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Capital Structure
Capital Structure
Coverage –
• Capital Structure concept
• Capital Structure planning
• Concept of Value of a Firm
• Significance of Cost of
Capital (WACC)
• Capital Structure theories –
 Net Income
 Net Operating Income
 Modigliani-Miller
 Traditional Approach
Capital Structure
Capital structure can be defined as the mix of owned
capital (equity, reserves & surplus) and borrowed capital
(debentures, loans from banks, financial institutions)
Maximization of shareholders’ wealth is prime objective
of a financial manager. The same may be achieved if an
optimal capital structure is designed for the company.
Planning a capital structure is a highly psychological,
complex and qualitative process.
It involves balancing the shareholders’ expectations
(risk & returns) and capital requirements of the firm.
Questions while Making the Financing Decision
 How should the investment project be financed?
 Does the way in which the investment projects are financed
matter?
 How does financing affect the shareholders’ risk, return and value?
 Does there exist an optimum financing mix in terms of the
maximum value to the firm’s shareholders?
 Can the optimum financing mix be determined in practice for a
company?
 What factors in practice should a company consider in designing
its financing policy?
Features of An Appropriate Capital Structure
Optimal capital structure is that capital structure at that level of
debt – equity proportion where the market value per share is
maximum and the cost of capital is minimum.
Appropriate capital structure should have the following features
Profitability / Return
Solvency / Risk
Flexibility
Conservation / Capacity
Control
Determinants of Capital Structure
Seasonal Variations
Tax benefit of Debt
Flexibility
Control
Industry Leverage Ratios
Agency Costs
Industry Life Cycle
Degree of Competition
Company Characteristics
Requirements of Investors
Timing of Public Issue
Legal Requirements
7
Factors Affecting Capital Structure:
 Business Risk
 Debt’s tax deductibility
 Ability to raise capital under adverse terms
 Managerial decisions:
 Conservative vs. Aggressive
 Minimize WACC
Factors affecting capital structure
INTERNAL
 Financial leverage
 Risk
 Growth and stability
 Retaining control
 Cost of capital
 Cash flows
 Flexibility
 Purpose of finance
 Asset structure
EXTERNAL
 Size of the company
 Nature of the industry
 Investors
 Cost of inflation
 Legal requirements
 Period of finance
 Level of interest rate
 Level of business activity
 Availability of funds
 Taxation policy
 Level of stock prices
 Conditions of the capital market
9
Value = + + ··· +
FCF1 FCF2 FCF∞
(1 + WACC)1 (1 + WACC)∞(1 + WACC)2
Free cash flow
(FCF)
Market interest rates
Firm’s business riskMarket risk aversion
Firm’s
debt/equity
mix
Cost of debt
Cost of equity
Weighted average
cost of capital
(WACC)
Net operating
profit after taxes
Required investments
in operating capital
−
=
Determinants of Intrinsic Value:
The Capital Structure Choice
Planning the Capital Structure Important
Considerations –
 Return: ability to generate maximum returns to the shareholders,
i.e. maximize EPS and market price per share.
 Cost: minimizes the cost of capital (WACC). Debt is cheaper than
equity due to tax shield on interest & no benefit on dividends.
 Risk: insolvency risk associated with high debt component.
 Control: avoid dilution of management control, hence debt
preferred to new equity shares.
 Flexible: altering capital structure without much costs & delays, to
raise funds whenever required.
 Capacity: ability to generate profits to pay interest and principal.
11
Goal of the Firm
 Maximize Firm Value
 Maximize Profits
 Minimize WACC
 Through:
 Lowering risk
 Increasing CFs
 Maximize Operating Profits
 Growth of Business
 Reduce Taxes
 Maximize ROIC
 Maximize shareholder Wealth
OPTIMAL CAPITAL STRUCTURE
The OCM can be defined as “ that capital structure or combination
of debt and equity that leads to the maximum value of the firm”
OCM maximises the value of the company and hence the wealth of
its owners and minimise the company’s cost of capital.
Consideration to be kept in mind while maximising the value of the
firm in achieving the goal of the optimal capital structure:
 If ROI > the fixed cost of funds, the company should prefer to
raise the funds having a fixed cost, such as, debentures, Loans .
It will increase EPS and MV of the firm.
 If debt is used as a source of finance, the firm saves a
considerable amount in payment of tax as interest is allowed as
a deductible expense in computation of tax.
 It should also avoid undue financial risk attached with the use
of increased debt financing.
 The Capital structure should be flexible.
Value of a Firm – directly co-related with the
maximization of shareholders’ wealth.
 Value of a firm depends upon earnings of a firm and its cost of
capital (i.e. WACC).
 Earnings are a function of investment decisions, operating
efficiencies, & WACC is a function of its capital structure.
 Value of firm is derived by capitalizing the earnings by its cost
of capital (WACC). Value of Firm = Earnings / WACC
 Thus, value of a firm varies due to changes in the earnings of a
company or its cost of capital, or both.
 Capital structure cannot affect the total earnings of a firm
(EBIT), but it can affect the residual shareholders’ earnings.
Particulars Rs.
Sales (A) 10,000
(-) Cost of goods sold (B) 4,000
Gross Profit (C = A - B) 6,000
(-) Operating expenses (D) 2,500
Operating Profit (EBIT) (E = C - D) 3,500
(-) Interest (F) 1,000
EBT (G = E - F) 2,500
(-) Tax @ 30% (H) 750
PAT (I = G - H) 1,750
(-) Preference Dividends (J) 750
Profit for Equity Shareholders (K = I - J) 1,000
No. of Equity Shares (L) 200
Earning per Share (EPS) (K/L) 5
An illustration of
Income Statement
15
How can capital structure affect value?
V = ∑
∞
t=1
FCFt
(1 + WACC)t
WACC= wd (1-T) rd + wsrs
16
The Effect of Additional
Debt on WACC
 Debtholders have a prior claim on cash flows
relative to stockholders.
