chapter 2- capital structure determination. after studying this chapter, you should be able to:...
TRANSCRIPT
Chapter 2- Capital Structure
Determination
Chapter 2- Capital Structure
Determination
After studying this chapter, you should be able to:
• 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.
Capital Structure
– 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.
Capital Structure -- The mix (or proportion) of a firm’s permanent long-term financing represented by debt,
preferred stock, and common stock equity.
A Conceptual Look --Relevant Rates of Return
ki = the yield on the company’s debt
Annual interest on debtMarket value of debt
IB ==ki
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.)
ES
A Conceptual Look --Relevant Rates of Return
==
ke = the expected return on the company’s equityEarnings available to
common shareholdersMarket value of common
stock outstanding
ke
Assumptions:• Earnings are not expected to grow• 100% dividend payout• Results in the valuation of a perpetuity
ES
OV
A Conceptual Look --Relevant Rates of Return
==
ko = an overall capitalization rate for the firm
Net operating incomeTotal market value of the firmko
Assumptions:• V = B + S = total market value of the firm• O = I + E = net operating income = interest paid
plus earnings available to common shareholders
OV
Capitalization Rate
Capitalization Rate, ko -- The discount rate used to determine the present value of a stream of expected
cash flows.
ko kekiB
B + SS
B + S= +
What happens to ki, ke, and ko when leverage, B/S, increases?
Net Operating Income Approach
Assume:– Net operating income equals $1,350– Market value of debt is $1,800 at 10% interest– Overall capitalization rate is 15%
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.
Required Rate of Return on Equity
Total firm value = O / ko = $1,350 / .15= $9,000
Market value = V - B = $9,000 - $1,800 of equity = $7,200
Required return = E / S on equity*= ($1,350 - $180) / $7,200
= 16.25%
Calculating the required rate of return on equity
* B / S = $1,800 / $7,200 = .25
Interest payments = $1,800 x 10%
Total firm value = O / ko = $1,350 / .15= $9,000
Market value = V - B = $9,000 - $3,000 of equity = $6,000
Required return = E / S on equity*= ($1,350 - $300) / $6,000
= 17.50%
Required Rate of Return on Equity
What is the rate of return on equity if B=$3,000?
* B / S = $3,000 / $6,000 = .50
Interest payments = $3,000 x 10%
B / S ki ke ko
0.00 --- 15.00% 15% 0.25 10% 16.25% 15% 0.50 10% 17.50% 15% 1.00 10% 20.00% 15% 2.00 10% 25.00% 15%
Required Rate of Return on Equity
Examine a variety of different debt-to-equity ratios and the resulting required rate of return on equity.
Calculated in slides 9 and 10
Required Rate of Return on Equity
Capital costs and the NOI approach in a graphical representation.
0 .25 .50 .75 1.0 1.25 1.50 1.75 2.0Financial Leverage (B / S)
.25
.20
.15
.10
.05
0
Capi
tal C
osts
(%)
ke = 16.25% and17.5% respectively
ki (Yield on debt)
ko (Capitalization rate)
ke (Required return on equity)
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.
Traditional Approach
Optimal Capital Structure -- The capital structure that minimizes the firm’s cost of capital and thereby maximizes the value of the firm.
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.
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).
Total Value Principle: Modigliani and Miller (M&M)
• 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.
Market value of debt ($65M)
Market value of equity ($35M)
Total firm marketvalue ($100M)
Total Value Principle: Modigliani and Miller
• M&M assume an absence of taxes and market imperfections.• Investors can substitute personal for corporate financial
leverage.
Market value of debt ($35M)
Market value of equity ($65M)
Total firm marketvalue ($100M)
Total market value is not altered by the capital structure (the total size of the pies are the same).
Arbitrage and Total Market Value of the Firm
Arbitrage -- Finding two assets that are essentially the same and buying the cheaper
and selling the more expensive.
Two firms that are alike in every respect EXCEPT capital structure MUST have the same market
value.
Otherwise, arbitrage is possible.