Capital Structure Concepts

1
Chapter 12

• Capital Structure Concepts

2
Introduction

• This chapter examines some of the basic concepts
  used in determining a firms optimal capital
  structure. It deals only with the total permanent
  sources of a firms financing.

3
Meaning of Capital Structure

• Capital Structure
• Permanent short-term debt
• Long-term debt
• Preferred Stock
• Common Stock

• Financial Structure
• Total Current liabilities
• Long-term debt
• Preferred Stock
• Common Stock

• Capital structure refers to the permanent debt,
  preferred stock and common equity of a firms
  balance sheet.

4
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

5
What Determines the Optimal Capital Structure ?

• Business risk of the firm
• Tax structure (Corporate Income Tax)
• Bankruptcy potential (Financial distress)
• Agency cost

6
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

7
Business Risk

• Business risk is the variability of firms
  operating earnings
• Factors affecting business risk
• Variability of sales volume
• Variability of selling prices
• Variability of costs
• Market power
• Extent of product diversification
• Level and rate of growth
• Degree of operating leverage (DOL)
• Use of assets having fixed costs

8
Financial Risk

• Variability of EPS and increased probability of
  bankruptcy that arise due to the use of
  fixed-cost funds.
• Higher the amount of fixed financial costs, the
  higher the amount of EBIT required to cover them.
• Financial Leverage Use of fixed-cost financing
  sources (largely debt) is called financial
  leverage.

9
Financial Leverage and Shareholder Returns

• Financial leverage magnifies shareholder returns.
  (see Table 12-1)
• For a given level of EBIT, higher financial
  leverage leads to an increase in ROE.
• When EBIT declines, the decline in ROE is more
  for firms with higher leverage.
• Financial leverage increases both potential
  returns and risk.
• Generally, firms with greater business risk must
  use less financial leverage.

10
Capital Structure Theory

• Studies the relationship between capital
  structure and the value of the firm.
• Capital structure
• Debt/assets
• Cost of capital
• Value of the firm

11
Capital Structure Models

• An optimal capital structure with
• Taxes
• An optimal capital structure with
• Taxes
• Financial distress costs
• Agency costs

12
Modigliani and Miller (MM) without Corporate
Income Tax (No-tax MM)

• Assume perfect capital markets
• No transaction costs.
• Market for securities is perfectly competitive.
• Information is available to all investors and is
  costless.
• Investors can borrow and lend at the same rate of
  interest.
• No corporate income taxes.
• No bankruptcy costs.

13
No-tax MM

• Cost of debt is less than cost of equity.
• When firm borrows more, it benefits from the
  lower cost of debt (Kd).
• However, when firm borrows more, the required
• return of shareholders (Ke)increase due to
  increased risk.
• Increase in cost of equity exactly offsets the
• benefits of more debt.
• Hence, the firms WACC (Ka) remains unchanged.
• Since the WACC does not change, the value of the
  firm (V) does not change.
• Value of the firm is not affected by the capital
  structure.
• Choice of debt vs. equity is irrelevant.

14
No-tax MM
Market value of firm Market value of equity
Market value of debt
D Dividend I Interest
15
No-tax MM

• Firm U (The unlevered firm)
• EBIT 1000
• Then
• D 1000, Ke10

• Firm L (The levered firm)
• 2,000 in debt financing
• EBIT 1000
• I 100 D900
• Kd5 (Kdcoupon rate)
• Ke11.25

16
No-tax MM
Cost of Capital

Ke
Ka
Kd
Financial Leverage
0
The overall cost of capital is independent of the
capital structure. The firms value is
independent of the capital structure.
17
Modigliani and Miller (MM) with Corporate Income
Tax (With-tax MM)

• Now, relax the no-tax assumption assume the
  existence of corporate income taxes.
• Interest on debt is tax deductible tax benefit
  to use of debt.
• Tax savings are called Tax Shield
• Tax Shield i x B x T
• PV of Tax Shield (i x B x T) / i
• B x T

18
With-tax MM T 40

• Firm U
• EBIT 1000
• Then
• D 600

• Firm L
• EBIT 1000
• I 100
• D50040540
• Tax shield amount IBT 0.052,0000.40 40

19
With-tax MM

• Market value of the levered firm is greater than
  the market value of the unlevered firm.
• Market Value Market Value
  Present Value
• of of of
• Levered Firm Unlevered Firm
  Tax Shield
• 6000 2000 x 0.4
• 6000 800 6800

20
With-tax MM
Cost of Capital

Ke
Ka
Ki kd(1-T)
0
Financial leverage
The cost of capital decreases with the amount of
debt. The firm maximizes its value by choosing a
capital structure that is all debt.
21
What Happens With Taxes, Bankruptcy, and Agency
Costs ?

• Market value of leveraged firm
• Market value of unleveraged firm
• PV of tax shield
• PV of bankruptcy costs (Financial Distress
  Costs)
• PV of agency costs

22
Costs of Financial Distress

• Higher leverage increases the potential for
  firms financial distress.
• Higher leverage leads to higher costs of
  financial distress.
• Direct costs
• Lenders may demand higher interest rates
• Distress incurs extra accounting legal costs
• If forced to liquidate, assets may have to be
  sold for less than market value

23
Costs of Financial Distress

• Indirect costs
• Lenders may decline to lend at all forcing the
  firm to forgo some investments
• Customers may shift their business to other firms
• These costs eventually offset the marginal
  benefits from the value of the tax shield.

24
Agency CostsStockholder-Bondholder
Relationship

• Investing in projects with high risk and high
  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.

25
Optimal Capital Structure with Taxes,
Financial Distress Agency Costs

• Benefit of leverage Higher leverage leads to
  larger tax savings.
• Costs of Leverage Higher leverage leads to
  higher financial distress costs and agency costs.
• There is a tradeoff between tax savings, and
  costs of financial distress and agency.

26
Optimal Capital Structure

• Value of the Levered Firm
• Value of the Unlevered Firm
• Present value of Tax Shield
• - Present Value of Financial Distress Costs
• - Present Value of Agency Costs
• (See Figures 12-4, 12-5, 12-6)