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copyright anbirts1 Capital Structure The Big Debate Well can you or cant you?

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copyright anbirts2 Capital Structure What do we mean? Basically, can we maximise shareholders wealth by varying the proportions of debt and equity in a companys capital make up?

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copyright anbirts3 Capital Structure Notationally K o = K i x (D) + K e x (E) (D+E) (D+E) K o = Overall Average cost of Capital K i = Cost of Debt D = Amount of Debt K e = Cost of Equity E = Amount of Equity

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copyright anbirts4 Capital Structure As Debt is usually cheaper than equity, why is it not an open and shut case? Consider Return on a project = 15% Needs £200-00 of capital Cash Return = £30 If all financing is equity then obviously ROE (return on equity) = 30 = 15% 200

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copyright anbirts5 Capital Structure Suppose instead it is financed 50/50 debt/ equity and cost of debt = 10% Then: Total Return = 30 Interest cost = 10 (100 x.10) Net Return 20 ROE = 20 = 20% 100 So far so good, some very happy shareholders

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copyright anbirts6 Capital Structure But disaster strikes and the return falls to £15 Now the returns are Total returns = 15 Interest cost = 10 Net return = 5 ROE = 5 = 5% 100

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copyright anbirts7 Capital Structure Whereas if the shareholders had not been so bold and had financed all Equity ROE = 15 = 7.5% 200 What effect has leverage had?

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copyright anbirts8 Capital Structure Results Range of ROEs % Leveraged 20 - 5 Un-leveraged 15 – 7.5 What effect will this have on expected/required equity returns?

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copyright anbirts9 Capital Structure Theoretical Positions Net Operating Approach (the makes no difference camp) Traditional Approach (the yes it does camp) Modigliani and Miller (the we can prove it does not matter camp)

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copyright anbirts10 Capital Structure Net Operating Approach Net operating income 1,000 Capitalisation rate (cost of Capital).15 Total value of firm 6,667 Market value of debt (cost 10%) 1,000 Market value of equity 5,667 Earnings for equity 1,000 – 100 = 900 ROE = 900 = 15.88% 5,667

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copyright anbirts11 Capital Structure Now change debt to 3,000 Operating income still 1,000 Overall capitalisation rate.15 Total value of firm 6,667 Market value of debt 3,000 Market value of equity 3,667 New equity earnings (1,000 – 300) = 700 ROE = 700 = 19.09 3,667 But note that total value of the firm is constant

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copyright anbirts12 Capital Structure Traditional approach – assumes there is an optimal structure therefore judicious use of leverage will increase value of firm

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copyright anbirts13 Capital Structure Arbitrage Support Basically the argument is i) that the company can do nothing that the shareholders cannot do for themselves and ii) that value comes from the cash flows into the company not from fiddling about within the company.

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copyright anbirts14 Capital Structure Arbitrage Support Co A Co B Net Op Income 10,000 10,000 Interest on debt (12% pa) nil 3,600 Net earnings 10,000 6,400 Equity req return.15.16 Market Value of equity 66,667 40,000 Market value of debt nil 30,000 Total value of the firm 66,667 70,000

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copyright anbirts15 Capital Structure M&M would argue that it would not be possible for one company to remain more valuable than the other, since the over valued company would be sold and the under valued company bought, until the prices equalise. A shareholder in B would do this, replicating Bs actions

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copyright anbirts16 Capital Structure Investor in B (IB) owns 1% of B i.e. 400 IB sell their shares for 400 Return would have been 64 (1% of 6,400) IB borrows 300 (1% of Bs debt) @ 12% IB buys 1% of A for 666.7 Net position Return on A 100.0 Less interest 36.0 Net return 64.0 same as in B but for 33.3 less personal outlay (700 – 666.7) so could spend on more A

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copyright anbirts17 Capital Structure QED But the proof relies on a few assumptions Capital markets are perfect (information is costless, no taxes, no transaction costs and so on) And they are not So we need to consider the imperfections

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copyright anbirts18 Capital Structure Effects of imperfections Taxes Financial distress Bankruptcy Corporate/private leverage Non debt tax shields

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copyright anbirts19 Capital Structure Taxes Co A Co B EBIT 2,000 2,000 Interest * - 600 Profit before tax 2,000 1,400 Taxes @ 40% 800 560 Shareholders income 1,200 840 Total income to debt and Shareholders 1,200 1,440 *(5,000 of debt @ 12% in B)

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copyright anbirts20 Capital Structure But has this increased shareholder value? Yes Suppose companies A and B have £8,000 of Capital. Co A would have 8,000 shares of £1-00 each Company As RoE is 1,200 = 15% 8,000 EPS = 15 pence, suppose PE = 6.66 Share value = 1.00

