The Capital Structure Decision

1
The Capital Structure Decision

• MM propositions

2
Todays plan

• Review what we have learned about market
  efficiency
• Why is it important?
• What are the three-forms of market efficiency?
• Can you give me an example for each form of
  market efficiency?
• The capital structure decision
• The capital structure without taxes
• MMs proposition 1
• MMs proposition 2
• The capital structure with taxes
• MMs proposition 1
• MMs proposition 2

3
What have we learned in the last lecture?

• What do we mean by market efficiency?
• Why is market efficiency important in corporate
  finance?
• What are the three-forms of market efficiency?
• Can you give me an example for each form of
  market efficiency?

4
Some true or false questions about market
efficiency

• 1 When securities are priced fairly, then
  financing at current market rates is a positive
  NPV transaction.
• 2 Firms should avoid financing through stock
  issues, since stock financing is a zero-NPV
  transaction.
• 3 If the market is efficient, stock prices
  should only be expected to react to new
  information that is released.
• 4 The intent of technical analysis is to discover
  patterns in past stock prices.
• 5 Technical analysts have no effect upon the
  efficiency of the stock market.
• 6 Market efficiency implies that security prices
  impound new information quickly.

5
Some true or false questions about market
efficiency

• 7. Financing decisions are easier to reverse than
  investment decisions.
• 8. In efficient capital markets, all securities
  are fairly priced.
• 9. If security prices follow a random walk, then
  on any particular day, the odds are that an
  increase or decrease in price is equally likely.
• 10. Fundamental analysts attempt to get rich by
  identifying patterns in stock prices.
• 11.Strong-form market efficiency implies that one
  could earn above average returns by examining
  the history of a firm's stock price.
• 12. Insider information has nothing to do with
  historical stock prices

6
Capital structure

• Does the size of a pizza have nothing to do with
  how it is sliced?
• Is the value of a firm also independent of how
  the firm mixes debt and equity?

7
Look at the both sides of a balance sheet
Asset
Liabilities and equity
Market value of equity
Market value of the asset
E
V
Market value of debt
D
VED
8
Does capital structure affect the firm value?
Equity
Debt
Debt
Equity
Debt
Equity
Govt.
wasted
Govt.
Slicing the pie doesnt affect the total
amount available to debt holders and equity
holders
Slicing the pie can affect the size of the
wasted slice
Slicing the pie can affect the size of the
slice going to government
9
MMs proposition 1

• Modigliani Miller
• If the investment opportunity is fixed, there
  are no taxes, and capital markets function well,
  the market value of a company does not depend on
  its capital structure.
• How can we understand this?
• The size of a pizza has nothing to do with how
  you slice it.

10
MM (Debt Policy Doesnt Matter)
Example - River Cruises - All Equity Financed
11
MM (Debt Policy Doesnt Matter)
Example cont. 50 debt
12
MM (Debt Policy Doesnt Matter)
Example - River Cruises - All Equity
Financed - Debt replicated by investors
13
MMs proposition 2

• Modigliani Miller
• If the investment opportunity is fixed, there
  are no taxes, and capital markets function well,
  the expected rate of return on the common stock
  of a levered firm increases in proportion to the
  debt-equity ratio (D/E), expressed in market
  values.
• The WACC is independent of how the firm is
  financed

14
WACC without taxes in MMs view
r
rE
WACC
rD
D V
15
Capital structure and Corporate Taxes

• The use of debt has a lot of implications
• Financial risk- The use of debt will increase the
  risk to share holders and thus Increase the
  variability of shareholder returns.
• Interest tax shield- The savings resulting from
  deductibility of interest payments.

16
An example on Tax shield

• You own all the equity of Space Babies Diaper
  Co.. The company has no debt. The companys
  annual cash flow is 1,000, before interest and
  taxes. The corporate tax rate is 40. You have
  the option to exchange 1/2 of your equity
  position for 10 bonds with a face value of
  1,000.
• Should you do this and why?

17
C.S. Corporate Taxes
All Equity 1/2 Debt EBIT 1,000 Inte
rest Pmt 0 Pretax Income 1,000 Taxe
s _at_ 40 400 Net Cash Flow 600
18
C.S. Corporate Taxes
All Equity 1/2 Debt EBIT 1,000 1,000
Interest Pmt 0 100 Pretax
Income 1,000 900 Taxes _at_ 40 400 360 Net
Cash Flow 600 540
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Capital Structure and Corporate Taxes
All Equity 1/2 Debt EBIT 1,000 1,000
Interest Pmt 0 100 Pretax
Income 1,000 900 Taxes _at_ 40 400 360 Net
Cash Flow 600 540
Total Cash Flow All Equity 600 1/2 Debt
640 (540 100)
20
Capital Structure and tax shield
D x rD x Tc rD

• PV of Tax Shield

D x Tc
Example Tax benefit 1000 x (.10) x (.40)
40 PV of 40 perpetuity 40 / .10
400 PV Tax Shield D x Tc 1000 x .4 400
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MMs proposition 1 with tax

• firm value value of all equity firm PV(tax
  shield)
• Example,
• all equality firm value 600/0.16,000
• PV( tax shield)400
• firm value6,400

22
MMs proposition 2

• The weighted average cost of capital is
  decreasing with the ratio of D/E, that is
• Can you understand this intuitively?

23
WACC Graph
24
Financial Distress

• Costs of Financial Distress - Costs arising from
  bankruptcy or distorted business decisions before
  bankruptcy.
• Market Value Value if all Equity Financed
• PV Tax Shield
• - PV Costs of Financial Distress

25
Financial distress

• Costs of Financial Distress - Costs arising from
  bankruptcy or distorted business decisions before
  bankruptcy.
• Market Value Value if all Equity Financed
• PV Tax Shield
• - PV Costs of Financial Distress

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Optimal Capital structure

• Trade-off Theory - Theory that capital structure
  is based on a trade-off between tax savings and
  distress costs of debt.
• Pecking Order Theory - Theory stating that firms
  prefer to issue debt rather than equity if
  internal finance is insufficient.

27
Financial Distress
Maximum value of firm
Costs of financial distress
PV of interest tax shields
Market Value of The Firm
Value of levered firm
Value of unlevered firm
Optimal amount of debt
Debt