Capital Structure Theory

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Econ173 Corporate Finance Brealey, Myers and
Allen Ch18 19
Lecture 5
Capital Structure Theory
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What is Capital Structure?

• Capital
• Long term money used to support business
  activity
• Capital Structure
• The split between shares, bonds, and other types
  of long term capital in business.

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Does Capital Structure Matter?

• Assets 1 million
• Case 1
• Capital Equity 1,000,000
• Case 2
• Capital Equity Debt
• 600,000 400,000
• 1 million
• Value of the firms VU VL 1m

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MM (Debt Policy Doesnt Matter)

• Modigliani Miller
• When there are no taxes and capital markets
  function well, it makes no difference whether the
  firm borrows or individual shareholders borrow.
  Therefore, the market value of a company does not
  depend on its capital structure.

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MM (Debt Policy Doesnt Matter)

• Assumptions
• By issuing 1 security (i.e. stock) rather than 2
  (i.e. stock and bond), company diminishes
  investor choice. This does not reduce value if
• Investors do not need choice, OR
• There are sufficient alternative securities
• Capital structure does not affect cash flows
  e.g...
• No taxes
• No bankruptcy costs
• No effect on management incentives

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All Equity Financed Firm
Example - Macbeth Spot Removers - All Equity
Financed
Expected outcome
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50 Debt Financed Firm
Example cont. 50 debt
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Home Made Leverage
Example - Macbeths - All Equity
Financed - Debt replicated by investors 2
shares _at_10 20, 50 debt borrow 10_at_10
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No Magic in Financial Leverage
MM'S PROPOSITION I If capital markets are
doing their job, firms cannot increase value
by tinkering with capital structure. V is
independent of the debt ratio. AN EVERYDAY
ANALOGY It should cost no more to assemble a
chicken than to buy one whole.
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MM Preposition I

• The market value of any firm is independent of
  its capital structure.

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Proposition II and Macbeth
More debt more financial risk for
shareholders more equity
return needed to compensate
for additional risk borne
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Leverage and Returns
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MM Proposition II
Macbeth continued (All equity D0, E10,000)
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MM Proposition II
Macbeth continued (50 Debt financed D5,000,
E5,000)
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MM Preposition II

• The expected return on the common stock of a
  levered firm increases in proportion to the
  debt-equity ratio (D/E), expressed in market
  value.

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MM Proposition II
r
rE
rA
rD
D E
Risk free debt
Risky debt
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Leverage and Risk
Macbeth continued
Leverage increases the risk of Macbeth shares
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Leverage and Returns
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Weighted Average Cost of Capital
Weighted Average Cost of Capital (WACC) is the
traditional view of capital structure, risk and
return.
WACC is a cost to the firm while rA is the
(average) return on the investment to capital
provider.
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CAPM Security Market Line
Expected Return
.20rE
Equity
.15rA
Assets
.10rD
Debt
Risk
ß E
ß A
ßD
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WACC

• Example - A firm has 2 mil of debt and 100,000
  of outstanding shares at 30 each. If they can
  borrow at 8 and the stockholders require 15
  return what is the firms WACC?

D 2 million E 100,000 shares X 30 per share
3 million V D E 2 3 5 million
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WACC

• Example - A firm has 2 mil of debt and 100,000
  of outstanding shares at 30 each. If they can
  borrow at 8 and the stockholders require 15
  return what is the firms WACC?

D 2 million E 100,000 shares X 30 per share
3 million V D E 2 3 5 million
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WACC (MM view)
r
rE
WACC
rD
D V
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• MM with Tax

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Capital Structure Corporate Taxes

• Financial Risk - Risk to shareholders resulting
  from the use of debt.
• Financial Leverage - Increase in the variability
  of shareholder returns that comes from the use of
  debt.
• Interest Tax Shield- Tax savings resulting from
  deductibility of interest payments.