 Debtholders’ “fixed” claim increases risk of
stockholders’ “residual” claim.
 Cost of stock, rs, goes up.
 Firm’s can deduct interest expenses.
 Reduces the taxes paid
 Frees up more cash for payments to investors
 Reduces after-tax cost of debt
(Continued…)
17
The Effect on WACC (Continued)
 Debt increases risk of bankruptcy
 Causes pre-tax cost of debt, rd, to increase
 Adding debt increase percent of firm financed with
low-cost debt (wd) and decreases percent financed
with high-cost equity (ws)
 Net effect on WACC = uncertain.
(Continued…)
18
The Effect of Additional Debt on FCF
 Additional debt increases the probability of
bankruptcy.
 Direct costs: Legal fees, “fire” sales, etc.
 Indirect costs: Lost customers, reduction in productivity
of managers and line workers, reduction in credit (i.e.,
accounts payable) offered by suppliers
(Continued…)
Capital Structure Theories
ASSUMPTIONS –
 Firms use only two sources of funds – equity & debt.
 No change in investment decisions of the firm, i.e. no change in total assets.
 100 % dividend payout ratio, i.e. no retained earnings.
 Business risk of firm is not affected by the financing mix.
 No corporate or personal taxation.
 Investors expect future profitability of the firm.
Capital Structure Theories –
A) Net Income Approach (NI)
 Net Income approach proposes that there is a definite relationship
between capital structure and value of the firm.
 The capital structure of a firm influences its cost of capital
(WACC), and thus directly affects the value of the firm.
 NI approach assumptions –
o NI approach assumes that a continuous increase in debt does
not affect the risk perception of investors.
o Cost of debt (Kd) is less than cost of equity (Ke) [i.e. Kd < Ke ]
o Corporate income taxes do not exist.
Net Income Approach (NI)
 As per NI approach, higher use of debt capital will result in
reduction of WACC. As a consequence, value of firm will be
increased.
Value of firm = Earnings (NOI or EBIT)
WACC
 Earnings (EBIT) being constant and WACC is reduced, the value
of a firm will always increase.
 Thus, as per NI approach, a firm will have maximum value at a
point where WACC is minimum, i.e. when the firm is almost debt-
financed. Thus there can be an Optimal Capital Structure.
Net Income Approach (NI)
As the proportion of
debt (Kd) in capital
structure increases,
the WACC (Ko)
reduces.
ke
ko
kd
Debt
Cost
kd
ke, ko
Net Income Approach (NI)
Calculate the value of Firm and WACC for the following capital structures
EBIT of a firm Rs. 200,000. Ke = 10%
Debt capital Rs. 500,000 Debt = Rs. 700,000 Debt = Rs. 200,000
Kd = 6%
Particulars case 1 case 2 case 3
EBIT 200,000 200,000 200,000
(-) Interest 30,000 42,000 12,000
EBT 170,000 158,000 188,000
Ke 10% 10% 10%
Value of Equity 1,700,000 1,580,000 1,880,000
(EBT / Ke)
Value of Debt 500,000 700,000 200,000
Total Value of Firm 2,200,000 2,280,000 2,080,000
WACC 9.09% 8.77% 9.62%
(EBIT / Value) * 100
Net Operating Income (NOI)
 Net Operating Income (NOI) approach is the exact opposite of
the Net Income (NI) approach.
 As per NOI approach, value of a firm is not dependent upon its
capital structure. Thus there is no Optimal Capital Structure.
 Assumptions –
o WACC is always constant, and it depends on the business risk
which remains constant.
o Value of the firm is calculated using the overall cost of capital
i.e. the WACC only. Thus the split between debt and equity is
not important.
o The cost of debt (Kd) is constant.
o Corporate income taxes do not exist.
Net Operating Income (NOI)
 NOI propositions (i.e. school of thought) –
The use of higher debt component (borrowing) in the capital
structure increases the risk of shareholders.
Increase in shareholders’ risk causes the equity capitalization
rate to increase, i.e. higher cost of equity (Ke)
A higher cost of equity (Ke) nullifies the advantages gained due
to cheaper cost of debt (Kd )
In other words, the finance mix is irrelevant and does not affect
the value of the firm.
NEUTRALIZATION
 The increase in the proportion of debt in the Capital
Structure would lead to increase in the financial risk of
equity share holders. The advantage associated with the
use of the relatively less expensive debt in terms of
explicit cost is exactly neutralized by the implicit cost
of debt represented by the increase in the cost of equity
capital.
Net Operating Income (NOI)
 Cost of capital (Ko)
is constant.
 As the proportion
of debt increases,
(Ke) increases.
 No effect on total
cost of capital (WACC)
ke
ko
kd
Debt
Cost
Net Operating Income (NOI)
Calculate the value of firm and cost of equity for the following capital structure -
EBIT = Rs. 200,000. WACC (Ko) = 10% Kd = 6%
Debt = Rs. 300,000, Rs. 400,000, Rs. 500,000 (under 3 options)
Particulars Option I Option II Option III
EBIT 200,000 200,000 200,000
WACC (Ko) 10% 10% 10%
Value of the firm 2,000,000 2,000,000 2,000,000
Value of Debt @ 6 % 300,000 400,000 500,000
Value of Equity (bal. fig) 1,700,000 1,600,000 1,500,000
Interest @ 6 % 18,000 24,000 30,000
EBT (EBIT - interest) 182,000 176,000 170,000
Hence, Cost of Equity (Ke) 10.71% 11.00% 11.33%
Traditional Approach
 The NI approach and NOI approach hold extreme views on the
relationship between capital structure, cost of capital and the value
of a firm.
 Traditional approach (‘intermediate approach’) is a compromise
between these two extreme approaches.
