topic 7 gangemi capital structure_1

8/8/2019 Topic 7 Gangemi Capital Structure_1

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WHICH PIE IS LARGER?WHICH PIE IS LARGER?

Shares

40%

Debt

60%Shares

60%

Debt

40%



Topic 7 Capital Structure

Overview

This topic is concerned with the issue of whether

there exists an ³Optimal Capital Structure´, one

that maximizes the value of the firm.



Capital Structurerepresents

The long-term sources of finance of the firm

Items found on the right hand side of the Balance

Sheet

The combination of debt and equity used to

finance the investment in real assets.

Established by financing decisions

Summarised by the Debt-to-equity ratio.



The effect on equity holders of introducing

³Financial Leverage´ into the firm¶s capital

structure.

Financial Leverage refers to the extent to

which a firm relies on debt .



Leverage (gearing) of a company can bemeasured using a leverage ratio:

Financial ³leverage´ (³gearing´)Financial ³leverage´ (³gearing´)

Leverage ratio !net debt

market capitalisation of equity



Capital structuresCapital structures

The net debt to equity ratio of Wesfarmers Ltd



ReturnsReturns

RETURN AVAILABL E TO SHA RE H O LD ER S

reflects the earning capacity of the firms assets

REQU I RE D R ATE OF RETURN TO SHA RE H O LD ER S

the minimum return demanded by shareholders given the

investment risk

reflects trade- off between risk and return



Firm¶s Cash FlowsFirm¶s Cash Flows

REVENUE

Fixed operating costsFixed operating costsVariable operating costsVariable operating costs

InterestInterestNET INCOME

[NI]

lessless

equalsequalsNET OPERATING INCOMENET OPERATING INCOME

[NOI][NOI]

lessless

equalsequals



Financing package Different levels of NOI ($000)

0 20 40 60 80

(a) All equity 0% 5% 10% 15% 20%

(b) 50% debt, 50% equity -10% 0% 10% 20% 30%

(c) 75% debt, 25% equity -30% -10% 10% 30% 50%

The below table shows the greater the debt to equity ratio

the greater the change in the available return to equity

holders as a result of a change in the level of Net Operating

Income (NOI)



Effects Of Financial Leverage

T he substitution of debt for equity in the capital structure

(1) It increases the available return to equity holders canhave on their investment.

-This is due to the firms assets being able to earn areturn greater than the cost of debt.

(2) It increases the risk (variability of the returns)associated with the investment.

-Thus, the greater the range of returnsavailable to shareholders.



Effects Of Financial LeverageEffects Of Financial Leverage

Having examined the impact of introducing debt wenow turn to examine how it could impact on thevalue of the firm through the firm¶s

Capital Structure



Capital Structure

Optimal Capital Structure

The combination of debt and equity that minimises

WACC such that the value of the firm is maximised.

Is there such a combination?



REAL ASSETS

GENERATE

A STREAM

OF

CASH FLOWS

- inventory

- machinery

- land & buildings

FINANCIAL ASSETS

CLAIMS

UPON THE

CASH FLOW

STREAM

- shares

- term loans

- mortgages

- debentures

Investing

Decision FinancingDecision



Value of the FirmValue of the Firm

The firm may be valued by discounting the future cashThe firm may be valued by discounting the future cash

flows of the firm by the WACCflows of the firm by the WACC

VV ==nn

77t = 1t = 1

NOINOItt

(1 + r)(1 + r)ttVV ==

nn

77t = 1t = 1

(Revenues(Revenues -- Costs)Costs)tt

(1 + r)(1 + r)tt



VV ==NOINOI

rr

e.g. Equity and debt

rr = r= ree ( ) + r( ) + rdd ( )( )EE

VV

DD

VV

SIMPLIFY BY ASSUMING NOI IS CONSTANT

We can now express the equation as a perpetuity.




As Net Operating Income increases the value of the firmincreases.

Net Operating Income reflects the Investment decision

of the firm

As the Weighted Average Cost of Capital decreases theValue of the firm increases. (Inverse relationship)

WACC reflects the Financing decision of the firm




THE BIG QUESTION TO CONSIDER:

Does substitution of cheaper debt

finance for equity reduce the overallweighted average cost of capital andthereby increase the value of the firm?



