CHAPTER 11 Capital Structure Decisions: Part II

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CHAPTER 11Capital Structure DecisionsPart II

• MM and Miller models
• Hamadas equation
• Financial distress and agency costs
• Trade-off models
• Asymmetric information theory

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Who are Modigliani and Miller (MM)?

• They published theoretical papers that changed
  the way people thought about financial leverage.
• They won Nobel prizes in economics because of
  their work.
• MMs papers were published in 1958 and 1963.
  Miller had a separate paper in 1977. The papers
  differed in their assumptions about taxes.

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What assumptions underlie the MMand Miller
models?

• Firms can be grouped into homogeneous classes
  based on business risk.
• Investors have identical expectations about
  firms future earnings.
• There are no transactions costs.

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• All cash flows are perpetuities. This implies
  perpetual debt is issued, firms have zero growth,
  and expected EBIT is constant over time.
• In their first paper (1958), MM also assumed that
  there are no corporate or personal taxes. Later
  relaxed.
• The assumptions were necessary in order for MM to
  use the arbitrage argument to develop and prove
  their equations.

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MM with Zero Taxes (1958)
Proposition I VL VU. Proposition II ksL
ksU (ksU - kd)(D/S).
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Given the following data, find V, S,ks, and WACC
for Firms U and L.

• Firms U and L are in same risk class.
• EBITU,L 500,000.
• Firm U has no debt ksU 14.
• Firm L has 1,000,000 debt at kd 8.
• The basic MM assumptions hold.
• There are no corporate or personal taxes.

From the Mini Case
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1. Find VU and VL.
EBIT ksU
500,000 0.14
VU
3,571,429. VL VU 3,571,429. Question Are
the MM assumptions required?
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2. Find the market value of Firm Ls debt and
equity.
VL D SL 3,571,429
3,571,429 1,000,000 SL
SL 2,571,429.
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3. Find ksL.
ksL ksU (ksU - kd)(D/S) 14.0 (14.0 -
8.0)( ) 14.0 2.33 16.33.
1,000,000 2,571,429
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4. Proposition I implies WACC ksU. Verify
for L using WACC formula.
WACC wdkd wceks (D/V)kd (S/V)ks
( )(8.0) (
)(16.33) 2.24 11.76
14.00.
1,000,000 3,571,429
2,571,429 3,571,429
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Graph the MM relationships between capital costs
and leverage as measured by D/V.
Without taxes
Cost of Capital ()
26 20 14 8
ks
WACC
kd
Debt/Value Ratio ()
0 20 40 60 80 100
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• The more debt the firm adds to its capital
  structure, the riskier the equity becomes and
  thus the higher its cost.
• Although kd remains constant, ks increases with
  leverage. The increase in ks is exactly
  sufficient to keep the WACC constant.

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Graph value versus leverage.
Value of Firm, V ()
4 3 2 1
VL
VU
Firm value (3.6 million)
0 0.5 1.0 1.5 2.0 2.5
Debt (millions of )
With zero taxes, MM argue that value is
unaffected by leverage.
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Find V, S, ks, and WACC for Firms U and L
assuming a 40 corporatetax rate.
With corporate taxes added, the MM propositions
become Proposition I VL VU
TD. Proposition II ksL ksU (ksU - kd)(1 -
T)(D/S).
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Notes About the New Propositions

• 1. When corporate taxes are added,VL ? VU. VL
  increases as debt is added to the capital
  structure, and the greater the debt usage, the
  higher the value of the firm.
• 2. ksL increases with leverage at a slower rate
  when corporate taxes are considered.

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1. Find VU and VL.
Note Represents a 40 decline from the no taxes
situation. VL VU TD 2,142,857
0.4(1,000,000) 2,142,857 400,000
2,542,857.
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2. Find market value of Firm Ls debt and equity.
VL D SL 2,542,857 2,542,857
1,000,000 SL SL 1,542,857.
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3. Find ksL.
ksL ksU (ksU - kd)(1 - T)(D/S)
14.0 (14.0 - 8.0)(0.6)( )
14.0 2.33 16.33.
1,000,000 1,542,857
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4. Find Firm Ls WACC.
WACCL (D/V)kd(1 - T) (S/V)ks (
)(8.0)(0.6) (
)(16.33) 1.89
9.91 11.80. When corporate taxes are
considered, the WACC is lower for L than for U.
1,000,000 2,542,857
1,542,857 2,542,857
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MM relationship between capital costs and
leverage when corporate taxes are considered.
Cost of Capital ()
26 20 14 8
ks
WACC
kd(1 - T)
Debt/Value Ratio ()
0 20 40 60 80 100
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MM relationship between value and debt when
corporate taxes are considered.
Value of Firm, V ()
4 3 2 1
VL
TD
VU
Debt (Millions of )
0 0.5 1.0 1.5 2.0 2.5
Under MM with corporate taxes, the firms value
increases continuously as more and more debt is
used.
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Assume investors have the following tax rates
Td 30 and Ts 12. What is the gain from
leverage according to the Miller model?
Millers Proposition I VL VU 1 -
D. Tc corporate tax rate. Td
personal tax rate on debt income. Ts personal
tax rate on stock income.
(1 - Tc)(1 - Ts) (1 - Td)
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Tc 40, Td 30, and Ts 12. VL
VU 1 - D
VU (1 - 0.75)D VU
0.25D. Value rises with debt each 100 increase
in debt raises Ls value by 25.
(1 - 0.40)(1 - 0.12) (1 - 0.30)
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How does this gain compare to the gain in the MM
model with corporate taxes?

• If only corporate taxes, then
• VL VU TcD VU 0.40D.
• Here 100 of debt raises value by 40. Thus,
  personal taxes lower the gain from leverage, but
  the net effect depends on tax rates.

