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Determination
1
Capital Structure
Determination
A Conceptual Look
The Total-Value Principle
Presence of Market Imperfections and
Incentive Issues
The Effect of Taxes
Taxes and Market Imperfections Combined
Financial Signaling
Timing and Flexibility
Financing Checklist
2
Capital Structure
Capital Structure -- The mix (or proportion) of
a firm’s permanent long-term financing
represented by debt, preferred stock, and
common stock equity.
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.
3
A Conceptual Look --
Relevant Rates of Return
ki = the yield on the company’s debt
I Annual interest on debt
ki =
B
=
Market value of debt
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.)
4
A Conceptual Look --
Relevant Rates of Return
ke = the expected return on the company’s equity
Earnings available to
E
E common shareholders
ke = S =
S Market value of common
stock outstanding
Assumptions:
• Earnings are not expected to grow
• 100% dividend payout
• Results in the valuation of a perpetuity
• Appropriate in this case for illustrating the
theory of the firm
5
A Conceptual Look --
Relevant Rates of Return
ko = an overall capitalization rate for the firm
O
O Net operating income
ko =
V
V
=
Total market value of the firm
Assumptions:
• V = B + S = total market value of the firm
• O = I + E = net operating income = interest
paid plus earnings available to common
shareholders
6
Capitalization Rate
Capitalization Rate, ko -- The discount rate
used to determine the present value of a
stream of expected cash flows.
B S
ko = ki + ke
B+S B+S
.20
ke (Required return on equity)
.15
ko (Capitalization rate)
.10
ki (Yield on debt)
.05
0
0 .25 .50 .75 1.0 1.25 1.50 1.75 2.0
12 Financial Leverage (B / S)
Summary of NOI Approach
Criticalassumption 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.
13
Traditional Approach
14
Optimal Capital Structure:
Traditional Approach
Traditional Approach
ke
.25
ko
Capital Costs (%)
.20
.15
ki
.10
Optimal Capital Structure
.05
0
Financial Leverage (B / S)
15
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).
16
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.
17
Total Value Principle:
Modigliani and Miller
Market value Market value
of debt ($35M) of debt ($65M)
Premium
ke with no leverage
on Equity (ke)
for financial
risk
ke without bankruptcy costs
Premium
for business
risk
Rf
Risk-free
rate
Financial Leverage (B / S)
27
Agency Costs
Agency Costs -- Costs associated with
monitoring management to ensure that it behaves
in ways consistent with the firm’s contractual
agreements with creditors and shareholders.
Monitoring includes bonding of agents, auditing
financial statements, and explicitly restricting
management decisions or actions.
Costs are borne by shareholders (Jensen & Meckling).
Monitoring costs, like bankruptcy costs, tend to rise at
an increasing rate with financial leverage.
28
Example of the Effects
of Corporate Taxes
The judicious use of financial leverage
(i.e., debt) provides a favorable impact
on a company’s total valuation.
Consider two identical firms EXCEPT:
Present value of
tax-shield benefits (r) (B) (tc)
= = (B) (tc)
of debt* r
2. Flexibility
A decision today impacts the options open to the firm for
future financing options – thereby reducing flexibility.
Often referred to as unused debt capacity.
39
Checklist of Practical and
Conceptual
Considerations
1. Taxes 6. EBIT-EPS
2. Explicit cost analysis
40