Transcript The Capital Structure Decision

The Capital Structure
Decision
MM propositions
FIN 351: lecture 12
Today’s plan


Review what we have learned about market efficiency
• Why is it important?
• What are the three-forms of market efficiency?
• Can you give me an example for each form of market
efficiency?
The capital structure decision
•
The capital structure without taxes
•
The capital structure with taxes
•
•
•
•
MM’s proposition 1
MM’s proposition 2
MM’s proposition 1
MM’s proposition 2
FIN 351: lecture 12
What have we learned in the last
lecture?




What do we mean by market
efficiency?
Why is market efficiency important in
corporate finance?
What are the three-forms of market
efficiency?
Can you give me an example for each
form of market efficiency?
FIN 351: lecture 12
Some true or false questions
about market efficiency
1 When securities are priced fairly, then financing at current
market rates is a positive NPV transaction.
2 Firms should avoid financing through stock issues, since
stock financing is a zero-NPV transaction.
3 If the market is efficient, stock prices should only be
expected to react to new information that is released.
4 The intent of technical analysis is to discover patterns in
past stock prices.
5 Technical analysts have no effect upon the efficiency of
the stock market.
6 Market efficiency implies that security prices impound new
information quickly.
FIN 351: lecture 12
Some true or false questions about
market efficiency
7. Financing decisions are easier to reverse than investment
decisions.
8. In efficient capital markets, all securities are fairly priced.
9. If security prices follow a random walk, then on any particular
day, the odds are that an increase or decrease in price is
equally likely.
10. Fundamental analysts attempt to get rich by identifying
patterns in stock prices.
11.Strong-form market efficiency implies that one could earn above
average returns by examining the history of a firm's stock price.
12. Insider information has nothing to do with historical stock
prices
FIN 351: lecture 12
Capital structure

Does the size of a pizza have nothing to
do with how it is sliced?

Is the value of a firm also independent of
how the firm mixes debt and equity?
FIN 351: lecture 12
Look at the both sides of a
balance sheet
Asset
Liabilities and equity
Market value of equity
E
Market value of the asset
V
Market value of debt
D
V=E+D
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Does capital structure affect
the firm value?
Equity
Debt
Debt
Equity
Govt.
Slicing the pie doesn’t
affect the total amount
available to debt
holders and equity holders
Slicing the pie can
affect the size of the slice
going to government
FIN 351: lecture 12
Equity
wasted
Debt
Govt.
Slicing the pie can
affect the size of the
wasted slice
MM’s proposition 1

Modigliani & Miller
• If the investment opportunity is fixed,
there
are no taxes, and capital markets function
well, the market value of a company does not
depend on its capital structure.

How can we understand this?
• The size of a pizza has nothing to do with how
you slice it.
FIN 351: lecture 12
M&M (Debt Policy Doesn’t Matter)
Example - River Cruises - All Equity Financed
Data
Number of shares
100,000
Price per share
$10
Market Value of Shares $ 1 million
Outcome
Operating Income
Earnings per share
Return on shares
State of the Economy
Slump
$75,000
$.75
7.5%
Expected
125,000
1.25
12.5%
FIN 351: lecture 12
Boom
175,000
1.75
17.5%
M&M (Debt Policy Doesn’t Matter)
Example
cont.
50% debt
Data
Number of shares
Price per share
Market Value of Shares
Market val ue of debt
Outcome
50,000
$10
$ 500,000
$ 500,000
State of the Economy
Operating Income
Interest
Equity earnings
Earnings per share
Return on shares
Slump
$75,000
$50,000
$25,000
$.50
5%
FIN 351: lecture 12
Expected
125,000
50,000
75,000
1.50
15%
Boom
175,000
50,000
125,000
2.50
25%
M&M (Debt Policy Doesn’t Matter)
Example - River Cruises - All Equity Financed
- Debt replicated by investors
Outcome
State of the Economy
Earnings on two shares
LESS : Interest @ 10%
Net earnings on investment
Return on $10 investment
Slump
$1.50
$1.00
$.50
5%
FIN 351: lecture 12
Expected
2.50
1.00
1.50
15%
Boom
3.50
1.00
2.50
25%
MM’s proposition 2

