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17-1
Chapter 17Chapter 17
Capital Structure Capital Structure DeterminationDetermination
Capital Structure Capital Structure DeterminationDetermination
© 2001 Prentice-Hall, Inc.Fundamentals of Financial Management, 11/e
Created by: Gregory A. Kuhlemeyer, Ph.D.Carroll College, Waukesha, WI
17-2
Capital Structure Capital Structure DeterminationDetermination
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
17-3
Capital StructureCapital Structure
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.
Capital Structure Capital Structure -- The mix (or proportion) of -- The mix (or proportion) of a firm’s permanent long-term financing a firm’s permanent long-term financing
represented by debt, preferred stock, and represented by debt, preferred stock, and common stock equity.common stock equity.
17-4
A Conceptual Look --A Conceptual Look --Relevant Rates of ReturnRelevant Rates of Return
kkii = the yield on the company’s debt = the yield on the company’s debt
Annual interest on debt
Market value of debt
I
B==kkii
Assumptions:• Interest paid 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.)
17-5
E
S
A Conceptual Look --A Conceptual Look --Relevant Rates of ReturnRelevant Rates of Return
==
kkee = the expected return on the company’s equity = the expected return on the company’s equityEarnings available to Earnings available to common shareholderscommon shareholders
Market value of common Market value of common stock outstandingstock outstanding
kkee
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 capital structure
E
S
17-6
O
V
A Conceptual Look --A Conceptual Look --Relevant Rates of ReturnRelevant Rates of Return
==
kkoo = an overall capitalization rate for the firm = an overall capitalization rate for the firm
Net operating incomeTotal market value of the firmkkoo
Assumptions:
• V = B + S = total market value of the firm• O = I + E = net operating income = interest
paid plus earnings available to common shareholders
O
V
17-7
Capitalization RateCapitalization Rate
Capitalization Rate, kCapitalization Rate, koo -- The discount rate used to determine the present value of a
stream of expected cash flows.
kkoo kkeekkii
BB + S
SB + S
= +
What happens to kkii, kkee, and kkoo when leverage, B/S, increases?
17-8
Net Operating Net Operating Income ApproachIncome Approach
Assume:
Net operating income equals $1,350
Market value of debt is $1,800 at 10% interest
Overall capitalization rate is 15%
Net Operating Income Approach Net Operating Income Approach -- A theory of -- A theory of capital structure in which the weighted average capital structure in which the weighted average
cost of capital and the total value of the firm cost of capital and the total value of the firm remain constant as financial leverage is changed.remain constant as financial leverage is changed.
17-9
Required Rate of Required Rate of Return on EquityReturn on Equity
Total firm valueTotal firm value = O / ko = $1,350$1,350 / .15= $9,000$9,000
Market value = V - B = $9,000$9,000 - $1,800$1,800 of equity = $7,200$7,200
Required returnRequired return = E / S on on equityequity* = ($1,350$1,350 - $180$180) / $7,200$7,200
= 16.25%16.25%
Calculating the required rate of return on equityCalculating the required rate of return on equity
* B / S = $1,800 / $7,200 = .25
Interest paymentsInterest payments = $1,800 x 10%= $1,800 x 10%
17-10
Total firm valueTotal firm value = O / ko = $1,350$1,350 / .15= $9,000$9,000
Market value = V - B = $9,000$9,000 - $3,000$3,000 of equity = $6,000$6,000
Required returnRequired return = E / S on on equityequity* = ($1,350$1,350 - $300$300) / $6,000$6,000
= 17.50%17.50%
Required Rate of Required Rate of Return on EquityReturn on Equity
What is the rate of return on equity if B=$3,000?What is the rate of return on equity if B=$3,000?
