Chapter 12Chapter 12

Capital Structure Capital Structure ConceptsConcepts

© 2001 South-Western College Publishing

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Capital Structure Vs.Capital Structure Vs. Financial Structure Financial Structure

Capital StructureCapital StructurePermanent s-t debtPermanent s-t debt L-T debtL-T debt P/SP/S C/SC/S

Financial StructureFinancial StructureTotal current Total current liabilitiesliabilities L-T debtL-T debt P/SP/S C/SC/S

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Capital Structure TerminologyCapital Structure Terminology

Optimal capital structureOptimal capital structure Minimizes a firm’s weighted cost of capitalMinimizes a firm’s weighted cost of capital Maximizes the value of the firmMaximizes the value of the firm

Target capital structureTarget capital structure Capital structure at which the firm plans to operateCapital structure at which the firm plans to operate

Debt capacityDebt capacity Amount of debt in the firm’s optimal capital structureAmount of debt in the firm’s optimal capital structure

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What Determines the Optimal What Determines the Optimal Capital Structure ?Capital Structure ?

Business risk of the firmBusiness risk of the firm Tax structureTax structure Bankruptcy potentialBankruptcy potential Agency costAgency cost Signaling effectsSignaling effects

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Capital Structure AssumptionsCapital Structure Assumptions

Firm’s investment policy is held constantFirm’s investment policy is held constant Capital structure changes the distribution of Capital structure changes the distribution of

the firm’s EBIT among the firm’s claimantsthe firm’s EBIT among the firm’s claimants Debtholders Preferred stockholders Common Debtholders Preferred stockholders Common stockholdersstockholders

Constant investment policy leaving the debt Constant investment policy leaving the debt capacity of the firm unchangedcapacity of the firm unchanged

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Factors Influencing a Firm’s Factors Influencing a Firm’s Business RiskBusiness Risk Variability of sales Variability of sales

volumevolume Variability of selling Variability of selling

priceprice Variability of costVariability of cost Amount of market Amount of market

powerpower

Extent of product Extent of product diversificationdiversification

Firm’s growth rateFirm’s growth rate Degree of operating Degree of operating

leverage ( DOL )leverage ( DOL ) Both systematic and Both systematic and

unsystematic riskunsystematic risk

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Financial RiskFinancial Risk

Variability of EPS and increased probability of Variability of EPS and increased probability of bankruptcybankruptcy

Factors indicating financial riskFactors indicating financial risk Debt-to asset ratio Debt-to asset ratio Debt-to-equity ratioDebt-to-equity ratio Fixed charge coverage ratio Fixed charge coverage ratio DFLDFL Probability distribution of profitsProbability distribution of profits Times interest earned ratio Times interest earned ratio EBIT-EPS analysisEBIT-EPS analysis

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Capital Structure TheoryCapital Structure Theory

Studies the relationship between:Studies the relationship between: Capital Structure Cost of capitalCapital Structure Cost of capital

debt/assets debt/assets value of the firm value of the firm

Capital Structure ModelsCapital Structure Models Show the role of:Show the role of:

Taxes Bankruptcy costs Agency costsTaxes Bankruptcy costs Agency costson the determination of an optimal capital structureon the determination of an optimal capital structure

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Modigliani and Miller ( MM )Modigliani and Miller ( MM )On Capital StructureOn Capital Structure Assumed perfect capital markets including:Assumed perfect capital markets including:

No taxesNo taxes No bankruptcy ( B ) costsNo bankruptcy ( B ) costs No agency ( A ) costsNo agency ( A ) costs

If leverage increases, the cost of equity (kIf leverage increases, the cost of equity (kee), ), increases to exactly offset the benefits of increases to exactly offset the benefits of more debt financing ( kmore debt financing ( kdd ), leaving the cost ), leaving the cost of capital ( kof capital ( kaa ) constant ) constant see model 1see model 1

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Costof

Capital

Debt

Total Assets

kd

ka

ke

Model 1Model 1

The overall cost of capital is independent of the capital structureThe overall cost of capital is independent of the capital structure

The firm’s value is independent of the capital structureThe firm’s value is independent of the capital structure

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MM Arbitrage ProofMM Arbitrage Proof

Value of U = D/ kValue of U = D/ kee

Value of L = D/ kValue of L = D/ kee + I/ k + I/ kdd

D paid to L’s stockholders are reduced by D paid to L’s stockholders are reduced by the amount of I paid on the debtthe amount of I paid on the debt

kkee is higher for L because of the additional is higher for L because of the additional leverage-induced riskleverage-induced risk

The values of U and L are identical due to The values of U and L are identical due to arbitragearbitrage

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What Happens with Taxes ?What Happens with Taxes ?