Modigliani & Miller
• If the investment opportunity is fixed,
•
there
are no taxes, and capital markets function
well, the expected rate of return on the
common stock of a levered firm increases in
proportion to the debt-equity ratio (D/E),
expressed in market values.
The WACC is independent of how the firm is
financed
FIN 351: lecture 12
WACC without taxes in MM’s view
r
rE
WACC
rD
D
V
FIN 351: lecture 12
Capital structure and Corporate
Taxes

The use of debt has a lot of implications:
•
•
Financial risk- The use of debt will increase the risk to
share holders and thus Increase the variability of
shareholder returns.
Interest tax shield- The savings resulting from
deductibility of interest payments.
FIN 351: lecture 12
An example on Tax shield
You own all the equity of Space Babies Diaper
Co.. The company has no debt. The company’s
annual cash flow is $1,000, before interest and
taxes. The corporate tax rate is 40%. You have
the option to exchange 1/2 of your equity position
for 10% bonds with a face value of $1,000.
Should you do this and why?
FIN 351: lecture 12
C.S. & Corporate Taxes
All Equity
EBIT
Interest Pmt
1,000
0
Pretax Income
1,000
Taxes @ 40%
400
Net Cash Flow
$600
FIN 351: lecture 12
1/2 Debt
C.S. & Corporate Taxes
All Equity
1/2 Debt
1,000
1,000
0
100
Pretax Income
1,000
900
Taxes @ 40%
400
360
$600
$540
EBIT
Interest Pmt
Net Cash Flow
FIN 351: lecture 12
Capital Structure and Corporate
Taxes
All Equity
1/2 Debt
1,000
1,000
0
100
Pretax Income
1,000
900
Taxes @ 40%
400
360
Net Cash Flow
$600
$540
EBIT
Interest Pmt
Total Cash Flow
All Equity = 600
*1/2 Debt = 640
(540 + 100)
FIN 351: lecture 12
Capital Structure and tax shield
PV of Tax Shield =
D x rD x Tc
rD
= D x Tc
Example:
Tax benefit = 1000 x (.10) x (.40) = $40
PV of 40 perpetuity = 40 / .10 = $400
PV Tax Shield = D x Tc = 1000 x .4 = $400
FIN 351: lecture 12
MM’s proposition 1 with tax

firm value = value of all equity firm + PV(tax
shield)
Example,
all equality firm value =600/0.1=6,000
PV( tax shield)=400
firm value=6,400
FIN 351: lecture 12
MM’s proposition 2

The weighted average cost of capital is
decreasing with the ratio of D/E, that is
 D 
 E 
WACC  (1  Tc )rdebt 

r
 equity 

DE
DE

Can you understand this intuitively?
FIN 351: lecture 12
WACC Graph
FIN 351: lecture 12
Financial Distress
Costs of Financial Distress - Costs arising from
bankruptcy or distorted business decisions
before bankruptcy.
Market Value =
Value if all Equity Financed
+ PV Tax Shield
- PV Costs of Financial
Distress
FIN 351: lecture 12
Financial distress
Costs of Financial Distress - Costs arising
from bankruptcy or distorted business
decisions before bankruptcy.
Market Value = Value if all Equity Financed
+ PV Tax Shield
- PV Costs of Financial
Distress
FIN 351: lecture 12
Optimal Capital structure
Trade-off Theory - Theory that capital structure
is based on a trade-off between tax savings
and distress costs of debt.
Pecking Order Theory - Theory stating that
firms prefer to issue debt rather than equity if
internal finance is insufficient.
FIN 351: lecture 12
Financial Distress
Market Value of The Firm
Maximum value of firm
Costs of
financial distress
PV of interest
tax shields
Value of levered firm
Value of
unlevered
firm
Optimal amount
of debt
Debt
FIN 351: lecture 12