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Chapter 16

Capital Structure Basic Concept


1.

Maximizing
interest:

firms value versus maximizing shareholders

To understand the relationships between firms value and shareholders


interest, we can use the following debt & farm value for better
understand the managers decision:
No debt
(Original capital
structure)

Value of Debt plus equity after payment


of dividend
(Three possibilities)
I
II
III
$0
$500
$500
$500
1000
750
500
250
$1000
$1250
$1000
$750

Debt
Equity
Firms
Value

Capital gains
Dividends
Net
gain
stockholders

or

loss

to

Payoff to shareholders after


restructuring
I
II
III
-$250
-$500
-$750
500
500
500
$250
$0
-$250

Here three situations showing that firms value have a positive relation
with shareholders interest.
So we can say, changes in capital structure benefits the stockholders
if and only the value of the firm increase. Conversely, these changes
hurt the stockholders if and only if the value of the firm decreases.
Managers should choose capital structure that has the highest firm
value because this capital structure will be most beneficial to the
firms stockholders.
2. Financial leverage and the firm value:
In this section, we want to determine that optimal capital structure.
Financial leverage can be defined as the degree to which a company
uses fixed-income securities, such as debt and preferred equity. With a
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high degree of financial leverage come high interest payments. As a


result, the bottom-line earnings per share are negatively affected by
interest payments. As interest payments increase as a result of
increased financial leverage, EPS is driven lower.
Financial risk is the risk to the stockholders that is caused by an
increase in debt and preferred equities in a company's capital
structure. As a company increases debt and preferred equities,
interest payments increase, reducing EPS. As a result, risk to
stockholder return is increased. A company should keep its optimal
capital structure in mind when making financing decisions to ensure
any increases in debt and preferred equity increase the value of the
company.
Financial Structure of a Firm:
Firms both current and proposed
presented in the following table:

Asset
Debt
Equity
Interest rate
Share price
Share outstanding

capital

Current
$8000
$0
$8000
10%
$20
400

structures

are

Proposed
$8000
$4000
$4000
10%
$20
200

Current Capital structure


Recession
5%
$400
5%
$1.00

ROA
Earnings
ROE
EPS

Expected
15%
$1200
15%
$3.00

Expansion
25%
$2000
25%
$5.00

Proposed Capital Structure: (Debt=$4000)


ROA
EBI
Interest
Earning
interest
ROE
EPS

after

Recession
5%
$400
-400
$0

Expected
15%
$1200
-400
$800

Expansion
25%
$2000
-400
$1600

0
$0

20%
$4.00

40%
$8.00

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Financial Leverage: EPS and EBI in graphically

In the above figure, the solid line represents the case of no leverage. The
line begins at the origin, indicating that EPS would be zero if EBI was zero.
The EPS rises in tandem with a rise in EBI.
The dotted line represents the case of $4000 of debt. Here EPS is negative
if EBI is Zero. This follows because $400 of interest must be paid regardless
of the firms profits.
Here the slope of the dotted line is higher than the slope of the solid line.
This occurs because the levered firm has fewer shares of stock outstanding
than the unlevered firm. Therefore any increase in EBI leads to a greater
rise in EPS for the levered firm because the earnings increase is distributed
over fewer shares of stock.
3. Modigliani and Miller (MM): Proposition II:
This implies that the expected rate of return on equity is positively related
to the firms debt-equity ratio. This makes intuitive sense because the risk of
equity rises with leverage. MM proposition II (no taxes) is expressed by the
following equation:
Rs=R0 +

B
S (R0-RB)
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Here, Rs is the cost of equity


RB is the cost of debt
R0 is the cost capital for all-equity firm
B
S is the debt-equity ratio.

Fig. MM
corporate

proposition

II

with no
taxes

If R0 exceeds the cost of debt R B then


the cost of equity rises with increases
in the debt-equity ratio. Normally R 0
exceeds RB. That is because even
unlevered equity is risky; it should
have an expected return greater than
that riskless debt.

