CHAPTER 13 Capital Structure and Leverage

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CHAPTER 13Capital Structure and Leverage

• Capital structure theory

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What is financial leverage?Financial risk?

• Financial leverage is the use of debt and
  preferred stock.
  
• Financial risk is the additional risk
  concentrated on common stockholders as a result
  of financial leverage.

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Capital Structure

• Capital structure refers to the long-term sources
  of capital equity and debt
  
• Theories deal with the relationship between
  capital structure and the value of the firm under
  various assumptions.
  
• Two types of firms
• Unlevered firm (U) firm that has no debt in
  capital structure
  
• Levered firm (L) firm that has some debt in
  capital structure
  
• Why do we observe different capital structures in
  the real world?
  

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Capital Structure Theory

• 1. Modigliani and Miller (MM) Without Tax
• In a perfect capital market, the value of the
  levered firm is equal to the value of the
  unlevered firm.
  
• VL VU
• A perfect capital market (PCM) is where
• market for securities is perfectly competitive
• Investors have equal access to all relevant
  Information
  
• firms and investors can borrow/lend at the same
  rate.
  
• no transaction costs
• no taxes
• no costs of financial distress

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• Rationale behind MM theory
• The value of a firm is its expected cash flows
  discounted at the WACC.
  
• Unlevered Firm
• All cash flows belong to shareholders.
• The value of the firm is the expected cash flows
  to shareholders discounted at the required rate
  of return of equity.
  
• Required rate of return of equity WACC

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• Rationale behind MM theory
• Levered Firm
• Cash flows belong to both shareholders and
  bondholders. But total cash flows remain the
  same.
  
• The value of the firm is total of the cash flows
  to shareholders and bondholders discounted at the
  WACC.
  
• The cost of debt is less than the cost of
  equity.
  
• Financing partly through debt, has the effect of
  reducing firms overall cost of capital (WACC).

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• However, debt increases risk to shareholders
  required return of equity rises. This has the
  effect of increasing WACC.
  
• The benefit of debt due to lower cost of debt is
  exactly offset by the increase in the required
  return of equity, leaving the WACC unchanged.
  
• Since WACC does not change (given the same amount
  of cash flows), the value of the firm does not
  change either.
  
• Leverage has no impact on value in a PCM.

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MM Arbitrage Proof

• Value of U D/ ks
• Value of L D/ ks I/ kd
• D paid to Ls stockholders are reduced by the
  amount of I paid on the debt
  
• ks is higher for L because of the additional
  leverage-induced risk
  
• The values of U and L are identical due to
  arbitrage

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MM without Tax Example

• Information on two firms identical in all
  respects except for the capital structures is
  given below
  

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MM without Tax Example

• Create income statements of two firms

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MM without Tax Example

• Value of the unlevered firm
• where ksU WACC

ksU cost of equity of unlevered firm
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MM without Tax Example

• Value of the levered firm

Where,
ksL cost of equity of levered firm
ksU cost of equity of unlevered firm
kd cost of debt B market value of debt S
market value of equity
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MM without Tax Example

• Value of the levered firm

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MM without Tax

• The overall cost of capital is independent of the
  capital structure
  
• The firms value is independent of the capital
  structure

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• If leverage increases, the cost of equity (ks),
  increases to exactly offset the benefits of more
  debt financing ( kd ), leaving the cost of
  capital ( ka ) constant

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2. MM with Tax

• Now, relax the no-tax assumption assume the
  existence of corporate income taxes (T).
  
• Interest on debt is tax deductible.
• Value of tax savings is a gain from the use of
  leverage.
  
• Gain from leverage (Tax Shield) TB
• Value of levered firm is equal to value of
  unlevered firm plus present value of the tax
  shield.

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What Happens with Taxes ?

• Same two equations
• VU D/ks VL D/ks I/kd
• D distributed to Us stockholders are reduced by
  the taxes paid on operating income and the value
  of U drops
  
• Since I is tax deductible, L realizes a tax
  savings
  
• PV of tax shield value of debt ( B ) tax rate
  (T)

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MM with Tax Example

• Recreate income statements of two firms assuming
  T40
  

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MM with Tax Example

• Value of the unlevered firm
• where ksU WACC

ksU cost of equity of unlevered firm
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MM with Tax Example

• Value of the levered firm

or
Where,
ksL cost of equity of levered firm
ksU cost of equity of unlevered firm
kd cost of debt B market value of debt S
market value of equity
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MM with Tax Example

• Value of the levered firm

or
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VL VU Value of Tax Shield
VL
MktValue of Firm
PV of Tax Shield
VU
Debt
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MM with Tax
The cost of capital decreases with the amount of
debt Firm maximizes its value by choosing a capit
al structure that is all debt.
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3. Trade-Off Model

• Cost of Financial Distress
• Higher leverage increases the potential for
  firms financial distress and financial distress
  costs.
  
• Financial distress costs
• Direct costs
• Lenders may demand higher interest rates
• Legal and administrative costs of reorganization
  / liquidation
  
• If forced to liquidate, assets may have to be
  sold for less than market value
  
• Indirect costs
• Lenders may decline to lend at all forcing the
  firm to forgo some investments
  
• Loss of customers and suppliers

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Agency costs

• Costs arising from conflicts between SH and BH,
  when the firm is facing financial distress /
  bankruptcy.
  
• Issuance of more debt by the firm, increasing the
  risks of bondholders.
  
• Taking on high-risk projects
• Value increase is captured by SH, while value
  decrease is detrimental to BH
  
• Milking the property
• Payment of dividends to SH.
• These conflicts lead to loss of efficiency and
  higher interest costs.
  
• After some level of debt, financial distress and
  agency costs tend to increase with the level of
  debt.
  

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Capital Structure Theory

• Benefit of leverage Higher leverage leads to
  larger tax savings.
  
• Costs of Leverage Higher leverage leads to
  higher financial distress costs and agency
  costs.
  
• There is a tradeoff between tax savings, and
  costs of financial distress and agency.
  
• The optimal capital structure for a firm is a
  tradeoff between benefit of debt (tax savings)
  and costs of debt (financial distress and agency
  costs).

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Optimal Debt Ratio
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Least Cost of Capital Structure is Optimal
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• What is the annual tax shield to a firm that has
  total assets of 80 million and a net worth of
  55 million, if the average interest rate on debt
  is 8.5, the average return on equity is 14, and
  the marginal tax rate is 35?

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• The management of Graphicopy is trying to
  determine how much debt they should have in their
  capital structure. If they sell 500,000 in
  perpetual bonds with a 9 percent coupon, what
  would be the present value of the tax shield?
  Assume the marginal tax rate is 35.

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• Calculate the market value of a firm with total
  assets of 60 million and a net worth of 35
  million. The firm's cost of equity is 15 and the
  cost of perpetual debt is 8. The firm has a
  perpetual net operating income (EBIT) of 4.5
  million and a marginal tax rate of 35.

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• RoTek has a capital structure of 300,000 in
  equity and 300,000 in perpetual debt. The firm's
  cost of equity is 14 percent and its cost of debt
  is 9 percent. If the firm has an expected,
  perpetual net operating income of 120,000 and a
  marginal tax rate of 40 percent, what is the
  market value of RoTek? Assume all net income is
  paid out as dividends.