capital structure and term structure theories

1. Presentation on
capital structure and term
structure theories
Prepared By
Mabruka Mohamed

2. Outline
 Capital structure :concepts
 Net income approach and traditional theories
 Net operating income approach and
Modigliani and Miller propositions
 Trade-off, agency cost ,and peking- order
theories
 Term structure theories
2

3. The Balance-Sheet Model of the
Firm
How can the firm
raise the money
for the required
investments?
The Capital Structure Decision
Current
Assets
Fixed Assets
1 Tangible
2 Intangible
Shareholders’
Equity
Current
Liabilities
Long-Term
Debt

4. Capital structure criteria
What is the optimal capital structure?
 Structure that minimizes overall cost of
financing (WACC)
 Structure that maximizes value of firm.

5. 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

6. Financial leverage
Financial leverage is the degree to which a company uses fixed-
income securities such as debt . The more debt financing a
company uses, the higher its financial leverage.
 Measurement
• Debt financial ratio
 D/ (D + E)
• Long term debt to capitalization
 LTD/(LTD+E)
 (Note: market(not book)values of debt and equity correctly
determine capital structure)

7. Financial Leverage, EPS, and ROE
Current
Assets $20,000
Debt $0
Equity $20,000
Debt/Equity ratio 0.00
Interest rate n/a
Shares outstanding 400
Share price $50
Proposed
$20,000
$8,000
$12,000
2/3
8%
240
$50
Firm A is unlevered firm currently has no debt . The firm
decided to borrow $8,000 by buy back 160 shares at $50
per share.

8. Levered
Recession Expected Expansion
EBIT $1,000 $2,000 $3,000
Interest 640 640 640
Net income $360 $1,360 $2,360
EPS $1.50 $5.67 $9.83
ROA 1.8% 6.8% 11.8%
ROE 3% 11% 20%
Proposed Shares Outstanding = 240 shares
EPS and ROE Under Both Capital Structures
All-Equity
Recession Expected Expansion
EBIT $1,000 $2,000 $3,000
Interest 0 0 0
Net income $1,000 $2,000 $3,000
EPS $2.50 $5.00 $7.50
ROA 5% 10% 15%
ROE 5% 10% 15%
Current Shares Outstanding = 400

9. Financial Leverage and EPS
(2.00)
0.00
2.00
4.00
6.00
8.00
10.00
12.00
1,000 2,000 3,000
EPS
Debt
No Debt
Break-even
point
EBIT in dollars, no taxes
Advantage
to debt
Disadvantage
to debt

10. Advantage and Disadvantages of Debt
Advantages of Debt Disadvantages of Debt
Interest is tax deductible Higher debt ratios lead to greater risk and
higher required interest rates (to
compensate for the additional risk(
Debt-holders are limited to a fixed return
Debt holders do not have voting rights

11. Capital structure theories
there exist conflicting theories on the relationship between capital
structure and the value of a firm.
RELEVANCE OF CAPITAL
STRUCTURE
IRRELEVANCE OF CAPITAL
STRUCTURE
The Net Income approach Net operating income approach
The traditional views M&M Proposition with out tax
M&M Proposition 2with tax
Trade –off ,pecking order and agency cost
theories

12. ASSUMPTIONS OF TRADITIONAL CAPITAL
STRUCTURE THEORIES
 Firms employ only two types of capital: debt and equity.
 The total assets of the firm are given. The degree of leverage can be changed by
selling debt to repurchase shares or selling shares to retire debt.
 Investors have the same subjective probability distributions of expected future
operating earnings for a given firm.
 The firm has a policy of paying 100 per cent dividends.
 The operating earnings of the firm are not expected to grow.
 the business risk is assumed to be constant and independent of capital structure and
financial risk.
 The corporate and personal income taxes do not exist.

13. RELEVANCE OF CAPITAL STRUCTURE: THE
NET INCOME AND THE TRADITIONAL VIEWS
firm L is a levered firm and it has financed its assets by equity and debt. It has
perpetual expected EBIT or net operating income (NOI) of Rs 1,000 and the
interest payment of Rs 300. The firm’s cost of equity ke, is 9.33 per cent
and the cost of debt, kd, is 6 per cent. What is the firm’s value?
NOI – interest = 1,000 – 300 = Rs 700, and the cost of equity is 9.33 per cent.

