Capital Structure Determination

Learning Outcome

Define capital structure. Explain the net operating income (NOI) approach to capital structure and valuation of a firm; and, calculate a firm's value using this approach. Explain the traditional approach to capital structure and the valuation of a firm. Discuss the relationship between financial leverage and the cost of capital as originally set forth by Modigliani and Miller (M&M) and evaluate their arguments. Describe various market imperfections and other "real world" factors that tend to dilute M&Ms original position. Present a number of reasonable arguments for believing that an optimal capital structure exists in theory. Explain how financial structure changes can be used for financial signaling purposes, and give some examples.

Capital Structure Determination

A Conceptual Look The Total-Value Principle Presence of Market Imperfections and Incentive Issues The Effect of Taxes Taxes and Market Imperfections Combined Financial Signaling Timing and Flexibility Financing Checklist

Capital Structure
Capital Structure -- The mix (or proportion) of a firms permanent long-term financing represented by debt, preferred stock, and common stock equity.
Concerned

with the effect of capital market decisions on security prices. (1) investment and asset management decisions are held constant and (2) consider only debt-versus-equity financing.

Assume:

A Conceptual Look -Relevant Rates of Return

ki = the yield on the companys debt

ki

I B

Annual interest on debt Market value of debt

Assumptions: Interest paid each and every year Bond life is infinite Results in the valuation of a perpetual bond No taxes (Note: allows us to focus on just capital structure issues.)

A Conceptual Look -Relevant Rates of Return

ke = the expected return on the companys equity Earnings available to E E common shareholders = = ke S Market value of common S stock outstanding
Assumptions: Earnings are not expected to grow 100% dividend payout Results in the valuation of a perpetuity Appropriate in this case for illustrating the theory of the firm

A Conceptual Look -Relevant Rates of Return

ko = an overall capitalization rate for the firm O O = V V Net operating income = Total market value of the firm

ko

Assumptions: V = B + S = total market value of the firm O = I + E = net operating income = interest paid plus earnings available to common shareholders

Capitalization Rate
Capitalization Rate, ko -- The discount rate used to determine the present value of a stream of expected cash flows.

k o = ki

B B+S

ke

S B+S

What happens to ki, ke, and ko when leverage, B/S, increases?

Net Operating Income Approach

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. Assume:
Net

operating income equals Rs.1,350

Market

value of debt is Rs.1,800 at 10% interest capitalization rate is 15%

Overall

Required Rate of Return on Equity

Calculating the required rate of return on equity Total firm value= O / ko = Rs.1,350 / .15 = Rs.9,000 Market value =V-B = Rs.9,000 Interest payments Rs.1,800 of equity = Rs.7,200
= Rs.1,800 x 10%

Required return on equity* Rs.7,200

=E/S = (Rs.1,350 - Rs.180) / = 16.25%

* B / S = Rs.1,800 / Rs.7,200 = .25

Required Rate of Return on Equity

What is the rate of return on equity if B=Rs.3,000? Total firm value= O / ko = Rs.1,350 / .15 = Rs.9,000 Market value =V-B = Rs.9,000 Interest payments Rs.3,000 of equity = Rs.6,000
= Rs.3,000 x 10%

Required return on equity* Rs.6,000

=E/S = (Rs.1,350 - Rs.300) / = 17.50%

* B / S = Rs.3,000 / Rs.6,000 = .50

Required Rate of Return on Equity

Examine a variety of different debt-to-equity ratios and the resulting required rate of return on equity. B/S 0.00 0.25 0.50 1.00 2.00 ki --10% 10% 10% 10% ke 15.00% 16.25% 17.50% 20.00% 25.00% ko 15% 15% 15% 15% 15%

Calculated in slides 9 and 10

Required Rate of Return on Equity

Capital costs and the NOI approach in a graphical representation.
.25 Capital Costs (%) .20 .15 ko (Capitalization rate) .10 ki (Yield on debt) .05 0 ke = 16.25% and 17.5% respectively ke (Required return on equity)

.25

.50

.75 1.0 1.25 1.50 Financial Leverage (B / S)

1.75

2.0

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 ki is constant, ke is a linear function of the debt-to-equity ratio. Thus, there is no one optimal capital structure.

