CH 16

Mah a Mobeen
Copyright 2011 John Wiley &

1
Copyright 2011 John Wiley & Sons Ltd
Sons Ltd
Chapter Sixteen
Capital Structure Policy

Sons Ltd
Learning Objectives
1. Describe the two Modigliani and Miller
propositions, the key assumptions underlying
them and their relevance to capital structure
decisions.
2. Discuss the benefits and costs of using debt
financing.
3. Describe the trade-off and pecking order
theories of capital structure choice and
explain what the empirical evidence tells us
about these theories.
4. Discuss some of the practical considerations

that managers are concerned with when they
choose a firms capital structure.
Sons Ltd
Quick Links
Capital Structure
The Optimal Capital Structure
The Modigliani and Miller Propositions
The Benefits and Costs of Using Debt
Other Benefits
The Costs of Debt
Two Theories of Capital Structure
Practical Considerations in Choosing
a Capital Structure
Sons Ltd
Capital Structure
A firms capital structure is the mix of financial
securities used to finance its activities.

The mix will always include ordinary shares and
will often include debt and preference shares.

The firm may have several classes of ordinary
shares, for example with different voting rights

and possibly different claims on the cash
flows available to shareholders.

Sons Ltd
Capital Structure
The debt at a firm can be long term or short term, secured or
unsecured, convertible or not convertible into ordinary shares, and so

on.
Preference shares can be cumulative or
non-cumulative and convertible or not

convertible into ordinary shares.
The fraction of the total financing that is
represented by debt is a measure of the

financial leverage in the firms capital structure.

Sons Ltd
Capital Structure
A higher fraction of debt indicates a higher
degree of financial leverage.

The amount of financial leverage in a firms
capital structure is important because it

affects the value of the firm.

Sons Ltd
The Optimal Capital

Structure
Managers at a firm choose a capital
structure so that the mix of securities

making up the capital structure minimises
the cost of financing the firms activities.
This mix is the optimal capital structure
because the capital structure that minimises

the cost of financing the firms projects is
also the capital structure that maximises the
total value of those projects and, therefore,
the overall value of the firm.

Sons Ltd
The Modigliani and Miller

Propositions
Modigliani and Miller Proposition 1 states
that the capital structure decisions a firm
makes will have no effect on the value of
the firm if:
1. There are no taxes.
2. There are no information or transaction costs.
3. The real investment policy of the firm is not

affected by its capital structure decisions.

Sons Ltd

Propositions
The real investment policy of the firm includes
the criteria that the firm uses in deciding which

real assets (projects) to invest in.
The market value of the debt plus the market
value of the equity must equal the value of

the cash flows produced by the firms assets.
VFirm = VAssets = VDebt + Vequity

Sons Ltd
(16.1)
10

Propositions
Modigliani and Miller Proposition 1 essentially
says that the combined value of the equity and

debt claims (represented by the present value of
free cash flows the firms assets are expected to
produce in the future) does not change when
you change the capital structure of the firm if no
one other than the shareholders and the debt
holders is receiving cash flows.

Sons Ltd
11

Propositions
Such a change is called a financial restructuring,
where a combination of financial transactions

occur that change the capital structure of the
firm without affecting its real assets.

Sons Ltd
12
Exhibit 16.1: Capital Structure

and Firm Value under M&M
Proposition 1

Sons Ltd
13

Propositions
Modigliani and Miller Proposition 2 states
that the cost of (required return on) a

firms ordinary shares is directly related to
the debt-to-equity ratio.
If a firm has one type of equity:
WACC = xDebtkDebt + xosk0s
(16.2)
If we rearrange equation 16.2, we have:
VDebt
Vos
k os k Assets
WACC = RA = (E/V)RE + (D/V)RD

RE = RA + (RA RD)(D/E)
k Assets k Debt

Sons Ltd
(16.3)
14

Propositions
M&M Proposition II Example
After its restructuring, Millennium Motors will
be financed with 20 per cent debt and 80 per
cent ordinary shares. The return on assets is
10 per cent and the return on debt is 5 per
cent. What is the cost of equity for the firm?
k os
0.2
0.10
0.10 0.05
0 .8
0.1125 , or 11 .25%
Sons Ltd
15

RA is the cost of the firms business

risk, i.e., the risk of the firms assets
(RA RD)(D/E) is the cost of the firms
financial risk, i.e., the additional return
required by stockholders to
compensate for the risk of leverage

Sons Ltd
16

Propositions
The first source of risk is business risk. It is
the risk associated with the characteristics of

the firms business activities.
The second source of risk is the capital structure
of the firm which reflects the effect that the firms

financing decisions have on the riskiness of the
cash flows that the shareholders will receive.
Financial risk is associated with required
payments to a firms lenders.

