Upload
nguyentruc
View
214
Download
2
Embed Size (px)
Citation preview
Capital Structure
Chapter 15 & 16
Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin
Capital Structure and the Pie
The value of a firm is defined to be the sum of the
value of the firm’s debt and the firm’s equity.
V = D + E
• If the goal of the firm’s
management is to make the
firm as valuable as possible,
then the firm should pick the
debt-equity ratio that makes
the pie as big as possible.
Value of the Firm
D E
Capital Structure
Capital structure refers to the mix of long term debt and
equity maintained by the firm.
Leverage - The use of debt in the company leverage results
from the use of fixed cost to magnify returns to the firm’s
owners
� increased leverage raises risk/return
� decreased leverage lowers risk/return
Management can control leverage in the capital structure, and
in turn affect firm value
Stockholder Interests
Is there a ratio of debt-to-equity that maximizes the shareholder’s value?
As it turns out, changes in capital structure benefit the stockholders if and only if the value of the firm increases.
Managers should choose the capital structure that they believe will have the highest firm value, because the capital structure will be most beneficial to firm’s stockholders.
What is leverage ?
Business Risk
arises as a result of
Operating Leverage
Financial Risk
arises as a result of
Financial Leverage
Analytical income statement
Operating
Leverage
Financial Total
Leverage Leverage
Sales- Cost of sales
Gross ProfitOperating ExpEBIT (Operating income)
- InterestNPBT
- TaxNPAT
- Preference Dividend- Earnings available for OS
- EPS
Business risk Financial risk
The variability or
uncertainty of a firm’s
operating income (EBIT)
Affected by:• Sales volume variability• Competition• Cost variability• Product diversification• Product demand• Operating leverage
The variability of a
firm’s earnings per
share and the
increased probability
of insolvency
when a firm uses
financial leverage.
Operating leverage
The responsiveness of the firm’s earnings before interest and taxes to changes in salesRevenue.
A firm with relatively high fixed operating costs will
experience more variation in operating income if
sales change
The use of fixed operating costs as opposed to
variable operating costs
Financial leverage
The use of fixed-cost sources of finance rather
than variable-cost sources to finance a portion of
the firm’s assets.
Fixed-cost sources
• Debt
• Preference shares
Variable-cost sources
• Ordinary shares
EBIT-EPS
Example: Our firm has
• 800,000 ordinary shares on issue,
• no debt,
• and a tax rate of 30%.
We need
$8,000,000 to finance a new project and are
considering 2 options:
1. Sell 200,000 new ordinary shares at $40 per share
2. Borrow $8,000,000 by issuing 10% bonds
Which is the best option?
EBIT-EPS
Assume EBIT to be $2,000,000
EBIT – Interest= EBT– Tax (30%)= Net incomeNo shares issuedEPS
Shares2,000,000
02,000,000
600,0001,400,0001,000,000
$1.40
Debt2,000,000
800,0001,200,000
360,000840,000800,000
$1. 05
EBIT-EPS
Assume EBIT to be $4,000,000
EBIT – Interest= EBT– Tax (30%)= Net incomeNo shares issuedEPS
Shares4,000,000
04,000,0001,200,0002,800,0001,000,000
$2.80
Debt4,000,000
800,0003,200,000
960,0002,240,000
800,000$2.80
EBIT-EPS
Assume EBIT to be $5,000,000
EBIT – Interest= EBT– Tax (30%)= Net incomeNo shares issuedEPS
Shares5,000,000
05,000,0001,500,0003,500,0001,000,000
$3.50
Debt5,000,000
800,0004,200,0001,260,0002,940,000
800,000$3.68
EBIT-EPS
EBIT$2,000,000
Ordinaryshare
financing
EBIT$4,000,000
Debtfinancing
EBIT$5,000,000
???
Conclusion so far
Higher level of debt increases EPS at higher
level of Earnings.
Debt is beneficial for stockholders
But debt is risky in a recession.
Which Capital structure is better ?
Break-even EBIT
EBIT
EPS
$2m $5m$3m $4m0
1
2
3
Sharefinancing
DebtfinancingFor EBIT up to
$4 million, share financing is best
For EBIT above $4 million, debt financing is best
MM Proposition 1 (no tax)
According to M & M, in a perfect market, no combination of capital structure will affect the firm’s value.
The value of a levered firm is the same as the value of an unlevered firm.
MM Proposition I (No Taxes)
…suggests that capital structure is irrelevant in determining the value of the firm:
Value of levered firm is the same as value of unlevered firm.
VL = VU
Total Cash Flow to Investors
The levered firm pays less in taxes than does the all-equity firm.
Thus, the sum of the debt plus the equity of the levered firm is
greater than the equity of the unlevered firm.
This is how cutting the pie differently can make the pie “larger.”
-the government takes a smaller slice of the pie!
E G D G
D
All-equity firm Levered firm
With Taxes….
In a world of taxes, the value of the firm increases
with leverage.
