capital structure thery and policyCh_06

7/29/2019 capital structure thery and policyCh_06

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Chapter - 15

Capital StructureTheory and Policy


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2Financial Management, Ninth Edition I M PandeyVikas Publishing House Pvt. Ltd.

Chapter Objectives

Understand the theoretical controversy about capitalstructure and the value of the firm.

Highlight the differences between the ModiglianiMiller view and the traditional view on the relationship

between capital structure and the cost of capital andthe value of the firm. Focus on the interest tax shield advantage of debt as

well as its disadvantage in terms of costs of financialdistress.

Explain how beta is related to capital structure andthe cost of capital.

Discuss the concept and utility of the adjustedpresent value (APV) in project evaluation.


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Debt-equity Mix and the Value of

the Firm Capital structure theories:

Net operating income (NOI) approach.

Traditional approach and Net income (NI)

approach.

MM hypothesis with and without corporate tax.

Millers hypothesis with corporate and personal

taxes.

Trade-off theory: costs and benefits of leverage.


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Net Income (NI) Approach

According to NI approachboth the cost of debt andthe cost of equity areindependent of the capitalstructure; they remain

constant regardless ofhow much debt the firmuses. As a result, theoverall cost of capitaldeclines and the firm valueincreases with debt. This

approach has no basis inreality; the optimumcapital structure would be100 per cent debtfinancing under NIapproach.

ke

kokd

Debt

Cost

kd

ke, ko


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Net Operating Income (NOI) Approach

According to NOIapproach the value ofthe firm and theweighted average costof capital are

independent of thefirms capital structure.In the absence of taxes,an individual holding allthe debt and equitysecurities will receive

the same cash flowsregardless of the capitalstructure and therefore,value of the company isthe same.

ke

ko

kd

Debt

Cost


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Net Operating Income

Approach

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 capitalstructure in which the weighted average cost of

capital and the total value of the firm remain constantas financial leverage is changed.


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Required Rate of

Return on Equity

Total firm value = O / ko = $1,350 / .15= $9,000

Market value = V - B = $9,000 - $1,800of equity = $7,200

Required return = E / S onequity* = ($1,350 - $180) / $7,200

= 16.25%

Calculating the required rate of return on equity

* B / S = $1,800 / $7,200 = .25

Interest payments

= $1,800 x 10%


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Total firm value = O / ko = $1,350 / .15= $9,000

Market value = V - B = $9,000 - $3,000of equity = $6,000

Required return = E / S onequity* = ($1,350 - $300) / $6,000

= 17.50%

Required Rate of

Return on Equity

What is the rate of return on equity if B=$3,000?

* B / S = $3,000 / $6,000 = .50

Interest payments

= $3,000 x 10%


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B / S ki ke ko0.00 --- 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%

Required Rate of

Return on Equity

Examine a variety of different debt-to-equityratios and the resulting required rate of return

on equity.

Calculated in slides 9 and 10


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Required Rate of

Return on Equity

Capital costs and the NOI approach in agraphical representation.

0 .25 .50 .75 1.0 1.25 1.50 1.75 2.0

Financial Leverage (B / S)

.25

.20

.15

.10

.05

0

CapitalC

osts(%)

ke = 16.25% and17.5% respectively

ki (Yield on debt)

ko (Capitalization rate)

ke (Required return on equity)


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Traditional Approach

The traditional approachargues that moderate degreeof debt can lower the firmsoverall cost of capital andthereby, increase the firm

value. The initial increase inthe cost of equity is more thanoffset by the lower cost ofdebt. But as debt increases,shareholders perceive higherrisk and the cost of equity

rises until a point is reachedat which the advantage oflower cost of debt is morethan offset by more expensiveequity.

ke

ko

kd

Debt

Cost


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Effect on Cost of Capital-Traditional TheoryNo Debt (in crore) 6% Debt (crore) 7% debt (crore)

NOI 150 150 150

Interest (Costof debt*debt)

0 18 42

NI 150 132 108

Cost of equity 0.1000 0.1056 0.1250

MV of equity 1500 1250 864

MV of debt 0 300 600

Value of firm 1500 1550 1464

E/V 1 0.806 0.590

D/V 0 0.194 0.410

COC 0.1000 0.0970 0.1030 12


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MM Approach Without Tax:

Proposition I MMs Proposition I statesthat the firms value isindependent of its capitalstructure. With personalleverage, shareholderscan receive exactly thesame return, with thesame risk, from a leveredfirm and an unleveredfirm. Thus, they will sell

shares of the over-pricedfirm and buy shares ofthe under-priced firmuntil the two valuesequate. This is calledarbitrage.

ko

Debt

Cost

MM's Proposition I


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Market valueof debt ($65M)

Market valueof equity ($35M)

Total firm marketvalue ($100M)

Total Value Principle:

Modigliani and Miller

M&M assume an absence of taxes and marketimperfections.

