Topic 7 Capital Structure

Overview

This topic is concerned with the issue of whether there exists an Optimal
Capital Structure, one that maximizes the value of the firm.

In order to address the issue, one needs to first examine the effect on equity
holders of introducing Financial Leverage into the firms capital structure

Financial Leverage refers to the extent to which a firm relies on debt.

Returns
RETURN AVAILABLE TO SHAREHOLDERS

reflects the earning capacity of the firms assets


REQUIRED RATE OF RETURN TO SHAREHOLDERS

the minimum return demanded by shareholders given the
investment risk
reflects trade- off between risk and return

Firms Cash Flows
REVENUE
Fixed operating costs
Variable operating costs
Interest NET INCOME
[NI]
less
equals
NET OPERATING INCOME
[NOI]
less
equals

Example

Assume that there are 3 identical firms, a , b and c.
Identical in all respects apart from the way in which the firm is financed.

We are initially neglecting the effects of corporate taxation

In each case the firm has total assets of $400,000 and but the mix of debt
and equity used to finance these assets differ

We assume that the return that the firm can earn on its assets in each
case is the case, 15%

Therefore, Net Operating Income of all 3 firms is the same at $60,000

The firms that use debt pay 10% interest


(a)
All equity
$

(b)
50% debt
50% equity


(c)
75% debt
25 % equity


Equity 400,000

200,000

100,000

Debt



200,000

300,000

Total Assets

400,000

400,000

400,000

Debt/Equity ratio

0

1:1

3:1

Net operating Income 60,000

60,000

60,000

Interest (at 10%)



20,000

30,000

Net Income

60,000

40,000

30,000

Return on Assets


15%

15%

15%

(Available) Return on Equity


15%

20%

30%





The previous analysis can be captured in algebraic form

Let = return available to equity holders

= return provided by the firms assets

ae
r
af
r
( )
E
D r E D r
r
d af
ae
+
=
( )
E
D
r r r r
d af af ae
+ =
=
ae
r
Net cash flow - interest
from firms assets payments
equity investments
=
What happens to the available return to equity holders as
result of the return earned on the firms assets decreasing?

Initially the return on the firms assets of $400,000 was 15%
giving a NOI of $60,000. We now assume the return on
assets falls to 9% giving a NOI of $36,000

It will be shown that the greater is the D/E ratio the greater
the drop in the available rate of return to equity holders


(a)
All equity
$

(b)
50% debt
50% equity


(c)
75% debt
25 % equity


Equity

400,000

200,000

100,000

Debt



200,000

300,000

Total Assets

400,000

400,000

400,000

Debt/Equity ratio

0

1:1

3:1

Net operating Income

36,000

36,000

36,000

Interest (at 10%)



20,000

30,000

Net Income

36,000

16,000

6,000

Return on Assets


9%

9%

9%

Available Return on Equity


9%

8%

6%

Change in available
return on equity

-40%

-60%

-80%

Financing Structure Different levels of NOI ($000)

0 20 40 60 80

(a) All equity 0% 5% 10% 15% 20%
(b) 50% debt, 50% equity -10% 0% 10% 20% 30%
(c) 75% debt, 25% equity -30% -10% 10% 30% 50%
The below table shows the greater the debt to equity ratio the
greater the change in the available return to equity holders as a
result of a change in the level of Net Operating Income (NOI)
Effects Of Financial Leverage
The substitution of debt for equity in the capital structure

(1) It increases the available return to equity holders can on their
investment. This is due to the firms assets being able to earn a return
greater than the cost of debt.
(2) It increases the risk (variability of the returns)
associated with the investment. Thus, the greater the range of
returns available to shareholders.

Having examined the impact of introducing debt we now turn to
examine how it could impact on the value of the firm through the
firms Capital Structure

Capital Structure
The long-term sources of finance of the firm
Items found on the right hand side of the Balance Sheet
The combination of debt and equity used to finance the
investment in real assets.
Established by financing decisions
Summarised by the Debt-to-Equity ratio (D/E)
Optimal Capital Structure
The combination of debt & equity that minimises WACC
such that the value of the firm is maximised.
Is there such a combination?
REAL ASSETS

GENERATE
A STREAM
OF
CASH FLOWS

- inventory
- machinery
- land & buildings



FINANCIAL ASSETS

CLAIMS
UPON THE
CASH FLOW
STREAM

- shares
- term loans
- mortgages
- debentures
Investing
Decision
Financing
Decision
Value of the Firm

