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CHAPTER 5 CAPITAL STRUCTURE Presenters name Presenters title dd Month yyyy
1. INTRODUCTION The capital structure decision affects financial risk and, hence, the value of the company. The capital structure theory helps us understand the factors most important in the relationship between capital structure and the value of the company. Copyright © 2013 CFA Institute 2
2. THE CAPITAL STRUCTURE DECISION Capital Structure Irrelevance Benefit from Tax Deductibility of Interest Costs of Financial Distress Agency Costs Costs of Asymmetric Information Copyright © 2013 CFA Institute 3 Development of the theory of capital structure, beginning with the capital structure theory of Miller and Modigliani:
THE WEIGHTED AVERAGE COST OF CAPITAL Copyright © 2013 CFA Institute 4
PROPOSITION I WITHOUT TAXES: CAPITAL STRUCTURE IRRELEVANCE Franco Modigliani and Merton Miller (MM) developed a theory that helps us understand how taxes and financial distress affect a companys capital structure decision. The assumptions of their model are unrealistic, but they help us work through the effects of the capital structure decision: 1.Investors have homogeneous expectations regarding future cash flows. 2.Bonds and stocks trade in perfect markets. 3.Investors can borrow and lend at the same rate. 4.There are no agency costs. 5.Investment and financing decisions are independent of one another. Copyright © 2013 CFA Institute 5
PROPOSITION I WITHOUT TAXES: CAPITAL STRUCTURE IRRELEVANCE Based on the assumptions that there are no taxes, costs of financial distress, or agency costs, so investors would value firms with the same cash flows as the same, regardless of how the firms are financed. Reasoning: There is no benefit to borrowing at the firm level because there is no interest deductibility. Firms would be indifferent to the source of capital and investors could use financial leverage if they wish. Copyright © 2013 CFA Institute 6 MM Proposition I The market value of a company is not affected by the capital structure of the company. MM Proposition I The market value of a company is not affected by the capital structure of the company.
PROPOSITION II WITHOUT TAXES: HIGHER FINANCIAL LEVERAGE Copyright © 2013 CFA Institute 7 MM Proposition II: The cost of equity is a linear function of the companys debt/equity ratio. MM Proposition II: The cost of equity is a linear function of the companys debt/equity ratio.
INTRODUCING TAXES INTO THE MM THEORY When taxes are introduced (specifically, the tax deductibility of interest by the firm), the value of the firm is enhanced by the tax shield provided by this interest deduction. The tax shield: -Lowers the cost of debt. -Lowers the WACC as more debt is used. -Increases the value of the firm by tD (that is, marginal tax rate times debt) Bottom line: The optimal capital structure is 99.99% debt. Copyright © 2013 CFA Institute 8 Without TaxesWith Taxes Value of the FirmV L = V U V L = V U + tD WACC Cost of Equity
INTRODUCING COSTS OF FINANCIAL DISTRESS Costs of financial distress are costs associated with a company that is having difficulty meeting its obligations. Costs of financial distress include the following: -Opportunity cost of not making optimal decisions -Inability to negotiate long-term supply contracts. -Loss of customers. The expected cost of financial distress increases as the relative use of debt financing increases. -This expected cost reduces the value of the firm, offsetting, in part, the benefit from interest deductibility. -The expected cost of distress affects the cost of debt and equity. Bottom line: There is an optimal capital structure at which the value of the firm is maximized and the cost of capital is minimized. Copyright © 2013 CFA Institute 9
AGENCY COSTS Agency costs are the costs associated with the separation of owners and management. Types of agency costs: -Monitoring costs -Bonding costs -Residual loss The better the corporate governance, the lower the agency costs. Agency costs increase the cost of equity and reduce the value of the firm. The higher the use of debt relative to equity, the greater the monitoring of the firm and, therefore, the lower the cost of equity. Copyright © 2013 CFA Institute 10
COSTS OF ASYMMETRIC INFORMATION Asymmetric information is the situation in which different parties have different information. -In a corporation, managers will have a better information set than investors. -The degree of asymmetric information varies among companies and industries. The pecking order theory argues that the capital structure decision is affected by managements choice of a source of capital that gives higher priority to sources that reveal the least amount of information. Copyright © 2013 CFA Institute 11
THE OPTIMAL CAPITAL STRUCTURE Copyright © 2013 CFA Institute 12 We cannot determine the optimal capital structure for a given company, but we know that it depends on the following: The business risk of the company. The tax situation of the company. The degree to which the companys assets are tangible. The companys corporate governance. The transparency of the financial information.
