1. Chapter 17 Capital Structure Determination

2. Copyright  2001 Prentice-Hall, Inc. Fundamentals of Financial Management, 11/e by Van Horne and Wachowicz. Slides prepared by Wu Xiaolan 1 Chapter Objectives Discuss the impact of financial leverage on a firm ’ s capital structure. Outline both MM Proposition I and MM Proposition II. Discuss the impact of corporate taxes on MM Propositions I and II. Explain the impact of bankruptcy costs on the value of a firm. Identify a firm ’ s optimal capital structure.

3. Copyright  2001 Prentice-Hall, Inc. Fundamentals of Financial Management, 11/e by Van Horne and Wachowicz. Slides prepared by Wu Xiaolan 2 Capital Structure -- The mix (or proportion) of a firm ’ s permanent long-term financing represented by debt, preferred stock, and common stock equity. 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.

4. Copyright  2001 Prentice-Hall, Inc. Fundamentals of Financial Management, 11/e by Van Horne and Wachowicz. Slides prepared by Wu Xiaolan 3 A Conceptual Look --Relevant Rates of Return k i = the yield on the company ’ s debt Annual interest on debt Market value of debt IBIB == kiki 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.)

5. Copyright  2001 Prentice-Hall, Inc. Fundamentals of Financial Management, 11/e by Van Horne and Wachowicz. Slides prepared by Wu Xiaolan 4 ESES A Conceptual Look --Relevant Rates of Return == k e = the expected return on the company’s equity Earnings available to common shareholders Market value of common stock outstanding keke Assumptions: Earnings are not expected to grow 100% dividend payout Results in the valuation of a perpetuity Appropriate in this case for illustrating the theory of the firm ESES

6. Copyright  2001 Prentice-Hall, Inc. Fundamentals of Financial Management, 11/e by Van Horne and Wachowicz. Slides prepared by Wu Xiaolan 5 OVOV A Conceptual Look --Relevant Rates of Return == k o = an overall capitalization rate for the firm Net operating income Total market value of the firm kokokoko Assumptions: V = B + S = total market value of the firm O = I + E = net operating income = interest paid plus earnings available to common shareholders OVOV

7. Copyright  2001 Prentice-Hall, Inc. Fundamentals of Financial Management, 11/e by Van Horne and Wachowicz. Slides prepared by Wu Xiaolan 6 Capitalization Rate Capitalization Rate, k o -- The discount rate used to determine the present value of a stream of expected cash flows. kokokoko keke kiki B B + S S B + S =+

8. Copyright  2001 Prentice-Hall, Inc. Fundamentals of Financial Management, 11/e by Van Horne and Wachowicz. Slides prepared by Wu Xiaolan 7 Net Income Approach -- A theory of capital structure in which the weighted average cost of capital will decrease and the total value of the firm will increase as financial leverage is becoming greater. Net Income Approach -- A theory of capital structure in which the weighted average cost of capital will decrease and the total value of the firm will increase as financial leverage is becoming greater. Assume:  Both k i and k e are unrelated to the financial leverage. Optimal Capital Structure -- The capital structure that minimizes the firm ’ s cost of capital and thereby maximizes the value of the firm.

9. Copyright  2001 Prentice-Hall, Inc. Fundamentals of Financial Management, 11/e by Van Horne and Wachowicz. Slides prepared by Wu Xiaolan 8 Net Income Approach KeKe KiKi B/V K 0 KoKo 100% B/V 100% V 0 V

10. Copyright  2001 Prentice-Hall, Inc. Fundamentals of Financial Management, 11/e by Van Horne and Wachowicz. Slides prepared by Wu Xiaolan 9 Summary of NI Approach Critical assumption is both k i and k e remain constant. As long as k i and k e are constant, k o is a decreasing linear function of the debt-to-equity ratio. Thus, there is a optimal capital structure when B/V is 100%.

11. Copyright  2001 Prentice-Hall, Inc. Fundamentals of Financial Management, 11/e by Van Horne and Wachowicz. Slides prepared by Wu Xiaolan 10 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. 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:  Both k i and k o remain constant.

12. Copyright  2001 Prentice-Hall, Inc. Fundamentals of Financial Management, 11/e by Van Horne and Wachowicz. Slides prepared by Wu Xiaolan 11 Required Rate of Return on Equity Capital costs and the NOI approach in a graphical representation. 0.25.50.75 1.0 1.25 1.50 1.75 2.0 Financial Leverage (B / S).25.20.15.10.05 0 Capital Costs (%) k e = 16.25% and 17.5% respectively k i (Yield on debt) k o (Capitalization rate) k e (Required return on equity)

13. Copyright  2001 Prentice-Hall, Inc. Fundamentals of Financial Management, 11/e by Van Horne and Wachowicz. Slides prepared by Wu Xiaolan 12 Summary of NOI Approach Critical assumption is k o 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 k i is constant, k e is a linear function of the debt-to-equity ratio. Thus, there is no one optimal capital structure.

