pp17

Chapter 17
Capital Structure
Determination
17.1 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
After Studying Chapter 17,
you should be able to:
1. Define capital structure.
2. Explain the net operating income (NOI) approach to capital
structure and valuation of a firm; and, calculate a firm's value
using this approach.
3. Explain the traditional approach to capital structure and the
valuation of a firm.
4. 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.
5. Describe various market imperfections and other "real world"
factors that tend to dilute M&Ms original position.
6. Present a number of reasonable arguments for believing that an
optimal capital structure exists in theory.
7. 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
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.
Assume: (1) investment and asset
management decisions are held constant and
(2) consider only debt-versus-equity financing.
A Conceptual Look
Relevant Rates of Return
ki = the yield on the companys debt
I Annual interest on debt
ki =
B
=
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
ke = the expected return on the companys equity
Earnings available to
E
E common shareholders
ke = S =
S Market value of common
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
ko = an overall capitalization rate for the firm

O
O Net operating income
ko =
V
V
= Total market value of the firm
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.
B S
ko = ki + ke
B+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 $1,350
Market value of debt is $1,800 at 10% interest
Overall capitalization rate is 15%
Required Rate of
Return on Equity
Calculating the required rate of return on equity
Total firm value = O / ko = $1,350 / 0.15
= $9,000
Market value =VB = $9,000 $1,800
of equity = $7,200 Interest payments
= $1,800 10%
Required return =E/S
on equity* = ($1,350 $180) / $7,200
= 16.25%
* B / S = $1,800 / $7,200 = 0.25
Required Rate of
Return on Equity
What is the rate of return on equity if B=$3,000?
Total firm value = O / ko = $1,350 / 0.15
= $9,000
Market value =VB = $9,000 $3,000
of equity = $6,000 Interest payments
= $3,000 10%
Required return =E/S
on equity* = ($1,350 - $300) / $6,000
= 17.50%
* B / S = $3,000 / $6,000 = 0.50
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 ki ke ko
0.00 15.00% 15%
0.25 10% 16.25% 15%
0.50 10% 17.50% 15%
1.00 10% 20.00% 15%
2.00 10% 25.00% 15%
Calculated in slides 9 and 10
Required Rate of
Return on Equity
Capital costs and the NOI approach in a
graphical representation.
0.25
ke = 16.25% and
17.5% respectively
Capital Costs (%)
0.20
ke (Required return on equity)
0.15
ko (Capitalization rate)
0.10
ki (Yield on debt)
0.05
0
0 0.25 0.50 0.75 1.0 1.25 1.50 1.75 2.0
Financial Leverage (B/S)
Excel & the NOI Approach
NOI Approach
You can create

this type of
analysis in
Excel also. You
can use some
modeling
experience to
write formulas
to calculate the
required rates.
Refer to VW13E-
17.xlsx on the NOI
Approach tab
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:
ke
0.25
ko
Capital Costs (%)
0.20
0.15
ki
0.10
Optimal Capital Structure
0.05
0
Financial Leverage (B / S)
Excel and the
Traditional
Approach
You can create this

type of analysis in
Excel also. We use
some assumptions
in this model built
into the formulas.
Refer to VW13E-
17.xlsx on the
Traditional
Approach tab
Summary of the
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 Market value
of debt ($35M) of debt ($65M)
Market value Market value

of equity ($65M) of equity ($35M)
Total firm market Total firm market

value ($100M) value ($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 $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 $10,000
Arbitrage Example:
Company NL
Valuation of Company NL
Earnings available to =E =OI
common shareholders = $10,000 - $0
= $10,000
Market value = E / ke
of equity = $10,000 / 0 .15
= $66,667
Total market value = $66,667 + $0
= $66,667
Overall capitalization rate = 15%
Debt-to-equity ratio =0
Arbitrage Example:
Company L
Valuation of Company L
common shareholders = $10,000 $3,600
= $6,400
Market value = E / ke
of equity = $6,400 / 0.16
= $40,000
Total market value = $40,000 + $30,000
= $70,000
Overall capitalization rate = 14.3%
Debt-to-equity ratio = 0.75
Completing an
Arbitrage Transaction
Assume you own 1% of the stock of
Company L (equity value = $400).
You should:
1. Sell the stock in Company L for $400.
2. Borrow $300 at 12% interest (equals 1% of
debt for Company L).
3. Buy 1% of the stock in Company NL for
$666.67. This leaves you with $33.33 for other
investments ($400 + $300 - $666.67).
Completing an
Original return on investment in Company L
$400 16% = $64
Return on investment after the transaction

