capital structure
TRANSCRIPT
CAPITAL STRUCTURE
Gagan Deep Sharma (Dr)
USMS, GGSIPU, New Delhi
CAPITAL STRUCTURE
A mix of debt, preferred stock, and common stock with which the firm plans to finance its investments.
Objective is to have such a mix of debt, preferred stock, and common equity which will maximize shareholder wealth or maximize market price per share
WACC depends on the mix of different securities in the capital structure. A change in the mix of different securities in the capital structure will cause a change in the WACC. Thus, there will be a mix of different securities in the capital structure at which WACC will be the least.
An optimal capital structure means a mix of different securities which will maximize the stock price share or minimize WACC.
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LEVERAGE AND CAPITAL STRUCTURE
Leverage means use of fixed cost source of funds. Generally, it refers to use of debt in the capital structure of the firm
How much leverage should be there in a firm? Why is this question important? Two reasons: a higher debt ratio can enhance the rate of return on equity capital during good economic
times
a higher debt ratio also increases the riskiness of the firm’s earnings stream
Capital structure decision involves a trade off between risk and return to maximize market price per share
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CAPITAL STRUCTURE
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CAPITAL STRUCTURE
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CAPITAL STRUCTURE
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CAPITAL STRUCTURE
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CAPITAL STRUCTURE
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CAPITAL STRUCTURE
Results
Range of ROEs
%
Leveraged 20 - 5
Un-leveraged 15 – 7.5
What effect will this have on expected/required equity returns?
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THEORETICAL POSITIONS
Net Operating Approach (the ‘makes no difference camp’)
Traditional Approach (the ‘yes it does camp’)
Modigliani and Miller (the ‘we can prove it does not matter camp’)
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NET OPERATING APPROACH
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NET OPERATING APPROACH
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Market value of debt ($65M)
Market valueof equity ($35M)
Total firm marketvalue ($100M)
TOTAL VALUE PRINCIPLE: MODIGLIANI AND MILLER
Market value of debt ($35M)
Market valueof 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).
M&M assume an absence of taxes and market imperfections.
Investors can substitute personal for corporate financial leverage.
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ARBITRAGE AND TOTAL MARKET VALUE OF THE FIRM
Arbitrage -- Finding two assets that are essentially the same and buying the cheaper and selling the more expensive.
Two firms that are alike in every respect EXCEPT capital structure MUST have the same
market value.
Otherwise, arbitrage is possible.
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ARBITRAGE EXAMPLE
Consider two firms that are identical in every respect EXCEPT:
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
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Earnings available to common shareholders = E = O – I = Rs 10,000 - 0= Rs 10,000
Market value of equity = E / ke
= Rs 10,000 / .15 = Rs 66,667
Total market value = Rs 66,667 + 0= Rs 66,667
Overall capitalization rate = 15%Debt-to-equity ratio = 0
ARBITRAGE EXAMPLE: COMPANY NL
Valuation of Company NL
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ARBITRAGE EXAMPLE: COMPANY L
Earnings available to common shareholders = E = O – I = Rs10,000 – Rs 3,600= Rs6,400
Market value of equity = E / ke
= Rs 6,400 / .16 = Rs40,000
Total market value = Rs 40,000 + Rs 30,000= Rs 70,000
Overall capitalization rate = 14.3%Debt-to-equity ratio = .75
Valuation of Company L
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COMPLETING AN ARBITRAGE TRANSACTION
Assume that you own 1% of the stock of Company L (equity value = Rs 400)
You should:
1. Sell the stock in Company L for Rs 400
2. Borrow Rs 300 at 12% interest (equals 1% of debt for Company L)
3. Buy 1% of the stock in Company NL for Rs 666.67. This leaves you with Rs 33.33 for other investments (Rs 400 + Rs 300 – Rs 666.67)
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Original return on investment in Company L
Rs 400 x 16% = Rs 64
Return on investment after the transaction
Rs 666.67 x 16% = Rs 100 return on Company NL
Rs 300 x 12% = Rs 36 interest paid
Rs 64 net return (Rs 100 – Rs 36) AND Rs 33.33 left over
This reduces the required net investment to Rs 366.67 to earn Rs 64
COMPLETING AN ARBITRAGE TRANSACTION
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SUMMARY OF THE ARBITRAGE TRANSACTION
The investor uses “personal” rather than corporate financial leverage.
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 acceptable.
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EFFECTS OF CORPORATE TAXES
Consider two identical firms EXCEPT:
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 $10,000
The judicious use of financial leverage (i.e., debt) provides a favorable impact on a
company’s total valuation
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Earnings available to common shareholders = E = O - I= Rs 2,000 – Rs 0= Rs 2,000
Tax Rate (T) = 40%Income available to common shareholders = EACS (1 - T)
= Rs 2,000 (1 - .4) = Rs 1,200
Total income available to all security holders = EAT + I= Rs 1,200 + 0= Rs 1,200
CORPORATE TAX EXAMPLE: COMPANY ND
Valuation of Company ND (having no debt)
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Earnings available to common shareholders = E = O - I= Rs 2,000 – Rs 600= Rs 1,400
Tax Rate (T) = 40%Income available to common shareholders = EACS (1 - T)
= Rs 1,400 (1 - .4) = Rs 840
Total income available to all security holders = EAT + I= Rs 840 + Rs 600= Rs 1,440*
CORPORATE TAX EXAMPLE: COMPANY D
Valuation of Company D (having some debt)
* Rs 240 annual tax-shield benefit of debt (i.e., Rs 1,440 – Rs 1,200)3/10/2014 GDS 23
TAX-SHIELD BENEFITS
Tax Shield -- A tax-deductible expense. The expense protects (shields) an equivalent amount of revenue from
being taxed by reducing taxable income.
Present value of tax-shield benefits of debt =
(r) (B) (tc)
r= (B) (tc)
* Alternatively, $240 annual tax shield / .12 = Rs 2,000, where Rs 240 = Rs 600 Interest expense x .40 tax rate
= (Rs 5,000) (.4) = Rs 2,000*
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VALUE OF THE LEVERED FIRM
Value of unlevered firm = Rs 1,200 / .16(Company ND) = Rs 7,500*
Value of levered firm = Rs 7,500 + Rs 2,000(Company D) = Rs 9,500
Value of Value of Present value oflevered = firm if + tax-shield benefits
firm unlevered of debt
* Assuming zero growth and 100% dividend payout3/10/2014 GDS 25
SUMMARY OF CORPORATE TAX EFFECTS
The greater the amount of debt, the greater the tax-shield benefits and the greater the value of the firm
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 amount of financial leverage.
This implies a capital structure of almost 100% debt! Yet, this is not consistent with actual behavior.
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