14. Copyright  2001 Prentice-Hall, Inc. Fundamentals of Financial Management, 11/e by Van Horne and Wachowicz. Slides prepared by Wu Xiaolan 13 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.

15. Copyright  2001 Prentice-Hall, Inc. Fundamentals of Financial Management, 11/e by Van Horne and Wachowicz. Slides prepared by Wu Xiaolan 14 Optimal Capital Structure: Traditional Approach Traditional Approach Financial Leverage (B / S).25.20.15.10.05 0 Capital Costs (%) kiki koko keke Optimal Capital Structure

16. Copyright  2001 Prentice-Hall, Inc. Fundamentals of Financial Management, 11/e by Van Horne and Wachowicz. Slides prepared by Wu Xiaolan 15 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 k o declines.  Then, increasing financial leverage and the associated increase in k e and k i more than offsets the benefits of lower cost debt financing. Thus, there is one optimal capital structure where k o is at its lowest point. This is also the point where the firm ’ s total value will be the largest (discounting at k o ).

17. Copyright  2001 Prentice-Hall, Inc. Fundamentals of Financial Management, 11/e by Van Horne and Wachowicz. Slides prepared by Wu Xiaolan 16 The Modigliani-Miller Theorem (intuition) It is after the ball game and the pizza man is delivering a pizza to Yogi. “Should I cut it into four slices as usual, Yogi?” asks the pizza man. “No,” replies Yogi, “Cut it into eight; I’m hungry tonight.”

18. Copyright  2001 Prentice-Hall, Inc. Fundamentals of Financial Management, 11/e by Van Horne and Wachowicz. Slides prepared by Wu Xiaolan 17 The Modigliani-Miller Theorem Intuition: the way that a pie is sliced does not effect its size. Equivocally, it is the size of the firm's cash flows and not how these cash flows are diced up that drives firm value. DebtEquity

19. Copyright  2001 Prentice-Hall, Inc. Fundamentals of Financial Management, 11/e by Van Horne and Wachowicz. Slides prepared by Wu Xiaolan 18 MM Proposition I The size of the pie does not depend on how it is sliced. The value of the firm is unaffected by its capital structure. Value of firm

20. Copyright  2001 Prentice-Hall, Inc. Fundamentals of Financial Management, 11/e by Van Horne and Wachowicz. Slides prepared by Wu Xiaolan 19 The Modigliani-Miller Theorem (Cont.) Modigliani and Miller Capital Structure Irrelevance Proposition I  The value of a company derives from the operations of the company.  Changes in capital structure only affect the way in which the distribution of the cash flows between stockholders and bondholders is achieved. Firm value is dependent not on how it is financed, but on its operations.

21. Copyright  2001 Prentice-Hall, Inc. Fundamentals of Financial Management, 11/e by Van Horne and Wachowicz. Slides prepared by Wu Xiaolan 20 M&M Irrelevance Proposition II True or false:  Firms can lower their cost of capital by substituting debt for equity, since debt is much cheaper than equity How can you support your argument? Definition of M&M II  The expected return on a levered firm’s equity is a linear function of firm’s debt to equity ratio.

22. Copyright  2001 Prentice-Hall, Inc. Fundamentals of Financial Management, 11/e by Van Horne and Wachowicz. Slides prepared by Wu Xiaolan 21 The MM Propositions I & II (No Taxes) Proposition I  Firm value is not affected by leverage V L = V U Proposition II  Leverage increases the risk and return to stockholders r s = r 0 + (B/S) (r 0 - r B ) r B is the interest rate (cost of debt) r s is the return on (levered) equity (cost of equity) r 0 is the return on unlevered equity (cost of capital) B is the value of debt S is the value of levered equity

23. Copyright  2001 Prentice-Hall, Inc. Fundamentals of Financial Management, 11/e by Van Horne and Wachowicz. Slides prepared by Wu Xiaolan 22 The MM Propositions I & II (with Corporate Taxes) Proposition I (with Corporate Taxes)  Firm value increases with leverage V L = V U + T C B Proposition II (with Corporate Taxes)  The increase in equity risk and return is partly offset by tax shield of the debt r S = r 0 + (B/S)×(1-T C )×(r 0 - r B ) r B is the interest rate (cost of debt) r S is the return on equity (cost of equity) r 0 is the return on unlevered equity (cost of capital) B is the value of debt S is the value of levered equity

