Capital Structure.pdf

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Capital Structure Determination Capital Structure Determination

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corporate finance

Transcript of Capital Structure.pdf

  • Capital Structure Determination

    Capital Structure Determination

  • Learning Outcome

    Define capital structure. Explain the net operating income (NOI) approach to capital

    structure and valuation of a firm; and, calculate a firm's value using this approach.

    Explain the traditional approach to capital structure and the valuation of a firm.

    Discuss the relationship between financial leverage and the cost of capital as originally set forth by Modigliani and Miller (M&M) and evaluate their arguments.

    Describe various market imperfections and other "real world" factors that tend to dilute M&Ms original position.

    Present a number of reasonable arguments for believing that an optimal capital structure exists in theory.

    Explain how financial structure changes can be used for financial signaling purposes, and give some examples.

  • Capital Structure Determination

    A Conceptual Look The Total-Value Principle Presence of Market Imperfections and

    Incentive Issues The Effect of Taxes Taxes and Market Imperfections Combined Financial Signaling Timing and Flexibility Financing Checklist

  • Capital Structure

    Concerned with the effect of capital market decisions on security prices.

    Assume: (1) investment and asset management decisions are held constant and (2) consider only debt-versus-equity financing.

    Capital Structure -- The mix (or proportion) of a firms permanent long-term financing

    represented by debt, preferred stock, and common stock equity.

  • A Conceptual Look --Relevant Rates of Return

    ki = the yield on the companys debtAnnual interest on debt

    Market value of debtIB ==ki

    Assumptions: Interest paid each and every year Bond life is infinite Results in the valuation of a perpetual bond No taxes (Note: allows us to focus on just

    capital structure issues.)

  • ES

    A Conceptual Look --Relevant Rates of Return

    ==

    ke = the expected return on the companys equityEarnings available to

    common shareholdersMarket value of common

    stock outstandingke

    Assumptions: Earnings are not expected to grow 100% dividend payout Results in the valuation of a perpetuity Appropriate in this case for illustrating the

    theory of the firm

    ES

  • OV

    A Conceptual Look --Relevant Rates of Return

    ==

    ko = an overall capitalization rate for the firm

    Net operating incomeTotal market value of the firmko

    Assumptions: V = B + S = total market value of the firm O = I + E = net operating income = interest

    paid plus earnings available to common shareholders

    OV

  • Capitalization RateCapitalization Rate, ko -- The discount rate used to determine the present value of a

    stream of expected cash flows.

    ko kekiB

    B + SS

    B + S= +

    What happens to ki, ke, and kowhen leverage, B/S, increases?

  • Net Operating Income Approach

    Assume: Net operating income equals Rs.1,350 Market value of debt is Rs.1,800 at 10%

    interest Overall capitalization rate is 15%

    Net Operating Income Approach -- A theory of capital structure in which the weighted average

    cost of capital and the total value of the firm remain constant as financial leverage is changed.

  • Required Rate of Return on Equity

    Total firm value= O / ko = Rs.1,350 / .15= Rs.9,000

    Market value = V - B = Rs.9,000 -Rs.1,800 of equity = Rs.7,200

    Required return = E / Son equity* = (Rs.1,350 - Rs.180) /

    Rs.7,200 = 16.25%

    Calculating the required rate of return on equity

    * B / S = Rs.1,800 / Rs.7,200 = .25

    Interest payments= Rs.1,800 x 10%

  • Total firm value= O / ko = Rs.1,350 / .15= Rs.9,000

    Market value = V - B = Rs.9,000 -Rs.3,000 of equity = Rs.6,000

    Required return = E / Son equity* = (Rs.1,350 - Rs.300) /

    Rs.6,000 = 17.50%

    Required Rate of Return on Equity

    What is the rate of return on equity if B=Rs.3,000?

    * B / S = Rs.3,000 / Rs.6,000 = .50

    Interest payments= Rs.3,000 x 10%

  • B / S ki ke ko 0.00 --- 15.00% 15%0.25 10% 16.25% 15%0.50 10% 17.50% 15%1.00 10% 20.00% 15%2.00 10% 25.00% 15%

    Required Rate of Return on Equity

    Examine a variety of different debt-to-equity ratios and the resulting required rate of

    return on equity.

    Calculated in slides 9 and 10

  • Required Rate of Return on Equity

    Capital costs and the NOI approach in a graphical representation.

