Financial Management 14 Edition

1. 7-1
Chapter 17Chapter 17
Capital StructureCapital Structure
DeterminationDetermination
Instructor: Ajab Khan Burki

2. 7-2
Capital StructureCapital Structure
DeterminationDetermination
A Conceptual Look
The Total-Value Principle
Presence of Market Imperfections and
Incentive Issues
The Effect of Taxes
Taxes and Market Imperfections
Combined
Financial Signaling

3. 7-3
Capital StructureCapital Structure
Concerned with the effect of capital market
decisions on security prices.
Assume: (1) investment and asset
management decisions are held constant and
(2) consider only debt-versus-equity financing.
Capital StructureCapital Structure -- The mix (or proportion) of-- The mix (or proportion) of
a firm’s permanent long-term financinga firm’s permanent long-term financing
represented by debt, preferred stock, andrepresented by debt, preferred stock, and
common stock equity.common stock equity.

4. 7-4
A Conceptual LookA Conceptual Look
--Relevant Rates of Return--Relevant Rates of Return
kkii = the yield on the company’s debt= the yield on the company’s debt
Annual interest on debt
Market value of debt
I
B
==kkii
Assumptions:
• Interest paid each and every year
• Bond life is infinite
• Results in the valuation of a perpetual
bond
• No taxes (Note: allows us to focus on just
capital structure issues.)

5. 7-5
E
S
A Conceptual LookA Conceptual Look
--Relevant Rates of Return--Relevant Rates of Return
==
kkee = the expected return on the company’s equity= the expected return on the company’s equity
Earnings available toEarnings available to
common shareholderscommon shareholders
Market value of commonMarket value of common
stock outstandingstock outstanding
kkee
Assumptions:
• Earnings are not expected to grow
• 100% dividend payout
• Results in the valuation of a perpetuity
• Appropriate in this case for illustrating the
theory of the firm
E
S

6. 7-6
O
V
A Conceptual LookA Conceptual Look
--Relevant Rates of Return--Relevant Rates of Return
==
kkoo = an overall capitalization rate for the firm= an overall capitalization rate for the firm
Net operating income
Total market value of the firmkkoo
Assumptions:
• V = B + S = total market value of the firm
• O = I + E = net operating income = interest
paid plus earnings available to common
shareholders
O
V

7. 7-7
Capitalization RateCapitalization Rate
Capitalization Rate, kCapitalization Rate, koo -- The discount rate
used to determine the present value of a
stream of expected cash flows.
kkoo kkeekkii
B
B + S
S
B + S
= +
What happens to kkii, kkee, and kkoo
when leverage, B/S, increases?

8. 7-8
Net OperatingNet Operating
Income ApproachIncome Approach
Assume:
Net operating income equals $1,350
Market value of debt is $1,800 at 10% interest
Overall capitalization rate is 15%
Net Operating Income ApproachNet Operating Income Approach -- A theory of-- A theory of
capital structure in which the weighted averagecapital structure in which the weighted average
cost of capital and the total value of the firmcost of capital and the total value of the firm
remain constant as financial leverage is changed.remain constant as financial leverage is changed.

9. 7-9
Required Rate ofRequired Rate of
Return on EquityReturn on Equity
Total firm valueTotal firm value= O / ko = $1,350$1,350 / .15
= $9,000$9,000
Market value = V - B = $9,000$9,000 - $1,800$1,800
of equity = $7,200$7,200
Required returnRequired return = E / S
on equityon equity* = ($1,350$1,350 - $180$180) / $7,200$7,200
= 16.25%16.25%
Calculating the required rate of return on equityCalculating the required rate of return on equity
* B / S = $1,800 / $7,200 = .25
Interest paymentsInterest payments
= $1,800 x 10%= $1,800 x 10%

10. 7-10
Total firm valueTotal firm value= O / ko = $1,350$1,350 / .15
= $9,000$9,000
Market value = V - B = $9,000$9,000 - $3,000$3,000
of equity = $6,000$6,000
Required returnRequired return = E / S
on equityon equity* = ($1,350$1,350 - $300$300) / $6,000$6,000
= 17.50%17.50%
Required Rate ofRequired Rate of
Return on EquityReturn on Equity
What is the rate of return on equity if B=$3,000?What is the rate of return on equity if B=$3,000?
* B / S = $3,000 / $6,000 = .50
Interest paymentsInterest payments
= $3,000 x 10%= $3,000 x 10%

