Presentation on capital structure and term structure theories Prepared ByMabruka Mohamed

Outline Capital structure :concepts Net income approach and traditional theories Net operating income approach and

Modigliani and Miller propositions Trade-off, agency cost ,and peking- order

theories Term structure theories

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The Balance-Sheet Model of the Firm

How can the firm raise the money for the required investments?

The Capital Structure Decision

Current Assets

Fixed Assets

1 Tangible

2 IntangibleShareholders’

Equity

Current Liabilities

Long-Term Debt

Capital structure criteria

What is the optimal capital structure? Structure that minimizes overall cost of

financing (WACC) Structure that maximizes value of firm.

Capital Structure and the Pie The value of a firm is defined to be the sum of the

value of the firm’s debt and the firm’s equity.V = B + S

• If the goal of the firm’s management is to make the firm as valuable as possible, then the firm should pick the debt-equity ratio that makes the pie as big as possible.

Value of the Firm

S BS BS BS B

Financial leverageFinancial leverage is the degree to which a company uses fixed-

income securities such as debt . The more debt financing a company uses, the higher its financial leverage.

Measurement • Debt financial ratio D/ (D + E)• Long term debt to capitalization LTD/(LTD+E) (Note: market(not book)values of debt and equity correctly

determine capital structure)

Financial Leverage, EPS, and ROE

CurrentAssets $20,000Debt $0Equity $20,000Debt/Equity ratio 0.00Interest rate n/aShares outstanding 400Share price $50

Proposed$20,000

$8,000$12,000

2/38%240$50

Firm A is unlevered firm currently has no debt . The firm decided to borrow $8,000 by buy back 160 shares at $50 per share.

LeveredRecession ExpectedExpansionEBIT $1,000$2,000 $3,000Interest 640640 640Net income $360$1,360 $2,360EPS $1.50$5.67 $9.83ROA 1.8%6.8% 11.8%ROE 3%11% 20%

Proposed Shares Outstanding = 240 shares

EPS and ROE Under Both Capital StructuresAll-EquityRecession Expected Expansion

EBIT $1,000 $2,000 $3,000Interest 0 0 0Net income $1,000 $2,000 $3,000EPS $2.50 $5.00 $7.50ROA 5% 10% 15%ROE 5% 10% 15%Current Shares Outstanding = 400

Financial Leverage and EPS

(2.00)

0.00

2.00

4.00

6.00

8.00

10.00

12.00

1,000 2,000 3,000

EPS

Debt

No Debt

Break-even point

EBIT in dollars, no taxes

Advantage to debt

Disadvantage to debt

Advantage and Disadvantages of DebtAdvantages of Debt Disadvantages of Debt

Interest is tax deductible Higher debt ratios lead to greater risk and higher required interest rates (to compensate for the additional risk)

Debt-holders are limited to a fixed return

Debt holders do not have voting rights

Capital structure theoriesthere exist conflicting theories on the relationship between capital

structure and the value of a firm. RELEVANCE OF CAPITAL STRUCTURE

IRRELEVANCE OF CAPITAL STRUCTURE

The Net Income approach Net operating income approach

The traditional views M&M Proposition with out tax

M&M Proposition 2with tax

Trade –off ,pecking order and agency cost theories

ASSUMPTIONS OF TRADITIONAL CAPITALSTRUCTURE THEORIES

Firms employ only two types of capital: debt and equity.

The total assets of the firm are given. The degree of leverage can be changed by

selling debt to repurchase shares or selling shares to retire debt.

Investors have the same subjective probability distributions of expected future

operating earnings for a given firm.

The firm has a policy of paying 100 per cent dividends.

The operating earnings of the firm are not expected to grow.

the business risk is assumed to be constant and independent of capital structure and

financial risk.

The corporate and personal income taxes do not exist.

RELEVANCE OF CAPITAL STRUCTURE: THE NET INCOME AND THE TRADITIONAL VIEWS

firm L is a levered firm and it has financed its assets by equity and debt. It hasperpetual expected EBIT or net operating income (NOI) of Rs 1,000 and the

interest payment of Rs 300. The firm’s cost of equity ke, is 9.33 per cent and the cost of debt, kd, is 6 per cent. What is the firm’s value?

