1 copyright 1996 by the mcgraw-hill companies, inc capital structure
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Copyright 1996 by The McGraw-Hill Companies, Inc
Capital StructureCapital Structure
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Copyright 1996 by The McGraw-Hill Companies, Inc
MODIGLIANI AND MILLERMODIGLIANI AND MILLER
ANY COMBINATION OF SECURITIES IS AS GOOD AS ANY OTHER
EXAMPLE: TWO FIRMS, SAME OPERATING INCOME– DIFFER ONLY IN CAPITAL
STRUCTURE
– FIRM U UNLEVERED, VU = EU
– FIRM L IS LEVERED, EL = VL - DL
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Copyright 1996 by The McGraw-Hill Companies, Inc
MODIGLIANI AND MILLERMODIGLIANI AND MILLERTWO STRATEGIESSTRATEGY 1
– BUY 1% OF FIRM U’s EQUITY– DOLLAR INVESTMENT .01 VU
– DOLLAR RETURN .01 PROFITSSTRATEGY 2
– BUY 1% OF FIRM L’s EQUITY AND DEBT– DOLLAR INVESTMENT .01DL + .01EL = .01VL
– DOLLAR RETURN FROM OWNING 01DL .01 INTEREST
FROM OWNING .01EL .01 (PROFITS - INTEREST)TOTAL .01 PROFITS
BOTH STRATEGIES HAVE SAME PAYOFF
– SAME PRICE, VU = VL
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Copyright 1996 by The McGraw-Hill Companies, Inc
MODIGLIANI AND MILLERMODIGLIANI AND MILLER
STRATEGY 3– BUY 1% OF FIRM L’s EQUITY– DOLLAR INVESTMENT .01 EL = .01(VL - DL)– DOLLAR RETURN .01 (PROFITS - INTEREST)
STRATEGY 4– BUY 1% OF FIRM U’s EQUITY– BORROW ON YOUR OWN ACCOUNT .01DL
– DOLLAR INVESTMENT .01(VU - DL)– DOLLAR RETURN
FROM BORROWING 01DL -.01 INTEREST FROM OWNING .01EL .01 (PROFITS
TOTAL .01 (PROFITS-INTEREST)BOTH STRATEGIES AGAIN PROMISE SAME PAYOFFMUST HAVE SAME COST
.01(VL - DL) = .01(VU - DL) AND VU = VL
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Copyright 1996 by The McGraw-Hill Companies, Inc
MODIGLIANI AND MILLERMODIGLIANI AND MILLER
DOESN’T MATTER WHAT RISK PREFERENCES ARE OF INVESTORS
ONLY CONDITION IS THAT INVESTORS CAN BORROW OR LEND FOR THEIR OWN ACCOUNT
– UNDO EFFECT OF ANY CHANGES IN FIRM’S CAPITAL STRUCTURE
MM PROPOSITION 1
– VALUE OF FIRM INDEPENDENT OF ITS CAPITAL STRUCTURE
– CAN ALSO BE PROVED USING CAPM (APPENDIX)
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Copyright 1996 by The McGraw-Hill Companies, Inc
VALUE ADDITIVITYVALUE ADDITIVITY
WE CAN SLICE A CASH FLOW INTO AS MANY PARTS AS WE LIKE– SUM OF THE PRESENT VALUE OF THE PARTS
ALWAYS EQUAL TO PRESENT VALUE OF THE ORIGINAL STREAM
– LAW OF CONSERVATION OF VALUEFIRM VALUE IS DETERMINED BY LEFT HAND SIDE OF
BALANCE SHEET BY REAL ASSETS– REGARDLESS OF CLAIMS AGAINST IT
SHOULD FIRM ISSUE PREFERRED OR COMMON STOCK?– PROPOSITION 1 SAYS CHOICE IS IRRELEVANT– IF IT DOESN’T AFFECT INVESTMENT, BORROWING
AND OPERATING POLICIES
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Copyright 1996 by The McGraw-Hill Companies, Inc
HOW LEVERAGE AFFECTS RETURNSHOW LEVERAGE AFFECTS RETURNS
EXPECTED RETURN ON THE ASSETS OF A FIRM
rA = EXPECTED OPERATING INCOME MARKET VALUE OF ALL SECURITIES
SUPPOSE INVESTOR HOLDS ALL DEBT AND EQUITY OF THE COMPANY
EXPECTED RETURN ON PORTFOLIO, rA , IS WEIGHTED AVERAGE OF EXPECTED RETURNS ON INDIVIDUAL SECURITIES
rA = (D/D+E)rD + (E/D+E)rE
rE = rA + (D/E)(rA - rD) MM PROPOSITION 2EXPECTED RETURN ON EQUITY
= EXPECTED RETURN ON ASSETS + DEBT - EQUITY RATIO x (EXPECTED RETURN ON ASSETS
-EXPECTED RETURN ON DEBT)
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Copyright 1996 by The McGraw-Hill Companies, Inc
LEVERAGE AND THE EXPECTED RETURN ON EQUITY
LEVERAGE AND THE EXPECTED RETURN ON EQUITY
AS LEVERAGE INCREASES, VA AND rA ARE UNCHANGED BUT THE EXPECTED RETURN ON EQUITY INCREASES
FOR RISKY DEBT, rD INCREASES AS LEVERAGE INCREASES
Debt-equity ratio (D/E)
Expected returnrE
rD
rA
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Copyright 1996 by The McGraw-Hill Companies, Inc
