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17.1 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Chapter 17
Capital Structure Determination
Capital Structure Determination
17.2 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
After Studying Chapter 17, you should be able to:
1. Define “capital structure.”2. Explain the net operating income (NOI) approach to capital
structure and valuation of a firm; and, calculate a firm's value using this approach.
3. Explain the traditional approach to capital structure and the valuation of a firm.
4. 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.
5. Describe various market imperfections and other "real world" factors that tend to dilute M&M’s original position.
6. Present a number of reasonable arguments for believing that an optimal capital structure exists in theory.
7. Explain how financial structure changes can be used for financial signaling purposes, and give some examples.
17.3 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
• 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 Determination
17.4 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
• 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 firm’s permanent long-term financing
represented by debt, preferred stock, and common stock equity.
Capital Structure
17.5 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
ki = the yield on the company’s debt
Annual interest on debt
Market value of debt
I
B ==ki
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
17.6 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
E
S==
ke = the expected return on the company’s equityEarnings available to common shareholders
Market value of common stock outstanding
ke
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
A Conceptual Look –Relevant Rates of Return
17.7 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
O
V ==
ko = an overall capitalization rate for the firm
Net operating incomeTotal market value of the firmko
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
A Conceptual Look –Relevant Rates of Return
17.8 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Capitalization Rate, ko – The discount rate used to determine the present value of a
stream of expected cash flows.
ko keki
BB + S
SB + S
= +
What happens to ki, ke, and ko when leverage, B/S, increases?
Capitalization Rate
17.9 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
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.
Net Operating Income Approach
17.10 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Total firm value = O / ko = $1,350 / 0.15= $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 = 0.25
Interest payments = $1,800 × 10%
Required Rate of Return on Equity
17.11 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Total firm value = O / ko = $1,350 / 0.15= $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%
What is the rate of return on equity if B=$3,000?
* B / S = $3,000 / $6,000 = 0.50
Interest payments = $3,000 × 10%
Required Rate of Return on Equity
17.12 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
B / S ki ke ko
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%
Examine a variety of different debt-to-equity ratios and the resulting required rate of
return on equity.
Calculated in slides 9 and 10
Required Rate of Return on Equity
17.13 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Capital costs and the NOI approach in a graphical representation.
0 0.25 0.50 0.75 1.0 1.25 1.50 1.75 2.0Financial Leverage (B/S)
0.25
0.20
0.15
0.10
0.05
0
Cap
ital
Co
sts
(%)
ke = 16.25% and17.5% respectively
ki (Yield on debt)
ko (Capitalization rate)
ke (Required return on equity)
Required Rate of Return on Equity
17.14 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
NOI Approach
You can create this type of analysis in Excel also. You can use some modeling experience to write formulas to calculate the required rates.
Refer to “VW13E-17.xlsx” on the ‘NOI Approach’ tab
Excel & the NOI Approach
17.15 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
• 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.
Summary of NOI Approach
17.16 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Optimal Capital Structure – The capital structure that minimizes the firm’s 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.
Traditional Approach
17.17 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Traditional Approach
Financial Leverage (B / S)
0.25
0.20
0.15
0.10
0.05
0
Cap
ital
Co
sts
(%)
ki
ko
ke
Optimal Capital Structure
Optimal Capital Structure: Traditional Approach
17.18 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Traditional Approach
You can create this type of analysis in Excel also. We use some assumptions in this model built into the formulas.
Refer to “VW13E-17.xlsx” on the ‘Traditional Approach’ tab
Excel and the Traditional Approach
17.19 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
• 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 ko declines.• Then, increasing financial leverage and the
associated increase in ke and ki more than offsetsthe 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 firm’s totalvalue will be the largest (discounting at ko).
Summary of the Traditional Approach
17.20 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
• Advocate that the relationship betweenfinancial leverage and the cost of capital is explained by the NOI approach.
• Provide behavioral justification for a constantko over the entire range of financial leverage possibilities.
• Total risk for all security holders of the firm isnot altered by the capital structure.
• Therefore, the total value of the firm is notaltered by the firm’s financing mix.
Total Value Principle: Modigliani and Miller (M&M)
17.21 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Market value of debt ($65M)
Market value of equity ($35M)
Total firm marketvalue ($100M)
• 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 marketvalue ($100M)
• Total market value is not altered by the capital structure (the total size of the pies are the same).
