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Copyright 1996 by The McGraw-Hill Companies, Inc

Capital StructureCapital Structure

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MODIGLIANI AND MILLERMODIGLIANI AND MILLER

ANY COMBINATION OF SECURITIES IS AS GOOD AS ANY OTHER

EXAMPLE: TWO FIRMS, SAME OPERATING INCOME– DIFFER ONLY IN CAPITAL

STRUCTURE

– FIRM U UNLEVERED, VU = EU

– FIRM L IS LEVERED, EL = VL - DL

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Copyright 1996 by The McGraw-Hill Companies, Inc

MODIGLIANI AND MILLERMODIGLIANI AND MILLERTWO STRATEGIESSTRATEGY 1

– BUY 1% OF FIRM U’s EQUITY– DOLLAR INVESTMENT .01 VU

– DOLLAR RETURN .01 PROFITSSTRATEGY 2

– BUY 1% OF FIRM L’s EQUITY AND DEBT– DOLLAR INVESTMENT .01DL + .01EL = .01VL

– DOLLAR RETURN FROM OWNING 01DL .01 INTEREST

FROM OWNING .01EL .01 (PROFITS - INTEREST)TOTAL .01 PROFITS

BOTH STRATEGIES HAVE SAME PAYOFF

– SAME PRICE, VU = VL

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Copyright 1996 by The McGraw-Hill Companies, Inc

MODIGLIANI AND MILLERMODIGLIANI AND MILLER

STRATEGY 3– BUY 1% OF FIRM L’s EQUITY– DOLLAR INVESTMENT .01 EL = .01(VL - DL)– DOLLAR RETURN .01 (PROFITS - INTEREST)

STRATEGY 4– BUY 1% OF FIRM U’s EQUITY– BORROW ON YOUR OWN ACCOUNT .01DL

– DOLLAR INVESTMENT .01(VU - DL)– DOLLAR RETURN

FROM BORROWING 01DL -.01 INTEREST FROM OWNING .01EL .01 (PROFITS

TOTAL .01 (PROFITS-INTEREST)BOTH STRATEGIES AGAIN PROMISE SAME PAYOFFMUST HAVE SAME COST

.01(VL - DL) = .01(VU - DL) AND VU = VL

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Copyright 1996 by The McGraw-Hill Companies, Inc

MODIGLIANI AND MILLERMODIGLIANI AND MILLER

DOESN’T MATTER WHAT RISK PREFERENCES ARE OF INVESTORS

ONLY CONDITION IS THAT INVESTORS CAN BORROW OR LEND FOR THEIR OWN ACCOUNT

– UNDO EFFECT OF ANY CHANGES IN FIRM’S CAPITAL STRUCTURE

MM PROPOSITION 1

– VALUE OF FIRM INDEPENDENT OF ITS CAPITAL STRUCTURE

– CAN ALSO BE PROVED USING CAPM (APPENDIX)

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VALUE ADDITIVITYVALUE ADDITIVITY

WE CAN SLICE A CASH FLOW INTO AS MANY PARTS AS WE LIKE– SUM OF THE PRESENT VALUE OF THE PARTS

ALWAYS EQUAL TO PRESENT VALUE OF THE ORIGINAL STREAM

– LAW OF CONSERVATION OF VALUEFIRM VALUE IS DETERMINED BY LEFT HAND SIDE OF

BALANCE SHEET BY REAL ASSETS– REGARDLESS OF CLAIMS AGAINST IT

SHOULD FIRM ISSUE PREFERRED OR COMMON STOCK?– PROPOSITION 1 SAYS CHOICE IS IRRELEVANT– IF IT DOESN’T AFFECT INVESTMENT, BORROWING

AND OPERATING POLICIES

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Copyright 1996 by The McGraw-Hill Companies, Inc

HOW LEVERAGE AFFECTS RETURNSHOW LEVERAGE AFFECTS RETURNS

EXPECTED RETURN ON THE ASSETS OF A FIRM

rA = EXPECTED OPERATING INCOME MARKET VALUE OF ALL SECURITIES

SUPPOSE INVESTOR HOLDS ALL DEBT AND EQUITY OF THE COMPANY

EXPECTED RETURN ON PORTFOLIO, rA , IS WEIGHTED AVERAGE OF EXPECTED RETURNS ON INDIVIDUAL SECURITIES

rA = (D/D+E)rD + (E/D+E)rE

rE = rA + (D/E)(rA - rD) MM PROPOSITION 2EXPECTED RETURN ON EQUITY

= EXPECTED RETURN ON ASSETS + DEBT - EQUITY RATIO x (EXPECTED RETURN ON ASSETS

-EXPECTED RETURN ON DEBT)

