13 Capital Structure Concepts ©2006 Thomson/South-Western

2 Introduction This chapter examines some of the basic concepts used in determining a firm’s optimal capital structure. It deals only with the total permanent sources of a firm’s financing.

3 Capital Structure Vs Financial Structure Capital Structure Permanent S-T debt  L-T debt  P/S  C/S Financial Structure Total current liabilities  L-T debt  P/S  C/S

4 Capital Structure Terminology Optimal capital structure  Minimizes a firm’s weighted cost of capital  Maximizes the value of the firm Target capital structure  Capital structure at which the firm plans to operate Debt capacity  Amount of debt in the firm’s optimal capital structure

5 What Determines the Optimal Capital Structure ? Business risk of the firm Tax structure Bankruptcy potential Potential agency costs Signaling effects

6 Capital Structure Assumptions Firm’s investment policy is held constant. Capital structure changes the distribution of the firm’s EBIT among the firm’s claimants.  Debtholders  Preferred stockholders  Common stockholders Constant investment policy leaving the debt capacity of the firm unchanged

7 Factors Influencing a Firm’s Business Risk Variability of sales volume Variability of selling price Variability of cost Amount of market power Extent of product diversification Firm’s growth rate Degree of operating leverage (DOL) Both systematic and unsystematic risk Web site for more info:

8 Financial Risk Variability of EPS and increased probability of bankruptcy Factors indicating financial risk  Debt-to asset ratio  Debt-to-equity ratio  Fixed charge coverage ratio  DFL  Probability distribution of profits  Times interest earned ratio  EBIT-EPS analysis

9

10 Capital Structure Theory Studies the relationship between  Capital structure Debt/assets  Cost of capital Value of the firm

11 Capital Structure Models The simplest model considers only  Taxes More complex models account for  Taxes  Financial distress costs  Agency costs

12 Modigliani and Miller (MM) On Capital Structure Assumed perfect capital markets including  No taxes  No bankruptcy (B) costs  No agency (A) costs If leverage increases, the cost of equity, k e, increases to exactly offset the benefits of more debt financing, k d, leaving the cost of capital, k a, constant. see model 1

13 Cost of Capital kdkd kaka keke Model 1 (MM) The overall cost of capital is independent of the capital structure. The firm’s value is independent of the capital structure. Debt Total Assets

14

15 MM Arbitrage Proof Value (V) of U = D/k e Value (V) of L = D/k e + I/k d D paid to L’s stockholders are reduced by the amount of I paid on the debt. k e is higher for L because of the additional leverage-induced risk. The values of U and L are identical due to arbitrage.

16 What Happens with Taxes ? Same two equations VU = D/k e VL = D/k e + I/k d D distributed to U’s stockholders are reduced by the taxes paid on operating income and the value of U drops. Since I is tax deductible, L realizes a tax savings. PV of tax shield = value of debt (B)  tax rate (T).

17 VL = VU + Value of Tax Shield Mkt Value of Firm Debt $ VLVL VUVU PV of Tax Shield

18 Model 2 (MM with taxes) Debt Total Assets k i = k d (1 – T) kaka keke Cost of Capital The cost of capital decreases with the amount of debt. The firm maximizes its value by choosing a capital structure that is all debt.

19 What Happens With Taxes, Bankruptcy, and Agency Costs ? B&A costs increase with the amount of leverage. Eventually offsets the marginal benefits from the value of the tax shield Market value of leveraged firm = Market value of unleveraged firm + PV of tax shield – PV of bankruptcy costs – PV of agency costs See optimal debt ratio slide

20 Bankruptcy Costs Lenders may demand higher interest rates. Lenders may decline to lend at all. Customers may shift their business to other firms. Distress incurs extra accounting & legal costs. If forced to liquidate, assets may have to be sold for less than market value.

21 Agency Costs Stockholder-Bondholder Relationship Investing in projects with high risk and high returns can shift wealth from bondholders to stockholders. Stockholders may forgo some profitable investments in the presence of debt. Stockholders might issue high quantities of new debt and diminish the protection afforded to earlier bondholders. Bondholders will shift monitoring and bonding costs back to the stockholders by charging higher interest rates.

22 Optimal Debt Ratio Debt Ratio VUVU PV of Tax Shield Mkt value of leveraged firm PV B&A Costs VLVL Optimal Debt Ratio Market Value of the Firm

23

24 Model 3 Least Cost Capital Structure is Optimal Cost of Capital B B + E kiki keke kaka Optimal Capital Structure 0 Optimal capital structure occurs where weighted cost of capital is minimized

25

26 Other Impacts on the Optimal Capital Structure Personal tax effects  Could reverse some tax benefits Industry effects  Profitability and bankruptcy patterns Signaling effects  Asymmetric information Managerial preferences  Pecking order theory

27 Capital Structure Implications for Managers A centrally important management decision Benefits of the tax shield from debt provide an incentive to use debt financing.  To the point that increasing A&B costs offset the debt advantage  Info on debt: Optimal capital structure is heavily influenced by business risk.

28 Capital Structure Implications for Managers Changes in capital structure signal important information to investors. Pecking order theory  Internal equity First choice  Debt  External equity Least preferred by management

29 LBO (Leveraged buyout) Can eliminate agency problems Increased operating efficiencies are often achieved.  Eliminating jobs  Reducing other payroll expenses  Closing inefficient plants Bondholders typically realize a loss in the value of their bonds. Ethical issues  Is it in the long-run interest of employees?  Are bondholders harmed in a LBO?  Managers acting as both buyers and sellers

30 Multinational Firms Have more complex capital structure decisions Finance investments in host country funds Some countries use more financial leverage than others. Some host countries restrict foreign investment. Risk of expropriation Some host countries provide low-cost financing.