Title: Capital Structure Determination
1Chapter 17
- Capital Structure Determination
2After Studying Chapter 17, you should be able to
- Define capital structure.
- Explain the net operating income (NOI) approach
to capital structure and valuation of a firm
and, calculate a firm's value using this
approach. - Explain the traditional approach to capital
structure and the valuation of a firm. - Discuss the relationship between financial
leverage and the cost of capital as originally
set forth by Modigliani and Miller (MM) and
evaluate their arguments. - Describe various market imperfections and other
"real world" factors that tend to dilute MMs
original position. - Present a number of reasonable arguments for
believing that an optimal capital structure
exists in theory. - Explain how financial structure changes can be
used for financial signaling purposes, and give
some examples.
3Capital Structure Determination
- A Conceptual Look
- The Total-Value Principle
- Presence of Market Imperfections and Incentive
Issues - The Effect of Taxes
- Taxes and Market Imperfections Combined
- Financial Signaling
4Capital Structure
Capital Structure -- The mix (or proportion) of a
firms permanent long-term financing represented
by debt, preferred stock, and common stock equity.
- Concerned with the effect of capital market
decisions on security prices. - Assume (1) investment and asset management
decisions are held constant and (2) consider only
debt-versus-equity financing.
5A Conceptual Look Relevant Rates of Return
- ki the yield on the companys debt
Annual interest on debt Market value of debt
I B
ki
- Assumptions
- Interest paid each and every year
- Bond life is infinite
- Results in the valuation of a perpetual bond
- No taxes (Note allows us to focus on just
capital structure issues.)
6A Conceptual Look Relevant Rates of Return
ke the expected return on the companys equity
Earnings available to common shareholders Market
value of common stock outstanding
E S
E S
ke
- Assumptions
- Earnings are not expected to grow
- 100 dividend payout
- Results in the valuation of a perpetuity
- Appropriate in this case for illustrating the
- theory of the firm
7A Conceptual Look Relevant Rates of Return
ko an overall capitalization rate for the firm
O V
O V
Net operating income Total market value of the
firm
ko
- Assumptions
- V B S total market value of the firm
- O I E net operating income interest paid
plus earnings available to common shareholders
8Capitalization Rate
Capitalization Rate, ko The discount rate used
to determine the present value of a stream of
expected cash flows.
B B S
S B S
ko
ke
ki
What happens to ki, ke, and ko when leverage,
B/S, increases?
9Net Operating Income Approach
Net Operating Income Approach A theory of
capital structure in which the weighted average
cost of capital and the total value of the firm
remain constant as financial leverage is changed.
- Assume
- Net operating income equals 1,350
- Market value of debt is 1,800 at 10 interest
- Overall capitalization rate is 15
10Required Rate of Return on Equity
Calculating the required rate of return on equity
- Total firm value O / ko 1,350 / 0.15
9,000 - Market value V B 9,000 1,800 of
equity 7,200 - Required return E / S on equity (1,350
180) / 7,200 16.25
Interest payments 1,800 10
B / S 1,800 / 7,200 0.25
11Required Rate of Return on Equity
What is the rate of return on equity if B3,000?
- Total firm value O / ko 1,350 / 0.15
9,000 - Market value V B 9,000 3,000 of
equity 6,000 - Required return E / S on equity (1,350
- 300) / 6,000 17.50
Interest payments 3,000 10
B / S 3,000 / 6,000 0.50
12Required Rate of Return on Equity
Examine a variety of different debt-to-equity
ratios and the resulting required rate of return
on equity.
- B / S ki ke ko
- 0.00 15.00 15
- 0.25 10 16.25 15
- 0.50 10 17.50 15
- 1.00 10 20.00 15
- 2.00 10 25.00 15
Calculated in slides 9 and 10
13Required Rate of Return on Equity
Capital costs and the NOI approach in a graphical
representation.
0.25
ke 16.25 and 17.5 respectively
0.20
ke (Required return on equity)
0.15
ko (Capitalization rate)
Capital Costs ()
0.10
ki (Yield on debt)
0.05
0
0 0.25 0.50 0.75 1.0
1.25 1.50 1.75 2.0 Financial
Leverage (B/S)
14Excel the NOI Approach
- NOI Approach
- You can create this type of analysis in Excel
also. You can use some modeling experience to
write formulas to calculate the required rates. - Refer to VW13E-17.xlsx on the NOI Approach tab
15Summary of NOI Approach
- Critical assumption is ko remains constant.
- An increase in cheaper debt funds is exactly
offset by an increase in the required rate of
return on equity. - As long as ki is constant, ke is a linear
function of the debt-to-equity ratio. - Thus, there is no one optimal capital structure.