    0 .25 .50 .75 1.0 1.25 1.50 1.75 2.0Financial Leverage (B / S)

    .25

    .20

    .15

    .10

    .05

    0

    Capi

    tal C

    ost

    s (%

    )

    ke = 16.25% and17.5% respectively

    ki (Yield on debt)ko (Capitalization rate)

    ke (Required return on equity)

  • Summary of NOI ApproachCritical assumption is ko remains constant.An increase in cheaper debt funds is

    exactly offset by an increase in the required rate of return on equity.

    As long as ki is constant, ke is a linear function of the debt-to-equity ratio.

    Thus, there is no one optimal capital structure.

  • Traditional Approach

    Optimal Capital Structure -- The capital structure that minimizes the firms cost of capital and thereby maximizes the value of the firm.

    Traditional Approach -- A theory of capital structure in which there exists an optimal capital structure and where management can increase the total value of the firm through the judicious

    use of financial leverage.

  • Optimal Capital Structure: Traditional Approach

    Traditional Approach

    Financial Leverage (B / S)

    .25

    .20

    .15

    .10

    .05

    0

    Capi

    tal C

    ost

    s (%

    )

    ki

    ko

    ke

    Optimal Capital Structure

  • Summary of the Traditional Approach

    The cost of capital is dependent on the capital structure of the firm. Initially, low-cost debt is not rising and replaces

    more expensive equity financing and ko declines. Then, increasing financial leverage and the

    associated increase in ke and ki more than offsets the benefits of lower cost debt financing.

    Thus, there is one optimal capital structurewhere ko is at its lowest point.

    This is also the point where the firms total value will be the largest (discounting at ko).

  • Total Value Principle: Modigliani and Miller (M&M)

    Advocate that the relationship between financial leverage and the cost of capital is explained by the NOI approach.

    Provide behavioral justification for a constant ko over the entire range of financial leverage possibilities.

    Total risk for all security holders of the firm is not altered by the capital structure.

    Therefore, the total value of the firm is not altered by the firms financing mix.

  • Market value of debt (Rs.65M)

    Market valueof equity (Rs.35M)

    Total firm marketvalue (Rs.100M)

    Total Value Principle: Modigliani and Miller

    M&M assume an absence of taxes and market imperfections.

    Investors can substitute personal for corporate financial leverage.

    Market value of debt (Rs.35M)

    Market valueof equity (Rs.65M)

    Total firm marketvalue (Rs.100M)

    Total market value is not altered by the capital structure (the total size of the pies are the same).

  • 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.

  • Arbitrage ExampleConsider two firms that are identical

    in every respect EXCEPT: Company NL -- no financial leverage Company L -- Rs.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 Rs.10,000

  • Earnings available to = E = O I common shareholders = Rs.10,000 - Rs.0

    = Rs.10,000Market value = E / ke

    of equity = Rs.10,000 / .15 = Rs.66,667

    Total market value = Rs.66,667 + Rs.0= Rs.66,667

    Overall capitalization rate = 15%Debt-to-equity ratio = 0

    Arbitrage Example: Company NL

    Valuation of Company NL

  • Arbitrage Example: Company L

    Earnings available to = Ecommon shareholders = Rs.10,000 - Rs.3,600

    = Rs.6,400Market value = E / ke

    of equity = Rs.6,400 / .16 = Rs.40,000

    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

  • Completing an Arbitrage Transaction

    Assume 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).

  • Completing an Arbitrage Transaction

    Original return on investment in Company LRs.400 x 16% = Rs.64

    Return on investment after the transactionRs.666.67 x 16% = Rs.100 return on Company NLRs.300 x 12% = Rs.36 interest paidRs.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.

  • Summary of the Arbitrage Transaction

    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.

    The investor uses personal rather than corporate financial leverage.

  • Market Imperfections and Incentive Issues

    Agency costs (Slide 29)Debt and the incentive to

    manage efficientlyInstitutional restrictionsTransaction costs

    Bankruptcy costs (Slide 28)

  • Required Rate of Return on Equity with Bankruptcy

    Financial Leverage (B / S)

    RfReq

    uire

    d R

    ate

    of R

    etu

    rno

    n Eq

    uity

    (k e

    ) ke with no leverage

    ke without bankruptcy costs

    ke with bankruptcy costs

    Premiumfor financial

    risk

    Premiumfor business

    risk

    Risk-freerate

  • Agency Costs

    Monitoring includes bonding of agents, auditing financial statements, and explicitly restricting management decisions or actions.