NOI – interest = 1,000 – 300 = Rs 700, and the cost of equity is 9.33 per cent.

Cost of capital

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Value of the firm (NI approach)

The cost of equity is 10%

The effect of leverage on the cost of capital under NI approach

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The Traditional View The traditional view has emerged as a compromise to the extreme position

taken by the NI approach. According to this view, the mix of debt and equity capital can increase the

value of the firm by reducing the weighted average cost of capital up to certain level of debt.

Exp ;firm is expecting a perpetual net operating income of Rs 150 crore on assets, (the cost of equity) is 10 percent.

It is considering substituting equity capital by issuing perpetual debentures of Rs 300 at 6 percent. The cost of equity is expected to increase to 10.56 per cent.

firm is also considering the alternative of raising perpetual debentures of Rs 600 crore and replace equity, The debt-holders will charge interest of 7 per cent, and the cost of equity will rise to 12.5 per cent to compensate shareholders for higher financial risk. 17

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Modigliani and Miller (MM) (1958) propositions1

Proposition I The value of the firm is NOT affected by changes in

the capital structure The cash flows of the firm do not change; therefore, value doesn’t change.

Firms with identical net operating income and business (operating) risk,but differing capital structure, should have same total value.

Firm value is not affected by leverageVL = VU

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Case I – MM Propositions II with out tax same with (net operating income approach )

Proposition II The WACC of the firm is NOT affected by capital structure.

RE = RA +D/E(RA-RD)RD is the interest rate (cost of debt)RE is the return on equity (cost of equity)RA is the return on unlevered equity (cost of capital)B is the value of debtE is the value of equity

the cost of equity rises with leverage ,because the risk to equity rises with leverage .

Taxes were ignored Bankruptcy costs and other agency cost were not considerered

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The CAPM Proposition II How does financial leverage affect systematic risk? The systematic risk of the stock depends on:

Systematic risk of the assets RA, (business risk) Level of leverage, D/E, (financial risk) RE = RA +(RA-RD)D/E

business risk Financial risk an increase in financial leverage should increase systematic risk since changes in

interest rates are a systematic risk factor and will have more impact the higher the financial leverage.

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Case II – Corporate taxes Interest is tax deductible when a firm adds debt, it reduces taxes, all

else equal The reduction in taxes increases the cash flow

of the firm.

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Case II – Example(interest tax shield)

Unlevered Firm

Levered Firm

EBIT 5,000 5,000

Interest 0 500

Taxable Income 5,000 4,500

Taxes (34%) 1,700 1,530

Net Income 3,300 2,970

CFFA 3,300 3,470

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Interest Tax Shield

Annual interest tax shield Tax rate times interest payment $6,250 in 8% debt = $500 in interest expense Annual tax shield = .34($500) = $170

Present value of annual interest tax shield Assume perpetual debt for simplicity PV = $170 / .08 = $2,125 PV = D(RD)(TC) / RD = D*TC = $6,250(.34) =

$2,125 26

Case II – Proposition II

The value of the firm increases by the present value of the annual interest tax shield Value of a levered firm = value of an

unlevered firm + PV of interest tax shield Value of equity = Value of the firm – Value of

debt

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Case II – Proposition II

The WACC decreases as D/E increases because of the government subsidy on interest payments

WACC= Ke* E/V+ Kd*D/V(1-Tc)

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Case III (trade-off theory)

Now they add bankruptcy costs As the D/E ratio increases, the probability of bankruptcy

increases This increased probability will increase the expected

bankruptcy costs At some point, the additional value of the interest tax shield

will be offset by the expected bankruptcy costs At this point, the value of the firm will start to decrease and

the WACC will start to increase as more debt is added

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Bankruptcy Costs Direct costs

Legal and administrative costs Ultimately cause bondholders to incur additional losses