Sons Ltd
17
Exhibit 16.2: Relations between

Business Risk, Financial Risk and
Total Equity Risk

Sons Ltd
18
Exhibit 16.3: Illustration of Relations

between Business Risk, Financial Risk
and Total Risk

Sons Ltd
19
Exhibit 16.4: Illustrations of

M&M
Proposition 2

Sons Ltd
20

Sons Ltd
21
Case I - No Taxes - Example

Data
Required return on assets = WACC = R A =

16%,
Cost of debt = RD = 10%
Percent of debt = D = 45%
E = 1 - 0.45 = 0.55 or 55%
D/E = 0.45/0.55 = 0.82
What is the cost of equity?

RE = 0.16 + (0.16 0.10)(.45/.55) = 20.91
Proof for WACC:

17-22

WACC = RCopyright
* 20.91% + 0.45 * 10% =
A = 0.55
2011 John Wiley &
Sons Ltd
Case I No Taxes
Example continued..
What happens if the firm increases leverage

so that D/E = 1.5? (before D/E = 0.82 when
D=45%,E=55%)
What is the cost of equity?
RE = 0.16 + (0.16 0.10)(1.5) = 0.25 or 25%
Proof for WACC:

WACC = RA = (E/V)RE + (D/V)RD E 1
V 1 D/E
From D/E = 1.5, D = 60%, E = 40%
WACC = 0.4 * 25% + 0.6 * 10% = 16%
Sons Ltd
17-23

Propositions
What the Modigliani and Miller
Propositions Tell Us
The value of the M&M analysis is that it tells
us exactly where we should look if we want to

understand how capital structure affects firm
value and the cost of equity.

Sons Ltd
24

Propositions
If financial policy matters, it must be becaus

1. Taxes matter.
2. Information or transaction costs matter.
3. Capital structure choices affect a firms real

investment policy.

Sons Ltd
25
The Benefits and Costs of

Using Debt
The most important benefit from including debt in a
firms capital structure stems from the fact that firms

can deduct interest payments for tax purposes but
in most casescannot deduct dividend payments.
This makes it less costly to distribute
cash to security holders through interest

payments than through dividends.

Sons Ltd
26
Exhibit 16.5: Capital Structure

and Firm Value with Taxes

Sons Ltd
27
Case II Introducing Taxes

What happens to the firms cash
flows?
Interest is tax deductible
Therefore, when a firm adds debt, it
reduces taxes, all else equal
The reduction in taxes increases the
cash flow of the firm
How should an increase in cash

flows affect the value of the firm?
17-28

Sons Ltd

Using Debt
The total amount of interest paid each year,
and therefore the amount that will be

deducted from the firms taxable income, is
D kDebt.
This will result in a reduction in taxes paid
(the interest tax shield) of D kDebt t,

where t is the firms marginal tax rate that
applies to the interest expense deduction.

Sons Ltd
29
Case II - with Taxes - Example

Unlevered Firm
Levered Firm
No Debt
EBIT
With Debt
5000
5000
Interest
Taxable
Income
5000
4500
Taxes (34%)
1700
1530
Net Income
3300
2970
CFFA
3300
3470

Sons Ltd
(6250@8%)
500
17-30
Interest Tax Shield

Annual interest tax shield
Tax rate times interest payment

6250 in 8% debt = 500 in interest expens
Annual tax shield = 0.34(500) = 170
Present value of annual interest tax sh

Assume perpetual debt for simplicity
PV = 170 / 0.08 = 2125
6250 0.08 0.34
6250 0.34 2125
0.08
D R D TC
PV
D TC
RD
PV