14. Cost of capital
14

15. Value of the firm (NI
approach)
The cost of equity is 10%

16. The effect of leverage on the cost
of capital under NI approach
16

17. The Traditional View
 The traditional view has emerged as a compromise to the extreme position
taken by the NI approach.
 According to this view, the mix of debt and equity capital can increase the
value of the firm by reducing the weighted average cost of capital up to
certain level of debt.
 Exp ;firm is expecting a perpetual net operating income of Rs 150 crore on
assets, (the cost of equity) is 10 percent.
 It is considering substituting equity capital by issuing perpetual debentures of
Rs 300 at 6 percent. The cost of equity is expected to increase to 10.56 per
cent.
 firm is also considering the alternative of raising perpetual debentures of Rs
600 crore and replace equity, The debt-holders will charge interest of 7 per
cent, and the cost of equity will rise to 12.5 per cent to compensate
shareholders for higher financial risk. 17

18. 18

19. Modigliani and Miller (MM) (1958) propositions1
 Proposition I
 The value of the firm is NOT affected by changes
in the capital structure
 The cash flows of the firm do not change; therefore
, value doesn’t change.
 Firms with identical net operating income and business (operating) risk,
but differing capital structure, should have same total value.
 Firm value is not affected by leverage
VL = VU
19

20. 20

21. Case I – MM Propositions II with
out tax same with (net operating income
approach )
 Proposition II
 The WACC of the firm is NOT affected by capital structure.
RE = RA +D/E(RA-RD)
RD is the interest rate (cost of debt)
RE is the return on equity (cost of equity)
RA is the return on unlevered equity (cost of capital)
B is the value of debt
E is the value of equity
 the cost of equity rises with leverage ,because the risk to equity rises
with leverage .
 Taxes were ignored
 Bankruptcy costs and other agency cost were not considerered
21

22. 22

23. The CAPM Proposition II
 How does financial leverage affect systematic risk?
 The systematic risk of the stock depends on:
 Systematic risk of the assets RA, (business risk)
 Level of leverage, D/E, (financial risk)
 RE = RA +(RA-RD)D/E
 business risk Financial risk
 an increase in financial leverage should increase systematic risk since changes in
interest rates are a systematic risk factor and will have more impact the higher
the financial leverage.
23

24. Case II – Corporate taxes
 Interest is tax deductible
 when a firm adds debt, it reduces taxes, all
else equal
 The reduction in taxes increases the cash flow
of the firm.
24

25. Case II – Example(interest tax shield)
Unlevered
Firm
Levered Firm
EBIT 5,000 5,000
Interest 0 500
Taxable Income 5,000 4,500
Taxes (34%) 1,700 1,530
Net Income 3,300 2,970
CFFA 3,300 3,470
25

26. Interest Tax Shield
 Annual interest tax shield
 Tax rate times interest payment
 $6,250 in 8% debt = $500 in interest expense
 Annual tax shield = .34($500) = $170
 Present value of annual interest tax shield
 Assume perpetual debt for simplicity
 PV = $170 / .08 = $2,125
 PV = D(RD)(TC) / RD = D*TC = $6,250(.34) =
$2,125 26

27. Case II – Proposition II
 The value of the firm increases by the
present value of the annual interest tax
shield
 Value of a levered firm = value of an unlevered
firm + PV of interest tax shield
 Value of equity = Value of the firm – Value of
debt
27

28. 28

29. Case II – Proposition II
The WACC decreases as D/E increases because of
the government subsidy on interest payments
WACC= Ke* E/V+ Kd*D/V(1-Tc)
29

30. Case III (trade-off theory)
 Now they add bankruptcy costs
 As the D/E ratio increases, the probability of bankruptcy
increases
 This increased probability will increase the expected
bankruptcy costs
 At some point, the additional value of the interest tax shield
will be offset by the expected bankruptcy costs
 At this point, the value of the firm will start to decrease and
the WACC will start to increase as more debt is added
30

31. Bankruptcy Costs
 Direct costs
 Legal and administrative costs
 Ultimately cause bondholders to incur additional losses
 Financial distress
 Significant problems in meeting debt obligations
 Indirect bankruptcy costs
 Larger than direct costs, but more difficult to measure and
estimate
 Assets lose value as management spends time worrying
about avoiding bankruptcy instead of running the business
 Also have lost sales, interrupted operations, and loss of
valuable employees 31

