Professional Documents
Culture Documents
Capital Structure Decisions
Capital Structure Decisions
Outline
Meaning of Capital Structure Optimal Capital Structure How much should a firm borrow? Does capital structure matter? Does it influence the value of the firm? Limits to the use of debt How companies establish their capital structure?
Capital Structure
A mix of debt, preferred stock, and common stock with which the firm plans to finance its investments. Objective is to have such a mix of debt, preferred stock, and common equity which will maximize shareholder wealth or maximize market price per share WACC depends on the mix of different securities in the capital structure. A change in the mix of different securities in the capital structure will cause a change in the WACC. Thus, there will be a mix of different securities in the capital structure at which WACC will be the least. An optimal capital structure means a mix of different securities which will maximize the stock price share or minimize WACC.
Capital structure decision involves a trade off between risk and return to maximize market price per share
Thus, mix between debt and equity is not important. Any benefit of low cost debt is completely offset by an increase in the cost of equity due to use of borrowing. Thus, overall cost of capital remains same and value of the firm does not change if we change the mix between debt and equity. Assumption of a world without taxes is quite unrealistic. M&M revisited their theory in their 1961 article. They assume a world with corporate taxes
In their 1963 article, they recognize that the value of the firm will increase or the cost of capital will decrease with leverage because interest on debt is a tax deductible expense. The value of the levered firm will be greater than the unlevered firm because the return to bondholders escapes taxation at the corporate level. The value of the levered firm will be more than the value of unlevered firm by the amount of the present value of the tax shield due to tax savings given by the tax deductibility of interest expense on debt. Present value of the tax shield is given by Tc v D Value of a leverered firm = [(1-Tc)EBIT/re] + TcD
Example
Firm L has employed a 6 percent debt of $300,000, while firm U is unlevered. Both the firms earn a before tax earnings of $120,000. The pure equity capitalization rate is 10 percent and the corporate tax rate is 34 percent. Find the market value of the firms.
(1 - Tc) EBIT re (1 - 0.34) $120,000 0.10
However, it also puts pressure on the firm, because interest and principal payments are obligations. If these obligations are not met, the firm may risk some sort of financial distress. The possibility of bankruptcy has a negative effect on the value of the firm. However, it is not the risk of bankruptcy itself that lowers value. Rather it is the cost associated with bankruptcy that lowers value. As the proportion of debt in the firms capital structure is increased, the probability of bankruptcy also increases. Consequently, the rate of return required by bondholders increases with leverage.
The optimal ratio of debt to equity is determined by taking an increasing amounts of debt until the marginal gain from leverage is equal to the marginal expected loss from the bankruptcy costs