Chapter 17 -- Capital Structure and Value

1
Chapter 17 -- Capital Structure and Value

• Overview
• Perfect markets and capital structure irrelevance
• Influence on capital structure
• Information problems and capital structure
• Other considerations
• Empirical evidence on capital structure and value

2
Perfect markets -- Modigliani and Miller

• No taxes, no bankruptcy, same information sets,
  no transaction cost
• Capital structure does not matter
• Shareholders will adjust the companys structure
  to whatever they want

3
Taxes and Capital Structure

• Differential tax rates
• Personal ordinary income rate
• What shareholders pay if they receive a dividend
• Corporate ordinary income rate
• What the corporation shares with the government
• Personal capital gains rate
• What you pay on the gain if you sell your stock

4
Taxes and Capital Structure

• Differential tax rates within the corporation
• May have other tax shields such as depreciation
• May not have the income to pay taxes

5
Bankruptcy or Liquidation cost and Capital
Structure

• Legal cost
• Disruption cost
• Expected bankruptcy cost and capital structure

6
Information Problems Agency Cost

• Agency cost of debt
• Cost borne by your debt-holders to monitor your
  actions or prospective actions
• very low when debt is low but goes up as debt in
  increased

7
Information Problems Agency Costs

• Agency cost of equity
• Cost borne by shareholders to monitor your
  actions
• High with no debt but decreases as debt increases
• These cost decrease because
• others (debt-holders) are monitoring, often with
  better information (monthly statements)
• Cost of a loss is less with others participating

8
Information Problems Agency Costs

• Look for the mixture of debt and equity that
  minimizes total agency costs

9
Information Problems Signaling

• Management may have a better information set than
  the shareholders
• Actions speak louder than words
• The assumption of debt signals managements
  confidence in future cash flows
• Issuing debt to buy back equity is a very
  positive signal

10
Other Considerations and Capital Structure Choice

• Unequal cost of corporate borrowing and personal
  borrowing
• This favors corporate borrowing over personal
  borrowing

11
Other Considerations and Capital Structure Choice

• Additional liability of homemade leverage
• Favors corporate over personal borrowing
• You can only lose the value of your stock
  investment
• With homemade leverage you can lose your personal
  assets
• Restrictions on homemade leverage

12
Empirical Evidence on Capital Structure and Value

• As theories predict, taxes, bankruptcy costs, and
  agency costs all have roles in determining
  capital structure
• Science is not so complete that we can predict or
  prescribe the exact optimal capital structure