Capital Structure Policy

• Chapter 15: 1,3,7,11,14,19

• Chapter 16: 2,5,6,16

I. Modigliani-Miller (MM) Capital Structure Propositions

Assumptions include:

Homogeneous expectations Perpetual cash flows: V = CF/rPerfect capital markets:

No taxes, transaction costs, costs of distressFirms and investors borrow and lend at the same rate rB

MM Proposition I: VL = VU

MM Propositions II: rS = r0 + B/S(r0 - rB) , where r0 is the cost of capital for an all equity firm.

The Impact of Financial Leverage: Financial Leverage, EPS and ROE

Current Proposed

Assets $5,000,000 $5,000,000

Debt $0 $2,500,000

Equity $5,000,000 $2,500,000

Debt/Equity ratio 0 1

Share price $10 $10

Shares outstanding 500,000 250,000

Interest rate na 10%

EPS and ROE under current capital structure

Recession Expected Expansion

EBIT $300,000 $650,000 $800,000

Interest $0 $0 $0

Net Income $300,000 $650,000 $800,000

EPS $0.60 $1.30 $1.60

ROE 6% 13% 16%

EPS and ROE under proposed capital structure

Recession Expected Expansion

EBIT $300,000 $650,000 $800,000

Interest $250,000 $250,000 $250,000

Net Income $50,000 $400,000 $550,000

EPS $0.20 $1.60 $2.20

ROE 2% 16% 22%

Ignoring taxes for the moment, consider

the following 2 alternatives Firm does not adopt proposed capital structure.

An investor puts up $500 and borrows $500 to buy 100 shares

EPS of $0.60 $1.30 $1.60 unlevered firm

Earnings for $60.00 $130.00 $160.00

100 shares

less interest on $50.00 $50.00 $50.00

$500 at 10%

Net earnings $10.00 $80.00 $110.00

ROE 2% 16% 22%

The ROE is the same as that of the levered firm.

Firm adopts proposed capital structure.

An investor puts up $500, $250 in stock and $250 in bonds EPS of $0.20 $1.60 $2.20 levered firm

Earnings for $5.00 $40.00 $55.00 25 shares

plus interest on $25.00 $25.00 $25.00 $250 at 10%

Net earnings $30.00 $65.00 $80.00

ROE 6% 13% 16%

The ROE is the same as that of the unlevered firm.

M&M Proposition II: With no taxes, WACC = R0 = (S/V) x RS + (B/V) x RB .Solving for RS,

RS = R0 + (R0 - RB) x (B/S)

Cost of Capital

(figure 15.3)

R0

RS=R0+(R0-RB) x B/S

RWACC

RB

B/S

15.7Rayburn Manufacturing is currently an all equity firm.

The firm’s equity is worth $2 million. The cost of that equity is 18 percent. Rayburn pays no taxes.

Rayburn plans to issue $400,000 in debt and to use the proceeds to repurchase stock. The cost of debt is 10 percent.

a) After Rayburn repurchases the stock, what will the firm’s overall cost of capital be?

b) After the repurchase, what will the cost of equity be?c) Explain you result in (b).

15.9The Gulf Power Company is an electric utility that is planning to build a

new conventional power plant. The company has traditionally paid out all earning to the stockholders as dividends, and has financed capital expenditures with new issues of common stock. There is no debt or preferred stock presently outstanding. Data on the company and the new power plant follow. Assume all earnings streams are perpetuities.

Company data: Current annual earnings: $27 million# outstanding shares: $10 million

New Power Plant: Initial outlay: $20 millionAdded annual earnings: $3 million

Management considers the power plant to have the same risk as existing assets. The current required rate of return on equity is 10 percent. Assume there are no taxes and no costs of bankruptcy.

What will the total market value of Gulf Power be if common stock is issued to finance the plant?

What will the total market value of the firm be if $20 million in bonds with an interest rate of 8 percent are issued to finance the plant? Assume the bonds are perpetuities.

Suppose Gulf Power issues the bonds. Calculate the rate of return required by stockholders after the financing has occurred and the plant has been built.

II. Modigliani Miller with Corporate Taxes (Tc)

PV of the interest tax shield = (TC x RB x B)/RB = TC x B.

VL = EBIT*(1-TC)/R0 + TCRBB/RB = VU + TCB

Proposition II becomes:

RS = R0 + (R0 - RB) x (B/S) x (1-TC)

Cost of Capital

(figure 15.6)

R0

RS=R0+(1-TC)(R0-RB) x B/S

RWACC

RB

B/S

15.17

Streiber Publishing Company, an all-equity firm, generates perpetual earnings before interest and taxes (EBIT) of $2.5 million per year. Streiber’s after tax, all-equity discount rate is 20 percent. The company’s tax rate is 34 percent.

a) What is the value of Streiber Publishing?b) If Streiber adjusts its capital structure to include

$600,000 of debt, what is the value of the firm?c) What assumptions are you making when you

are valuing Streiber?

