ECF 2222 CORPORATE FINANCE II

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ECF 2222 CORPORATE FINANCE II

• WEEK 7
• CAPITAL STRUCTURE I

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Learning Objectives

• The definition of capital structure
• Understanding the concept of the optimal capital
  structure
• The effects of financial leverage
• Discuss Miller and Modiglianis Propositions
• Proposition 1 The Law of Conservation of
  Value Proposition 2 The Natural Conservation of
  Risk

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CAPITAL STRUCTUREIS IT RELEVANT?

• The upshot of the matter is that we still dont
  have an accepted, coherent theory of capital
  structure. It is not for want of argument on the
  subject. Brealey and Myers 1991, p.322

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CAPITAL STRUCTURE

• Question Can a company increase the
  shareholders wealth by varying the combinations
  of debt and equity?
• Hypothesis

Ho Capital structure is irrelevant H1 Capital
structure is not irrelevant
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The definition of capital structure

• Capital structure
• The mix of debt and equity finance used by a
  company.

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Understanding the concept of the optimal capital
structure

• Optimal capital structure
• The capital structure which maximises the
  value of a company.
• Does the value of the net operating cash flow
  stream depend on how it is divided between
  payments to lenders and shareholders?

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Some concepts of capital structure

• What is financial leverage?
• It is the relationship between borrowings and
  equity.

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Some concepts of capital structure

• Measures of financial leverage
• Debt to Equity, Debt to Total Assets and Interest
  Coverage.
• Leverage varies both within and between
  industries.
• In 2000, Woolworths debt levels were much lower
  than David Jones, even though they are both in
  the same industry.

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Some concepts of capital structure

• Business risk
• The variability of future net cash flows
  attributed to the nature of the companys
  operations (the risk faced by shareholders if the
  company is financed only by equity).
• Financial risk
• The risk attributable to the use of debt as a
  source of finance.

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Effects of financial leverage

• Expected rate of return on equity is increased.
• Variability of returns to shareholders increases.
• Increasing leverage involves a trade-off between
  risk and return.

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EXAMPLE 13.1 (Bird et al, 2002, Pg. 382)

• Dribnor Ltd
• Issued capital of 1 million ordinary shares with
  a market price of 2 each
• Considering repurchasing half of its shares by
  borrowing at 12 per annum
• Companys expected earnings before interest is
  300 000 per annum
• Analyse the effects of earnings at the following
  levels 200 000, 240 000 and 300 000.

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EXAMPLE 13.1 (Bird et al, 2002, Pg. 382)
Earnings (000s) 200 240 300 400 ROR
Assets () 10
12 15
20 EXISTING CAPITAL STRUCTURE (100
EQUITY) No. of Shares (mill) 1 1
1 1 EPS (cents) 20 24 30 40 ROR
Equity () 10
12 15
20 PROPOSED CAPITAL
STRUCTURE (50 EQUITY, 50 DEBT) No. of Shares
(mill) 0.5 0.5 0.5 0.5 Interest on
Debt(12) 120 120 120 120 Earnings for OS
80 120 180 280 EPS (cents)
16 24 36 56 ROR Equity ()
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12 18
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Expected position
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PROPOSED 50/50 D/E
ROR EQUITY
EXISTING 100 E
ROR ASSETS
Figure 13.1 p.383
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Effects of financial leverage

• Financial leverage has important effects, but
  does a change in the capital structure change the
  value of the company and therefore affect
  shareholders wealth?

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These two say No!
Capital Structure Irrelevance
Miller (1923-2000) Modigliani
Modigliani, F. and Miller, M.H. (1958), The
Cost of Capital, Corporation Finance and the
Theory of Investment, American Economic Review,
(48), pp.261-297.
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MM ASSUMPTIONS

• Perfect capital market
• no transaction costs
• costless access to information
• rational investors
• infinitely divisible securities
• Individuals borrow at corporate rate
• no costs of liquidation
• Risk measured by ?EBIT, of which all investors
  agree on
• Earnings constant in perpetuity.