Sons Ltd
17-31
Case II - with Taxes - Proposition

I
The value of the firm increases by the
present value of the annual interest tax
shield
Value of a levered firm = value of an unlevered

firm + PV of interest tax shield
Assuming perpetual cash flows
VU = EBIT(1-T) / RU
with no debt
RU = RA= RE and VU = E
VL = VU + D*TC
E = VL - D
17-32

Sons Ltd
Case II with Taxes

Proposition I - Example
Data Inc. has earnings of 25 million per
year every year. The firm has no debt and
the cost of capital is 12%. If tax is 35%
what is the value of the firm?
EBIT = 25 million; Tax rate = TC= 35%;
Unlevered cost of capital = RU= 12% = RA = RE
VU = ?
VU = EBIT(1-T) / RU
VU = 25(1-0.35) / 0.12 = $135.42 million
VU = E
17-33

Sons Ltd
Case II with Taxes

Proposition I - Example (cont.)
Data Inc. decides to issue bonds that have a
market value of 75 million at a cost of 9%.
What is the value of the firm? What will be
the value of equity?
D = $75 million, RD= 9%, VL = ?, E = ?
VU = 135.42 (calculated on previous slide)
VL = VU + tax shield
VL = VU + D*TC
VL = 135.42 + 75(0.35) = $161.67 million
E = VL - D
17-34
E = 161.67 75 =
$86.67 million
Sons Ltd
Figure 17.4 Case II - with Taxes
Proposition I
17-35

Sons Ltd
Case II with Taxes Proposition II
Recap: In case I Proposition II - no taxe

RE increases as Debt increases
WACC is unchanged
When taxes are introduced in Case II:

RE increases as Debt increases
RE = RU + (RU RD)(D/E)(1-TC)
WACC decreases as D/E increases because th

cost of
debt decreases
RL = WACC = (E/V)RE + (D/V)(RD)(1-TC)
17-36

Sons Ltd
Case II with Taxes

Proposition II - Example
Data Inc. info from Case II proposition I:
EBIT = 25 million; TC= 35%; D = $75 million;
RD= 9%; Unlevered cost of capital = RU= 12%
E = $86.67m; VL = $161.67m
D/E = 75/86.67 = 0.87,
E/V = 86.67/161.67 = 0.54,
D/V = 75/161.67 = 0.46
RE = RU + (RU RD)(D/E)(1-TC)
RE = 0.12 + (0.12-0.09)(0.87)(1-0.35) = 13.69%
RL = WACC = (E/V)RE + (D/V)(RD)(1-TC)

17-37
RL = WACC = (0.54)(0.1369) + (0.46)(0.09)

(1-.35) = 10.05% Copyright 2011 John Wiley &
Sons Ltd
Example: Case II
Proposition II
Suppose Data Inc. changes its capital structure
so that the debt-to-equity ratio becomes 1.
Before: D/E = 0.87, E= 54%, D=46%
Now: D/E = 1, E= 50%, D=50%
What will happen to the cost of equity under

the new capital structure? (previously 13.69%)
RE = 0.12 + (0.12 0.09)(1)(1-0.35) = 13.95%
What will happen to the weighted average cost

of capital? (previously 10.05%)
WACC = 0.5(0.1395) + 0.5(0.09)(1-0.35) = 9.9%
What if D/E = 1.25?, RE = ?, WACC = ?

17-38

Sons Ltd
Figure 17.5 - Case II with Taxes
Proposition II
17-39

Sons Ltd
Case III with Bankruptcy Costs

Now we add bankruptcy costs
As the D/E ratio increases, the
probability of bankruptcy increases
This increased probability will increase
the expected bankruptcy costs
At some point, the additional value of
the interest tax shield will be offset by
the increase in expected bankruptcy
cost
At this point, the value of the firm will
start to decrease and the WACC will start
to increase as more debt is added
17-40

Sons Ltd
Case III with

Bankruptcy costs
Figure 17.6
17-41

Sons Ltd
Figure 17.7
17-42
Case III with Bankruptcy

costs

Sons Ltd
Bankruptcy Costs
Direct costs
Legal and administrative costs
Indirect costs
Larger than direct costs & more difficult to
measure and estimate
Financial distress costs
All costs associated with going bankrupt and

avoiding bankruptcy
17-43

Sons Ltd
Conclusions
Case I no taxes or bankruptcy costs
No optimal capital structure
Case II corporate taxes but no bankruptcy costs
Optimal capital structure is almost 100% debt