rErE
INCREASE IN EXPECTED EQUITY RETURN REFLECTS INCREASED RISK
INCREASE IN LEVERAGE INCREASES AMPLITUDE OF VARIATIONS IN CASH FLOWS AVAILABLE TO SHAREHOLDERS– SAME CHANGE IN OPERATING INCOME NOW
DISTRIBUTED AMONG FEWER SHARESWE CAN UNDERSTAND THE INCREASED RISK IN
TERMS OF s
WE KNOW THAT
A = (D/D + E)D + (E/D + E)E
E = A + (D/E)(A - D )
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Copyright 1996 by The McGraw-Hill Companies, Inc
INTEREST TAX SHIELDINTEREST TAX SHIELD
DISCOUNT INTEREST TAX SHIELD AT EXPECTED RATE OF RETURN DEMANDED BY INVESTORS HOLDING THE FIRM’S DEBT
PV (TAX SHIELD) = 28/.08 = $350MORE GENERALLY,
PV (TAX SHIELD)
= TAX RATE x INTEREST PAYMENT / DISCOUNT RATE
= TC (rDD) /rD
= TC DVALUE OF FIRM INCREASES BY PV(TAX SHIELD)
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Copyright 1996 by The McGraw-Hill Companies, Inc
INTEREST TAX SHIELDINTEREST TAX SHIELD
WHY DID WE SEEM TO DISCOUNT TAX SHIELD BY PRE-TAX INTEREST RATE OF 8%?
PERSONAL TAXES REDUCE THE VALUE OF THE TAX-SHIELD TO THE INVESTOR
BUT THE APPROPRIATE AFTER-TAX DISCOUNT RATE IS ALSO LOWER
PV (TAX SHIELD = TC (rDD)(1-TP) / rD(1-TP)
= TC D
WHICH WAS OUR ORIGINAL FORMULA
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Copyright 1996 by The McGraw-Hill Companies, Inc
MM PROPOSITION 1 WITH TAXESMM PROPOSITION 1 WITH TAXES
VALUE OF FIRM
= VALUE IF ALL-EQUITY-FINANCED + PV(TAX SHIELD)
SPECIAL CASE OF PERMANENT DEBTVALUE OF FIRM = VALUE IF ALL-EQUITY-FINANCED
+TCD
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Copyright 1996 by The McGraw-Hill Companies, Inc
COSTS OF FINANCIAL DISTRESSCOSTS OF FINANCIAL DISTRESS
FIRM HAS DIFFICULTY MEETING ITS FINANCIAL OBLIGATIONS– OR CANNOT MEET ITS OBLIGATIONS– SOMETIMES LEADS TO BANKRUPTCY
INVESTORS MAY BE CONCERNED THAT LEVERED FIRM MAY FALL INTO FINANCIAL DISTRESSVALUE OF FIRM
= VALUE IF ALL EQUITY-FINANCED+ PV(TAX SHIELD)- PV(COSTS OF FINANCIAL DISTRESS)
COSTS OF FINANCIAL DISTRESS DEPEND ON:– PROBABILITY OF DISTRESS– MAGNITUDE OF COSTS ENCOUNTERED IF DISTRESS
OCCURS
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Copyright 1996 by The McGraw-Hill Companies, Inc
COSTS OF FINANCIAL DISTRESS REDUCE
THE OPTIMAL DEBT RATIO
COSTS OF FINANCIAL DISTRESS REDUCE
THE OPTIMAL DEBT RATIOFirm Value PV Tax Shield
PV Costs Of Distress
Debt Ratio
Optimum
Value of levered firm
Value If All Equity Financed
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Copyright 1996 by The McGraw-Hill Companies, Inc
OPTIMAL CAPITAL STRUCTUREOPTIMAL CAPITAL STRUCTURE
PV OF TAX SHIELD GRADUALLY INCREASES AS FIRM BORROWS MORE
AT MODERATE DEBT LEVELS PV(FINANCIAL DISTRESS) SMALL– TAX ADVANTAGES DOMINATE
WITH MORE DEBT, PROBABILITY OF FINANCIAL DISTRESS INCREASES– ALSO TAX ADVANTAGE OF DEBT STARTS
TO DECLINE AS FIRM CAN NO LONGER BE SURE OF PROFITING FROM THE TAX SHIELD IN ALL STATES OF THE WORLD
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Copyright 1996 by The McGraw-Hill Companies, Inc
COSTS OF FINANCIAL DISTRESSCOSTS OF FINANCIAL DISTRESS
BANKRUPTCY COSTSCORPORATE BANKRUPTCY OCCURS WHEN
STOCKHOLDERS EXERCISE THEIR RIGHT TO DEFAULT– VALUABLE RIGHT– WHEN A FIRM GETS INTO TROUBLE,
STOCKHOLDERS CAN WALK AWAY– FORMER CREDITORS BECOME THE NEW
STOCKHOLDERS
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Copyright 1996 by The McGraw-Hill Companies, Inc
COSTS OF DISTRESS VARY WITH TYPE OF ASSET
COSTS OF DISTRESS VARY WITH TYPE OF ASSET
YOUR COMPANY OWNS HOTEL– OCCUPANCY FALLS– FIRM GOES BANKRUPT
MORTGAGE HOLDER SELLS TO NEW OWNER– LOW BANKRUPTCY COSTS – LEGAL AND COURT FEES
HOTEL BUSINESS UNAFFECTED BY BANKRUPTCY
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Copyright 1996 by The McGraw-Hill Companies, Inc
