theories capital structure

8/8/2019 Theories Capital Structure

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Copyright 1996 by The McGraw-Hill Companies, Inc

Capital Structure

Capital Structure


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MODIGLIANIANDMILLER

MODIGLIANIANDMILLER

ANY COMBINATIONOF SECURITIES IS ASGOODAS ANYOTHER

EXAMPLE:TWOFIRMS, SAMEOPERATINGINCOME

DIFFERONLYIN CAPITAL STRUCTURE FIRM U UNLEVERED, VU = EU FIRMLIS LEVERED, EL = VL - DL


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MODIGLIANIANDMILLER

MODIGLIANIANDMILLER

TWO STRATEGIES STRATEGY 1

BUY 1% OFFIRM Us EQUITY

DOLLARINVESTMENT .01 VU

DOLLARRETURN .01 PROFITS STRATEGY 2

BUY 1% OFFIRMLs EQUITYANDDEBT

DOLLARINVESTMENT .01DL+ .01EL= .01VL

DOLLARRETURNFROMOWNING01DL .01 INTEREST

FROMOWNING.01EL .01 (PROFITS - INTEREST)

TOTAL .01 PROFITS

BOTH STRATEGIES HAVE SAMEPAYOFF

SAMEPRICE, VU = VL


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MODIGLIANIANDMILLER

MODIGLIANIANDMILLER

STRATEGY 3 BUY 1% OFFIRMLs EQUITY

DOLLARINVESTMENT .01 EL= .01(VL - DL) DOLLARRETURN .01 (PROFITS - INTEREST)

STRATEGY 4

BUY 1% OFFIRM Us EQUITY BORROWONYOUROWNACCOUNT.01DL DOLLARINVESTMENT .01(VU - DL) DOLLARRETURN

FROMBORROWING01DL -.01 INTERESTFROMOWNING.01EL .01 (PROFITSTOTAL .01 (PROFITS-INTEREST)

BOTH STRATEGIES AGAINPROMISE SAMEPAYOFF

MUSTHAVE SAME COST

.01(V

L -D

L) = .01(V

U -D

L)ANDV

U =V

L


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MODIGLIANIANDMILLER

MODIGLIANIANDMILLER

DOESNTMATTERWHATRISKPREFERENCES AREOFINVESTORS

ONLY CONDITIONIS THATINVESTORSCANBORROWORLENDFORTHEIROWNACCOUNT

UNDOEFFECTOFANY CHANGES INFIRMS CAPITAL STRUCTURE

MMPROPOSITION 1 VALUEOFFIRMINDEPENDENTOFITS

CAPITAL STRUCTURE

CANALSOBEPROVED USING CAPM

(APPENDIX)


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VALUEADDITIVITY

VALUEADDITIVITY

WE CAN SLICEA CASHFLOWINTOAS MANYPARTSASWELIKE

SUMOFTHEPRESENTVALUEOFTHEPARTSALWAYS EQUALTOPRESENTVALUEOFTHEORIGINAL STREAM

LAWOF CONSERVATIONOFVALUE

FIRMVALUEIS DETERMINEDBYLEFTHAND SIDEOFBALANCE SHEETBYREALASSETS

REGARDLESS OF CLAIMS AGAINSTIT

SHOULDFIRMISSUEPREFERREDOR COMMONSTOCK?

PROPOSITION 1 SAYS CHOICEIS IRRELEVANT

IFITDOESNTAFFECTINVESTMENT,

BORROWINGANDOPERATINGPOLICIES


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HOWLEVERAGEAFFECTS RETURNSHOWLEVERAGEAFFECTS RETURNS

EXPECTEDRETURNONTHEASSETS OFAFIRMrA = EXPECTEDOPERATINGINCOME

MARKETVALUEOFALL SECURITIES

SUPPOSEINVESTORHOLDS ALLDEBTANDEQUITY

OFTHE COMPANY EXPECTEDRETURNONPORTFOLIO, rA, IS

WEIGHTEDAVERAGEOFEXPECTEDRETURNS ONINDIVIDUAL SECURITIES

rA = (D/D+E)rD + (E/D+E)rErE = rA + (D/E)(rA - rD) MMPROPOSITION 2EXPECTEDRETURNONEQUITY

= EXPECTEDRETURNONASSETS

+ DEBT- EQUITYRATIO x (EXPECTEDRETURNONASSETS

-EXPECTEDRETURNONDEBT)