32. 32

33. Agency cost of capital structure theory
 Jensen and Meckling 1976
 There are agency problems between managers and shareholders
and between debt and equity holders
 These parties are not equal access to information .
 The agency cost because there is conflict between shareholders
and mangers and between the shareholders and bond holders.
 agency cost of shareholders :the costs incurred if the agent uses to
company's resources for his own benefit; or
B) the cost of techniques that principals use to prevent the agent
from prioritizing his interests over the shareholders
33

34.  agency cost of debt managers may want to engage in risky
actions they hope will benefit shareholders, who seek a high
rate of return. Bondholders, who are typically interested in a
safer investment, may want to place restrictions on the use of
their money to reduce their risk.
34

35. Packed order theories
Myers and Majluf (1984) .
Pecking Order Theory - Theory stating that firms prefer to issue debt rather than
equity if internal finance is insufficient
The announcement of a stock issue drives down the stock price because
investors believe managers are more likely to issue when shares are
overpriced.
Therefore firms prefer internal finance since funds can be raised
without sending adverse signals.
If external finance is required, firms issue debt first and equity as a last
resort.
35

36. The term structure of interest rates
 The term structure of interest rates compares
the interest rates on securities, assuming that
all characteristics (i.e., default risk, liquidity
risk) except maturity are the same.
 Bonds with identical risk, liquidity, and tax
characteristics may have different interest
rates because the time remaining to maturity
is differ
36

37. Term Structure of Interest Rates
 Yield curve: a plot of the yield on bonds with
differing terms to maturity but the same risk.
 Upward-sloping: long-term rates are above
short-term rates
 Flat: short- and long-term rates are the same
 Inverted: long-term rates are below short-term
rates

38. Term Structure of Interest Rates:
the Yield Curve
Yield to
Maturity
Time to Maturity
(a)
(b)
(c)
(a) Upward sloping
(b) Inverted or downward
sloping
(c) Flat

39. Term Structure Facts
 Fact 1: Interest rates for different maturities
tend to move together over time.
 Fact 2: Yields on short-term bond more
volatile than yields on long-term bonds.
39

40.  Fact 3: Long-term yield tends to be higher
than short term yields (i.e. yield curves
 usually are upward sloping).
40

41. The Expectations Theory
 The key assumption behind this theory is that buyers of bonds do not
prefer bonds of one maturity over another, so they will not hold any
quantity of a bond if its expected return is less than that of another bond
with a different maturity.
interest rate on the long bond is the average of the interests on short bonds
expected over the life of the long bond. More generally, for n-period
bonds
interest rates of different maturities will move together (Fact 1)
If the current short term rate changes so it will have very little impact on long
term yield (fact2)
This theory can not explain the third fact
41

42. Expectations Theory
Long-term interest rates are geometric averages of current
and expected future short-term interest rates
(EXAMPLE)
Long-term interest rates are geometric averages of current
and expected future short-term interest rates
(EXAMPLE)
1))](1))...((1)(1[( /1
112111
−+++= N
NN
rErERR

44. Segmented Markets Theory
 Bonds of different maturities are completely segmented
 The interest rate for each bond with a different maturity is
determined by the demand for and supply of that bond
 longer bonds that have associated with them inflation and interest
rate risks are completely different assets than the shorter bonds so the
expected returns from a bond of one maturity has no effect on the
demand for a bond of another maturity.
 Investors have preferences for bonds of one maturity over another
 If investors generally prefer bonds with shorter maturities that have
less interest-rate risk, then this explains why yield curves usually
slope upward (fact 3)

45. 2-45
Liquidity Premium Theory
Long-term interest rates are geometric averages of current
and expected future short-term interest rates plus
liquidity risk premiums that increase with maturity
Lt = liquidity premium for period t
L2 < L3 < …<LN
Long-term interest rates are geometric averages of current
and expected future short-term interest rates plus
liquidity risk premiums that increase with maturity
Lt = liquidity premium for period t
L2 < L3 < …<LN
1)])(1)...()(1)(1[( /1
1212111
−+++++= N
NNN
LrELrERR

46. Liquidity Premium ( Preferred Habitat)
Theories
 Interest rates on different maturity bonds move together over
time.
 Yield curves typically slope upward; explained
by a larger liquidity premium as the term to
maturity lengthens.
 Investors have a preference for bonds of one maturity over
another
 They will be willing to buy bonds of different maturities only if
they earn a somewhat higher expected return
 Investors are likely to prefer short-term bonds over longer-term
bonds

48. Thank You
48