capital structure 2015
TRANSCRIPT
9-19-1
Institute of Human Resource Advancement
University of Colombo
• Lecturer: Dr. A. A. Azeez
• Program: MBM
• Subject : MBM 14-Financial Management
• Topic : Capital Structure Policy
• Date : 02. 05.2015
9-29-2
Capital Structure
Capital Structure -- The mix (or proportion) of a
firm’s permanent long-term financing represented
by debt, preferred stock, and common stock
equity.
9-39-3
Capital Structure and the Pie
• The value of a firm is defined to be the sum of
the value of the firm’s debt and the firm’s equity.
V = B + S
• If the goal of the firm’s
management is to make the
firm as valuable as possible,
then the firm should pick the
debt-equity ratio that makes
the pie as big as possible.
Value of the Firm
S BS BS BS B
9-49-4
Capital Restructuring
• We are going to look at how changes in capital
structure affect the value of the firm, all else equal
• Capital restructuring involves changing the amount of
leverage a firm has without changing the firm’s assets
• The firm can increase leverage by issuing debt and
repurchasing outstanding shares
• The firm can decrease leverage by issuing new shares
and retiring outstanding debt
16-4
9-59-5
Choosing a Capital Structure
• What is the primary goal of financial managers?
– Maximize stockholder wealth
• We want to choose the capital structure that will
maximize stockholder wealth
• We can maximize stockholder wealth by
maximizing the value of the firm or minimizing
the WACC
16-5
9-69-6
The Effect of Leverage
• How does leverage affect the EPS and ROE of a firm?
• When we increase the amount of debt financing, we increase the fixed interest expense
• If we have a really good year, then we pay our fixed cost and we have more left over for our stockholders
• If we have a really bad year, we still have to pay our fixed costs and we have less left over for our stockholders
• Leverage amplifies the variation in both EPS and ROE
16-6
9-79-7
Financial Leverage, EPS, and ROE
Current
Assets $20,000
Debt $0
Equity $20,000
Debt/Equity ratio 0.00
Interest rate n/a
Shares outstanding 400
Share price $50
Proposed
$20,000
$8,000
$12,000
2/3
8%
240
$50
Consider an all-equity firm that is contemplating going into
debt.
9-89-8
EPS and ROE Under Current
Structure
Recession Expected Expansion
EBIT $1,000 $2,000 $3,000
Interest 0 0 0
Net income $1,000 $2,000 $3,000
EPS $2.50 $5.00 $7.50
ROA 5% 10% 15%
ROE 5% 10% 15%
Current Shares Outstanding = 400 shares
9-99-9
EPS and ROE Under Proposed
Structure
Recession Expected Expansion
EBIT $1,000 $2,000 $3,000
Interest 640 640 640
Net income $360 $1,360 $2,360
EPS $1.50 $5.67 $9.83
ROA 1.8% 6.8% 11.8%
ROE 3.0% 11.3% 19.7%
Proposed Shares Outstanding = 240 shares
9-109-10
Financial Leverage and EPS
(2.00)
0.00
2.00
4.00
6.00
8.00
10.00
12.00
1,000 2,000 3,000
EP
S
Debt
No Debt
Break-even
point
EBIT in dollars, no taxes
Advantage
to debt
Disadvantage
to debt
9-119-11
Debt-equity Mix and the Value
of the Firm
Capital structure theories:
• Net operating income (NOI) approach.
• Traditional approach.
• MM hypothesis with and without corporate
tax.
• Trade-off theory: costs and benefits of
leverage.
• Pecking-order theory
9-129-12
Net Operating
Income Approach
Assume:
– Net operating income equals Rs.1,350
– Market value of debt is Rs.1,800 at 10% interest
– Overall capitalization rate is 15%
Net Operating Income Approach -- A theory of
capital structure in which the weighted average
cost of capital and the total value of the firm
remain constant as financial leverage is changed.
9-139-13
Required Rate of
Return on Equity
Total firm value = O / ko = 1,350 / .15
= 9,000
Market value = V - B = 9,000 - 1,800
of equity = 7,200
Required return = E / S
on equity* = (1,350 - 180) / 7,200
= 16.25%
Calculating the required rate of return on equity
* B / S = 1,800 / 7,200 = .25
Interest payments
= 1,800 x 10%
9-149-14
Total firm value = O / ko = 1,350 / .15
= 9,000
Market value = V - B = 9,000 - 3,000
of equity = 6,000
Required return = E / S
on equity* = (1,350 - 300) / 6,000
= 17.50%
Required Rate of
Return on Equity
What is the rate of return on equity if B=Rs.3,000?