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LEVERAGEANDTHEEXPECTEDRETURNONEQUITYLEVERAGEANDTHEEXPECTEDRETURNONEQUITY

AS LEVERAGE INCREASES, VA

AND rA

ARE UNCHANGED

BUT THE EXPECTED RETURN ON EQUITY INCREASES

FOR RISKY DEBT, rD INCREASES AS LEVERAGE INCREASES

Debt-equity ratio (D/E)

Expected returnrE

rD

rA


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rErE

INCREASEINEXPECTEDEQUITYRETURNREFLECTSINCREASEDRISK

INCREASEINLEVERAGEINCREASES AMPLITUDEOFVARIATIONS IN CASHFLOWS AVAILABLETOSHAREHOLDERS

SAME CHANGEINOPERATINGINCOMENOWDISTRIBUTEDAMONGFEWER SHARES

WE CAN UNDERSTANDTHEINCREASEDRISK INTERMS OFFs

WE KNOWTHAT

FA = (D/D + E)FD + (E/D + E)FE

FE =FA + (D/E)(FA -FD)


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INTERESTTAX SHIELDINTERESTTAX SHIELD

WHYDIDWE SEEMTODISCOUNTTAXSHIELDBYPRE-TAXINTERESTRATEOF8%?

PERSONALTAXES REDUCETHEVALUEOF

THETAX-SHIELDTOTHEINVESTOR BUTTHEAPPROPRIATEAFTER-TAX

DISCOUNTRATE IS ALSOLOWER

PV (TAX SHIELD = TC (rDD)(1-TP) /rD(1-TP)

=T

CD

WHICHWAS OURORIGINALFORMULA


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MMPROPOSITION 1WITHTAXESMMPROPOSITION 1WITHTAXES

VALUEOFFIRM

= VALUEIFALL-EQUITY-FINANCED + PV(TAX SHIELD)

SPECIAL CASEOFPERMANENTDEBT

VALUEOFFIRM = VALUEIFALL-EQUITY-FINANCED +TCD


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COSTS OFFINANCIALDISTRESSCOSTS OFFINANCIALDISTRESS

FIRMHAS DIFFICULTYMEETINGITS FINANCIALOBLIGATIONS

OR CANNOTMEETITS OBLIGATIONS

SOMETIMES LEADS TOBANKRUPTCY

INVESTORS MAYBE CONCERNEDTHATLEVEREDFIRMMAYFALLINTOFINANCIALDISTRESS

VALUEOFFIRM

= VALUEIFALLEQUITY-FINANCED

+ PV(TAX SHIELD)

- PV(COSTS OFFINANCIALDISTRESS)

COSTS OFFINANCIALDISTRESS DEPENDON:

