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Corporate Finance
Tutorial 8: Capital Structure
Suggested Solutions
Sample Examination Question 1
The assumptions underlie Modigliani and Millers proposition of firm value should be
independent of capital structure are as follows:
! Financing decisions do not affect the return from physical investments
! Capital markets are frictionless or perfect
Unlimited borrowing and lending opportunities at Rf
No Taxes
No transaction costs
! Investors are rational and care only about their wealth
Prefer more than less
Dont mind whether the wealth is in cash or capital gain
! Investors and insiders have equal access to information and have same expectations
regarding the future
Sample Examination Question 2
!
!
!
!
!
2 firms:
Unlevered all-equity firm and
Levered firm with B units of debt at RD
An investor holding the same ! proportion of unlevered firms equity and levered
firms equity and debt
2 possible outcomes 1 period ahead
Cash flow from firm > Face value of its debt or
Cash flow from firm < Face value of its debt B
Let X represents the firms cash flow
Payoff for the investor under the 2 scenarios for both unlevered and levered firms are
as follows:
Payoff for Unlevered Firm
!X
!B(1 + RD)
Equity
!X
!X
Total
!X
!X
!X
!X
Debt
!
!
All investment income are the same => All investment should have the same value
Conclusion: Investor is indifferent to a firms financing decision (or capital structure)
Corporate Finance
Interest payments are tax deductible for the firm & taxable as income for debt
investor resulting in a net amount of rdD(1 ! Td)
Firms taxable profit in period t is EBITt rdD resulting in income payable to equity
holders of (EBITt rdD)(1 Tc) before personal tax
After considering personal tax, the net income to the equity holders will be
(EBITt rdD)(1 Tc)(1 Te)
Therefore, total payments to both debt and equity holders respectively in a certain
period t is
Ct = (EBITt rdD)(1 Tc)(1 Te) + rdD(1 ! Td)
Ct = Net Income to Equity Holders + Net Income to Debt Holders
Ct = EBITt (1 Tc)(1 Te) rdD(1 Tc)(1 Te) + rdD(1 ! Td)
Ct = EBITt (1 Tc)(1 Te) + rdD[(1 ! Td) (1 Tc)(1 Te)]
Corporate Finance
Conclusion:
To maximise the firms value in a world of corporate tax only, the firm should take on as
much debt as possible
Note:
Optimal Capital Structure will be neither all-equity nor all-debt if bankruptcy cost is
considered, as the value of levered firm will now be
VL = VU + DTc ! PV(Corporate Distress)
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One possible solution to this agency cost of outside equity is to finance the firm
using more debt and less outside equity. Alternatively, firm can choose to
repurchase outside equity with debt. Both strategies lead to increase in
managers proportion of the firm outstanding equity.
Therefore, as the proportion of outstanding equity held by manager increases
with leverage, the manager chooses to supply more effort, leading to increase in
firm value. This implies that as leverage increases, agency cost of outside equity
decreases.
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(b)
Myers-Majluf (1984) pecking order theory of finance concentrates on the
information revealed by security issues under asymmetric information market.
Extending the theory to cover riskless and risky debt as well as equity : When a
firm issues riskless debt, it does not convey any information to the market since
there is no default possibility. This does not allow the firm to exploit the market
and therefore equity prices do not react to the issue. Only high-quality firms will
be able to issue riskless debt.
As for risky debt, there is a possibility of default and hence the security could be
mis-priced. Market will over-priced the debt when it under estimated the
probability of default. Thus, issues of risky debt convey some information to the
market but less clearly than the issuance of equity. Compared to equity issuance,
the equity prices will fall by a smaller amount when risky debt is issued. Equity
issues cause stock prices to drop a lot as the market infers that firms that issue
are of very poor quality.
The choice of security issuance, which results in a change in a firms capital
structure, affects firm value. Therefore, it can be more costly to issue equity than
to issue debt for corporations.
