Capital Structure

FINC 3630 - Yost

Capital Structure

Optimal Capital Structure What is capital structure? How should a firm choose a debt-to-

equity ratio? The goal: _________________________

Which is done by: __________________

Which is done by: __________________

Capital Structure

FINC 3630 - Yost

Financial LeverageScenario

A B CMarket Value of Debt $0 $50 $75Market Value of Equity $100 $50 $25Market Value of AssetsDebt-to-Equity RatioNumber of Shares ($1 each) 100 50 25

Financial LeverageScenario

A B CCorporate Borrowing Rate 8% 8% 8%EBIT $20 $20 $20Interest Expense $0 $4 $6Taxes (assume 0%) $0 $0 $0Net Income

Capital Structure

FINC 3630 - Yost

Financial LeverageScenario

A B CROAROEEPS e (assume A= 1) 1.0 2.0 4.0

Asset Betas and Equity Betas

EquityC

Asset Debt])T-[(1 Equity

Equity

Equity

DebtT-11 CAssetEquity

Capital Structure

FINC 3630 - Yost

Financial Leverage What is financial leverage? What are the effects of financial leverage? What is meant by “homemade leverage”?

The use of ________________ to change the overall amount of financial leverage to which an individual is exposed.

Homemade Leverage Assume the firm in the previous

example has no debt (Scenario A).

Also assume you personally prefer to have the leverage in Scenario C.

How could you do this on your own?

Capital Structure

FINC 3630 - Yost

The M&M Propositions Why is Keven obsessed with M&Ms? Franco Modigliani and Merton Miller won Nobel

prizes for the following (irrelevance) propositions. Consider a world of no taxes (we will consider the

role of taxes later), no bankruptcy costs, and perfect, efficient capital markets. People can borrow and lend at the same rate as the firm.

Capital Structure

FINC 3630 - Yost

M&M Proposition I (no taxes) Does capital structure

matter?

In our world of no taxes, bankruptcy costs, and perfect, efficient markets, is an individual firm’s capital structure important?

M&M Proposition I (no taxes) The value of the firm is _____________

the firm’s capital structure. VL = VU

Capital Structure

FINC 3630 - Yost

M&M Proposition II (no taxes) What happens to the risk

shareholders face when the firm increases its use of debt?

What happens to beta? What happens to the

cost of equity?

M&M Proposition II (no taxes) The firm’s cost of equity capital is a

positive linear function of the firm’s debt-to-equity ratio.

E

DRRRR DAAE

Capital Structure

FINC 3630 - Yost

M&M Proposition II (no taxes)Cost of Capital

Debt-to-Equity Ratio

RD

RE

WACCRA •

An Example (no taxes)Executive Chalk is financed solely by common stock and has outstanding 25 million shares with a market value of $10 per share. It now announces that it intends to issue $160 million of debt and use the proceeds to buy back common stock. The firm’s current cost of equity is 10 percent. The cost of debt is 8 percent.

Capital Structure

FINC 3630 - Yost

An Example (no taxes) -- continued

How many shares can the company buy back? What is the market value of the firm after the

change in capital structure? What is the firm’s new debt-to-equity ratio? After the repurchase, what will be the firm’s

new cost of equity? New cost of capital?

Capital Structure

FINC 3630 - Yost

Agree or Disagree? The assumption of no taxes is a fair and

realistic assumption.

Agree or Disagree

Capital Structure:The Sequel

Capital Structure

FINC 3630 - Yost

Review Financial Leverage:

1. Magnifies the gains and losses to shareholders.

2. Increases the risk (e) to shareholders.

e = A [1 + (1 - t)(D/E)]

Review In our happy

financial world world of no taxes, perfect, efficient financial markets, and no costs of financial distress, with homemade leverage…

Capital Structure

FINC 3630 - Yost

M&M Proposition I (no taxes)

The value of the firm is ____________ the firm’s capital structure.

_______________

M&M Proposition II (no taxes) The firm’s cost of equity capital is a positive

linear function of the firm’s debt-to-equity ratio.

