Capital Structure MM Theory 1. Capital Structure “neither a borrower nor a lender be” (Source: Shakespeare`s Hamlet) “The firm`s mix of securities(long.

Capital Structure MM Theory

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Capital Structure“neither a borrower nor a lender be”

(Source: Shakespeare`s Hamlet)

• “The firm`s mix of securities(long term debt & equity) is known as capital structure”.

The issues that we seek to address here are:

• How does a firm select its capital structure (debt-equity ratio)?

• Shareholders want management to choose capital structure that maximize firm value. • Is there an optimal capital structure?

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Value and Capital Structure•Consider simple balance sheet, with all

entries expresses as current market value.

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Assets Liabilities and Stockholder’s Equity

Value of cash flows from firm’s real assets and operations

Market value of debt

Market value of equity

Value of Firm Value of Firm

Average Book Debt RatiosIndustry Debt Ratio

Software and programming 0.06 Semiconductors 0.09 Communications equipment 0.13 Biotech 0.28 Retail 0.34 Hotels and motels 0.37 Chemical manufacturing 0.53 Airlines 0.59 Electric utilities 0.60 Real estate operations 0.62 Beverages (alcohol) 0.63 -------------------------------------- --------Average for US Companies 0.51

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M&M (Debt Policy Doesn’t Matter)•Modigliani & Miller

▫When there are no taxes and capital markets function well, the market value of a company does not depend on its capital structure. In other words, financial managers cannot increase value by changing the mix securities used to finance the company.

▫MM`s proposition or MM debt irrelevance proposition states that “under ideal conditions the firm`s debt policy shouldn`t matter to shareholders”.

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M&M (Debt Policy Doesn’t Matter)Assumptions

• Capital markets have to be “well functioning”

– Investor can borrow and lend money on the same terms as the firm.

– Capital markets are efficient• Capital structure does not affect cash flows, if

– No taxes– No bankruptcy costs– No effect on management incentives

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M&M (Debt Policy Doesn’t Matter)

17.5%12.5%7.5% shares on Return

1.751.25$.75shareper Earnings

175,000125,000$75,000Income Operating

BoomExpectedSlump

Economy theof State Outcome

million 1 $Shares of ValueMarket

$10shareper Price

100,000shares ofNumber

Data

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Example - River Cruises - All Equity Financed

M&M (Debt Policy Doesn’t Matter)

25%15%5% shares on Return

2.501.50$.50shareper Earnings

125,00075,000$25,000earningsEquity

50,00050,000$50,000Interest

175,000125,000$75,000Income Operating

BoomExpectedSlump

Economy theof State Outcome

500,000 $debt of ueMarket val

500,000 $Shares of ValueMarket

$10shareper Price

50,000shares ofNumber

Data

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50% debt

Now restructuring occurs with equal distribution of debt & equity.

M&M (Debt Policy Doesn’t Matter)

25%15%5% investment$10 on Return

2.501.50$.50investmenton earningsNet

1.001.00$1.00 10% @Interest :LESS

3.502.50$1.50shares on two Earnings

BoomExpectedSlump

Economy theof State Outcome

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Example - River Cruises - All Equity Financed

- Debt replicated by investors

M&M (Debt Policy Doesn’t Matter)

17.5%12.5%7.5% investment$20 on Return

3.502.50$1.50investmenton earningsNet

1.001.00$1.0010% @Interest :PLUS

2.501.50$0.50share oneon Earnings

BoomExpectedSlump

Economy theof State Outcome

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Example - River Cruises – Firm debt at 50% - Investor can unwrap debt

- $10 invested in share & $10 lend at 10%

Capital Structure(Definition)•Operating Risk (business risk) – Risk

in the firm’s operating income.

•Financial Risk - Risk to shareholders resulting from the use of debt.

•Financial Leverage - Increase in the variability of shareholder returns that comes from the use of debt.

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Cost of Capital

a

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•MM`s proposition 1 states that firm`s capital structure does not effect firm`s operating income or value of its asset, but it affects the financial risk of firm.e.g.• From previous example following are the returns:

• With all equity financing return was 1.25/10 = .125 = 12.5%

• With debt-equity structure return was 1.50/10 = .15 = 15%

River Cruises`s Return on assets

1. 12.5% is the expected return from all equity investment.2. Expected return on leveraged firm:

Expected return on equity = requity = .15 = 1.50%Return on debt = rdebt = .10 = 10%

• Overall return is: (.5 x .10) + (.5 x .15) = .125 = rasset

rassets = ( rdebt x D/V ) + ( requity x E/V )

So total return on both structure remains same.• Here is formula for expected return from leveraged firm.

requity = rassets + D/E (rassets -rdebt)

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River Cruises`s Cost of Equity• River Cruise with all equity • requity = rassets = expected operating income market value of all securities

= 125,000/1,000,000 = .125 = 12.5%

• requity = rassets + D/E (rassets -rdebt) =.125 + 500,000/500,000 (.125-.10) = .15 = 15%• Debt increase the return but also increase the financial risk

& cause shareholders to demand higher return on their investment.

• Once you recognise this cost, debt is no cheaper than equity.