11. 7-11
B / S kkii kkee kkoo
0.00 ------ 15.00%15.00% 15%15%
0.25 10%10% 16.25%16.25% 15%15%
0.50 10%10% 17.50%17.50% 15%15%
1.00 10%10% 20.00%20.00% 15%15%
2.00 10%10% 25.00%25.00% 15%15%
Required Rate ofRequired Rate of
Return on EquityReturn on Equity
Examine a variety of different debt-to-equityExamine a variety of different debt-to-equity
ratios and the resulting required rate ofratios and the resulting required rate of
return on equity.return on equity.
Calculated in slides 9 and 10

12. 7-12
Required Rate ofRequired Rate of
Return on EquityReturn on Equity
Capital costs and the NOI approach in aCapital costs and the NOI approach in a
graphical representation.graphical representation.
0 .25 .50 .75 1.0 1.25 1.50 1.75 2.0
Financial Leverage (B / S)
.25
.20
.15.15
.10.10
.05
0
CapitalCosts(%)
kkee = 16.25% and= 16.25% and
17.5% respectively17.5% respectively
kkii (Yield on debt)(Yield on debt)
kkoo (Capitalization rate)(Capitalization rate)
kkee (Required return on equity)(Required return on equity)

13. 7-13
Summary of NOI ApproachSummary of NOI Approach
Critical assumption is ko remains constant.
An increase in cheaper debt funds is
exactly offset by an increase in the
required rate of return on equity.
As long as ki is constant, ke is a linear
function of the debt-to-equity ratio.
Thus, there is no one optimal capitalno one optimal capital
structurestructure.

14. 7-14
Traditional ApproachTraditional Approach
Optimal Capital StructureOptimal Capital Structure -- The capital structure
that minimizes the firm’s cost of capital and
thereby maximizes the value of the firm.
Traditional ApproachTraditional Approach -- A theory of capital
structure in which there exists an optimal capitaloptimal capital
structurestructure and where management can increase
the total value of the firm through the judicious
use of financial leverage.

15. 7-15
Optimal Capital Structure:Optimal Capital Structure:
Traditional ApproachTraditional Approach
Traditional ApproachTraditional Approach
Financial Leverage (B / S)
.25
.20
.15.15
.10.10
.05
0
CapitalCosts(%)
kkii
kkoo
kkee
Optimal Capital StructureOptimal Capital Structure

16. 7-16
Summary of theSummary of the
Traditional ApproachTraditional 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 structureone 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).

17. 7-17
Total Value Principle:Total Value Principle:
Modigliani and Miller (M&M)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.

18. 7-18
Market value
of debt ($65M)
Market value
of equity ($35M)
Total firm market
value ($100M)
Total Value Principle:Total Value Principle:
Modigliani and MillerModigliani and Miller
M&M assume an absence of taxes and market
imperfections.
Investors can substitute personal for corporate
financial leverage.
Market value
of debt ($35M)
Market value
of equity ($65M)
Total firm market
value ($100M)
Total market value is not altered by the capital
structure (the total size of the pies are the same).

19. 7-19
Arbitrage and TotalArbitrage and Total
Market Value of the FirmMarket Value of the Firm
ArbitrageArbitrage -- Finding two assets that are-- Finding two assets that are
essentially the same and buying theessentially the same and buying the
cheaper and selling the more expensive.cheaper and selling the more expensive.
Two firms that are alike in every respect
EXCEPTEXCEPT capital structure MUSTMUST have
the same market value.
Otherwise, arbitragearbitrage is possible.