Each additional dollar of debt increases the cash flo
of the firm
Case III corporate taxes and bankruptcy costs
Optimal capital structure is part debt and part equi

Occurs where the benefit from an additional dollar
debt just offsets the increase in expected bankruptcy
costs
17-44

Sons Ltd
Figur
e
17.8
17-45

Sons Ltd
Managerial
Recommendations
The tax benefit is only important if
the firm has a large tax liability
Risk of financial distress
The greater the risk of financial
distress, the less debt will be optimal
for the firm
The cost of financial distress varies
across firms and industries and as a
manager you need to understand the
cost for your industry
17-46

Sons Ltd

Using Debt
Effect of Debt Example

You are considering borrowing 1 000 000 at an
interest rate of 6 per cent for your pizza
business. Your pizza business generates pretax
cash flows of 300 000 each year and pays
taxes at a rate of 25 per cent. What is the value
of your firm without debt and how much would
debt increase its value? What is WACC before
and after restructuring?
VFirm = [300 000 (1 0.25)]/0.10 = 2 250 000
Value of tax shield = 1 000 000 0.25 = 250 000
Sons Ltd
47

Using Debt
Effect of Debt Example
WACC before financial restructuring = k os = 10%

After restructuring:
Value of equity = 2 500 000 1 000 000
= 1 500 000
After-tax cash flows to shareholders
= [300 000 (1 000 000 0.06)] (1 0.25)
= 180 000
kos = 180 000/1 500 000 = 0.12, or 12 per cent
WACC = (1 000 000/2 500 000)(0.06)(1 0.25)
+ (1 500 000/2 500 000)(0.12)
= 0.09, or 9%

Sons Ltd
48

Using Debt
The perpetuity model assumes that
1. The firm will continue to be in business forever.
2. The firm will be able to realise the tax savings

in the years in which the interest payments
are made (the firms EBIT will always be at
least as great as the interest expense).
3. The firms tax rate will remain constant.

Sons Ltd
49
Exhibit 16.6: How Firm Value

Changes

Sons Ltd
50
Exhibit 16.7: The Effect of Taxes on

the Firm Value and WACC of
Millennium Motors

Sons Ltd
51
Other Benefits
Underwriting spreads and out-of-pocket
costs are more than three times as large for

share sales as they are for bond sales.
Debt provides managers with incentives to
focus on maximising the cash flows that the

firm produces since interest and principal
payments must be made when they are due.

Sons Ltd
52
Other Benefits
Because managers must make these interest
and principal payments or face the prospect

of bankruptcy, not making the payments can
destroy a managers career.
Debt can be used to limit the ability of bad
managers to waste the shareholders

money on things such as fancy jet aircraft,
plush offices and other negative-NPV
projects that benefit the managers
personally.
Sons Ltd
53
The Costs of Debt

At some point, the costs begin to exceed the
benefits and adding more debt financing

destroys firm value.
Financial managers want to add debt just to
the point at which the value of the firm is

maximised.

Sons Ltd
54
Exhibit 16.8: Trade-Off Theory

of Capital Structure

Sons Ltd
55
The Costs of Debt

Bankruptcy costs, also referred to as costs of
financial distress, are costs associated with

financial difficulties that a firm might get into
because it uses too much debt financing.
The term bankruptcy cost is used rather loosely
in capital structure discussions to refer to costs

incurred when a firm gets into financial distress.
Firms can incur bankruptcy costs even if they
never actually file for bankruptcy.

Sons Ltd
56
The Costs of Debt

Direct Bankruptcy Costs are out-of-pocket costs
that a firm incurs as a result of financial distress.
They include things such as fees paid to
lawyers, accountants and consultants.
Indirect Bankruptcy Costs are costs associated
with changes in the behaviour of people who

deal with a firm in financial distress.

