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Contemporary Financial Management
Chapter 12:Capital Structure Concepts
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Introduction
This chapter examines the basic concepts related to a firm’s optimal capital structure.
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Capital Structure Theory
Studies the relationship between:
Capital structure
• The mix of debt & equity securities on the right hand side of the Balance Sheet
Cost of capital
• The return demanded by investors
• Impacts on the value of the firm
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Capital vs. Financial Structure
Capital Structure Amount of permanent short-term debt, long-
term debt, preferred shares and common equity used to finance the firm.
Financial Structure Amount of current liabilities, long-term debt,
preferred shares and common equity used to finance a firm.
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Capital Structure Terminology
Optimal capital structure Minimizes a firm’s weighted average cost of
capital (WACC) Maximizes the value of the firm
Target capital structure Capital structure the firm plans to maintain
Debt capacity Amount of debt in the firm’s optimal capital
structure
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Capital Structure Assumptions
Firm’s investment policy is held constant
Capital structure changes the distribution of the firm’s EBIT among the firm’s claimants Debt holders Preferred shareholders Common shareholders
Fixed investment policy leaves the debt capacity of the firm unchanged
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Factors Affecting Capital Structure
Business risk of the firm
Tax structure
Bankruptcy potential
Agency costs
Signaling effects
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Factors Affecting Business Risk
Variability of sales volume
Variability of selling price
Variability of input costs
Degree of market power
Extent of product diversification
Firm’s growth rate
Degree of operating leverage (DOL)
Both systematic and unsystematic risk
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Financial Risk
The variability of earnings per share (EPS)
Financial risk affects the probability of bankruptcy
Indicators of financial risk Debt to assets ratio Debt to equity ratio Fixed charge coverage ratio Times interest earned ratio Degree of Financial Leverage Probability distribution of profits EBIT-EPS analysis
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Three Capital Structure Models
Capital Structure With No Taxes
Optimal Capital Structure With Taxes
Optimal Capital Structure WithTaxes, Financial Distress Costs & Agency Costs
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Capital Structure is Irrelevant
Modigliani & Miller (MM) were the pioneers in developing the theory of capital structure
MM began by assuming perfect capital markets, including: No taxes No bankruptcy (B) costs No agency (A) costs
MM also recognized that debt will always cost less than equity because: Interest is tax deductible Debt securities are less risky than equity
securities
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MM’s Two Propositions
Proposition #1: The market value of the firm is independent of
capital structure. Therefore, capital structure is irrelevant.
Proposition #2: The cost of capital remains constant as capital
structure changes. As the quantity of debt rises, the return demanded by the shareholder increases linearly, exactly offsetting the benefit due to the lower cost of debt.
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Cost
of
Capit
al (%
)
kd
ka
ke
Modigliani & Miller on Capital Structure
If leverage increases, the cost of equity, ke, increases to exactly offset the benefits of more debt, leaving the cost of capital, ka, constant.
Financial Leverage (Debt-to-equity ratio)
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MM Arbitrage Proof
Market value of the firm: Market value of equity + Market value of debt
Value of firm with no debt:
Value of firm with debt:
e
DividendsV =
k
e d
Dividends InterestV = +
k k
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Example: Value of an Unlevered Firm
A firm with no debt pays out $1 Million in dividends. If shareholders require a 20% return, what is the market value of the firm?
e
DividendsV
k
$1,000,0000.20
$5,000,000
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Example: Value of a Levered Firm
The same firm now acquires debt at 10%, on which it pays interest of $250,000. Since this is world with no taxes, the firm has $750,000 which it pays in dividends. Since the firm is now more risky, shareholders require a 30% return. What is the market value of the firm?
e d
Dividends InterestV
k k
$750,000 $250,0000.30 0.10
$2,500,000 2,500,000 $5,000,000
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Why?
Dividends paid to shareholders of the levered firm are reduced by the amount of interest paid on the debt.
ke is higher for the levered firm because of the additional leverage-induced risk.
The values of the levered and the unlevered firm are identical due to arbitrage.
Thus MM’s Proposition #1: the value of the firm is independent of capital structure (in a world with no taxes)
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What Happens with Taxes ?
The firm’s operating income is now reduced by the amount of taxes paid
Since dividends to shareholders are paid out of after-tax income, the value of the unlevered firm should drop
But interest is a tax-deductible expense, creating a valuable tax-shield
The result - the value of the levered firm should be higher than the value of the unlevered firm
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The Tax Shield due to Interest
A tax shield is the amount of tax the firm would have paid, had it not incurred the interest expense.