Why Is Debt Cheaper Than Equity?Why Is Debt Cheaper Than Equity?

1. Debt holders have priority over equity holders intheir claims on the firm¶s cash flow stream.

2. Debt is a contractual claim

3. Common stock dividends are a residual claim

4. Lenders therefore face lower risk than equity

investors.

Consequently, the return required by debt holders

(lenders) is less than the return required by

shareholders



TRADITIONAL APPROACHTRADITIONAL APPROACH

The traditional approach to capital structure assumes that there isan optimal capital structure and management can increase thetotal value of the firm through the financing method.

The approach implies that the cost of capital is dependent on thecapital structure of the firm.

However, this is a practical approach without a theoretical basis.

The determinants of, or path to, the optimal D/E ratio were neverspecified (no formal model has been developed.)



The Traditional View Of TheThe Traditional View Of TheEffect Of LeverageEffect Of Leverage

As the amount of debt increases, this initiallyreduces the WACC (because debt is cheaper thanequity)

However, the cost of debt is not constant but atsome point increases.

The required rate of return that shareholdersdemand also increases as the level of debt increasesand this offsets the initial reduction in WACC.



The Traditional View Of TheThe Traditional View Of TheEffect Of LeverageEffect Of Leverage

Traditional view - there is an optimal capitalstructure.

It is where WACC is at a minimum andconsequently the value of the firm is at amaximum



The Traditional View Of The Effect Of The Traditional View Of The Effect Of LeverageLeverage

Cost of

Capital

LeverageD/V

0

(a) The Effect on the Cost of Capital

r e

r d

r

TotalValue

Leverage0DV

(b) The Effect on Firm Value

V



Example:Example: Cost of capital and leverageCost of capital and leverage

r = rd (D/V) + re (E/V)

0.086 = 0.05(10/100) + 0.090 (90/100)

0.084 = 0.05(25/100) + 0.095 (75/100)

0.075 = 0.05(50/100) + 0.10 (50/100)

BUT

0.077 = 0.07(90/100) + 0.14 (10/100)



Modigliani (Franco,) and Miller (Merton,) TheModigliani (Franco,) and Miller (Merton,) TheOriginal M and M (Before MarshallOriginal M and M (Before Marshall MathersMathers))



Modigliani and Miller (M&M)Modigliani and Miller (M&M)

Questioned the traditional view

M and M examined the relationship between

firm value and financing choice

Analysis based on perfect market (oh,oh!)

assumptions



Modigliani and Miller (M&M)Modigliani and Miller (M&M)

M and M undertook studies of electricutilities and oil companies.

E vidence supported conclusion thatthere was no relationship between D/Eratios and cost of capital in these

industries



ASSUMPTIONS UNDERLYINGASSUMPTIONS UNDERLYINGM & M ANALYSISM & M ANALYSIS

1. a perfectly competitive market in which all investors haveperfect knowledge and act rationally;

2. investors are perfectly certain about the future profitability

of any company

3. all companies can be divided into homogenous risk classes

4. no personal or company tax

5. individuals and companies can raise unlimited debt funds atthe same rate of interest



M&M Proposition 1M&M Proposition 1 In perfect capital markets (with no taxes and no bankruptcy

costs) the value of the firm is independent of its capital structure.(i.e. Capital structure is irrelevant.)

1. The WACC does not vary with changes in the debt/equity ratio.

2. A firm cannot change its total value just by dividing its cash flows into

different streams (different classes of investors).3. The firm's value is determined by its real assets, not by the securities it

issues.

4. Claims on firms in same business risk class and with same earningsstreams are perfect substitutes and must sell for the same value -otherwise could make arbitrage profits.

PROVIDED

Personal borrowing is a perfect substitute for corporate borrowing.



MM Proposition IMM Proposition I

Shares40%

Debt

60%

The size of the pie does not depend on how it is sliced.

The value of the firm is unaffected by its capital structure.

Value of firm Value of firm

Sha es

60%

De

40%



M&M Proof Of Capital StructureM&M Proof Of Capital StructureIrrelevance In Perfect Capital MarketsIrrelevance In Perfect Capital Markets

IMPORTANT POINT!

