Presentation on theme: "Rest of Chapter 14. Capital Structure M&M (Modigliani and Miller) concepts 2."— Presentation transcript:
Rest of Chapter 14
Capital Structure M&M (Modigliani and Miller) concepts 2
Capital structure refers to the mix of a firm’s debt and equity financing Financial leverage refers to using borrowed money to enhance the effectiveness of invested equity Measured with the debt ratio (TL/TA) More leverage means more risk (measures used debt ratio, TIE, and DFL) Higher leverage increases the company’s beta (higher cost of equity) More risk means a higher cost of capital (higher required rate of return on investments) 3 skim
Equity at a point in time is fixed Add equity over time with retained earnings Do not have easy access to equity capital market Capital structure is an extremely important business decision and directly affects the size of the business Trade off of more risk as additional debt is taken versus the additional return from adding the debt 4
Capital structure is independent (mostly) of the size of the company and its asset mix The question is: can the use of debt increase the firm’s stock price? An optimal capital structure maximizes stock price The relationship between capital structure and stock price is not precise nor fully understood 5 skim
Borrowing money (leverage) is used to increase average ROE and EPS The use of borrowed money incurs interest, which increases DFL and decreases TIE When the rate of return (BEP) is greater than the interest rate then financial leverage will improve a firm’s ROE and EPS However, if BEP is lower than the interest rate then borrowing money will worsen EPS and ROE 6
Return on Capital Employed (ROCE) ◦ Measures the profitability of operations before financing charges but after taxes on a basis comparable to ROE 7 When the ROCE exceeds the after-tax cost of debt, more leverage improves ROE and EPS When ROCE is less than the after-tax cost of debt, more leverage makes ROE and EPS worse BEP: Can compare to pre tax interest rate.
8 As the firm’s debt ratio rises, both EPS and ROE rise dramatically. While EAT falls, the number of shares outstanding falls at a faster rate as debt replaces equity.
9 ABC is now doing rather poorly—ROE and ROCE are quite low. As the firm adds leverage, EPS and ROE decrease.
Leverage enhances returns while it adds risk, pushing stock prices in opposite directions ◦ Enhanced performance increases dividends, which increases the PV of dividends per share (driving up the stock’s price) ◦ The increased risk increases the stocks beta and this decreases the PV of dividends per share (drives down the stock’s price) Which effect dominates is a big question? Principle of increasing. Risk increases at an increasing rate as leverage increases. ◦ At low leverage an increase in debt increases risk a little ◦ At high leverage an increase in debt increases risk a lot 10
When leverage is low an increase in debt has a positive effect on stock prices At high debt levels concerns about risk dominate and adding more debt decreases the stock’s price As leverage increase its effect goes from positive to negative, which results in an optimum capital structure 11
There is no way to determine the exact optimum amount of leverage for a particular company at a particular time ◦ Appropriate level tends to vary according to Nature of a company’s business If firm has high business risk (DOL) it should use less leverage Economic climate If the outlook is poor investors are likely to be more sensitive to risk As a practical matter the optimum capital structure is a guess The best we can usually do is compare to the industry average 13
A firm’s target capital structure that we use in calculating the WACC is management’s estimate of the optimal capital structure ◦ An approximation or best guess as to the amount of debt that will maximize the firm’s stock price 14
Restrictive Assumptions in the Original Model ◦ In 1958 MM published their first paper on capital structure Included numerous restrictions such as No income taxes Securities trade in perfectly efficient capital markets with no transaction costs No costs to bankruptcy Investors and companies can borrow or lend as much as they want at the same rate 15
The Result ◦ Under MM’s initial set of restrictions, value is independent of capital structure ◦ As cheaper debt is added the cost of equity increases because of increased risk However the weight of the more expensive equity is decreasing while the weight of the cheaper debt is increasing, leading to a constant weighted average cost of capital Thus the PV of the firm does not change 16
The Assumptions and Reality ◦ Income taxes exist and favor debt ◦ The costs of bankruptcy are quite large ◦ Individuals cannot borrow at the same rate as companies and interest rates usually rise as more money is borrowed Interpreting the Result ◦ The MM result implies that leverage affects value because of market imperfections Such as taxes and transaction costs (including bankruptcy) 17
Financing and the U.S. Tax System ◦ Tax system favors debt financing over equity financing Interest expense on debt is tax deductible while dividends on stock are not Bankruptcy costs (favor equity financing) ◦ Greater chance of incurring cost as more debt is used, thus causes value of stock to decline at some point as risk gets too high Interest rate on debt rises as debt increases – causing stock price to decline at some point Relaxing MM assumptions suggests that an optimal amount of debt exists for a corporation, but doesn’t really help us find it. 18
Capital Structures Around the World Capital Structure Percentages for Selected Countries Ranked by Common Equity Ratios, 1995 Source: Essentials of Managerial Finance by Besley and Brigham