 Traditional approach confirms the existence of an optimal capital
structure; where WACC is minimum and value is the firm is
maximum.
 As per this approach, a best possible mix of debt and equity will
maximize the value of the firm.
Traditional Approach
The approach works in 3 stages –
1) Value of the firm increases with an increase in borrowings (since
Kd < Ke). As a result, the WACC reduces gradually. This
phenomenon is up to a certain point.
2) At the end of this phenomenon, reduction in WACC ceases and
it tends to stabilize. Further increase in borrowings will not affect
WACC and the value of firm will also stagnate.
3) Increase in debt beyond this point increases shareholders’ risk
(financial risk) and hence Ke increases. Kd also rises due to higher
debt, WACC increases & value of firm decreases.
Traditional Approach
 Cost of capital (Ko)
is reduces initially.
 At a point, it settles
 But after this point,
(Ko) increases, due
to increase in the
cost of equity. (Ke)
ke
ko
kd
Debt
Cost
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 structure where
ko is at its lowest point.
 This is also the point where the firm’s total value
will be the largest (discounting at ko).
Traditional Approach
EBIT = Rs. 150,000, presently 100% equity finance with Ke = 16%. Introduction of debt to
the extent of Rs. 300,000 @ 10% interest rate or Rs. 500,000 @ 12%.
For case I, Ke = 17% and for case II, Ke = 20%. Find the value of firm and the WACC
Particulars Presently case I case II
Debt component - 300,000 500,000
Rate of interest 0% 10% 12%
EBIT 150,000 150,000 150,000
(-) Interest - 30,000 60,000
EBT 150,000 120,000 90,000
Cost of equity (Ke) 16% 17% 20%
Value of Equity (EBT / Ke) 937,500 705,882 450,000
Total Value of Firm (Db + Eq) 937,500 1,005,882 950,000
WACC (EBIT / Value) * 100 16.00% 14.91% 15.79%
Optimal Capital Structure:
Traditional Approach
Financial Leverage (D / S)
.25
.20
.15
.10
.05
0
CapitalCosts(%)
ki
ko
ke
Optimal Capital Structure
Optimum Capital Structure
 The optimal (best) situation is associated with the
minimum overall cost of capital:
 Optimum capital structure means the lowest WACC
 Usually occurs with 30-50% debt in a firm’s capital
structure
 WACC is also referred to as the required rate of return
or the discount rate
Optimal Capital Structure
Cost (After-tax) Weights Weighted
Cost
Financial Plan A:
Debt………………………… 6.5% 20% 1.3%
Equity………………………. 12.0 80 9.6
10.9%
Financial Plan B:
Debt………………………… 7.0% 40% 2.8%
Equity………………………. 12.5 60 7.5
10.3%
Financial Plan C:
Debt………………………… 9.0% 60% 5.4%
Equity………………………. 15.0 40 6.0
11.4%
Cost of capital curve
Modigliani – Miller Model (MM)
 MM approach supports the NOI approach, i.e. the capital
structure (debt-equity mix) has no effect on value of a firm.
 Further, the MM model adds a behavioural justification in favour
of the NOI approach (personal leverage).
 Assumptions –
 Capital markets are perfect and investors are free to buy, sell, &
switch between securities. Securities are infinitely divisible.
 Investors can borrow without restrictions at par with the firms.
 Investors are rational & informed of risk-return of all
securities.
 All firms belong to a homogeneous risk class.
 No corporate income tax, and no transaction costs.
 100 % dividend payout ratio, i.e. no profits retention
Modigliani – Miller Model (MM)
MM Model proposition –
o Value of a firm is independent of the capital structure.
o Value of firm is equal to the capitalized value of operating
income (i.e. EBIT) by the appropriate rate (i.e. WACC).
o Value of Firm = Mkt. Value of Equity + Mkt. Value of Debt
= Expected EBIT or Expected NOI
Expected WACC or Overall Capitalization Rate
Modigliani – Miller Model (MM)
MM Model proposition –
o As per MM, identical firms (except capital structure) will
have the same level of earnings.
o As per MM approach, if market values of identical firms
are different, ‘arbitrage process’ will take place.
o In this process, investors will switch their securities
between identical firms (from levered firms to un-levered
firms) and receive the same returns from both firms.
Modigliani – Miller Model (MM)
Levered Firm
• Value of levered firm = Rs. 110,000
• Equity Rs. 60,000 + Debt Rs. 50,000
• Kd = 6 % , EBIT = Rs. 10,000,
• Investor holds 10 % share capital
Un-Levered Firm
• Value of un-levered firm = Rs. 100,000 (all equity)
• EBIT = Rs. 10,000 and investor holds 10 % share capital
Modigliani – Miller Model (MM)
   
 
Return from Levered Firm:
10 110,000 50 000 10% 60,000 6 000
10% 10,000 6% 50,000 1,000 300 700
Alternate Strategy:
1. Sell shares in : 10% 60,000 6,000
2. Borrow (personal leverage):
Investment % , ,
Return
L
   
       
 
10% 50,000 5,000
3. Buy shares in : 10% 100,000 10,000
Return from Alternate Strategy:
10,000
10% 10,000 1,000
: Interest on personal borrowing 6% 5,000 300
Net return 1,000 300 700
Ca
U
Investment
Return
Less
 
 

  
  
  
sh available 11,000 10,000 1,000  
43
Modigliani-Miller (MM) Theory:
Zero Taxes
Firm U Firm L
EBIT Rs.3,000 Rs.3,000
Interest 0 1,200
NI Rs.3,000 Rs.1,800
CF to shareholder Rs.3,000 Rs.1,800
CF to debtholder 0 Rs.1,200
Total CF Rs.3,000 Rs.3,000
Notice that the total CF are identical for both firms.
44
MM Results: Zero Taxes
 MM assume: (1) no transactions costs; (2) no restrictions or
costs to short sales; and (3) individuals can borrow at the
same rate as corporations.
