Download Chapter 17 -- Capital Structure Determination

Chapter 17
Capital Structure
Determination
17.1
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
After Studying Chapter 17,
you should be able to:
1.
2.
3.
4.
5.
6.
7.
17.2
Define “capital structure.”
Explain the net operating income (NOI) approach to capital
structure and valuation of a firm; and, calculate a firm's value
using this approach.
Explain the traditional approach to capital structure and the
valuation of a firm.
Discuss the relationship between financial leverage and the cost
of capital as originally set forth by Modigliani and Miller (M&M)
and evaluate their arguments.
Describe various market imperfections and other "real world"
factors that tend to dilute M&M’s original position.
Present a number of reasonable arguments for believing that an
optimal capital structure exists in theory.
Explain how financial structure changes can be used for
financial signaling purposes, and give some examples.
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
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
17.3
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
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.
17.4
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
A Conceptual Look –
Relevant Rates of Return
ki = the yield on the company’s debt
ki
=
I
B
=
Annual interest on debt
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.)
17.5
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
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 =
Market value of common
S
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
17.6
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
A Conceptual Look –
Relevant Rates of Return
ko = an overall capitalization rate for the firm
ko
O
O
=
V
V
Net operating income
= Total market value of the firm
Assumptions:
• V = B + S = total market value of the firm
• O = I + E = net operating income = interest
paid plus earnings available to common
shareholders
17.7
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Capitalization Rate
Capitalization Rate, ko – The discount rate
used to determine the present value of a
stream of expected cash flows.
ko = ki
B
B+S
+
ke
S
B+S
What happens to ki, ke, and ko
when leverage, B/S, increases?
17.8
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
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%
17.9
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Required Rate of
Return on Equity
Calculating the required rate of return on equity
Total firm value
= O / ko
= $9,000
= $1,350 / 0.15
Market value
of equity
=V–B
= $7,200
= $9,000 – $1,800
Required return
on equity*
=E/S
= ($1,350 – $180) / $7,200
= 16.25%
Interest payments
= $1,800 × 10%
* B / S = $1,800 / $7,200 = 0.25
17.10
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Required Rate of
Return on Equity
What is the rate of return on equity if B=$3,000?
Total firm value
= O / ko
= $9,000
= $1,350 / 0.15
Market value
of equity
=V–B
= $6,000
= $9,000 – $3,000
Required return
on equity*
=E/S
= ($1,350 - $300) / $6,000
= 17.50%
Interest payments
= $3,000 × 10%
* B / S = $3,000 / $6,000 = 0.50
17.11
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
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
0.00
0.25
0.50
1.00
2.00
ki
—
10%
10%
10%
10%
ke
15.00%
16.25%
17.50%
20.00%
25.00%
ko
15%
15%
15%
15%
15%
Calculated in slides 9 and 10
17.12
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Required Rate of
Return on Equity
Capital costs and the NOI approach in a
graphical representation.
Capital Costs (%)
0.25
ke = 16.25% and
17.5% respectively
0.20
ke (Required return on equity)
0.15
ko (Capitalization rate)
0.10
ki (Yield on debt)
0.05
0
0
17.13
0.25
0.50
0.75
1.0 1.25 1.50
Financial Leverage (B/S)
1.75
2.0
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Excel & the NOI Approach
NOI Approach
You can create
this type of
analysis in
Excel also. You
can use some
modeling
experience to
write formulas
to calculate the
required rates.
Refer to “VW13E17.xlsx” on the ‘NOI
Approach’ tab
17.14
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
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.
17.15
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
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.
17.16
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Optimal Capital Structure:
Traditional Approach
Traditional Approach
ke
Capital Costs (%)
0.25
ko
0.20
0.15
ki
0.10
Optimal Capital Structure
0.05
0
Financial Leverage (B / S)
17.17
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Excel and the
Traditional Approach
Traditional
Approach
You can create this
type of analysis in
Excel also. We use
some assumptions
in this model built
into the formulas.
Refer to “VW13E17.xlsx” on the
‘Traditional
Approach’ tab
17.18
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
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).
•
17.19
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Total Value Principle:
Modigliani and Miller (M&M)
•
•
•
•
17.20
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.
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Total Value Principle:
Modigliani and Miller
Market value
of debt ($35M)
Market value
of debt ($65M)
Market value
of equity ($65M)
Market value
of equity ($35M)
Total firm market
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.
•
17.21
Total firm market
value ($100M)
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
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.
