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- 1. Copyright © 2009 Pearson Prentice Hall. All rights reserved. Chapter 15 Capital Structure
- 2. 15- Chapter Outline 15.1 Capital Structure Choices 15.2 Capital Structure in Perfect Capital Markets 15.3 Debt and Taxes 15.4 Costs of Bankruptcy and Financial Distress 15.5 Optimal Capital Structure: The Tradeoff Theory 15.6 Additional Consequences of Leverage: Agency Costs and Information 15.7 Capital Structure: Putting It All Together
- 3. 15- Learning Objectives • Examine how capital structures vary across industries and companies • Understand why investment decisions, rather than financing decisions, fundamentally determine the value and cost of capital of the firm • Describe how leverage increases the risk of the firm’s equity • Demonstrate how debt can affect firm value through taxes and bankruptcy costs • Show how the optimal mix of debt and equity trades off the costs (including financial distress costs) and benefits (including the tax advantage) of debt • Analyze how debt can alter the incentives of managers to choose different projects and can be used as a signal to investors • Weigh the many costs and benefits to debt that a manager must balance when deciding how to finance the firm’s investments
- 4. 15- 15.1 Capital Structure Choices • The collection of securities a firm issues to raise capital from investors is called the firm’s capital structure. • When raising funds from outside investors, a firm must choose what type of security to issue and what capital structure to have.
- 5. 15- 15.1 Capital Structure Choices • Firms consider whether the securities issued: w Will receive a fair price in the market w Have tax consequences w Entail transactions costs w Change its future investment opportunities
- 6. 15- 15.1 Capital Structure Choices • A firm’s debt-to-value ratio D / (E+D) is the fraction of the firm’s total value that corresponds to debt
- 7. Figure 15.1 Debt-to-Value Ratio [D/(E + D)] for Select Industries
- 8. 15- Figure 15.2 Capital Structures of Blockbuster and Netflix
- 9. 15- 15.2 Capital Structure in Perfect Capital Markets • A perfect capital market is a market in which: w Securities are fairly priced w No tax consequences or transactions costs w Investment cash flows are independent of financing choices
- 10. 15- 15.2 Capital Structure in Perfect Capital Markets • Unlevered equity: equity in a firm with no debt • Levered equity: equity in a firm that has debt outstanding • Leverage will increase the risk of the firm’s equity and raise its equity cost of capital
- 11. 15- 15.2 Capital Structure in Perfect Capital Markets • Modigliani and Miller (MM) concluded that with perfect capital markets the total value of a firm should not depend on its capital structure. w When the firm has no debt, the cash flows paid to equity holders correspond to the free cash flows generated by the firm’s assets. w When the firm has debt, these cash flows are divided between debt and equity holders. w With perfect capital markets, the total paid to all investors still corresponds to the free cash flows generated by the firm’s assets. w Therefore, the value of the unlevered firm, VU, must equal the total value of the levered firm, VL, which is the combined value D + E of its debt D and levered equity E .
- 12. 15- Figure 15.3 Unlevered Versus Levered Cash Flows with Perfect Capital Markets
- 13. 15- MM Proposition I • MM Proposition I: In a perfect capital market, the total value of a firm is equal to the market value of the free cash flows generated by its assets and is not affected by its choice of capital structure. w We can write this result in an equation: VL= E + D =VU (Eq. 15.1) VL= value of the firm with leverage VU= value of the unlevered firm
- 14. unlevered levered $30,000 down $15,000 down $15,000 borrowed $30,000 equity $15,000 equity $15,000 debt if interest rate is at 5% then if we pay back the loan in one year, we would payback $15,750
- 15. unlevered levered $30,000 equity $15,000 equity $15,000 debt if interest rate is at 5% then if we pay back the loan in one year, we would payback $15,750 demand cash ﬂow low $27,000 medium $34,500 high $42,000
- 16. unlevered levered $30,000 equity $15,000 equity $15,000 debt if interest rate is at 5% then if we pay back the loan in one year, we would payback $15,750 demand cash ﬂow low $27,000 medium $34,500 high $42,000 equation % returns 27,000/30,000 90% -10% 34,500/30,000 115% 15% 42,000/30,000 140% 40% equation % returns (27,000-15,750)/15,000 75% -25% (34,500-15,750)/15,000 125% 25% (42,000-15,750)/15,000 175% 75% so do u see the advantages of borrowing funds?
- 17. 15- Table 15.1 Returns to Equity in Different Scenarios with and without Leverage Assumptions for leverage: $15,000 borrowed to be paid back in one year at 5% interest, 15,000×1.05 = 15,750 = + + Free cash flows are given for the three scenarios If unlevered: $30,000 equity no debt If levered: $15,000 equity $15,000 debt + = = Equity risk premium: 10% if unlevered 20% if levered
- 18. 15- 15.2 Capital Structure in Perfect Capital Markets • Homemade leverage: when investors use leverage in their own portfolios to adjust the leverage choice made by the firm. • Homemade leverage is a perfect substitute for the use of leverage by the firm in perfect capital markets.
