Chapter 12 Capital Structure  Quick Review of Capital Markets  Benefits of Borrowing  Pecking Order Hypothesis  Modigliani and Miller Optimal Capital Structure Theory

Quick review of Capital Markets  Capital Markets  Borrow from more than one year  Various types of markets  Bond  Equity  Investors return is borrower’s cost  Not all borrowers get the same rate  Function of risk to investor  See Example 12.1, Lucky Larry at 11.11% and Sometimes Lucky Sherry at 42.86%

Benefits of Borrowing  Using other people’s money  Financial leverage  Cost of debt is less than the anticipated return of the investment  Financial leverage benefit measured via EPS  Owners of the firm can be better off with debt financing  Example 12.2 – Jordan Enterprises  Adding debt improves EPS if earnings exceed $960,000  Adding debt hurts EPS if earnings less than $960,000  Jordan Enterprises will add debt if it believes earnings will be greater than $960,000

Pecking Order Hypothesis (POH)  Preferred borrowing pattern  Borrow from cheapest source first  Asymmetric information  Firms know more than lenders  Information is costly to obtain  Information may be proprietary  Borrowing pattern from POH  Internal first  Avoid swings in dividend payments  External financing – cheapest first (debt) and equity as last resort

Pecking Order Hypothesis (POH)  Example 12.3 – Abbot and Costello borrowing choices  Outsiders believe managers only issue equity when stock over priced  Outsiders therefore lower price they will pay for equity  Managers thus choose to issue debt if possible  More profitable companies  Borrow less from external sources  Therefore have lower debt-equity ratios

Modigliani and Miller Optimal Capital Structure Theory  Starts with a world of no taxes  Two Propositions  Proposition I – It is irrelevant what borrowing pattern a firm chooses…the value of the firm remains the same  Proposition II – cost of equity is a function of three things  Require return on assets  Cost of debt  Debt-Equity ratio  In world of no taxes, WACC is constant and the firm is insensitive to the funding choice

Modigliani and Miller Optimal Capital Structure Theory  Modified to a world of corporate taxes  Proposition I – all debt financing is optimal  Proposition II – the WACC of the firm falls as more debt is added  What is happening in this world?  Government is losing out to equity holders  Tax shield due to interest payments reduces government’s direct share of profits and captured by equity holders  V L = V E + D x T C

Modigliani and Miller Optimal Capital Structure Theory  One more modification – World of corporate taxes and bankruptcy  Bankruptcy is costly  When debt payments cannot be made equity holders lose company to debt holders  Must avoid bankruptcy  Optimal debt-equity ratio arises  At point where marginal benefits of debt financing equal marginal costs of bankruptcy  At this point WACC is lowest and value of firm highest

Problems  Problem 3 – Benefits of Borrowing  Problem 7 – Pecking Order Hypothesis  Problem 9 – Finding WACC  Problem 11 – M&M in World of No Taxes