Chapter 12&13

Capital Structure

BUS286 Corporate Finance

Introduction

 Capital structure:
 The mix of debt and equity finance used by a company.
 Debt to equity, debt to total assets, and interest coverage.
 Optimal capital structure:
 The capital structure that maximizes the value of a company.
i.e. Market value equity + market value debt
 Does the value of the net operating cash flow stream
depends on how it is divided between payments to lenders
and shareholders?
Business and Financial Risk

 Business risk:
 The variability of future net cash flows attributed to the
nature of the company’s operations
 The risk faced by shareholders if the company is financed
only by equity.
 Financial risk:
 The risk involved in using debt as a source of finance.
Effects of Financial Leverage

 Effects of financial leverage:

 Expected rate of return on equity increases
 Provided rate of return on the company’s assets is greater than
the interest rate on the loan.

 Variability of returns to shareholders increases.

 Increasing leverage involves a trade-off between risk and
return.
Effects of Financial Leverage
 EMU Ltd. has no debt. The following scenarios for next period’s
profit available to shareholders:
 Case 1 Case 2
 EBIT 10,000 15,000
 Less tax @20% 2,000 3,000
 Profit 8,000 12,000

 A 50% higher EBIT results in 50% higher profit available to

shareholders.
 A 33% lower EBIT results in 33% lower profit available to
shareholders
Effects of Financial Leverage

 What if EMU Ltd. has debt, with an associated interest payment of $3000.
Profit scenarios are: Case 1 Case2
 EBIT 10,000 15,000
 Less interest 3,000 3,000
 EBT 7,000 12,000
 Less tax @20% 1,400 2,400
 Profit 5,600 9,600

 A 50% higher EBIT results in 71% higher funds available to shareholders.

 A 33% lower EBIT results in 42% lower funds available to shareholders
Four capital structure theories

 MM leverage irrelevance: company value depends on

investment rather than financing decisions.
 Trade-off theory: tax benefits of debt vs financial distress
and agency costs
 Pecking order theory: information on projects is
asymmetric, and internal finance is highest in pecking order
 Free cash flow theory: emphasizes agency costs with the
discipline of debt reducing unprofitable investment
Modigliani and Miller Analysis

 Assumptions:
 Capital markets are perfect.
 Companies and individuals can borrow at the same interest
rate.
 There are no taxes.
 There are no costs associated with the liquidation of a
company.
 Companies have a fixed investment policy so that
investment decisions are not affected by financing decisions.
MM’s Proposition 1 — Law of conservation of value

 The market value of any firm is independent of its capital

structure.
 Changing debt to equity changes the way net operating
income is divided between lenders and shareholders, but
will not change the value of the company.
 Focus on dollar values, the dollar value of a company is
independent of the company’s capital structure.
MM’s Proposition 2 — Natural conservation of risk

 Focus on a company’s cost of capital — require return on

the securities
 The cost of equity of a levered firm is equal to the cost of
equity of an unlevered firm plus a financial risk premium,
which depends on the degree of financial leverage.
E D
k0  ke   k d 
V V

D
ke  k0  ( k0  k d ) 
E
MM’s Proposition 3

 The appropriate discount rate for a particular investment

proposal is independent of how the proposal is to be
financed.
 The key factor determining the discount rate or a
proposal is the level of risk associated with the project.
 This is consistent with the irrelevance of the financing
decision: Proposition 1.
Including Factors MM Excluded

 Capital market imperfections will impede the MM 1958

propositions:
 Company and personal taxes.
 Transaction costs.
 Costs associated with financial distress.
 Agency costs.
 Different cost of borrowing for corporations and individuals.
The Effects of Taxes on Capital Structure — Under Classical Tax System

 Classical tax system:

 Leverage will increase a firm’s value because interest on
debt is a tax deductible expense resulting in an increase in
the after-tax net cash flows to investors.
 The main implication of Proposition 1 with company tax is
clear but extreme:
 A company should borrow so much that its company tax bill is
reduced to zero.
The Effects of Taxes on Capital Structure — Under Classical Tax System

 Company tax and personal tax —interaction

 The preferred source of finance depends on comparison
between:
 the personal tax rate on debt and
 the combined effect of the corporate tax rate and the personal
tax rate on equity.

 Personal taxes (Miller, 1977):

 The presence of taxes on personal income may reduce the
tax advantage associated with debt financing.
The Effect of Taxes on Capital Structure — Imputation Tax System

 The imputation tax system:

 Income distributed as franked dividends to resident shareholders
is effectively taxed only once at the shareholder’s personal tax
rate.
 Interest paid to lenders is taxed only once at lender’s personal
tax rate.
 The imputation system has the potential to lead to neutrality
between debt and equity.
 There is a possible bias towards equity for investors with
personal income tax rates greater than the company tax rate.
The Costs of Financial Distress

 Non-tax factors that can cause a company’s value to depend

on its capital structure.
 Financial distress:
 Can lead to liquidation of the company.
 Costs include fees for insolvency specialists
 Indirect Costs of Financial Distress:
 Effect of lost sales and reduced operating efficiency.
 Managerial time devoted to attempts to avert failure (less
attention paid to issues such as product quality and employee
safety).
Agency Costs

 Agency Costs: Agency costs arise from the potential for conflicts of
interest between the parties forming the contractual relationships
of the firm.
 A Company May:
 Issue new debt ranking higher than existing debt
 Increase dividend payout, increasing riskiness of debt and transfer
wealth from lenders to shareholders.
 Take on risky investments. If successful, benefits flow to shareholders.
If it fails, most costs borne by lenders.
 If a company’s debt is very risky it may not be in the interest of
shareholders to contribute additional capital to finance new low –risk
investments. If investments are successful the value will go to debt
holders
 Optimal Capital Structure
 Trade-off theory:

 The possibility of a trade-off between the

opposing effects of the benefits of debt
finance and the costs of financial distress
may mean that an optimal capital structure
exists.
 Implication:

 Management should aim to maintain a

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target debt–equity ratio.
Capital Structure with Information Asymmetry

 Myers explains this pecking order based on

information asymmetry.
 Information asymmetry is a situation where all relevant
information is not known by all interested parties.

 Typically, this involves company insiders (managers) having

more information about the company’s prospects than
outsiders (shareholders and lenders).

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Capital Structure with Information Asymmetry

 Pecking order theory:

 In raising finance, managers follow a pecking order in which:

 internal funds are preferred,

 followed by debt,
 hybrid securities,
 as a last resort, a new issue of ordinary
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shares.
 Free Cash Flow Theory — Jensen’s (1986)

 Reserve borrowing capacity in mature companies can

cause free cash flows.
 Free Cash Flow (FCF) offers slack for management.
 Reserves may not generate adequate returns and should be paid
out to investors

 Debt offers a control effect — generating a credible

commitment not to misuse free cash flow, as it is
required to service debt.
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