Capital Structure Determination

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Chapter 17

• Capital Structure Determination

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After Studying Chapter 17, you should be able to

1. Define capital structure.
2. Explain the net operating income (NOI) approach
   to capital structure and valuation of a firm
   and, calculate a firm's value using this
   approach.
3. Explain the traditional approach to capital
   structure and the valuation of a firm.
4. Discuss the relationship between financial
   leverage and the cost of capital as originally
   set forth by Modigliani and Miller (MM) and
   evaluate their arguments.
5. Describe various market imperfections and other
   "real world" factors that tend to dilute MMs
   original position.
6. Present a number of reasonable arguments for
   believing that an optimal capital structure
   exists in theory.
7. Explain how financial structure changes can be
   used for financial signaling purposes, and give
   some examples.

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Capital Structure Determination

• 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

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Capital Structure
Capital Structure -- The mix (or proportion) of a
firms permanent long-term financing represented
by debt, preferred stock, and common stock equity.

• 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.

5
A Conceptual Look Relevant Rates of Return

• ki the yield on the companys debt

Annual interest on debt Market value of debt
I B
ki

• 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.)

6
A Conceptual Look Relevant Rates of Return
ke the expected return on the companys equity
Earnings available to common shareholders Market
value of common stock outstanding
E S
E S
ke

• 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

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A Conceptual Look Relevant Rates of Return
ko an overall capitalization rate for the firm
O V
O V
Net operating income Total market value of the
firm
ko

• Assumptions
• V B S total market value of the firm
• O I E net operating income interest paid
  plus earnings available to common shareholders

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Capitalization Rate
Capitalization Rate, ko The discount rate used
to determine the present value of a stream of
expected cash flows.
B B S
S B S
ko
ke
ki


What happens to ki, ke, and ko when leverage,
B/S, increases?
9
Net Operating Income Approach
Net Operating Income Approach A theory of
capital structure in which the weighted average
cost of capital and the total value of the firm
remain constant as financial leverage is changed.

• Assume
• Net operating income equals 1,350
• Market value of debt is 1,800 at 10 interest
• Overall capitalization rate is 15

10
Required Rate of Return on Equity
Calculating the required rate of return on equity

• Total firm value O / ko 1,350 / 0.15
  9,000
• Market value V B 9,000 1,800 of
  equity 7,200
• Required return E / S on equity (1,350
  180) / 7,200 16.25

Interest payments 1,800 10
B / S 1,800 / 7,200 0.25
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Required Rate of Return on Equity
What is the rate of return on equity if B3,000?

• Total firm value O / ko 1,350 / 0.15
  9,000
• Market value V B 9,000 3,000 of
  equity 6,000
• Required return E / S on equity (1,350
  - 300) / 6,000 17.50

Interest payments 3,000 10
B / S 3,000 / 6,000 0.50
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Required Rate of Return on Equity
Examine a variety of different debt-to-equity
ratios and the resulting required rate of return
on equity.

• B / S ki ke ko
• 0.00 15.00 15
• 0.25 10 16.25 15
• 0.50 10 17.50 15
• 1.00 10 20.00 15
• 2.00 10 25.00 15

Calculated in slides 9 and 10
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Required Rate of Return on Equity
Capital costs and the NOI approach in a graphical
representation.
0.25
ke 16.25 and 17.5 respectively

0.20
ke (Required return on equity)
0.15
ko (Capitalization rate)
Capital Costs ()
0.10
ki (Yield on debt)
0.05
0
0 0.25 0.50 0.75 1.0
1.25 1.50 1.75 2.0 Financial
Leverage (B/S)
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Excel the NOI Approach

• NOI Approach
• You can create this type of analysis in Excel
  also. You can use some modeling experience to
  write formulas to calculate the required rates.
• Refer to VW13E-17.xlsx on the NOI Approach tab

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Summary 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 capital structure.

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Traditional Approach
Traditional Approach A theory of capital
structure in which there exists an optimal
capital structure and where management can
increase the total value of the firm through the
judicious use of financial leverage.

• Optimal Capital Structure The capital structure
  that minimizes the firms cost of capital and
  thereby maximizes the value of the firm.

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Optimal Capital Structure Traditional Approach
Traditional Approach
ke
0.25
ko

0.20
0.15
ki
Capital Costs ()
0.10
Optimal Capital Structure
0.05
0
Financial Leverage (B / S)
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Excel and the Traditional Approach

• Traditional Approach
• You can create this type of analysis in Excel
  also. We use some assumptions in this model built
  into the formulas.
• Refer to VW13E-17.xlsx on the Traditional
  Approach tab

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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
  theassociated increase in ke and ki more than
  offsetsthe 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 firms
  totalvalue will be the largest (discounting at
  ko).

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Total Value Principle Modigliani and Miller
(MM)

• Advocate that the relationship betweenfinancial
  leverage and the cost of capital is explained by
  the NOI approach.
• Provide behavioral justification for a
  constantko over the entire range of financial
  leverage possibilities.
• Total risk for all security holders of the firm
  isnot altered by the capital structure.
• Therefore, the total value of the firm is
  notaltered by the firms financing mix.

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Total Value Principle Modigliani and Miller
Market value of debt (65M) Market
value of equity (35M) Total firm
market value (100M)
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).

• MM assume an absence of taxes and market
  imperfections.
• Investors can substitute personal for corporate
  financial leverage.