Example:

Firm L and firm U have identical assets capable of generatingidentical cash flows . T he only difference is that Firm L is morehighly levered.

± If Firm L has the same cost of equity as firm U, and uses cheaper debt, itwill have a lower WACC its value will be higher than Firm U

± Investors will sell their shares in Firm L and buy equivalent cash flowstream in Firm U thus making an arbitrage profit. The sale of Firm L shareswill cause Firm L¶s price to fall. The increase demand of Firm U¶s shares will

cause Firm U¶s price to rise.

T he process will continue until the value of each firm is the same.



Irrelevance PropositionIRRELEVANCE PROPOSITION

Assume two firms with the same business risk and the same NOI

Un-levered FirmNOI = $2,000 re =10%

Vu = $20,000

Levered Firm

D = $10,000 rd = 5%

NOI = $2,000 re =10%

Interest = $500

NI = $1,500

E = 1,500/0.1 = $15,000

VL = $10,000 + $15,000= $25,000



Assume they own 10% Equity (E) of the levered Firm, (i.e.

$1,500 which provides a 10% claim on NIL of $150)

The operation

1. Sell E in the levered firm for $1,500

2. Borrow $1,000 at 5%

D/E =1000/1500 =2/3

Same as levered Firm

3. Buy 10% of the E in the un-levered firm for $2,000

The Arbitrager



Arbitrage Results

(i) Receives 10% of the income of the un-levered firm = $200

(ii) Pays $50 interest on personal borrowing

(i) + (ii) implies individual receives net $150 which is what individual

was receiving from their share in the un-levered firm.

NB: Individual had available $2,500

(D = $1,000, E = $1,500) used $2,000 to buy shares in un-leveredfirm which means that $500 still available to earn income on!!!



M & M Proposition 1

Cost of Capital

Leverage0

( a)Th

eEff

ect on

t he

Cost

of C apital

r e

r d

r

TotalValue

Leverage0

(b ) The Eff ect on F irm V alue

V



M&M Proposition 2M&M Proposition 2

How does the required return on

equity in a levered firm change as

the degree of leverage changes?




The required rate of return by equity

holders can be shown to be equal to the

required rate of return for un-levered

equity plus the ³financial risk

premium´ which is a function of thedebt-equity ratio.



Assume NOIu = NOIL

From M & M Theorem 1 Vu = VL

Vu = NOIu / r*e r

r*e is the required return on equity capital in a firm with no debt (pure

equity firm)

VL = NOIL / r

Where r is the required rate of return on capital ( both debt and

equity) in a levered firm.

r = rd (D/V) + re (E/V)



Since from Modigliani and Miller

we know thatVu = VL we require that

r*e = r = rd (D/V) + re (E/V)

r*e = rd (D/V) + re (E/V)

Solving for re

re= r*e + ( r*e ± rd).D/E

We recognize that in an all equity firm r*e = raf

Therefore re = raf +(raf ±rd).D/E



Assume a Modigliani and Miller world

with no taxes where the required rateof return of an un-levered firm is 9.6%.

What is the cost of equity in an

identical levered firm where the cost of

debt is 7% and the D/V ratio is 0.5?

a. 10.8%

b. 12.20%c. 10%d. 13.5%



0.096 = (0.5)(0.07) + (0.5)(x)

.096 = .035 + 5x

.096 - .035 = .035-.035+5x

.061 = .5x

x - .1220 or r^e = 12.20%




This shows that as the degree of

leverage increases the required rate

of return on equity in a levered firm

increases exactly in line with the

increase in the available rate of

return



For capital structure to be irrelevant

the return equity holders require on

their investment mustincrease inline with the return available to

them.

Returns to Equity



As µcheaper¶ debt is substituted for

equity in the capital structure, the

return required by the equity holdersincreases in response to the increased

risk associated with their investment,

and thereby (exactly) offsets the effecton the overall cost of capital of the

µcheaper¶ debt finance.

