Chapter 17

Capital Structure
Determination
17-1

2001 Prentice-Hall, Inc.

Fundamentals of Financial Management, 11/e
Created by: Gregory A. Kuhlemeyer, Ph.D.
Carroll College, Waukesha, WI

Capital Structure
Determination

17-2

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.

17-3

A Conceptual Look
--Relevant Rates of Return
ki = the yield on the companys debt

ki

17-4

I
B

Annual interest on debt

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
--Relevant Rates of Return
ke = the expected return on the companys equity
Earnings available to
E
E
common shareholders
ke = S =
Market value of common
S
stock outstanding

17-5

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
--Relevant Rates of Return
ko = an overall capitalization rate for the firm

ko

O
O
=
V
V

Net operating income

=
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
17-6

Capitalization Rate
Capitalization Rate, ko -- The discount rate
used to determine the present value of a
stream of expected cash flows.

ko = k i

B
B+S

ke

S
B+S

What happens to ki, ke, and ko

when leverage, B/S, increases?
17-7

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%

17-8

Required Rate of
Return on Equity
Calculating the required rate of return on equity
Total firm value=
value O / ko
$9,000

= $1,350 / .15

Market value = V - B
equity = $7,200

= $9,000 - $1,800 of

Required return
=E/S
($1,350 - $180)
$180 / $7,200
17-9

Interest payments
= $1,800 x 10%

on equity*
equity =
= 16.25%

* B / S = $1,800 / $7,200 = .25

Required Rate of
Return on Equity
What is the rate of return on equity if B=$3,000?
Total firm value=
value O / ko
$9,000

= $1,350 / .15

Market value = V - B
equity = $6,000

= $9,000 - $3,000 of

Required return
=E/S
($1,350 - $300)
$300 / $6,000
17-10

Interest payments
= $3,000 x 10%

on equity*
equity =
= 17.50%

* B / S = $3,000 / $6,000 = .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
0.00
0.25
0.50
1.00
2.00
17-11

ki
--10%
10%
10%
10%

ke
15.00%
16.25%
17.50%
20.00%
25.00%

ko
15%
15%
15%
15%
15%

Calculated in slides 9 and 10

Required Rate of
Return on Equity
Capital costs and the NOI approach in a
graphical representation.
Capital Costs (%)

.25

ke = 16.25% and
17.5% respectively

.20
.15

ke (Required return on equity)

ko (Capitalization rate)

.10

ki (Yield on debt)

.05
0

0
17-12

.25

.50

.75
1.0 1.25 1.50
Financial Leverage (B / S)

1.75

2.0

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.
structure

17-13

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.
17-14

Optimal Capital Structure:

Traditional Approach
Traditional Approach
ke

Capital Costs (%)

.25

ko

.20
.15

ki

.10
.05

Optimal Capital Structure

Financial Leverage (B / S)
17-15

Summary of the
Traditional Approach

The cost of capital is dependent on the capital

structure of the firm.

17-16

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)

17-17

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
of debt ($35M)

Market value
of debt ($65M)

Market value
of equity ($65M)

Market value
of equity ($35M)

Total firm market

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.

17-18

Total firm market

value ($100M)

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.
17-19

Arbitrage Example
Consider two firms that are identical
in every respect EXCEPT:
EXCEPT

17-20

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
common shareholders
Market value
of equity
Total market value

17-21

Overall capitalization rate

Debt-to-equity ratio

=E =OI
= $10,000 - $0
= $10,000
= E / ke
= $10,000 / .15
= $66,667
= $66,667 + $0
= $66,667
= 15%
=0

Arbitrage Example:
Company L
Valuation of Company L
Earnings available to
common shareholders
Market value
of equity
Total market value

17-22

Overall capitalization rate

Debt-to-equity ratio

=E =OI
= $10,000 - $3,600
= $6,400
= E / ke
= $6,400 / .16
= $40,000
= $40,000 + $30,000
= $70,000
= 14.3%
= .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).
17-23

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)
$36 AND $33.33 left over.
over
This reduces the required net investment to
$366.67 to earn $64.

17-24

Summary of the
Arbitrage Transaction

17-25

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
Agency

costs (Slide 27)

costs (Slide 28)

Debt

and the incentive to

manage efficiently

17-26

Institutional

restrictions

Transaction

costs

Required Rate of Return

on Equity with Bankruptcy
Required Rate of Return
on Equity (ke)

ke with bankruptcy costs

Premium
for financial
risk

ke with no leverage
ke without bankruptcy costs

Premium
for business
risk

Rf

Risk-free
rate

Financial Leverage (B / S)
17-27

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.

17-28

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:
EXCEPT

17-29

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)
Earnings available to
common shareholders
Tax Rate (T)
Income available to
common shareholders

17-30

=E =O-I
= $2,000 - $0
= $2,000
= 40%
= EACS (1 - T)
= $2,000 (1 - .4)
.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)
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)
.4
$840
Total income available to
= EAT + I
security holders
= $840 + $600
$1,440*
$1,440
17-31

all
=

* $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
of debt*
debt

17-32

(r) (B) (tc)

r

($5,000)
$5,000 (.4)
.4 =

(B) (tc)
$2,000**
$2,000

* Permanent debt, so treated as a perpetuity

** Alternatively, $240 annual tax shield / .12 = $2,000, where
$240=$600 Interest expense x .40 tax rate.

Value of the Levered Firm

Value of
levered
firm

Value of
firm if
+
unlevered

Present value of
tax-shield benefits
of debt

Value of unlevered firm

= $1,200 / .16
(Company ND)
= $7,500*
$7,500
Value of levered firm = $7,500 + $2,000
(Company D) = $9,500
17-33

* 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.
leverage
This implies a capital structure of almost 100%
debt! Yet, this is not consistent with actual
behavior.

17-34

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%.

17-35

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.
costs
17-36

Cost of Capital (%)

Bankruptcy Costs,
Agency Costs, and Taxes
Minimum Cost
of Capital Point

Taxes, bankruptcy, and

agency costs combined

Optimal Financial Leverage

Net tax effect

Financial Leverage (B/S)

17-37

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.
undervalued

This is a valid signal because of the possibility

of bankruptcy.

17-38