Financial distress Significant problems in meeting debt obligations

Indirect bankruptcy costs Larger than direct costs, but more difficult to measure and

estimate Assets lose value as management spends time worrying

about avoiding bankruptcy instead of running the business Also have lost sales, interrupted operations, and loss of

valuable employees 31

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Agency cost of capital structure theory Jensen and Meckling 1976 There are agency problems between managers and shareholders

and between debt and equity holders These parties are not equal access to information . The agency cost because there is conflict between shareholders

and mangers and between the shareholders and bond holders. agency cost of shareholders :the costs incurred if the agent uses to

company's resources for his own benefit; orB) the cost of techniques that principals use to prevent the agent from prioritizing his interests over the shareholders

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agency cost of debt managers may want to engage in risky actions they hope will benefit shareholders, who seek a high rate of return. Bondholders, who are typically interested in a safer investment, may want to place restrictions on the use of their money to reduce their risk.

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Packed order theoriesMyers and Majluf (1984) .Pecking Order Theory - Theory stating that firms prefer to issue debt rather than

equity if internal finance is insufficientThe announcement of a stock issue drives down the stock price because investors believe managers are more likely to issue when shares are overpriced.

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

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

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The term structure of interest rates The term structure of interest rates compares

the interest rates on securities, assuming that all characteristics (i.e., default risk, liquidity risk) except maturity are the same.

Bonds with identical risk, liquidity, and tax characteristics may have different interest rates because the time remaining to maturity is differ

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Term Structure of Interest Rates

Yield curve: a plot of the yield on bonds with differing terms to maturity but the same risk. Upward-sloping: long-term rates are above

short-term rates Flat: short- and long-term rates are the same Inverted: long-term rates are below short-term

rates

Term Structure of Interest Rates:the Yield Curve

Yield toMaturity

Time to Maturity

(a)

(b)

(c)

(a) Upward sloping(b) Inverted or downward sloping(c) Flat

Term Structure Facts Fact 1: Interest rates for different maturities tend

to move together over time. Fact 2: Yields on short-term bond more volatile

than yields on long-term bonds.

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Fact 3: Long-term yield tends to be higher than short term yields (i.e. yield curves

usually are upward sloping).

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The Expectations Theory The key assumption behind this theory is that buyers of bonds do not prefer

bonds of one maturity over another, so they will not hold any quantity of a bond if its expected return is less than that of another bond with a different maturity.

interest rate on the long bond is the average of the interests on short bonds expected over the life of the long bond. More generally, for n-period bonds

interest rates of different maturities will move together (Fact 1)If the current short term rate changes so it will have very little impact on long

term yield (fact2)This theory can not explain the third fact

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Expectations Theory

Long-term interest rates are geometric averages of current and expected future short-term interest rates

(EXAMPLE)

1))](1))...((1)(1[( /1112111 N

NN rErERR

Segmented Markets Theory Bonds of different maturities are completely segmented The interest rate for each bond with a different maturity is

determined by the demand for and supply of that bond longer bonds that have associated with them inflation and interest

rate risks are completely different assets than the shorter bonds so the expected returns from a bond of one maturity has no effect on the demand for a bond of another maturity.

Investors have preferences for bonds of one maturity over another If investors generally prefer bonds with shorter maturities that have

less interest-rate risk, then this explains why yield curves usually slope upward (fact 3)

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Liquidity Premium Theory

Long-term interest rates are geometric averages of current and expected future short-term interest rates plus liquidity risk premiums that increase with maturity

Lt = liquidity premium for period tL2 < L3 < …<LN

1)])(1)...()(1)(1[( /11212111 N

NNN LrELrERR

Liquidity Premium ( Preferred Habitat) Theories Interest rates on different maturity bonds move together over time. Yield curves typically slope upward; explained

by a larger liquidity premium as the term to maturity lengthens.

Investors have a preference for bonds of one maturity over another They will be willing to buy bonds of different maturities only if

they earn a somewhat higher expected return Investors are likely to prefer short-term bonds over longer-term

bonds

Thank You

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