The weighted Average Cost of Capital (RWACC) & corporate Taxes:


The weighted average cost of capital (WACC) is the rate that a company
is expected to pay on average to all its security holders to finance its assets.
A higher debt-to-equity ratio leads to a higher required return on equity,
because of the higher risk involved for equity-holders in a company with
debt. The formula is derived from the theory of weighted average cost of
capital (WACC).
S
RWACC= V L

B
RS+ VL

RB (1-tc)

Where, VL=(S+B)
tc is the corporate tax
In the no taxes case, RWACC is not affected by leverage. However, because
debt is tax advantage relative to equity, it can be shown that RWACC declines
with leverage in a world with corporate taxes.
Summary of Modigliani Miller propositions with corporate taxes:

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MM implies that the capital structure decision is a matter of indifference,


whereas the decision appears to be a weighty one in the real world. To
achieve real-world applicability, we must considered corporate taxes.
Expected return on levered equity can be expressed as under:
Rs=R0 +

B
S (R0-RB) (1-tc)

Here value is positively related to leverage. This result implies that firms
should have a capital structure almost entirely composed of debt. Because
real-world firms select more moderate levels of debt.

Chapter 17
Capital Structure
Limits to the Use of Debt
1. Cost of Financial distress
Cost of financial distress indicates when a firm has debt of capital structure
it has an obligation of Principle and Interest payments, if this obligation are
not met then the firm may face financial distress which may lead to
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Bankruptcy. The more debt a company takes on, the more it risks being
unable to meet its financial obligations to creditors. A highly leveraged firm
is more vulnerable to a decrease in profitability. Therefore, a highly levered
firm has a higher risk of bankruptcy. Bankruptcy costs vary for different
types of firms, but they typically include legal fees and, losses incurred from
selling assets at distressed fire-sale prices, and the departure of valuable
human capital. The way to measure bankruptcy cost is to multiply the
probability of bankruptcy by the expected cost of bankruptcy. A company
should consider the expected cost of bankruptcy when deciding how much
debt to take on.
a. Direct Cost of Financial distress: This is the legal and Administrative cost of Liquidation or Reorganization.

There are also several indirect costs associated with financial distress.
When a company is experiencing financial distress, conservative managers
may cut down on research and development, marketing research, and other
investments to spare cash. The firm may also incur opportunity costs if
trepid managers pass on risky corporate projects. Also, financial distress
can affect a firms reputation. A company in financial distress may lose
customers, be forced to pay a higher cost of capital, receive less
favorable trade credit terms from suppliers, and be vulnerable to tactics
from aggressive industry competitors.
b. Indirect cost of Financial distress
Impaired ability to conduct business.
Any fees or penalties that result from a bankruptcy or liquidation.
An obvious example is thefee one must pay to a bankruptcy attorney. Howev
er, other fees, perhaps broker
fees
resulting from the liquidation of stock, may also be attached. Indirect cost
of financial distress may be the culprit because some of the customers were
demanding cash payment others are halted or canceled shipments.

Agency cost:

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There is an agency cost that exists in every business that has owners or
shareholders and managers who are not necessarily owners. Agency cost
means that shareholders and business managers may not necessarily agree
on the actions that are best for the business firm and that there is an
inherent cost to that disagreement. That leads to what is called the agency
problem. The principal-agent cost problem is complex and usually requires
more than monetary incentives to solve.

(i)

Selfish Investment Strategy:


Selfish strategy 1: Incentive to take large risks
Selfish strategy 2: Incentive toward underinvestment
Selfish strategy 3: Milking the property

Selfish Strategy 1: Incentive to Take Large Risks


The Gamble
Win Big
Lose Big

Probability
10%
90%

Payoff
$1,000
$0

Cost of investment is $200 (the entire firms cash).