Investors can substitute personal for corporate financial

leverage.

Market valueof debt ($35M)

Market valueof equity ($65M)

Total firm marketvalue ($100M)

Total market value and cost of capital is not altered by

the capital structure (total size of the pies are the same).


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Arbitrage

Levered Firm ( ):

60,000 50,000 110,000

interest rate 6%; NOI 10,000

shares held by an investor in 10%Unlevered Firm ( ):

100,000

NOI 10,000

l l l

d

l

u u

L

V S D

k X

L

U

V S

X


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Arbitrage

Return from Levered Firm:

10 110, 000 50 000 10% 60, 000 6 000

10% 10, 000 6% 50, 000 1,000 300 700

Alternate Strategy:

1. Sell shares in : 10% 60,000 6,000

2. Borrow (personal leverage):

Investment % , ,

Return

L

10% 50,000 5,000

3. Buy shares in : 10% 100,000 10,000

Return from Alternate Strategy:

10,000

10% 10,000 1,000

: Interest on personal borrowing 6% 5,000 300

Net return 1,000 300 700

Ca

U

Investment

Return

Less

sh available 11,000 10,000 1,000


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MMs Proposition II

The cost of equity for alevered firm equals theconstant overall cost ofcapital plus a risk premiumthat equals the spread

between the overall cost ofcapital and the cost of debtmultiplied by the firmsdebt-equity ratio. Forfinancial leverage to beirrelevant, the overall cost

of capital must remainconstant, regardless of theamount of debt employed.This implies that the cost ofequity must rise asfinancial risk increases.

ke

ko

kd

Debt

Cost

MM's Proposition II


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MM Propositions I and II

/

o

o

de

e o o d

MM Proposition I :

XV

k

XkV

MM Proposition II :

X k Dk

Sk k (k k )D S


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MM Hypothesis With Corporate Tax

Under current laws in most countries, debt has an

important advantage over equity: interest payments on

debt are tax deductible, whereas dividend payments and

retained earnings are not. Investors in a levered firm

receive in the aggregate the unlevered cash flow plus an

amount equal to the tax deduction on interest. Capitalising

the first component of cash flow at the all-equity rate and

the second at the cost of debt shows that the value of the

levered firm is equal to the value of the unlevered firm plus

the interest tax shield which is tax rate times the debt

(if the shield is fully usable).

It is assumed that the firm will borrow the same amount of

debt in perpetuity and will always be able to use the tax

shield. Also, it ignores bankruptcy and agency costs.


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LEVERAGE BENEFIT UNDER CORPOATE AND PERSONAL TAXES

Unlev Lev Unlev LevCorp tax 0% 0% 35% 35%

Corp tax on div 0% 0% 10% 10%

Pers tax on div 0% 0% 0% 0%

Pers tax on int 0% 0% 0% 0%

PBIT 2500 2500 2500 2500

Int 0 700 0 700

PBT 2500 1800 2500 1800

Corp tax 0 0 875 630PAT 2500 1800 1625 1170

Div 2500 1800 1477 1064

Div tax 0 0 148 106

Tol corp tax 0 0 1023 736

Div income 2500 1800 1477 1064

Pers tax on div 0 0 0 0

AT div income 2500 1800 1477 1064

Int income 0 700 0 700Pers tax on int 0 0 0 0

AT int income 0 700 0 700

AT total income 2500 2500 1477 1764

Net leverage benifit 0 287


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MM Hypothesis with Corporate Tax

After-tax earnings of Unlevered Firm:

(1 )

Value of Unlevered Firm:

(1 )

After-tax earnings of Levered Firm:

( )(1 )

(1 )

Value of Levered Firm:

(1 )

