Contemporary Financial Management

© 2004 by Nelson, a division of Thomson Canada Limited

Contemporary Financial Management

Chapter 12:Capital Structure Concepts

© 2004 by Nelson, a division of Thomson Canada Limited2

Introduction

This chapter examines the basic concepts related to a firm’s optimal capital structure.


Capital Structure Theory

Studies the relationship between:

Capital structure

• The mix of debt & equity securities on the right hand side of the Balance Sheet

Cost of capital

• The return demanded by investors

• Impacts on the value of the firm


Capital vs. Financial Structure

Capital Structure Amount of permanent short-term debt, long-

term debt, preferred shares and common equity used to finance the firm.

Financial Structure Amount of current liabilities, long-term debt,

preferred shares and common equity used to finance a firm.


Capital Structure Terminology

Optimal capital structure Minimizes a firm’s weighted average cost of

capital (WACC) Maximizes the value of the firm

Target capital structure Capital structure the firm plans to maintain

Debt capacity Amount of debt in the firm’s optimal capital

structure


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 Debt holders Preferred shareholders Common shareholders

Fixed investment policy leaves the debt capacity of the firm unchanged


Factors Affecting Capital Structure

Business risk of the firm

Tax structure

Bankruptcy potential

Agency costs

Signaling effects


Factors Affecting Business Risk

Variability of sales volume

Variability of selling price

Variability of input costs

Degree of market power

Extent of product diversification

Firm’s growth rate

Degree of operating leverage (DOL)

Both systematic and unsystematic risk


Financial Risk

The variability of earnings per share (EPS)

Financial risk affects the probability of bankruptcy

Indicators of financial risk Debt to assets ratio Debt to equity ratio Fixed charge coverage ratio Times interest earned ratio Degree of Financial Leverage Probability distribution of profits EBIT-EPS analysis


Three Capital Structure Models

Capital Structure With No Taxes

Optimal Capital Structure With Taxes

Optimal Capital Structure WithTaxes, Financial Distress Costs & Agency Costs


Capital Structure is Irrelevant

Modigliani & Miller (MM) were the pioneers in developing the theory of capital structure

MM began by assuming perfect capital markets, including: No taxes No bankruptcy (B) costs No agency (A) costs

MM also recognized that debt will always cost less than equity because: Interest is tax deductible Debt securities are less risky than equity

securities


MM’s Two Propositions

Proposition #1: The market value of the firm is independent of

capital structure. Therefore, capital structure is irrelevant.

Proposition #2: The cost of capital remains constant as capital

structure changes. As the quantity of debt rises, the return demanded by the shareholder increases linearly, exactly offsetting the benefit due to the lower cost of debt.


Cost

of

Capit

al (%

)

kd

ka

ke

Modigliani & Miller on Capital Structure

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

Financial Leverage (Debt-to-equity ratio)


MM Arbitrage Proof

Market value of the firm: Market value of equity + Market value of debt

Value of firm with no debt:

Value of firm with debt:

e

DividendsV =

k

e d

Dividends InterestV = +

k k


Example: Value of an Unlevered Firm

A firm with no debt pays out $1 Million in dividends. If shareholders require a 20% return, what is the market value of the firm?

e

DividendsV

k

$1,000,0000.20

$5,000,000


Example: Value of a Levered Firm

The same firm now acquires debt at 10%, on which it pays interest of $250,000. Since this is world with no taxes, the firm has $750,000 which it pays in dividends. Since the firm is now more risky, shareholders require a 30% return. What is the market value of the firm?

e d

Dividends InterestV

k k

$750,000 $250,0000.30 0.10

$2,500,000 2,500,000 $5,000,000


Why?

Dividends paid to shareholders of the levered firm are reduced by the amount of interest paid on the debt.

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

The values of the levered and the unlevered firm are identical due to arbitrage.

Thus MM’s Proposition #1: the value of the firm is independent of capital structure (in a world with no taxes)


What Happens with Taxes ?

The firm’s operating income is now reduced by the amount of taxes paid

Since dividends to shareholders are paid out of after-tax income, the value of the unlevered firm should drop

But interest is a tax-deductible expense, creating a valuable tax-shield

The result - the value of the levered firm should be higher than the value of the unlevered firm


The Tax Shield due to Interest

A tax shield is the amount of tax the firm would have paid, had it not incurred the interest expense.