20. 7-20
Arbitrage ExampleArbitrage Example
Consider two firms that are identical
in every respect EXCEPTEXCEPT:
Company NL -- no financial leverage
Company L -- $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 $10,000

21. 7-21
Earnings available toEarnings available to = EE = O – I
common shareholderscommon shareholders = $10,000$10,000 - $0
= $10,000$10,000
Market valueMarket value = E / ke
of equityof equity = $10,000$10,000 / .15
= $66,667$66,667
Total market valueTotal market value = $66,667$66,667 + $0
= $66,667$66,667
Overall capitalization rateOverall capitalization rate = 15%15%
Debt-to-equity ratio = 0
Arbitrage Example:Arbitrage Example:
Company NLCompany NL
Valuation of Company NLValuation of Company NL

22. 7-22
Arbitrage Example:Arbitrage Example:
Company LCompany L
Earnings available toEarnings available to = EE = O – I
common shareholderscommon shareholders = $10,000$10,000 - $3,600
= $6,400$6,400
Market valueMarket value = E / ke
of equityof equity = $6,400$6,400 / .16
= $40,000$40,000
Total market valueTotal market value = $40,000$40,000 + $30,000
= $70,000$70,000
Overall capitalization rateOverall capitalization rate = 14.3%14.3%
Debt-to-equity ratio = .75
Valuation of Company LValuation of Company L

23. 7-23
Completing anCompleting an
Arbitrage TransactionArbitrage Transaction
Assume you own 1% of the stock of
Company L (equity value = $400).
You should:
1. Sell the stock in Company L for $400.
2. Borrow $300 at 12% interest (equals 1% of debt
for Company L).
3. Buy 1% of the stock in Company NL for
$666.67. This leaves you with $33.33 for other
investments ($400 + $300 - $666.67).

24. 7-24
Completing anCompleting an
Arbitrage TransactionArbitrage Transaction
Original return on investment in Company LOriginal return on investment in Company L
$400 x 16% = $64
Return on investment after the transaction
$666.67 x 16% = $100 return on Company NL$100 return on Company NL
$300 x 12% = $36 interest paid$36 interest paid
$64 net return$64 net return ($100$100 - $36$36) AND $33.33 left over$33.33 left over.
This reduces the required net investment to
$366.67 to earn $64.

25. 7-25
Summary of theSummary of the
Arbitrage TransactionArbitrage 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 asTherefore, all capital structures are equally as
acceptable.acceptable.
The investor uses “personal” rather than
corporate financial leverage.

26. 7-26
Market ImperfectionsMarket Imperfections
and Incentive Issuesand Incentive Issues
Agency costs (Slide 28)
Debt and the incentive to
manage efficiently
Institutional restrictions
Transaction costs
Bankruptcy costs (Slide 27)

27. 7-27
Required Rate of ReturnRequired Rate of Return
on Equity with Bankruptcyon Equity with Bankruptcy
Financial Leverage (B / S)
RRff
RequiredRateofReturn
onEquity(ke)
kkee with no leveragewith no leverage
kkee without bankruptcy costswithout bankruptcy costs
kkee with bankruptcy costswith bankruptcy costs
PremiumPremium
for financialfor financial
riskrisk
PremiumPremium
for businessfor business
riskrisk
Risk-freeRisk-free
raterate

28. 7-28
Agency CostsAgency 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 CostsAgency Costs -- Costs associated with monitoring-- Costs associated with monitoring
management to ensure that it behaves in waysmanagement to ensure that it behaves in ways
consistent with the firm’s contractual agreementsconsistent with the firm’s contractual agreements
with creditors and shareholders.with creditors and shareholders.

29. 7-29
Example of the EffectsExample of the Effects
of Corporate Taxesof Corporate Taxes
Consider two identical firms EXCEPTEXCEPT:
Company ND -- no debt, 16% required return
Company D -- $5,000 of 12% debt
Corporate tax rate is 40% for each company
NOI for each firm is $10,000
The judicious use of financial leveragefinancial leverage
(i.e., debt)(i.e., debt) provides a favorable impact
on a company’s total valuation.