VL = VU + TC B
Modigliani and Miller (MM) showed that the value of an unlevered firm (one with no debt) was the same as a levered firm (Text: Extreme Position 1). That is
VL = VU
but that when tax was introduced, it had the effect of increasing the value of the firm by the tax saving (in perpetuity). That is
VL = VU + TCD
where TCD is the corporate tax rate debt
Who saves more Tax?
Unlevered
(No Debt)
Levered
(Debt)
Revenue 100 100
COGS 60 60
Gross Profit 40 40
Interest - 10
Net Profit 40 30
Less Tax (30%)
12 9
Profit AT 28 21
Total Cash Flow to Investors
The levered firm pays less in taxes than does the all-equity firm.
Thus, the sum of the debt plus the equity of the levered firm is
greater than the equity of the unlevered firm.
This is how cutting the pie differently can make the pie “larger.”
-the government takes a smaller slice of the pie!
S G S G
B
All-equity firm Levered firm
DEF is currently an unlevered firm. The company expects to generate $153.85 in earnings before interest and tax (EBIT) in perpetuity. The corporate tax rate is 35%. All earnings are paid out as dividends.
Unlevered
NoDebt($)
Value of equity 500.00
Value of debt 0.00
Value of firm 500.00
EBIT 153.85
Interest (10%) 0.00
Taxable income 153.85
Tax (35%) -53.85
Net income 100.00
KE 0.2000
Workings
Value of Company without Debt
value of debt = 0
value of the firm = value of equity + Debt (0)
= $ 500 + $ 0
= $ 500
500$0.20
$100
K
incomeNet V
UE,
E ===
The firm is considering a capital restructure to allow $200 of debt. Its cost of debt capital is 10%. Unlevered firms in the same industry have a cost of equity capital of 20%. What will the new value of the firm?
Levered FirmVL = Debt + equity = $ 500 + 0.35 ( 200) = $ 570
Value of equity = Value of firm – Value of Debt= $ 570 - $ 200 = $ 370
The EBIT of the levered firm is the same as that of the unlevered firm as the operations of the firm have not changed. However, the firm now has to pay $20 in interest payments [$200(0.10)] which reduces the taxable income, the tax payable and the amount available to shareholders. But the implication here is that the debt has been used to retire equity (the operating cash flow has not changed, only how the assets are financed) there are fewer shares over which to distribute the income.
Unlevered
($)
Levered
($)
Value of equity 500.00 370.00
Value of debt 0.00 200.00
Value of firm 500.00 570.00
EBIT 153.85 153.85
Interest (10%) 0.00 -20.00
Taxable income 153.85 133.85
Tax (35%) -53.85 -46.85
Net income 100.00 87.00
KE 0.2000 0.2351
%51.23370$
$87
equity of value
incomeNet K LE, ===
Example
1. Alpha is an unlevered firm in which shareholders require a return of 15% after-tax. Alpha is valued at $100,000 and corporate taxes are 40%.
1. What are the perpetual earnings before interest and taxes in Alpha?
2. What is the value of Alpha if it issues $80,000 in perpetual debt at 10% interest?
3. What return will shareholders require in Alpha after it becomes levered?
4. What is the weighted average cost of capital in Alpha if it is unlevered?
5. What is the weighted average cost of capital in Alpha after it issues the debt?
Unlevered Levered
MV Equity
MV Debt
MV Firm
EBIT
Interest at 10%
EBT
Tax at 40%
NOI
RE
( )
( )
%98.10
000,510$
000,100$30.0108.0
000,510$
000,410$1229.0
V
Dtc1R
V
ERWACC DE
=
−+=
−+=
Question
Beta Ltd is an unlevered firm whose net cash flows are constant in perpetuity.
What is the after tax return Beta's shareholders require if Beta is valued at $480 ,000 with annual net cash flows before tax of $80,000, when the corporate tax rate is 30%?
Beta has decided to issue $100,000 in perpetual debt at 10% interest. What will be the debt adjusted value of Beta after it issues the new debt?
What return will shareholders require in Beta after it becomes levered?
What is Beta's weighted average cost of capital before the issue of debt?
What is Beta's weighted average cost of capital following the issue of debt?
where: KE,L = cost of equity for levered firm
KE,U = cost of equity for unlevered firm
KD = cost of debt
T = Tax rate
)K(KEquity
DebtKK DUE,UE,LE, −+=
T)-)(1K(KEquity
DebtKK DUE,UE,LE, −+=
Before Tax
After Tax
Alpha and Omega are identical firms in every way except Alpha has debt in its capital structure. Both firms have earnings before interest and tax (EBIT) of $450,000 and a tax rate of 30%.
i. The market value of Alpha’s debt is $300,000 issued at a cost of 12%. The required rate of return on its equity is 18%. What is the market value of its equity?
ii. What is the market value of Alpha?
iii. As Omega has no debt in its capital structure (unlevered), what is the market value of Omega?
iv. What is the required rate of return on Omega’s equity?