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Capital Structure Choices and Theory

This chapter delves into the principles and objectives behind a firm's capital structure, exploring why capital structures vary across industries and how they influence financial decisions. Learn about financial analysis tools and the Modigliani and Miller Capital Structure Theorem.

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Capital Structure Choices and Theory

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  1. Chapter 15Capital Structure Policy

  2. Slide Contents • Principles Applied in This Chapter • Learning Objectives • A Glance at Capital Structure Choices in Practice • Capital Structure Theory • Why Do Capital Structures Differ Across Industries? • Making Financing Decisions • Key Terms

  3. Learning Objectives • Describe a firm's capital structure. • Explain why firms have different capital structures and how capital structure influences a firm's weighted average cost of capital. • Describe some fundamental differences in industries that drive differences in the way they finance their investments. • Use the basic tools of financial analysis to analyze a firm's financing decision.

  4. Principles Applied in This Chapter • Principle 2: There is a Risk-Return Tradeoff • Principle 3: Cash Flows Are the Source of Value • Principle 5: Investors Respond to Incentives

  5. 15.1 A Glance at Capital Structure Choices in Practice

  6. A Glance at Capital Structure Choices in Practice • The primary objective of capital structure management is to maximize the total value of the firm's outstanding debt and equity. • The resulting financing mix that maximizes this combined value is called the optimal capital structure.

  7. Defining a Firm's Capital Structure • Capital structure = owner's equity + interest bearing debt • Financial structure = Capital structure + non-interest bearing liabilities (such as accounts payable). It is also described using a firm's debt ratio.

  8. Defining the Firm's Capital Structure (cont.) The Debt to Enterprise Value ratio is commonly used to describe a firm's capital structure.

  9. Defining the Firm's Capital Structure (cont.) The book value of interest bearing debt includes: • Short-term notes payable (e.g., bank loans), • Current portion of long-term debt, and • Long-term debt.

  10. Table 15.1 Financial and Capital Structures for Selected Firms (Year-End 2012)

  11. Defining the Firm's Capital Structure (cont.) Table 15-1 shows that debt ratio is always higher than the debt-to-enterprise value because: • Debt ratio is based on book value and book value of equity is always lower than its market value. • Debt to value ratio excludes non-interest bearing debt in the numerator resulting in a lower value.

  12. Defining the Firm's Capital Structure (cont.) Table 15-1 also reports the Times Interest Earned Ratio, which measures the firm's ability to pay the interest on its debt out of operating earnings.

  13. Financial Leverage • By borrowing a portion of firm's capital at a fixed rate of interest, firm can “leverage” the rate of return it earns on its total capital into an even higher rate of return on the firm's equity. • For example, if the firm is earning 17% on its investments and paying only 8% on borrowed money, the 9% differential goes to the firm's owners. This is known as favorable financial leverage. If it earns less than 8%, it will be unfavorable financial leverage.

  14. How Do Firms in Different Industries Finance Their Assets? Figure 15.1 Debt-to-Enterprise-Value Ratios for Selected Industries

  15. 15.2 Capital Structure Theory

  16. A First Look at the Modigliani and Miller Capital Structure Theorem Modigliani and Miller showed that, under idealistic conditions, the level of debt in its capital structure does not matter. The theory relies on two basic assumptions: • The cash flows that a firm generates are not affected by how the firm is financed. • Financial markets are perfect.

  17. A First Look at the Modigliani and Miller Capital Structure Theorem (cont.) Assumption 2 of perfect market implies that the packaging of cash flows, that is whether they are distributed to investors as dividends or interest payments, is not important. When the two assumptions hold, the value of the firm is not affected by how it is financed.

  18. Figure 15.2 Assumption 1: Cash Distributions to Bondholders and Stockholders Are Not Affected by Financial Leverage

  19. Capital Structure, the Cost of Equity, and the Weighted Average Cost of Capital When there are no taxes, the firm's weighted average cost of capital is also unaffected by its capital structure.

  20. Capital Structure, the Cost of Equity, and the Weighted Average Cost of Capital (cont.) Assume, we are valuing a firm whose cash flows are a level perpetuity. The value of the firms is then represented by the following equation.

  21. Capital Structure, the Cost of Equity, and the Weighted Average Cost of Capital (cont.) Since firm value and firm cash flows are unaffected by the capital structure, the firm's weighted average cost of capital is also unaffected.

  22. Capital Structure, the Cost of Equity, and the Weighted Average Cost of Capital (cont.) • The cost of equity (eq. 15-7) increases with the debt to equity ratio (D/E). • However, because of less weight on the more expensive equity, the WACC (eq. 15-6) does not change and is always equal to the cost of capital of an unlevered firm.

  23. Capital Structure, the Cost of Equity, and the Weighted Average Cost of Capital (cont.) Example JNK can borrow money at 9% and its cost of capital if it uses no financial leverage is 11%. It has a debt-to-equity ratio of 1.0, the cost of debt is 8%, and weighted average cost of capital is 10%. What is the cost of equity for JNK?

