1. 17.1 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. Chapter 17 Capital Structure Determination

2. 17.2 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. After Studying Chapter 17, you should be able to: 1. Define “capital structure.” 2. Explain the net operating income (NOI) approach to capital structure and valuation of a firm; and, calculate a firm's value using this approach. 3. Explain the traditional approach to capital structure and the valuation of a firm. 4. Discuss the relationship between financial leverage and the cost of capital as originally set forth by Modigliani and Miller (M&M) and evaluate their arguments. 5. Describe various market imperfections and other "real world" factors that tend to dilute M&M’s original position. 6. Present a number of reasonable arguments for believing that an optimal capital structure exists in theory. 7. Explain how financial structure changes can be used for financial signaling purposes, and give some examples.

3. 17.3 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. A Conceptual Look The Total-Value Principle Presence of Market Imperfections and Incentive Issues The Effect of Taxes Taxes and Market Imperfections Combined Capital Structure Determination

4. 17.4 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. 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. Capital Structure -- The mix (or proportion) of a firm’s permanent long-term financing represented by debt, preferred stock, and common stock equity. Capital Structure

5. 17.5 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. k i = the yield on the company’s debt Annual interest on debt Market value of debt IBIB == kikikiki 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.) A Conceptual Look – Relevant Rates of Return

6. 17.6 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. ESES == k e = the expected return on the company’s equity Earnings available to common shareholders Market value of common stock outstanding kekekeke 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 ESES A Conceptual Look – Relevant Rates of Return

7. 17.7 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. OVOV == k o = an overall capitalisation rate for the firm Net operating income Total market value of the firm kokokoko Assumptions: V = B + S = total market value of the firm O = I + E = net operating income = interest paid plus earnings available to common shareholders OVOV A Conceptual Look – Relevant Rates of Return

8. 17.8 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. Capitalisation Rate, k o Capitalisation Rate, k o – The discount rate used to determine the present value of a stream of expected cash flows. kokokoko kekekeke kikikiki B B + S S B + S =+ k i k e k o What happens to k i, k e, and k o when leverage, B/S, increases? Capitalisation Rate

9. 17.9 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. Assume: Net operating income equals $1,350 Market value of debt is $1,800 at 10% interest k oOverall capitalisation rate is 15% = k o Net Operating Income Approach – A theory of capital structure in which the weighted average cost of capital and the total value of the firm remain constant as financial leverage is changed. Net Operating Income Approach

10. 17.10 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. Total firm value$1,350 $9,000 Total firm value= O / k o = $1,350 / 0.15 = $9,000 $9,000$1,800 $7,200 Market value= V – B= $9,000 – $1,800 of equity= $7,200 Required return on equity$1,350$180$7,200 16.25% Required return= E / S on equity*= ($1,350 – $180) / $7,200 = 16.25% Calculating the required rate of return on equity * B / S = $1,800 / $7,200 = 0.25 Interest payments = $1,800 × 10% = $1,800 × 10% Required Rate of Return on Equity

11. 17.11 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. Total firm value$1,350 $9,000 Total firm value= O / k o = $1,350 / 0.15 = $9,000 $9,000$3,000 $6,000 Market value= V – B= $9,000 – $3,000 of equity= $6,000 Required return on equity$1,350$300$6,000 17.50% Required return= E / S on equity*= ($1,350 - $300) / $6,000 = 17.50% What is the rate of return on equity if B=$3,000? * B / S = $3,000 / $6,000 = 0.50 Interest payments = $3,000 × 10% = $3,000 × 10% Required Rate of Return on Equity

12. 17.12 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. k i k e k o B / S k i k e k o —15.00% 15% 0.00 —15.00% 15% 10% 16.25% 15% 0.25 0.2:0.8 10% 16.25% 15% 10% 17.50% 15% 0.50 0.33:0.67 10% 17.50% 15% 10% 20.00% 15% 1.00 0.5:0.5 10% 20.00% 15% 10% 25.00% 15% 2.00 0.67:0.33 10% 25.00% 15% Examine a variety of different debt-to-equity ratios and the resulting required rate of return on equity. Calculated in slides 9 and 10 Required Rate of Return on Equity

13. 17.13 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. Capital costs and the NOI approach in a graphical representation. 0 0.25 0.50 0.75 1.0 1.25 1.50 1.75 2.0 Financial Leverage (B/S) 0.25 0.20 0.15 0.10 0.05 0 Capital Costs (%) k e = 16.25% and 17.5% respectively k i (Yield on debt) k o (Capitalisation rate) k e (Required return on equity) Required Rate of Return on Equity

14. 17.14 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. NOI Approach You can create this type of analysis in Excel also. You can use some modeling experience to write formulas to calculate the required rates. Refer to “VW13E- 17.xlsx” on the ‘NOI Approach’ tab Excel & the NOI Approach