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LEVERAGE AND THE EXPECTED RETURN ON EQUITY

LEVERAGE AND THE EXPECTED RETURN ON EQUITY

AS LEVERAGE INCREASES, VA AND rA ARE UNCHANGED BUT THE EXPECTED RETURN ON EQUITY INCREASES

FOR RISKY DEBT, rD INCREASES AS LEVERAGE INCREASES

Debt-equity ratio (D/E)

Expected returnrE

rD

rA

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Copyright 1996 by The McGraw-Hill Companies, Inc

rErE

INCREASE IN EXPECTED EQUITY RETURN REFLECTS INCREASED RISK

INCREASE IN LEVERAGE INCREASES AMPLITUDE OF VARIATIONS IN CASH FLOWS AVAILABLE TO SHAREHOLDERS– SAME CHANGE IN OPERATING INCOME NOW

DISTRIBUTED AMONG FEWER SHARESWE CAN UNDERSTAND THE INCREASED RISK IN

TERMS OF s

WE KNOW THAT

A = (D/D + E)D + (E/D + E)E

E = A + (D/E)(A - D )

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INTEREST TAX SHIELDINTEREST TAX SHIELD

DISCOUNT INTEREST TAX SHIELD AT EXPECTED RATE OF RETURN DEMANDED BY INVESTORS HOLDING THE FIRM’S DEBT

PV (TAX SHIELD) = 28/.08 = $350MORE GENERALLY,

PV (TAX SHIELD)

= TAX RATE x INTEREST PAYMENT / DISCOUNT RATE

= TC (rDD) /rD

= TC DVALUE OF FIRM INCREASES BY PV(TAX SHIELD)

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INTEREST TAX SHIELDINTEREST TAX SHIELD

WHY DID WE SEEM TO DISCOUNT TAX SHIELD BY PRE-TAX INTEREST RATE OF 8%?

PERSONAL TAXES REDUCE THE VALUE OF THE TAX-SHIELD TO THE INVESTOR

BUT THE APPROPRIATE AFTER-TAX DISCOUNT RATE IS ALSO LOWER

PV (TAX SHIELD = TC (rDD)(1-TP) / rD(1-TP)

= TC D

WHICH WAS OUR ORIGINAL FORMULA

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MM PROPOSITION 1 WITH TAXESMM PROPOSITION 1 WITH TAXES

VALUE OF FIRM

= VALUE IF ALL-EQUITY-FINANCED + PV(TAX SHIELD)

SPECIAL CASE OF PERMANENT DEBTVALUE OF FIRM = VALUE IF ALL-EQUITY-FINANCED

+TCD

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COSTS OF FINANCIAL DISTRESSCOSTS OF FINANCIAL DISTRESS

FIRM HAS DIFFICULTY MEETING ITS FINANCIAL OBLIGATIONS– OR CANNOT MEET ITS OBLIGATIONS– SOMETIMES LEADS TO BANKRUPTCY

INVESTORS MAY BE CONCERNED THAT LEVERED FIRM MAY FALL INTO FINANCIAL DISTRESSVALUE OF FIRM

= VALUE IF ALL EQUITY-FINANCED+ PV(TAX SHIELD)- PV(COSTS OF FINANCIAL DISTRESS)

COSTS OF FINANCIAL DISTRESS DEPEND ON:– PROBABILITY OF DISTRESS– MAGNITUDE OF COSTS ENCOUNTERED IF DISTRESS

OCCURS

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COSTS OF FINANCIAL DISTRESS REDUCE

THE OPTIMAL DEBT RATIO

COSTS OF FINANCIAL DISTRESS REDUCE

THE OPTIMAL DEBT RATIOFirm Value PV Tax Shield

PV Costs Of Distress

Debt Ratio

Optimum

Value of levered firm

Value If All Equity Financed

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OPTIMAL CAPITAL STRUCTUREOPTIMAL CAPITAL STRUCTURE

PV OF TAX SHIELD GRADUALLY INCREASES AS FIRM BORROWS MORE

AT MODERATE DEBT LEVELS PV(FINANCIAL DISTRESS) SMALL– TAX ADVANTAGES DOMINATE

WITH MORE DEBT, PROBABILITY OF FINANCIAL DISTRESS INCREASES– ALSO TAX ADVANTAGE OF DEBT STARTS

TO DECLINE AS FIRM CAN NO LONGER BE SURE OF PROFITING FROM THE TAX SHIELD IN ALL STATES OF THE WORLD

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COSTS OF FINANCIAL DISTRESSCOSTS OF FINANCIAL DISTRESS

BANKRUPTCY COSTSCORPORATE BANKRUPTCY OCCURS WHEN

STOCKHOLDERS EXERCISE THEIR RIGHT TO DEFAULT– VALUABLE RIGHT– WHEN A FIRM GETS INTO TROUBLE,

STOCKHOLDERS CAN WALK AWAY– FORMER CREDITORS BECOME THE NEW

STOCKHOLDERS

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COSTS OF DISTRESS VARY WITH TYPE OF ASSET