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MM’s Proposition II (w/fixed interest rate)

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Debt-Equity ratio, D/E

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• MM II proposition continues to predict that return on package of debt and equity does not change.• However the expected rate of return on equity increases as the firm`s debt equity ratio increases.

MM’s Proposition II

•When the possibility of bankruptcy and its associated costs are considered, the optimal capital structure (optimal debt-equity ratio ) is at the point where the additional tax-shield benefit of taking on one more dollar of debt (marginal benefit) is equal to the cost of bankruptcy (marginal cost).

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Capital Structure & Corporate Taxes• MM propositions suggest that debt policy

should not matter. Then why financial managers do worry about their debt policy?Answer lies in the assumption we made before MM propositions.

Debt and Taxes at River Cruises:• Interest is tax deductible expense, while

equity income is subject to corporate tax.• Interest Tax Shield: Tax savings resulting from

deductibility of interest payments.

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Capital Structure & Corporate Taxes(continued)

Zero Debt $500,000 of Debt

Expected operating income 125,000 125,000

Debt interest at 10% 0 50,000

Before tax income 125,000 75,000

Tax at 35% 43,750 26,750

After tax income 81,250 48,750

Combined debt & equity income (debt interest + after tax income)

81,250 98,750

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A clear savings of 17,500 is visible,

Capital Structure & Corporate Taxes(continued)

Annual tax shield = Corporate tax rate X Interest payment

= Tc x (rdebt x D) = .35 x (500,000 x 0.10)

= 17,500

Tc = Corporate taxrdebt = Interest rateD = Amount borrowed

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Capital Structure & Corporate Taxes(continued)•If tax shield is permanent, we can use the

perpetuity formula to calculate present value

•PV tax shields = annual tax shield rdebt

= Tc x (rdebt x D) = TcD rdebt

= .35 x 500,000 = $175,000

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How interest tax shield contribute the value of stockholder`s equity

Value of levered firm = value of all equity financed + PV of tax shield

• In case of permanent debt:Value of levered firm = value of all equity financed + TcD

“So borrowing increases the firm value & shareholder`s wealth by the PV of tax savings.”

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Financial Distress• Costs of Financial Distress - Costs arising

from bankruptcy or distorted business decisions before bankruptcy.▫As the firm assumes more debt, it becomes more

risky, i.e., will have a higher chance of defaulting on its debt and investors will therefore demand a higher return.

▫Financial distress based on – probability of distress & the magnitude of costs encountered if it occurs.

▫WorldCom paid $800 M to $1 Billion in fees during 21 months it spent in Chapter 11. Normally it is 3%.

• Market Value = Value if all Equity Financed + PV Tax Shield - PV Costs of Financial Distress

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Financial Distress (Trade-off theory)

a

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Debt

Mar

ket V

alue

of T

he F

irm

Value ofunlevered

firm

PV of interesttax shields

Costs offinancial distress

Value of levered firm

Optimal amount of debt

Maximum value of firm

Financial Distress“Borrow $1000 and you`ve got a banker. Borrow $10,000,000 and you`ve got a partner.”

1st Game: Bet the Bank`s Money – • Before bankruptcy as all agree that there is no

shareholder equity – so they`ve nothing to lose. So managers of failing firm gamble literally.

2nd Game: Don`t Bet Your Own Money – If probability of default is high:

• Managers & shareholders tempted to take high risky project.

• However, stockholders may refuse to contribute more equity.

• Stockholders would rather take money out of firm than put new money in.

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Financial Choices• Trade-off Theory - Theory that capital structure

is based on a trade-off between tax savings and financial distress costs of debt.• Debt level should be increased till point where value of

additional interest tax shield is exactly offset by the additional cost of financial distress.

• Pecking Order Theory - Theory stating that firms prefer to issue debt rather than equity if internal finance is insufficient.

• Financial Slack - Reserve of ready cash or unused borrowing capacity.• Financing is readily available for positive NPV

projects.• Too much leads to high perks or ill-advised

acquisitions etc.

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Pecking Order Theory•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:1. Internal funds2. External funds

1. Debt 2. Equity

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Pecking Order Theory• There are three factors that the pecking

order theory is based on and that must be considered by firms when raising capital.

1. Internal funds are cheapest to use (no issuance costs) and require no private information release.

2. Debt financing is cheaper than equity financing.

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Pecking Order Theory3. Managers tend to know more about the

future performance of the firm than lenders and investors. Because of this asymmetric information, investors may make inferences about the value of the firm based on the external source of capital the firm chooses to raise.

Equity financing inference – firm is currently overvalued

Debt financing inference – firm is correctly or undervalued

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Pecking Order Theory• The pecking order theory suggests that the firm

will first use internal funds. More profitable companies will therefore have less use of external sources of capital and may have lower debt-equity ratios.

• If internal funds are exhausted, then the firm will issue debt until it has reached its debt capacity .

• Only at this point will firms issue new equity.

• This theory also suggests that there is no target debt-equity mix for a firm.

• Peaking order theory work best for mature firms.

• Fast-growing high tech firms often resort to a series of common stock issues to finance their investments. Here common stock come at the top of peaking order.

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