FINANCIAL MANAGEMENT CHAPTER 12

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FINANCIAL MANAGEMENT CHAPTER 12

  1. 1. Chapter 12: Capital Structure Theory and Taxes Financial Management, 3e Megginson, Smart, and Graham © 2010 South-Western/Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.
  2. 2. Capital Structure The term capital structure refers to the mix of debt and equity securities that a firm uses to finance its activities. © 2010 South-Western/Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. 2
  3. 3. Table 12.1 2009 Long-Term Debt-to-Assets Ratios © 2010 South-Western/Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. 3
  4. 4. Financial Leverage  The fundamental principle of financial leverage: Substituting debt for equity increases expected returns to shareholders— measured by earnings per share or ROE—but also increases the risk of those returns. © 2010 South-Western/Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. 4
  5. 5. Financial Leverage  When firms borrow money, we say that they use financial leverage. firm with debt on its balance sheet is a levered firm.  A firm that finances its operations entirely with equity is an unlevered firm.  In Britain, they refer to debt as gearing.  These terms imply that debt magnifies a firm’s financial performance in some way. A  That effect can be either positive or negative, depending on the returns a firm earns on the money it borrows. © 2010 South-Western/Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. 5
  6. 6. Table 12.2 Current & Proposed Capital Structures for High-Tech Mfg. Corp. © 2010 South-Western/Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. 6
  7. 7. Table 12.3 Expected Cash Flows… Three Equally Likely Outcomes © 2010 South-Western/Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. 7
  8. 8. Figure 12.1 The Effect of Leverage on the Sensitivity of EPS to Changes in Cash Flow © 2010 South-Western/Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. 8
  9. 9. What Companies Do Globally CFO Survey: The Importance of Capital Structure Decisions © 2010 South-Western/Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. 9
  10. 10. The Modigliani & Miller Propositions  Modigliani and Miller (M&M) argument: Capital structure decisions do not affect firm value.  Managers who operate in imperfect markets can see more clearly how market imperfections might lead them to choose one capital structure over another.  M&M’s argument rests on the principle of no arbitrage. © 2010 South-Western/Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. 10
  11. 11. The M&M Capital Structure Model First model to show that capital structure decision may be irrelevant Assumes perfect markets, no taxes or transactions costs Firm value is determined by: Key insight Cash flows generated Underlying business risk Capital structure merely determines how cash flows and risks are allocated between bondholders and stockholders. © 2010 South-Western/Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. 11
  12. 12. Assumptions of the M&M Capital Structure Model markets are perfect – neither firms nor investors pay taxes or transactions costs.  Capital  Investors can borrow and lend at the same rate that corporations can.  There are no information asymmetries. © 2010 South-Western/Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. 12
  13. 13. M&M Proposition I  In perfect markets, a firm’s total market value equals the value of its assets and is independent of the firm’s capital structure.  The value of the assets equals the present value of the cash flows generated by the assets. © 2010 South-Western/Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. 13
  14. 14. M&M Proposition I  Because the proposition leads to the conclusion that the firm’s capital structure does not matter, it is popularly known as the “irrelevance proposition .”  The firm’s market value equals the present value of the cash flows it generates regardless of the capital structure it chooses. © 2010 South-Western/Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. 14
  15. 15. M&M Proposition I Use arbitrage arguments to prove Proposition I. Proposition I: Market value of a firm is driven by two factors: cash flow and risk (determines the discount rate). Firms U and L belong to same risk class and have same expected EBIT $2,000,000 per year in perpetuity. Firm U has no debt. Firm L has both debt and equity. Required return (r) for firms of this risk class is 10%. Under Proposition I, market value of Firms U and L should be identical. © 2010 South-Western/Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. 15
  16. 16. Table 12.4 UnleverCo and LeverCo When Proposition I Holds © 2010 South-Western/Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.
  17. 17. Table 12.5 Disequilibrium Values for UnleverCo and LeverCo If LeverCo’s Required Return is 12.5% © 2010 South-Western/Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.
  18. 18. Additional Example: M&M Proposition I Market value of assets should be $20,000,000 $2,000,000 10% $2,000,000 10% Firm U Earnings before interest (no taxes) Required return on assets Market value of assets Debt Firm L $2,000,000 $2,000,000 10% 10% $20,000,000 $20,000,000 $0 $10,000,000 Interest rate on debt 6% Interest expense Shares outstanding Price per share Market value of equity $600,000 1,000,000 500,000 $20 $20 $20,000,000 $10,000,000 Market value of Firm U = 1,000,000 × $20 = $20,000,000 Market value of Firm L = 500,000 × $20 + $10,000,000 = $20,000,000 © 2010 South-Western/Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. 18
  19. 19. M&M Proposition I What is the return the shareholders of the two firms expect on their shares? Firm U has no debt. Required return on equity equals required return on assets of 10% Required return on equity = 10% Firm L pays $600,000 interest. EBIT is $2,000,000. Shareholders receive a cash dividend of $1,400,000, or $2.80/share. Share price = $20. Required return on equity = $2.80/$20 = 14% © 2010 South-Western/Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. 19
