Financial Management Lesson 10 Capital Structure Theory Lecture 11 Chapter 15

Financial ManagementLesson 10

Capital Structure Theory

Lecture 11Chapter 15


Which one is more?

How would you like your pizza to be sliced? By 4 or 8 pieces?

Let’s make it 4, I cannot eat 8 pieces.


Capital Structure and the Pie

The value of a firm is defined to be the sum of the value of the firm’s debt and the firm’s equity.

V = B + S

• If the goal of the firm’s management is to make the firm as valuable as possible, then the firm should pick the debt-equity ratio that makes the pie as big as possible.

Value of the Firm

S BS BS BS B


What is pizza for us?Our assets determine the size of the pizza;

The mix of securities determines how the pizza is sliced;

The only way to increase the amount of pizza is to increase the value of assets (pizza), not slicing (financing) in a new combination of slices;


Value and Capital Structure

Assets Liabilities and Stockholder’s Equity

Value of cash flows from firm’s real assets and operations

Market value of debt

Market value of equity

Value of Firm Value of Firm


Debt ratio

The ratio of total liabilities to total assets;

It measures the percentage of funds provided by creditors


Average Book Debt Ratios

Industry Debt RatioSoftware and programming 0.06 Semiconductors 0.09 Communications equipment 0.13 Biotech 0.28 Retail 0.34 Hotels and motels 0.37 Chemical manufacturing 0.53 Airlines 0.59 Electric utilities 0.60 Real estate operations 0.62 Beverages (alcohol) 0.63 -------------------------------------- --------Average for US Companies 0.51


Modigliani and Miller

Modern capital structure theory began in 1958;

Professors Franco Modigliani and Merton Miller (MM) issued an article concerning how a firm’s value is linked with its capital structure;


M&M (Debt Policy Doesn’t Matter)

Modigliani & MillerWhen there are no taxes and capital markets

function well, the market value of a company does not depend on its capital structure.

In other words, financial managers cannot increase value by changing the mix securities used to finance the company.



Assumptions

By issuing 1 security rather than 2, company diminishes investor choice. This does not reduce value if: Investors do not need choice, OR There are sufficient alternative securities

Capital structure does not affect cash flows e.g...No taxesNo bankruptcy costsNo effect on management incentives


Example - River Cruises - All Equity Financed

17.5%12.5%7.5% shares on Return

1.751.25$.75shareper Earnings

175,000125,000$75,000Income Operating

BoomExpectedSlump

Economy theof State Outcome

million 1 $Shares of ValueMarket

$10shareper Price

100,000shares ofNumber

Data



What is what?

To calculate Earnings per share, take

Operating income

number of shares outstanding ; or

75,000/100,000=0.75 pTo calculate return on shares, take Operating income/ market value of shares75,000/1,000,000=0.075=7.5%


Example

cont.

50% debt

25%15%5% shares on Return

2.501.50$.50shareper Earnings

125,00075,000$25,000earningsEquity

50,00050,000$50,000Interest

175,000125,000$75,000Income Operating

BoomExpectedSlump


500,000 $debt of ueMarket val

500,000 $Shares of ValueMarket

$10shareper Price

50,000shares ofNumber

Data



What is what?

To calculate Earnings per share, take

Operating income

number of shares outstanding ; or

25,000/50,000=0.5 pTo calculate return on shares, take Operating income/ market value of shares25,000/500,000=0.075=0.05%


Example - River Cruises - All Equity Financed

- Debt replicated by investors

25%15%5% investment$10 on Return

2.501.50$.50investment on earningsNet

1.001.00$1.0010% @Interest :LESS

3.502.50$1.50shares twoon Earnings

BoomExpectedSlump




Example - River Cruises – Firm debt at 50%

- Investor can unwrap debt

17.5%12.5%7.5% investment$10 on Return

3.502.50$1.50investmenton earningsNet

1.001.00$1.0010% @Interest :PLUS

2.501.50$0.50share oneon Earnings

BoomExpectedSlump




MM Proposition I (No Taxes)

We can create a levered or unlevered position by adjusting the trading in our own account.

