Chapter 9 Theory of Capital Structure

1®2002 Prentice Hall Publishing

Chapter 9Theory of Capital Structure

2®2002 Prentice Hall Publishing

Introduction to the Theory

• Capital structure is the proportions ofCapital structure is the proportions of– Debt Debt – Preferred stockPreferred stock– Common stockCommon stock

• AssumptionsAssumptions• DefinitionsDefinitions• NOI approachNOI approach• Traditional approachTraditional approach

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Assumptions

• No taxes & no bankruptcy costsNo taxes & no bankruptcy costs

• No transaction costsNo transaction costs

• Pay all earnings in dividendsPay all earnings in dividends

• Same expected future operating earnings for Same expected future operating earnings for all investorsall investors

• No growth of earningsNo growth of earnings

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Definitions• kkii is the yield on the company’s debt is the yield on the company’s debt

• kkee is the earnings/price ratio is the earnings/price ratio

– Required rate of return for investorsRequired rate of return for investors

• kk00 is an overall capitalization rate for the firm is an overall capitalization rate for the firm

– Weighted average cost of capital (WACC)Weighted average cost of capital (WACC)

goutstandindebt of ueMarket val

chargesinterest Annualk i

goutstandinstock of ueMarket val

rstockholdecommon toavailable Earnings ke

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Calculating NOI Approach

NOINOIXX

Overall capitalization rateOverall capitalization rate==

Total value of firmTotal value of firm––

Market value of debtMarket value of debt==

Market value of stockMarket value of stock

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NOI Approach

• Required return on equity increases linearly Required return on equity increases linearly with leveragewith leverage

• Total valuation of the firm unaffected by it Total valuation of the firm unaffected by it capital structurecapital structure

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Important Assumptions of NOI Approach

• kk0 0 is constantis constant– Regardless of the degree of leverageRegardless of the degree of leverage

• Breakdown between debt and equity Breakdown between debt and equity unimportantunimportant

• If kIf ki i remains constant, remains constant, kke e is a constant linear is a constant linear function of the debt-to-equity ratiofunction of the debt-to-equity ratio

• kk0 0 cannot be altered through leveragecannot be altered through leverage– No one optimal capital leverageNo one optimal capital leverage

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Traditional Approach

• There is an optimal capital structureThere is an optimal capital structure

• Increase the total value of the firm through Increase the total value of the firm through leverageleverage

• Cost of capital is independent of the capital Cost of capital is independent of the capital structurestructure

• Optimal capital structure existsOptimal capital structure exists

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Modigliani-Miller (MM) Position

• Assumptions are importantAssumptions are important

• Capital structure is irrelevantCapital structure is irrelevant

• Total investment value of a corporation Total investment value of a corporation depends on profitability and riskdepends on profitability and risk

• Value is the same regardless of financing mixValue is the same regardless of financing mix

• Homemade leverageHomemade leverage

• Arbitrage efficiencyArbitrage efficiency

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Irrelevance in a CAPM Framework

• As leverage increasesAs leverage increases

– Expected return and beta increase Expected return and beta increase proportionallyproportionally

• The change in expected return and beta The change in expected return and beta offset each other with respect to share priceoffset each other with respect to share price

• Share price is invariant with respect to Share price is invariant with respect to leverageleverage

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Taxes and Capital Structure

• Important market imperfectionsImportant market imperfections

• Corporate taxesCorporate taxes

• Components of overall valueComponents of overall value

Value if levered + Value of tax shield Value if levered + Value of tax shield

• Optimal strategy is to maximize leverageOptimal strategy is to maximize leverage

– Not consistent with corporate behaviorNot consistent with corporate behavior

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Uncertainty of Tax Shield

• Income is consistently low or negativeIncome is consistently low or negative

• BankruptcyBankruptcy

• Change in the corporate tax rateChange in the corporate tax rate

• RedundancyRedundancy

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New Value Equation

Value of Value if Pure value Value lostValue of Value if Pure value Value lost firm = Unlevered + of corporate – through taxfirm = Unlevered + of corporate – through tax tax shield shieldtax shield shield uncertainty uncertainty

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Corporate Plus Personal Taxes

• Personal taxes can reduce the corporate tax Personal taxes can reduce the corporate tax advantageadvantage

• Dividends versus capital gainsDividends versus capital gains

• Debt or stock incomeDebt or stock income

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Merton Miller’s Equilibrium• In market equilibrium personal and corporate tax In market equilibrium personal and corporate tax

effects cancel outeffects cancel out• Investor clienteles and market equilibriumInvestor clienteles and market equilibrium• Completing the marketCompleting the market• CounterargumentsCounterarguments

– Zero personal tax on stock income is suspectZero personal tax on stock income is suspect– Disturbing relationship betweenDisturbing relationship between