* B / S = $3,000 / $6,000 = .50
Interest paymentsInterest payments = $3,000 x 10%= $3,000 x 10%
17-11
B / S kkii kkee k ko o
0.00 ------ 15.00%15.00% 15% 15% 0.25 10%10% 16.25%16.25% 15% 15% 0.50 10%10% 17.50%17.50% 15% 15% 1.00 10%10% 20.00%20.00% 15% 15% 2.00 10%10% 25.00%25.00% 15% 15%
Required Rate of Required Rate of Return on EquityReturn on Equity
Examine a variety of different debt-to-equity Examine a variety of different debt-to-equity ratios and the resulting required rate of ratios and the resulting required rate of
return on equity.return on equity.
Calculated in slides 9 and 10
17-12
Required Rate of Required Rate of Return on EquityReturn on Equity
Capital costs and the NOI approach in a Capital costs and the NOI approach in a graphical representation.graphical representation.
0 .25 .50 .75 1.0 1.25 1.50 1.75 2.0Financial Leverage (B / S)
.25
.20
.15.15
.10.10
.05
0
Cap
ital
Co
sts
(%)
kkee = 16.25% and = 16.25% and
17.5% respectively17.5% respectively
kkii (Yield on debt) (Yield on debt)
kko o (Capitalization rate)(Capitalization rate)
kke e (Required return on equity)(Required return on equity)
17-13
Summary of NOI ApproachSummary 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 no one optimal capital structurestructure.
17-14
Traditional ApproachTraditional Approach
Optimal Capital Structure Optimal Capital Structure -- The capital structure that minimizes the firm’s cost of capital and thereby maximizes the value of the firm.
Traditional Approach Traditional Approach -- A theory of capital structure in which there exists an optimal capital optimal capital structure structure and where management can increase the total value of the firm through the judicious
use of financial leverage.
17-15
Optimal Capital Structure: Optimal Capital Structure: Traditional ApproachTraditional Approach
Traditional ApproachTraditional Approach
Financial Leverage (B / S)
.25
.20
.15.15
.10.10
.05
0
Cap
ital
Co
sts
(%)
kkii
kkoo
kkee
Optimal Capital StructureOptimal Capital Structure
17-16
Summary of the Summary of the Traditional ApproachTraditional 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 the
associated increase in ke more than offsets the benefits of lower cost debt financing.
Thus, there is one optimal capital structureone optimal capital structure where ko is at its lowest point.
This is also the point where the firm’s total value will be the largest (discounting at ko).
17-17
Total Value Principle: Total Value Principle: Modigliani and Miller (M&M)Modigliani and Miller (M&M)
Advocate that the relationship between financial leverage and the cost of capital is explained by the NOI approach.
Provide behavioral justification for a constant ko over the entire range of financial leverage possibilities.
Total risk for all security holders of the firm is not altered by the capital structure.
Therefore, the total value of the firm is not altered by the firm’s financing mix.
17-18
Market value of debt ($65M)
Market value of equity ($35M)
Total firm marketvalue ($100M)
Total Value Principle: Total Value Principle: Modigliani and MillerModigliani and Miller
M&M assume an absence of taxes and market imperfections.
Investors can substitute personal for corporate financial leverage.
Market value of debt ($35M)
Market value of equity ($65M)
Total firm marketvalue ($100M)
Total market value is not altered by the capital structure (the total size of the pies are the same).
17-19
Arbitrage and Total Arbitrage and Total Market Value of the FirmMarket Value of the Firm
Arbitrage Arbitrage -- Finding two assets that are -- Finding two assets that are essentially the same and buying the essentially the same and buying the
cheaper and selling the more expensive.cheaper and selling the more expensive.
Two firms that are alike in every respect EXCEPTEXCEPT capital structure MUSTMUST have
the same market value.
Otherwise, arbitragearbitrage is possible.