T

u

T

d d

d

d

l

u d

u

u

X X T

X T

Vk

X X k D T k D

X T Tk D

T k DX TV

k k

V TD


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Millers Approach WITH Corporate

and Personal Taxes To establish an optimum capital structure bothcorporate and personal taxes paid on operatingincome should be minimised. The personal tax rate isdifficult to determine because of the differing taxstatus of investors, and that capital gains are only

taxed when shares are sold. Merton miller proposed that the original MM

proposition I holds in a world with both corporate andpersonal taxes because he assumes the personal taxrate on equity income is zero. Companies will issuedebt up to a point at which the tax bracket of themarginal bondholder just equals the corporate taxrate. At this point, there will be no net tax advantage to

companies from issuing additional debt.

It is now widely accepted that the effect of personaltaxes is to lower the estimate of the interest tax shield.


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LEVERAGE BENEFIT UNDER CORPOATE AND PERSONAL TAXES

Unlev Lev Unlev Lev Unlev Lev Unlev Lev Unlev Lev

Corp tax 0% 0% 35% 35% 35% 35% 35% 35% 35% 35%

Corp tax on div 0% 0% 10% 10% 10% 10% 10% 10% 10% 10%Pers tax on div 0% 0% 0% 0% 20% 20% 20% 20% 20% 20%

Pers tax on int 0% 0% 0% 0% 0% 0% 20% 20% 30% 30%

PBIT 2500 2500 2500 2500 2500 2500 2500 2500 2500 2500

Int 0 700 0 700 0 700 0 700 0 700

PBT 2500 1800 2500 1800 2500 1800 2500 1800 2500 1800

Corp tax 0 0 875 630 875 630 875 630 875 630

PAT 2500 1800 1625 1170 1625 1170 1625 1170 1625 1170Div 2500 1800 1477 1064 1477 1064 1477 1064 1407 1064

Div tax 0 0 148 106 148 106 148 106 148 106

Tol corp tax 0 0 1023 736 1023 736 1023 736 1023 736

Div income 2500 1800 1477 1064 1477 1064 1477 1064 1407 1064

Pers tax on div 0 0 0 0 295 213 295 213 281 213

AT div income 2500 1800 1477 1064 1182 851.2 1182 851.2 1126 851.2

Int income 0 700 0 700 0 700 0 700 0 700

Pers tax on int 0 0 0 0 0 0 0 140 0 210AT int income 0 700 0 700 0 700 0 560 0 490

AT tota l income 2500 2500 1477 1764 1182 1551 1182 1411 1126 1341

Net leverage benifit 0 287 370 230 216


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Millers Approach with Corporate

and Personal TaxesAfter-tax earnings of Unlevered Firm:(1 )(1 )

Value of Unlevered Firm:

(1 )(1 )

After-tax earnings of Levered Firm:

( )(1 )(1 ) (1 )

(1 )(1 ) (1 ) (1 )(1 )

Va

T

T

d e d d

d d d d e

e

e

e

uu

X X T T

X T TV

k

X X k D T T k D T

X T T k D T k D T T

lue of Levered Firm:

(1 ) (1 )(1 )(1 )(1 )

(1 ) (1 )

(1 )(1 )1

(1 )

d d e

l

u d

b

e

e b

e

u

k D T T T X T TV

k T k T

T TV D

T


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Demand rate ofinterest

Supply rateof interest

Borrowing

is= i

o/(1 T

c)

id = io/(1 Tb)

%


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Financial Distress

Financial distress arises when a firm is not able tomeet its obligations to debt-holders.

For a given level of debt, financial distress occursbecause of the business (operating) risk . with higherbusiness risk, the probability of financial distressbecomes greater. Determinants of business risk are:

Operating leverage (fixed and variable costs)

Cyclical variations

Intensity of competition

Price fluctuations

Firm size and diversification

Stages in the industry life cycle


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Consequences of Financial Distress

Bankruptcy costs

Specific bankruptcy costs include legal andadministrative costs along with the sale of assets atdistress prices to meet creditor claims. Lendersbuild into their required interest rate the expectedcosts of bankruptcy which reduces the market valueof equity by a corresponding amount.

Indirect costs

Investing in risky projects. Reluctance to undertake profitableprojects.

Premature liquidation.

Short-term orientation.