24. Copyright  2001 Prentice-Hall, Inc. Fundamentals of Financial Management, 11/e by Van Horne and Wachowicz. Slides prepared by Wu Xiaolan 23 Discussion of the assumptions of the Modigliani-Miller Theorem: No change in investment policy. Perfect capital market  No transaction costs  No taxes  No bankruptcy costs  Competitive market  Individuals can borrow at the same rate as the corporations.  Symmetric information All cash flows are perpetuities, meaning a zero growth rate. Homogeneous expectation

25. Copyright  2001 Prentice-Hall, Inc. Fundamentals of Financial Management, 11/e by Van Horne and Wachowicz. Slides prepared by Wu Xiaolan 24 Graphical representation of M&M with corporate tax Debt as % of capital Total Firm Value M&M: =

26. Copyright  2001 Prentice-Hall, Inc. Fundamentals of Financial Management, 11/e by Van Horne and Wachowicz. Slides prepared by Wu Xiaolan 25 Absolute priority rule Absolute priority rule states that debt holders must be paid in full before equity holders receive any proceeds of the bankruptcy, secured debt holders be paid before unsecured debt holder, and senior debt holders be paid before junior debt holder. Who gets paid first?  Secured claims  Administrative claims  Gap claims: post-filing/pre-trustee expenses  Wages & salaries ($2,000 limit per person)  Benefit plan claims  Consumer claims and deposits.  Taxes and rents.  Unsecured creditors.  Preferred stockholders.  Common stockholders.

27. Copyright  2001 Prentice-Hall, Inc. Fundamentals of Financial Management, 11/e by Van Horne and Wachowicz. Slides prepared by Wu Xiaolan 26 Bankruptcy Technical Insolvency Insolvency in Bankruptcy Legal Bankruptcy

28. Copyright  2001 Prentice-Hall, Inc. Fundamentals of Financial Management, 11/e by Van Horne and Wachowicz. Slides prepared by Wu Xiaolan 27 Bankruptcy Costs -- Direct bankruptcy costs Direct costs of financial distress are the legal and administrative charges that occur during bankruptcy proceedings and that are taken from the cash flows that otherwise would go to the bondholders and stockholders.

29. Copyright  2001 Prentice-Hall, Inc. Fundamentals of Financial Management, 11/e by Van Horne and Wachowicz. Slides prepared by Wu Xiaolan 28 Direct bankruptcy costs (cont.) Some estimates the tax advantages of debt (T c D) are maybe 20 cents on the dollar. Thus, they argue the costs in terms of expected financial distress are small compared to its advantages. Because most of the direct costs of bankruptcy are the same for both small and large firms, the bankruptcy costs of small firms as a proportion of the value of their assets, are much larger. For small firms, these costs may be fairly large, perhaps 20-25% of a firm’s value.

30. Copyright  2001 Prentice-Hall, Inc. Fundamentals of Financial Management, 11/e by Van Horne and Wachowicz. Slides prepared by Wu Xiaolan 29 Bankruptcy Costs -- Indirect bankruptcy costs Indirect bankruptcy costs: potential costs due to firm’s liquidation. Also known as financial distress costs. Types of indirect bankruptcy costs:  Loss of valuable trademark, brand, etc.  Impaired ability to conduct business  Loss of potential business deals, partners,  Assets sold in fire-sale  Employees  Agency costs

31. Copyright  2001 Prentice-Hall, Inc. Fundamentals of Financial Management, 11/e by Van Horne and Wachowicz. Slides prepared by Wu Xiaolan 30 Example In the late 1970s, a financially distressed Chrysler would have defaulted on its debt had the government not intervened. In 1979, Chrysler offered rebates on its cars and trucks to attract customers who might have avoided Chrysler vehicles because of the company’s financial distress. Assuming a $300 rebate on each vehicle and if Chrysler sold 1,438,000 cars and trucks in 1979, then how much financial costs come from this rebate incentive?

32. Copyright  2001 Prentice-Hall, Inc. Fundamentals of Financial Management, 11/e by Van Horne and Wachowicz. Slides prepared by Wu Xiaolan 31 Agency Costs Agency costs: conflict between debt holders and equity holders, old bondholders and new bondholders The incentives of equity holders to maximize the value of their shares are not necessarily consistent with the incentive to maximize the total value of the firm’s debt and equity. Total assets of firm = total debt + total equity

33. Copyright  2001 Prentice-Hall, Inc. Fundamentals of Financial Management, 11/e by Van Horne and Wachowicz. Slides prepared by Wu Xiaolan 32 Who bears the bankruptcy costs? (Direct costs) Under the absolute priority rule, most of a firm’s value in the event of bankruptcy is transferred to its debt holders. Since the direct costs of bankruptcy diminish the value of the firm, most direct costs are thus ultimately borne by the firm’s debt holder.