Sons Ltd
57
The Costs of Debt

Some of this firms potential customers will
decide to purchase a competitors products

because of:
Concerns that the firm will not be able
to honour its warranties.
Parts or service will not be available
in the future.
Some customers will demand a lower
price to compensate them for these risks.

Sons Ltd
58
The Costs of Debt

When suppliers learn that a firm is in financial
distress, they will worry about not being paid;

to protect against losses for future shipments,
they often begin to require cash on delivery.
Employees at a distressed firm will worry that
their jobs or benefits are in danger and some

start looking for new jobs.
If the firm enters into the formal bankruptcy
process, it incurs another indirect bankruptcy

cost because a bankruptcy court must
approve all investments made by the firm.
Sons Ltd
59
The Costs of Debt

Agency costs result from conflicts of interest
between principals and agents where one

party, known as the principal, delegates its
decision-making authority to another party,
known as the agent.
The agent is expected to act in the interest
of the principal but agents sometimes have

interests that conflict with those of the
principal.

Sons Ltd
60
The Costs of Debt

Shareholder-Manager Agency Costs occur to
the extent that if the incentives of the

managers are not perfectly identical to those
of the shareholders, managers will make some
decisions that benefit themselves at the
expense of the shareholders.
Using debt financing provides managers with
incentives to focus on maximising the cash

flows that the firm produces and limits the
ability of bad managers to waste the
shareholders money on negative-NPV projects.
Sons Ltd
61
The Costs of Debt

These benefits amount to reductions in the
agency costs associated with the principalagent relationship between shareholders

and managers.
While the use of debt financing can reduce
agency costs, it can also increase these costs

by altering the behaviour of managers who
have a high proportion of their wealth riding on
the success of the firm, through their
shareholdings, future income and reputations.

Sons Ltd
62
The Costs of Debt

The use of debt increases the volatility of a
firms earnings and the probability that the firm

will get into financial difficulty.
Increased risk causes managers to make
more conservative decisions.

Shareholder-Lender Agency Costs can occur
when investors lend money to a firm and

delegate authority to the shareholders to
decide how that money will be used.

Sons Ltd
63
The Costs of Debt

Lenders expect that the shareholders, through the managers
they appoint, will invest the money in a way that enables the
firm to make all of the interest and principal payments that
have been promised.
However, shareholders may have
incentives to use the money in ways that

are not in the best interests of the lenders.

Sons Ltd
64
The Costs of Debt

Lenders know that shareholders have
incentives to distribute some or all of the funds

that they borrow as dividends and so they
protect themselves against this sort of
behaviour by including provisions in the lending
agreements that limit the ability of shareholders
to pay dividends and conduct other behaviours.
These protections are not foolproof.

Sons Ltd
65
The Costs of Debt

One example of this behaviour is known
as the asset substitution problem, where

once a loan has been made to a firm, the
shareholders have an incentive to switch
from less risky assets to more risky
assets, such as negative-NPV projects.

Sons Ltd
66
The Costs of Debt

Another example behaviour is known as
the underinvestment problem and it

occurs in a financially distressed firm
when the value that is created by
investing in a positive-NPV project is
likely to go to the lenders instead of the
shareholders; therefore the firm forgoes
financing and undertaking the project.

Sons Ltd
67
Two Theories of Capital

Structure
Trade-Off Theory
The trade-off theory of capital structure says
that managers choose a specific target capital

structure based on the trade-offs between the
benefits and the costs of debt.
The theory says that managers will increase
debt to the point at which the costs and

benefits of adding additional debt are exactly
equal because this is the capital structure
that maximises firm value.
Sons Ltd
68

Structure
The Pecking Order Theory
The pecking order theory recognises that
different types of capital have different costs.

This leads to a pecking order in the financing
choices that managers make. Managers
choose the least expensive capital first then
move to increasingly costly capital when the
lower-cost sources of capital are no longer
available.

Sons Ltd
69

Structure
The Pecking Order Theory
Managers view internally generated funds, or
cash on hand, as the cheapest source of capital.

Debt is more costly to obtain than internally
generated funds but is still relatively inexpensive.
Raising money by selling shares is the
most expensive.

Sons Ltd
70

Structure
The Empirical Evidence
When researchers compare the capital
structures in different industries, they find

evidence that supports the trade-off theory.
Some researchers argue that, on
average, debt levels appear to be lower

than the trade-off theory suggests they
should be.