17-20
Arbitrage ExampleArbitrage Example
Consider two firms that are identical in every respect EXCEPTEXCEPT:
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
17-21
Earnings available to Earnings available to = EE = O – I common shareholderscommon shareholders = $10,000$10,000 - $0
= $10,000$10,000
Market valueMarket value = E / ke of of
equityequity = $10,000$10,000 / .15 = $66,667$66,667
Total market valueTotal market value = $66,667$66,667 + $0= $66,667$66,667
Overall capitalization rateOverall capitalization rate = 15%15%Debt-to-equity ratio = 0
Arbitrage Example: Arbitrage Example: Company NLCompany NL
Valuation of Company NLValuation of Company NL
17-22
Arbitrage Example: Arbitrage Example: Company LCompany L
Earnings available to Earnings available to = EE = O – I common shareholderscommon shareholders = $10,000$10,000 - $3,600
= $6,400$6,400
Market valueMarket value = E / ke of of
equityequity = $6,400$6,400 / .16 = $40,000$40,000
Total market valueTotal market value = $40,000$40,000 + $30,000= $70,000$70,000
Overall capitalization rateOverall capitalization rate = 14.3%14.3%Debt-to-equity ratio = .75
Valuation of Company LValuation of Company L
17-23
Completing an Completing an Arbitrage TransactionArbitrage 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).
17-24
Completing an Completing an Arbitrage TransactionArbitrage Transaction
Original return on investment in Company LOriginal return on investment in Company L
$400 x 16% = $64
Return on investment after the transaction $666.67 x 15% = $100 return on Company NL$100 return on Company NL $300 x 12% = $36 interest paid$36 interest paid $64 net return $64 net return ($100$100 - $36$36) AND $33.33 left over$33.33 left over.
This reduces the required net investment to $366.67 to earn $64.
17-25
Summary of the Summary of the Arbitrage TransactionArbitrage Transaction
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 Therefore, all capital structures are equally as acceptable.acceptable.
The investor uses “personal” rather than corporate financial leverage.
17-26
Market Imperfections Market Imperfections and Incentive Issuesand Incentive Issues
Agency costs (Slide 28)
Debt and the incentive to manage efficiently
Institutional restrictions
Transaction costs
Bankruptcy costs (Slide 27)
17-27
Required Rate of Return Required Rate of Return on Equity with Bankruptcyon Equity with Bankruptcy
Financial Leverage (B / S)
RRffReq
uir
ed R
ate
of
Ret
urn
on
Eq
uit
y (k
e) kke e with no leveragewith no leverage
kkee without bankruptcy costs without bankruptcy costs
kkee with bankruptcy costs with bankruptcy costs
PremiumPremiumfor financialfor financial
riskrisk
PremiumPremiumfor businessfor business
riskrisk
Risk-freeRisk-freeraterate
17-28
Agency CostsAgency Costs
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.
Agency Costs Agency Costs -- Costs associated with monitoring -- Costs associated with monitoring management to ensure that it behaves in ways management to ensure that it behaves in ways
consistent with the firm’s contractual agreements consistent with the firm’s contractual agreements with creditors and shareholders.with creditors and shareholders.
17-29
Example of the Effects Example of the Effects of Corporate Taxesof Corporate Taxes
Consider two identical firms EXCEPTEXCEPT:
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 $2,000
The judicious use of financial leverage financial leverage (i.e., debt) (i.e., debt) provides a favorable impact
on a company’s total valuation.
