Title: MBA 643 Managerial Finance Lecture 12: Corporate Capital Structure Policy
1MBA 643Managerial FinanceLecture 12 Corporate
Capital Structure Policy
2Overview
- A firm consists of assets, which produce a stream
of cash flows. The capital structure decision
determines how those assets will be paid for, and
how the cash flows will be allocated among
different claims (debt or equity). - An important question (revisit) Can a firm
increase the value of its assets by issuing a
particular set of securities?
3The Modigliani/Miller Theorem (1958)
- Proposition I If
- There are no taxes
- There are no contracting costs
- The firms investment policy is fixed
- Then
- The value of the firm is independent of its
financing policy. - A Quick Lesson on Logic
- If A then B implies If (not B) then (not
A)
4Restatement of Proposition I
- If the choice of capital structure affects
current firm value, then it does so by - Changing tax liabilities
- Changing contracting costs
- Changing investment incentives
E
D
5Example 1.A
- The Nantucket Nugget is unlevered and is valued
at 640,000. Nantucket is currently deciding
whether including debt in their capital structure
would increase their value. Under consideration
is issuing 300,000 in new debt with an 8
interest rate. Nantucket would repurchase
300,000 of stock with the proceeds of the debt
issue. There are currently 32,000 shares
outstanding and their effective tax rate is zero.
What is the change in value? How many shares of
stock will be repurchased? - Old CS V 640,000 E
- New CS D 300,000 and E 640,000-300,000
340,000 - Price 640,000/32,000 20
- Shares repurchased 300,000/20 15,000 (shares)
6MM Proposition II (no taxes)
- MM(I) implies rA is independent of leverage.
- Remember rWACC rA D/A rD E/A rE
- gt rE rA (D/E)(rA rD)
- MM (II) rE increases with leverage.
r ()
rE
rA
rD
D/E
riskless debt
risky debt
7MM II (no taxes)
- The expected return on equity (rE) increases
linearly with the D/E ratio as long as debt is
risk-free. But if leverage increases the risk of
the debt, debtholders demand a higher return on
debt. This causes the rate of increase in rE to
slow down. - Example 1.B The Nantucket Nugget currently has
rE 12. After Nantucket repurchases the stock,
what will the firms overall cost of capital (rA)
be? - According to MM I, rA rE 12
- After the repurchase, what will be cost of equity
be? - rE rA(D/E)(rA rD) 0.12300,000/340,000(0.1
2-0.08) 15.53
8Relaxing the MM Assumptions
- If debt policy were completely irrelevant, debt
ratios would look random. But, they dont. Debt
ratios tend to cluster within industries,
suggesting that firm characteristics are
important.
Median Industry Debt Ratios, 1993 Median Industry Debt Ratios, 1993
Apparel 0.059
Chemicals 0.097
Oil and Gas Extraction 0.195
Restaurants 0.248
Communications 0.438
Air Transportation 0.566
Hotels and Lodging 0.602
9What Can Explain Firms Financing Choices?
- We know that if capital structure matters, it
matters because at least one of the MM
assumptions are violated. - Taxes (Corporate and individual)
- Costs of financial distress (Bankruptcy costs)
- Agency costs
- We discuss the first two assumptions in this
lecture.
10Corporate Taxes (MM, 1963)
- Interest payments to bondholders are deductible
for tax purposes while dividend payments to
equityholders are not.
D
E
TC
11How Much a Firm Can Save By Using Debt?
- If the firm uses debt
- Interest payment rDD
- Interest payment can be deducted before tax is
calculated. - So, tax reduction from interest payment TCrDD
- If we assume the companys debt is permanent,
then - PV(tax shield) TCrDD/rD TCD
- MM I with corporate taxes
- VL VU TCD
- Value of a levered firm Value if all-equity
financed PV of tax shield - MM II with corporate taxes
- rE rA D/E(1-TC)(rA rD)
Tax Shield
12Example 2
- Blue Inc. has no debt and is expected to generate
4 million in EBIT in perpetuity. TC30. All
after-tax earnings are paid as dividends. The
firm is considering a restructuring, allowing 10
million in debt with an interest rate of 8. The
unlevered rE18. - What is the current value of Blue?
- VUEBIT(1-TC)/rA(40.7)/0.18 15.56 million
- What will the new value be after the
restructuring? - VLVUTCxD 15.56 0.310 18.56 million
- New CS D10 million, E8.56 million
- What will the new required return on equity be?
- rE rA D/E(1-TC)(rA rD)
0.18(10/8.56)(0.7)(0.18-0.08) 26.18
13Personal Taxes
- Unfortunately, the above MM I implies that 100
debt financing is optimal. In reality, we dont
observe firms with debt ratios equal to 100. - There are two costs associated with debt
- Personal taxes
- Bankruptcy costs
- When corporations pay interest on debt, they
reduce their own taxes, but increase the taxes of
individuals (debtholders). Thus, while there is
a corporate tax advantage to debt, there is a tax
disadvantage to the debtholders.
14Personal Taxes
- Ultimately, the corporations must bear all of the
taxes associated with its activities either
directly or indirectly through higher required
rates of return on debt. - Under corporate and personal taxes, we have the
new valuation model (Miller, 1977) - TB personal tax rate on ordinary income such as
interest - TS personal tax rate on equity distributions
such as dividend - If (1-TB)(1-TC)(1-TS), then debt policy is
irrelevant again. - If TBTS, then we go back to the world without
personal taxes.
15Bankruptcy Costs
- If the costs of financial distress are positive,
then this implies that 100 debt financing is NOT
optimal. - New Valuation Model VL VU TCD - BC
- Bankruptcy is a legal mechanism that allows firms
to renegotiate the terms of their debt contracts. - Direct bankruptcy costs costs of using this
legal framework. - Indirect bankruptcy costs loss in value realized
when customers nd suppliers abandon a bankrupt
firm.
16More on Bankruptcy
- Default
- When the firm is in violation of debt covenants
or any other contract provisions. - Bankruptcy
- The legal proceedings under which court
protection allows the firm to liquidate (Chapter
7) or reorganize (Chapter 11). - Liquidation (Chapter 7)
- The death of the firm. Its assets are sold and
the proceeds distributed to claimholders. - Only 10 of all bankruptcies end in Chapter 7.
- Reorganization (Chapter 11)
- 90 are reorganizations which are debtor friendly.
17Put Everything Together-- The Trade-off Theory
Firm Value
Optimal Capital Structure
VU PV(tax shield)
BC
VL VU PV(tax shield) - BC
PV(tax shield)
Value if all equity financed (VU)
Debt Ratio
18An Alternative Explanation on CS-- The Pecking
Order Theory
- Information asymmetry between financial managers
and outside investors - Equity issuances send a signal to the market that
managers feel its a window of opportunity to
issue more equities. - Over-valuation argument
- Rules of the Pecking Order
- Internal financing Use project-generated CFs
- External financing Issue the Safest Securities
first. - Debt financing
- Equity financing (last resort)