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Debt Policy and Shareholders Conflicts

Shareholdermanager conflicts Managers have a tendency to consume some of the

firms resources in the form of various perquisites.

Managers have a tendency to become unduly riskaverse and shirk their responsibilities as they haveno equity interest or when their equity interest falls.They may be passing up profitable opportunities.

Shareholderbondholder conflicts Shareholder value is created either by increasing the

value of the firm or by reducing the the value of its

bonds. Increasing the risk of the firm or issuingsubstantial new debt are ways to redistribute wealthfrom bondholders to shareholders. Shareholders donot like excessive debt.


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Monitoring and Agency Costs

Monitoring Outside investors will discount the prices they are

willing to pay for the firms securities realising that

managers may not operate in their best interests.

Firms agree for monitoring and restrictive covenants

to assure the suppliers of capital that they will notoperate contrary to their interests.

Agency Costs Agency costs are the costs of the monitoring and

control mechanisms.

Agency costs of debt include the recognition of the

possibility of wealth expropriation by shareholders.

Agency costs of equity include the incentive that

management has to expand the firm beyond the

point at which shareholder wealth is maximised.


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Financial Management, Ninth Edition I M PandeyVikas Publishing House Pvt. Ltd.

Debt

Mark

etValueofT

heFirm

Value ofunlevered

firm

PV of interest

tax shields

Costs offinancial distress

Value of levered firm

Optimal amountof debt

Maximum value of firm

Financial Distress


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Optimum Capital Structure:

Trade-off Theory The optimum capital structure is a function of: Agency costs associated with debt

The costs of financial distress

Interest tax shield

The value of a levered firm is:

Value of unlevered firm

+ PV of tax shield

PV of financial distress


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Pecking Order Theory

The announcement of a share issue reduces the share price

because investors believe managers are more likely to issue

when shares are overpriced.

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.

The most profitable firms borrow less not because they havelower target debt ratios but because they don't need external

finance.


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Pecking Order Theory

Impl icat ions:

Internal equity may be better than external

equity.

Financial slack is valuable.

If external capital is required, debt is better.


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Features of an Appropriate Capital

Structure Return Risk

Flexibi l i ty

Capacity

Contro l


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Approaches to Establish Appropriate

Capital Structure EBITEPS app roachfor analyzing the

impact of debt on EPS.

Valuat ion app roachfor determining the

impact of debt on the shareholders value. Cash f low app roachfor analyzing the firms

ability to service debt.


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Cash Flow Approach to Target Capital

Structure Cash adequacy and solvency

In determining a firms target capital structure, a key

issue is the firms ability to service its debt. The focus of

this analysis is also on the risk of cash insolvencythe

probability of running out of the cashgiven aparticular amount of debt in the capital structure. This

analysis is based on a thorough cash flow analysis and

not on rules of thumb based on various coverage ratios.

Components of cash flow analysis

Operating cash flows

Non-operating cash flows

Financial cash flows


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Reserve financial capacity

Reduction in operating and financial flexibility is

costly to firms competing in charging product and

factor markets. Thus firms need to maintain reserve

financial resources in the form of unused debt

capacity, large quantities of liquid assets, excess

lines of credit, access to a broad range of fund

sources.

Focus of cash flow analysis

Focus on liquidity and solvency Identifies discretionary cash flows

Lists reserve financial flows

Goes beyond financial statement analysis

Relates debt policy to the firm value


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Cash Flow Analysis Versus EBITEPS

Analysis The cash flow analysis has the following advantages

over EBITEPS analysis: It focuses on the liquidityand solvencyof the firm over a

long-period of time, even encompassing adversecircumstances. Thus, it evaluates the firms ability to meetfixed obligations.

It goes beyond the analysis of profit and loss statement andalso considers changes in the balance sheet items.

It identifies discretionary cash flows. The firm can thusprepare an action plan to face adverse situations.

It provides a list ofpotential financial flows which can beutilized under emergency.

It is a long-term dynamic analysis and does not remainconfined to a single period analysis.


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Practical Considerations in Determining

Capital Structure Control

Widely-held Companies

Closely-held Companies

Flexibility

Loan Covenants Early Repay abil i t y

Reserve Capacit y

Marketability

Market Cond it ions

Flotat ion Cos ts

Capacity of Raising Funds

Agency Costs

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