Capital Structure Decisions Chapter 15 and 16

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Capital Structure DecisionsChapter 15 and 16

• Financial Policy and Planning
• (MB 29)

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Outline

• Meaning of Capital Structure
• Optimal Capital Structure
• How much should a firm borrow? Does capital
  structure matter? Does it influence the value of
  the firm?
• Limits to the use of debt
• How companies establish their capital structure?

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Capital Structure

• A mix of debt, preferred stock, and common stock
  with which the firm plans to finance its
  investments.
• Objective is to have such a mix of debt,
  preferred stock, and common equity which will
  maximize shareholder wealth or maximize market
  price per share
• WACC depends on the mix of different securities
  in the capital structure. A change in the mix of
  different securities in the capital structure
  will cause a change in the WACC. Thus, there
  will be a mix of different securities in the
  capital structure at which WACC will be the
  least.
• An optimal capital structure means a mix of
  different securities which will maximize the
  stock price share or minimize WACC.

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Leverage and Capital Structure

• Leverage means use of fixed cost source of funds.
  Generally, it refers to use of debt in the
  capital structure of the firm
• How much leverage should be there in a firm? Why
  is this question important? Two reasons
• a higher debt ratio can enhance the rate of
  return on equity capital during good economic
  times
• a higher debt ratio also increases the riskiness
  of the firms earnings stream
• Capital structure decision involves a trade off
  between risk and return to maximize market price
  per share

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Does capital structure matter?

• Not really According to Modigliani and Miller
  (1958) article, in a world without corporate
  taxes, it mix between debt and equity does not
  matter
• Value of the firm is independent of capital
  structure decisions
• Value of a firm equals operating income divided
  by overall cost of capital.

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• Thus, mix between debt and equity is not
  important. Any benefit of low cost debt is
  completely offset by an increase in the cost of
  equity due to use of borrowing.
• Thus, overall cost of capital remains same and
  value of the firm does not change if we change
  the mix between debt and equity.
• Assumption of a world without taxes is quite
  unrealistic. MM revisited their theory in their
  1961 article.
• They assume a world with corporate taxes

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MM with corporate taxes

• If we follow MM (1958), we should not worry
  about mixture of debt and equity in the capital
  structure.
• These decisions should be relegated to the
  background because they do not affect the value
  of the firm. So, financial managers should not
  worry about these decisions.
• Still financial managers do show concern for a
  debt policy, which is carefully developed. And
  we find a pattern among companies in the use of
  debt in different industries.
• M-Ms argument that the value and the cost of
  capital of a firm remains constant with leverage
  will not hold when corporate taxes are assumed to
  exist.

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• In their 1963 article, they recognize that the
  value of the firm will increase or the cost of
  capital will decrease with leverage because
  interest on debt is a tax deductible expense.
• The value of the levered firm will be greater
  than the unlevered firm because the return to
  bondholders escapes taxation at the corporate
  level.
• The value of the levered firm will be more than
  the value of unlevered firm by the amount of the
  present value of the tax shield due to tax
  savings given by the tax deductibility of
  interest expense on debt.
• Present value of the tax shield is given by Tc ?
  D
• Value of a leverered firm (1-Tc)EBIT/re TcD

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Example

• Firm L has employed a 6 percent debt of 300,000,
  while firm U is unlevered. Both the firms earn a
  before tax earnings of 120,000. The pure equity
  capitalization rate is 10 percent and the
  corporate tax rate is 34 percent. Find the market
  value of the firms.
• (1 - Tc) EBIT (1 - 0.34) 120,000
• Vu --------------- --------------------------
  --- 792,000
• re 0.10
• VL VU Tc D
• 792,000 0.34 ? 300,000
• 894,000

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MM Proposition II with corporate taxes

• Re rA D/E ? (1 - Tc) ? (rA - rD)

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Limits to the Use of Debt

• According to MM theory with taxes, value of
  levered firm equals the value of unlevered plus
  the value of the tax shield
• Accordingly, the more the debt in the capital
  structure, the higher will be the value of a
  levered firm.
• One can always increase firm value by increasing
  leverage, implying that firms should issue
  maximum debt.
• This is inconsistent with the real world, where
  firms generally employ moderate amount of debt.
• The answer lies in bankruptcy costs. Debt
  provides tax benefits to the firm.

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• However, it also puts pressure on the firm,
  because interest and principal payments are
  obligations. If these obligations are not met,
  the firm may risk some sort of financial
  distress.
• The possibility of bankruptcy has a negative
  effect on the value of the firm. However, it is
  not the risk of bankruptcy itself that lowers
  value. Rather it is the cost associated with
  bankruptcy that lowers value.
• As the proportion of debt in the firms capital
  structure is increased, the probability of
  bankruptcy also increases. Consequently, the
  rate of return required by bondholders increases
  with leverage.

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• The optimal ratio of debt to equity is determined
  by taking an increasing amounts of debt until the
  marginal gain from leverage is equal to the
  marginal expected loss from the bankruptcy costs

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How Firms Establish Capital Structure?

• Most corporations have low debt-asset ratios
• Changes in Financial Leverage affect Firm Value
• There are differences in the Capital Structures
  of Different Industries
• Most companies have a target debt ratio
• Target debt ratio is dependent on taxes, types of
  assets, uncertainty of operating income, and
  pecking order and financial slack.