  24. Capital Structure, the Cost of Equity, and the Weighted Average Cost of Capital (cont.) • Cost of equity = .11 + (.11-.08) × 1.0 = .14 or 14%

  25. Figure 15.3 Cost of Capital and Capital Structure: M&M Theory

  26. Figure 15.3 Cost of Capital and Capital Structure: M&M Theory (cont.)

  27. Why Capital Structure Matters in Reality? Financial managers care a great deal about how their firms are financed. Indeed, there can be negative consequences for firms that select an inappropriate capital structure, which means that, in reality, at least one of the two M&M assumptions is violated.

  28. Violation of Assumption 2 Transaction costs can be important and because of these costs, the rate at which investors can borrow may differ from the rate at which firms can borrow. When this is the case, firm values may depend on how they are financed.

  29. Violation of Assumption 1 There are three reasons why capital structure affects the total cash flows available to a firm's debt and equity holders: • Interest is a tax-deductible expense, while dividends are not. Thus, after taxes, firms have more money to distribute to their debt and equity holders if they use debt financing.

  30. Violation of Assumption 1 (cont.) • Debt financing creates a fixed legal obligation. If the firm defaults on its payments, the firm will incur the added cost that the bankruptcy process entails. • The threat of bankruptcy can influence the behavior of a firm's executives as well as its employees and customers.

  31. Corporate Taxes and Capital Structure Since interest payments are tax deductible (and dividends are not), the after-tax cash flows will be higher if the firm's capital structure includes more debt.

  32. Corporate Taxes and Capital Structure (cont.) Consider two firms identical in every respect except for their capital structure. • Firm A has no debt and has total equity financing of $2,000. • Firm B has borrowed $1,000 on which it pays 5% interest and raised the remaining $1,000 with equity. • Each firm has operating income of $200,000. • The corporate tax rate is 25%.

  33. Corporate Taxes and Capital Structure (cont.)

  34. Corporate Taxes and Capital Structure (cont.) • If we assume that both firms payout 100% of earnings in common stock dividends, we get the following:

  35. Corporate Taxes and Capital Structure (cont.) • The $12.50 can be traced to the tax benefits of interest payments, 0.25 ×$50 = $12.50. This is referred to as interest tax savings. • These tax savings add value to the firm and provide an incentive to the firm to include more debt.

  36. Corporate Taxes and the WACC The tax deductibility of interest expense causes the firm's weighted average cost of capital to decline as it includes more debt in the capital structure.

  37. Corporate Taxes and the WACC (cont.) Example JNK's cost of capital if it uses no financial leverage is 11%. It has a debt equity ratio of 1.0, the cost of debt is 8% before taxes, and the tax rate is 40%. What will be the cost of equity and weighted average cost of capital if the debt to equity ratio is 1 (i.e. 50% debt and 50% equity).

  38. Corporate Taxes and the WACC (cont.) Cost of equity =.11 + (.11-.08)(1)(1-.40) = .128 or 12.8%

  39. Corporate Taxes and the WACC (cont.) kWACC = .08(1-.40) × .50 + .128 × .50 kWACC = .088 or 8.8%

  40. Corporate Taxes and the WACC (cont.) • Figure 15-4 shows that as debt to equity ratio rises, the WACC declines while the cost of equity increases. • Thus the tax benefit of interest expense favors use of debt over equity.

  41. Figure 15.4 The Cost of Equity and WACC with Tax-Deductible Interest Expense

  42. Figure 15.4 The Cost of Equity and WACC with Tax-Deductible Interest Expense (cont.)

  43. Bankruptcy and Financial Distress Costs Even though debt provides valuable tax savings, a firm cannot keep on increasing debt. If the firm's debt obligations (i.e. interest expense) exceed it's ability to generate cash, it will be forced into bankruptcy and incur financial distress costs.

  44. The Tradeoff Theory and the Optimal Capital Structure Thus two factors can have material impact on the role of capital structure in determining firm value and firms must tradeoff the pluses and minuses of both these factors: • Interest expense is tax deductible. • Debt makes it more likely that firms will experience financial distress costs.

  45. Table 15.2 Leverage and the Probability of Default

  46. Table 15.2 Leverage and the Probability of Default (cont.)

  47. Figure 15.5 The Cost of Capital and the Tradeoff Theory

  48. Capital Structure Decisions and Agency Costs Debt financing can help reduce agency costs. For example, debt financing by creating fixed dollar obligations will reduce the firm's discretionary control over cash and thus reduce wasteful spending.

  49. Making Financing Choices When Managers are Better Informed than Shareholders When firms issue new shares, it is perceived that the firm's stock is overpriced and accordingly share price generally falls. This provides an added incentive for firms to prefer debt.

  50. Making Financing Choices When Managers are Better Informed than Shareholders (cont.) Stewart Myers suggested that because of the information issues that arise when firms issue equity, firms tend to adhere to the following pecking order when they raise capital: • Internal sources of financing • Marketable securities • Debt • Hybrid securities • Equity

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