The firm may be valued by discounting the future cash
flows of the firm by the WACC
V =
n

t = 1
NOI
t

(1 + r)
t
V =
n

t = 1
(Revenues - Costs)t
(1 + r)
t
n

i = 1
r =
r
i
X
i
V =
NOI
r
e.g. Equity and debt
r = r
e
( ) + r
d
( )
E
V
D
V
SIMPLIFY BY ASSUMING NOI IS CONSTANT
We can now express the equation as a perpetuity.
Value of the Firm
As NOI increases the value of the firm increases.
NOI reflects the Investment decision of the firm
As the Weighted Average Cost of Capital decreases the Value of
the firm increases.
WACC reflects the Financing decision of the firm
Is there a minimum value of the WACC which maximizes the
value of the firm and how is it achieved?

THE BIG QUESTION
Does substitution of cheaper debt finance for equity reduce the
overall weighted average cost of capital and thereby increase the
value of the firm?


Why Is Debt Cheaper Than Equity?

Debt holders have priority over equity holders in their claims on
the firms cash flow stream.
Debt is a contractual claim
Dividends are a residual claim
Lenders therefore face lower risk than equity investors.
Consequently, the return required by debt holders (lenders) is
less than the return required by shareholders
TRADITIONAL APPROACH

The traditional approach to capital structure assumes that there is
an optimal capital structure and management can increase the
total value of the firm through the financing method.

The approach implies that the cost of capital is dependent on the
capital structure of the firm.

This was a practical approach without a theoretical basis.

The determinants of, or path to, the optimal D/E ratio were never
specified (no formal model)

The Traditional View Of The
Effect Of Leverage
As the amount of debt increases, this initially reduces the WACC
(because debt is cheaper than equity)

However, the cost of debt is not constant but at some point increases.

The required rate of return that shareholders demand, cost of equity,
also increases as the level of debt increases and this offsets the initial
reduction in WACC.

Traditional view - there is an optimal capital structure.
It is where WACC is at a minimum and consequently the value of the
firm is at a maximum
The Traditional View Of The
Effect Of Leverage
Cost of
Capital
Leverage
D/V
0
(a) The Effect on the Cost of Capital
r
e
r
d
r
Total
Value
Leverage 0
D
V


(b) The Effect on Firm Value
V
Example
r = r
d
(D/V) + r
e
(E/V)


0.086 = 0.05(10/100) + 0.090 (90/100)

0.084 = 0.05(25/100) + 0.095 (75/100)

0.075 = 0.05(50/100) + 0.10 (50/100)

BUT

0.077 = 0.07(90/100) + 0.14 (10/100)


Modigliani and Miller (M&M)
questioned the traditional view

examined the relationship between firm value and financing
choice

analysis based on perfect market assumptions

undertook studies of electric utilities and oil companies -
evidence supported conclusion that there was no
relationship between D/E ratios and cost of capital in these
industries
ASSUMPTIONS UNDERLYING
M & M ANALYSIS
1. a perfectly competitive market in which all investors have
perfect knowledge and act rationally;

2. investors are perfectly certain about the future profitability
of any company;

3. all companies can be divided into homogenous risk classes;

4. no personal or company tax;

5. individuals and companies can raise unlimited debt funds at
the same rate of interest;
M&M Proposition 1

In perfect capital markets (with no taxes and no bankruptcy costs) the
value of the firm is independent of its capital structure. i.e. Capital
Structure is irrelevant.
The WACC does not vary with changes in the debt/equity ratio.
A firm cannot change its total value just by dividing its cash flows into
different streams (different classes of investors).
The firm's value is determined by its real assets, not by the securities it
issues.
Claims on firms in same business risk class and with same earnings
streams are perfect substitutes and must sell for the same value -
otherwise could make arbitrage profits.

PROVIDED
Personal borrowing is a perfect substitute for corporate borrowing.


MM Proposition I
Shares
40%
Debt
60%
The size of the pie does not depend on how it is sliced.
The value of the firm is unaffected by its capital structure.
Value of firm
Value of firm
Shares
60%
Debt
40%
M&M Proof Of Capital Structure
Irrelevance In Perfect Capital Markets

E.g. Firm L and firm U have identical assets capable of generating
identical cash flows . The only difference is that Firm L is more highly
levered.