* B / S = 3,000 / 6,000 = .50
Interest payments
= 3,000 x 10%
9-159-15
B / S kd ke ko
0.00 --- 15.00% 15%
0.25 10% 16.25% 15%
0.50 10% 17.50% 15%
1.00 10% 20.00% 15%
2.00 10% 25.00% 15%
Required Rate of
Return on Equity
Examine a variety of different debt-to-equity
ratios and the resulting required rate of
return on equity.
Calculated in slides 9 and 10
9-169-16
Required Rate of
Return on Equity
Capital costs and the NOI approach in a
graphical representation.
0 .25 .50 .75 1.0 1.25 1.50 1.75 2.0
Financial Leverage (B / S)
.25
.20
.15
.10
.05
0
Cap
ital C
osts
(%
)
ke = 16.25% and
17.5% respectively
kd (Yield on debt)
ko (Capitalization rate)
ke (Required return on equity)
9-179-17
Summary of NOI Approach
• Critical assumption is ko remains constant.
• An increase in cheaper debt funds is exactly offset
by an increase in the required rate of return on
equity.
• As long as kd is constant, ke is a linear function of
the debt-to-equity ratio.
• Thus, there is no one optimal capital structure.
9-189-18
Traditional Approach
Optimal Capital Structure -- The capital structure that
minimizes the firm’s cost of capital and thereby
maximizes the value of the firm.
Traditional Approach -- A theory of capital
structure in which there exists an optimal capital
structure and where management can increase
the total value of the firm through the judicious
use of financial leverage.
9-199-19
Optimal Capital Structure:
Traditional Approach
Traditional Approach
Financial Leverage (B / S)
.25
.20
.15
.10
.05
0
Cap
ital C
osts
(%
)
kd
ko
ke
Optimal Capital Structure
9-209-20
Summary of the
Traditional Approach
• The cost of capital is dependent on the capital
structure of the firm.
– Initially, low-cost debt is not rising and replaces
more expensive equity financing and ko declines.
– Then, increasing financial leverage and the
associated increase in ke and kd more than offsets
the benefits of lower cost debt financing.
• Thus, there is one optimal capital structure where ko
is at its lowest point.
• This is also the point where the firm’s total value will
be the largest (discounting at ko).
9-219-21
Total Value Principle:
Modigliani and Miller (M&M)
• Advocate that the relationship between financial
leverage and the cost of capital is explained by
the NOI approach.
• Provide behavioral justification for a constant ko
over the entire range of financial leverage
possibilities.
• Total risk for all security holders of the firm is not
altered by the capital structure.
• Therefore, the total value of the firm is not altered
by the firm’s financing mix.
9-229-22
Market value
of debt (65M)
Market value
of equity (35M)
Total firm market
value (100M)
Total Value Principle:
Modigliani and Miller
• M&M assume an absence of taxes and market imperfections.
• Investors can substitute personal for corporate financial leverage.
Market value
of debt (35M)
Market value
of equity (65M)
Total firm market
value (100M)
Total market value is not altered by the capital
structure (the total size of the pies are the same).
9-239-23
Assumptions of the M&M
Model• Homogeneous Expectations
• Homogeneous Business Risk Classes
• Perpetual Cash Flows
• Perfect Capital Markets:
– Perfect competition
– Firms and investors can borrow/lend at the same rate
– Equal access to all relevant information
– No transaction costs
– No taxes
9-249-24
Arbitrage and Total
Market Value of the Firm
Arbitrage -- Finding two assets that are
essentially the same and buying the cheaper and
selling the more expensive.
Two firms that are alike in every respect
EXCEPT capital structure MUST have
the same market value.
Otherwise, arbitrage is possible.