 MM prove that if the total CF to investors of Firm U and
Firm L are equal, then arbitrage is possible unless the total
values of Firm U and Firm L are equal:
 VL = VU.
 Because FCF and values of firms L and U are equal, their
WACCs are equal.
 Therefore, capital structure is irrelevant.
45
MM Theory: Corporate Taxes
 Corporate tax laws allow interest to be deducted,
which reduces taxes paid by levered firms.
 Therefore, more CF goes to investors and less to taxes
when leverage is used.
 In other words, the debt “shields” some of the firm’s
CF from taxes.
46
MM Result: Corporate Taxes
 MM show that the total CF to Firm L’s investors is
equal to the total CF to Firm U’s investor plus an
additional amount due to interest deductibility:
 CFL = CFU + rdDT.
 What is value of these cash flows?
 Value of CFU = VU
 MM show that the value of rdDT = TD
 Therefore, VL = VU + TD.
 If T=40%, then every rupee of debt adds 40 paise
of extra value to firm.
47
Value of Firm, V
0
Debt
VL
VU
Under MM with corporate taxes, the firm’s value
increases continuously as more and more debt is used.
TD
MM relationship between value and debt when
corporate taxes are considered.
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
company’s total valuation.
Earnings available to = E = O - I
common shareholders = Rs.2,000 - Rs.0
= Rs.2,000
Tax Rate (T) = 40%
Income available to = EACS (1 - T)common
shareholders = Rs.2,000 (1 - .4)
= Rs.1,200
Total income available to = EAT + I all
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 - I
common shareholders = Rs.2,000 - Rs.600
= Rs.1,400
Tax Rate (T) = 40%
Income available to = EACS (1 - T)common
shareholders = Rs.1,400 (1 - .4)
= Rs.840
Total income available to = EAT + I all
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 Benefits
Tax Shield -- A tax-deductible expense. The expense
protects (shields) an equivalent dollar amount of revenue
from being taxed by reducing taxable income.
Present value of
tax-shield benefits
of debt*
=
(r) (D) (tc)
r
= (D) (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 of
levered = 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 taxes
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%.
Uncertainty of tax-shield benefits
Uncertainty 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, and
agency costs combined
Net tax effect
Financial Leverage (D/S)
CostofCapital(%)
Minimum Cost
of 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 firm’s 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.
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 firm’s contractual agreements with creditors and
shareholders.
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 firm’s financing mix.
Market value
of debt (Rs.65M)
Market value
of equity (Rs.35M)
Total firm market
value (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 value
of equity (Rs.65M)
Total firm market
value (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 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
Earnings available to = E = O – I
common shareholders = Rs.10,000 - Rs.0
= Rs.10,000
Market 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 = E = O – I
common shareholders = Rs.10,000 - Rs.3,600
= Rs.6,400
Market 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 L
Rs.400 x 16% = Rs.64
Return on investment after the transaction
 Rs.666.67 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.
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.
70
Miller’s Theory: Corporate and
Personal Taxes
 Personal taxes lessen the advantage of corporate debt:
 Corporate taxes favor debt financing since corporations
can deduct interest expenses.
 Personal taxes favor equity financing, since no gain is
reported until stock is sold, and long-term gains are
taxed at a lower rate.
71
Miller’s Model with Corporate and
Personal Taxes
VL = VU + 1− D
Tc = corporate tax rate.
Td = personal tax rate on debt income.
Ts = personal tax rate on stock income.
(1 - Tc)(1 - Ts)
(1 - Td)
72
Tc = 40%, Td = 30%,
and Ts = 12%.
VL = VU + 1− D
= VU + (1 - 0.75)D
= VU + 0.25D.
Value rises with debt; each Rs.1 increase in debt
raises L’s value by Rs.0.25.
(1 - 0.40)(1 - 0.12)
(1 - 0.30)
73
Conclusions with Personal Taxes
 Use of debt financing remains advantageous, but
benefits are less than under only corporate taxes.
 Firms should still use 100% debt.
 Note: However, Miller argued that in equilibrium, the
tax rates of marginal investors would adjust until there
was no advantage to debt.
74
Trade-off Theory
 MM theory ignores bankruptcy (financial distress)
costs, which increase as more leverage is used.
 At low leverage levels, tax benefits outweigh
bankruptcy costs.
 At high levels, bankruptcy costs outweigh tax
benefits.
 An optimal capital structure exists that balances
these costs and benefits.
75
Tax Shield vs. Cost of Financial Distress
Value of Firm, V
0 Debt
VL
VU
Tax Shield
Distress Costs
76
Signaling Theory
 MM assumed that investors and managers have
the same information.
 But, managers often have better information.
Thus, they would:
 Sell stock if stock is overvalued.
 Sell bonds if stock is undervalued.
 Investors understand this, so view new stock sales
as a negative signal.
 Implications for managers?
77
Pecking Order Theory
 Firms use internally generated funds first, because
there are no flotation costs or negative signals.
 If more funds are needed, firms then issue debt
because it has lower flotation costs than equity and
not negative signals.
 If more funds are needed, firms then issue equity.
Market Imperfections
and Incentive Issues
 Agency costs (Slide 17-29)
 Debt and the incentive to manage efficiently
 Institutional restrictions
 Transaction costs
Bankruptcy costs (Slide 17-28)
Required Rate of Return on
Equity with Bankruptcy
Financial Leverage (D / S)
Rf
RequiredRateofReturn
onEquity(ke)
ke with no leverage
ke without bankruptcy costs
ke with bankruptcy costs
Premium
for financial
risk
Premium
for business
risk
Risk-free
rate

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Capital structure-theories

  • 2. Capital Structure Coverage – • Capital Structure concept • Capital Structure planning • Concept of Value of a Firm • Significance of Cost of Capital (WACC) • Capital Structure theories –  Net Income  Net Operating Income  Modigliani-Miller  Traditional Approach
  • 3. Capital Structure Capital structure can be defined as the mix of owned capital (equity, reserves & surplus) and borrowed capital (debentures, loans from banks, financial institutions) Maximization of shareholders’ wealth is prime objective of a financial manager. The same may be achieved if an optimal capital structure is designed for the company. Planning a capital structure is a highly psychological, complex and qualitative process. It involves balancing the shareholders’ expectations (risk & returns) and capital requirements of the firm.