The annual tax shield is equal to:
The PV of the tax shield is equal to:
Annual Tax Shield = i×D×T
Tax Shield
i×D×TPV = = D×T
i
I = interest rate D = Face value of debt T = Tax rate
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Example: The Impact of Tax
Firm U Firm L
EBIT $1,000 $1,000
Less Interest 0 100
Income before Tax 1,000 900
Less Tax @ 40% 400 360
Income (for Dividends) 600 540
Interest + Dividends 600 640
Return on debt - 5%
Market value of debt - 2,000
Return on equity 10% 11.25%
Market value of equity $6,000 $4,800
Market value of firm $6,000 $6,800
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Market Value of the Unlevered Firm
UnleveredFirm e
DividendsV =
k
600=
0.10
= $6,000
Market value of the firm: Market value of equity + Market value of debt
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Market Value of the Levered Firm
LeveredFirm e d
Dividends InterestV = +
k k
540 100= +
0.1125 0.05
= $6,800
Market value of the firm: Market value of equity + Market value of debt
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Why the Difference?
The difference in value between the levered and the unlevered firm in a world including taxes is due to the value of the tax shield
Therefore: Market value (MV) of levered firm = MV of unlevered firm + PV of the tax shield
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VL = VU + Present Value of Tax Shield
MktValue
of Firm
Debt $
VU
VL
PV ofTax Shield
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Capital Structure
ki = kd (1 – T)
ka
ke
Cost
of
Capit
al (%
)
The cost of capital decreases with the amount of debt. The firm maximizes its value by choosing a capital structure that is all debt.
Financial Leverage (Debt-to-equity)
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The Problem?
If the value of the firm increases linearly with debt, the logical conclusion would be that all firms should be financed with 100% debt!
This conclusion defies logic and is counter to customary practice
What are we missing?
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Financial Distress (Bankruptcy) Costs
Financial distress costs include:
Costs incurred to avoid bankruptcy• Pay higher interest rates due to greater risk
Direct & indirect costs incurred if the firm files for bankruptcy• Direct costs – costs paid by debtors in the
bankruptcy & restructuring process• Indirect costs – costs due to loss of customers,
suppliers, employees plus the cost of management’s time
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Bankruptcy 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 and legal costs
If forced to liquidate, assets may have to be sold for less than market value
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Agency Costs
The firm’s debt & equity holders (the principals) are usually not the firm’s managers
The principals employ agents (firm management) to manage the firm on their behalf
Conflicts often develop between the interests of the principals and the interests of the agents
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Agency Costs & Shareholders
Shareholders have an incentive to undertake risky projects financed with debt If the project succeeds, the shareholders win If the project fails, the bondholders suffer the
loss
Therefore, bondholders will Charge higher interest rates, or Implement protective covenants to protect
themselves
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Agency Costs & Shareholders
Investing in high risk/high return projects can shift wealth from bondholders to shareholders
Shareholders may forgo some profitable investments in debt is required
Shareholders may issue high quantities of new debt, diminishing the protection afforded to earlier bondholders
Bondholders will shift monitoring and bonding costs back to the shareholders by charging higher interest rates & imposing covenants
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Taxes, Bankruptcy and Agency Costs
Bankrupcty and agency costs increase with the amount of leverage
At some point, these offset the positive benefits from the value of the tax shield
Market value of unlevered firm+ PV of tax shield– PV of bankruptcy costs– PV of agency costs Market value of leverage firm
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Optimal Debt Ratio
DebtRatio
VU
PVof Tax
Shield
Mkt value of le
veraged firm PVB&ACosts
VL
Optimal Debt Ratio
Market Value of the Firm
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Least Cost Capital Structure
Cost of Capital
DD + E
ki
ke
ka
Optimal CapitalStructure
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Other Considerations
Personal tax costs (interest is fully taxable) Could offset some corporate tax advantages No optimal capital structure when both corporate &
personal taxes are considered
Industry effects Firms with stable cash flows tend to have higher
debt ratios More profitable firms tend to have lower debt ratios Market appears to reward firms with capital
structures appropriate to their industry
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Other Considerations
Signaling effects (Asymmetric Information) Firm management have access to confidential
information Management decisions may be a signal to the
market
Managerial preferences (Pecking order theory) Firms prefer internal to external financing
• New issues incur flotation costs• External financing incurs more monitoring by the
market
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Pecking Order Theory
Firms have a definite preference in the order in which they finance new projects
InternalEquity
DebtExternalEquity
MostPreferred
LeastPreferred
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Major Points
Choosing an appropriate capital structure is an important management decision
In a world with no taxes, the value of the unlevered firm equals the value of the levered firm
In a world with taxes, interest creates a valuable tax shield.
The value of the levered firm equals the value of
the unlevered plus the PV of the tax shield
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Major Points
Financial distress & agency costs increase as debt rises, eventually offsetting the marginal value of the interest tax shield
Optimal capital structures appear to be influenced by Variability of cash flows Nature of the industry