Returns to Equity



ExampleExample

Capital structure: equity = 40% debt = 60% rd = 8%

assume business risk re* = 8.8%

re = re* + (re* - rd) D/E

re = 8.8% + (8.8% - 8%) 6/4

re = 10%WACC = re (E/V) + rd (D/V)

= 10% x 40/100 + 8% x 60/100

= 4% +4.8%

= 8.8%



ExampleExample

If capital structure changes so debt increases to 70%,

M & M argue that this will increase the financial risk to

shareholders and their required rate of return will increase.

re = re* + (re* - rd) D/E

re = 8.8% + (8.8% - 8%) 7/3

re = 10.67%

When capital structure changes

WACC = 10.67% x 30/100 + 8% x 70/100

= 3.2% + 5.6%

= 8.8% no change in WACC



Type of RisksType of Risks

NO DEBT: NOI = NI (all variability in net incomecomes from business risk).

DEBT: when the firm borrows, it becomes subjectto financial risk and business risk; interestis subtracted from the NOI, the effect beingan increase in the variability of the NIstream.

= an additional source of risk

= shareholder expected return increases



BUSINESS RISK :risk due to nature of the products sold by the company e.g.

new competition, technological improvements, etc.

FINANCIAL RISK:

risk due to using debt (directly related to amount of debt inthe capital structure).



Decomposition Of EquityDecomposition Of EquityHolders¶ Required ReturnsHolders¶ Required Returns

re = RF + BRP + FRP

Return on aReturn on a

Risk Risk--freefree

investmentinvestment

Premium forPremium for

Business Risk Business Risk

Premium forPremium for

Financial Risk Financial Risk

Risk inherent in

firm¶s operations

Risk introduced through the addition of

debt into the capital structure



Thus, the expected return to equity holders is equal

to the required rate of return for unlevered equityplus the financial risk premium which is a functionof the debt-equity ratio.

re = return to equity holdersre*= rate of return required by shareholders in a un-levered

firm

rd = rate of return required by debt holders

M and M Proposition 2M and M Proposition 2

DDEE

rree == rree* + (r* + (ree** -- rrdd))

BusinessRisk

FinancialRisk



Conclusion from Proposition 2Conclusion from Proposition 2

1. Increasing leverage does not affect the cost of

capital

2. The cost of debt is an explicit cost included inthe cost of capital.

3. The financial risk created by leverage is an

implicit cost of debt which increases the cost of

capital by increasing the required rate of

return by equity holders.



Summary

Capital Structure Irrelevance

r

NOIV !

WACC

¹ º ¸©

ª¨¹

º ¸©

ª¨!

V

Er V

Dr r ed

Constant Proportions changing

? A ¹ º

¸©ª

¨! E

D

r r r r d*e*ee

varies linearly (and positively) with changes in financial

leverage and offsets the effect on r of the lower cost,dr

er




The appropriate discount rate for a particular

investment proposal is completely independent of

how the investment is financed. Therefore, thefinancing decision is irrelevant from the point-of-

view of maximising shareholder wealth.

The appropriate discount rate depends on the

features of the investment proposal, especially risk .



INTRODUCTION TO MARKETINTRODUCTION TO MARKETIMPERFECTIONSIMPERFECTIONS

Capital structure Decision with CorporateCapital structure Decision with CorporateTaxationTaxation

M & M introduced corporate taxes

conclusion:

interest is tax deductible

thus borrowing represents a tax saving

thus the value of the levered firm is greater than the valueof the un-levered firm by the value of the present value of the tax benefits

or VL > VU

where VL = VU + P.V. of the tax savings oninterest



Imperfect Capital MarketsImperfect Capital MarketsCorporate TaxesCorporate Taxes

Levered firms have additional taxdeductions associated with the interestpayments

Value of the levered firm will be greater thanthe value of the un-levered firm by thepresent value of the tax benefits

Implies existence of an optimal capitalstructure - ALL DEBT

NotationNotation



NotationNotation

Vu = value of an un-levered firm

VL = value of a levered firm

rd = rate of return required by debt holders

re* = rate of return required by shareholdersin an un-levered firm

re = rate of return required by shareholdersin a levered firm



Vu =

VL

=

VL =

VL =

NOI (1 - tc)

re*

NOI (1 - tc)

re*

NOI (1 - tc)

re*

(rd) (D) tc

rd

+

+ D tc

+ D tcVu

Present value of the

interest tax shield



Modigliani & Miller AnalysisModigliani & Miller Analysis Introduction of Corporate T axes Introduction of Corporate T axes

VV

00DD

EE

VVLL

VVuu

PresentV

alue of PresentV

alue of Interest Tax ShieldsInterest Tax Shields

(D t(D tcc))



Cost Of CapitalCost Of Capital

Optimal capital structure will be 100% debt. This willminimise the cost of capital and thereby maximise the value

of the firm.

rr

WACCWACC

DDEE



Why Are All Debt Capital Structures NotWhy Are All Debt Capital Structures NotObserved?Observed?