Required return is 50%.
Expected CF from the Gamble = $1,000 0.10 + $0 = $100
NPV= -$200+ ($100/1.5)=-$133
Expected CF from the Gamble
To Bondholders = $300 0.10 + $0 = $30
To Stockholders = ($1000 $300) 0.10 + $0 = $70
PV of Bonds without the Gamble = $200
PV of Stocks Without the Gamble = $0
PV of Bonds With the Gamble: 30/20=1.5
PV of Stocks with the Gamble: 70/47=1.5
Selfish Stockholders Accept Negative NPV Project with Large Risks.

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Selfish Strategy 2: Incentive toward Underinvestment


Expected CF from the government sponsored project:
To Bondholder = $300
To Stockholder = ($350 $300) = $50
PV of Bonds without the Project = $200
PV of Stocks without the Project = $0
PV of Bonds with the Project: $ 272.73=$ 300/1.1
PV of Stocks with the Project: -$54.44= ($ 50/1.1)-100
Selfish Stockholders Forego Positive NPV Project.

Selfish Strategy 3: Milking the Property


Liquidating dividends
Suppose our firm paid out a $200 dividend to the shareholders. This
leaves the firm insolvent, with nothing for the bondholders, but plenty for
the former shareholders.
Such tactics often violate bond indentures.
Increase perquisites to shareholders and/or management

2). Can Costs of Debt Be Reduced?


Each of the costs of financial distress we have mentioned is substantial in
its own right. The sum of them may well affect debt financing severely.
Thus, managers have an incentive to reduce these costs.

Protective Covenants:
A part of an indenture or loan agreement that limits certain actions
a company may
take
during
the term of
the loan to
protect
the lender's interests. Component of loan agreement or indenture that
imposes restrictions on company actions to protect the lenders. These
restrictions may be in force during the term of the loan. Protective
covenants can be classified into two types:
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(i)

Negative covenant

(ii)

Positive covenant

Negative covenant:

Pay dividends beyond specified amount.


Sell more senior debt & amount of new debt is limited.
Refund existing bond issue with new bonds paying lower interest rate.
Buy another companys bonds.

Positive covenant:

Use proceeds from sale of assets for other assets.


Allow redemption in event of merger or spin-off.
Maintain good condition of assets.
Provide audited financial information.

3) Signaling:
Financing decision by managers that provide signaling effect to investors
that suggest increase the value of firm. For example; debt signaling,
concerning exchange offers. Firms often change their debt levels through
exchange offers, of which there are two types.
The first type of offer allows stockholders to exchange some of their stock
for debt, thereby increasing leverage.
The second type allows bondholders to exchange some of their debt for
stock, decreasing leverage.

Possible Signaling Effect:


Repurchase have a positive signaling effect.
For Example, if the stock is undervaluing management may
tender for shares at a premium. This signals that the share
prices are undervalued.
Dutch auction self-tenders have less signaling power likely due
to a smaller tender premium.
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Open market purchase has only a modest positive signaling


effect likely due to many programs being instituted after
significant share price declines.

4) The Pecking-Order Theory:


The pecking-order theory implies that managers prefer internal to external
financing. If external financing is required, managers tend to choose the
safest securities, such as debt. Firms may accumulate slack to avoid
external equity. The pecking order theories of capital structure is the most
influential theories of corporate leverage. It explains the inverse
relationship between profitability and debt ratio.
Theory stating that firms prefer to issue debt rather than equity if internal
finance is insufficient.

According to the pecking-order theory:

There is no target D/E ratio


Profitable firms use less debt (they use self-financing instead)
Companies like financial slack

The pecking order theory suggests that there is an order of preference for
the firm of capital sources when funding is needed.
The firm will seek to satisfy funding needs in the following order:
Internal funds
External funds
Debt
Equity

(a) Rules of the Pecking Order:


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Rule 1: Use internal financing first.


Rule 2: Issue debt next, equity last.

(b) Implications:
The pecking-order Theory is at odds with the trade-off theory:
There is no target D/E ratio.
Profitable firms use less debt.
Companies like financial flexibility

Reference:
1) Corporate Finance Book-By Stephen A. Ross, Randolph W. Westerfield
& Jeffrey Jaffe.
2) www.google.com/images.
3) Website.

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