$666.67 16% = $100 return on Company NL
$300 12% = $36 interest paid
$64 net return ($100 $36) AND $33.33 left over.
This reduces the required net investment to
$366.67 to earn $64.
Summary of the
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 costs (Slide 1730)
Agency costs (Slide 1731)
Debt and the incentive to manage
efficiently
Institutional restrictions
Transaction costs
Required Rate of Return
on Equity with Bankruptcy
ke with bankruptcy costs
Required Rate of Return
Premium
ke with no leverage
on Equity (ke)
for financial
risk
ke without bankruptcy costs
Premium
for business
risk
Rf
Risk-free
rate
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 $5,000 of 12% debt
Corporate tax rate is 40% for each company
NOI for each firm is $10,000
Corporate Tax Example:
Company ND
Valuation of Company ND (Note: has no debt)
common shareholders = $2,000 $0
= $2,000
Tax Rate (T) = 40%
Income available to = EACS (1 T)
common shareholders = $2,000 (1 0.4)
= $1,200
Total income available to = EAT + I
all security holders = $1,200 + 0
= $1,200
Corporate Tax Example:
Company D
Valuation of Company D (Note: has some debt)
common shareholders = $2,000 $600
= $1,400
Tax Rate (T) = 40%
Income available to = EACS (1 T)
common shareholders = $1,400 (1 0.4)
= $840
Total income available to = EAT + I
all security holders = $840 + $600
= $1,440*
* $240 annual tax-shield benefit of debt (i.e., $1,440 - $1,200)
Tax-Shield Benefits
Tax Shield A tax-deductible expense. The
expense protects (shields) an equivalent dollar
amount of revenue from being taxed by reducing
taxable income.
Present value of
tax-shield benefits (r) (B) (tc)
= = (B) (tc)
of debt* r
= ($5,000) (0.4) = $2,000**
* Permanent debt, so treated as a perpetuity
** Alternatively, $240 annual tax shield / 0.12 = $2,000, where
$240=$600 Interest expense 0.40 tax rate.
Value of the Levered Firm
Value of Value of Present value of

levered = firm if + tax-shield benefits
firm unlevered of debt
Value of unlevered firm = $1,200 / 0.16

(Company ND) = $7,500*
Value of levered firm = $7,500 + $2,000

(Company D) = $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 Taxes, bankruptcy, and

of Capital Point 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 unused debt capacity.
Checklist of Practical and
Conceptual Considerations
Taxes EBIT-EPS
Explicit cost analysis
Cash-flow ability to Capital structure

service debt ratios
Agency costs and Security rating

incentive issues Timing
Financial signaling Flexibility

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Chapter 17

Capital Structure -- The mix (or proportion) of

ko = an overall capitalization rate for the firm

Capitalization Rate, ko The discount rate

What happens to ki, ke, and ko

You can create

Traditional Approach A theory of capital

Optimal Capital Structure The capital structure

You can create this

Market value Market value

Total firm market Total firm market

Total market value is not altered by the capital

Two firms that are alike in every respect

Arbitrage Finding two assets that are

Consider two firms that are identical

Return on investment after the transaction

Agency Costs -- Costs associated with

The judicious use of financial leverage

Company ND no debt, 16% required return

Value of Value of Present value of

Value of unlevered firm = $1,200 / 0.16

Value of levered firm = $7,500 + $2,000

Minimum Cost Taxes, bankruptcy, and

Net tax effect

Financial Leverage (B/S)

Cash-flow ability to Capital structure

Agency costs and Security rating

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