Capital Structure Policy

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Capital StructurePolicy
Professor Dr. Rainer Stachuletz Corporate
Finance Berlin School of Economics
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Financial Leverage
High Tech Manufacturing Corporation (HTMC) is an
all-equity firm with 200,000 shares outstanding.
HTMCs Chief Financial Officer is considering
changing the capital structure to be 50 equity
and 50 debt.
Proposal to issue 5,000,000 in debt, at 6
interest, and buy back 100,000 shares (at 50 per
share)
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Current and Proposed Capital Structure for HTCM
Market value of assets is 10,000,000
What is the expected ROE with the new capital
structure ?
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Return on Equity
Next year,the economy exhibits equal
probabilities of continuing to grow at a normal
rate, fall into recession or to boom into even
higher growth rates.
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Cash Flows if Economy Experiences Recession or
Boom
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Cash Flows if Economy Experiences Normal Growth
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Using Debt to Magnify Risk and Expected Return
If EBIT lt 600,000 (the break-even point),
shareholders earn a lower EPS with the proposed
capital structure.
If EBIT gt 600,000 (the break-even point),
shareholders earn a higher EPS with the proposed
capital structure.
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Does Financial LeverageIncrease the Firm Value?
Substituting debt for equity will increase EPS,
but does not maximize the firms value.
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The Modigliani and MillerCapital Structure Model
First model to show that capital structure
decision may be irrelevant
Assumes perfect markets, no taxes or transactions
costs
Capital structure merely determines how risk is
allocated between bondholders and stockholders.
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MM Propositions
Proposition I Market value of a firm is
independent of its capital structure.
Market value of a firm is given by capitalizing
its expected net operating income (EBIT) at the
rate r.
Proposition II The expected return on a levered
firms equity, rl, is a linear function of firms
debt to equity ratio.
Substituting debt for equity causes the cost of
equity to rise, negating any costs savings from
the switch.
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MM Proposition I
HTMC expected EBIT is 1,000,000 and required
return on assets is 10.
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MM Proposition II
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MM Proposition II
If proposition II holds, WACC is independent of
capital structure.
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Firms Cost Of Equity Under MM Proposition II
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MM with Taxes
Most countries allow firms to deduct interest as
an expense, but not dividends.
Deductibility lowers the after-tax cost of debt.
By using more debt, firms shelter more cash flow
from taxes.
Maximum firm value is reached at 100 debt!
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Models Of Capital Structure with Corporate
Income Taxes
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The MM Model With Corporate And Personal Taxes
Incorporating corporate income taxes yields a
straight-forward result use 100 leverage.
This is not observed in the market. How can we
explain that firms use less than 100 debt?

• Two obvious reasons personal taxes and
  deadweight costs of corporate bankruptcy.
• Perhaps personal taxes offset corporate taxes.
• Equity financing renders personal tax advantages
  (capital gains and sometimes dividends taxed at
  lower rates than interest income).

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Miller (1977) And The Gain From Leverage
Miller proposed a model where corporate tax
benefits of leverage partially or fully offset by
personal taxes.
Tc Tax rate on corporate profits Tps
Personal tax rate on income from stock (capital
gain and dividends) Tpd Personal tax rate on
income from debt (interest income) D Market
value of a firm's outstanding debt
This is a general formulation. It includes
original no-tax model as special case, where
GL0. Also includes case where only corporate
taxes apply.
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Bankruptcy Cost
The costs of going bankrupt matter in the capital
structure decision rather than the possibility of
bankruptcy itself.
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Bankruptcy Costs
Indirect costs are likely to be much larger, and
will likely vary a great deal based on the type
of firm in distress.
Firms with mostly tangible assets tend to issue
more debt than do firms with intangible assets.
Costs may be high
When the firms product requires that the firm
stay in business (e.g., when warranties or
service are important), or
When the firm must make additional investments in
product quality to maintain customers.
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Agency Costs And Capital Structure
Debt helps mitigate these costs, but debt has its
own agency costs.
Bondholders protect themselves with positive and
negative covenants in lending contracts.
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The Agency Cost / Tax Shield Trade-Off Model Of
Corporate Leverage
Companies trade off tax and agency cost benefits
of debt against the costs of bankruptcy and
agency costs of debt.
Empirical research offers support for the model.
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Evidence on Capital Structure
More profitable firms tend to use less leverage.
High-growth firms borrow less than mature firms
do.
Firms product market strategies and asset bases
influence their capital structure choices.
Stock market generally views leverage-increasing
events positively.
Tax deductibility of interest gives firms an
incentive to use debt.
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Capital Structure Policy

• Capital structures vary across firms, industries,
  and countries.
• Modigliani and Miller showed that in a world of
  frictionless capital markets capital structure is
  irrelevant.
• Personal taxes on debt, bankruptcy costs, agency
  costs, and asymmetric information influence level
  of debt the firm chooses to have.