PROBABILITYOFDISTRESS

MAGNITUDEOF COSTS ENCOUNTEREDIFDISTRESS OCCURS


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COSTS OFFINANCIALDISTRESS REDUCETHEOPTIMALDEBTRATIO

COSTS OFFINANCIALDISTRESS REDUCETHEOPTIMALDEBTRATIO

Firm Value PV Tax Shield

PV Costs Of Distress

Debt Ratio

Optimum

Value of levered firm

Value If All

Equity Financed


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OPTIMAL CAPITAL STRUCTUREOPTIMAL CAPITAL STRUCTURE

PVOFTAX SHIELDGRADUALLYINCREASES AS FIRMBORROWS MORE

ATMODERATEDEBTLEVELSPV(FINANCIALDISTRESS) SMALL

TAXADVANTAGES DOMINATE WITHMOREDEBT, PROBABILITYOF

FINANCIALDISTRESS INCREASES

ALSOTAXADVANTAGEOFDEBT

STARTS TODECLINEAS FIRM CANNOLONGERBE SUREOFPROFITINGFROMTHETAX SHIELDINALL STATES OFTHEWORLD


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COSTS OFFINANCIALDISTRESSCOSTS OFFINANCIALDISTRESS

BANKRUPTCY COSTS

CORPORATEBANKRUPTCYOCCURS WHENSTOCKHOLDERS EXERCISETHEIRRIGHTTODEFAULT

VALUABLERIGHTWHENAFIRMGETS INTOTROUBLE,

STOCKHOLDERS CANWALK AWAY

FORMER CREDITORS BECOMETHENEW

STOCKHOLDERS


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COSTS OFDISTRESS VARYWITHTYPEOFASSETCOSTS OFDISTRESS VARYWITHTYPEOFASSET

YOUR COMPANYOWNS ELECTRONICS COMPANY STOCKHOLDERS MAYBE UNWILLINGTOPROVIDE

MORE CAPITALINFINANCIALDISTRESS

MORE SERIOUS THANFORHOTEL

IF COMPANYGOES BANKRUPT CREDITORWOULDHAVEDIFFICULTY SELLING

OFFASSETS

MANYASSETS INTANGIBLE

ALSODIFFICULTIN CARRYINGONAS GOINGCONCERN

ODDS OFDEFECTIONS BY KEYEMPLOYEES

ASSURANCES TO CUSTOMERS THATFIRMWILLBEAROUNDTO SERVICEITS PRODUCTS


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PECKINGORDEROFFINANCING CHOICESPECKINGORDEROFFINANCING CHOICES

MANAGERS KNOWMOREABOUTTHEIRFIRMTHANOUTSIDERS

PROSPECTS, RISKS

ASYMMETRIC INFORMATION

MANAGERS KNOWMORETHANINVESTORS

DIVIDEND SIGNALING

INVESTORS INTERPRETINCREASEIN

DIVIDENDAS SIGNOFMANAGEMENT CONFIDENCE

ASYMMETRIC INFORMATIONAFFECTSCHOICEBETWEEN

INTERNALVS EXTERNALFINANCING

ISSUINGDEBTVS E UITY


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PECKINGORDERPECKINGORDER

LEADS TOFOLLOWINGPECKINGORDER

INVESTMENTS FIRSTFINANCEDWITH

INTERNALFUNDS

NEWDEBT

NEWEQUITY


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Financial Choices

Trade-off Theory - Theory that capital structure is based on atrade-off between tax savings and distress costs of debt.

Pecking Order Theory - Theory stating that firms prefer toissue debt rather than equity if internal finance is

insufficient.


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Trade Off Theory &PricesTrade Off Theory &Prices

1. Stock-for-debt Stock price

exchange offers falls

Debt-for-stock Stock price

exchange offers rises

2. Issuing common stock drives down stock prices;repurchase increases stock prices.

3. Issuing straight debt has a small negative impact.


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Issues and Stock PricesIssues and Stock Prices

Why do security issues affect stock price? The demandfor a firms securities oughtto be flat.

Any firm is a drop in the bucket.

Plenty of close substitutes.

Large debt issues dont significantly depress the stockprice.


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PeckingOrder TheoryPeckingOrder Theory

Consider the following story:

The announcement of a stock issue drives down the stock price becauseinvestors believe managers are more likely to issue when shares areoverpriced.

Therefore firms prefer internal finance since funds can beraised without sending adverse signals.

If external finance is required, firms issue debt first and equity as a lastresort.

The most profitable firms borrow less not because they have lower target

debt ratios but because they don't need external finance.


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PeckingOrder TheoryPeckingOrder Theory

Some Implications:

Internal equity may be better than external equity.

Financial slack is valuable.

If external capital is required, debt is better. (There is less

room for difference in opinions about what debt is worth).

theories capital structure

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