30. 7-30
Earnings available toEarnings available to = EE = OO - I
common shareholderscommon shareholders = $2,000$2,000 - $0
= $2,000$2,000
Tax RateTax Rate (TT) = 40%40%
Income available toIncome available to = EACSEACS (1 - TT)
common shareholderscommon shareholders = $2,000$2,000 (1 - .4.4)
= $1,200$1,200
Total income available toTotal income available to = EATEAT + I
all security holdersall security holders = $1,200$1,200 + 0
= $1,200$1,200
Corporate Tax Example:Corporate Tax Example:
Company NDCompany ND
Valuation of Company NDValuation of Company ND (Note: has no debt)

31. 7-31
Earnings available toEarnings available to = EE = OO - I
common shareholderscommon shareholders = $2,000$2,000 - $600
= $1,400$1,400
Tax RateTax Rate (TT) = 40%40%
Income available toIncome available to = EACSEACS (1 - TT)
common shareholderscommon shareholders = $1,400$1,400 (1 - .4.4)
= $840$840
Total income available toTotal income available to = EATEAT + I
all security holdersall security holders = $840$840 + $600
= $1,440$1,440*
Corporate Tax Example:Corporate Tax Example:
Company DCompany D
Valuation of Company DValuation of Company D (Note: has some debt)
* $240 annual tax-shield benefit of debt (i.e., $1,440 - $1,200)

32. 7-32
Tax-Shield BenefitsTax-Shield Benefits
Tax ShieldTax Shield -- A tax-deductible expense. The-- A tax-deductible expense. The
expense protects (shields) an equivalent dollarexpense protects (shields) an equivalent dollar
amount of revenue from being taxed by reducingamount of revenue from being taxed by reducing
taxable income.taxable income.
Present value ofPresent value of
tax-shield benefitstax-shield benefits
of debtof debt*
=
(rr) (BB) (ttcc)
rr
= (BB) (ttcc)
* Permanent debt, so treated as a perpetuity
** Alternatively, $240 annual tax shield / .12 = $2,000, where
$240=$600 Interest expense x .40 tax rate.
= ($5,000$5,000) (.4.4) = $2,000$2,000**

33. 7-33
Value of the Levered FirmValue of the Levered Firm
Value of unlevered firmValue of unlevered firm = $1,200 / .16
(Company ND)(Company ND) = $7,500$7,500*
Value of levered firmValue of levered firm = $7,500$7,500 + $2,000$2,000
(Company D)(Company D) = $9,500$9,500
Value ofValue of Value ofValue of Present value ofPresent value of
leveredlevered = firm iffirm if + tax-shield benefitstax-shield benefits
firmfirm unleveredunlevered of debtof debt
* Assuming zero growth and 100% dividend payout

34. 7-34
Summary ofSummary of
Corporate Tax EffectsCorporate 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 maximumtake on the maximum
amount of financial leverageamount of financial leverage.
This implies a capital structure of almost 100%This implies a capital structure of almost 100%
debt!debt! Yet, this is notnot consistent with actual
behavior.
The greater the amount of debt, the greater the
tax-shield benefits and the greater the value of the
firm.

35. 7-35
Other Tax IssuesOther Tax Issues
Corporate plus personal taxesCorporate 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 benefitsUncertainty of tax-shield benefits
Uncertainty increases the possibility of
bankruptcy and liquidation, which reduces
the value of the tax shield.

36. 7-36
Bankruptcy Costs,Bankruptcy Costs,
Agency Costs, and TaxesAgency Costs, and Taxes
As financial leverage increases, tax-shieldtax-shield
benefitsbenefits increase as do bankruptcy andbankruptcy and
agency costsagency costs.
Value of levered firmValue of levered firm
= Value ofValue of firm iffirm if unleveredunlevered
+ Present value of tax-shield benefitsPresent value of tax-shield benefits
of debtof debt
- Present value ofPresent value of bankruptcy andbankruptcy and
agency costsagency costs

37. 7-37
Bankruptcy Costs,Bankruptcy Costs,
Agency Costs, and TaxesAgency Costs, and Taxes
Optimal Financial LeverageOptimal Financial Leverage
Taxes, bankruptcy, andTaxes, bankruptcy, and
agency costs combinedagency costs combined
Net tax effectNet tax effect
Financial Leverage (B/S)
CostofCapital(%)
Minimum Cost
of Capital Point

38. 7-38
Financial SignalingFinancial 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 isconveys that the firm’s stock price is
undervaluedundervalued.
This is a valid signalvalid 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.