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Capital Structure Corporate Taxes
The tax deductibility of interest increases the
total distributed income to both bondholders and
shareholders.
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Capital Structure Corporate Taxes

• Example - You own all the equity of Space Babies
  Diaper Co. The company has no debt. The
  companys annual cash flow is 900,000 before
  interest and taxes. The corporate tax rate is 35
  You have the option to exchange 1/2 of your
  equity position for 5 bonds with a face value of
  2,000,000.
• Should you do this and why?

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Capital Structure Corporate Taxes

• Example - You own all the equity of Space Babies
  Diaper Co. The company has no debt. The
  companys annual cash flow is 900,000 before
  interest and taxes. The corporate tax rate is 35
  You have the option to exchange 1/2 of your
  equity position for 5 bonds with a face value of
  2,000,000.
• Should you do this and why?

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Capital Structure Corporate Taxes
D x rD x Tc rD

• PV of Tax Shield
• (assume perpetuity)

D x Tc
Example Tax benefit 2,000,000 x (.05) x (.35)
35,000 PV of 35,000 in perpetuity 35,000
/ .05 700,000 PV Tax Shield 2,000,000 x
.35 700,000
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Capital Structure Corporate Taxes

• Firm Value
• Value of All Equity Firm PV Tax Shield

Example All Equity Value 585 / .05
11,700,000 PV Tax Shield
700,000 Firm Value with 1/2 Debt
12,400,000
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Capital Structure Corporate Taxes
Pfizer Balance Sheet, March 2004 (figures in
millions)
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Capital Structure Corporate Taxes
Pfizer Balance Sheet, March 2004 (figures in
millions) (w/ 1 billion Debt for Equity Swap)
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• Omit Personal Taxation

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

• The tax benefit from interest expense
  deductibility must be included in the cost of
  funds.
• This tax benefit reduces the effective cost of
  debt by a factor of the marginal tax rate.

Old Formula
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After Tax WACC
Tax Adjusted Formula
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After Tax WACC

• Example - Union Pacific
• The firm has a marginal tax rate of 35. The
  cost of equity is 10.0 and the pretax cost of
  debt is 5.5. Given the book and market value
  balance sheets, what is the tax adjusted WACC?

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After Tax WACC

• Example - Union Pacific - continued

MARKET VALUES
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After Tax WACC

• Example - Union Pacific - continued

Debt ratio (D/V) 7.6/22.6 .34 or 34 Equity
ratio (E/V) 15/22.6 .66 or 66
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After Tax WACC

• Example - Union Pacific - continued

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Weighted Average Cost of Capitalwith corporation
tax (traditional view)
r
Includes Bankruptcy Risk
rE
WACC
rD
D V
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Financial Choices

• MM Without Tax
• MM With Corporation Tax (Personal Taxes not
  covered)
• 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.

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Trade Off Theory Prices

• 1. Stock-for-debt Stock price
• exchange offers falls
• Debt-for-stock Stock price
• exchange offers rises
• 2. Issuing common stock drives down stock
  prices repurchase increases stock prices.
• 3. Issuing straight debt has a small negative
  impact.

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Issues and Stock Prices

• Why do security issues affect stock price? The
  demand for a firms securities ought to be flat.
• Any firm is a drop in the bucket.
• Plenty of close substitutes.
• Large debt issues dont significantly depress
  the stock price.

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Pecking Order Theory

• Consider the following story
• The announcement of a stock issue drives
  down the stock price because investors believe
  managers are more likely to issue when shares are
  overpriced.
• Therefore firms prefer internal finance
  since funds can be raised without sending
  adverse signals.
• If external finance is required, firms issue
  debt first and equity as a last resort.
• The most profitable firms borrow less not
  because they have lower target debt ratios but
  because they don't need external finance.

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Pecking Order Theory

• Some Implications
• Internal equity may be better than external
  equity.
• Financial slack is valuable.
• If external capital is required, debt is better.
  (There is less room for difference in opinions
  about what debt is worth).

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Exercises

• Chapter 17
• Q17-1 to Q17-8, P17-1, P17-3 to P17-13
• Chapter 18
• Q18-1, Q18-2, Q18-4 to Q18-10, P18-1, P18-3,
  P18-7, P18-8, P18-10