1. Business Finance (MGT 232)
Lecture 24

2. Capital Structure Determination

3. Overview of the Last Lecture
Market Value Ratios
EPS
DPS
DPO
P/E
Common Size Analysis
Index Analysis

4. Capital Structure Determination
A Conceptual Look
The Total-Value Principle
Presence of Market Imperfections and Incentive Issues
The Effect of Taxes
Taxes and Market Imperfections Combined
Financial Signaling

5. Capital Structure
Capital Structure -- The mix (or proportion) of a firm’s permanent long-term financing represented by debt, preferred stock, and common stock equity.
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.

6. A Conceptual Look --Relevant Rates of Return
ri = the yield on the company’s debt I B
Annual interest on debt
Market value of debt ri = =
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.)

7. A Conceptual Look --Relevant Rates of Return
re = the expected return on the company’s equity
Earnings available to
common shareholders
Market value of common
stock outstanding E S E S re = =
Assumptions:
Earnings are not expected to grow
100% dividend payout
Results in the valuation of a perpetuity

8. A Conceptual Look --Relevant Rates of Return
ro = an overall capitalization rate for the firm O V O V
Net operating income
Total market value of the firm ro = =
Assumptions:
V = B + S = total market value of the firm
O = I + E = net operating income = interest paid plus earnings available to common shareholders

9. Capitalization Rate B B + S S B + S ro ri re
Capitalization Rate, ro -- The discount rate used to determine the present value of a stream of expected cash flows. B
B + S S
B + S ro = ri + re

10. Net Operating Income Approach
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.
Assume:
Net operating income equals Rs.1,350
Market value of debt is Rs.1,800 at 10% interest
Overall capitalization rate is 15%

11. Net Operating Income Approach
Lets assum that a firm’s Net operating income equals Rs.1,350 with Market value of debt is Rs.1,800 at 10% interest and Overall capitalization rate is 15%
We can find out Required return on equity
What happens to ki, ke, and ko
when leverage, B/S, increases?

12. Required Rate of Return on Equity
Calculating the required rate of return on equity
Total firm value = O / ro = Rs.1,350 / = Rs.9,000
Market value = V - B = Rs.9,000 -Rs.1,800
of equity = Rs.7,200
Required return = E / S
on equity* = (Rs.1,350 - Rs.180) / Rs.7, = 16.25%
Interest payments
= Rs.1,800 x 10%
* B / S = Rs.1,800 / Rs.7,200 = .25

13. Required Rate of Return on Equity
What is the rate of return on equity if B=Rs.3,000?
Total firm value = O / ro = Rs.1,350 / = Rs.9,000
Market value = V - B = Rs.9,000 - Rs.3,000
of equity = Rs.6,000
Required return = E / S
on equity* = (Rs.1,350 - Rs.300) / Rs.6, = 17.50%
Interest payments
= Rs.3,000 x 10%
* B / S = Rs.3,000 / Rs.6,000 = .50

14. Required Rate of Return on Equity
Examine a variety of different debt-to-equity ratios and the resulting required rate of return on equity.
B / S ri re ro
% %
% % %
% % %
% % %
% % %

15. Required Rate of Return on Equity
Capital costs and the NOI approach in a graphical representation.
.25
re = 16.25% and
17.5% respectively
.20
re (Required return on equity)
.15
ro (Capitalization rate)
Capital Costs (%)
.10
ri (Yield on debt)
.05
Financial Leverage (B / S)

16. Summary of NOI Approach
Critical assumption is ro 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 ri is constant, re is a linear function of the debt-to-equity ratio.
Thus, there is no one optimal capital structure.

17. Traditional Approach
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.
Optimal Capital Structure -- The capital structure that minimizes the firm’s cost of capital and thereby maximizes the value of the firm.

18. Summary of the Traditional Approach
Financial leverage can be defined as the degree to which a company uses fixed-income securities, such as debt and preferred equity.
With a high degree of financial leverage come high interest payments.
As a result, the bottom-line earnings per share is negatively affected by interest payments. As interest payments increase as a result of increased financial leverage, EPS is driven lower.

19. Optimal Capital Structure: Traditional Approach
.25 ro
.20
.15 ri
Capital Costs (%)
.10
Optimal Capital Structure
.05
Financial Leverage (B / S)

20. Summary of the Traditional Approach
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 ro declines.
Then, increasing financial leverage and the associated increase in re and ri more than offsets the benefits of lower cost debt financing.
Thus, there is one optimal capital structure where ro is at its lowest point.
This is also the point where the firm’s total value will be the largest (discounting at ro).

21. Summary Capital Structure Required rate of return on debt and equity
Total Capitalization rate
NOI Approach
Traditional Approach