j. k. dietrich - gsba 548 – mba.pm spring 2007 capital structure april 30, 2007 (la) and april 26,...

J. K. Dietrich - GSBA 548 – MBA.PM Spring 2007

Capital Structure

April 30, 2007 (LA)

and April 26, 2007 (OCC)


An unlevered company is an all equity firm A levered company has debt and equity in

its capital structure The capital structure debate concerns the

impact on total firm value of companies having identical assets but different capital structures, i.e. levered versus unlevered

If debt in capital structure adds value, it adds to shareholders’ value

Capital Structure Debate


Summary M-M Debate Issues M-M ISSUES STATE

OF DEBATE CAPITAL STRUCTURE IRRELEVANT

(1) TAXES (2) BANKRUPTCY (3) AGENCY (4) EQUILIBRIUM

TRADEOFFS

DIVIDENDS IRRELEVANT

(1) INFORMATION (2) TAXES (3) MILLER-SCHOLES

EVIDENCE


Debate and Basic Concepts Portfolios

– Investors hold portfolios– Portfolios may contain bonds, stocks, and be

leveraged with debt Efficient markets

– Informed investors, transactions costs low Arbitrage

– Strong economic force operating at all times– Search for profits from “buy cheap, sell dear”


Returns to Debt and Equity Each claimant on the income of the firm has

expected returns based on the degree of risk associated with the income from the claims

Management of firms must satisfy expectations of providers of capital to maintain value of firm

If higher returns are earned, shareholders gain


Distribution of Corporate Income

EAC (Div + Retained Earnings)

I (Fixed Claims)

T (No Value to Investors)

E B I T


Capital Structure Modigliani and Miller (1958, 1963) “Pie Model of Firm Value” (pp. 2ff, 423ff)

V = B + S Unlevered versus levered firm Weighted average cost of capital (no taxes)

SSBS

BSBB

WACC rrr


Propositions I and II Assumptions

– No taxes– Markets efficient– No bankruptcy or reorganization costs– Homemade leverage possible– Example problems

Economic forces simple and powerful What are investors willing to pay for?


Investor Returns from EBIT

Absence of taxes in M-M Propositions EBIT = operating income paid to

shareholders and bondholders Homemade leverage possible at same terms

as firm’s cost of debt Unmaking leverage possible by buying debt What can firms do for investors they can’t

do for themselves in efficient markets?


Capital Structure Irrelevant Proposition I (pp. 428-430)

(Value of firm not influenced by B and S) Proposition II (p. 432, equation 15.3)

(Overall discount rate not influenced by B and S)

oLU r

EBITSBVV

)rr(S

Brr BooS


M-M Proposition I and II Graphs

rB

Cost of Funds

D/E D/E

Firm Value

rWACC

rS

Vo

00


Issues in M-M Analysis Taxes reduce cost of debt Bankruptcy costs from failure to make

scheduled debt payments– Attorneys– Lost sales, production– Costs of reorganization, acquisition

Agency costs of debt– Incentives of bond and stockholders– Costs of monitoring


Value of Claims on Firm: Taxes

Unlevered firm’s value (p. 442):

Levered firm’s value (p. 442, equation 15.5):

0r

)C

T(1E(EBIT)

UV

B

BC

0

CL r

BrT

r

)T1()EBIT(EV


The Capital Structure Debate

rB

Cost of Funds

D/E D/E

Firm ValuerS

rWACCVo

0 0


Capital Structure & Equilibrium

In equilibrium, both firms and investors expected after-tax returns on debt and equity must be consistent with each other

Value of firm will be influenced by corporate and personal tax rates (see p. 478):

B)T1(

)T1()T1(1VV

B

SCUL


State of Capital Structure Debate Market equilibrium pricing reduces value of

debt financing (“Debt and Taxes” argument of Miller)

Some debt financing seems reasonable Over some range precise D/E value not

clear and there are adjustment costs– Pecking order theory of financing (p. 472)– Investment banking fees– Costs of going to market


Debt and Equity as Financial Claims on a Firm’s Assets

F = Face Value of Debt

Val

ue o

f C

laim

0

Debt Claims

Equity Claim

Value of Assets


Debt as a Fixed Claim

F = Face Value of Debt0

Debt Claims

Value of Assets

Val

ue o

f C

laim


Equity, a Residual Claim

Equity Claim

F = Face Value of Debt0Value of Assets

Val

ue o

f C

laim


Debt and Equity asContingent Claims

F = Face Value of Debt0

Equity Claim

Probability Scale

Debt ClaimsVal

ue o

f C

laim


Last Classes

Prepare Chapter 18 problems Submit Part 4 (group part only) and

organize group time to incorporate feedback and complete project summary

Review course materials and midterm performance to identify topics where you need clarification or assistance

j. k. dietrich - gsba 548 – mba.pm spring 2007 capital structure april 30, 2007 (la) and april 26,...

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