FINANCIAL MANAGEMENT CHAPTER 12

© 2010 South-Western/Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.

Chapter 12:Capital Structure

Theory and Taxes

Financial Management, 3eMegginson, Smart, and Graham


The term capital structure refers to the mix of debt and equity securities that a firm uses to finance its activities.

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Capital Structure

© 2010 South-Western/Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. 3

Table 12.1 2009 Long-Term Debt-to-Assets Ratios


The fundamental principle of financial leverage: Substituting debt for equity

increases expected returns to shareholders—measured by earnings per share or ROE—but also increases the risk of those returns.

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Financial Leverage


When firms borrow money, we say that they use financial leverage. A firm with debt on its balance sheet is a

levered firm. A firm that finances its operations entirely

with equity is an unlevered firm. In Britain, they refer to debt as gearing. These terms imply that debt magnifies a

firm’s financial performance in some way. That effect can be either positive or

negative, depending on the returns a firm earns on the money it borrows.

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Financial Leverage


Table 12.2 Current & Proposed Capital Structures for High-Tech Mfg. Corp.

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Table 12.3 Expected Cash Flows…Three Equally Likely Outcomes

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Figure 12.1 The Effect of Leverage on theSensitivity of EPS to Changes in Cash Flow

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What Companies Do Globally

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CFO Survey: The Importance of Capital Structure Decisions


The Modigliani & Miller Propositions

Modigliani and Miller (M&M) argument: Capital structure decisions do not affect firm value.Managers who operate in imperfect

markets can see more clearly how market imperfections might lead them to choose one capital structure over another.

M&M’s argument rests on the principle of no arbitrage.

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The M&M Capital Structure ModelFirst model to show that capital structure

decision may be irrelevant Assumes perfect markets, no taxes or

transactions costs

Key insight

Firm value is determined by:

Cash flows generated

Underlying business risk

Capital structure merely determines how cash flows and risks are allocated between bondholders and stockholders.


Assumptions of the M&M Capital Structure Model

Capital markets are perfect – neither firms nor investors pay taxes or transactions costs.

Investors can borrow and lend at the same rate that corporations can.

There are no information asymmetries.

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In perfect markets, a firm’s total market value equals the value of its assets and is independent of the firm’s capital structure.

The value of the assets equals the present value of the cash flows generated by the assets.

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M&M Proposition I


Because the proposition leads to the conclusion that the firm’s capital structure does not matter, it is popularly known as the “irrelevance proposition.”

The firm’s market value equals the present value of the cash flows it generates regardless of the capital structure it chooses.

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M&M Proposition I


M&M Proposition IUse arbitrage arguments to prove Proposition

I.

Firm U has no debt.Firm L has both debt and

equity.Required return (r) for firms of this risk class is 10%.

Firms U and L belong to same risk class and have same expected EBIT $2,000,000 per year in

perpetuity.

Proposition I: Market value of a firm is driven by two factors: cash flow and risk (determines the discount rate).

Under Proposition I, market value of Firms U and L should be identical.


Table 12.4 UnleverCo and LeverCo When Proposition I Holds


Table 12.5 Disequilibrium Values for UnleverCo and LeverCo If LeverCo’s Required Return is 12.5%


Firm U Firm LEarnings before interest (no taxes)

$2,000,000 $2,000,000

Required return on assets 10% 10%Market value of assetsDebt $0 $10,000,000Interest rate on debt 6%Interest expense $600,000Shares outstanding 1,000,000 500,000Price per share $20 $20Market value of equity $20,000,000 $10,000,000

Market value of assets should be

$20,000,000

$20,000,000

%10000,000,2$

$20,000,000

%10000,000,2$

Market value of Firm U = 1,000,000 $20 = $20,000,000Market value of Firm L = 500,000 $20 + $10,000,000 =

$20,000,000

Additional Example: M&M Proposition I


What is the return the shareholders of the two firms expect on their shares?

Firm U has no debt.

Required return on equity equals required return on

assets of 10%

Required return on equity = 10%

Firm L pays $600,000 interest.EBIT is

$2,000,000.

Shareholders receive a cash dividend of $1,400,000, or

$2.80/share. Share price = $20.

Required return on equity = $2.80/$20 = 14%

M&M Proposition I


What if the shares of the levered firm are selling at premium?

