Chapter 12 Capital Structure: Theory and Taxes Professor XXXXX Course Name / # © 2007 Thomson South-Western.

Chapter 12Capital Structure: Theory and Taxes

Professor XXXXXCourse Name / #

© 2007 Thomson South-Western

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The fundamental principle of financial leverage: Substituting debt for equity

increases expected returns to shareholders—measured by earnings per share or ROE—and the risk (dispersion) of those returns.

Financial Leverage

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Financial Leverage

When firms borrow money, we say that they use financial leverage. a firm with debt on its balance sheet is a

levered firm a firm that finances its operations entirely

with equity is an unlevered firm. In Britain, they refer to debt as gearing. These terms imply that debt magnifies a

firm’s financial performance in some way. That effect can be either positive or

negative, depending on the returns a firm earns on the money it borrows.

Recapitalization

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Example: Using Debt to IncreaseExpected Earnings per Share

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Evidence on Capital Structure 1) More profitable firms tend to use less

leverage.

2) High-growth firms borrow less than mature firms do.

3) Firms’ product market strategies and asset bases influence capital structure

choice. 4) Stock market generally views leverage-

increasing events positively.

5) Tax deductibility of interest gives firms an incentive to use debt.

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Worldwide Capital Structure Patterns

Firms in the same industry often have similar capital structures regardless of their home country.

Capital structures vary across countries. Leverage ratios vary inversely with financial

distress costs. Corporate and personal taxes influence capital

structures, but taxes alone cannot explain differences in leverage across firms, industries, or countries.

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Worldwide Capital Structure Patterns

Markets interpret leverage-increasing events as “good news” and leverage-decreasing events as “bad news.”

Corporations strive to maintain target capital structures.

Research suggests that corporations like to operate within target leverage zones and will issue new equity (debt) when debt ratios get too high (low).

There is some evidence that, within industries, leverage varies inversely with profitability.

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Theoretical Models Of Capital Structure

Modigliani and Miller’s (M&M) capital structure model

The agency cost/tax shield trade-off model

The pecking order theory

The signaling model

The market-timing model

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The Agency Cost/Tax-shield Trade-off Model

The trade-off model: predicts that managers choose the capital structure that strikes a balance between debt’s tax advantages and its agency costs.

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The Pecking-order Model

Strongest challenger to the trade-off model

Consists of two assumptions: Managers are better informed

about their own firms’ prospects than are outside investors (an asymmetric information assumption)

Managers act in the best interests of existing shareholders

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The Signaling Model

The signaling model assumes that managers know more about a firm’s prospects than investors do and that in the absence of any compelling evidence to the contrary, investors assign an “average” valuation to each firm.

If managers feel that investors undervalue the firm, the only way to convince them of the firm’s true value is to send a signal that a less-valuable firm cannot mimic. One such signal is to issue debt Investors respond to the signal by bidding up the

share prices of debt-issuing firms.

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The Market-timing Model

Firms time the market by issuing equity when share values are high and issuing debt when share prices are low.

As a consequence, a firm’s capital structure simply reflects the cumulative effects of its managers’ past market-timing activities.

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The Modigliani & Miller Propositions

Modigliani and Miller (M&M) argument: capital structure decisions cannot affect firm valueManagers who operate in imperfect

markets can see more clearly how market imperfections might lead them to choose one capital structure over another.

M&M’s argument rests on the principle of no arbitrage

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The M&M Capital Structure Model

First model to show that capital structure decision may be irrelevant

Assumes perfect markets, no taxes or transactions costs

Key insight

Firm value is determined by:

Cash flows generated

Underlying business risk

Capital structure merely determines how cash flows and risks are allocated between bondholders and stockholders.

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Assumptions Of The M&M Capital Structure Model

Capital markets are frictionless – neither firms nor investors pay taxes or transactions costs.

Investors can borrow and lend at the same rate that corporations can.

Firms are identical in every respect except for capital structure.

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M&M Proposition I

In perfect markets, a firm’s total market value equals the value of its assets and is independent of the firm’s capital structure.

The value of the assets equals the present value of the cash flows generated by the assets.

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M&M Proposition I

Because the proposition leads to the conclusion that the firm’s capital structure does not matter, it is popularly known as the “irrelevance proposition.”

The firm’s market value equals the present value of the cash flows it generates regardless of the capital structure it chooses.

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M&M Proposition I

Use arbitrage arguments to prove proposition I

Firm U has no debt.Firm L has both debt and

equity.

Required return r for firms of this risk class is 10%.

Firms U and L belong to same risk class and have same expected EBIT $2,000,000 per year in

perpetuity.

Proposition I: Market value of a firm is driven by two factors: cash flow and risk (determines the discount rate).

Under proposition I, market value of firms U and L should be identical.