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copyright anbirts21 Capital Structure Company Bs Capital is: 5,000 debt 3,000 equity Therefore Bs RoE is 840 = 28% 3,000 EPS = 28 pence, PE is 6.66 Share value = 1.87

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copyright anbirts22 Capital Structure A gift from the Government? Suppose debt interest was deducted after tax. Then EBIT 2,000 Tax at 40% 800 Net after tax 1,200 Deduct debt interest 600 Income for shareholders 600

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copyright anbirts23 Capital Structure Where does that leave us? RoE = 600 = 20% 3,000 So where does the extra 8% come from? 240 = 8% 3,000

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copyright anbirts24 Capital Structure b effect of increasing price of debt c effect of adjustment for risk (including NPV of bankruptcy costs) d loss of tax shield Trade off theory e cost of financial distress Effect of Costs of Bankruptcy & Financial Distress on the Value of the Firm company value utilising debt shield to maximum

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copyright anbirts25 Capital Structure Debt Equity Tot Prption Cost aftTax Wghtd cost % wghtd 0 7 12 100 20 7 12.5 80 30 7.5 13 70 50 8 14 50 70 9.5 18 30 80 11.5 21 20 Tax Rate 30%

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copyright anbirts27 Capital Structure Debt Equity Tot Prption Cost aftTax Wghtd cost % wghtd 0 7 4.9 0 12 100 12 12 20 7 4.9.98 12.5 80 10 10.98 30 7.5 5.25 1.575 13 70 9.1 10.68 50 8 5.6 2.8 14 50 7 9.8 70 9.5 6.65 4.65 18 30 5.4 10.05 80 11.5 8.05 6.44 21 20 4.2 10.64 Tax Rate 30%

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copyright anbirts28 Capital Structure Cost of 13 Capital 12 11 10 0 50 100 Gearing/Leverage

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copyright anbirts29 Capital Structure So how will we decide on leverage level? Industry norms Coverage ratios * interest * interest plus principal

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copyright anbirts30 Capital Structure Coverage Ratios Interest EBIT Interest on Debt Or 7,000,000 = 3.89 1,800,000 * 8 % of 22,500,000 loan repayable over 10 years tax rate of 25%

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copyright anbirts31 Capital structure Coverage Ratios Interest plus Principal EBIT Interest + Principal 1 – Tax Rate 7,000,000 1,800,000 + 2,250,000 = 1.46 1-.25

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copyright anbirts32 Capital Structure Coverage Ratios But what is a suitable coverage ratio? Variability Trend Analysis Industry Norms All Commitments

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copyright anbirts33 Capital Structure Profitability * pecking order Size * portfolio effect * pecking order Asset type Volatility of earnings International / cultural norms

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copyright anbirts34 Capital Structure EBIT/EPS Analysis Question, what form of financing will result in the largest EPS? Situation (Example from Van Horne) -Co issued 200,000 shares worth 50 each -Co needs to borrow a further 5,000,000 -Co may borrow at 12% -Tax Rate 40%

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copyright anbirts35 Capital Structure EPS/EBIT Shares Debt EBIT 2,400,000 2,400,000 Interest - 600,000 EBT 2,400,000 1,800,000 Tax @ 40% 960,000 720,000 E after T 1,440,000 1,080,000 No of shares 300,000 200,000 EPS 4.8 5.4

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copyright anbirts36 Capital Structure EPS/EBIT Break Even Point E 6 P 5 S 4 3 * 2 1 0 EBIT 1 2 3 4 5 6 Millions

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copyright anbirts37 Capital Structure EPS/EBIT A Formula may be used (EBIT * – C 1 )(1 –t) = (EBIT * – C 2 )(1-t) S 1 S 2 EBIT * = Break Even EBIT C 1, C 2 = annual interest expense T= Corporate tax rate S 1, S 2 = Number of shares outstanding after financing

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copyright anbirts38 Capital Structure EPS/EBIT (EBIT * - 0)(.6) = (EBIT * - 600,000)(.6) 300,000 200,000.6(EBIT * )(200,000) =.6(EBIT * )(300,000) –.6(600,000)(300,000) 60,000EBIT * = 108,000,000,000 EBIT * = 1,800,000

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copyright anbirts39 Cost of Capital Objective is to minimise cost of capital Risk Free Rate Types Debt Sources Cost of Capital Equity Risk Return Dividend Capital growth -Market - Environment -Business - Portfolio -Political Capital Structure

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