16Traditional Approach
Traditional Approach A theory of capital
structure in which there exists an optimal
capital structure and where management can
increase the total value of the firm through the
judicious use of financial leverage.
- Optimal Capital Structure The capital structure
that minimizes the firms cost of capital and
thereby maximizes the value of the firm.
17Optimal Capital Structure Traditional Approach
Traditional Approach
ke
0.25
ko
0.20
0.15
ki
Capital Costs ()
0.10
Optimal Capital Structure
0.05
0
Financial Leverage (B / S)
18Excel and the Traditional Approach
- Traditional Approach
- You can create this type of analysis in Excel
also. We use some assumptions in this model built
into the formulas. - Refer to VW13E-17.xlsx on the Traditional
Approach tab
19Summary of the Traditional Approach
- The cost of capital is dependent on the capital
structure of the firm. - Initially, low-cost debt is not rising and
replaces more expensive equity financing and ko
declines. - Then, increasing financial leverage and
theassociated increase in ke and ki more than
offsetsthe benefits of lower cost debt
financing. - Thus, there is one optimal capital structure
where ko is at its lowest point. - This is also the point where the firms
totalvalue will be the largest (discounting at
ko).
20Total Value Principle Modigliani and Miller
(MM)
- Advocate that the relationship betweenfinancial
leverage and the cost of capital is explained by
the NOI approach. - Provide behavioral justification for a
constantko over the entire range of financial
leverage possibilities. - Total risk for all security holders of the firm
isnot altered by the capital structure. - Therefore, the total value of the firm is
notaltered by the firms financing mix.
21Total Value Principle Modigliani and Miller
Market value of debt (65M) Market
value of equity (35M) Total firm
market value (100M)
Market value of debt (35M) Market
value of equity (65M) Total firm
market value (100M)
- Total market value is not altered by the capital
structure (the total size of the pies are the
same).
- MM assume an absence of taxes and market
imperfections. - Investors can substitute personal for corporate
financial leverage.
22Arbitrage and Total Market Value of the Firm
Two firms that are alike in every respect EXCEPT
capital structure MUST have the same market
value. Otherwise, arbitrage is possible.
- Arbitrage Finding two assets that are
essentially the same and buying the cheaper and
selling the more expensive.
23Arbitrage Example
- Consider two firms that are identical in every
respect EXCEPT - Company NL no financial leverage
- Company L 30,000 of 12 debt
- Market value of debt for Company L equals its par
value - Required return on equity Company NL is
15 Company L is 16 - NOI for each firm is 10,000
24Arbitrage Example Company NL
Valuation of Company NL
- Earnings available to E O I common
shareholders 10,000 - 0 10,000 - Market value E / ke of equity
10,000 / 0 .15 66,667 - Total market value 66,667 0 66,667
- Overall capitalization rate 15
- Debt-to-equity ratio 0
25Arbitrage Example Company L
Valuation of Company L
- Earnings available to E O I common
shareholders 10,000 3,600 6,400 - Market value E / ke of equity
6,400 / 0.16 40,000 - Total market value 40,000 30,000
70,000 - Overall capitalization rate 14.3
- Debt-to-equity ratio 0.75
26Completing an Arbitrage Transaction
- Assume you own 1 of the stock of Company L
(equity value 400). - You should
- 1. Sell the stock in Company L for 400.
- 2. Borrow 300 at 12 interest (equals 1 of debt
for Company L). - 3. Buy 1 of the stock in Company NL for 666.67.
This leaves you with 33.33 for other
investments (400 300 - 666.67).
27Completing an Arbitrage Transaction
Original return on investment in Company L 400
16 64
- Return on investment after the transaction
- 666.67 16 100 return on Company NL
- 300 12 36 interest paid
- 64 net return (100 36) AND 33.33 left over.
- This reduces the required net investment to
366.67 to earn 64.
28Summary of the Arbitrage Transaction
- The investor uses personal rather than
corporate financial leverage.
- The equity share price in Company NL rises based
on increased share demand. - The equity share price in Company L falls based
on selling pressures. - Arbitrage continues until total firm values are
identical for companies NL and L. - Therefore, all capital structures are equally as
acceptable.
29Market Imperfections and Incentive Issues
- Bankruptcy costs (Slide 1730)
- Agency costs (Slide 1731)
- Debt and the incentive to manage efficiently
- Institutional restrictions
- Transaction costs
30Required Rate of Return on Equity with Bankruptcy
ke with bankruptcy costs
Premium for financial risk
ke with no leverage
Required Rate of Return on Equity (ke)
ke without bankruptcy costs
Premium for business risk
Rf
Risk-free rate
Financial Leverage (B / S)
31Agency Costs
Agency Costs -- Costs associated with monitoring
management to ensure that it behaves in ways
consistent with the firms contractual agreements
with creditors and shareholders.
