Chapter 9 Theory of Capital Structure

1. Chapter 9Theory of Capital Structure

2. Introduction to the Theory • Capital structure is the proportions of • Debt • Preferred stock • Common stock • Assumptions • Definitions • NOI approach • Traditional approach

3. Assumptions • No taxes & no bankruptcy costs • No transaction costs • Pay all earnings in dividends • Same expected future operating earnings for all investors • No growth of earnings

4. Definitions • ki is the yield on the company’s debt • keis the earnings/price ratio • Required rate of return for investors • k0 is an overall capitalization rate for the firm • Weighted average cost of capital (WACC)

5. Calculating NOI Approach NOI X Overall capitalization rate = Total value of firm – Market value of debt = Market value of stock

6. NOI Approach • Required return on equity increases linearly with leverage • Total valuation of the firm unaffected by it capital structure

7. Important Assumptions of NOI Approach • k0 is constant • Regardless of the degree of leverage • Breakdown between debt and equity unimportant • If ki remains constant, ke is a constant linear function of the debt-to-equity ratio • k0 cannot be altered through leverage • No one optimal capital leverage

8. Traditional Approach • There is an optimal capital structure • Increase the total value of the firm through leverage • Cost of capital is independent of the capital structure • Optimal capital structure exists

9. Modigliani-Miller (MM) Position • Assumptions are important • Capital structure is irrelevant • Total investment value of a corporation depends on profitability and risk • Value is the same regardless of financing mix • Homemade leverage • Arbitrage efficiency

10. Irrelevance in a CAPM Framework • As leverage increases • Expected return and beta increase proportionally • The change in expected return and beta offset each other with respect to share price • Share price is invariant with respect to leverage

11. Taxes and Capital Structure • Important market imperfections • Corporate taxes • Components of overall value Value if levered + Value of tax shield • Optimal strategy is to maximize leverage • Not consistent with corporate behavior

12. Uncertainty of Tax Shield • Income is consistently low or negative • Bankruptcy • Change in the corporate tax rate • Redundancy

13. New Value Equation Value of Value if Pure value Value lost firm = Unlevered + of corporate – through tax tax shield shield uncertainty

14. Corporate Plus Personal Taxes • Personal taxes can reduce the corporate tax advantage • Dividends versus capital gains • Debt or stock income

15. Merton Miller’s Equilibrium • In market equilibrium personal and corporate tax effects cancel out • Investor clienteles and market equilibrium • Completing the market • Counterarguments • Zero personal tax on stock income is suspect • Disturbing relationship between • Corporate debt • Stock returns • Returns on tax-exempt municipal bonds

16. Recapitulation • Tax advantage to borrowing • Moderate amounts of debt • Tax shield uncertainty is not great • Some lessening of the corporate tax effect • Owing to personal taxes • Greater the tax wedge • Lower the overall tax shield

17. Effects of Bankruptcy Costs • Less than perfect capital markets • Administrative costs to bankruptcy • Assets liquidated at < economic value • Relationship to leverage • Deadweight loss to suppliers of capital • Taxes and bankruptcy costs • Trade-off between • Tax effects of leverage • Bankruptcy costs associated with high leverage • Most important imperfections

18. Other Imperfections • Corporate and homemade leverage not being perfect substitutes • Advantage to corporation borrowing • Arbitrage process • Institutional restrictions • Adverse effects on market value • Greater the importance of imperfections • Less effective MM arbitrage process • Greater the case for an optimal capital structure

19. Incentive Issues and Agency Costs • Agency costs • Stakeholders monitoring • Equity holders • Debt holders • Management • Other stakeholders

20. Debt Holders Versus Equity Holders • Equity of a firm • Call option on the firm’s total value • Debtholders are the writers of the option

21. Effect of Variance and the Riskiness of Assets • By increasing the riskiness of the company • Stockholders increase the value of their stock • At the direct expense of the debt holders

22. Changing the Proportion of Debt • Will affect the relative valuation • Of debt • Of equity • Relationship between the proportion of debt and valuation • Increasing the proportion of debt • Results in a decline in the price of debt • Results in an increase in share price

23. Protective Covenants • Restrict the stockholders’ ability • To increase the assets riskiness • To increase leverage • MM argument • “Me-first” rules

24. The Underinvestment Problem • Result of equity holders not wishing to invest when the rewards favor debt holders • Disappears when • Investors own both stocks and bonds • By contracting between debt holders and stockholders

25. Agency Costs More Broadly Defined • Monitoring • Cost is born by stockholders • Debt holders charge more interest • May limit the optimal amount of debt • Optimal balance between • Monitoring costs • Interest rate charged on debt

26. Organizational Incentives to Manage Efficiently • Leveraged companies • May be lean because management cuts the fat • Running scared • Debt brings capital-market discipline to management • Company with little debt • Significant free cash flow • Have a tendency to squander funds

27. Asymmetric Information • Signaling effect • Assumes there is information asymmetry • Credibility of a financial signal depends on asymmetric information • The greater the asymmetry in information the greater the likely stock reaction to a financing announcement • What is significant? • The signal conveyed by a changed capital structure