One of the many reasons for company to repurchase its own share is to signal
managers belief that the companys share is under-valued, and by financing the
share buyback scheme via retained earnings (riskless debt) is to deploy its excess
cash flow and/or substitute cash dividend payment. That reassures market of
the firms quality on one hand, but can increase the cost of capital for future
investments on the other hand. Hence, the net effect is ambiguous
Corporate Finance
Corporate Finance
(b)
The Debt overhang problem identified by Myers (1977) is a form of agency cost
of debt. It demonstrates that when debt levels are high, the management of firms,
acting in the interest of current shareholders, will choose to reject some positive
NPV projects as little of that projects payoff accrues to equity-holders. As a
result, even in the absence of bankruptcy costs, heavily indebted firms will see
reductions in corporate value. Apart from firms with high borrowing,
corporations with little worth of tangible assets that can act as security for their
borrowing or high growth firm (whose assets may still be investment projects
due to be started rather than actual investments) will also suffer debt overhang
problem. To protect itself from this type of problem, a firm should aim for low
level of debt, short maturity as opposed to long maturity debt, include debt
covenants in loan document, issue convertible debt, corporate governance etc.
(c)
Given
Rf = 0.05
V0 = $1,000,000
VH = $1,800,000
B = $ 600,000
VL = $ 500,000
Equation 1
Equation 2
Equation 1 2
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Corporate Finance
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Corporate Finance
State 2
State 3
Expected NPV
Probabilities
0.25
0.50
0.25
Cash Flow A
40
50
60
50
Cash Flow B
20
40
80
45
Both projects expected to have positive NPV with Project A having lower risk
and higher expected NPV of 50 while Project B is riskier with lower expected
NPV of 45. Clearly project A is superior to project B.
Now, lets assume debt-holders have a claim of 50 that must be repaid from the
chosen project.
Project A
Only in Stage 3 will equity-holders get a pay-off of 10 (i.e. 60 50) implying an
expected pay-off to equity-holders of 10 x 0.25 = 2.50 while the expected pay-off
to debt-holders is (0.25 x 40) + (0.50 x 50) + (0.25 x 50) = 47.50.
Project B
Only in Stage 3 will equity-holders get a pay-off of 30 (i.e. 80 50), implying an
expected pay-off to equity-holders of 30 x 0.25 = 7.50 while the expected pay-off
to debt-holders is (0.25 x 20) + (0.50 x 40) + (0.25 x 50) = 37.50.
Manager will choose Project B as it maximises expected pay-off to equity-holders
but debt-holders are worse off since the firms value is lower when Project B is
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Corporate Finance
chosen i.e. expected NPV of 50 for Project A vis--vis 45 for Project B. Debtholders in this case will bear the cost of asset substitution.
However, if debt repayment were 30 then expected pay-off to equity-holder are
as follows:
Project A:
Project B:
Manager will then choose Project A which will cause debt-holders to be happy as
their pay-offs are better as well:
Project A:
Project B:
Therefore, when the face value of debt is lower, the manager will choose the lowrisk, high-expected return project. This implies that the lower the debt, the higher
the firm value.
In conclusion, capital structure of a firm affects the value of the firm and this
relationship can be represented graphically as follows:
To mitigate this problem, a firm should aim for low level of debt, short maturity
as opposed to long maturity debt, and/or use of convertible debt to finance new
projects.
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Corporate Finance
(b)
The crux of Ross (1977) signaling argument for debt is as follows:
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Corporate Finance
Interest payments are tax deductible for the firm & taxable as income for debt
investor resulting in a net amount of RdD(1 ! Td)
After considering personal tax, the net income to the equity holders will be
(EBITt RdD)(1 Tc)(1 Te)
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Corporate Finance
Part (b)
The Trade-Off Theory of Capital Structure refers to the idea that a company
chooses how much debt finance and how much equity finance to use by
balancing the costs and benefits. Proposition I & II of Modigliani and Miller
states that:
I: Value of a Levered Firm = Value of an Unlevered Firm + Value of the Tax
Shield, implying that firms which want to maximize their values should
maximise their level of debt.
