understanding capital structure

8/7/2019 Understanding Capital Structure

http://slidepdf.com/reader/full/understanding-capital-structure 1/31

www.HelpWithAssignment.com



` A company can obtain long-term financing in theform of equity, debt or a combination of both.

` Capital structure is the proportion of debt and

preference and equity shares on a firm¶s balancesheet.




` Optimal Capital structure is the capital is thecapital structure at which the weighted averagecost of capital is minimum and thereby maximum

value of the firm.




` The relative proportions of debt, equity and other securities that a firm has outstanding constitute itscapital structure.

` When corporations raise funds from outsideinvestors, they must choose which type of securityissue.




` The most common choices are financing throughequity alone and financing through a combinationof debt and equity.

` So V = B + S = D + E




` Shareholders are interested in maximizing thevalue of the firm¶s shares.

` A key question is: What is the ratio of debt to

equity, if any, that maximizes the shareholder¶svalue?




` As it turns out, changes in capital structure benefitshareholders if and only if the value of the firmincreases.

` So we concern ourselves with the question of which proportion of debt versus equity maximizesthe overall value of the firm.




` We assume perfect capital markets in thefollowing analysis: Perfect competition

Equal access to information No transaction costs

No taxes (later we drop this assumption)

` We also assume that the individual can borrow atthe same rate as the firm.




` We will compare a firm whose capital structure isall equity, with a firm that is identical, except that ithas some debt in its capital structure.




` Suppose a firm has 1000 shares, a share price of $10, a market value of $10,000, and operatingincome as described in the table below.

` This income is a perpetuity, and all earnings arepaid out as a dividend to investors. Expectedincome is $1500 and expected return is 15%.




Outcomes

OperatingIncome

500 1000 1500 2000

Earnings PerShare

0.50 1.00 1.50 2.00

Return OnEquity

5% 10% 15% 20%

Expected!




` Suppose the firm borrows $5,000 at 10% rate of interest and buys back 500 of its shares to createthe following new situation: # shares 500, B =

$5000, S = $5000, shares value: $10, annualinterest: $500




Outcomes

Operating

Income

500 1000 1500 2000

Interest 500 500 500 500

Equity Earnings 0 500 1000 1500

Earnings Per

Share

0 1 2 3

ReturnOn

equity

0% 10% 20% 30%

Expected




` Argument that value has increased: If operatingincome is greater than $1,000 then the expectedReturn On Equity increases.

` Since we expect operating income of $1,500,leverage must have added value. Shareholdersexpect 20% ROE with leverage.




` Counter-argument: Suppose an investor takes $10of his/her own money and borrows $10 at 10%interest and invests the $20 to buy 2 shares of the

unlevered firm.




Outcomes

Operating

Income

500 1000 1500 2000

Earnings on 2Shares

1 2 3 4

Interest on $10

at 10%

1 1 1 1

Net Earnings on

2 shares

0 1 2 3

Return on $10

Investment

0 10 20 30

Expected




` Note: Investor gets the same result fromborrowing personally as he/she gets frominvesting in the leveraged firm.

` Therefore, the firm is not doing anything byleveraging that the investor could not do on his/her own.

` This implies VL = VU. This is the famous

Modigliani-Miller Proposition I.




` So leverage increases the expected earnings per share, but not the share price. How can that be?




` Leverage also increases the riskiness of theearnings. We must discount those higher expected earnings at a higher discount rate.

` All equity: 1.50/.15 = $10` Leveraged: 2.00/.20 = $10

` Recall: The value of a firm = the PV of the futurecash flows.




` If the firm is all equity financed, then VU = C1/(1+r 0)+ C2/(1+r 0)

2 + « where r 0 is the cost of capital of an all equity financed firm.

` If there is some debt in the capital structure, thecost of capital is given by:




` Since the value of the company doesn¶t changewith leverage, VL = VU, and so r must equal r 0 ±that is, r must be constant as debt is added to the

capital structure (remember here we are assumingno taxes etc.).




` The idea is that as ³expensive´ equity is replacedwith ³cheap´ debt, the risk to equity increases, asa result of the increased leverage, and so r S

increases.` The increase in r S just balances against the

increased fraction of cheaper debt, so that r staysconstant.




` r 0 = cost of capital for the all equity firm = r a =required/expected return on the assets ± reflectsbusiness risk ± not financial leverage. If we solve:

` r 0 = [B/(B+S)]r B + [S/(B+S)]r S for r S, we get r S = r 0+[B/S](r 0 ± r B)




` This is Modigliani-Miller Proposition II.

` In our example above, r a = 1500/10,000 = 15%. If B = S = 5000, then:

` r S = 15% + [5000/5000](15% - 10%) = 20%` Initially the firm was all equity, had 1,000 shares at

$10/share and equity worth $10,000

` V = 1500/.15 = (CF/r S) = $10,000




` With $5,000 debt at 10% and $5,000 equity, nowr S = 20%, up from 15% and:

` V = 500/.10 + 1000/.20 = interest payment/r B +

CF/r S = 5,000 + 5,000 = 10,000




` Essentially, we split a single cash flow of 1500/year, discounted at 15% into 2 cash flows of 500 and 1000, the former discounted at 10% and

the latter discounted at 20%




` At HelpWithAssignment.com we provide bestquality Assignment help, Homework help,Online Tutoring and Thesis and Dissertation

help as well.




` For any of the above services you can contact usat http://www.helpwithassignment.com/

http://www.helpwithassignment.com/finance-assignment-help




` You can visit our blogs at http://www.helpwithassignment.blogspot.com

http://www.helpwithasignment.wordpress.com

Thank You


understanding capital structure

Documents