There must be factors that offset the taxadvantages of debt finance when borrowingbecomes too high:

1. Personal Taxes

2. Financial Distress Costs

3. Conflict of Interest Costsetc.



The impact of the introduction of personal taxes is beyond thescope of this course.

A formal analysis of personal taxes is contained in the appendix tothis topic.



In SummaryIn Summary

If corporate taxes are introduced to be consistent need toalso consider the impact of personal taxes.

Need to consider the way in which the corporate tax system

and the personal tax system are integrated, in particular asregards the treatment of dividends

e.g. are dividends taxed twice?

is there a dividend imputation system in place?

Need to consider whether equity income is treated morefavourably than debt income by the personal tax system.

How are capital gains taxed?



Depending on the exact nature of the overall tax system can endwith a variety of results.

If the tax system is perfect, in the sense that an individual pays thesame amount of tax whether they receive a dollar of debt incomeor a dollar of equity income, then its back to the originalModigliani Miller result in that the capital structure does not

matter.

If Dividends are taxed twice once at the company level and once atthe individual level ( Classical Tax system) then could be back tothe conclusion the more debt in the capital structure the greaterthe value of the firm.

If debt income is treated more ( less) favourably by the tax systemthan equity income an increase in debt (equity) will increase the

value of the firm



2. Financial Distress Costs2. Financial Distress Costs

Financial Distress:

When a firm cannot meets itscreditors commitments

Financial Distress Costs:

Costs of managerial time devoted to avert failure, fees paid to

insolvency specialists, etc.



Direct vs Indirect Bankruptcy CostsDirect vs Indirect Bankruptcy Costs

Direct costs

T hose costs are directly associated with bankruptcy,eg legal and administrative expenses.

Indirect costsT hose costs associated with spending resources toavoid bankruptcy.

The static theory of capital structure

A firm borrows up to the point where the tax benefit from an extra dollar in debt is exactly equal to thecost that comes from the increased probability of financial distress.



2. Financial Distress Costs2. Financial Distress Costs

As debt increases to a point where there us a possibility of financial distress and the F.D.C. increase, there is anoffsetting effect, i.e. the P.V. of the F.D.C. offset the P.V. of the interest tax shields.

where VL = VU

+ PV of the Tax Saving on Interest

- P.V. of the F.D.C.

At the point where this offsetting begins we find the optimalcapital structure for a firm.



2. Financial Distress Costs2. Financial Distress CostsValue of the firm

(VL)

VL+ VU + TC x D

Financial distress costs

Actual firm

value

VU = Value of firm

with no debt

Total debt

(D)D*

Optimal amount

of debt

VU

Maximum

firm value VL*

The gain from the tax shield on debt is offset by financial distress costs. An

optimal capital structure exists which just balances the additional gain from

leverage against the added financial distress cost.



3. Conflict Of Interest Costs3. Conflict Of Interest Costs

Debt holders may fear management will transfer wealthfrom themselves to shareholders.

± They need to protect themselves from erosion of wealth(increase rd or impose covenants)

± this is likely to increase as the D/E ratio increases

± these costs are part of financial distress costs



APPENDIX A . Personal Taxes (Miller 1977)APPENDIX A . Personal Taxes (Miller 1977)

analysis based on the classical tax system

assumed re equals zero ( rd and tc are important)

investors are risk-neutral and debt is risk-less

there are different clienteles of investors (based on personal tax rate)

Investors face a choice of either

± a) tax-exempt Govt. bonds or

± b) investment in risky firms

± To entice investors to invest in debt rather than equity, the firm must offerhigh enough returns (before tax) to offset the disadvantage of higher

personal tax rates.

This counterbalances the interest deductibility of debt (the shareholders of levered firms end up receiving no benefit from the tax deductibility of intereston corporate debt because the firms are in effect forced to pay debt holderspersonal taxes in the form of higher returns).



