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.
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
Capital Structure -- The mix (or proportion) of a firms permanent long-term financing represented by debt, preferred stock, and common stock equity.
Concerned
with the effect of capital market decisions on security prices. (1) investment and asset management decisions are held constant and (2) consider only debt-versus-equity financing.
Assume:
ki
I B
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.)
ko
Assumptions: V = B + S = total market value of the firm O = I + E = net operating income = interest paid plus earnings available to common shareholders
Capitalization Rate
Capitalization Rate, ko -- The discount rate used to determine the present value of a stream of expected cash flows.
k o = ki
B B+S
ke
S B+S
Market
Overall
.25
.50
1.75
2.0
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
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 -- The capital structure that minimizes the firms cost of capital and thereby maximizes the value of the firm.
Financial Leverage (B / S)
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 structure where ko is at its lowest point. This is also the point where the firms total value will be the largest (discounting at ko).
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.
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.
Arbitrage Example
Consider 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
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.
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.
Institutional Transaction
ke with no leverage
ke without bankruptcy costs
Premium for financial risk Premium for business risk Risk-free rate
Rf
Financial Leverage (B / S)
Agency Costs
Agency Costs -- Costs associated with monitoring management to ensure that it behaves in ways consistent with the firms contractual agreements with creditors and shareholders.
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.
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
Tax-Shield Benefits
Tax Shield -- A tax-deductible expense. The expense protects (shields) an equivalent rupee amount of revenue from being taxed by reducing taxable income.
Present value of tax-shield benefits of debt* = = (r) (B) (tc) r (Rs.5,000) (.4) = = (B) (tc) Rs.2,000**
* 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.
Value of unlevered firm (Company ND) Value of levered firm Rs.2,000 (Company D) Rs.9,500
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.
of tax-shield benefits
Uncertainty increases the possibility of bankruptcy and liquidation, which reduces the value of the tax shield.
Corporate
Personal taxes reduce the corporate tax advantage associated with debt. Only a small portion of the explanation why corporate debt usage is not near 100%.
Financial Signaling
A manager may use capital structure changes to convey information about the profitability and risk of the firm. 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.
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.
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.
Taxes Explicit cost Cash-flow ability to service debt Agency costs and incentive issues Financial signaling
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