If Firm L has the same cost of equity as firm U, and uses cheaper debt, it
will have a lower WACC its value will be higher than Firm U

Investors will sell their shares in Firm L and buy equivalent cash flow
stream in Firm U thus making an arbitrage profit. The sale of Firm L
shares will cause Firm Ls price to fall. The increase demand of Firm
Us shares will cause Firm Us price to rise.

The process will continue until the value of each firm is the same.
Irrelevance Proposition
IRRELEVANCE PROPOSITION
Assume two firms with the same business risk and the same NOI
Un-levered Firm
NOI = $2,000 re =10%

V
u
= $20,000
Levered Firm

D = $10,000 rd = 5%

NOI = $2,000 re =10%

Interest = $500
NI = $1,500

E = 1,500/0.1 = $15,000

V
L
= $10,000 + $15,000 = $25,000
Assume they own 10% Equity (E) of the Levered Firm, i.e.
$1,500 which provides a 10% claim on NI
L
of $150

The operation
1. Sell E in the levered firm for $1,500

2. Borrow $1,000 at 5%

D/E =1000/1500 =2/3

Same as levered Firm

3. Buy 10% of the E in the un-levered firm for $2,000
The Arbitrager

Arbitrage Results

(i) Receives 10% of the income of the un-levered firm = $200

(ii) Pays $50 interest on personal borrowing

(i) + (ii) implies individual receives net $150 which is what individual
was receiving from their share in the un-levered firm.


NB: Individual had available $2,500
(D = $1,000, E = $1,500) used $2,000 to buy shares in un-levered
firm which means that $500 still available to earn income on!!!

M & M Proposition 1
Cost of
Capital
Leverage 0
(a) The Effect on the Cost of Capital
r
e
r
d
r
Total
Value
Leverage 0
(b) The Effect on Firm Value
V
M&M Proposition 2
The issue to be investigated is how exactly does the required
return on equity in a levered firm change as the degree of
leverage (D/E) changes?

Result: The required rate of return by equity holders can be
shown to be equal to the required rate of return for un-
levered equity plus the financial risk premium which is a
function of the debt-equity ratio.




Assume NOIu = NOIL

From M & M Theorem 1 V
u
= V
L


V
u
= NOIu / r*e r

r*e is the required return on equity capital in a firm with no debt (pure
equity firm)

VL = NOIL / r

Where r is the required rate of return on capital ( both debt and
equity) in a levered firm.

r = rd (D/V) + re (E/V)

Since from Modigliani and Miller

we know that V
U
= V
L
we require that
r*
e
= r = r
d
(D/V) + r
e
(E/V)
r*
e
= r
d
(D/V) + r
e
(E/V)
Solving for r
e

r
e
= r*
e
+ (r*
e
r
d
).D/E
We recognize that in an all equity (un-levered) firm r*
e
= r
af

Therefore r
e
= r
af
+ (r
af
r
d
).D/E

This shows that as the degree of leverage (D/E) increases
the required rate of return on equity (r
e
) in a levered
firm increases exactly in line with the increase in the
available rate of return (r
ae
)
( )
E
D
r r r r
d af af ae
+ =
For capital structure to be irrelevant the return equity
holders require on their investment must increase in
line with the return available to them.

As cheaper debt is substituted for equity in the
capital structure, the return required by the equity
holders increases in response to the increased risk
associated with their investment, and thereby
(exactly) offsets the effect on the overall cost of
capital of the cheaper debt finance.








Returns to Equity
Example
Capital structure: equity = 40% debt = 60% r
d
= 8%
assume business risk r
e
* = 8.8%

r
e
= r
e
* + (r
e
* - r
d
)

D/E
r
e
= 8.8% + (8.8% - 8%)

6/4
r
e
= 10%

WACC = re (E/V) + rd (D/V)
= 10% x 40/100 + 8% x 60/100
= 4% +4.8%
= 8.8%




Example
If capital structure changes so debt increases to 70%,
M & M argue that this will increase the financial risk to
shareholders and their required rate of return will increase.
re = re* + (re* - rd) D/E
re = 8.8% + (8.8% - 8%) 7/3
re = 10.67%

When capital structure changes
WACC = 10.67%

x 30/100 + 8% x 70/100
= 3.2% + 5.6%
= 8.8% no change in WACC




Type of Risks
NO DEBT: NOI = NI (all variability in net income
comes from business risk).

DEBT: when the firm borrows, it becomes subject
to financial risk and business risk; interest
is subtracted from the NOI, the effect being
an increase in the variability of the NI stream.