Total Value Principle: Modigliani and Miller
17.22 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
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.
Arbitrage and Total Market Value of the Firm
17.23 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
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
Arbitrage Example
17.24 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Earnings available to = E = O – I common shareholders = $10,000 - $0
= $10,000
Market value = E / ke of equity = $10,000 / 0 .15
= $66,667
Total market value = $66,667 + $0= $66,667
Overall capitalization rate = 15%Debt-to-equity ratio = 0
Valuation of Company NL
Arbitrage Example: Company NL
17.25 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Earnings available to = E = O – I common shareholders = $10,000 – $3,600
= $6,400
Market value = E / ke of equity = $6,400 / 0.16
= $40,000
Total market value = $40,000 + $30,000= $70,000
Overall capitalization rate = 14.3%Debt-to-equity ratio = 0.75
Valuation of Company L
Arbitrage Example: Company L
17.26 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
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).
Completing an Arbitrage Transaction
17.27 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Original return on investment in Company L
$400 × 16% = $64
Return on investment after the transaction• $666.67 × 16% = $100 return on Company NL• $300 × 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.
Completing an Arbitrage Transaction
17.28 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
• 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.
Summary of the Arbitrage Transaction
17.29 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
• Agency costs (Slide 17–31)• Debt and the incentive to manage
efficiently• Institutional restrictions• Transaction costs
• Bankruptcy costs (Slide 17–30)
Market Imperfections and Incentive Issues
17.30 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Financial Leverage (B / S)
RfReq
uir
ed R
ate
of
Ret
urn
on
Eq
uit
y (k
e) ke with no leverage
ke without bankruptcy costs
ke with bankruptcy costs
Premiumfor financial
risk
Premiumfor business
risk
Risk-freerate
Required Rate of Return on Equity with Bankruptcy
17.31 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
• 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 firm’s contractual agreements with creditors and shareholders.
Agency Costs
17.32 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
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 company’s total valuation.
Example of the Effects of Corporate Taxes
17.33 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Earnings available to = E = O – Icommon shareholders = $2,000 –
$0 = $2,000
Tax Rate (T) = 40%
Income available to = EACS (1 – T)common shareholders = $2,000 (1 – 0.4)
= $1,200
Total income available to = EAT + I all security holders = $1,200 + 0
= $1,200
Valuation of Company ND (Note: has no debt)
Corporate Tax Example: Company ND
17.34 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Earnings available to = E = O – Icommon shareholders = $2,000 –
$600 = $1,400
Tax Rate (T) = 40%
Income available to = EACS (1 – T)common shareholders = $1,400 (1 – 0.4)
= $840
Total income available to = EAT + I all security holders = $840 + $600
= $1,440*
Valuation of Company D (Note: has some debt)
* $240 annual tax-shield benefit of debt (i.e., $1,440 - $1,200)
Corporate Tax Example: Company D
17.35 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
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 oftax-shield benefits
of debt*= (r) (B) (tc)
r= (B) (tc)
* Permanent debt, so treated as a perpetuity** Alternatively, $240 annual tax shield / 0.12 = $2,000, where
$240=$600 Interest expense × 0.40 tax rate.
= ($5,000) (0.4) = $2,000**
Tax-Shield Benefits
17.36 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Value of unlevered firm = $1,200 / 0.16(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
Value of the Levered Firm
17.37 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
• 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.
Summary of Corporate Tax Effects
17.38 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
• 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.
Other Tax Issues
17.39 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
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
Bankruptcy Costs, Agency Costs, and Taxes
17.40 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Optimal Financial Leverage
Taxes, bankruptcy, andagency costs combined
Net tax effect
Financial Leverage (B/S)
Co
st o
f C
apit
al (
%)
Minimum Costof Capital Point
Bankruptcy Costs, Agency Costs, and Taxes
17.41 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
• 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 firm’s 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.
Financial Signaling
17.42 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
2. Flexibility• A decision today impacts the options open to the firm for
future financing options – thereby reducing flexibility.• Often referred to 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.
Timing and Flexibility
17.43 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
• Taxes
• Explicit cost
• Cash-flow ability to service debt
• Agency costs and incentive issues
• Financial signaling
• EBIT-EPS analysis
• Capital structure ratios
• Security rating
• Timing
• Flexibility
Checklist of Practical and Conceptual Considerations