RE = RA + (RA – RD)(D/E)

Capital Structure

FINC 3630 - Yost

M&M Proposition II (no taxes)Cost of Capital

Debt-to-Equity Ratio

RD

RE

WACCRA •

But then the IRS said, “Let there be taxes.”

And there were.

Capital Structure

FINC 3630 - Yost

Features of Debt Two features of debt that we ignored

in our “perfect” financial world in the previous lecture:

1. ____________________________

2. ____________________________

Back to our previous example…Scenario

A B CCorporate Borrowing Rate 8% 8% 8%EBIT $20 $20 $20Interest Expense $0 $4 $6Taxes (assume 50%) $10 $8 $7Net Income

Capital Structure

FINC 3630 - Yost

Back to our previous example…Scenario

A B CCash Flow to StockholdersCash Flow to DebtholdersTotal Cash Flow from Assets

What, then, should happen to firm value?

Firm Value with Debt and Taxes

Capital Structure

FINC 3630 - Yost

M&M Proposition I (with taxes) VL = VU + ______ How do we calculate the value of the firm? VU = [EBIT x (1 – tc)] / RA

Assume that the cost of equity for the firm in scenario A is 10%. Complete the following balance sheet:

Back to our previous example…Scenario

A B CMarket Value of Debt $0 $50 $75Market Value of EquityMarket Value of AssetsDebt-to-Equity RatioROE (assume $1 per share)

Capital Structure

FINC 3630 - Yost

M&M Proposition I (with taxes)Value of the Firm (V)

Debt-to-Equity Ratio

VL = VU + (tc x D)

VU

Tc x D

VU

M&M Proposition II (with taxes) The firm’s cost of equity capital is a

positive linear function of the firm’s debt-to-equity ratio.

RE = RA + (RA – RD)(D/E)(1 - tc)

Capital Structure

FINC 3630 - Yost

M&M Proposition II (with taxes)

Assume that the cost of equity for the firm in scenario A is 10%. What is the required rate of return on equity for each scenario?

M&M Proposition II (with taxes) What is the WACC in each scenario?

Capital Structure

FINC 3630 - Yost

M&M Proposition II (with taxes)Cost of Capital

Debt-to-Equity Ratio

RD

RE

WACC

RA •

Therefore… What is the optimal capital structure?

Why don’t we see this?

Capital Structure

FINC 3630 - Yost

Let’s take another look…Executive Chalk is financed solely by common stock and has outstanding 25 million shares with a market value of $10 per share. It now announces that it intends to issue $160 million of debt and use the proceeds to buy back common stock. The firm’s current cost of equity is 10 percent. The cost of debt is 8 percent. The tax rate is 35 percent. Assume a M&M world, where all assumptions hold.

Capital Structure

FINC 3630 - Yost

Let’s take another look… What is the market value of the firm after

the announcement? How many shares can the company buy

back? What is the firm’s new debt-to-equity ratio? After the repurchase, what will be the firm’s

new cost of equity? New cost of capital?

Optimal Capital Structure(with taxes and bankruptcy costs)

Why do different firms have different capital structures?

____________________ greater for some firms.

____________________ greater for some firms.

Capital Structure

FINC 3630 - Yost

The Costs of Financial Distress _________ Costs

Legal expenses Administrative expenses

_________ Costs Lost sales Lost time Loss of morale and employees

Optimal Capital Structure(with taxes and bankruptcy costs)

Trade-Off Theory of Capital Structure:The firm borrow up to the point where the tax benefits from an extra dollar of debt is _______________ the cost that comes from the increased probability of financial distress.

Capital Structure

FINC 3630 - Yost

Optimal Capital Structure(with taxes and bankruptcy costs)Value of the Firm (V)

Debt-to-Equity Ratio

VL = VU + (tc x D)

VU

Tc x D

VU

ActualValue

PV of Financial Distress Costs

D*

Suggested Problems Questions:

16-1(a - b), 16-4, 16-5, 16-8 17-2

Problems: 16-9, 16-10, and 16-11 17-6 and 17-7