• Corporate debt Corporate debt • Stock returnsStock returns• Returns on tax-exempt municipal bondsReturns on tax-exempt municipal bonds

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Recapitulation

• Tax advantage to borrowingTax advantage to borrowing

– Moderate amounts of debtModerate amounts of debt

– Tax shield uncertainty is not greatTax shield uncertainty is not great

• Some lessening of the corporate tax effectSome lessening of the corporate tax effect

– Owing to personal taxesOwing to personal taxes

• Greater the tax wedgeGreater the tax wedge

– Lower the overall tax shieldLower the overall tax shield

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Effects of Bankruptcy Costs• Less than perfect capital marketsLess than perfect capital markets

– Administrative costs to bankruptcyAdministrative costs to bankruptcy– Assets liquidated at < economic valueAssets liquidated at < economic value

• Relationship to leverageRelationship to leverage– Deadweight loss to suppliers of capitalDeadweight loss to suppliers of capital

• Taxes and bankruptcy costsTaxes and bankruptcy costs– Trade-off betweenTrade-off between

• Tax effects of leverageTax effects of leverage• Bankruptcy costs associated with high leverageBankruptcy costs associated with high leverage

– Most important imperfectionsMost important imperfections

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Other Imperfections• Corporate and homemade leverage not being Corporate and homemade leverage not being

perfect substitutesperfect substitutes– Advantage to corporation borrowingAdvantage to corporation borrowing– Arbitrage processArbitrage process

• Institutional restrictionsInstitutional restrictions– Adverse effects on market valueAdverse effects on market value

• Greater the importance of imperfectionsGreater the importance of imperfections– Less effective MM arbitrage processLess effective MM arbitrage process– Greater the case for an optimal capital structureGreater the case for an optimal capital structure

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Incentive Issues and Agency Costs

• Agency costs Agency costs

– Stakeholders monitoringStakeholders monitoring

• Equity holdersEquity holders

• Debt holdersDebt holders

• ManagementManagement

• Other stakeholdersOther stakeholders

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Debt Holders Versus Equity Holders

• Equity of a firmEquity of a firm

– Call option on the firm’s total valueCall option on the firm’s total value

• Debtholders are the writers of the optionDebtholders are the writers of the option

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Effect of Variance and the Riskiness of Assets

• By increasing the riskiness of the companyBy increasing the riskiness of the company

– Stockholders increase the value of their Stockholders increase the value of their stockstock

– At the direct expense of the debt holdersAt the direct expense of the debt holders

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Changing the Proportion of Debt

• Will affect the relative valuationWill affect the relative valuation

– Of debtOf debt

– Of equityOf equity

• Relationship between the proportion of debt and Relationship between the proportion of debt and valuationvaluation

– Increasing the proportion of debtIncreasing the proportion of debt

• Results in a decline in the price of debtResults in a decline in the price of debt

• Results in an increase in share priceResults in an increase in share price

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Protective Covenants

• Restrict the stockholders’ abilityRestrict the stockholders’ ability

– To increase the assets riskinessTo increase the assets riskiness

– To increase leverageTo increase leverage

• MM argumentMM argument

• ““Me-first” rulesMe-first” rules

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The Underinvestment Problem

• Result of equity holders not wishing to Result of equity holders not wishing to invest when the rewards favor debt holdersinvest when the rewards favor debt holders

• Disappears whenDisappears when

– Investors own both stocks and bondsInvestors own both stocks and bonds

– By contracting between debt holders and By contracting between debt holders and stockholdersstockholders

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Agency Costs More Broadly Defined

• MonitoringMonitoring

– Cost is born by stockholdersCost is born by stockholders

– Debt holders charge more interestDebt holders charge more interest

– May limit the optimal amount of debtMay limit the optimal amount of debt

• Optimal balance betweenOptimal balance between

– Monitoring costsMonitoring costs

– Interest rate charged on debtInterest rate charged on debt

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Organizational Incentives to Manage Efficiently

• Leveraged companies Leveraged companies – May be lean because management cuts the fatMay be lean because management cuts the fat– Running scaredRunning scared

• Debt brings capital-market discipline to Debt brings capital-market discipline to managementmanagement

• Company with little debtCompany with little debt– Significant free cash flowSignificant free cash flow– Have a tendency to squander fundsHave a tendency to squander funds

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Asymmetric Information

• Signaling effectSignaling effect– Assumes there is information asymmetryAssumes there is information asymmetry

• Credibility of a financial signal depends on Credibility of a financial signal depends on asymmetric informationasymmetric information

• The greater the asymmetry in information the The greater the asymmetry in information the greater the likely stock reaction to a financing greater the likely stock reaction to a financing announcementannouncement

• What is significant?What is significant?– The signal conveyed by a changed capital The signal conveyed by a changed capital

structure structure