Traditional Approach
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. Optimal Capital Structure -- The capital structure that minimizes the firms cost of capital and thereby maximizes the value of the firm.

Optimal Capital Structure: Traditional Approach

Traditional Approach
.25 Capital Costs (%) .20 .15 ki .10 Optimal Capital Structure .05 0 ke ko

Financial Leverage (B / S)

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 ki 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 firms total value will be the largest (discounting at ko).

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 firms financing mix.

Total Value Principle: Modigliani and Miller

Market value of debt (Rs.35M) Market value of equity (Rs.65M) Total firm market value (Rs.100M) Market value of debt (Rs.65M) Market value of equity (Rs.35M) Total firm market value (Rs.100M)

Total market value is not altered by the capital structure (the total size of the pies are the same). M&M assume an absence of taxes and market imperfections. Investors can substitute personal for corporate financial leverage.

Arbitrage and Total Market Value of the Firm

Two firms that are alike in every respect EXCEPT capital structure MUST have the same market value. Otherwise, arbitrage is possible. Arbitrage -- Finding two assets that are essentially the same and buying the cheaper and selling the more expensive.

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

Arbitrage Example: Company NL

Valuation of Company NL
Earnings available to common shareholders Market value of equity Total market value Overall capitalization rate Debt-to-equity ratio =E =OI = Rs.10,000 - Rs.0 = Rs.10,000 = E / ke = Rs.10,000 / .15 = Rs.66,667 = Rs.66,667 + Rs.0 = Rs.66,667 = 15% =0

Arbitrage Example: Company L

Valuation of Company L
Earnings available to =E common shareholders = Rs.10,000 - Rs.3,600 = Rs.6,400 Market value = E / ke of equity = Rs.6,400 / .16 = Rs.40,000 Total market value = Rs.40,000 + Rs.30,000 = Rs.70,000 Overall capitalization rate = 14.3% Debt-to-equity ratio = .75

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 Rs.400. 2. Borrow Rs.300 at 12% interest (equals 1% of debt for Company L). 3. Buy 1% of the stock in Company NL for Rs.666.67. This leaves you with Rs.33.33 for other investments (Rs.400 + Rs.300 Rs.666.67).

Completing an Arbitrage Transaction

Original return on investment in Company L Rs.400 x 16% = Rs.64 Return on investment after the transaction
Rs.666.67

x 16% = Rs.100 return on Company NL Rs.300 x 12% = Rs.36 interest paid Rs.64 net return (Rs.100 - Rs.36) AND Rs.33.33 left over. This reduces the required net investment to Rs.366.67 to earn Rs.64.

Summary of the Arbitrage Transaction

The investor uses personal rather than corporate financial leverage. 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 as acceptable.

Market Imperfections and Incentive Issues

Bankruptcy Agency Debt

costs (Slide 28)

costs (Slide 29)

and the incentive to manage efficiently restrictions costs

Institutional Transaction

Required Rate of Return on Equity with Bankruptcy

ke with bankruptcy costs

Required Rate of Return on Equity (ke)

ke with no leverage
ke without bankruptcy costs

Premium for financial risk Premium for business risk Risk-free rate

Rf

Financial Leverage (B / S)

Agency Costs
Agency Costs -- Costs associated with monitoring management to ensure that it behaves in ways consistent with the firms contractual agreements with creditors and shareholders.

Monitoring includes bonding of agents, auditing financial statements, and explicitly restricting management decisions or actions. Costs are borne by shareholders (Jensen & Meckling). Monitoring costs, like bankruptcy costs, tend to rise at an increasing rate with financial leverage.

