Professional Documents
Culture Documents
Learning Objectives
Introduction to the Theory Modigliani-Miller Position Taxes and Capital Structure Effects of Bankruptcy Costs Other Imperfections Incentive Issues and Agency Costs Financial Signaling
What is Capital?
Capital is money that is used to generate income or make an investment.
For Example: The money you use to buy shares of a mutual fund is capital that you're investing in the fund.
Capital Structure
CAPITAL
CAPITAL DEBT
CAPITAL EQUITY
BONDS/ TFCs
BORROWINGS
DEBENTURS etc
DEPOSITS
COMMON STOSKS
PREFERRED STOCKS
RETAIN EARNING
Financial Structure
Ordinary shares
Capital Structure
Introduction to Theory
The affects of change in Financial mix on total valuation of firm and its required returns. The total valuation of the firm and its cost of capital varies with the change in debt to equity, or degree of leverage.
Leverage
To borrow money to finance the purchase of asset Measured by debt to equity ratio It tells how many assets are financed by debt and how many are financed by equity
Assumptions
There are no corporate and personal tax and bankruptcy cost. The ratio of debt or equity for a firm is changed by 1issuing debt to 2repurchase stock or 3issue stocks to pay off debt.
The firm has a policy of paying 100%of its earnings in dividends. Means all the capital requirement will be met either by debt or equity.
The expected values of the subjective probability distributions of expected future operating earnings for each company are the same for all investors in the market. The operating earnings of the firm are not expected to grow. The expected values of the probability distributions of expected operating earnings for all future periods are the same as present operating earnings.
Cost of Capital Debt ki = I = Annual Interest Charges B Market value of debt outstanding
V=B+S
ko is the overall capitalization rate. It is the weighted average cost of capital and is expressed as: ko = kI [B/(B+S)] + ke [S /(B+S)]
Assumption 2 "The ratio of debt or equity for a firm is changed by issuing debt to repurchase stock or issue stocks to pay off debt". According to this assumption Debt increase to repurchase stock value Rs.2,000/ Value of stocks decrease from Rs.5,667/- to Rs.3,667/ Value of firm/company is unaffected by its capital structure i.e. Rs.6,667/ ke increases with the increase in leverage
25 Capital Costs (%) 20 ke (Required return on equity) ko (Capitalization rate) ki (Yield on debt)
15
10 5 0
Financial Leverage (B / S)
From the graph, we can view that if the overall capitalization rate and cost of debt capital remain constant than with the increase in leverage the return on equity will also increase.
Traditional Approach
This approach to valuation and leverage assumes that there is an optimal capital structure that the firm can increase the total value of the firm through the well judged use of leverage. Approach suggests that the cost of capital lower by increasing the leverage and using cheaper debt funds.
Traditional Approach
25 Capital Costs (%) ke ko
20
15 10 5 0
Financial Leverage (B / S)
Modigiliani-Miller Position
Two economists who demonstrated that with perfect financial markets capital structure is irrelevant. MM in their original position advocate that the relationship between leverage and the cost of capital is explained by the net operating income approach. They take the position that the cost of capital, ko, remain constant throughout all degrees of leverage
Modigiliani-Miller Position
The total pie does not change as it is divided into debt, equity, and other securities. MM assume that capital structure changes are not a thing of value in the perfect capital market world.
Value of Fim Value of Firm
Debt Edquity
Debt Edquity
Homemade Leverage
Consider two firms identical in every respect except company A is not levered, while company B has Rs.3,000,000/- of 12% bonds outstanding. According to traditional position, company B may have a higher total value and lower average cost of capital than company A.
ke
S B
0.16
Rs.4,000,000 3,000,000
V
ko B/S
Rs.6,666,667
Rs.7,000,000
14.3% 75.0%
Arbitrage- Buying one asset in one market at a lower price and simultaneously selling an identical asset in another market at a higher price.
MM maintain that this situation cannot continue (i.e; different returns for different companies), for arbitrage will drive the total values of the two firms together. Company B cannot command a higher total because of financing mix different from company A's.
Arbitrage Steps
1.
2. 3. 4. 5.
6.