Capital structure is irrelevant in determining the value of the firm:

VL = VU


MM Propositions I & II (With Taxes)

Proposition I (with Corporate Taxes)Firm value increases with leverage

VL = VU + TC DProposition II (with Corporate Taxes)

Some of the increase in equity risk and return is offset by the interest tax shield;


Operating Risk (business risk):The riskiness inherent in the firm’s operations if it

uses no debt;A firm has little business risk if the demand for its

product is stable, if the prices of its inputs and products remain constant;

The lower a firm’s business risk, the higher its optimal debt ratio;

C.S. & Corporate Taxes


Financial Risk: Risk to shareholders resulting from the use of debt;Financial Leverage - Increase in the variability of

shareholder returns that comes from the use of debt.It is the extent to which fixed-income securities

(debt and preferred stock) are used in a firm’s capital structure;



The dollar interest is

Interest rate x Amount borrowedThe reduction in corporate taxes is

corporate tax rate x dollar amount of interest Interest Tax Shield- Tax savings resulting from

deductibility of interest payments.The present value of the tax shield is

PV of tax shield = annual tax shield/ rdebt

= Tc x (rdebt x D)/rdebt

= Tc D



Cost of Capital

)( debtassetsassetsequity rrE

Drr

ED

Er

ED

DrTWACC c equitydebt)1(


M&M Proposition II

The cost of equity depends on three things” The required rate of return on the firm’s

assets;The firm’s cost of debt;The firm’s debt/equity ratio, D/E


r

DV

rD

rE

MM’s Proposition II (w/fixed interest rate)

rA


What is what?

As the firm raises its debt/equity ratio, the increase in leverage raises the risk of the equity and the required return or cost of equity;


Includes Bankruptcy Risk

r

DV

rD

rE

MM’s Proposition II (w/risky debt)

rA

Risk free debt

Risky debt


r

DV

rD

rE

WACC

Weighted Average Cost of Capital

WACC with no bankruptcy risk


Example - You own all the equity of Space Babies Diaper Co. The company has no debt. The company’s annual cash flow is $10,000, before interest and taxes. The corporate tax rate is 35%. You have the option to exchange part of your equity position for 6% bonds with a face value of $50,000.

Should you do this and why?



C.S. & Corporate TaxesExample - You own all the equity of Space Babies Diaper Co. The company

has no debt. The company’s annual cash flow is $10,000, before interest and taxes. The corporate tax rate is 35%. You have the option to exchange part of your equity position for 6% bonds with a face value of $50,000.


4,5506,500FlowCash Net

2,4503,50035% @ Taxes

7,00010,000IncomePretax

3,0000PmtInterest

10,00010,000EBIT

Debt 1/2Equity All



Total Cash Flow

All Equity = 6,500

*1/2 Debt = 7,550*1/2 Debt = 7,550

(4,550 + 3,000)

Example - You own all the equity of Space Babies Diaper Co. The company has no debt. The company’s annual cash flow is $10,000, before interest and taxes. The corporate tax rate is 35%. You have the option to exchange part of your equity position for 6% bonds with a face value of $50,000.


4,5506,500FlowCash Net

2,4503,50035% @ Taxes

7,00010,000IncomePretax

3,0000PmtInterest

10,00010,000EBIT

Debt 1/2Equity All


Capital Structure

PV of Tax Shield = (assume perpetuity)

D x rD x Tc

rD

= D x Tc

Example:

Tax benefit = 10,000 x (.06) x (.35) = $210

PV of 210 perpetuity = 210 / .06 = $3,500

PV Tax Shield = D x Tc = 10,000 x .35 = $3,500


Total Cash Flow to Investors

The levered firm pays less in taxes than does the all-equity firm.