17.22
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Arbitrage Example
Consider two firms that are identical
in every respect EXCEPT:
•
•
•
•
•
17.23
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
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Arbitrage Example:
Company NL
Valuation of Company NL
Earnings available to
common shareholders
Market value
of equity
Total market value
Overall capitalization rate
Debt-to-equity ratio
17.24
=E =O–I
= $10,000 - $0
= $10,000
= E / ke
= $10,000 / 0 .15
= $66,667
= $66,667 + $0
= $66,667
= 15%
=0
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Arbitrage Example:
Company L
Valuation of Company L
Earnings available to
common shareholders
Market value
of equity
Total market value
Overall capitalization rate
Debt-to-equity ratio
17.25
=E =O–I
= $10,000 – $3,600
= $6,400
= E / ke
= $6,400 / 0.16
= $40,000
= $40,000 + $30,000
= $70,000
= 14.3%
= 0.75
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Completing an
Arbitrage Transaction
Assume you own 1% of the stock of
Company L (equity value = $400).
You should:
17.26
•
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).
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Completing an
Arbitrage Transaction
Original return on investment in Company L
$400 × 16% = $64
Return on investment after the transaction
• $666.67 × 16% = $100 return on Company NL
• $300 × 12% = $36 interest paid
• $64 net return ($100 – $36) AND $33.33 left over.
This reduces the required net investment to
$366.67 to earn $64.
17.27
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
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.
17.28
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Market Imperfections
and Incentive Issues
17.29
•
Bankruptcy costs (Slide 17–30)
•
Agency costs (Slide 17–31)
•
Debt and the incentive to manage
efficiently
•
Institutional restrictions
•
Transaction costs
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Required Rate of Return
on Equity with Bankruptcy
Required Rate of Return
on Equity (ke)
ke with bankruptcy costs
Premium
for financial
risk
ke with no leverage
ke without bankruptcy costs
Premium
for business
risk
Rf
Risk-free
rate
Financial Leverage (B / S)
17.30
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
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.
17.31
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
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:
•
•
•
•
17.32
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
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Corporate Tax Example:
Company ND
Valuation of Company ND (Note: has no debt)
Earnings available to
common shareholders
Tax Rate (T)
Income available to
common shareholders
Total income available to
all security holders
17.33
=E =O–I
= $2,000 – $0
= $2,000
= 40%
= EACS (1 – T)
= $2,000 (1 – 0.4)
= $1,200
= EAT + I
= $1,200 + 0
= $1,200
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Corporate Tax Example:
Company D
Valuation of Company D (Note: has some debt)
Earnings available to
common shareholders
Tax Rate (T)
Income available to
common shareholders
Total income available to
all security holders
=E =O–I
= $2,000 – $600
= $1,400
= 40%
= EACS (1 – T)
= $1,400 (1 – 0.4)
= $840
= EAT + I
= $840 + $600
= $1,440*
* $240 annual tax-shield benefit of debt (i.e., $1,440 - $1,200)
17.34
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
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
of debt*
=
(r) (B) (tc)
r
=
($5,000) (0.4) =
=
(B) (tc)
$2,000**
* Permanent debt, so treated as a perpetuity
** Alternatively, $240 annual tax shield / 0.12 = $2,000, where
$240=$600 Interest expense × 0.40 tax rate.
17.35
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Value of the Levered Firm
Value of
levered
firm
=
Value of
firm if
+
unlevered
Present value of
tax-shield benefits
of debt
Value of unlevered firm
(Company ND)
= $1,200 / 0.16
= $7,500*
Value of levered firm
(Company D)
= $7,500 + $2,000
= $9,500
* Assuming zero growth and 100% dividend payout
17.36
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Summary of
Corporate Tax Effects
• The greater the amount of debt, the greater the taxshield 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.
• This implies a capital structure of almost 100%
debt! Yet, this is not consistent with actual
behavior.
17.37
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
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%.
17.38
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
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.
17.39
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Cost of Capital (%)
Bankruptcy Costs,
Agency Costs, and Taxes
Minimum Cost
of Capital Point
Taxes, bankruptcy, and
agency costs combined
Net tax effect
Optimal Financial Leverage
Financial Leverage (B/S)
17.40
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
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.
• This is a valid signal because of the possibility of
bankruptcy.
17.41
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Timing and Flexibility
1.
2.
Timing
•
After appropriate capital structure determined it is still
difficult to decide when to issue debt or equity and in
what order
•
Factors considered include the current and expected
health of the firm and market conditions.
Flexibility
•
•
17.42
A decision today impacts the options open to the firm for
future financing options – thereby reducing flexibility.
Often referred to unused debt capacity.
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Checklist of Practical and
Conceptual Considerations
Taxes
•
Explicit cost
•
Cash-flow ability to •
service debt
•
Agency costs and
•
incentive issues
•
17.43
•
•
•
Financial signaling •
EBIT-EPS
analysis
Capital structure
ratios
Security rating
Timing
Flexibility
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.