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MM PROPOSITIONS

• Proposition One
• Law of Conservation of Value

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MM PROPOSITIONS

• Proposition One
• Law of Conservation of Value
• Proposition Two
• Natural Conservation of Risk
• The cost of equity of a levered coy.
  cost of equity of unlevered
• risk premium dependent on fin leverage

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MM PROPOSITIONS

• Proposition One
• Law of Conservation of Value
• Proposition Two
• Natural Conservation of Risk
• Proposition Three
• The cutoff point for investments is independent
  of the investment financing

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PROPOSITION ONE Law of Conservation of Value
Market value of company independent of capital
Structure. Market value is the capitalisation
of operating earnings.
No matter how its broken up - its still the
same
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PROPOSITION ONE Law of Conservation of Value
Market value of company independent of capital
Structure. Market value is the capitalisation
of operating earnings.

• Two companies with the same
• earnings from the same risk
• group should be worth same
• If not arbitrage profit available

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Arbitrage

• Arbitrage involves buying an asset and
  simultaneously selling it for a higher price,
  usually in another market, so as to make a
  risk-free profit.

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EXAMPLE 13.2 (Bird et al, 2002, Pg. 384)

• Proof for Proposition I
• Consider two alternative capital structures 100
  equity and D/E ratio of 5050
• Suppose an investor has 20 000 to invest and
  wants a levered investment. One way to ahcieve
  this is to buy shares in the levered company.
• 20 000 will buy 2 of the shares in a levered
  company (20 000/1 000 000 2)
• Company faces uncertain profitability but assume
  cashflow or EBIT is either 200 000 or 400 000.

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EXAMPLE 13.2 (Bird et al, 2002, Pg. 384)

• Corporate Leverage
• Earnings before Interest 200 000 400 000
• Investment of 20 000 in levered company
• Company interest expense -120 000 -120 000
• Earnings for shareholders 80 000 280
  000
• Investors share of earnings 1 600 5
  600

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EXAMPLE 13.2 (Bird et al, 2002, Pg. 384)

• Now suppose the company chooses the unlevered
  capital structure but the investor still wants a
  levered investment.
• To replicate the same leverage as the levered
  company, the investor has to borrow 20 000.
• With 40 000, the investor will still able to buy
  2 of the companys shares (40 000/2 000 000
  2)

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EXAMPLE 13.2 (Bird et al, 2002, Pg. 384)

• Homemade Leverage
• Earnings before Interest 200 000 400
  000
• Investment of 40 000 in levered company
• Earnings for shareholders (2) 4 000 8
  000
• Less Interest paid by investor -2 400 -2
  400
• Investors net return 1 600
  5 600

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EXAMPLE 13.2 (Bird et al, 2002, Pg. 384)

• What do we know from this example?
• The investors net return is exactly the same
  regardless of whether the company borrows or
  whether the investor borrows.
• Because the net return is the same, the value of
  the company must also be the same regardless of
  the capital structure adopted.
• There is no reason for investors to pay a premium
  for shares in levered companies because investors
  can borrow to create homemade leverage.
• Under MM assumptions, homemade leverage is a
  perfect substitute for corporate leverage.

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EXAMPLE 13.3 (Bird et al, 2002, Pg. 385)

• Undoing corporate leverage
• Consider a different (reversed) situation, where
  the company has a levered capital structure but
  the investor wants an unlevered investment
• In this case, the investor could effectively
  undo corporate leverage by buying shares in a
  levered company and lending money.
• The investor can achieve the equivalent of
  investing in an unlevered company by investing
  10 000 and lending 10 000 at an interest rate
  of 12.

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EXAMPLE 13.3 (Bird et al, 2002, Pg. 385)

• Investing in an unlevered company
• Earnings before Interest 200
  000 400 000
• Investment of 40 000 in levered company
• Investors share of earnings (1) 2 000
  4 000
• Undoing corporate leverage
• Earnings before Interest 200
  000 400 000
• Companys interest expense -120 000
  -120 000
• Earnings avail. to s/holders 80
  000 80 000
• Investors share of earnings (1) 800
  2 800
• Interest received on loan of 10 000 1 200
  1 200
• Total dollar return
  2 000 4 000

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• What do we know from the last two examples?
• We have assumed that the last the values of the
  levered and unlevered companies were the same.
• But what would happen if the values of the two
  companies were not the same?
• Arbitrage would occur investors would earn
  immediate profit with no risk

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EXAMPLE 13.4 (Bird et al, 2002, Pg. 386)

• Process of arbitrage
• Consider two companies a levered company, L and
  the unlevered company U.
• Both companies have the same assets which
  generate cashflows of 80 000 per annum in
  perpetuity.
• Ls debt has a market value of 200 000 and it
  pays interest of 10 per annum.
• EBIT are available to ordinary shareholders and
  are assumed to be paid to them as dividends.
• There are no taxes.