If a rational investor owns 1% of the stocks of company B, the leverage firm, worth Rs.40,000/- (1% of Rs.4,000,000). Sell the stock in company B for Rs.40,000/-. Borrow Rs.30,000/- @12% interest. Buy 1% of shares of company A (1% of 6,666,667) the unleveraged firm, for Rs.66,666.67. The expected return on investment in company B's stock was 16% on a Rs.40,000/-, or Rs.6,400/-( i.e; Rs.40,000 * 0.16) The expected return on investment in company A is 15% on a Rs.66,666.67 investment or Rs10,000/- (i.e; Rs.66,667 * 0.15). Return on investment in company A Less: Interest (Rs.30,000 * 0.12) Net Return Rs.10,000/3,600/Rs. 6,400/-
Interest payment against debt is deductible as an expense. Whereas dividends or retained earnings associated with stocks are not deductible by the corporation for the tax purposes. For Example: Suppose the EBIT are Rs.4,000,000/- for company X and Y and they are alike in every respect except in leverage. Company Y has Rs.5,000,000/- in debt at 12% interest, whereas company X has no debt.
Company X
EBIT Interest Income debt holder Profit before tax to Rs.2,000,000 0 Rs.2,000,000
Company Y
Rs.2,000,000 600,000 Rs.1,400,000
Taxes @40%
Income available to stockholders Income available to stock & debt holders
800,000
Rs.1,200,000 Rs.1,200,000
560,000
Rs.840,000 Rs.1,440,000
It can be viewed that the total income for the leverage company Y is greater than the unleveraged company X. Reason behind it is that in case of Leverage Company for the use of debt, total income to all investor's increases by the interest payment times the tax rate. It amounts to Rs.600,000 x 0.40= Rs.240,000/- represent a tax shield that government provides the leverage company as compare to unleveraged company.
Present value of tax shield = tc r B/ r = tc B= 0.40x 5,000,000= Rs.2,000,000/Where, B is market value of debt.
Tax shield is a thing of value and that the overall value of company will be Rs.2,000,000/- more if debt is employed than if the company has no debt.
Present value of Rs.240,000 discounted at 12%= Rs.240,000/0.12= Rs.2,000,000/ Value of Firm = Value of unleveraged + Value of Tax Shield = Rs.7,500,000 + 2,000,000= 9,500,000/COMPNAY X EBIT INTEREST ON DEBT EARNING AVAILIABLE TO CS TAX @40% INCOME AVAILABLE TO STOCKHOLDERS Rs.2,000,000 800,000 Rs.1,200,000 Rs.2,000,000 COMPNAY Y Rs.2,000,000 *600,000 Rs.1,400,000 560,000 Rs.840,000
Rs.1,200,000
0 0.16 Rs.7,500,000
Rs.1,440,000
2,000,000
Rs.9,500,000
It means that tax shield is the difference in the value of firm, which is the sum of value of unleveraged firm plus tax shield. i.e; Rs.7,500,000 + Rs.2,000,000= Rs.9,500,000/-
Debt=
Company A EBIT
Interest Income on Debt Profit before tax Tax @35% Income available Stockholders to 2600000
Company B 4000000
720000 3280000 1148000 2132000
4000000
0 4000000 1400000
2600000
2852000
Tax shield to leverage company 6000000* 0.35 = 2,100,000 Value of Firm = Value of unleveraged + Value of Tax Shield = Rs.17,333,333 + 2,100,000= 19,433,333/If the return on equity on unleveraged company is 15%, it means that tax shield is the difference in the value of firm, which is the sum of value of unleveraged firm plus tax shield. i.e; Rs.2,600,000/0.15=17,333,333 + Rs.2,100,000= Rs.19,433,333/-
Redundancy is another argument. The notion here is that companies have ways other than interest on debt to shelter income- leasing, foreign tax shelters, investment in intangible assets etc. Uncertainty of Tax Shield- if the reported income is consistently low or negative, the tax shield on debt is reduced or even eliminated. It is expressed as Value of firm= Value if unlevered + Pure value of corporate tax shield value lost through tax shield uncertainty.
The presence of taxes on personal income may reduce or possibly eliminate the corporate tax advantage associated with debt. However, the corporate tax advantage remains, if returns on debt and on stock are taxed at the same personal rate.
Company X Debt Income Less: Personal Taxes of 30% Debt income after personal taxes Income available to stockholders Less: personal taxes of 30% Shareholder income after personal taxes Income available to stock & debt holders after personal taxes.
Rs.1,200,000
-360,000
Rs.840,000
-252,000
Rs.840,000
Rs.1,200,000
588,000
Rs.1,008,000
Where B= Market value of debt tc= Corporate Tax tps =Personal income tax rate applicable to CS tpd = Personal income tax rate applicable to debt income If tps= tpd Present Value of Tax Shield= tcB
Capital Gain Income- charge at lower rate, in Pakistan there is no CGT if an investment period exceed three years.
Bankruptcy Costs
The presence of bankruptcy costs is another imperfection effecting capital structure decisions. Bankruptcy Costs are dead weight loss to suppliers of capital.