The annual tax shield is equal to:

The PV of the tax shield is equal to:

Annual Tax Shield = i×D×T

Tax Shield

i×D×TPV = = D×T

i

I = interest rate D = Face value of debt T = Tax rate


Example: The Impact of Tax

Firm U Firm L

EBIT $1,000 $1,000

Less Interest 0 100

Income before Tax 1,000 900

Less Tax @ 40% 400 360

Income (for Dividends) 600 540

Interest + Dividends 600 640

Return on debt - 5%

Market value of debt - 2,000

Return on equity 10% 11.25%

Market value of equity $6,000 $4,800

Market value of firm $6,000 $6,800


Market Value of the Unlevered Firm

UnleveredFirm e

DividendsV =

k

600=

0.10

= $6,000



Market Value of the Levered Firm

LeveredFirm e d

Dividends InterestV = +

k k

540 100= +

0.1125 0.05

= $6,800



Why the Difference?

The difference in value between the levered and the unlevered firm in a world including taxes is due to the value of the tax shield

Therefore: Market value (MV) of levered firm = MV of unlevered firm + PV of the tax shield


VL = VU + Present Value of Tax Shield

MktValue

of Firm

Debt $

VU

VL

PV ofTax Shield


Capital Structure

ki = kd (1 – T)

ka

ke

Cost

of

Capit

al (%

)

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

Financial Leverage (Debt-to-equity)


The Problem?

If the value of the firm increases linearly with debt, the logical conclusion would be that all firms should be financed with 100% debt!

This conclusion defies logic and is counter to customary practice

What are we missing?


Financial Distress (Bankruptcy) Costs

Financial distress costs include:

Costs incurred to avoid bankruptcy• Pay higher interest rates due to greater risk

Direct & indirect costs incurred if the firm files for bankruptcy• Direct costs – costs paid by debtors in the

bankruptcy & restructuring process• Indirect costs – costs due to loss of customers,

suppliers, employees plus the cost of management’s time


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 and legal costs

If forced to liquidate, assets may have to be sold for less than market value


Agency Costs

The firm’s debt & equity holders (the principals) are usually not the firm’s managers

The principals employ agents (firm management) to manage the firm on their behalf

Conflicts often develop between the interests of the principals and the interests of the agents


Agency Costs & Shareholders

Shareholders have an incentive to undertake risky projects financed with debt If the project succeeds, the shareholders win If the project fails, the bondholders suffer the

loss

Therefore, bondholders will Charge higher interest rates, or Implement protective covenants to protect

themselves


Agency Costs & Shareholders

Investing in high risk/high return projects can shift wealth from bondholders to shareholders

Shareholders may forgo some profitable investments in debt is required

Shareholders may issue high quantities of new debt, diminishing the protection afforded to earlier bondholders

Bondholders will shift monitoring and bonding costs back to the shareholders by charging higher interest rates & imposing covenants


Taxes, Bankruptcy and Agency Costs

Bankrupcty and agency costs increase with the amount of leverage

At some point, these offset the positive benefits from the value of the tax shield

Market value of unlevered firm+ PV of tax shield– PV of bankruptcy costs– PV of agency costs Market value of leverage firm


Optimal Debt Ratio

DebtRatio

VU

PVof Tax

Shield

Mkt value of le

veraged firm PVB&ACosts

VL

Optimal Debt Ratio

Market Value of the Firm


Least Cost Capital Structure

Cost of Capital

DD + E

ki

ke

ka

Optimal CapitalStructure


Other Considerations

Personal tax costs (interest is fully taxable) Could offset some corporate tax advantages No optimal capital structure when both corporate &

personal taxes are considered

Industry effects Firms with stable cash flows tend to have higher

debt ratios More profitable firms tend to have lower debt ratios Market appears to reward firms with capital

structures appropriate to their industry


Other Considerations

Signaling effects (Asymmetric Information) Firm management have access to confidential

information Management decisions may be a signal to the

market

Managerial preferences (Pecking order theory) Firms prefer internal to external financing

• New issues incur flotation costs• External financing incurs more monitoring by the

market


Pecking Order Theory

Firms have a definite preference in the order in which they finance new projects

InternalEquity

DebtExternalEquity

MostPreferred

LeastPreferred


Major Points

Choosing an appropriate capital structure is an important management decision

In a world with no taxes, the value of the unlevered firm equals the value of the levered firm

In a world with taxes, interest creates a valuable tax shield.

The value of the levered firm equals the value of

the unlevered plus the PV of the tax shield


Major Points

Financial distress & agency costs increase as debt rises, eventually offsetting the marginal value of the interest tax shield

Optimal capital structures appear to be influenced by Variability of cash flows Nature of the industry

Contemporary Financial Management

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