Firm LStock price $20Total firm value $20,000,000Debt value $10,000,000Shares outstanding 500,000Dividend per share $2.80Required return on equity 0.14

$25$22,500,000

Assume the stock price of Firm L is $25.Total firm value increases to $22,500,000.The price of $25 per share implies a return of $2.80/$20 = 0.112.0.112

Firm L stockholders can use “homemade leverage” to generate arbitrage profit.

M&M Proposition I


Assume investor owns

5,000 shares of Firm L.

• The investor owns 1% of Firm L.• He earns $2.80 per share in

dividends.• The shares will generate $14,000

each year.The investor could earn an arbitrage profit from the

following:

Borrow an amount equal to 1% of Firm L debt • $100,000 at 6%

interestBuy 1% of Firm U equity • 10,000 shares at $20

per share

Sell 5,000 of Firm L at $25/share • Proceeds of $125,000

M&M Proposition I


TradesProceeds from stock sale $125,000Proceeds from borrowing $100,000Total proceeds $225,000Cost of Firm U shares -$200,000Net proceeds $25,000

The net return on the new

portfolio

• $2 dividend per share of Firm U, or $20,000 for 10,000 shares

• $6,000 interest expense on borrowed money

• $14,000 cash inflow next year on the new portfolio

Using homemade leverage, investor has

built a portfolio of $200,000 of Firm U's

stock and $100,000 in personal debt.

Investor has $25,000 remaining.

The same return expected on the original 1% stake in Firm L's shares!

The cost of building this portfolio is just $200,000, which is $25,000 less than the cost of 5,000 Firm L shares.

M&M Proposition I


Proposition II and the WACCThough debt is less costly for firms

to issue than equity, issuing debt causes the required return on the remaining equity to rise.

Based on the core finance principle that investors expect compensation for risk, shareholders of levered firms demand higher returns than do shareholders in all-equity companies.

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Proposition II and the WACCProposition II says that the expected

return on a levered firm’s equity (rl) rises with the debt-to-equity ratio:

Proposition II rearranged is the WACC:

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Figure 12.2 M&M Proposition II – The Case of Perfect Capital Markets

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The M&M Model with Corporate Taxes

Firms can treat interest payments to lenders as a tax-deductible business expense.

Dividend payments to shareholders receive no similar tax advantage.

Intuitively, this should lead to a tax advantage for debt, meaning that managers can increase firm value by issuing debt.

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Table 12.6 Income Statements for UnleverCo and Leverco with Corporate Income Taxes

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Determining the Values of UnleverCo and LeverCo

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Figure 12.3 Impact of Taxes on Firm Value

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Figure 12.3 Impact of Taxes on Firm Value

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Example: Corporate Tax Rate and Corporate Value

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The M&M Model with Corporate and Personal Taxes

Miller: Debt’s tax advantage over equity at the corporate level might be partially or fully offset by a tax disadvantage at the individual level.

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Example: All-Debt Capital Structure and Personal Taxes

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What Companies Do Globally: Tax Factors in Emerging Markets

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What Companies Do Globally: Net Gain from Leverage in Emerging Markets

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Bond Market Equilibrium with Corporate and Personal Taxes

Wouldn’t taxable investors also demand a higher interest rate to compensate them for taxes due?

Yes, but Miller explains that interest rates do not rise immediately for two reasons: 1. Some investors, such as endowments and

pension funds, do not have to pay taxes on interest income.

2. Investors who do not enjoy this tax-exempt status can buy municipal bonds, which pay interest that is tax free.

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Nondebt Tax Shields (NDTS)

Companies with large amounts of depreciation, investment tax credits, R&D expenditures, and other nondebt tax shields should employ less debt financing than otherwise equivalent companies with fewer such shields.

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Figure 12.4 The Effect of Leverage on Firm Value with and without Taxes


How Taxes Should Affect Capital Structure

1. The higher the corporate income tax rate, Tc, the higher will be the equilibrium leverage level economy-wide. An increase in Tc should cause debt ratios to increase for most firms.

2. The higher the personal tax rate on equity-related investment income (dividends and capital gains), Tps, the higher will be the equilibrium leverage level. An increase in Tps should cause debt ratios to increase.

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How Taxes Should Affect Capital Structure

3. The higher the personal tax rate on interest income, Tpd, the lower will be the equilibrium leverage level. An increase in Tpd should cause debt ratios to fall.

4. The more nondebt tax shields a company has, the lower will be the equilibrium leverage level.

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Education

FINANCIAL MANAGEMENT CHAPTER 12