Thus, the sum of the debt plus the equity of the levered firm is greater than the equity of the unlevered firm.

This is how cutting the pie differently can make the pie “larger.” -the government takes a smaller slice of the pie!

S G S G

B

All-equity firm Levered firm


The levered firm pays less in taxes than does the all-equity firm.

Thus, the sum of the debt plus the equity of the levered firm is greater than the equity of the unlevered firm.

This is how cutting the pie differently can make the pie “larger.” -the government takes a smaller slice of the pie!


Financial Distress

Costs of Financial Distress - Costs arising from bankruptcy or distorted business decisions before bankruptcy.

Market Value = Value if all Equity Financed

+ PV Tax Shield

- PV Costs of Financial Distress


Financial Distress

Debt

Mar

ket V

alue

of

The

Fir

m

Value ofunlevered

firm

PV of interesttax shields

Costs offinancial distress

Value of levered firm

Optimal amount of debt

Maximum value of firm


Risk and Cost of Debt

As debt increases, the probability of financial distress, or even bankruptcy, goes up;

With higher bankruptcy risk, debtholders will insist on a higher promised return;

This increases the pre-tax cost of debt, rd;


Optimal Capital Structure

Managers should choose the capital structure that maximizes shareholders’ wealth;

This can be done by through a trial capital structure;

It is based on the market values of the debt and equity, and then estimate the wealth of the shareholders under this capital structure;

This approach is repeated until an optimal capital structure is found;


Five steps for the analysis of each capital structure Estimate the interest rate the firm will pay;Estimate the cost of equity;Estimate the weighted average cost of

capital;Estimate the free cash flows and their

present value (the value of the firm);Deduct the value of the debt to find the

shareholders wealth which you want to maximize;


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.


Financial Slack

Financial slack - ready access to cash from the sale of assets or debt financing;

It provides flexibility and is valuable to the financial manager.

Excessive financial slack encourages excessive expenditure, limited dividends, and low NPV investments.


Financial Slack

Use of debt and the accompanying interest and principal payments require use of cash to service debt, thus reducing excessive cash.

The optimal level of financial slack is just enough cash to satisfy liquidity needs and to finance all positive NPV investments.


Summary: No Taxes

In a world of no taxes, the value of the firm is unaffected by capital structure.

This is M&M Proposition I:

VL = VU

Proposition I holds because shareholders can achieve any pattern of payouts they desire with homemade leverage.

In a world of no taxes, M&M Proposition II states that leverage increases the risk and return to stockholders.

)( 00 BL

S RRS

BRR


Summary: Taxes

In a world of taxes, but no bankruptcy costs, the value of the firm increases with leverage.

This is M&M Proposition I:VL = VU + TC B

Proposition I holds because shareholders can achieve any pattern of payouts they desire with homemade leverage.

In a world of taxes, M&M Proposition II states that leverage increases the risk and return to stockholders.


Let’s try…

Thompson & Thomson is an all equity firm that has 500,000 shares of stock outstanding. The company is in the process of borrowing $8 million at 9% interest to repurchase 200,000 shares of the outstanding stock.

What is the value of this firm if you ignore taxes?


Calculations

Price per share = $8m 200k = $40; [(500,000 200,000) $40] + $8m = 500,000 $40 = $20m;

Value of the firm is $20m


Another one

Your firm has a $250,000 bond issue outstanding.

These bonds have a 7% coupon, pay interest semiannually, and have a current market price equal to 103% of face value.

What is the amount of the annual interest tax shield given a tax rate of 35%?


Solution

Annual interest tax shield == $250,000 .07 .35 = $6,125


The last one

Juanita’s Steak House has $12,000 of debt outstanding that is selling at par and has a coupon rate of 8%.

The tax rate is 34%. What is the present value of the tax shield?


See how it is simple

Present value of the tax shield = =0.34 $12,000 = $4,080


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Financial Management Lesson 10 Capital Structure Theory Lecture 11 Chapter 15