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EXAMPLE 13.4 (Bird et al, 2002, Pg. 386)

• 
  COY.U COY. L
• Earnings before Interest 80 000 80 000
• - Interest on debt (10) 0 20
  000
• Income avail OSHolders 80 000 60 000
• ? Expected return on equity 0.14 0.15
• Market Value Equity (E) 571 429
  400 000
• Market Value Debt (D) 0 200
  000
• Total Value D E 571 429
  600 000

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EXAMPLE 13.4 (Bird et al, 2002, Pg. 386)

• Based on the previous table, the levered company
  has a higher total market value than U.
• This shouldnt occur as the investor can earn an
  arbitrage profit by selling shares in L,
  borrowing by means of a personal loan and
  investing the proceeds in the shares of U which
  is undervalued relative to L.
• Consider an investor who owns 1 share in L.
  Since the total market value of Ls shares is
  400 000, the investors market value of shares
  in L is 4 000.

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EXAMPLE 13.4 (Bird et al, 2002, Pg. 386)

• Recognising arbitrage opportunity, the investor
  sells shares for 4 000.
• Borrows 2 000 _at_ 10 to replicate the leverage of
  L.
• Investor uses 6 000 to invest in U.
• ORIGINALLY, INVESTORS RETURNS ARE
• 15 OF 4 000 600
• NET INCOME FROM ARBITRAGE
• Income from investment in U 6 000 x 0.14
  840
• Less Interest on borrowing 2 000 x 0.15
  200
• Equals Net income
  640
• Therefore, the investor can increase annual
  income by 40 with no change in risk.

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PROPOSITION TWO

• Natural Conservation of Risk
• The cost of equity of a levered company cost
  of equity of unlevered risk premium dependant
  on financial leverage

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IT DOESNT MATTER - MM
Ke
COST
K - Overall Cost
Kd
Figure 13.2
Leverage (D/E)
Conclusion - D/E Irrelevant
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PROPOSITION TWO
Natural Conservation of Risk
The cost of equity of a levered company cost
of equity of unlevered risk premium dependant
on financial leverage ke k0 (k0
kd) (D/E) (13.3) Increasing lower cost
debt has implicit cost Appearance of lower
cost an illusion
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PROPOSITION TWO

• Earnings (000s) 200 240 300 400
• ROR Assets () 10
  12 15
  20
• EXISTING CAPITAL STRUCTURE (100 EQUITY)
• No. of Shares (mill) 1 1 1 1
• EPS (cents) 20 24 30 40
• ROR Equity () 10
  12 15
  20
• PROPOSED CAPITAL STRUCTURE (50 EQUITY, 50 DEBT)
• No. of Shares (mill) 0.5 0.5 0.5 0.5
• Interest on Debt (12) 120 120 120 120
• Earnings for OS 80 120 180 280
• EPS (cents) 16 24 36 56
• ROR Equity () 8
  12 18
  28

Table 13.2, p.382
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PROPOSED 50/50 D/E
ROR EQUITY
EXISTING 100 E

• Debt - explicit implicit cost
• Implicit - Financial Risk
• Expected Return ?
• So does Required Return

ROR ASSETS
Figure 13.1, p.383
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MM2 - with risky debt
Ke
COST
K
Kd
Risk-free debt Risky Debt
Figure 13.3
Leverage (D/E)
Conclusion - D/E Irrelevant
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PROPOSITION THREE The cutoff point for
investments is independent of the investment
financing

• INVESTMENT DECISION INDEPENDENT OF FINANCING
• INVESTMENT DISCOUNT RATE DETERMINED BY RISK OF
  INVESTMENT

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CAPITAL STRUCTURE

• Given MM assumptions - irrelevant!
• Where does relevance come from - look at the
  assumptions

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Assignment

• Have you a partner?
• Fix a meeting schedule
• Ensure you both have a copy
• Do not assume
• If problems SEE ME, soon