Capital Structure

Determination
 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
7-1
 Capital Structure
Capital Structure -- The mix (or proportion) of
a firm’s permanent long-term financing
represented by debt, preferred stock, and
common stock equity.
 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.
7-2
 A Conceptual Look
--Relevant Rates of Return
ki = the yield on the company’s debt
I Annual interest on debt
ki = =
B Market value of debt

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.)
7-3
 A Conceptual Look
--Relevant Rates of Return
ke = the expected return on the company’s equity
Earnings available to
E
E common shareholders
ke = S =
S Market value of common
stock outstanding
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
7-4
 A Conceptual Look
--Relevant Rates of Return
ko = an overall capitalization rate for the firm
O
O Net operating income
ko =
V
=
Total market value of the firm
V

Assumptions:
• V = B + S = total market value of the firm
• O = I + E = net operating income = interest
paid plus earnings available to common
shareholders
7-5
 Capitalization Rate
Capitalization Rate, ko -- The discount rate
used to determine the present value of a
stream of expected cash flows.

B S
ko = ki + ke
B+S B+S

What happens to ki, ke, and ko

when leverage, B/S, increases?
7-6
 Net Operating
Income Approach
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.
Assume:
 Net operating income equals $1,350
 Market value of debt is $1,800 at 10% interest
 Overall capitalization rate is 15%
7-7
 Required Rate of
Return on Equity
Calculating the required rate of return on equity

Total firm value=

value O / ko = $1,350 / .15 =
$9,000
Market value = V - B = $9,000 - $1,800 of
equity = $7,200 Interest payments
= $1,800 x 10%
Required return =E/S on equity*
equity =
($1,350 - $180)
$180 / $7,200 = 16.25%

7-8 * B / S = $1,800 / $7,200 = .25

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

Total firm value=

value O / ko = $1,350 / .15 =
$9,000
Market value = V - B = $9,000 - $3,000 of
equity = $6,000 Interest payments
= $3,000 x 10%
Required return =E/S on equity*
equity =
($1,350 - $300)
$300 / $6,000 = 17.50%

7-9 * B / S = $3,000 / $6,000 = .50

 Required Rate of
Return on Equity
Examine a variety of different debt-to-equity
ratios and the resulting required rate of
return on equity.
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%
7-10 Calculated in slides 9 and 10
 Required Rate of
Return on Equity
Capital costs and the NOI approach in a
graphical representation.
.25
ke = 16.25% and
.20 17.5% respectively
Capital Costs (%)

ke (Required return on equity)

.15
ko (Capitalization rate)
.10
ki (Yield on debt)
.05

0
0 .25 .50 .75 1.0 1.25 1.50 1.75 2.0
7-11 Financial Leverage (B / S)
 Summary of NOI Approach
 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.
structure
7-12
 Traditional Approach

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.

Optimal Capital Structure -- The capital structure

that minimizes the firm’s cost of capital and
thereby maximizes the value of the firm.

7-13
 Optimal Capital Structure:
Traditional Approach
Traditional Approach

ke
.25
ko
.20
Capital Costs (%)

.15
ki
.10
Optimal Capital Structure
.05

0
Financial Leverage (B / S)
7-14
 Summary of the
Traditional Approach
 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 offsets the
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 total
value will be the largest (discounting at ko).
7-15
 Total Value Principle:
Modigliani and Miller (M&M)
 Advocate that the relationship between
financial leverage and the cost of capital is
explained by the NOI approach.
 Provide behavioral justification for a constant
ko over the entire range of financial leverage
possibilities.
 Total risk for all security holders of the firm is
not altered by the capital structure.
 Therefore, the total value of the firm is not
altered by the firm’s financing mix.
7-16
 Total Value Principle:
Modigliani and Miller
Market value Market value
of debt ($35M) of debt ($65M)

Market value Market value

of equity ($65M) of equity ($35M)

Total firm market Total firm market

value ($100M) value ($100M)

 Total market value is not altered by the capital

structure (the total size of the pies are the same).
 M&M assume an absence of taxes and market
imperfections.
 Investors can substitute personal for corporate
financial leverage.
7-17
 Arbitrage and Total
Market Value of the Firm
Two firms that are alike in every respect
EXCEPT capital structure MUST have
the same market value.
Otherwise, arbitrage is possible.

Arbitrage -- Finding two assets that are

essentially the same and buying the
cheaper and selling the more expensive.