III. Limits to use of debt: bankruptcy & distress costs.

An optimal capital structure will balance the valuable interest tax shield against the higher probability of facing bankruptcy costs.

Expected costs of distress = probability of distress x distress costs

Direct costs of financial distressIndirect costs of financial distressAgency costs of debt & equity

Agency costs of debt: Overinvestment in risky projects

• Tri-State Paving, Inc.– Owners-managers literally took all of the company’s cash to Las Vegas in an

attempt to win enough money “to pay the corporate-debtor’s creditors and solve the financial problems of all three debtors ...”

• Continental Airlines.– Frank Lorenzo’s Texas Air purchased a controlling interest in Continental

Airlines cheaply when the latter was already in serious financial difficulty. Continental filed Chapter 11, locked the union out, and attempted to hire a new, non-union labor force while selling tickets to anywhere in the US for $49. Creditors opposed the scheme. Had it been unsuccessful, they would have born most of the cost

• Sambo’s Restaurants.– While In Chapter 11, Sambo’s Restaurants borrowed against its

unencumbered assets and invested the money in changing the name, look, and concept of its restaurants. The gamble failed, the money was lost, and unsecured creditors ended up with only about 11 cents on the dollar

• Storage Technology– Storage Technology brought a new data-storage device to the market during

its Chapter 11 case. The produce was so successful that the company was solvent with a substantial cushion of equity by the time it emerged.

IV. Empirical Implications of Capital Structure Theories

Effects of changing capital structure

Stock repurchases

Debt/equity swaps

Factors to consider in establishing a capital structure: Taxes

Type of assets

Uncertainty of operating income

Pecking order and financial slack

Example: Optimal capital structureFirm invests $500,000 in PPE, WC; generates EBIT of $120,000 in perpetuity100% dividend payout; capex = depreciation; no sales growth; tax rate = .5

1 Debt in capital structure

0% 10% 20% 30% 40% 50%

2 EBIT $120,000 $120,000 $120,000

$120,000 $120,000 $120,000

3 Interest 0 4,125 8,750 14,625 22,000 31,250

4 Profit before tax 120,000 115,875 111,250 105,375 98,000 88,750

5 Tax 60,000 57,938 55,625 52,688 49,000 44,375

6 Profit after tax 60,000 57,938 55,625 52,688 49,000 44,375

7 Dividends 60,000 57,938 55,625 52,688 49,000 44,375

8 Total pmts to security holders

60,000 62,063 64,375 67,313 71,000 75,625

9 Cost of debt 8.00% 8.25% 8.75% 9.75% 11.00% 12.50%

10 Cost of equity 12.00% 12.50% 13.00% 13.50% 14.50% 16.00%

11 Market value of debt 0 50,000 100,000 150,000 200,000 250,000

12 Market value of equity

500,000 463,500 427,885 390,278 337,931 277,344

13 Market value of firm 500,000 513,500 527,885 540,278 537,931 527,344

14. Book value of debt 0 50,000 100,000 150,000 200,000 250,000

15. Book value of equity 500,000 450,000 400,000 350,000 300,000 250,000

16. Book value of firm 500,000 500,000 500,000 500,000 500,000 500,000

17. Return on total capital 12.0% 12.4% 12.9% 13.5% 14.2% 15.1%

18. Return on equity 12.0% 12.9% 13.9% 15.1% 16.3% 17.8%

19. Number of shares outstanding

5,000 4,513 4,053 3,612 3,141 2,630

20. Price per share $100.00 $102.70 $105.58 $108.06 $107.59 $105.47

21. EPS $12.00 $12.84 $13.73 $14.59 $15.60 $16.88

22. PE ratio $8.33 $8.00 $7.69 $7.41 $6.90 $6.25

23. Book value debt ratio 0.0% 10.0% 20.0% 30.0% 40.0% 50.0%

24. Market value debt ratio 0.0% 9.7% 18.9% 27.8% 37.2% 47.4%

25. WACC 12.0% 11.7% 11.4% 11.1% 11.2% 11.4%

26. FCF $60,000 $60,000 $60,000 $60,000 $60,000 $60,000

27. Market value of firm $500,000 $513,500 $527,885 $540,278 $537,931 $527,344

V. Implementing capital structure models.

Operating income approach

Cost of capital approach**

APV (adjusted present value) approach**

Comparables approach