Capital Structure Policy Chapter 15: 1,3,7,11,14,19 Chapter 16: 2,5,6,16
I. Modigliani-Miller (MM) Capital Structure Propositions Assumptions include: Homogeneous expectations Perpetual cash flows: V = CF/r Perfect capital markets: No taxes, transaction costs, costs of distress Firms and investors borrow and lend at the same rate r B MM Proposition I:V L = V U MM Propositions II: r S = r 0 + B/S(r 0 - r B ), where r 0 is the cost of capital for an all equity firm.
The Impact of Financial Leverage: Financial Leverage, EPS and ROE
EPS and ROE under current capital structure
EPS and ROE under proposed capital structure
Ignoring taxes for the moment, consider the following 2 alternatives Firm does not adopt proposed capital structure. An investor puts up $500 and borrows $500 to buy 100 shares The ROE is the same as that of the levered firm.
Firm adopts proposed capital structure. An investor puts up $500, $250 in stock and $250 in bonds The ROE is the same as that of the unlevered firm.
M&M Proposition II: With no taxes, WACC = R 0 = (S/V) x R S + (B/V) x R B. Solving for R S, R S = R 0 + (R 0 - R B ) x (B/S) Cost of Capital (figure 15.3) R0R0 R S =R 0 +(R 0 -R B ) x B/S R WACC RBRB B/S
15.7 Rayburn Manufacturing is currently an all equity firm. The firm’s equity is worth $2 million. The cost of that equity is 18 percent. Rayburn pays no taxes. Rayburn plans to issue $400,000 in debt and to use the proceeds to repurchase stock. The cost of debt is 10 percent. a)After Rayburn repurchases the stock, what will the firm’s overall cost of capital be? b)After the repurchase, what will the cost of equity be? c)Explain you result in (b).
15.9 The Gulf Power Company is an electric utility that is planning to build a new conventional power plant. The company has traditionally paid out all earning to the stockholders as dividends, and has financed capital expenditures with new issues of common stock. There is no debt or preferred stock presently outstanding. Data on the company and the new power plant follow. Assume all earnings streams are perpetuities. Company data:Current annual earnings: $27 million # outstanding shares: $10 million New Power Plant: Initial outlay: $20 million Added annual earnings: $3 million Management considers the power plant to have the same risk as existing assets. The current required rate of return on equity is 10 percent. Assume there are no taxes and no costs of bankruptcy. What will the total market value of Gulf Power be if common stock is issued to finance the plant? What will the total market value of the firm be if $20 million in bonds with an interest rate of 8 percent are issued to finance the plant? Assume the bonds are perpetuities. Suppose Gulf Power issues the bonds. Calculate the rate of return required by stockholders after the financing has occurred and the plant has been built.
II. Modigliani Miller with Corporate Taxes (T c ) PV of the interest tax shield = (T C x R B x B)/R B = T C x B. V L = EBIT*(1-T C )/R 0 + T C R B B/R B = V U + T C B Proposition II becomes: R S = R 0 + (R 0 - R B ) x (B/S) x (1-T C ) Cost of Capital (figure 15.6) R0R0 R S =R 0 +(1-T C )(R 0 -R B ) x B/S R WACC RBRB B/S
15.17 Streiber Publishing Company, an all-equity firm, generates perpetual earnings before interest and taxes (EBIT) of $2.5 million per year. Streiber’s after tax, all-equity discount rate is 20 percent. The company’s tax rate is 34 percent. a)What is the value of Streiber Publishing? b)If Streiber adjusts its capital structure to include $600,000 of debt, what is the value of the firm? c)What assumptions are you making when you are valuing Streiber?
III. Limits to use of debt: bankruptcy & distress costs. An optimal capital structure will balance the valuable interest tax shield against the higher probability of facing bankruptcy costs. Expected costs of distress = probability of distress x distress costs Direct costs of financial distress Indirect costs of financial distress Agency costs of debt & equity
Agency costs of debt: Overinvestment in risky projects Tri-State Paving, Inc. –Owners-managers literally took all of the company’s cash to Las Vegas in an attempt to win enough money “to pay the corporate-debtor’s creditors and solve the financial problems of all three debtors...” Continental Airlines. –Frank Lorenzo’s Texas Air purchased a controlling interest in Continental Airlines cheaply when the latter was already in serious financial difficulty. Continental filed Chapter 11, locked the union out, and attempted to hire a new, non-union labor force while selling tickets to anywhere in the US for $49. Creditors opposed the scheme. Had it been unsuccessful, they would have born most of the cost Sambo’s Restaurants. –While In Chapter 11, Sambo’s Restaurants borrowed against its unencumbered assets and invested the money in changing the name, look, and concept of its restaurants. The gamble failed, the money was lost, and unsecured creditors ended up with only about 11 cents on the dollar Storage Technology –Storage Technology brought a new data-storage device to the market during its Chapter 11 case. The produce was so successful that the company was solvent with a substantial cushion of equity by the time it emerged.
IV. Empirical Implications of Capital Structure Theories Effects of changing capital structure Stock repurchases Debt/equity swaps Factors to consider in establishing a capital structure: Taxes Type of assets Uncertainty of operating income Pecking order and financial slack
Example: Optimal capital structure Firm invests $500,000 in PPE, WC; generates EBIT of $120,000 in perpetuity 100% dividend payout; capex = depreciation; no sales growth; tax rate =.5 1Debt in capital structure 0%10%20%30%40%50% 2EBIT$120,000 3Interest04,1258,75014,62522,00031,250 4Profit before tax120,000115,875111,250105,37598,00088,750 5Tax60,00057,93855,62552,68849,00044,375 6Profit after tax60,00057,93855,62552,68849,00044,375 7Dividends60,00057,93855,62552,68849,00044,375 8Total pmts to security holders 60,00062,06364,37567,31371,00075,625 9Cost of debt8.00%8.25%8.75%9.75%11.00%12.50% 10Cost of equity12.00%12.50%13.00%13.50%14.50%16.00% 11Market value of debt050,000100,000150,000200,000250,000 12Market value of equity 500,000463,500427,885390,278337,931277,344 13Market value of firm500,000513,500527,885540,278537,931527,344
14.Book value of debt050,000100,000150,000200,000250, Book value of equity500,000450,000400,000350,000300,000250, Book value of firm500, Return on total capital12.0%12.4%12.9%13.5%14.2%15.1% 18.Return on equity12.0%12.9%13.9%15.1%16.3%17.8% 19.Number of shares outstanding 5,0004,5134,0533,6123,1412, Price per share$100.00$102.70$105.58$108.06$107.59$ EPS$12.00$12.84$13.73$14.59$15.60$ PE ratio$8.33$8.00$7.69$7.41$6.90$ Book value debt ratio0.0%10.0%20.0%30.0%40.0%50.0% 24.Market value debt ratio0.0%9.7%18.9%27.8%37.2%47.4% 25.WACC12.0%11.7%11.4%11.1%11.2%11.4% 26.FCF$60, Market value of firm$500,000$513,500$527,885$540,278$537,931$527,344
V. Implementing capital structure models. Operating income approach Cost of capital approach** APV (adjusted present value) approach** Comparables approach