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When Miller brought in personaltaxes, the value
enhancement of debt was lowered. Why?

• 1. Corporate tax laws favor debt over equity
  financing because interest expense is tax
  deductible while dividends are not.

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• 2. However, personal tax laws favor equity over
  debt because stocks provide both tax deferral and
  a lower capital gains tax rate.
• 3. This lowers the relative cost of equity
  vis-a-vis MMs no-personal-tax world and
  decreases the spread between debt and equity
  costs.
• 4. Thus, some of the advantage of debt financing
  is lost, so debt financing is less valuable to
  firms.

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What does capital structure theoryprescribe for
corporate managers?

• 1. MM, No Taxes Capital structure is
  irrelevant--no impact on value or WACC.
• 2. MM, Corporate Taxes Value increases, so
  firms should use (almost) 100 debt financing.
• 3. Miller, Personal Taxes Value increases, but
  less than under MM, so again firms should use
  (almost) 100 debt financing.

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Do firms follow the recommendationsof capital
structure theory?

• Firms dont follow MM/Miller to 100 debt. Debt
  ratios average about 40.
• However, debt ratios did increase after MM. Many
  think debt ratios were too low, and MM led to
  changes in financial policies.

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Define financial distress andagency costs.

• Financial distress As firms use more and more
  debt financing, they face a higher probability of
  future financial distress, which brings with it
  lower sales, EBIT, and bankruptcy costs. Lowers
  value of stock and bonds.

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• Agency costs The costs of managers not behaving
  in the best interests of shareholders and the
  resulting costs of monitoring managers actions.
  Lowers value of stock and bonds.

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How do financial distress and agency costs change
the MM and Miller models?

• MM/Miller ignored these costs, hence those models
  show firm value increasing continuously with
  leverage.
• Since financial distress and agency costs
  increase with leverage, such costs reduce the
  value of debt financing.

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Heres a valuation model which includes financial
distress andagency costs

• X represents either Tc in the MM model or the
  more complex Miller term.
• Now, optimal leverage involves a tradeoff between
  the tax benefits of debt and the costs associated
  with financial distress and agency.

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Relationships between capital costs and leverage
when financial distress and agency costs are
considered.
Cost of Capital ()
ks
14 4
WACC or ka
kd(1 - T)
Debt/Value Ratio ()
D
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Relationship between value and leverage.
Note that value is maximized and WACC is
minimized at the same capital structure.
Value of Firm V ()
4 3 2 1
Debt ()
D
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Tradeoff theory (Static Tradeoff Theory)

• The optimal capital structure involves a balance
  between
• the tax-shield benefits of leverage and
• the costs associated with financial distress and
  agency problems.
• rationalizes moderate borrowing
• mature firms with tangible assets should borrow
  more than growth firms

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Implications of Tradeoff Theory

• Firms with more business risk ought to use less
  debt than lower risk firms
• Firms that have tangible, readily marketable
  assets such as real estate can use more debt than
  firms whose value is derived from intangible
  assets.
• Firms that are currently paying taxes at the
  highest rate should use more debt than firms with
  lower current/ or prospective tax rates.

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Reality

• Firms prefer to finance with internally generated
  funds - retained earnings and depreciation.
• Firms set their target payout ratios based on
  their expected future investment opportunities
  and expected future cash flows
• Dividends are sticky in the short run.
• There is a pecking order of financing, not the
  balanced approach that is called for under the
  tradeoff theory.

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How are financial and business risk measured in a
market risk framework?
ksL kRF (kM-kRF)bU (kM -
kRF)bU(1 - T)(D/S)
.
(Hamadas equation)
Pure time value
Business risk premium
Financial risk premium
ksL
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Hamadas equation for beta b


bU Unlevered beta, which reflects the business
risk of the firm Business risk
bU(1 - T)(D/S) Increased volatility of the
returnsto equitydue to the use of
debt Financialrisk
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What is the asymmetric information, or signaling,
theory of capital structure?

• Theory recognizes that market participants do not
  have homogeneous expectations--managers typically
  have better information than investors.
• Thus, financing actions are interpreted by
  investors as signals of managerial expectations
  for the future.

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• Managers will issue new common stock only when no
  other alternatives exist or when the stock is
  overvalued.
• Investors recognize this, so new stock sales are
  treated as negative signals and stock price
  falls.
• Managers do not want to trigger a price decline,
  so firms maintain a reserve borrowing capacity.
• Managers act in the best interests of current
  shareholders.

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Important implication

• Because managers are reluctant to take actions
  which lower their firms stock price, they try to
  maintain a reserve borrowing capacity which can
  be tapped if external equity is needed. They do
  not want to be forced into a new equity issue at
  the wrong time.

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What is the pecking order theoryof capital
structure?

• Results of a survey by Donaldson and the
  asymmetric information theory.
• Firms follow a specific financing order
• First use internal funds.
• Next, draw on marketable securities.
• Then, issue new debt.
• Finally, and only as a last resort, issue new
  common stock.

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Does the pecking order theory make sense?
Explain.Is the pecking order theory consistent
with the trade-off theory?

• It is consistent with the asymmetric information
  theory, in which managers avoid issuing equity.
• Especially true for mature companies which go to
  the markets infrequently.
• It is not consistent with trade-off theory.

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Organizational Theory of Capital Structure

• Maximize Corporate Wealth
• Organizations act in their own interest
• The most profitable firms borrow the least
• Some regard the substitution of Debt for Equity
  as a Good Change

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Conclusion

• MM and Miller models
• Financial Distress and Agency Costs
• Hamada Equation
• Tradeoff Theory
• Asymmetric Information Theory
• Pecking Order Theory