7-18
 Arbitrage Example
Consider two firms that are identical
in every respect EXCEPT:
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
7-19
 Arbitrage Example:
Company NL
Valuation of Company NL
Earnings available to =E =O–I
common shareholders = $10,000 - $0
= $10,000
Market value = E / ke
of equity = $10,000 / .15
= $66,667
Total market value = $66,667 + $0
= $66,667
Overall capitalization rate = 15%
Debt-to-equity ratio =0
7-20
 Arbitrage Example:
Company L
Valuation of Company L
Earnings available to =E =O–I
common shareholders = $10,000 - $3,600
= $6,400
Market value = E / ke
of equity = $6,400 / .16
= $40,000
Total market value = $40,000 + $30,000
= $70,000
Overall capitalization rate = 14.3%
Debt-to-equity ratio = .75
7-21
 Completing an
Arbitrage Transaction
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).
7-22
 Completing an
Arbitrage Transaction
Original return on investment in Company L
$400 x 16% = $64

Return on investment after the transaction

 $666.67 x 16% = $100 return on Company NL
 $300 x 12% = $36 interest paid
 $64 net return ($100 - $36)
$36 AND $33.33 left over.
over
This reduces the required net investment to
$366.67 to earn $64.
7-23
 Summary of the
Arbitrage Transaction
 The investor uses “personal” rather than
corporate financial leverage.
 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.
7-24
 Market Imperfections
and Incentive Issues
 Bankruptcy costs (Slide 27)
 Agency costs (Slide 28)
 Debt
and the incentive to
manage efficiently
 Institutional restrictions
 Transaction costs
7-25
 Required Rate of Return
on Equity with Bankruptcy
ke with bankruptcy costs
Required Rate of Return

Premium
ke with no leverage for financial
on Equity (ke)

risk
ke without bankruptcy costs

Premium
for business
risk
Rf
Risk-free
rate

Financial Leverage (B / S)
7-26
 Agency Costs
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.
 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.
7-27
 Example of the Effects
of Corporate Taxes
The judicious use of financial leverage
(i.e., debt) provides a favorable impact
on a company’s total valuation.
Consider two identical firms EXCEPT:
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
7-28
 Corporate Tax Example:
Company ND
Valuation of Company ND (Note: has no debt)
Earnings available to =E =O-I
common shareholders = $2,000 - $0
= $2,000
Tax Rate (T) = 40%
Income available to = EACS (1 - T)
common shareholders = $2,000 (1 - .4)
.4
= $1,200
Total income available to = EAT + I
all security holders = $1,200 + 0
= $1,200
7-29
 Corporate Tax Example:
Company D
Valuation of Company D (Note: has some debt)
Earnings available to = E = O - I common
shareholders = $2,000 - $600 = $1,400
Tax Rate (T) = 40%
Income available to = EACS (1 - T)
common shareholders = $1,400 (1 - .4)
.4 =
$840
Total income available to = EAT + I all
security holders = $840 + $600 =
$1,440*
$1,440

7-30 * $240 annual tax-shield benefit of debt (i.e., $1,440 - $1,200)

 Tax-Shield Benefits
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 of
tax-shield benefits (r) (B) (tc)
= = (B) (tc)
of debt*
debt r

= ($5,000)
$5,000 (.4)
.4 = $2,000**
$2,000
* Permanent debt, so treated as a perpetuity
** Alternatively, $240 annual tax shield / .12 = $2,000, where
7-31 $240=$600 Interest expense x .40 tax rate.
 Value of the Levered Firm
Value of Value of Present value of
levered = firm if + tax-shield benefits
firm unlevered of debt

Value of unlevered firm = $1,200 / .16

(Company ND) = $7,500*
$7,500

Value of levered firm = $7,500 + $2,000

(Company D) = $9,500

* Assuming zero growth and 100% dividend payout

7-32
 Summary of
Corporate Tax Effects
 The greater the amount of debt, the greater the tax-
shield benefits and the greater the value of the firm.

 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.
leverage
 This implies a capital structure of almost 100%
debt! Yet, this is not consistent with actual
behavior.
7-33
 Other Tax Issues
 Uncertainty of tax-shield benefits
Uncertainty increases the possibility of
bankruptcy and liquidation, which reduces the
value of the tax shield.
 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%.
7-34
 Bankruptcy Costs,
Agency Costs, and Taxes
Value of levered firm
= Value of firm if unlevered
+ Present value of tax-shield benefits
of debt
- Present value of bankruptcy and
agency costs
As financial leverage increases, tax-shield
benefits increase as do bankruptcy and
agency costs.
costs
7-35
 Bankruptcy Costs,
Agency Costs, and Taxes
Cost of Capital (%)

Minimum Cost Taxes, bankruptcy, and

of Capital Point agency costs combined

Net tax effect

Optimal Financial Leverage

Financial Leverage (B/S)

7-36
 Financial Signaling
 A manager may use capital structure changes to
convey information about the profitability and risk
of the firm.
 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.
undervalued
 This is a valid signal because of the possibility
of bankruptcy.
7-37