15. 17.15 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. Critical assumption is k o 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 k i is constant, k e is a linear function of the debt-to-equity ratio. no one optimal capital structureThus, there is no one optimal capital structure. Summary of NOI Approach

16. 17.16 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. Optimal Capital Structure Optimal Capital Structure – The capital structure that minimises the firm’s cost of capital and thereby maximises the value of the firm. Traditional Approach optimal capital structure Traditional Approach – A theory of capital structure in which there exists an optimal capital structure and where management can increase the total value of the firm through the judicious use of financial leverage. Traditional Approach

17. 17.17 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. Traditional Approach Financial Leverage (B / S) 0.25 0.20 0.15 0.10 0.05 0 Capital Costs (%) kikikiki kokokoko kekekeke Optimal Capital Structure Optimal Capital Structure: Traditional Approach

18. 17.18 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. Traditional Approach You can create this type of analysis in Excel also. We use some assumptions in this model built into the formulas. Refer to “VW13E- 17.xlsx” on the ‘Traditional Approach’ tab Excel and the Traditional Approach

19. 17.19 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. 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 k o declines. Then, increasing financial leverage and the associated increase in k e and k i more than offsets the benefits of lower cost debt financing. one optimal capital structureThus, there is one optimal capital structure where k o is at its lowest point. This is also the point where the firm’s total value will be the largest (discounting at k o ). Summary of the Traditional Approach

20. 17.20 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. Say that the relationship between financial leverage and the cost of capital is explained by the NOI approach. Provide behavioral justification for a constant k o 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. Total Value Principle: Modigliani and Miller (M&M)

21. 17.21 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. Market value of debt ($65M) Market value of equity ($35M) Total firm market value ($100M) M&M assume an absence of taxes and market imperfections. Investors can substitute personal for corporate financial leverage. Market value of debt ($35M) Market value of equity ($65M) Total firm market value ($100M) Total market value is not altered by the capital structure (the total size of the pies are the same). Total Value Principle: Modigliani and Miller

22. 17.22 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. Arbitrage – Finding two assets that are essentially the same and buying the cheaper and selling the more expensive. EXCEPTMUST Two firms that are alike in every respect EXCEPT capital structure MUST have the same market value. arbitrage Otherwise, arbitrage is possible. Arbitrage and Total Market Value of the Firm

23. 17.23 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. EXCEPT Consider two firms that are identical in every respect EXCEPT: Company NL – no financial leverage Company L – $30,000 of 12% debt Market value of debt for Company L equals its par value Required return on equity – Company NL is 15% – Company L is 16% NOI for each firm is $10,000 Arbitrage Example

24. 17.24 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. Earnings available to E common shareholders$10,000 $10,000 Earnings available to = E= O – I common shareholders= $10,000 - $0 = $10,000 Market value of equity$10,000 $66,667 Market value= E / k e of equity= $10,000 / 0.15 = $66,667 Total market value$66,667 $66,667 Total market value= $66,667 + $0 = $66,667 Overall capitalisation rate15% Overall capitalisation rate= 15% Debt-to-equity ratio= 0 Valuation of Company NL Arbitrage Example: Company NL

25. 17.25 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. Earnings available to E common shareholders$10,000 $6,400 Earnings available to = E= O – I common shareholders= $10,000 – $3,600 = $6,400 Market value of equity$6,400 $40,000 Market value= E / k e of equity= $6,400 / 0.16 = $40,000 Total market value$40,000 $70,000 Total market value= $40,000 + $30,000 = $70,000 Overall capitalisation rate14.3% Overall capitalisation rate= 14.3% Debt-to-equity ratio= 0.75 Valuation of Company L Arbitrage Example: Company L

26. 17.26 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. Assume you own 1% of the stock of Company L (equity value = $400). You should: 1.Sell the stock in Company L for $400. 2.Borrow $300 at 12% interest (equals 1% of debt for Company L). 3.Buy 1% of the stock in Company NL for $666.67. This leaves you with $33.33 for other investments ($400 + $300 - $666.67). Completing an Arbitrage Transaction

27. 17.27 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. Original return on investment in Company L $400 × 16% = $64 Return on investment after the transaction $100 return on Company NL$666.67 × 16% = $100 return on Company NL $36 interest paid$300 × 12% = $36 interest paid $64 net return $100$36$33.33 left over$64 net return ($100 – $36) AND $33.33 left over. This reduces the required net investment to $366.67 to earn $64. Completing an Arbitrage Transaction

28. 17.28 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. The equity share price in Company NL rises based on increased share demand. The equity share price in Company L falls based on selling pressures. Arbitrage continues until total firm values are identical for companies NL and L. Therefore, all capital structures are equally as acceptable.Therefore, all capital structures are equally as acceptable. The investor uses “personal” rather than corporate financial leverage. Summary of the Arbitrage Transaction

29. 17.29 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. Agency costs (Slide 31) Debt and the incentive to manage efficiently Institutional restrictions Transaction costs Bankruptcy costs (Slide 30) Market Imperfections and Incentive Issues