- Monitoring includes bonding of agents, auditing
financial statements, and explicitly restricting
management decisions or actions. - Costs are borne by shareholders (Jensen
Meckling). - Monitoring costs, like bankruptcy costs, tend to
rise at an increasing rate with financial
leverage.
32Example of the Effects of Corporate Taxes
The judicious use of financial leverage (i.e.,
debt) provides a favorable impact on a companys
total valuation.
- Consider two identical firms EXCEPT
- Company ND no debt, 16 required return
- Company D 5,000 of 12 debt
- Corporate tax rate is 40 for each company
- NOI for each firm is 10,000
33Corporate Tax Example Company ND
Valuation of Company ND (Note has no debt)
- Earnings available to E O I common
shareholders 2,000 0 2,000 - Tax Rate (T) 40
- Income available to EACS (1 T) common
shareholders 2,000 (1 0.4) 1,200 - Total income available to EAT I all security
holders 1,200 0 1,200
34Corporate Tax Example Company D
Valuation of Company D (Note has some debt)
- Earnings available to E O I common
shareholders 2,000 600 1,400 - Tax Rate (T) 40
- Income available to EACS (1 T) common
shareholders 1,400 (1 0.4) 840 - Total income available to EAT I all security
holders 840 600 1,440
240 annual tax-shield benefit of debt (i.e.,
1,440 - 1,200)
35Tax-Shield Benefits
Tax Shield A tax-deductible expense. The
expense protects (shields) an equivalent dollar
amount of revenue from being taxed by reducing
taxable income.
Present value of tax-shield benefits of debt
(r) (B) (tc)
(B) (tc)
r
(5,000) (0.4) 2,000
Permanent debt, so treated as a perpetuity
Alternatively, 240 annual tax shield / 0.12
2,000, where 240600 Interest expense 0.40
tax rate.
36Value of the Levered Firm
Value of Value of Present value of
levered firm if tax-shield
benefits firm unlevered of debt
- Value of unlevered firm 1,200 / 0.16 (Company
ND) 7,500 - Value of levered firm 7,500 2,000
(Company D) 9,500
Assuming zero growth and 100 dividend payout
37Summary of Corporate Tax Effects
- The greater the amount of debt, the greater the
tax-shield benefits and the greater the value of
the firm.
- The greater the financial leverage, the lower the
cost of capital of the firm. - The adjusted MM proposition suggests an optimal
strategy is to take on the maximum amount of
financial leverage. - This implies a capital structure of almost 100
debt! Yet, this is not consistent with actual
behavior.
38Other Tax Issues
- Uncertainty of tax-shield benefits
- Uncertainty increases the possibility of
bankruptcy and liquidation, which reduces the
value of the tax shield.
- Corporate plus personal taxes
- Personal taxes reduce the corporate tax advantage
associated with debt. - Only a small portion of the explanation why
corporate debt usage is not near 100.
39Bankruptcy Costs, Agency Costs, and Taxes
Value of levered firm Value of firm if
unlevered Present value of tax-shield
benefits of debt - Present value
of bankruptcy and agency costs
- As financial leverage increases, tax-shield
benefits increase as do bankruptcy and agency
costs.
40Bankruptcy Costs, Agency Costs, and Taxes
Taxes, bankruptcy, and agency costs combined
Minimum Cost of Capital Point
Cost of Capital ()
Net tax effect
Optimal Financial Leverage
Financial Leverage (B/S)
41Financial Signaling
- A manager may use capital structure changes to
convey information about the profitability and
risk of the firm.
- Informational Asymmetry is based on the idea that
insiders (managers) know something about the firm
that outsiders (security holders) do not. - Changing the capital structure to include more
debt conveys that the firms stock price is
undervalued. - This is a valid signal because of the possibility
of bankruptcy.
42Timing and Flexibility
- Timing
- After appropriate capital structure determined it
is still difficult to decide when to issue debt
or equity and in what order - Factors considered include the current and
expected health of the firm and market conditions.
- Flexibility
- A decision today impacts the options open to the
firm for future financing options thereby
reducing flexibility. - Often referred to unused debt capacity.
43Checklist of Practical and Conceptual
Considerations
- Taxes
- Explicit cost
- Cash-flow ability to service debt
- Agency costs and incentive issues
- Financial signaling
- EBIT-EPS analysis
- Capital structure ratios
- Security rating
- Timing
- Flexibility