Same two equationsSame two equations

VU = D/kVU = D/kee VL = D/k VL = D/kee + I/k + I/kdd

D distributed to U’s stockholders are reduced by D distributed to U’s stockholders are reduced by the taxes paid on operating income and the value the taxes paid on operating income and the value of U dropsof U drops

Since I is tax deductible, L realizes a tax savingsSince I is tax deductible, L realizes a tax savings PV of tax shield = value of debt ( B ) PV of tax shield = value of debt ( B ) tax rate tax rate

(T)(T)

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VL = VU + Value of Tax ShieldVL = VU + Value of Tax ShieldMkt

Valueof Firm

Debt $

VU

VL

PV of

Tax Shield

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Model 2Model 2

Costof

Capital

Debt

Total assets

ki = kd ( 1 - T )

ka

ke

The cost of capital decreases with the amount of debtFirm maximizes its value by choosing a capital structure that is all debt

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What Happens With Taxes, What Happens With Taxes, Bankruptcy, & Agency Costs ?Bankruptcy, & Agency Costs ? B & A costs increase with the amount of leverageB & A costs increase with the amount of leverage Eventually offset the marginal benefits from the Eventually offset the marginal benefits from the

value of the tax shieldvalue of the tax shield Market value of levered firmMarket value of levered firm

= Market value of unlevered firm= Market value of unlevered firm

+ PV of tax shield+ PV of tax shield

- PV of bankruptcy costs- PV of bankruptcy costs

- PV of agency costs - PV of agency costs See optimal debt ratio slideSee optimal debt ratio slide

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Bankruptcy CostsBankruptcy Costs

Lenders may demand higher interest ratesLenders may demand higher interest rates Lenders may decline to lend at allLenders may decline to lend at all Customers may shift their business to other Customers may shift their business to other

firmsfirms Distress incurs extra accounting & legal Distress incurs extra accounting & legal

costscosts If forced to liquidate, assets may have to be If forced to liquidate, assets may have to be

sold for less than market valuesold for less than market value

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Agency CostsAgency Costs Stockholder-Bondholder RelationshipStockholder-Bondholder Relationship

Investing in projects with high risk and high returns Investing in projects with high risk and high returns can shift wealth from bondholders to stockholderscan shift wealth from bondholders to stockholders

Stockholders may forgo some profitable Stockholders may forgo some profitable investments in the presence of debtinvestments in the presence of debt

Stockholders might issue high quantities of new Stockholders might issue high quantities of new debt and diminish the protection afforded to earlier debt and diminish the protection afforded to earlier bondholdersbondholders

Bondholders will shift monitoring and bonding Bondholders will shift monitoring and bonding costs back to the stockholders by charging higher costs back to the stockholders by charging higher interest ratesinterest rates

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Optimal Debt RatioOptimal Debt RatioMkt Valueof the Firm

Debt Ratio

VU

PVof Tax

Shield

Mkt value of le

vered firm PVB & ACosts

VL

Optimal Debt Ratio

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Model 3Model 3Least Cost Capital Structure is OptimalLeast Cost Capital Structure is Optimal

Cost of Capital

BB + E

ki

ke

ka

Optimal Capital Structure0

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Other Impacts on the Optimal Other Impacts on the Optimal Capital StructureCapital Structure Personal tax effectsPersonal tax effects

Could reverse some tax benefitsCould reverse some tax benefits Industry effectsIndustry effects

Profitability and bankruptcy patternsProfitability and bankruptcy patterns Signaling effectsSignaling effects

Asymmetric informationAsymmetric information Managerial preferencesManagerial preferences

Pecking order theoryPecking order theory

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Capital Structure Implications for Capital Structure Implications for ManagersManagers

A centrally important management decisionA centrally important management decision Benefits of the tax shield from debt provide Benefits of the tax shield from debt provide

an incentive to use debt financingan incentive to use debt financing To the point that increasing A & B costs offset To the point that increasing A & B costs offset

the debt advantagethe debt advantage

Optimal capital structure is heavily Optimal capital structure is heavily influenced by business riskinfluenced by business risk

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Capital Structure Implications for Capital Structure Implications for ManagersManagers

Changes in capital structure signal important Changes in capital structure signal important information to investorsinformation to investors

Pecking order theoryPecking order theory Internal equity Internal equity First choice First choice

DebtDebt External equity External equity Least preferred by managementLeast preferred by management

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LBOLBO

Can eliminate agency problemsCan eliminate agency problems Increased operating efficiencies are often achievedIncreased operating efficiencies are often achieved

Eliminating jobs Reducing other payroll expenses Closing inefficient plantsEliminating jobs Reducing other payroll expenses Closing inefficient plants

Bondholders typically realize a loss in the value of Bondholders typically realize a loss in the value of their bonds their bonds

Ethical issuesEthical issues Is it in the long-run interest of employees ?Is it in the long-run interest of employees ? Are bondholders harmed in a LBO ?Are bondholders harmed in a LBO ? Managers acting as both buyers and sellersManagers acting as both buyers and sellers

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Multinational FirmsMultinational Firms

Have more complex capital structure decisionsHave more complex capital structure decisions Finance investments in host country fundsFinance investments in host country funds Some countries use more financial leverage than Some countries use more financial leverage than

othersothers Some host countries restrict foreign investmentSome host countries restrict foreign investment Risk of expropriationRisk of expropriation Some host countries provide low-cost financingSome host countries provide low-cost financing