Chapter 9Theory of Capital StructureHow do we want to finance our firms assets?

Balance Sheet Current Current Assets Liabilities

Debt and Fixed Preferred Assets Shareholders Equity

Balance Sheet Current Current Assets Liabilities

Debt and Fixed Preferred Assets Shareholders Equity

Balance Sheet Current Current Assets Liabilities

Debt and Fixed Preferred Assets Shareholders EquityFinancialStructure

Balance Sheet Current Current Assets Liabilities

Debt and Fixed Preferred Assets Shareholders Equity

Balance Sheet Current Current Assets Liabilities

Debt and Fixed Preferred Assets Shareholders EquityCapitalStructure

Why is Capital Structure Important?1) Leverage: higher financial leverage means higher returns to stockholders, but higher risk due to interest payments.2) Cost of Capital: Each source of financing has a different cost. Capital structure affects the cost of capital.3) The Optimal Capital Structure is the one that minimizes the firms cost of capital and maximizes firm value.

Introduction to the TheoryCapital structure is the proportions ofDebt Preferred stockCommon stockAssumptionsDefinitionsNOI approachTraditional approachMiller Modigliani Approach

AssumptionsNo taxes & no bankruptcy costsNo transaction costsPay all earnings in dividendsSame expected future operating earnings for all investorsNo growth of earnings

Definitionski is the yield on the companys debt

ke is the earnings/price ratio Required rate of return for investors

k0 is an overall capitalization rate for the firmWeighted average cost of capital (WACC)

Calculating NOI ApproachNOIXOverall capitalization rate=Total value of firmMarket value of debt=Market value of stock

NOI ApproachRequired return on equity increases linearly with leverage

Total valuation of the firm unaffected by its capital structure

NOI ApproachCost ofCapitalke0% debt financial leverage 100%debt.ke = cost of equityki = cost of debtko = cost of capital

NOI Approach.

NOI Approach

NOI Approach

NOI Approach

NOI Approachkeki

NOI ApproachIf we have perfect capital markets, capital structure is irrelevant. In other words, changes in capital structure do not affect firm value.

Important Assumptions of NOI Approachk0 is constantRegardless of the degree of leverageBreakdown between debt and equity unimportantIf ki remains constant, ke is a constant linear function of the debt-to-equity ratiok0 cannot be altered through leverageNo one optimal capital leverage

Traditional ApproachThere is an optimal capital structure

Increase the total value of the firm through leverage

Cost of capital is dependent of the capital structureOptimal capital structure exists

Traditional Approach

Traditional Approach

Traditional Approach

Traditional Approach

Traditional Approach

Traditional Approach

Traditional Approach

Traditional Approach

Traditional Approach

Traditional Approach

Traditional Approach

Traditional Approach

Modigliani-Miller (MM) PositionAssumptions are importantCapital structure is irrelevantTotal investment value of a corporation depends on profitability and riskValue is the same regardless of financing mixHomemade leverageArbitrage efficiency

Irrelevance in a CAPM Framework As leverage increasesExpected return and beta increase proportionallyThe change in expected return and beta offset each other with respect to share priceShare price is invariant with respect to leverage

Taxes and Capital StructureImportant market imperfectionsCorporate taxesComponents of overall value Value if levered + Value of tax shield Optimal strategy is to maximize leverageNot consistent with corporate behavior

Uncertainty of Tax ShieldIncome is consistently low or negativeBankruptcyChange in the corporate tax rateRedundancy

Remember this example?Tax effects of financing with debt with stock with debtEBIT 400,000 400,000- interest expense 0 (50,000)EBT 400,000 350,000- taxes (34%) (136,000) (119,000)EAT 264,000 231,000- dividends (50,000) 0Retained earnings 214,000 231,000

Remember this example?Tax effects of financing with debt with stock with debtEBIT 400,000 400,000- interest expense 0 (50,000)EBT 400,000 350,000- taxes (34%) (136,000) (119,000)EAT 264,000 231,000- dividends (50,000) 0Retained earnings 214,000 231,000

New Value Equation

Value of Value if Pure value Value lost firm = Unlevered + of corporate through tax tax shield shield uncertainty

Corporate Plus Personal TaxesPersonal taxes can reduce the corporate tax advantage

Dividends versus capital gains

Debt or stock income

Merton Millers EquilibriumIn market equilibrium personal and corporate tax effects cancel outInvestor clienteles and market equilibriumCompleting the marketCounterargumentsZero personal tax on stock income is suspectDisturbing relationship betweenCorporate debt Stock returnsReturns on tax-exempt municipal bonds

RecapitulationTax advantage to borrowingModerate amounts of debtTax shield uncertainty is not greatSome lessening of the corporate tax effectOwing to personal taxesGreater the tax wedgeLower the overall tax shield

Effects of Bankruptcy CostsLess than perfect capital marketsAdministrative costs to bankruptcyAssets liquidated at < economic valueRelationship to leverageDeadweight loss to suppliers of capitalTaxes and bankruptcy costsTrade-off betweenTax effects of leverageBankruptcy costs associated with high leverageMost important imperfections

Other ImperfectionsCorporate and homemade leverage not being perfect substitutesAdvantage to corporation borrowingArbitrage processInstitutional restrictionsAdverse effects on market valueGreater the importance of imperfectionsLess effective MM arbitrage processGreater the case for an optimal capital structure

Incentive Issues and Agency CostsAgency costs Stakeholders monitoringEquity holdersDebt holdersManagementOther stakeholders

Debt Holders Versus Equity HoldersEquity of a firmCall option on the firms total value

Debtholders are the writers of the option

Effect of Variance and the Riskiness of AssetsBy increasing the riskiness of the companyStockholders increase the value of their stockAt the direct expense of the debt holders

Changing the Proportion of DebtWill affect the relative valuationOf debtOf equityRelationship between the proportion of debt and valuationIncreasing the proportion of debtResults in a decline in the price of debtResults in an increase in share price

Protective CovenantsRestrict the stockholders abilityTo increase the assets riskinessTo increase leverage

MM argument

Me-first rules

The Underinvestment ProblemResult of equity holders not wishing to invest when the rewards favor debt holdersDisappears whenInvestors own both stocks and bondsBy contracting between debt holders and stockholders

Agency Costs More Broadly DefinedMonitoringCost is born by stockholdersDebt holders charge more interestMay limit the optimal amount of debtOptimal balance betweenMonitoring costsInterest rate charged on debt

Organizational Incentives to Manage EfficientlyLeveraged companies May be lean because management cuts the fatRunning scaredDebt brings capital-market discipline to managementCompany with little debtSignificant free cash flowHave a tendency to squander funds

Asymmetric InformationSignaling effectAssumes there is information asymmetryCredibility of a financial signal depends on asymmetric informationThe greater the asymmetry in information the greater the likely stock reaction to a financing announcementWhat is significant?The signal conveyed by a changed capital structure

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