  • 4. Questions while Making the Financing Decision  How should the investment project be financed?  Does the way in which the investment projects are financed matter?  How does financing affect the shareholders’ risk, return and value?  Does there exist an optimum financing mix in terms of the maximum value to the firm’s shareholders?  Can the optimum financing mix be determined in practice for a company?  What factors in practice should a company consider in designing its financing policy?
  • 5. Features of An Appropriate Capital Structure Optimal capital structure is that capital structure at that level of debt – equity proportion where the market value per share is maximum and the cost of capital is minimum. Appropriate capital structure should have the following features Profitability / Return Solvency / Risk Flexibility Conservation / Capacity Control
  • 6. Determinants of Capital Structure Seasonal Variations Tax benefit of Debt Flexibility Control Industry Leverage Ratios Agency Costs Industry Life Cycle Degree of Competition Company Characteristics Requirements of Investors Timing of Public Issue Legal Requirements
  • 7. 7 Factors Affecting Capital Structure:  Business Risk  Debt’s tax deductibility  Ability to raise capital under adverse terms  Managerial decisions:  Conservative vs. Aggressive  Minimize WACC
  • 8. Factors affecting capital structure INTERNAL  Financial leverage  Risk  Growth and stability  Retaining control  Cost of capital  Cash flows  Flexibility  Purpose of finance  Asset structure EXTERNAL  Size of the company  Nature of the industry  Investors  Cost of inflation  Legal requirements  Period of finance  Level of interest rate  Level of business activity  Availability of funds  Taxation policy  Level of stock prices  Conditions of the capital market
  • 9. 9 Value = + + ··· + FCF1 FCF2 FCF∞ (1 + WACC)1 (1 + WACC)∞(1 + WACC)2 Free cash flow (FCF) Market interest rates Firm’s business riskMarket risk aversion Firm’s debt/equity mix Cost of debt Cost of equity Weighted average cost of capital (WACC) Net operating profit after taxes Required investments in operating capital − = Determinants of Intrinsic Value: The Capital Structure Choice
  • 10. Planning the Capital Structure Important Considerations –  Return: ability to generate maximum returns to the shareholders, i.e. maximize EPS and market price per share.  Cost: minimizes the cost of capital (WACC). Debt is cheaper than equity due to tax shield on interest & no benefit on dividends.  Risk: insolvency risk associated with high debt component.  Control: avoid dilution of management control, hence debt preferred to new equity shares.  Flexible: altering capital structure without much costs & delays, to raise funds whenever required.  Capacity: ability to generate profits to pay interest and principal.
  • 11. 11 Goal of the Firm  Maximize Firm Value  Maximize Profits  Minimize WACC  Through:  Lowering risk  Increasing CFs  Maximize Operating Profits  Growth of Business  Reduce Taxes  Maximize ROIC  Maximize shareholder Wealth
  • 12. OPTIMAL CAPITAL STRUCTURE The OCM can be defined as “ that capital structure or combination of debt and equity that leads to the maximum value of the firm” OCM maximises the value of the company and hence the wealth of its owners and minimise the company’s cost of capital. Consideration to be kept in mind while maximising the value of the firm in achieving the goal of the optimal capital structure:  If ROI > the fixed cost of funds, the company should prefer to raise the funds having a fixed cost, such as, debentures, Loans . It will increase EPS and MV of the firm.  If debt is used as a source of finance, the firm saves a considerable amount in payment of tax as interest is allowed as a deductible expense in computation of tax.  It should also avoid undue financial risk attached with the use of increased debt financing.  The Capital structure should be flexible.
  • 13. Value of a Firm – directly co-related with the maximization of shareholders’ wealth.  Value of a firm depends upon earnings of a firm and its cost of capital (i.e. WACC).  Earnings are a function of investment decisions, operating efficiencies, & WACC is a function of its capital structure.  Value of firm is derived by capitalizing the earnings by its cost of capital (WACC). Value of Firm = Earnings / WACC  Thus, value of a firm varies due to changes in the earnings of a company or its cost of capital, or both.  Capital structure cannot affect the total earnings of a firm (EBIT), but it can affect the residual shareholders’ earnings.
  • 14. Particulars Rs. Sales (A) 10,000 (-) Cost of goods sold (B) 4,000 Gross Profit (C = A - B) 6,000 (-) Operating expenses (D) 2,500 Operating Profit (EBIT) (E = C - D) 3,500 (-) Interest (F) 1,000 EBT (G = E - F) 2,500 (-) Tax @ 30% (H) 750 PAT (I = G - H) 1,750 (-) Preference Dividends (J) 750 Profit for Equity Shareholders (K = I - J) 1,000 No. of Equity Shares (L) 200 Earning per Share (EPS) (K/L) 5 An illustration of Income Statement
  • 15. 15 How can capital structure affect value? V = ∑ ∞ t=1 FCFt (1 + WACC)t WACC= wd (1-T) rd + wsrs
  • 16. 16 The Effect of Additional Debt on WACC  Debtholders have a prior claim on cash flows relative to stockholders.  Debtholders’ “fixed” claim increases risk of stockholders’ “residual” claim.  Cost of stock, rs, goes up.  Firm’s can deduct interest expenses.  Reduces the taxes paid  Frees up more cash for payments to investors  Reduces after-tax cost of debt (Continued…)
  • 17. 17 The Effect on WACC (Continued)  Debt increases risk of bankruptcy  Causes pre-tax cost of debt, rd, to increase  Adding debt increase percent of firm financed with low-cost debt (wd) and decreases percent financed with high-cost equity (ws)  Net effect on WACC = uncertain. (Continued…)
  • 18. 18 The Effect of Additional Debt on FCF  Additional debt increases the probability of bankruptcy.  Direct costs: Legal fees, “fire” sales, etc.  Indirect costs: Lost customers, reduction in productivity of managers and line workers, reduction in credit (i.e., accounts payable) offered by suppliers (Continued…)
  • 19. Capital Structure Theories ASSUMPTIONS –  Firms use only two sources of funds – equity & debt.  No change in investment decisions of the firm, i.e. no change in total assets.  100 % dividend payout ratio, i.e. no retained earnings.  Business risk of firm is not affected by the financing mix.  No corporate or personal taxation.  Investors expect future profitability of the firm.