Sons Ltd
71
Exhibit 16.9: Average Capital

Structures for Selected
Industries in Europe at the End
of 2006

Sons Ltd
72

Structure
More general evidence also indicates that the
more profitable a firm is, the less debt it tends

to have, which is exactly opposite what the
trade-off theory suggests we should see.
This evidence is consistent with the pecking
order theory.
The pecking order theory is also supported by
the fact that, in an average year, public firms

actually repurchase more shares than they sell.

Sons Ltd
73

Structure
Both the trade-off theory and the pecking
order theory offer some insights into how

managers choose the capital structures for
their firms but neither is able to explain all
of the capital structure choices that we
observe.

Sons Ltd
74
Practical Considerations
in Choosing a Capital
Structure
Managers do not think only in terms of a
trade-off or a pecking order but are

concerned with how their financing decisions
will influence the practical issues that they
must deal with when managing a business.
Financial flexibility is an important consideration
in many capital structure decisions.

Sons Ltd
75
Structure
Managers must ensure that they retain
sufficient financial resources in the firm to

take advantage of unexpected opportunities
as well as unforeseen problems.
They try to manage their firms capital structures
in a way that limits the risk to a reasonable level.

Sons Ltd
76
Structure
Managers think about leverage and the
effect that interest expense has on the

reported value of the firms net profit.
Managers consider control implications
when choosing between equity and debt

financing of the firm.

Sons Ltd
77

CH 16

Hochgeladen von

Dokumentinformationen

Originaltitel

Copyright

Verfügbare Formate

Dieses Dokument teilen

Dokument teilen oder einbetten

Freigabeoptionen

Stufen Sie dieses Dokument als nützlich ein?

Sind diese Inhalte unangemessen?

Copyright:

Verfügbare Formate

CH 16

Hochgeladen von

Copyright:

Verfügbare Formate

Mah a Mobeen

Copyright 2011 John Wiley &

Copyright 2011 John Wiley &

4. Discuss some of the practical considerations

securities used to finance its activities.

will often include debt and preference shares.

shares, for example with different voting rights

Copyright 2011 John Wiley &

unsecured, convertible or not convertible into ordinary shares, and so

Preference shares can be cumulative or

non-cumulative and convertible or not

represented by debt is a measure of the

Copyright 2011 John Wiley &

degree of financial leverage.

capital structure is important because it

Copyright 2011 John Wiley &

The Optimal Capital

structure so that the mix of securities

This mix is the optimal capital structure

because the capital structure that minimises

Copyright 2011 John Wiley &

The Modigliani and Miller

3. The real investment policy of the firm is not

Copyright 2011 John Wiley &

The Modigliani and Miller

the criteria that the firm uses in deciding which

value of the equity must equal the value of

Copyright 2011 John Wiley &

The Modigliani and Miller

says that the combined value of the equity and

Copyright 2011 John Wiley &

The Modigliani and Miller

where a combination of financial transactions

Copyright 2011 John Wiley &

Exhibit 16.1: Capital Structure

Copyright 2011 John Wiley &

The Modigliani and Miller

that the cost of (required return on) a

WACC = RA = (E/V)RE + (D/V)RD

Copyright 2011 John Wiley &

The Modigliani and Miller

WACC = RA = (E/V)RE + (D/V)RD

RA is the cost of the firms business

Copyright 2011 John Wiley &

The Modigliani and Miller

the risk associated with the characteristics of

The second source of risk is the capital structure

of the firm which reflects the effect that the firms

payments to a firms lenders.

Exhibit 16.2: Relations between

Copyright 2011 John Wiley &

Exhibit 16.3: Illustration of Relations

Copyright 2011 John Wiley &

Exhibit 16.4: Illustrations of

Copyright 2011 John Wiley &

Copyright 2011 John Wiley &

Case I - No Taxes - Example

Required return on assets = WACC = R A =

What is the cost of equity?

RE = 0.16 + (0.16 0.10)(.45/.55) = 20.91

Proof for WACC:

WACC = RA = (E/V)RE + (D/V)RD

What happens if the firm increases leverage