34. Copyright  2001 Prentice-Hall, Inc. Fundamentals of Financial Management, 11/e by Van Horne and Wachowicz. Slides prepared by Wu Xiaolan 33 Who bears the bankruptcy costs? (Cont.) Since lenders realize they will be bearing costs in the event of bankruptcy, they change a higher interest rate, default premium, on the firms that are in financial distress.  Default premium: the differences between the promised yield to the bond’s lenders and the yield on a bond with no default. Thus, equity holders are, in effect, paying the expected bankruptcy costs whenever they issue risky debt.

35. Copyright  2001 Prentice-Hall, Inc. Fundamentals of Financial Management, 11/e by Van Horne and Wachowicz. Slides prepared by Wu Xiaolan 34 Optimal Capital Structure: Optimal capital structure is achieved by finding the point at which the tax benefit of an extra dollar of debt = potential cost of financial distress. This is the point of:  Optimal amount of debt  Maximum value of the firm  Optimal debt to equity ratio  Minimal cost of WACC This will obviously vary from firm to firm and takes some effort to evaluate. No single equation can guarantee profitability or even survival

36. Copyright  2001 Prentice-Hall, Inc. Fundamentals of Financial Management, 11/e by Van Horne and Wachowicz. Slides prepared by Wu Xiaolan 35 Concluding remarks on capital structure Where do we stand? Do we have an optimal capital structure? What do we mean by optimal capital structure? There are two main theories of capital structure choice: trade-off theory and pecking order theory.

37. Copyright  2001 Prentice-Hall, Inc. Fundamentals of Financial Management, 11/e by Van Horne and Wachowicz. Slides prepared by Wu Xiaolan 36 Trade-off theory The trade-off theory says that companies have optimal debt-equity ratios, by trading off the benefits of debt against its costs What are some advantages and disadvantages of debt that you can think of?  The good news: interest payments are deductible and create a debt tax shield (T C D).  The bad news: all else equal, borrowing more money increases the probability (and therefore the expected value) of direct and indirect bankruptcy costs.

38. Copyright  2001 Prentice-Hall, Inc. Fundamentals of Financial Management, 11/e by Van Horne and Wachowicz. Slides prepared by Wu Xiaolan 37 Trade-off theory (Cont.) Debt (B) Value of firm (V) 0 Present value of tax shield on debt Present value of financial distress costs Value of firm under MM with corporate taxes and debt V L = V U + T C B V = Actual value of firm V U = Value of firm with no debt B*B* Maximum firm value Optimal amount of debt

39. Copyright  2001 Prentice-Hall, Inc. Fundamentals of Financial Management, 11/e by Van Horne and Wachowicz. Slides prepared by Wu Xiaolan 38 Trade-off theory (Cont.) What does this trade-off formula tells us? Based on the trade-off theory, what prediction can we make?

40. Copyright  2001 Prentice-Hall, Inc. Fundamentals of Financial Management, 11/e by Van Horne and Wachowicz. Slides prepared by Wu Xiaolan 39 Pecking-order theory Pecking-order theory is the main contender to the trade- off theory. It bases its argument on information asymmetry. It argues that actual corporate leverage ratios typically do not reflect capital structure targets. Instead, the widely observed corporate practice is financing new investment with internal financing when possible and issuing debt rather than equity if external financing is needed.

41. Copyright  2001 Prentice-Hall, Inc. Fundamentals of Financial Management, 11/e by Van Horne and Wachowicz. Slides prepared by Wu Xiaolan 40 Pecking-order theory (Cont.) According to the theory, management is reluctant to issue underpriced equity (though often willing to issue fairly priced or overpriced equity). Investors thus interpret management decisions to raise equity as a sign that the firm is overvalued and devalue the firm’s stock.

42. Copyright  2001 Prentice-Hall, Inc. Fundamentals of Financial Management, 11/e by Van Horne and Wachowicz. Slides prepared by Wu Xiaolan 41 Critical considerations: Firms with greater risk of financial distress must borrow less The greater volatility in EBIT, the less a firm should borrow (magnify risk of losses) Costs of financial distress can be minimized the more easily firm assets can be liquidated to cover obligations A firm with more liquid assets may therefore have less financial risk in borrowing A firm with more proprietary assets (unique to the firm, hard to liquidate) should minimize borrowing

43. Copyright  2001 Prentice-Hall, Inc. Fundamentals of Financial Management, 11/e by Van Horne and Wachowicz. Slides prepared by Wu Xiaolan 42 Lower financial leverage Bondholder claim Bankruptcy claim Tax claim Shareholder claim Higher financial leverage Bondholder claim Bankruptcy claim Tax claim Shareholder claim The Extended Pie Model