  • 20. Capital Structure Theories – A) Net Income Approach (NI)  Net Income approach proposes that there is a definite relationship between capital structure and value of the firm.  The capital structure of a firm influences its cost of capital (WACC), and thus directly affects the value of the firm.  NI approach assumptions – o NI approach assumes that a continuous increase in debt does not affect the risk perception of investors. o Cost of debt (Kd) is less than cost of equity (Ke) [i.e. Kd < Ke ] o Corporate income taxes do not exist.
  • 21. Net Income Approach (NI)  As per NI approach, higher use of debt capital will result in reduction of WACC. As a consequence, value of firm will be increased. Value of firm = Earnings (NOI or EBIT) WACC  Earnings (EBIT) being constant and WACC is reduced, the value of a firm will always increase.  Thus, as per NI approach, a firm will have maximum value at a point where WACC is minimum, i.e. when the firm is almost debt- financed. Thus there can be an Optimal Capital Structure.
  • 22. Net Income Approach (NI) As the proportion of debt (Kd) in capital structure increases, the WACC (Ko) reduces. ke ko kd Debt Cost kd ke, ko
  • 23. Net Income Approach (NI) Calculate the value of Firm and WACC for the following capital structures EBIT of a firm Rs. 200,000. Ke = 10% Debt capital Rs. 500,000 Debt = Rs. 700,000 Debt = Rs. 200,000 Kd = 6% Particulars case 1 case 2 case 3 EBIT 200,000 200,000 200,000 (-) Interest 30,000 42,000 12,000 EBT 170,000 158,000 188,000 Ke 10% 10% 10% Value of Equity 1,700,000 1,580,000 1,880,000 (EBT / Ke) Value of Debt 500,000 700,000 200,000 Total Value of Firm 2,200,000 2,280,000 2,080,000 WACC 9.09% 8.77% 9.62% (EBIT / Value) * 100
  • 24. Net Operating Income (NOI)  Net Operating Income (NOI) approach is the exact opposite of the Net Income (NI) approach.  As per NOI approach, value of a firm is not dependent upon its capital structure. Thus there is no Optimal Capital Structure.  Assumptions – o WACC is always constant, and it depends on the business risk which remains constant. o Value of the firm is calculated using the overall cost of capital i.e. the WACC only. Thus the split between debt and equity is not important. o The cost of debt (Kd) is constant. o Corporate income taxes do not exist.
  • 25. Net Operating Income (NOI)  NOI propositions (i.e. school of thought) – The use of higher debt component (borrowing) in the capital structure increases the risk of shareholders. Increase in shareholders’ risk causes the equity capitalization rate to increase, i.e. higher cost of equity (Ke) A higher cost of equity (Ke) nullifies the advantages gained due to cheaper cost of debt (Kd ) In other words, the finance mix is irrelevant and does not affect the value of the firm.
  • 26. NEUTRALIZATION  The increase in the proportion of debt in the Capital Structure would lead to increase in the financial risk of equity share holders. The advantage associated with the use of the relatively less expensive debt in terms of explicit cost is exactly neutralized by the implicit cost of debt represented by the increase in the cost of equity capital.
  • 27. Net Operating Income (NOI)  Cost of capital (Ko) is constant.  As the proportion of debt increases, (Ke) increases.  No effect on total cost of capital (WACC) ke ko kd Debt Cost
  • 28. Net Operating Income (NOI) Calculate the value of firm and cost of equity for the following capital structure - EBIT = Rs. 200,000. WACC (Ko) = 10% Kd = 6% Debt = Rs. 300,000, Rs. 400,000, Rs. 500,000 (under 3 options) Particulars Option I Option II Option III EBIT 200,000 200,000 200,000 WACC (Ko) 10% 10% 10% Value of the firm 2,000,000 2,000,000 2,000,000 Value of Debt @ 6 % 300,000 400,000 500,000 Value of Equity (bal. fig) 1,700,000 1,600,000 1,500,000 Interest @ 6 % 18,000 24,000 30,000 EBT (EBIT - interest) 182,000 176,000 170,000 Hence, Cost of Equity (Ke) 10.71% 11.00% 11.33%
  • 29. Traditional Approach  The NI approach and NOI approach hold extreme views on the relationship between capital structure, cost of capital and the value of a firm.  Traditional approach (‘intermediate approach’) is a compromise between these two extreme approaches.  Traditional approach confirms the existence of an optimal capital structure; where WACC is minimum and value is the firm is maximum.  As per this approach, a best possible mix of debt and equity will maximize the value of the firm.
  • 30. Traditional Approach The approach works in 3 stages – 1) Value of the firm increases with an increase in borrowings (since Kd < Ke). As a result, the WACC reduces gradually. This phenomenon is up to a certain point. 2) At the end of this phenomenon, reduction in WACC ceases and it tends to stabilize. Further increase in borrowings will not affect WACC and the value of firm will also stagnate. 3) Increase in debt beyond this point increases shareholders’ risk (financial risk) and hence Ke increases. Kd also rises due to higher debt, WACC increases & value of firm decreases.