  20. 20. M&M Proposition I What if the shares of the levered firm are selling at premium? Firm L Stock price Total firm value Debt value $25 $20 $22,500,000 $20,000,000 $10,000,000 Shares outstanding 500,000 Dividend per share $2.80 0.112 0.14 Required return on equity Assume the stock price of Firm L is $25. Total firm value increases to $22,500,000. The price of $25 per share implies a return of $2.80/$20 = 0.112. Firm L stockholders can use “homemade leverage” to generate arbitrage profit. © 2010 South-Western/Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. 20
  21. 21. M&M Proposition I Assume investor owns 5,000 shares of Firm L. • • • The investor owns 1% of Firm L. He earns $2.80 per share in dividends. The shares will generate $14,000 each year. The investor could earn an arbitrage profit from the following: Sell 5,000 of Firm L at $25/share • Proceeds of $125,000 Borrow an amount equal to 1% of Firm L debt • $100,000 at 6% interest Buy 1% of Firm U equity • 10,000 shares at $20 per share 21 © 2010 South-Western/Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.
  22. 22. M&M Proposition I Trades Proceeds from stock sale $125,000 Proceeds from borrowing $100,000 Total proceeds $225,000 Cost of Firm U shares -$200,000 Net proceeds $25,000 • The net return on the new portfolio • • Using homemade leverage, investor has built a portfolio of $200,000 of Firm U's stock and $100,000 in personal debt. Investor has $25,000 remaining. $2 dividend per share of Firm U, or $20,000 for 10,000 shares $6,000 interest expense on borrowed money $14,000 cash inflow next year on the new portfolio The same return expected on the original 1% stake in Firm L's shares! The cost of building this portfolio is just $200,000, which is $25,000 less than the cost of 5,000 Firm L shares. © 2010 South-Western/Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. 22
  23. 23. Proposition II and the WACC  Though debt is less costly for firms to issue than equity, issuing debt causes the required return on the remaining equity to rise.  Based on the core finance principle that investors expect compensation for risk, shareholders of levered firms demand higher returns than do shareholders in all-equity companies. © 2010 South-Western/Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. 23
  24. 24. Proposition II and the WACC  Proposition II says that the expected return on a levered firm’s equity (rl) rises with the debt-to-equity ratio:  Proposition II rearranged is the WACC: © 2010 South-Western/Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. 24
  25. 25. Figure 12.2 M&M Proposition II – The Case of Perfect Capital Markets © 2010 South-Western/Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. 25
  26. 26. The M&M Model with Corporate Taxes  Firms can treat interest payments to lenders as a tax-deductible business expense.  Dividend payments to shareholders receive no similar tax advantage.  Intuitively, this should lead to a tax advantage for debt, meaning that managers can increase firm value by issuing debt. © 2010 South-Western/Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. 26
  27. 27. Table 12.6 Income Statements for UnleverCo and Leverco with Corporate Income Taxes © 2010 South-Western/Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. 27
  28. 28. Determining the Values of UnleverCo and LeverCo © 2010 South-Western/Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. 28
  29. 29. Figure 12.3 Impact of Taxes on Firm Value © 2010 South-Western/Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. 29
  30. 30. Figure 12.3 Impact of Taxes on Firm Value © 2010 South-Western/Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. 30
  31. 31. Example: Corporate Tax Rate and Corporate Value © 2010 South-Western/Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. 31
  32. 32. The M&M Model with Corporate and Personal Taxes  Miller: Debt’s tax advantage over equity at the corporate level might be partially or fully offset by a tax disadvantage at the individual level. © 2010 South-Western/Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. 32
  33. 33. Example: All-Debt Capital Structure and Personal Taxes © 2010 South-Western/Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. 33
  34. 34. What Companies Do Globally: Tax Factors in Emerging Markets © 2010 South-Western/Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. 34
  35. 35. What Companies Do Globally: Net Gain from Leverage in Emerging Markets © 2010 South-Western/Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. 35
  36. 36. Bond Market Equilibrium with Corporate and Personal Taxes  Wouldn’t taxable investors also demand a higher interest rate to compensate them for taxes due?  Yes, but Miller explains that interest rates do not rise immediately for two reasons: 1. 2. Some investors, such as endowments and pension funds, do not have to pay taxes on interest income. Investors who do not enjoy this tax-exempt status can buy municipal bonds, which pay interest that is tax free. © 2010 South-Western/Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. 36
  37. 37. Nondebt Tax Shields (NDTS)  Companies with large amounts of depreciation, investment tax credits, R&D expenditures, and other nondebt tax shields should employ less debt financing than otherwise equivalent companies with fewer such shields. © 2010 South-Western/Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. 37
  38. 38. Figure 12.4 The Effect of Leverage on Firm Value with and without Taxes © 2010 South-Western/Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.
  39. 39. How Taxes Should Affect Capital Structure 1. The higher the corporate income tax rate, Tc, the higher will be the equilibrium leverage level economy-wide. An increase in Tc should cause debt ratios to increase for most firms. 2. The higher the personal tax rate on equityrelated investment income (dividends and capital gains), Tps, the higher will be the equilibrium leverage level. An increase in Tps should cause debt ratios to increase. © 2010 South-Western/Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. 39
  40. 40. How Taxes Should Affect Capital Structure 3. The higher the personal tax rate on interest income, Tpd, the lower will be the equilibrium leverage level. An increase in Tpd should cause debt ratios to fall. 4. The more nondebt tax shields a company has, the lower will be the equilibrium leverage level. © 2010 South-Western/Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. 40

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