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M&M Proposition I

Firm U Firm L

Earnings before interest (no taxes)

$2,000,000 $2,000,000

Required return on assets 10% 10%

Market value of assets

Debt $0 $10,000,000

Interest rate on debt 6%

Interest expense $600,000

Shares outstanding 1,000,000 500,000

Price per share $20 $20

Market value of equity $20,000,000 $10,000,000

Market value of assets should be

$20,000,000

$20,000,000

%10

000,000,2$

$20,000,000

%10

000,000,2$

Market value of firm U = 1,000,000 x $20 = $20,000,000Market value of firm L = 500,000 x $20 + $10,000,000 = $20,000,000

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M&M Proposition I

What is the return the shareholders of the two firms expect on their shares?

Firm U has no debt

Required return on equity equals required return on

assets of 10%

Required return on equity = 10%

Firm L pays $600,000 interest.EBIT is

$2,000,000

Shareholders receive a cash dividend of $1,400,000, or

$2.80/share. Share price = $20.

Required return on equity = $2.80/$20 = 14%

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M&M Proposition I

What if the shares of the levered firm are selling at premium?

Firm L

Stock price $20

Total firm value $20,000,000

Debt value $10,000,000

Shares outstanding 500,000

Dividend per share $2.80

Required return on equity 0.14

$25

$22,500,000

Assume the stock price of firm L is $25.

Total firm value increases to $22,500,000.The price of $25 per share implies a return of $2.80/$20 = 0.112.0.112

Firm L stockholders can use “homemade leverage” to generate arbitrage profit.

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M&M Proposition I

Assume investor owns

5,000 shares of firm L

• The investor owns 1% of firm L.• He earns $2.80 per share in

dividends.• The shares will generate $14,000

each year.The investor could earn an arbitrage profit from the

following:

Borrow an amount equal to 1% of firm L debt

• $100,000 at 6% interest

Buy 1% of firm U equity • 10,000 shares at $20 per share

Sell 5,000 of firm L at $25 per share

• Proceeds of $125,000

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M&M Proposition I

Trades

Proceeds from stock sale $125,000

Proceeds from borrowing $100,000

Total proceeds $225,000

Cost of firm U shares -$200,000

Net proceeds $25,000

The net return on the new

portfolio

• $2 dividend per share of firm U, $20,000 for 10,000 shares

• $6,000 interest expense on borrowed money

• $14,000 cash inflow next year on the new portfolio

Using homemade leverage, investor has

built a portfolio of $200,000 of firm U's

stock and $100,000 in personal debt.

Investor has $25,000 remaining.

The same return expected on the original 1% stake in firm L's shares!

The cost of building this portfolio is just $200,000 , $25,000 less than the cost of 5,000 firm L shares.

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Proposition II And The WACC

Though debt is less costly for firms to issue than equity, issuing debt causes the required return on the remaining equity to rise.

Based on the core finance principle that investors expect compensation for risk, shareholders of levered firms demand higher returns than do shareholders in all-equity companies.

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Proposition II And The WACC

Proposition II says that the expected return on a levered firm’s equity, rl, rises with the debt-to-equity ratio:

Proposition II rearranged is the

WACC:

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M&M Proposition II Illustrated—The Cost of Equity, Cost of Debt, and WACC for a Firm in a World without Taxes

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The M&M Model With Corporate Taxes

Firms can treat interest payments to lenders as a tax-deductible business expense.

Dividend payments to shareholders receive no similar tax advantage.

Intuitively, this should lead to a tax advantage for debt, meaning that managers can increase firm value by issuing debt.

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Determining The Present ValueOf Debt Tax ShieldsAssume the firm always renews its debt when it matures

– the interest deduction becomes a perpetuity equal to the tax rate times the interest paid.

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The Impact of Taxes on Proposition I

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The Impact of Taxes on Proposition I

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The M&M Model With CorporateAnd Personal Taxes

Miller argued that debt’s tax advantage over equity at the corporate level might be partially or fully offset by a tax disadvantage at the individual level

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Bond Market Equilibrium With Corporate And Personal Taxes

Wouldn’t taxable investors also demand a higher interest rate to compensate them for taxes due?

The answer is yes, but …. Miller explains that interest rates do not rise immediately for two reasons: (1) Some investors, such as endowments

and pension funds, do not have to pay taxes on interest income.

(2) Investors who do not enjoy this tax-exempt status can buy municipal bonds, which pay interest that is tax free.

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Bond Market Equilibrium in the Miller (1977) Model

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Other Tax-based Models Of Capital Structure

The Nondebt tax shields (NDTS) hypothesis states that companies with large amounts of depreciation, investment tax credits, R&D expenditures, and other nondebt tax shields should employ less debt financing than otherwise equivalent companies with fewer such shields. Later research found that leverage seemed

to be directly, not inversely, related to the availability of NDTS.

The secured debt hypothesis implies that firms rich in tangible assets are able to use higher levels of (secured) debt.

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How Taxes Should Affect Capital Structure

1. The higher the corporate income tax rate, Tc, the higher will be the equilibrium leverage level economy-wide. An increase in Tc should cause debt ratios to increase for most firms.

2. The higher the personal tax rate on equity-related investment income (dividends and capital gains), Tps, the higher will be the equilibrium leverage level. An increase in Tps should cause debt ratios to increase.

3. The higher the personal tax rate on interest income, Tpd, the lower will be the equilibrium leverage level. An increase in Tpd should cause debt ratios to fall.