COSTS OF DISTRESS VARY WITH TYPE OF ASSET

YOUR COMPANY OWNS HOTEL– OCCUPANCY FALLS– FIRM GOES BANKRUPT

MORTGAGE HOLDER SELLS TO NEW OWNER– LOW BANKRUPTCY COSTS – LEGAL AND COURT FEES

HOTEL BUSINESS UNAFFECTED BY BANKRUPTCY

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Copyright 1996 by The McGraw-Hill Companies, Inc

COSTS OF DISTRESS VARY WITH TYPE OF ASSET

COSTS OF DISTRESS VARY WITH TYPE OF ASSET

YOUR COMPANY OWNS ELECTRONICS COMPANYSTOCKHOLDERS MAY BE UNWILLING TO PROVIDE

MORE CAPITAL IN FINANCIAL DISTRESS– MORE SERIOUS THAN FOR HOTEL

IF COMPANY GOES BANKRUPT– CREDITOR WOULD HAVE DIFFICULTY SELLING OFF

ASSETS– MANY ASSETS INTANGIBLE

ALSO DIFFICULT IN CARRYING ON AS GOING CONCERN– ODDS OF DEFECTIONS BY KEY EMPLOYEES– ASSURANCES TO CUSTOMERS THAT FIRM WILL BE

AROUND TO SERVICE ITS PRODUCTS

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COSTS OF DISTRESS VARY WITH TYPE OF ASSET

COSTS OF DISTRESS VARY WITH TYPE OF ASSET

SOME ASSETS, LIKE COMMERCIAL REAL ESTATE, CAN GO THROUGH BANKRUPTCY LARGELY UNSCATHED

BUT COMPANIES WITH INTANGIBLE ASSETS THAT ARE INTEGRAL PART OF FIRM AS GOING CONCERN SUFFER MAJOR LOSS IN BANKRUPTCY

REASON DEBT-EQUITY RATIOS LOW IN PHARMACEUTICAL INDUSTRY– NEEDS CONTINUED R&D

DEBT-EQUITY RATIOS ALSO LOW IN MANY SERVICE INDUSTRIES– INTANGIBLE INVESTMENTS IN HUMAN CAPITAL

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Copyright 1996 by The McGraw-Hill Companies, Inc

PECKING ORDER OF FINANCING CHOICES

PECKING ORDER OF FINANCING CHOICES

MANAGERS KNOW MORE ABOUT THEIR FIRM THAN OUTSIDERS– PROSPECTS, RISKS

ASYMMETRIC INFORMATION– MANAGERS KNOW MORE THAN INVESTORS– DIVIDEND SIGNALING

– INVESTORS INTERPRET INCREASE IN DIVIDEND AS SIGN OF MANAGEMENT CONFIDENCE

ASYMMETRIC INFORMATION AFFECTS CHOICE BETWEEN– INTERNAL VS EXTERNAL FINANCING– ISSUING DEBT VS EQUITY

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PECKING ORDERPECKING ORDER

LEADS TO FOLLOWING PECKING ORDER– INVESTMENTS FIRST FINANCED

WITH– INTERNAL FUNDS– NEW DEBT– NEW EQUITY

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Copyright 1996 by The McGraw-Hill Companies, Inc

Financial Choices

Trade-off Theory - Theory that capital structure is based on a trade-off between tax savings and distress costs of debt.

Pecking Order Theory - Theory stating that firms prefer to issue debt rather than equity if internal finance is insufficient.

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Trade Off Theory & PricesTrade Off Theory & Prices

1. Stock-for-debt Stock price

exchange offers falls

Debt-for-stock Stock price

exchange offers rises

2. Issuing common stock drives down stock prices; repurchase increases stock prices.

3. Issuing straight debt has a small negative impact.

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Copyright 1996 by The McGraw-Hill Companies, Inc

Issues and Stock PricesIssues and Stock Prices

Why do security issues affect stock price? The demand for a firm’s securities ought to be flat.

Any firm is a drop in the bucket.

Plenty of close substitutes.

Large debt issues don’t significantly depress the stock price.

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Copyright 1996 by The McGraw-Hill Companies, Inc

Pecking Order TheoryPecking Order Theory

Consider the following story:

The announcement of a stock issue drives down the stock price because investors believe managers are more likely to issue when shares are overpriced.

Therefore firms prefer internal finance since funds can be raised without sending adverse signals.

If external finance is required, firms issue debt first and equity as a last resort.

The most profitable firms borrow less not because they have lower target debt ratios but because they don't need external finance.

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Pecking Order TheoryPecking Order Theory

Some Implications: Internal equity may be better than external equity.

Financial slack is valuable.

If external capital is required, debt is better. (There is less room for difference in opinions about what debt is worth).