30. 17.30 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. Financial Leverage (B / S) RfRfRfRf Required Rate of Return on Equity (k e ) k e with no leverage k e without bankruptcy costs k e with bankruptcy costs Premium for financial risk Premium for business risk Risk-freerate Required Rate of Return on Equity with Bankruptcy

31. 17.31 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. 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. 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. Agency Costs

32. 17.32 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. EXCEPT Consider two identical firms EXCEPT: Company ND – no debt, 16% required return Company D – $5,000 of 12% debt Corporate tax rate is 40% for each company NOI for each firm is $10,000 financial leverage (i.e., debt) Careful use of financial leverage (i.e., debt) provides a favorable impact on a company’s total valuation. Example of the Effects of Corporate Taxes

33. 17.33 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. Earnings available to EO common shareholders$2,000 $2,000 Earnings available to = E= O – I common shareholders= $2,000 – $0 = $2,000 Tax Rate T40% Tax Rate (T)= 40% Income available toEACST common shareholders$2,0000.4 $1,200 Income available to= EACS (1 – T) common shareholders= $2,000 (1 – 0.4) = $1,200 Total income available toEAT all security holders$1,200 $1,200 Total income available to= EAT + I all security holders= $1,200 + 0 = $1,200 Valuation of Company ND Valuation of Company ND (Note: has no debt) Corporate Tax Example: Company ND

34. 17.34 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. Earnings available to EO common shareholders$2,000 $1,400 Earnings available to = E= O – I common shareholders= $2,000 – $600 = $1,400 Tax Rate T40% Tax Rate (T)= 40% Income available toEACST common shareholders$1,4000.4 $840 Income available to= EACS (1 – T) common shareholders= $1,400 (1 – 0.4) = $840 Total income available toEAT all security holders$840 $1,440 Total income available to= EAT + I all security holders= $840 + $600 = $1,440* Valuation of Company D Valuation of Company D (Note: has some debt) * $240 annual tax-shield benefit of debt (i.e., $1,440 - $1,200) Corporate Tax Example: Company D

35. 17.35 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. Tax Shield – A tax-deductible expense. The expense protects (shields) an equivalent dollar amount of revenue from being taxed by reducing taxable income. Present value of tax-shield benefits of debt of debt* = rBt c (r) (B) (t c ) r Bt c = (B) (t c ) r = interest rate on debt, B = market value of debt, t c = Coy tax rate * Permanent debt, so treated as a perpetuity ** Alternatively, $240 annual tax shield / 0.12 = $2,000, where $240=$600 Interest expense × 0.40 tax rate. = $5,0000.4$2,000 ($5,000) (0.4) = $2,000** Tax-Shield Benefits

36. 17.36 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. Value of unlevered firm (Company ND)$7,500 Value of unlevered firm = $1,200 / 0.16 (Company ND)= $7,500* Value of levered firm $7,500$2,000 (Company D)$9,500 Value of levered firm = $7,500 + $2,000 (Company D)= $9,500 Value ofValue ofPresent value of Value ofValue of Present value of leveredfirm iftax-shield benefits levered = firm if+ tax-shield benefits firmunleveredof debt firmunlevered of debt * Assuming zero growth and 100% dividend payout Value of the Levered Firm

37. 17.37 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. The greater the financial leverage, the lower the cost of capital of the firm. take on the maximum amount of financial leverageThe adjusted M&M proposition suggests an optimal strategy is to take on the maximum amount of financial leverage. This implies a capital structure of almost 100% debt! notThis implies a capital structure of almost 100% debt! Yet, this is not consistent with actual behavior. The greater the amount of debt, the greater the tax- shield benefits and the greater the value of the firm. Summary of Corporate Tax Effects

38. 17.38 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. Corporate plus personal taxesCorporate plus personal taxes Personal taxes reduce the corporate tax advantage associated with debt. Only a small portion of the explanation why corporate debt usage is not near 100%. Uncertainty of tax-shield benefitsUncertainty of tax-shield benefits Uncertainty increases the possibility of bankruptcy and liquidation, which reduces the value of the tax shield. Other Tax Issues

39. 17.39 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. tax-shield benefits bankruptcy and agency costs As financial leverage increases, tax-shield benefits increase as do bankruptcy and agency costs. Value of levered firm Value of firm ifunlevered = Value of firm if unlevered Present value of tax-shield benefits of debt + Present value of tax-shield benefits of debt Present value of bankruptcy and agency costs - Present value of bankruptcy and agency costs Bankruptcy Costs, Agency Costs, and Taxes

40. 17.40 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. Optimal Financial Leverage Taxes, bankruptcy, and agency costs combined Net tax effect Financial Leverage (B/S) Cost of Capital (%) Minimum Cost of Capital Point Bankruptcy Costs, Agency Costs, and Taxes