You are on page 1of 41

17-1

Chapter 17
Capital Structure
Determination
Pearson Education Limited 2004
Fundamentals of Financial Management, 12/e
Created by: Gregory A. Kuhlemeyer, Ph.D.
Carroll College, Waukesha, WI
17-2
After studying Chapter 17,
you should be able to:
Define capital structure.
Explain the net operating income (NOI) approach to capital
structure and valuation of a firm; and, calculate a firm's value
using this approach.
Explain the traditional approach to capital structure and the
valuation of a firm.
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.
Describe various market imperfections and other "real world"
factors that tend to dilute M&Ms original position.
Present a number of reasonable arguments for believing that
an optimal capital structure exists in theory.
Explain how financial structure changes can be used for
financial signaling purposes, and give some examples.
17-3
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
Timing and Flexibility
Financing Checklist
17-4
Capital Structure
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.
Capital Structure -- The mix (or proportion) of
a firms permanent long-term financing
represented by debt, preferred stock, and
common stock equity.
17-5
A Conceptual Look --
Relevant Rates of Return
k
i
= the yield on the companys debt
Annual interest on debt
Market value of debt
I
B
= = k
i
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.)
17-6
E
S
A Conceptual Look --
Relevant Rates of Return
= =
k
e
= the expected return on the companys equity
Earnings available to
common shareholders
Market value of common
stock outstanding
k
e
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
E
S
17-7
O
V
A Conceptual Look --
Relevant Rates of Return
= =
k
o
= an overall capitalization rate for the firm
Net operating income
Total market value of the firm
k
o
Assumptions:
V = B + S = total market value of the firm
O = I + E = net operating income = interest
paid plus earnings available to common
shareholders
O
V
17-8
Capitalization Rate
Capitalization Rate, k
o
-- The discount rate
used to determine the present value of a
stream of expected cash flows.
k
o
k
e
k
i
B
B + S
S
B + S
= +
What happens to k
i
, k
e
, and k
o

when leverage, B/S, increases?
17-9
Net Operating
Income Approach
Assume:
Net operating income equals $1,350
Market value of debt is $1,800 at 10% interest
Overall capitalization rate is 15%
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.
17-10
Required Rate of
Return on Equity
Total firm value = O / k
o
= $1,350 / .15
= $9,000
Market value = V - B = $9,000 - $1,800
of equity = $7,200
Required return = E / S
on equity* = ($1,350 - $180) / $7,200
= 16.25%
Calculating the required rate of return on equity
* B / S = $1,800 / $7,200 = .25
Interest payments
= $1,800 x 10%
17-11
Total firm value = O / k
o
= $1,350 / .15
= $9,000
Market value = V - B = $9,000 - $3,000
of equity = $6,000
Required return = E / S
on equity* = ($1,350 - $300) / $6,000
= 17.50%
Required Rate of
Return on Equity
What is the rate of return on equity if B=$3,000?
* B / S = $3,000 / $6,000 = .50
Interest payments
= $3,000 x 10%
17-12
B / S k
i
k
e
k
o

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%
Required Rate of
Return on Equity
Examine a variety of different debt-to-equity
ratios and the resulting required rate of
return on equity.
Calculated in slides 9 and 10
17-13

Required Rate of
Return on Equity
Capital costs and the NOI approach in a
graphical representation.
0 .25 .50 .75 1.0 1.25 1.50 1.75 2.0
Financial Leverage (B / S)
.25
.20
.15
.10
.05
0
C
a
p
i
t
a
l

C
o
s
t
s

(
%
)

k
e
= 16.25% and
17.5% respectively
k
i
(Yield on debt)
k
o
(Capitalization rate)
k
e
(Required return on equity)
17-14
Summary of NOI Approach
Critical assumption is k
o
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 k
i
is constant, k
e
is a linear
function of the debt-to-equity ratio.
Thus, there is no one optimal capital
structure.
17-15
Traditional Approach
Optimal Capital Structure -- The capital structure
that minimizes the firms cost of capital and
thereby maximizes the value of the firm.
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.
17-16

Optimal Capital Structure:
Traditional Approach
Traditional Approach
Financial Leverage (B / S)
.25
.20
.15
.10
.05
0
C
a
p
i
t
a
l

C
o
s
t
s

(
%
)

k
i
k
o
k
e
Optimal Capital Structure
17-17
Summary of the
Traditional Approach
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 k
o
declines.
Then, increasing financial leverage and the
associated increase in k
e
and k
i
more than offsets
the benefits of lower cost debt financing.
Thus, there is one optimal capital structure
where k
o
is at its lowest point.
This is also the point where the firms total
value will be the largest (discounting at k
o
).
17-18
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
k
o
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.
17-19
Market value
of debt ($65M)

Market value
of equity ($35M)

Total firm market
value ($100M)
Total Value Principle:
Modigliani and Miller
M&M assume an absence of taxes and market
imperfections.
Investors can substitute personal for corporate
financial leverage.
Market value
of debt ($35M)

Market value
of equity ($65M)

Total firm market
value ($100M)
Total market value is not altered by the capital
structure (the total size of the pies are the same).
17-20
Arbitrage and Total
Market Value of the Firm
Arbitrage -- Finding two assets that are
essentially the same and buying the
cheaper and selling the more expensive.

