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Capital Structure Concepts

©2006 Thomson/South-Western

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Introduction

This chapter examines some of the basic concepts used in determining a firm’s optimal capital structure. It deals only with the total permanent sources of a firm’s financing.

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Capital Structure Vs Financial Structure Capital Structure

Permanent S-T

debt

L-T debt

P/S

C/S

Financial Structure

Total current

liabilities

L-T debt

P/S

C/S

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Capital Structure Terminology Optimal capital structure

Minimizes a firm’s weighted cost of capital Maximizes the value of the firm

Target capital structure Capital structure at which the firm plans to

operate Debt capacity

Amount of debt in the firm’s optimal capital structure

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What Determines the Optimal Capital Structure ? Business risk of the firm

Tax structure

Bankruptcy potential

Potential agency costs

Signaling effects

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Capital Structure Assumptions Firm’s investment policy is held constant. Capital structure changes the distribution

of the firm’s EBIT among the firm’s claimants. Debtholders Preferred stockholders Common stockholders

Constant investment policy leaving the debt capacity of the firm unchanged

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Factors Influencing a Firm’s Business Risk Variability of sales

volume

Variability of selling

price

Variability of cost

Amount of market

power

Extent of product

diversification

Firm’s growth rate

Degree of operating

leverage (DOL)

Both systematic and

unsystematic risk

Web site for more info: http://finance.yahoo.com/

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Financial Risk

Variability of EPS and increased probability of bankruptcy

Factors indicating financial risk Debt-to asset ratio Debt-to-equity ratio Fixed charge coverage ratio DFL Probability distribution of profits Times interest earned ratio EBIT-EPS analysis

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Capital Structure Theory

Studies the relationship between

Capital structure

Debt/assets

Cost of capital

Value of the firm

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Capital Structure Models

The simplest model considers only

Taxes

More complex models account for

Taxes

Financial distress costs

Agency costs

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Modigliani and Miller (MM) On Capital Structure Assumed perfect capital markets

including No taxes No bankruptcy (B) costs No agency (A) costs

If leverage increases, the cost of equity, ke, increases to exactly offset the benefits of more debt financing, kd, leaving the cost of capital, ka, constant. see model 1

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Cost ofCapital

kd

ka

ke

Model 1 (MM)

The overall cost of capital is independent of the capital structure. The firm’s value is independent of the capital structure.

Debt

Total Assets

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MM Arbitrage Proof

Value (V) of U = D/ke

Value (V) of L = D/ke + I/kd

D paid to L’s stockholders are reduced by the amount of I paid on the debt.

ke is higher for L because of the additional leverage-induced risk.

The values of U and L are identical due to arbitrage.

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What Happens with Taxes ? Same two equations VU = D/ke VL = D/ke + I/kd D distributed to U’s stockholders are

reduced by the taxes paid on operating income and the value of U drops.

Since I is tax deductible, L realizes a tax savings.

PV of tax shield = value of debt (B) tax rate (T).

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VL = VU + Value of Tax Shield

MktValue

of Firm

Debt $

VL

VU

PV of

Tax Shield

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Model 2 (MM with taxes)

DebtTotal Assets

ki = kd (1 – T)

ka

ke

Cost ofCapital

The cost of capital decreases with the amount of debt. The firm maximizes its value by choosing a capital structure that is all debt.

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What Happens With Taxes, Bankruptcy, and Agency Costs ? B&A costs increase with the amount of

leverage. Eventually offsets the marginal benefits

from the value of the tax shield Market value of leveraged firm

= Market value of unleveraged firm

+ PV of tax shield

– PV of bankruptcy costs– PV of agency costs See optimal debt ratio slide

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Bankruptcy Costs

Lenders may demand higher interest rates.

Lenders may decline to lend at all. Customers may shift their business to

other firms. Distress incurs extra accounting & legal

costs. If forced to liquidate, assets may have to

be sold for less than market value.

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Agency CostsStockholder-Bondholder Relationship

Investing in projects with high risk and high returns can shift wealth from bondholders to stockholders.

Stockholders may forgo some profitable investments in the presence of debt.

Stockholders might issue high quantities of new debt and diminish the protection afforded to earlier bondholders.

Bondholders will shift monitoring and bonding costs back to the stockholders by charging higher interest rates.

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Optimal Debt Ratio

DebtRatio

VU

PVof Tax

Shield

M

kt value of leveraged firm

PVB&A

Costs

VL

Optimal Debt Ratio

Market Value of the Firm

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Model 3Least Cost Capital Structure is Optimal

Cost of Capital

BB + E

ki

ke

ka

Optimal CapitalStructure

0

Optimal capital structureoccurs where weightedcost of capital is minimized

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Other Impacts on the Optimal Capital Structure Personal tax effects

Could reverse some tax benefits Industry effects

Profitability and bankruptcy patterns Signaling effects

Asymmetric information Managerial preferences

Pecking order theory

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Capital Structure Implications for Managers

A centrally important management decision

Benefits of the tax shield from debt provide an incentive to use debt financing. To the point that increasing A&B costs

offset the debt advantage Info on debt: http://www.thomsoninvest.net/

Optimal capital structure is heavily influenced by business risk.

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Capital Structure Implications for Managers

Changes in capital structure signal important

information to investors.

Pecking order theory

Internal equity First choice

Debt

External equity Least preferred by management

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LBO (Leveraged buyout) Can eliminate agency problems Increased operating efficiencies are often achieved.

Eliminating jobs Reducing other payroll expenses Closing inefficient plants

Bondholders typically realize a loss in the value of their bonds.

Ethical issues Is it in the long-run interest of employees? Are bondholders harmed in a LBO? Managers acting as both buyers and sellers

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Multinational Firms

Have more complex capital structure decisions Finance investments in host country funds Some countries use more financial leverage

than others. Some host countries restrict foreign investment. Risk of expropriation Some host countries provide low-cost financing.