TRADE-OFF THEORY: VALUE OF THE FIRM Copyright © 2013 CFA Institute 13
DEVIATING FROM TARGET A companys capital structure may be different from its target capital structure because of the following: -Market values of outstanding issues change constantly. -Market conditions that are favorable to one type of security over another. -Market conditions in which it is inadvisable or too expensive to raise capital. -Investment banking fees that encourage larger, less frequent security issuance. Copyright © 2013 CFA Institute 14
3. PRACTICAL ISSUES IN CAPITAL STRUCTURE POLICY Debt RatingsFactors to Consider Leverage in an International Setting Copyright © 2013 CFA Institute 15
DEBT RATINGS Companies consider debt ratings in making capital structure decisions because the cost of debt is affected by the rating. The spread between AAA rated and BBB rated bond yields is around 100 bps. Copyright © 2013 CFA Institute 16 Moodys Standard & PoorsFitch Highest qualityAaaAAA Investment grade High qualityAaAA Upper medium gradeAAA Medium gradeBaaBBB SpeculativeBaBB Speculative grade Highly speculativeBBB Substantial riskCaaCCC Extremely speculativeCa Possibly in defaultC Default DDDD-D Bond Ratings by Moodys, Standard & Poors, and Fitch
EVALUATING CAPITAL STRUCTURE POLICY Analysts consider a companys capital structure -Over time. -Compared with competitors with similar business risk. -Considering the companys corporate governance. Analysts must also consider -The industry in which the company operates. -The regulatory environment. -The extent to which the company has tangible assets. -The degree of information asymmetry. -The need for financial flexibility. Copyright © 2013 CFA Institute 17
LEVERAGE IN AN INTERNATIONAL SETTING Country-specific factors affect a companys choice of capital structure and the maturity structure within the capital structure. Types of factors to consider: -Institutional and legal environments -Financial markets and banking sector -Macroeconomic factors Copyright © 2013 CFA Institute 18
COUNTRY-SPECIFIC FACTORS Country-Specific Factor If a Country … then D/E Ratio is Potentially … and Debt Maturity is Potentially Institutional framework Legal system efficiencyis more efficientLowerLonger Legal system originhas common law as opposed to civil law LowerLonger Information intermediaries has auditors and analystsLowerLonger Taxationhas taxes that favor equityLower Copyright © 2013 CFA Institute 19 Country-Specific Factors and Their Assumed Impacts on the Companies Capital Structure p. 222
COUNTRY-SPECIFIC FACTORS Country-Specific Factor If a Country … then D/E Ratio is Potentially … and Debt Maturity is Potentially Banking system, financial markets Equity and bond markets has active bond and stock markets Longer Bank-based or market- based country has a bank-based financial systemHigher Investors has large institutional investorsLowerLonger Macroeconomic environment Inflationhas high inflationLowerShorter Growthhas high GDP growthLowerLonger Copyright © 2013 CFA Institute 20 Country-Specific Factors and Their Assumed Impacts on the Companies Capital Structure
4. SUMMARY The goal of the capital structure decision is to determine the financial leverage that maximizes the value of the company (or minimizes the weighted average cost of capital). In the Modigliani and Miller theory developed without taxes, capital structure is irrelevant and has no effect on company value. The deductibility of interest lowers the cost of debt and the cost of capital for the company as a whole. Adding the tax shield provided by debt to the Modigliani and Miller framework suggests that the optimal capital structure is all debt. In the Modigliani and Miller propositions with and without taxes, increasing a companys relative use of debt in the capital structure increases the risk for equity providers and, hence, the cost of equity capital. When there are bankruptcy costs, a high debt ratio increases the risk of bankruptcy. Using more debt in a companys capital structure reduces the net agency costs of equity. Copyright © 2013 CFA Institute 21
SUMMARY (CONTINUED) The costs of asymmetric information increase as more equity is used versus debt, suggesting the pecking order theory of leverage, in which new equity issuance is the least preferred method of raising capital. According to the static trade-off theory of capital structure, in choosing a capital structure, a company balances the value of the tax benefit from deductibility of interest with the present value of the costs of financial distress. At the optimal target capital structure, the incremental tax shield benefit is exactly offset by the incremental costs of financial distress. A company may identify its target capital structure, but its capital structure at any point in time may not be equal to its target for many reasons. Many companies have goals for maintaining a certain credit rating, and these goals are influenced by the relative costs of debt financing among the different rating classes. In evaluating a companys capital structure, the financial analyst must look at the capital structure of the company over time, the capital structure of competitors that have similar business risk, and company-specific factors that may affect agency costs. Copyright © 2013 CFA Institute 22
SUMMARY (CONTINUED) Good corporate governance and accounting transparency should lower the net agency costs of equity. When comparing capital structures of companies in different countries, an analyst must consider a variety of characteristics that might differ and affect both the typical capital structure and the debt maturity structure. Copyright © 2013 CFA Institute 23
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