Download The Capital Structure

The Capital Structure
Some classic arguments
FIN 819
Today’s plan
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The capital structure without corporate taxes
Valuing risky corporate bonds
Capital structure with corporate taxes
Two theories for the optimal capital structure
in the real world.
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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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Capital structure
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Capital structure refers to the mix of debt
and equity of a firm.
Capital structure has two related
questions:
• Does the capital structure affect the value of a
•
firm? Or does the amount of debt a firm has
affect its value?
What is the optimal amount of debt a firm
should have?
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Capital structure
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Does the size of a pizza have nothing to
do with how it is sliced?
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Is the value of a firm also independent of
how the firm mixes debt and equity?
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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
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Equity
wasted
Debt
Govt.
Slicing the pie can
affect the size of the
wasted slice
Capital structure without
corporate taxes
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If there is no corporate tax, we will have
the following two famous results
• M&M propositions 1 and 2
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Pay attention to the condition for these
propositions to be valid
Why do we consider such simple,
unrealistic situations?
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MM’s proposition 1 (without tax)
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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.
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What is the intuition for this result?
Can we use different ways to prove this?
FIN 819
MM’s proposition 2 (without tax)
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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 a constant.
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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
State of the Economy
Operating Income
Slump
Expected
$75,000 125,000
Boom
175,000
Earnings per share
Return on shares
$.75
7.5%
1.75
17.5%
1.25
12.5%
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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
50,000
$10
$ 500,000
$ 500,000
Outcome
Operating Income
Interest
Equity earnings
Earnings per share
Return on shares
State of the Economy
Slump
$75,000
$50,000
$25,000
$.50
5%
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Expected
125,000
50,000
75,000
1.50
15%
Boom
175,000
50,000
125,000
2.50
25%
WACC without taxes in MM’s view
rE
r
WACC
rD
D
V
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Valuing risky debt
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So far, we have learned how to value a riskfree debt. By risk-free debt, we mean that bond
investors always get paid for what they are
promised when they lend money to firms or
governments.
In reality, corporate bonds are not risk-free.
When firms borrow money from the bond
holders, they may not have enough cash to
pay the bond holders in the future.
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Valuing risky debt
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To illustrate how to value a risky debt, we
focus on a simple situation:
• Firms have a zero-coupon bond.
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More specific, suppose that a firm has
issued $K million zero-coupon bonds
maturing at time T. Let the market value
of the firm asset at time T be V(T).
FIN 819
Valuing risky corporate debts
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Using the put-call parity, we have
D  Ke
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r f T
 P( K , T )
Where P(K,T) is the value of a European
put option with the strike price K and the
maturity date T
Please try to derive this formula and
understand this situation?
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Example
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Problem: On march 4, 1994, Chrysler was the eighth
largest U.S. firm according to Fortune magazine. It
issued 20-years zero-coupon debt with book value of
$36.994 billion. The book value of the asset is $43.83
billion and the market value of equity is $21.0468
billions. The risk free rate was 8% and the volatility of
the asset return is 30%.
•
•
What is the market value of the debt?
What is the interest rate charged on Chrysler’s debt?
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Solution
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The market value of the debt is $5.98
million
The interest rate charge on Chrysler’s
debt is 9.11%.
The market value of the asset is $27.03
million
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Capital structure with taxes
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If there is corporate tax, we also have
two famous results:
• M&M propositions 1 and 2
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Remember that to make the two
propositions valid, we still have to
assume that the investment opportunity
is fixed and the financial market
functions very well.
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MM’s propositions withtax
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MM’s proposition 1
• firm value = value of all equity firm + PV (tax
shield)
• PV(tax shield)=TcD
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MM’s proposition 2
•
•
The weighted average cost of capital is decreasing
with the ratio of D/E, and the cost of equity is
increasing with D/E.
Can you prove and understand these results?
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WACC Graph
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Optimal Capital structure with
tax
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So according to M&M proposition 1 with
tax, the optimal capital structure is that
firms issue all the debt.
In the real world, very few firms issue
all the debt to raise money
What is wrong with M&M propositions?
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Capital structure with financial
distress cost
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
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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.
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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
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