Example of the Effects of Corporate Taxes

The judicious use of financial leverage (i.e., debt) provides a favorable impact on a companys total valuation.
Consider two identical firms EXCEPT:
Company

ND -- no debt, 16% required

return Company D -- Rs.5,000 of 12% debt Corporate tax rate is 40% for each company NOI for each firm is Rs.10,000

Corporate Tax Example: Company ND

Valuation of Company ND (Note: has no debt)
Earnings available to common shareholders Tax Rate (T) Income available to common shareholders Total income available to all security holders =E =O-I = Rs.2,000 - Rs.0 = Rs.2,000 = 40% = EACS (1 - T) = Rs.2,000 (1 - .4) = Rs.1,200 = EAT + I = Rs.1,200 + 0 = Rs.1,200

Corporate Tax Example: Company D

Valuation of Company D (Note: has some debt)
Earnings available to common shareholders Tax Rate (T) Income available to common shareholders Total income available to all security holders =E =O-I = Rs.2,000 - Rs.600 = Rs.1,400 = 40% = EACS (1 - T) = Rs.1,400 (1 - .4) = Rs.840 = EAT + I = Rs.840 + Rs.600 = Rs.1,440*

* Rs.240 annual tax-shield benefit of debt (i.e., Rs.1,440 - Rs.1,200)

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 (Rs.5,000) (.4) = = (B) (tc) Rs.2,000**

* Permanent debt, so treated as a perpetuity ** Alternatively, Rs.240 annual tax shield / .12 = Rs.2,000, where Rs.240=Rs.600 Interest expense x .40 tax rate.

Value of the Levered Firm

Value of levered firm = Value of firm if + unlevered Present value of tax-shield benefits of debt = Rs.1,200 / .16 = Rs.7,500* = Rs.7,500 + =

Value of unlevered firm (Company ND) Value of levered firm Rs.2,000 (Company D) Rs.9,500

* Assuming zero growth and 100% dividend payout

Summary of Corporate Tax Effects

The greater the amount of debt, the greater the tax-shield benefits and the greater the value of the firm. 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. This implies a capital structure of almost 100% debt! Yet, this is not consistent with actual behavior.

Other Tax Issues

Uncertainty

of tax-shield benefits

Uncertainty increases the possibility of bankruptcy and liquidation, which reduces the value of the tax shield.
Corporate

plus personal taxes

Personal taxes reduce the corporate tax advantage associated with debt. Only a small portion of the explanation why corporate debt usage is not near 100%.

Bankruptcy Costs, Agency Costs, and Taxes

Value of levered firm = Value of firm if unlevered + Present value of tax-shield benefits of debt - Present value of bankruptcy and agency costs As financial leverage increases, tax-shield benefits increase as do bankruptcy and agency costs.

Bankruptcy Costs, Agency Costs, and Taxes

Cost of Capital (%)
Minimum Cost of Capital Point Taxes, bankruptcy, and agency costs combined

Net tax effect Optimal Financial Leverage

Financial Leverage (B/S)

Financial Signaling

A manager may use capital structure changes to convey information about the profitability and risk of the firm. Informational Asymmetry is based on the idea that insiders (managers) know something about the firm that outsiders (security holders) do not. Changing the capital structure to include more debt conveys that the firms stock price is undervalued. This is a valid signal because of the possibility of bankruptcy.

Timing and Flexibility

1.

Timing

After appropriate capital structure determined it is still difficult to decide when to issue debt or equity and in what order. Factors considered include the current and expected health of the firm and market conditions.

2.

Flexibility

A decision today impacts the options open to the firm for future financing options thereby reducing flexibility. Often referred to as unused debt capacity.

Checklist of Practical and Conceptual Considerations

1. 2. 3.

Taxes Explicit cost Cash-flow ability to service debt Agency costs and incentive issues Financial signaling

6.

EBIT-EPS analysis Capital structure ratios Security rating Timing Flexibility

7.

4.

8. 9. 10.

5.