    Costs are borne by shareholders (Jensen & Meckling). Monitoring costs, like bankruptcy costs, tend to rise at

    an increasing rate with financial leverage.

    Agency Costs -- Costs associated with monitoring management to ensure that it behaves

    in ways consistent with the firms contractual agreements with creditors and shareholders.

  • Example of the Effects of Corporate Taxes

    Consider two identical firms EXCEPT:

    Company ND -- no debt, 16% required return

    Company D -- Rs.5,000 of 12% debt Corporate tax rate is 40% for each company NOI for each firm is Rs.10,000

    The judicious use of financial leverage (i.e., debt) provides a favorable impact

    on a companys total valuation.

  • Earnings available to = E = O - Icommon shareholders = Rs.2,000 - Rs.0

    = Rs.2,000Tax Rate (T) = 40%Income available to = EACS (1 - T)

    common shareholders = Rs.2,000 (1 - .4) = Rs.1,200

    Total income available to = EAT + Iall security holders = Rs.1,200 + 0

    = Rs.1,200

    Corporate Tax Example: Company ND

    Valuation of Company ND (Note: has no debt)

  • Earnings available to = E = O - Icommon shareholders = Rs.2,000 - Rs.600

    = Rs.1,400Tax Rate (T) = 40%Income available to = EACS (1 - T)

    common shareholders = Rs.1,400 (1 - .4) = Rs.840

    Total income available to = EAT + Iall security holders = Rs.840 + Rs.600

    = Rs.1,440*

    Corporate Tax Example: Company D

    Valuation of Company D (Note: has some debt)

    * Rs.240 annual tax-shield benefit of debt (i.e., Rs.1,440 - Rs.1,200)

  • Tax-Shield BenefitsTax Shield -- A tax-deductible expense. The

    expense protects (shields) an equivalent rupee amount of revenue from being taxed by reducing

    taxable income.

    Present value oftax-shield benefits

    of debt*=

    (r) (B) (tc)r

    = (B) (tc)

    * Permanent debt, so treated as a perpetuity** Alternatively, Rs.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**

  • 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 payout

  • Summary of Corporate Tax Effects

    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.

    The greater the amount of debt, the greater the tax-shield benefits and the greater the value of the firm.

  • Other Tax Issues

    Corporate plus personal taxesPersonal taxes reduce the corporate tax advantage associated with debt.Only a small portion of the explanation why corporate debt usage is not near 100%.

    Uncertainty of tax-shield benefitsUncertainty increases the possibility of bankruptcy and liquidation, which reduces the value of the tax shield.

  • Bankruptcy Costs, Agency Costs, and Taxes

    As financial leverage increases, tax-shield benefits increase as do bankruptcy and agency costs.

    Value of levered firm= Value of firm if unlevered + Present value of tax-shield benefits

    of debt - Present value of bankruptcy and

    agency costs

  • Bankruptcy Costs, Agency Costs, and Taxes

    Optimal Financial Leverage

    Taxes, bankruptcy, andagency costs combined

    Net tax effect

    Financial Leverage (B/S)

    Cost

    o

    f Cap

    ital (%

    )

    Minimum Costof Capital Point

  • Financial Signaling

    Informational Asymmetry is based on the idea that insiders (managers) know something about the firm that outsiders (security holders) do not.

    Changing the capital structure to include more debt conveys that the firms stock price is undervalued.

    This is a valid signal because of the possibility of bankruptcy.

    A manager may use capital structure changes to convey information about the profitability and risk of the firm.

  • Timing and Flexibility

    2. Flexibility A decision today impacts the options open to the firm for

    future financing options thereby reducing flexibility. Often referred to as unused debt capacity.

    1. Timing After appropriate capital structure determined it is still

    difficult to decide when to issue debt or equity and in what order.

    Factors considered include the current and expected health of the firm and market conditions.

  • Checklist of Practical and Conceptual Considerations

    1. Taxes2. Explicit cost3. Cash-flow ability to

    service debt4. Agency costs and

    incentive issues5. Financial signaling

    6. EBIT-EPS analysis

    7. Capital structure ratios

    8. Security rating9. Timing10. Flexibility