9-259-25
Arbitrage Example
Consider two firms that are identical
in every respect EXCEPT:
Company NL -- no financial leverage
Company L – Rs.30,000 of 12% debt
Market value of debt for Company L equals its
par value
Required return on equity
-- Company NL is 15%
-- Company L is 16%
NOI for each firm is Rs.10,000
9-269-26
Earnings available to = E = O – I
common shareholders = 10,000 - 0= 10,000
Market value = E / ke
of equity = 10,000 / .15 = 66,667
Total market value = 66,667 + 0= 66,667
Overall capitalization rate = 15%
Debt-to-equity ratio = 0
Arbitrage Example:
Company NL
Valuation of Company NL
9-279-27
Arbitrage Example:
Company L
Earnings available to = E = O – I
common shareholders =10,000 - 3,600
= 6,400
Market value = E / ke
of equity = 6,400 / .16
= 40,000
Total market value = 40,000 + 30,000
= 70,000
Overall capitalization rate = 14.3%
Debt-to-equity ratio = .75
Valuation of Company L
9-289-28
Completing an
Arbitrage Transaction
Assume you own 1% of the stock of
Company L (equity value = Rs.400).
You should:
1. Sell the stock in Company L for 400.
2. Borrow 300 at 12% interest (equals 1% of debt
for Company L).
3. Buy 1% of the stock in Company NL for 666.67.
This leaves you with 33.33 for other
investments (400 + 300 - 666.67).
9-299-29
Completing an
Arbitrage Transaction
Original return on investment in Company L
400 x 16% = 64
Return on investment after the transaction
666.67 x 15% = 100 return on Company NL
300 x 12% = 36 interest paid
64 net return (100 - 36) AND 33.33 left over.
This reduces the required net investment to
366.67 to earn 64.
9-309-30
Summary of the
Arbitrage Transaction
• The equity share price in Company NL rises
based on increased share demand.
• The equity share price in Company L falls
based on selling pressures.
• Arbitrage continues until total firm values are
identical for companies NL and L.
• Therefore, all capital structures are equally asacceptable.
The investor uses “personal” rather than
corporate financial leverage.
9-319-31
MM Proposition I (No Taxes)
• We can create a levered or unlevered
position by adjusting the trading in our own
account.
• This homemade leverage suggests that
capital structure is irrelevant in
determining the value of the firm:
VL = VU
9-329-32
MM Proposition II (No Taxes)
• Proposition II
– Leverage increases the risk and return to
stockholders
Rs = R0 + (B / SL) (R0 - RB)
RB is the interest rate (cost of debt)
Rs is the return on (levered) equity (cost of equity)
R0 is the return on unlevered equity (cost of
capital)
B is the value of debt
SL is the value of levered equity
9-339-33
MM Proposition II (No Taxes)
Debt-to-equity Ratio
Cost
of
capit
al:
R (
%)
R0
RB
SBW ACC RSB
SR
SB
BR
)( 00 B
L
S RRS
BRR
RB
S
B
9-349-34
MM Propositions I & II (With Taxes)
• Proposition I (with Corporate Taxes)
– Firm value increases with leverage
VL = VU + TC B
• Proposition II (with Corporate Taxes)
– Some of the increase in equity risk and return
is offset by the interest tax shieldRS = R0 + (B/S)×(1-TC)×(R0 - RB)
RB is the interest rate (cost of debt)
RS is the return on equity (cost of equity)
R0 is the return on unlevered equity (cost of capital)
B is the value of debt
S is the value of levered equity
9-359-35
The Effect of Financial Leverage
Debt-to-equityratio (B/S)
Cost of capital: R(%)
R0
RB
)()1( 00 BC
L
S RRTS
BRR
S
L
LCB
LW ACC R
SB
STR
SB
BR
)1(
)( 00 B
L
S RRS
BRR
9-369-36
Example of the Effects
of Corporate Taxes
Consider two identical firms EXCEPT:
– Company ND -- no debt, 16% required return
– Company D -- 5,000 of 12% debt
– Corporate tax rate is 40% for each company
– NOI for each firm is 2,000
The judicious use of financial leverage
(i.e., debt) provides a favorable impact
on a company’s total valuation.