Two firms that are alike in every respect
EXCEPT capital structure MUST have
the same market value.
Otherwise, arbitrage is possible.
17-21
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
17-22
Earnings available to = E = O I
common shareholders = $10,000 - $0
= $10,000
Market value = E / k
e

of equity = $10,000 / .15
= $66,667
Total market value = $66,667 + $0
= $66,667
Overall capitalization rate = 15%
Debt-to-equity ratio = 0
Arbitrage Example:
Company NL
Valuation of Company NL
17-23
Arbitrage Example:
Company L
Earnings available to = E = O I
common shareholders = $10,000 - $3,600
= $6,400
Market value = E / k
e

of equity = $6,400 / .16
= $40,000
Total market value = $40,000 + $30,000
= $70,000
Overall capitalization rate = 14.3%
Debt-to-equity ratio = .75
Valuation of Company L
17-24
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).
17-25
Completing an
Arbitrage Transaction
Original return on investment in Company L
$400 x 16% = $64
Return on investment after the transaction
$666.67 x 16% = $100 return on Company NL
$300 x 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.
17-26
Summary of the
Arbitrage Transaction
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.
The investor uses personal rather than
corporate financial leverage.
17-27
Market Imperfections
and Incentive Issues
Agency costs (Slide 17-29)
Debt and the incentive to
manage efficiently
Institutional restrictions
Transaction costs
Bankruptcy costs (Slide 17-28)
17-28

Required Rate of Return
on Equity with Bankruptcy
Financial Leverage (B / S)
R
f
R
e
q
u
i
r
e
d

R
a
t
e

o
f

R
e
t
u
r
n

o
n

E
q
u
i
t
y

(
k
e
)

k
e
with no leverage
k
e
without bankruptcy costs
k
e
with bankruptcy costs
Premium
for financial
risk
Premium
for business
risk
Risk-free
rate
17-29
Agency Costs
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.
Agency Costs -- Costs associated with
monitoring management to ensure that it behaves
in ways consistent with the firms contractual
agreements with creditors and shareholders.
17-30
Example of the Effects
of Corporate Taxes
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
The judicious use of financial leverage
(i.e., debt) provides a favorable impact
on a companys total valuation.
17-31
Earnings available to = E = O - I
common shareholders = $2,000 - $0
= $2,000
Tax Rate (T) = 40%
Income available to = EACS (1 - T)
common shareholders = $2,000 (1 - .4)
= $1,200
Total income available to = EAT + I
all security holders = $1,200 + 0
= $1,200
Corporate Tax Example:
Company ND
Valuation of Company ND (Note: has no debt)
17-32
Earnings available to = E = O - I
common shareholders = $2,000 - $600
= $1,400
Tax Rate (T) = 40%
Income available to = EACS (1 - T)
common shareholders = $1,400 (1 - .4)
= $840
Total income available to = EAT + I
all security holders = $840 + $600
= $1,440*
Corporate Tax Example:
Company D
Valuation of Company D (Note: has some debt)
* $240 annual tax-shield benefit of debt (i.e., $1,440 - $1,200)
17-33
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
of debt*
=
(r) (B) (t
c
)
r
= (B) (t
c
)
* Permanent debt, so treated as a perpetuity
** Alternatively, $240 annual tax shield / .12 = $2,000, where
$240=$600 Interest expense x .40 tax rate.
=
($5,000) (.4) = $2,000**
17-34
Value of the Levered Firm
Value of unlevered firm = $1,200 / .16
(Company ND) = $7,500*
Value of levered firm = $7,500 + $2,000
(Company D) = $9,500
Value of Value of Present value of
levered = firm if + tax-shield benefits
firm unlevered of debt
* Assuming zero growth and 100% dividend payout
17-35
Summary of
Corporate Tax Effects
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.
The greater the amount of debt, the greater the
tax-shield benefits and the greater the value of the
firm.
17-36
Other Tax Issues
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%.
Uncertainty of tax-shield benefits
Uncertainty increases the possibility of
bankruptcy and liquidation, which reduces
the value of the tax shield.
17-37
Bankruptcy Costs,
Agency Costs, and Taxes
As financial leverage increases, tax-shield
benefits increase as do bankruptcy and
agency costs.
Value of levered firm
= Value of firm if unlevered
+ Present value of tax-shield benefits
of debt
- Present value of bankruptcy and
agency costs
17-38
Bankruptcy Costs,
Agency Costs, and Taxes
Optimal Financial Leverage
Taxes, bankruptcy, and
agency costs combined
Net tax effect
Financial Leverage (B/S)
C
o
s
t

o
f

C
a
p
i
t
a
l

(
%
)

Minimum Cost
of Capital Point
17-39
Financial Signaling
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.
A manager may use capital structure changes
to convey information about the profitability
and risk of the firm.
17-40
Timing and Flexibility
2. Flexibility
A decision today impacts the options open to the firm for
future financing options thereby reducing flexibility.
Often referred to as unused debt capacity.
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.
17-41
Checklist of Practical and
Conceptual
Considerations
1. Taxes
2. Explicit cost
3. Cash-flow ability to
service debt
4. Agency costs and
incentive issues
5. Financial signaling
6. EBIT-EPS
analysis
7. Capital structure
ratios
8. Security rating
9. Timing
10. Flexibility