II: Increase in debt will increase the financial risk of equity. Therefore,
Re = Ra + (Ra Rd)(1 - Tc) *D/E
Non-trivial costs of financial distress or bankruptcy shows that cost of debt
(return + financial distress) and the benefits of tax shield arising from debt, a
firm should try to maximise its value by carefully trading off these two effects.
Therefore one might suggest that the optimal capital structure exists when the
marginal cost of financial distress = the marginal tax shield effect.
Firm Value
PV (bankruptcy cost)
PV (Interest
tax shield)
Value of
Unlevered Firm
D/E*
D/E
As the Debt equity ratio (ie leverage) increases, there is a trade-off between the
interest tax shield and bankruptcy, causing an optimum capital structure, D/E*
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Corporate Finance
Part (c)
(i) With the backing from the government, the potential bankruptcy cost
would be low for this water company. The high profit that the company
is generating will be able to absorb the interest on debt, thereby
enhancing the tax advantage from debt.
Based on the Trade-off Theory, this company is likely to have a higher
level of debt.
(ii)
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Corporate Finance
= WD # D + W E #
=
D(1-Tc ) # D +
E
#E
D(1-Tc ) + E
D(1-Tc ) + E
=0 +
60_______ (1.20)
40 (1 - 0.4) + 60
60
(1.20) = 0.8571
24 + 60
(b)
To calculate the companys MV after proposed project and financing
option
Market Value of Firm (before project) = 100mm
$
VD = 0.4 (100 mm ) = 40mm
VE = 60mm
If project is undertaken and financed by equity
VD
New VE
= 0.3
0.7
or
VD
New VF
$
New VF =
0.3
1
VD
0.3
40
0.3
= 133.33 mm
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Corporate Finance
(c)
NPV of Project
New VF
$
= VD + New VE
New VE = New VF - VD
= 133.33 mm 40mm
= 93.33 mm
= WD # D + W E #
=
D(1-Tc ) # D +
D(1-Tc ) + E
E
#E
D(1-Tc ) + E
= D(1-Tc ) # D + E# E_
D(1-Tc ) + E
# A [D(1-Tc ) + E] = D(1-Tc ) # D + E# E
E# E = D(1-Tc ) (# A - # D ) + # A E
# E = # A + D (1- TC ) [# A - # D]
E
= 0.857 + 0.3 (1 0.4) [0.857 0 ]
0.7
= 0.857 +
0.18_ (0.857)
0.7
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Corporate Finance
(e)
When funding a project with new equity, a firm might lose out on the
opportunity to further enhance the benefit of tax shield effect on debt.
Hence before deciding on the financing option, the company should
examine the trade-off between gain on tax shield and cost of financial
distress. However, in this case, West Central plc has already had a 40 to
60 split of debt and equity. Further increase in debt might not be
financially advantageous due to the potentially higher cost of financial
distress.
Apart from the trade-off effect, the company might also want to
consider the possible impact on its share price as a result of new equity
issue, i.e. the pecking order theory of finance. Event study evidence on
new security issues indicates 3% drop in share price, whereas risky debt
issues cause small price drops, which are not statistically different from
zero.
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Corporate Finance
Debt
Equity
Total
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(b)
(c)
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D/E
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However, when the face value of debt is low, the manager will choose
the low-risk, high-expected return project, leading to a higher value of
debt holders and equity holders. This implies that the lower the debt,
the higher the firm value. Graphically, the relationship can be shown as
follows:
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Corporate Finance
Cost
D/E
From the diagram, the agency cost of debt increases with debt.
Combining these two agency costs will give rise to the total agency cost.
When total agency cost is at its minimum, value of firm is at its
maximum and optimal level of debt, or optimal capital structure of firm,
can be identified.
Cost
Total Cost
Cmin
Agency cost of
debt
0
Agency cost of
equity
D/E*
D/E
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