1. Personal Taxes (Miller 1977)1. Personal Taxes (Miller 1977)

Any gain from leverage on the relationship between two typesof personal taxes and the corporate tax rate.

VVLL = V= Vuu + D.t+ D.tcc

where (1where (1 -- ttcc) (1) (1-- ttpsps)) == afterafter--tax return to shareholderstax return to shareholders

(1(1 -- ttpdpd)) == afterafter--tax return to debt holderstax return to debt holders

= = VVuu ++ [[11 -- ]] DD(1(1 -- ttcc) (1) (1 -- ttpsps))

(1(1 -- ttpdpd))

DD[ ][ ] == GGLL (gain or leverage)(gain or leverage)11 -- (1(1 -- ttcc) (1) (1 -- ttpsps))

(1(1 -- ttpdpd))



1. Personal Taxes (Miller 1977)1. Personal Taxes (Miller 1977)

A point is reached where

(1 - tc) (1- tps) = (1 - tpd)

At this point the gain from leverage is zero and theadvantage of issuing more debt vanishes completely.

At this point a capital structure is optimal

Because this level of debt is optimal for all firms, the D/E isoptimal for the economy as a whole, not for the individual

firm.



Miller¶s Analysis Corporate &Miller¶s Analysis Corporate &Personal TaxesPersonal Taxes

00 DD

VVLL = V= Vuu ++ [1[1 -- ]] DD(1(1 -- ttcc) (1) (1 -- ttpsps))

(1(1 -- ttpdpd))

VVLL

VVuu

VVLL = V= Vuu + D t+ D tcc IF IF ttpsps = t= tpdpd

VVLL > V> Vuu IF IF (1(1 -- ttpdpd) > (1) > (1 -- ttcc) (1) (1 -- ttpsps))

VVLL = V= Vuu IF IF (1(1 -- ttpdpd) = (1) = (1 -- ttcc) (1) (1 -- ttpsps))

VVLL < V< Vuu IF IF (1(1 -- ttpdpd) < (1) < (1 -- ttcc) (1) (1 -- ttpsps))



Example

Assume that there are 3 identical firms, a , b and c.

Identical in all respects apart from the way in which the firmis financed.

No corporate taxation

In each case the firm has total assets of $400,000 and but themix of debt and equity used to finance these assets differ

We assume that the return that the firm can earn on itsassets in each case is the case, 15%

Therefore Net operating Income of all 3 firms is the same at

$60,000The firms that use debt pay 10% interest



(a)All equity

$

(b)50 debt

50 equity

(c)75% debt

25 % equity

Equity 400,000 200,000 100,000

Debt 200,000 300,000

Total Assets 400,000 400,000 400,000

Debt/Equity ratio 0 1:1 3:1

Net operating Income 60,000 60,000 60,000

Interest (at 10%) 20,000 30,000

Net Income 60,000 40,000 30,000

Return on Assets 15% 15% 15%

Available Return on

Equity

15% 20% 30%



The previous analysis can be captured in algebraic

form:

Let = return available to equity holders

= return provided by the firms assets

aer

af r

E

Dr EDr r

daae

!

E

Dr r r r daaae !

!aer

et cash low - interest

rom irms assets payments

equity investments

=

( ) ( ) ( )



(a)

All equity

$

(b)

50% debt

50% equity

(c)

75% debt

25 % equity

Equity 400,000 200,000 100,000

Debt 200,000 300,000

Total Assets 400,000 400,000 400,000

Debt/Equity ratio 0 1:1 3:1

Net operating Income 36,000 36,000 36,000

Interest (at 10%) 20,000 30,000

Net Income 36,000 16,000 6,000

Return on Assets 9% 9% 9%

Available Return on Equity 9% 8% 6%

Change in available

return on equity-40% -60% -80%



What happens to the available return toequity holders as result of the return earned

on the firms assets decreasing?

1. Initially the return on the firms assets of $400,000 was

15% giving a NOI of $60,000. We now assume the returnon assets falls to 9% giving a NOI of $36,000

2. It will be shown that the greater is the D/E ratio the

greater the drop in the available rate of return to equityholders

topic 7 gangemi capital structure_1

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