theory - Alternative to Static
  Tradeoff Theory
• Internal equity Debt External
  equity
• First choice
  Least preferred by management
  

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Pecking Order Theory

• The pecking order of financing is internal
  financing first, and then if external financing
  is used, debt securities are issued before
  external equity.
• Alternative concept to Static Tradeoff Theory
• There may be no particular target or optimal
  capital structure for a firm.
• Profitable firms with limited needs for
  investment funds will tend to build up financial
  slack.

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LBO

• Can eliminate agency problems
• Increased operating efficiencies may be achieved
• Eliminating jobs Reducing other payroll
  expenses Closing inefficient plants
• Bondholders typically realize a loss in the value
  of their bonds
• Ethical issues
• Is it in the long-run interest of employees ?
• Are bondholders harmed in a LBO ?
• Managers acting as both buyers and sellers
• Are LBOs successful?

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Multinational Firms

• Have more complex capital structure decisions
• Finance investments in host country funds
• Exchange rate risk
• Some countries use more financial leverage than
  others
• Some host countries restrict foreign investment
• Risk of expropriation
• Some host countries provide low-cost financing

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Conclusion

• Capital Structure
• Business Risk
• Financial Leverage
• Capital Structure Models
• Static Tradeoff Theory
• Pecking Order Theory and Asymmetric Information