COSTS OF DISTRESS VARY WITH TYPE OF ASSET
COSTS OF DISTRESS VARY WITH TYPE OF ASSET
YOUR COMPANY OWNS ELECTRONICS COMPANYSTOCKHOLDERS MAY BE UNWILLING TO PROVIDE
MORE CAPITAL IN FINANCIAL DISTRESS– MORE SERIOUS THAN FOR HOTEL
IF COMPANY GOES BANKRUPT– CREDITOR WOULD HAVE DIFFICULTY SELLING OFF
ASSETS– MANY ASSETS INTANGIBLE
ALSO DIFFICULT IN CARRYING ON AS GOING CONCERN– ODDS OF DEFECTIONS BY KEY EMPLOYEES– ASSURANCES TO CUSTOMERS THAT FIRM WILL BE
AROUND TO SERVICE ITS PRODUCTS
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Copyright 1996 by The McGraw-Hill Companies, Inc
COSTS OF DISTRESS VARY WITH TYPE OF ASSET
COSTS OF DISTRESS VARY WITH TYPE OF ASSET
SOME ASSETS, LIKE COMMERCIAL REAL ESTATE, CAN GO THROUGH BANKRUPTCY LARGELY UNSCATHED
BUT COMPANIES WITH INTANGIBLE ASSETS THAT ARE INTEGRAL PART OF FIRM AS GOING CONCERN SUFFER MAJOR LOSS IN BANKRUPTCY
REASON DEBT-EQUITY RATIOS LOW IN PHARMACEUTICAL INDUSTRY– NEEDS CONTINUED R&D
DEBT-EQUITY RATIOS ALSO LOW IN MANY SERVICE INDUSTRIES– INTANGIBLE INVESTMENTS IN HUMAN CAPITAL
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Copyright 1996 by The McGraw-Hill Companies, Inc
PECKING ORDER OF FINANCING CHOICES
PECKING ORDER OF FINANCING CHOICES
MANAGERS KNOW MORE ABOUT THEIR FIRM THAN OUTSIDERS– PROSPECTS, RISKS
ASYMMETRIC INFORMATION– MANAGERS KNOW MORE THAN INVESTORS– DIVIDEND SIGNALING
– INVESTORS INTERPRET INCREASE IN DIVIDEND AS SIGN OF MANAGEMENT CONFIDENCE
ASYMMETRIC INFORMATION AFFECTS CHOICE BETWEEN– INTERNAL VS EXTERNAL FINANCING– ISSUING DEBT VS EQUITY
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Copyright 1996 by The McGraw-Hill Companies, Inc
PECKING ORDERPECKING ORDER
LEADS TO FOLLOWING PECKING ORDER– INVESTMENTS FIRST FINANCED
WITH– INTERNAL FUNDS– NEW DEBT– NEW EQUITY
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Copyright 1996 by The McGraw-Hill Companies, Inc
Financial Choices
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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Copyright 1996 by The McGraw-Hill Companies, Inc
Trade Off Theory & PricesTrade Off Theory & Prices
1. Stock-for-debt Stock price
exchange offers falls
Debt-for-stock Stock price
exchange offers rises
2. Issuing common stock drives down stock prices; repurchase increases stock prices.
3. Issuing straight debt has a small negative impact.
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Copyright 1996 by The McGraw-Hill Companies, Inc
Issues and Stock PricesIssues and Stock Prices
Why do security issues affect stock price? The demand for a firm’s securities ought to be flat.
Any firm is a drop in the bucket.
Plenty of close substitutes.
Large debt issues don’t significantly depress the stock price.
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Copyright 1996 by The McGraw-Hill Companies, Inc
Pecking Order TheoryPecking Order Theory
Consider the following story:
The announcement of a stock issue drives down the stock price because investors believe managers are more likely to issue when shares are overpriced.
Therefore firms prefer internal finance since funds can be raised without sending adverse signals.
If external finance is required, firms issue debt first and equity as a last resort.
The most profitable firms borrow less not because they have lower target debt ratios but because they don't need external finance.
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Copyright 1996 by The McGraw-Hill Companies, Inc
Pecking Order TheoryPecking Order Theory
Some Implications: Internal equity may be better than external equity.
Financial slack is valuable.
If external capital is required, debt is better. (There is less room for difference in opinions about what debt is worth).