= an additional source of risk
= shareholder expected return increases

BUSINESS RISK:
risk due to nature of the products sold by the company e.g.
new competition, technological improvements, etc.

FINANCIAL RISK:
risk due to using debt (directly related to amount of debt in
the capital structure).
Decomposition Of Equity
Holders Required Returns
r
e
= RF + BRP + FRP
Return on a
Risk-free
investment
Premium for
Business Risk
Premium for
Financial Risk
Risk inherent in
firms operations
Risk introduced through the addition of
debt into the capital structure
Thus, the expected return to equity holders is equal to the
required rate of return for un-levered equity plus the
financial risk premium which is a function of the debt-
equity ratio.






r
e
= return to equity holders
r
e
*= rate of return required by shareholders in a un-levered firm
r
d
= rate of return required by debt holders

Proposition 2
D
E
r
e
= r
e
* + (r
e
* - r
d
) x
Business
Risk
Financial
Risk
Conclusion from Proposition 2



Increasing leverage does not affect the cost of capital.

The cost of debt is an explicit cost included in the cost of capital.

The financial risk created by leverage is an implicit cost of debt
which increases the cost of capital by increasing the required rate
of return by equity holders.







Summary
Capital Structure Irrelevance
r
NOI
V=
WACC
|
.
|

\
|
+
|
.
|

\
|
=
V
E
r
V
D
r r
e d
Constant Proportions changing
| |
|
.
|

\
|
+ =
E
D
r r r r
d e e e
* *
r
e
varies linearly (and positively) with changes in financial leverage
and offsets the effect on r of the lower cost (r
d
)
M&M Proposition 3
The appropriate discount rate for a particular investment
proposal is completely independent of how the investment is
financed. Therefore, the financing decision is irrelevant
from the point-of-view of maximising shareholder wealth.

The appropriate discount rate depends on the features of
the investment proposal, especially risk.


INTRODUCTION TO MARKET
IMPERFECTIONS
Capital structure Decision with Corporate
Taxation

M & M introduced corporate taxes conclusion:
interest is tax deductible
thus borrowing represents a tax saving
thus the value of the levered firm is greater than the value
of the un-levered firm by the value of the present value of
the tax benefits
or V
L
> V
U


where V
L
= V
U
+ P.V. of the tax savings on
interest
Imperfect Capital Markets
Corporate Taxes

Levered firms have additional tax deductions
associated with the interest payments

Value of the levered firm (V
L
) will be greater than
the value of the un-levered firm (V
U
) by the present
value of the tax benefits

Implies existence of an optimal capital structure -
ALL DEBT
Notation
V
u
= value of an un-levered firm

V
L
= value of a levered firm

r
d
= rate of return required by debt holders

r
e
* = rate of return required by shareholders
in an un-levered firm

r
e
= rate of return required by shareholders
in a levered firm
V
u
=

V
L
=

V
L
=



V
L
=
NOI (1 - t
c
)
r
e
*
NOI (1 - t
c
)
r
e
*
NOI (1 - t
c
)
r
e
*
(r
d
) (D) t
c

r
d
+
+
D t
c
+ D t
c
V
u
Present value of the
interest tax shield
Modigliani & Miller Analysis
I ntroduction of Corporate Taxes
V
0
D
E
V
L
V
u
Present Value of
Interest Tax Shields
(D t
c
)
Cost Of Capital
Optimal capital structure will be 100% debt. This will
minimise the cost of capital and thereby maximise the value
of the firm.
r
WACC
D
E
Why Are All Debt Capital
Structures Not Observed?
There must be factors that offset the tax advantages of debt
finance when borrowing becomes too high e.g.

1. Personal Taxes
2. Financial Distress Costs
3. Conflict of Interest Costs
etc.

The impact of the introduction of personal taxes is beyond the scope of this
course.
A formal analysis of personal taxes is contained in the appendix to this topic.

In Summary

If corporate taxes are introduced to be consistent need to also consider the
impact of personal taxes.
Need to consider the way in which the corporate tax system and the personal
tax system are integrated, in particular as regards the treatment of dividends
e.g. are dividends taxed twice?
is there a dividend imputation system in place?
Need to consider whether equity income is treated more favourably than debt
income by the personal tax system.
How are capital gains taxed?


Depending on the exact nature of the overall tax system can end
with a variety of results.