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Arbitrage and Total Market Value of the Firm
Two firms that are alike in every respect EXCEPT
capital structure MUST have the same market
value. Otherwise, arbitrage is possible.

• Arbitrage Finding two assets that are
  essentially the same and buying the cheaper and
  selling the more expensive.

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Arbitrage Example

• Consider two firms that are identical in every
  respect EXCEPT
• 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

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Arbitrage Example Company NL
Valuation of Company NL

• Earnings available to E O I common
  shareholders 10,000 - 0 10,000
• Market value E / ke of equity
  10,000 / 0 .15 66,667
• Total market value 66,667 0 66,667
• Overall capitalization rate 15
• Debt-to-equity ratio 0

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Arbitrage Example Company L
Valuation of Company L

• Earnings available to E O I common
  shareholders 10,000 3,600 6,400
• Market value E / ke of equity
  6,400 / 0.16 40,000
• Total market value 40,000 30,000
  70,000
• Overall capitalization rate 14.3
• Debt-to-equity ratio 0.75

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Completing an Arbitrage 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).

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Completing an Arbitrage Transaction
Original return on investment in Company L 400
16 64

• Return on investment after the transaction
• 666.67 16 100 return on Company NL
• 300 12 36 interest paid
• 64 net return (100 36) AND 33.33 left over.
• This reduces the required net investment to
  366.67 to earn 64.

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Summary of the Arbitrage Transaction

• The investor uses personal rather than
  corporate financial leverage.

• 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.

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Market Imperfections and Incentive Issues

• Bankruptcy costs (Slide 1730)

• Agency costs (Slide 1731)
• Debt and the incentive to manage efficiently
• Institutional restrictions
• Transaction costs

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Required Rate of Return on Equity with Bankruptcy
ke with bankruptcy costs
Premium for financial risk
ke with no leverage

Required Rate of Return on Equity (ke)
ke without bankruptcy costs
Premium for business risk
Rf
Risk-free rate
Financial Leverage (B / S)
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Agency Costs
Agency Costs -- Costs associated with monitoring
management to ensure that it behaves in ways
consistent with the firms contractual agreements
with creditors and shareholders.

• 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.

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Example of the Effects of Corporate Taxes
The judicious use of financial leverage (i.e.,
debt) provides a favorable impact on a companys
total valuation.

• Consider two identical firms EXCEPT
• 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

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Corporate Tax Example Company ND
Valuation of Company ND (Note has no debt)

• Earnings available to E O I common
  shareholders 2,000 0 2,000
• Tax Rate (T) 40
• Income available to EACS (1 T) common
  shareholders 2,000 (1 0.4) 1,200
• Total income available to EAT I all security
  holders 1,200 0 1,200

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Corporate Tax Example Company D
Valuation of Company D (Note has some debt)

• Earnings available to E O I common
  shareholders 2,000 600 1,400
• Tax Rate (T) 40
• Income available to EACS (1 T) common
  shareholders 1,400 (1 0.4) 840
• Total income available to EAT I all security
  holders 840 600 1,440

240 annual tax-shield benefit of debt (i.e.,
1,440 - 1,200)
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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) (B) (tc)

(B) (tc)
r
(5,000) (0.4) 2,000

Permanent debt, so treated as a perpetuity
Alternatively, 240 annual tax shield / 0.12
2,000, where 240600 Interest expense 0.40
tax rate.
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Value of the Levered Firm
Value of Value of Present value of
levered firm if tax-shield
benefits firm unlevered of debt

• Value of unlevered firm 1,200 / 0.16 (Company
  ND) 7,500
• Value of levered firm 7,500 2,000
  (Company D) 9,500

Assuming zero growth and 100 dividend payout
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Summary of Corporate Tax Effects

• The greater the amount of debt, the greater the
  tax-shield benefits and the greater the value of
  the firm.

• The greater the financial leverage, the lower the
  cost of capital of the firm.
• The adjusted MM 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.

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Other Tax Issues

• Uncertainty of tax-shield benefits
• Uncertainty increases the possibility of
  bankruptcy and liquidation, which reduces the
  value of the tax shield.

• 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.

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Bankruptcy Costs, Agency Costs, and Taxes
Value of levered firm Value of firm if
unlevered Present value of tax-shield
benefits of debt - Present value
of bankruptcy and agency costs

• As financial leverage increases, tax-shield
  benefits increase as do bankruptcy and agency
  costs.

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Bankruptcy Costs, Agency Costs, and Taxes
Taxes, bankruptcy, and agency costs combined
Minimum Cost of Capital Point
Cost of Capital ()
Net tax effect
Optimal Financial Leverage
Financial Leverage (B/S)
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Financial Signaling

• A manager may use capital structure changes to
  convey information about the profitability and
  risk of the firm.

• 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 firms stock price is
  undervalued.
• This is a valid signal because of the possibility
  of bankruptcy.

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Timing and Flexibility

• 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.

• Flexibility
• A decision today impacts the options open to the
  firm for future financing options thereby
  reducing flexibility.
• Often referred to unused debt capacity.

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Checklist of Practical and Conceptual
Considerations

• Taxes
• Explicit cost
• Cash-flow ability to service debt
• Agency costs and incentive issues
• Financial signaling

• EBIT-EPS analysis
• Capital structure ratios
• Security rating
• Timing
• Flexibility