  • 31. Traditional Approach  Cost of capital (Ko) is reduces initially.  At a point, it settles  But after this point, (Ko) increases, due to increase in the cost of equity. (Ke) ke ko kd Debt Cost
  • 32. 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 structure where ko is at its lowest point.  This is also the point where the firm’s total value will be the largest (discounting at ko).
  • 33. Traditional Approach EBIT = Rs. 150,000, presently 100% equity finance with Ke = 16%. Introduction of debt to the extent of Rs. 300,000 @ 10% interest rate or Rs. 500,000 @ 12%. For case I, Ke = 17% and for case II, Ke = 20%. Find the value of firm and the WACC Particulars Presently case I case II Debt component - 300,000 500,000 Rate of interest 0% 10% 12% EBIT 150,000 150,000 150,000 (-) Interest - 30,000 60,000 EBT 150,000 120,000 90,000 Cost of equity (Ke) 16% 17% 20% Value of Equity (EBT / Ke) 937,500 705,882 450,000 Total Value of Firm (Db + Eq) 937,500 1,005,882 950,000 WACC (EBIT / Value) * 100 16.00% 14.91% 15.79%
  • 34. Optimal Capital Structure: Traditional Approach Financial Leverage (D / S) .25 .20 .15 .10 .05 0 CapitalCosts(%) ki ko ke Optimal Capital Structure
  • 35. Optimum Capital Structure  The optimal (best) situation is associated with the minimum overall cost of capital:  Optimum capital structure means the lowest WACC  Usually occurs with 30-50% debt in a firm’s capital structure  WACC is also referred to as the required rate of return or the discount rate
  • 36. Optimal Capital Structure Cost (After-tax) Weights Weighted Cost Financial Plan A: Debt………………………… 6.5% 20% 1.3% Equity………………………. 12.0 80 9.6 10.9% Financial Plan B: Debt………………………… 7.0% 40% 2.8% Equity………………………. 12.5 60 7.5 10.3% Financial Plan C: Debt………………………… 9.0% 60% 5.4% Equity………………………. 15.0 40 6.0 11.4%
  • 38. Modigliani – Miller Model (MM)  MM approach supports the NOI approach, i.e. the capital structure (debt-equity mix) has no effect on value of a firm.  Further, the MM model adds a behavioural justification in favour of the NOI approach (personal leverage).  Assumptions –  Capital markets are perfect and investors are free to buy, sell, & switch between securities. Securities are infinitely divisible.  Investors can borrow without restrictions at par with the firms.  Investors are rational & informed of risk-return of all securities.  All firms belong to a homogeneous risk class.  No corporate income tax, and no transaction costs.  100 % dividend payout ratio, i.e. no profits retention
  • 39. Modigliani – Miller Model (MM) MM Model proposition – o Value of a firm is independent of the capital structure. o Value of firm is equal to the capitalized value of operating income (i.e. EBIT) by the appropriate rate (i.e. WACC). o Value of Firm = Mkt. Value of Equity + Mkt. Value of Debt = Expected EBIT or Expected NOI Expected WACC or Overall Capitalization Rate
  • 40. Modigliani – Miller Model (MM) MM Model proposition – o As per MM, identical firms (except capital structure) will have the same level of earnings. o As per MM approach, if market values of identical firms are different, ‘arbitrage process’ will take place. o In this process, investors will switch their securities between identical firms (from levered firms to un-levered firms) and receive the same returns from both firms.
  • 41. Modigliani – Miller Model (MM) Levered Firm • Value of levered firm = Rs. 110,000 • Equity Rs. 60,000 + Debt Rs. 50,000 • Kd = 6 % , EBIT = Rs. 10,000, • Investor holds 10 % share capital Un-Levered Firm • Value of un-levered firm = Rs. 100,000 (all equity) • EBIT = Rs. 10,000 and investor holds 10 % share capital
  • 42. Modigliani – Miller Model (MM)       Return from Levered Firm: 10 110,000 50 000 10% 60,000 6 000 10% 10,000 6% 50,000 1,000 300 700 Alternate Strategy: 1. Sell shares in : 10% 60,000 6,000 2. Borrow (personal leverage): Investment % , , Return L               10% 50,000 5,000 3. Buy shares in : 10% 100,000 10,000 Return from Alternate Strategy: 10,000 10% 10,000 1,000 : Interest on personal borrowing 6% 5,000 300 Net return 1,000 300 700 Ca U Investment Return Less               sh available 11,000 10,000 1,000  
  • 43. 43 Modigliani-Miller (MM) Theory: Zero Taxes Firm U Firm L EBIT Rs.3,000 Rs.3,000 Interest 0 1,200 NI Rs.3,000 Rs.1,800 CF to shareholder Rs.3,000 Rs.1,800 CF to debtholder 0 Rs.1,200 Total CF Rs.3,000 Rs.3,000 Notice that the total CF are identical for both firms.
  • 44. 44 MM Results: Zero Taxes  MM assume: (1) no transactions costs; (2) no restrictions or costs to short sales; and (3) individuals can borrow at the same rate as corporations.  MM prove that if the total CF to investors of Firm U and Firm L are equal, then arbitrage is possible unless the total values of Firm U and Firm L are equal:  VL = VU.  Because FCF and values of firms L and U are equal, their WACCs are equal.  Therefore, capital structure is irrelevant.
  • 45. 45 MM Theory: Corporate Taxes  Corporate tax laws allow interest to be deducted, which reduces taxes paid by levered firms.  Therefore, more CF goes to investors and less to taxes when leverage is used.  In other words, the debt “shields” some of the firm’s CF from taxes.