If the tax system is perfect, in the sense that an individual pays the
same amount of tax whether they receive a dollar of debt income
or a dollar of equity income, then its back to the original
Modigliani Miller result in that the capital structure does not
matter.

If Dividends are taxed twice once at the company level and once at
the individual level ( Classical Tax system) then could be back to
the conclusion the more debt in the capital structure the greater
the value of the firm.

If debt income is treated more ( less) favourably by the tax system
than equity income an increase in debt (equity) will increase the
value of the firm
2. Financial Distress Costs
Financial Distress:
When a firm cannot meets its
creditors commitments


Financial Distress Costs:
Costs of managerial time devoted to avert failure, fees paid to
insolvency specialists, etc.

Direct vs Indirect Bankruptcy Costs
Direct costs
Those costs are directly associated with bankruptcy, e.g. legal
and administrative expenses.
Indirect costs
Those costs associated with spending resources to avoid
bankruptcy.
The static theory of capital structure
A firm borrows up to the point where the tax benefit from an
extra dollar in debt is exactly equal to the cost that comes from
the increased probability of financial distress.
2. Financial Distress Costs
As debt increases to a point where there us a possibility of
financial distress and the F.D.C. increase, there is an
offsetting effect, i.e. the PV of the F.D.C. offset the PV of the
interest tax shields.

where V
L
= V
U
+ PV of the Tax Saving on Interest
- PV of the Financial Distress Cost



At the point where this offsetting begins we find the optimal
capital structure for a firm.
2. Financial Distress Costs
Value of the firm
(V
L
)
V
L
+ V
U
+ T
C
x D
Financial distress costs
Actual firm
value
V
U
= Value of firm
with no debt
Total debt
(D)
D*
Optimal amount
of debt
V
U
Maximum
firm value V
L
*
The gain from the tax shield on debt is offset by financial distress costs. An
optimal capital structure exists which just balances the additional gain from
leverage against the added financial distress cost.
3. Conflict Of Interest Costs
Debt holders may fear management will transfer wealth
from themselves to shareholders.

They need to protect themselves from erosion of wealth
(increase r
d
or impose covenants)

this is likely to increase as the D/E ratio increases

these costs are part of financial distress costs
APPENDIX A . Personal Taxes (Miller 1977)
analysis based on the classical tax system
assumed r
e
equals zero ( r
d
and t
c
are important)
investors are risk-neutral and debt is risk-less
there are different clienteles of investors (based on personal tax rate)

Investors face a choice of either
a) tax-exempt Govt. bonds or
b) investment in risky firms
To entice investors to invest in debt rather than equity, the firm must offer
high enough returns (before tax) to offset the disadvantage of higher
personal tax rates.

This counterbalances the interest deductibility of debt (the shareholders of
levered firms end up receiving no benefit from the tax deductibility of interest
on corporate debt because the firms are in effect forced to pay debt holders
personal taxes in the form of higher returns).


1. Personal Taxes (Miller 1977)
Any gain from leverage on the relationship between two types
of personal taxes and the corporate tax rate.

V
L
= V
u
+ D.t
c


where (1 - t
c
) (1- t
ps
) = after-tax return to shareholders
(1 - t
pd
) = after-tax return to debt holders


= V
u
+ [1 - ] D
(1 - t
c
) (1 - t
ps
)
(1 - t
pd
)
D[ ] = G
L
(gain or leverage)
1 - (1 - t
c
) (1 - t
ps
)
(1 - t
pd
)
1. Personal Taxes (Miller 1977)
A point is reached where

(1 - t
c
) (1- t
ps
) = (1 - t
pd
)

At this point the gain from leverage is zero and the
advantage of issuing more debt vanishes completely.

At this point a capital structure is optimal

Because this level of debt is optimal for all firms, the D/E is
optimal for the economy as a whole, not for the individual
firm.

Millers Analysis Corporate &
Personal Taxes
0 D
V
L
= V
u
+ [1 - ] D
(1 - t
c
) (1 - t
ps
)
(1 - t
pd
)
V
L
V
u
V
L
= V
u
+ D t
c
I F t
ps
= t
pd
V
L
> V
u
IF (1 - t
pd
) > (1 - t
c
) (1 - t
ps
)
V
L
= V
u
IF (1 - t
pd
) = (1 - t
c
) (1 - t
ps
)
V
L
< V
u
IF (1 - t
pd
) < (1 - t
c
) (1 - t
ps
)