Chapter 12 Capital Structure

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Chapter 12Capital Structure

• Quick Review of Capital Markets
• Benefits of Borrowing
• Pecking Order Hypothesis
• Modigliani and Miller Optimal Capital Structure
  Theory

2
Quick review of Capital Markets

• Capital Markets
• Borrow from more than one year
• Various types of markets
• Bond
• Equity
• Investors return is borrowers cost
• Not all borrowers get the same rate
• Function of risk to investor
• See Example 12.1, Lucky Larry at 11.11 and
  Sometimes Lucky Sherry at 42.86

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Benefits of Borrowing

• Using other peoples money
• Financial leverage
• Cost of debt is less than the anticipated return
  of the investment
• Financial leverage benefit measured via EPS
• Owners of the firm can be better off with debt
  financing
• Example 12.2 Jordan Enterprises
• Adding debt improves EPS if earnings exceed
  960,000
• Adding debt hurts EPS if earnings less than
  960,000
• Jordan Enterprises will add debt if it believes
  earnings will be greater than 960,000

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Pecking Order Hypothesis (POH)

• Preferred borrowing pattern
• Borrow from cheapest source first
• Asymmetric information
• Firms know more than lenders
• Information is costly to obtain
• Information may be proprietary
• Borrowing pattern from POH
• Internal first
• Avoid swings in dividend payments
• External financing cheapest first (debt) and
  equity as last resort

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Pecking Order Hypothesis (POH)

• Example 12.3 Abbot and Costello borrowing
  choices
• Outsiders believe managers only issue equity when
  stock over priced
• Outsiders therefore lower price they will pay for
  equity
• Managers thus choose to issue debt if possible
• More profitable companies
• Borrow less from external sources
• Therefore have lower debt-equity ratios

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Modigliani and Miller Optimal Capital Structure
Theory

• Starts with a world of no taxes
• Two Propositions
• Proposition I It is irrelevant what borrowing
  pattern a firm choosesthe value of the firm
  remains the same
• Proposition II cost of equity is a function of
  three things
• Require return on assets
• Cost of debt
• Debt-Equity ratio
• In world of no taxes, WACC is constant and the
  firm is insensitive to the funding choice

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Modigliani and Miller Optimal Capital Structure
Theory

• Modified to a world of corporate taxes
• Proposition I all debt financing is optimal
• Proposition II the WACC of the firm falls as
  more debt is added
• What is happening in this world?
• Government is losing out to equity holders
• Tax shield due to interest payments reduces
  governments direct share of profits and captured
  by equity holders
• VL VE D x TC

8
Modigliani and Miller Optimal Capital Structure
Theory

• One more modification World of corporate taxes
  and bankruptcy
• Bankruptcy is costly
• When debt payments cannot be made equity holders
  lose company to debt holders
• Must avoid bankruptcy
• Optimal debt-equity ratio arises
• At point where marginal benefits of debt
  financing equal marginal costs of bankruptcy
• At this point WACC is lowest and value of firm
  highest

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Problems

• Problem 3 Benefits of Borrowing
• Problem 7 Pecking Order Hypothesis
• Problem 9 Finding WACC
• Problem 11 MM in World of No Taxes