17-30
Earnings available to Earnings available to = EE = OO - Icommon shareholderscommon shareholders = $2,000$2,000 - $0
= $2,000$2,000
Tax Rate Tax Rate (TT) = 40%40%
Income available toIncome available to = EACSEACS (1 - TT)common shareholderscommon shareholders = $2,000$2,000 (1 - .4.4)
= $1,200$1,200
Total income available toTotal income available to = EATEAT + I all all security holderssecurity holders = $1,200$1,200 + 0
= $1,200$1,200
Corporate Tax Example: Corporate Tax Example: Company NDCompany ND
Valuation of Company NDValuation of Company ND (Note: has no debt)
17-31
Earnings available to Earnings available to = EE = OO - Icommon shareholderscommon shareholders = $2,000$2,000 - $600
= $1,400$1,400
Tax Rate Tax Rate (TT) = 40%40%
Income available toIncome available to = EACSEACS (1 - TT)common shareholderscommon shareholders = $1,400$1,400 (1 - .4.4)
= $840$840
Total income available toTotal income available to = EATEAT + I all all security holderssecurity holders = $840$840 + $600
= $1,440$1,440*
Corporate Tax Example: Corporate Tax Example: Company DCompany D
Valuation of Company DValuation of Company D (Note: has some debt)
* $240 annual tax-shield benefit of debt (i.e., $1,440 - $1,200)
17-32
Tax-Shield BenefitsTax-Shield Benefits
Tax Shield Tax Shield -- A tax-deductible expense. The -- A tax-deductible expense. The expense protects (shields) an equivalent dollar expense protects (shields) an equivalent dollar
amount of revenue from being taxed by reducing amount of revenue from being taxed by reducing taxable income.taxable income.
Present value ofPresent value oftax-shield benefitstax-shield benefits
of debtof debt*= (rr) (BB) (ttcc)
rr= (BB) (ttcc)
* Permanent debt, so treated as a perpetuity** Alternatively, $240 annual tax shield / .12 = $2,000, where
$240=$600 Interest expense x .40 tax rate.
= ($5,000$5,000) (.4.4) = $2,000$2,000**
17-33
Value of the Levered FirmValue of the Levered Firm
Value of unlevered firm Value of unlevered firm = $1,200 / .16(Company ND)(Company ND) = $7,500$7,500*
Value of levered firm Value of levered firm = $7,500$7,500 + $2,000$2,000 (Company D)(Company D) = $9,500$9,500
Value ofValue of Value ofValue of Present value Present value ofof
leveredlevered = firm iffirm if + tax-shield tax-shield benefitsbenefits
firmfirm unleveredunlevered of debtof debt
* Assuming zero growth and 100% dividend payout
17-34
Summary of Summary of Corporate Tax EffectsCorporate Tax Effects
The greater the financial leverage, the lower the cost of capital of the firm.
The adjusted M&M proposition suggests an optimal strategy is to take on the maximum take on the maximum amount of financial leverageamount of financial leverage.
This implies a capital structure of almost 100% This implies a capital structure of almost 100% debt! debt! Yet, this is notnot consistent with actual behavior.
The greater the amount of debt, the greater the tax-shield benefits and the greater the value of the firm.
17-35
Other Tax IssuesOther Tax Issues
Corporate plus personal taxesCorporate 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%.
Uncertainty of tax-shield benefitsUncertainty of tax-shield benefits
Uncertainty increases the possibility of bankruptcy and liquidation, which reduces the value of the tax shield.
17-36
Bankruptcy Costs, Bankruptcy Costs, Agency Costs, and TaxesAgency Costs, and Taxes
As financial leverage increases, tax-shield tax-shield benefits benefits increase as do bankruptcy and bankruptcy and agency costsagency costs.
Value of levered firmValue of levered firm= Value ofValue of firm iffirm if unlevered unlevered + Present value of tax-shield benefits Present value of tax-shield benefits of debt of debt - Present value ofPresent value of bankruptcy and bankruptcy and agency costs agency costs
17-37
Bankruptcy Costs, Bankruptcy Costs, Agency Costs, and TaxesAgency Costs, and Taxes
Optimal Financial LeverageOptimal Financial Leverage
Taxes, bankruptcy, andTaxes, bankruptcy, andagency costs combinedagency costs combined
Net tax effectNet tax effect
Financial Leverage (B/S)
Co
st o
f C
apit
al (
%)
Minimum Costof Capital Point
17-38
Financial SignalingFinancial Signaling
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 firm’s stock price is conveys that the firm’s stock price is undervaluedundervalued.
This is a valid signal valid signal because of the possibility of bankruptcy.
A manager may use capital structure changes to convey information about the profitability and risk of the firm.