9-379-37
Earnings available to = E = O - I
common shareholders = 2,000 - 0= 2,000
Tax Rate (T) = 40%
Income available to = EACS (1 - T)
common shareholders = 2,000 (1 - .4) = 1,200
Total income available to = EAT + I
all security holders = 1,200 + 0= 1,200
Corporate Tax Example:
Company ND
Valuation of Company ND (Note: has no debt)
9-389-38
Earnings available to = E = O - I
common shareholders = 2,000 - 600= 1,400
Tax Rate (T) = 40%Income available to = EACS (1 - T)common shareholders = 1,400 (1 - .4)
= 840Total income available to = EAT + I
all security holders = 840 + 600= 1,440*
Corporate Tax Example:
Company D
Valuation of Company D (Note: has some debt)
* 240 annual tax-shield benefit of debt (i.e., 1,440 - 1,200)
9-399-39
Tax-Shield Benefits
Tax Shield -- A tax-deductible expense. The
expense protects (shields) an equivalent rupee
amount of revenue from being taxed by reducing
taxable income.
Present value of
tax-shield benefits
of debt*=
(r) (B) (tc)
r= (B) (tc)
* Permanent debt, so treated as a perpetuity
** Alternatively, 240 annual tax shield / .12 = 2,000, where
240=600 Interest expense x .40 tax rate.
= (5,000) (.4) = 2,000**
9-409-40
Value of the Levered Firm
Value of unlevered firm = 1,200 / .16
(Company ND) = 7,500*
Value of levered firm = 7,500 + 2,000
(Company D) = 9,500
Value of Value of Present value of
levered = firm if + tax-shield benefits
firm unlevered of debt
* Assuming zero growth and 100% dividend payout
9-419-41
Summary of
Corporate Tax Effects
• The greater the financial leverage, the lower
the cost of capital of the firm.
• The adjusted M&M proposition suggests an
optimal strategy is to take on the maximum
amount of financial leverage.
The greater the amount of debt, the greater the
tax-shield benefits and the greater the value of
the firm.
9-429-42
Financial Distress
• Financial distress arises when a firm is not able tomeet its obligations to debt-holders.
• For a given level of debt, financial distress occursbecause of the business (operating) risk . with higherbusiness risk, the probability of financial distressbecomes greater. Determinants of business risk are:
– Operating leverage (fixed and variable costs)
– Cyclical variations
– Intensity of competition
– Price fluctuations
– Firm size and diversification
9-439-43
Consequences of Financial Distress
– Bankruptcy costs
Specific bankruptcy costs include legal andadministrative costs along with the sale of assets at“distress” prices to meet creditor claims. Lendersbuild into their required interest rate the expectedcosts of bankruptcy which reduces the market value
of equity by a corresponding amount.– Indirect costs
• Investing in risky projects.
• Reluctance to undertake profitable projects.
• Premature liquidation.
• Short-term orientation.
9-449-44
Agency Costs
• Monitoring includes bonding of agents, auditing financial statements, and explicitly restricting management decisions or actions.
• Monitoring costs, like bankruptcy costs, tend to rise at an increasing rate with financial leverage.
Agency Costs -- Costs associated with monitoring
management to ensure that it behaves in ways
consistent with the firm’s contractual agreements with
creditors and shareholders.
9-459-45
Bankruptcy Costs,
Agency Costs, and Taxes
As financial leverage increases, tax-shield benefits increase as do bankruptcy and agency costs.
Value of levered firm
= Value of firm if unlevered
+ Present value of tax-shield benefits
of debt
- Present value of bankruptcy and
agency costs
9-469-46
Tax Effects and Financial Distress
Debt (B)
Value of firm (V)
0
Present value of taxshield on debt
Present value offinancial distress costs
Value of firm underMM with corporatetaxes and debt
VL = VU + TCB
V = Actual value of firm
VU = Value of firm with no debt
B*
Maximumfirm value
Optimal amount of debt
9-479-47
Optimum Capital Structure:
Trade-off Theory
• The optimum capital structure is a function of:– Agency costs associated with debt
– The costs of financial distress
– Interest tax shield
• The value of a levered firm is:Value of unlevered firm
+ PV of tax shield
– PV of financial distress (bankruptcy and
agency costs)
9-489-48
The Pecking-Order Theory
• Theory stating that firms prefer to issue
debt rather than equity if internal financing
is insufficient.
– Rule 1
• Use internal financing first
– Rule 2
• Issue debt next, new equity last
• The pecking-order theory is at odds with
the tradeoff theory:
– There is no target D/E ratio
– Profitable firms use less debt
– Companies like financial slack 16-48