- 19. 15- MM Proposition II: The Cost of Capital of Levered Equity • MM Proposition II: The Cost of Capital of Levered Equity (Eq. 15.3) rE = expected return (cost of capita) of levered equity
- 20. computing the equity cost of capital Because your ﬁrm’s assets have a market value of $30,000, by MM Proposition I the equity will have a market value of $15,000 = $30,000 – $15,000.We can use Eq. 15.3 to compute the cost of equity.We know the unlevered cost of equity is ru = 15%.We also know that rD is 5%. rE .15 15000 15000 .15 .05−( )+ ?= = = .25
- 21. unlevered levered $30,000 equity $15,000 equity $15,000 debt if interest rate is at 5% then if we pay back the loan in one year, we would payback $15,750 demand cash ﬂow low $27,000 medium $34,500 high $42,000 equation % returns 27,000/30,000 90% -10% 34,500/30,000 115% 15% 42,000/30,000 140% 40% equation % returns (27,000-15,750)/15,000 75% -25% (34,500-15,750)/15,000 125% 25% (42,000-15,750)/15,000 175% 75% so do u see the advantages of borrowing funds?
- 22. 15- 15.3 Debt and Taxes • In the real world, markets are imperfect, and these imperfections can create a role for the firm’s capital structure. A firm’s capital structure can affect the corporate taxes it must pay. w Corporations can deduct interest expenses from their taxable income. w The deduction reduces the taxes paid which increases the amount available to pay investors. w In doing so, the interest tax deduction increases the value of the corporation.
- 23. 15- 15.3 Debt and Taxes • Consider the impact of interest expenses on taxes paid by Safeway, Inc., a grocery store chain. • In 2006, Safeway had earnings before interest and taxes of $1.65 billion, and interest expenses of $400 million. Given a corporate tax rate of 35%, we can compare Safeway’s actual net income with what it would have been without debt.
- 24. 15- Table 15.2 Safeway’s Income with and without Leverage, 2006 ($ million)
- 25. 15- 15.3 Debt and Taxes • Interest Tax Shield: The gain to investors from the tax deductibility of interest payments Interest Tax Shield = Corporate Tax Rate × Interest Payments
- 26. 15- Example 15.3 Computing the Interest Tax Shield Problem: • Shown on the next slide is the income statement for D.F. Builders (DFB). Given its marginal corporate tax rate of 35%, what is the amount of the interest tax shield for DFB in years 2005 through 2008?
- 27. 15- Example 15.3 Computing the Interest Tax Shield
- 28. 15- Example 15.3 Computing the Interest Tax Shield Solution: Plan: • From Eq. 15.4, the interest tax shield is the tax rate of 35% multiplied by the interest payments in each year.
- 29. 15- Example 15.3 Computing the Interest Tax Shield Execute:
- 30. 15- Example 15.3 Computing the Interest Tax Shield Evaluate: • By using debt, DFB is able to reduce its taxable income and therefore decreased its total tax payments by $115.5 million over the four-year period. Thus the total amount of cash flows available to all investors (debtholders and equity holders) is $115.5 million higher over the four- year period.
- 31. 15- Example 15.3a Computing the Interest Tax Shield Problem: • Shown on the next slide is the income statement for Invite Only, an invitation/card company. Given its marginal corporate tax rate of 40%, what is the amount of the interest tax shield for Invite Only in years 2006 through 2008?
- 32. 15- Example 15.3a Computing the Interest Tax Shield Invite Only Income Statement ($ million) 2006 2007 2008 Total sales $4,750 $5,350 $6,177 Cost of sales –2,543 –2,428 –3,114 Selling, general, and administrative expense –446 –399 –470 Depreciation –32 –29 –35 Operating Income 1,729 2,494 2,558 Other income 14 12 16 EBIT 1,743 2,506 2,574 Interest expense –100 –110 –115 Income before tax 1,643 2,396 2,459 Taxes (40%) –657 –958 –984 Net income $986 $1,438 $1,475
- 33. 15- Example 15.3a Computing the Interest Tax Shield Solution: Plan: • From Eq. 15.4, the interest tax shield is the tax rate of 40% multiplied by the interest payments in each year.
- 34. 15- Example 15.3a Computing the Interest Tax Shield Execute: ($ million) 2006 2007 2008 Interest expense –100 –110 –115 Interest tax shield (40% × interest expense) 40 44 46
- 35. 15- Example 15.3a Computing the Interest Tax Shield Evaluate: • By using debt, Invite Only is able to reduce its taxable income and decrease its total tax payments. Therefore, the total amount of cash flows available to all investors (debtholders and equity holders) is $130 million higher over the three-year period.
- 36. 15- 15.3 Debt and Taxes • When a firm uses debt, the interest tax shield provides a corporate tax benefit each year. To determine the benefit of leverage for the value of the firm, we must compute the present value of the stream of future interest tax shields the firm will receive.
- 37. 15- Figure 15.6 The Cash Flows of the Unlevered and Levered Firm
- 38. 15- 15.3 Debt and Taxes • The graph shows that by increasing the cash flows paid to debtholders through interest payments, a firm reduces the amount paid in taxes. • The increase in total cash flows paid to investors is the interest tax shield.
- 39. 15- Value of the Interest Tax Shield • Cash flows of the levered firm are equal to the sum of the cash flows from the unlevered firm plus the interest tax shield. By the Valuation Principle the same must be true for the present values of these cash flows. • Here’s the change to MM Proposition I with the presence of taxes: The total value of the levered firm exceeds the value of the firm without leverage due to the present value of the tax savings from debt: VL = VU + PV(Interest Tax Shield) (Eq. 15.5)

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