If there is a possibility of bankruptcy and if the administrative and other costs associated with the bankruptcy are significant; a leveraged firm may be less attractive then an unlevered one.
In Perfect Capital Markets: - Bankruptcy costs are zero. - If the firm goes bankrupt presumably the assets can be sold at their economic value with no liquidating or legal costs involved.
Less Than Perfect Markets: - Their are administrative costs to bankruptcy. - Assets may have to be liquidated at least than their economic value.
Bankruptcy Costs
Relationship to Leverage:
A levered firm is a less attractive investment option as opposed to a unlevered firm. The expected cost of bankruptcy increases at an increasing rate beyond a certain point and has a negative effect on the overall value of the firm and on its cost of capital. Ex Post cost of bankruptcy is beard by creditors. Ex ante cost is passed on to stockholders. Even thought the market equilibrium process is assumed to be efficient, the investors are unable to diversify the bankruptcy costs since they represent a dead weight loss. The investors penalize the price of the stock as leverage increases. Here the required rate of return for investors, k is divided into its components parts. There is the risk free rate Rf plus a premium for business risk.
ke without bankruptcy costs Premium for Business Risk Risk-free rate LEVERAGE B/S
ke with no leverage
Bankruptcy Costs
Taxes and Bankruptcy Costs:
As the company increases its leverage the present value of the tax shield increase at least for a while.
The net tax effect will have a positive influence on value at least for moderate amounts of leverage, bankruptcy costs and tax-shield uncertainty exert a negative influence.
VALUE OF FIRM
Bankruptcy Costs
Increasing leverage and the consequent increase in chances of bankruptcy cause the value of the firm to increase at a decreasing rate and eventually to decline. This can be expressed as:
The optimal capital structure is the point at which the value of the firm is maximized. Thus we have a trade-off between the tax effects and bankruptcy costs.
Bankruptcy Costs
Other Imperfections:
Other imperfections also exists that impede the equilibrium of security prices with respect to their expected risks and returns. These imperfections must be material and one-directional.
Bankruptcy Costs
Homemade leverage involves certain inconveniences: 1. Stockholders who other wise have limited liability with stocks have unlimited liability with personal leverage. The costs of borrowing will be higher for a person than fore corporations.
2.
Arbitrage:
Arbitrage may occur without the individual actually borrowing.
Financial intermediaries may also replicate financial claims of ether the levered or unlevered company and buy the stock of the other if chances for profit exist.
Bankruptcy Costs
Institutional Restrictions:
Certain restrictions may retard the arbitrage process. Regulatory bodies restrict stock and bond investment to a list of companies that fulfill certain standards such a only safe amount of leverage. With such restrictions the point at which the firm's value lie turns down with leverage comes sooner than depicted.
In this case the writers of the option are the debt holders.
If we assume that debt is represented by discount bonds that pay only at maturity. We can then view the firm as been sold to debt holders by the stockholders with an option to buy it back at a specified price.
The option has and exercise price equal to the face value of the debt and its expiration date is the maturity of the debt.
VALUE OF DEBT, Vd
Vd = Vf
Vd = D
VALUE OF THE FIRM, Vf
V0 = 0
V0 = Vf - D
Protective Covenants
A part of an indenture or loan agreement that limits certain actions a company may take during the term of the loan to protect the debt holders interests. These covenants may be used to restrict the stockholders ability to increase the asset riskiness of the company and/or its leverage. Reputation of the buyer may affect the terms of the loan. New borrowers with short track records generally face more restrictions than does a company with a long standing, high credit raring.
Me-first rule
Me-first rule is defined as a prior arrangement to protect bondholders from uncompensated shifts of wealth from bondholders to stockholders through a change in the capital structure of the firm. Me- first rule ensures that one party cannot gain at the expense of the other. To the extent that me-first rules are not effective, capital structure decisions may be relevant even in the absence of taxes and bankruptcy costs.
Therefore, managers may avoid risky projects even if they have positive NPVs. A possible remedy for stock holders is to own both stocks and bonds in the company. If the incentives of both debt holders and stock holders can somehow be brought together by this means or by contracting between the to parties, the underinvestment problem disappears.
Relationships among taxes, bankruptcy costs and firm values need to be modified.
Leverage B/S
Signaling Theory
Signal: An action taken by a firms management that provides clues to investors about how management views the firms prospects MM assumed that investors and managers have the same information. But, managers often have better information.
69
Symmetric Information: Investors and managers have identical information about the firms prospects. Asymmetric Information: Informational Asymmetry is based on the idea that insiders (managers) know something about the firm that outsiders (security holders) do not. Financial Signaling: A manager may use capital structure changes to convey information about the profitability and risk of the firm.