Capital Structure Decision

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Capital Structure Decision. MM propositions. Today’s plan. Review what we have learned in the last lecture The capital structure decision The capital structure without taxes MM’s proposition 1 MM’s proposition 2 The capital structure with taxes MM’s proposition 1 MM’s proposition 2.

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Capital Structure Decision

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Capital Structure Decision

MM propositions

Financial management: lecture 10

Today’s plan
• Review what we have learned in the last lecture
• The capital structure decision
• The capital structure without taxes
• MM’s proposition 1
• MM’s proposition 2
• The capital structure with taxes
• MM’s proposition 1
• MM’s proposition 2

Financial management: lecture 10

What have we learned in the last lecture
• In the last lecture, we have discussed the case in the end of chapter 12, what have you learned from this case?
• In the last lecture, we have also discussed three forms of market efficiency, what are they and what is your understanding of these three forms of market efficiency?

Financial management: lecture 10

Look at the both sides of a balance sheet

Asset

Liabilities and equity

Market value of equity

Market value of the asset

E

V

Market value of debt

D

V=E+D

Financial management: lecture 10

Capital structure
• Capital structure refers to the mix of debt and equity in a firm.
• We often use D/E or D/V (V=D+E) to indicate the capital structure of a firm.
• Usually, the higher the ratio, the more debt a firm has
• The capital structure problem for a firm is to determine what is the maximum amount of debt a firm should have to maximize the firm’s value.

Financial management: lecture 10

Does capital structure affect the firm value?

Equity

Debt

Debt

Equity

Debt

Equity

wasted

Govt.

Govt.

Slicing the pie doesn’t

affect the total amount

available to debt

holders and equity holders

Slicing the pie can

affect the size of the

wasted slice

Slicing the pie can

affect the size of the slice

going to government

Financial management: lecture 10

MM’s proposition 1
• Modigliani & Miller
• If the investment opportunity is fixed, there are no taxes, and capital markets function well, the market value of a company does not depend on its capital structure.
• How can we understand this?
• The size of a pizza has nothing to do with how you slice it.

Financial management: lecture 10

MM’s proposition 2
• Modigliani & Miller
• If the investment opportunity is fixed, there are no taxes, and capital markets function well, the expected rate of return on the common stock of a levered firm increases in proportion to the debt-equity ratio (D/E), expressed in market values.
• The WACC is independent of how the firm is financed

Financial management: lecture 10

WACC without taxes in MM’s view

r

rE

WACC

rD

D

V

Financial management: lecture 10

M&M (Debt Policy Doesn’t Matter)

Example - River Cruises - All Equity Financed

Financial management: lecture 10

M&M (Debt Policy Doesn’t Matter)

Example

cont.

50% debt

Financial management: lecture 10

M&M (Debt Policy Doesn’t Matter)

Example - River Cruises - All Equity Financed

- Debt replicated by investors

Financial management: lecture 10

Capital structure and Corporate Taxes
• The use of debt has a lot of implications:
• Financial risk- The use of debt will increase the risk to share holders and thus Increase the variability of shareholder returns.
• Interest tax shield- The savings resulting from deductibility of interest payments.

Financial management: lecture 10

An example on Tax shield

You own all the equity of Space Babies Diaper Co.. The company has no debt. The company’s annual cash flow is \$1,000, before interest and taxes. The corporate tax rate is 40%. You have the option to exchange 1/2 of your equity position for 10% bonds with a face value of \$1,000.

Should you do this and why?

Financial management: lecture 10

C.S. & Corporate Taxes

All Equity 1/2 Debt

EBIT 1,000

Interest Pmt 0

Pretax Income 1,000

Taxes @ 40% 400

Net Cash Flow \$600

Financial management: lecture 10

C.S. & Corporate Taxes

All Equity 1/2 Debt

EBIT 1,000 1,000

Interest Pmt 0 100

Pretax Income 1,000 900

Taxes @ 40% 400 360

Net Cash Flow \$600 \$540

Financial management: lecture 10

Capital Structure and Corporate Taxes

All Equity 1/2 Debt

EBIT 1,000 1,000

Interest Pmt 0 100

Pretax Income 1,000 900

Taxes @ 40% 400 360

Net Cash Flow \$600 \$540

Total Cash Flow

All Equity = 600

*1/2 Debt = 640

(540 + 100)

Financial management: lecture 10

Capital Structure and tax shield

PV of Tax Shield =

D x rD x Tc

rD

= D x Tc

Example:

Tax benefit = 1000 x (.10) x (.40) = \$40

PV of 40 perpetuity = 40 / .10 = \$400

PV Tax Shield = D x Tc = 1000 x .4 = \$400

Financial management: lecture 10

MM’s proposition 1 with tax
• firm value = value of all equity firm + PV(tax shield)

Example,

all equality firm value =600/0.1=6,000

PV( tax shield)=400

firm value=6,400

Financial management: lecture 10

MM’s proposition 2
• The weighted average cost of capital is decreasing with the ratio of D/E, that is
• Can you understand this intuitively?

Financial management: lecture 10

WACC Graph

Financial management: lecture 10

Financial Distress

Costs of Financial Distress - Costs arising from bankruptcy or distorted business decisions before bankruptcy.

Market Value = Value if all Equity Financed

+ PV Tax Shield

- PV Costs of Financial Distress

Financial management: lecture 10

Financial distress

Costs of Financial Distress - Costs arising from bankruptcy or distorted business decisions before bankruptcy.

Market Value = Value if all Equity Financed

+ PV Tax Shield

- PV Costs of Financial Distress

Financial management: lecture 10

Optimal Capital structure

Trade-off Theory - Theory that capital structure is based on a trade-off between tax savings and distress costs of debt.

Pecking Order Theory - Theory stating that firms prefer to issue debt rather than equity if internal finance is insufficient.

Financial management: lecture 10

Financial Distress

Maximum value of firm

Costs of

financial distress

PV of interest

tax shields

Market Value of The Firm

Value of levered firm

Value of

unlevered

firm

Optimal amount

of debt

Debt

Financial management: lecture 10