  • 46. 46 MM Result: Corporate Taxes  MM show that the total CF to Firm L’s investors is equal to the total CF to Firm U’s investor plus an additional amount due to interest deductibility:  CFL = CFU + rdDT.  What is value of these cash flows?  Value of CFU = VU  MM show that the value of rdDT = TD  Therefore, VL = VU + TD.  If T=40%, then every rupee of debt adds 40 paise of extra value to firm.
  • 47. 47 Value of Firm, V 0 Debt VL VU Under MM with corporate taxes, the firm’s value increases continuously as more and more debt is used. TD MM relationship between value and debt when corporate taxes are considered.
  • 48. 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 company’s total valuation.
  • 49. Earnings available to = E = O - I common shareholders = Rs.2,000 - Rs.0 = Rs.2,000 Tax Rate (T) = 40% Income available to = EACS (1 - T)common shareholders = Rs.2,000 (1 - .4) = Rs.1,200 Total income available to = EAT + I all security holders = Rs.1,200 + 0 = Rs.1,200 Corporate Tax Example: Company ND Valuation of Company ND (Note: has no debt)
  • 50. Earnings available to = E = O - I common shareholders = Rs.2,000 - Rs.600 = Rs.1,400 Tax Rate (T) = 40% Income available to = EACS (1 - T)common shareholders = Rs.1,400 (1 - .4) = Rs.840 Total income available to = EAT + I all 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)
  • 51. Tax-Shield Benefits Tax Shield -- A tax-deductible expense. The expense protects (shields) an equivalent dollar amount of revenue from being taxed by reducing taxable income. Present value of tax-shield benefits of debt* = (r) (D) (tc) r = (D) (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**
  • 52. 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 of levered = firm if + tax-shield benefits firm unlevered of debt * Assuming zero growth and 100% dividend payout
  • 53. 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.
  • 54. Other Tax Issues  Corporate plus personal taxes 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%. Uncertainty of tax-shield benefits Uncertainty increases the possibility of bankruptcy and liquidation, which reduces the value of the tax shield.
  • 55. 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
  • 56. Bankruptcy Costs, Agency Costs, and Taxes Optimal Financial Leverage Taxes, bankruptcy, and agency costs combined Net tax effect Financial Leverage (D/S) CostofCapital(%) Minimum Cost of Capital Point
  • 57. 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 firm’s 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.
  • 58. 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.
  • 59. 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 firm’s contractual agreements with creditors and shareholders.
  • 60. 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 firm’s financing mix.
  • 61. Market value of debt (Rs.65M) Market value of equity (Rs.35M) Total firm market value (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 value of equity (Rs.65M) Total firm market value (Rs.100M)  Total market value is not altered by the capital structure (the total size of the pies are the same).
  • 62. 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.
  • 63. 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
  • 64. Earnings available to = E = O – I common shareholders = Rs.10,000 - Rs.0 = Rs.10,000 Market 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
  • 65. Arbitrage Example: Company L Earnings available to = E = O – I common shareholders = Rs.10,000 - Rs.3,600 = Rs.6,400 Market 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
  • 66. 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).
  • 67. Completing an Arbitrage Transaction Original return on investment in Company L Rs.400 x 16% = Rs.64 Return on investment after the transaction  Rs.666.67 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.
  • 68. 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.
  • 69.
  • 70. 70 Miller’s Theory: Corporate and Personal Taxes  Personal taxes lessen the advantage of corporate debt:  Corporate taxes favor debt financing since corporations can deduct interest expenses.  Personal taxes favor equity financing, since no gain is reported until stock is sold, and long-term gains are taxed at a lower rate.
  • 71. 71 Miller’s Model with Corporate and Personal Taxes VL = VU + 1− D Tc = corporate tax rate. Td = personal tax rate on debt income. Ts = personal tax rate on stock income. (1 - Tc)(1 - Ts) (1 - Td)
  • 72. 72 Tc = 40%, Td = 30%, and Ts = 12%. VL = VU + 1− D = VU + (1 - 0.75)D = VU + 0.25D. Value rises with debt; each Rs.1 increase in debt raises L’s value by Rs.0.25. (1 - 0.40)(1 - 0.12) (1 - 0.30)
  • 73. 73 Conclusions with Personal Taxes  Use of debt financing remains advantageous, but benefits are less than under only corporate taxes.  Firms should still use 100% debt.  Note: However, Miller argued that in equilibrium, the tax rates of marginal investors would adjust until there was no advantage to debt.
  • 74. 74 Trade-off Theory  MM theory ignores bankruptcy (financial distress) costs, which increase as more leverage is used.  At low leverage levels, tax benefits outweigh bankruptcy costs.  At high levels, bankruptcy costs outweigh tax benefits.  An optimal capital structure exists that balances these costs and benefits.
  • 75. 75 Tax Shield vs. Cost of Financial Distress Value of Firm, V 0 Debt VL VU Tax Shield Distress Costs
  • 76. 76 Signaling Theory  MM assumed that investors and managers have the same information.  But, managers often have better information. Thus, they would:  Sell stock if stock is overvalued.  Sell bonds if stock is undervalued.  Investors understand this, so view new stock sales as a negative signal.  Implications for managers?
  • 77. 77 Pecking Order Theory  Firms use internally generated funds first, because there are no flotation costs or negative signals.  If more funds are needed, firms then issue debt because it has lower flotation costs than equity and not negative signals.  If more funds are needed, firms then issue equity.
  • 78. Market Imperfections and Incentive Issues  Agency costs (Slide 17-29)  Debt and the incentive to manage efficiently  Institutional restrictions  Transaction costs Bankruptcy costs (Slide 17-28)
  • 79. Required Rate of Return on Equity with Bankruptcy Financial Leverage (D / S) Rf RequiredRateofReturn onEquity(ke) ke with no leverage ke without bankruptcy costs ke with bankruptcy costs Premium for financial risk Premium for business risk Risk-free rate