11. Capital Structure.ppt

8/9/2019 11. Capital Structure.ppt

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1

Capital Structure, Dividend Policy(Chapters 14-18)

Proft and loss diagrams

Principle o fnancial leverage

!a" o the Conservation o #nvestment$alue

Standard allacy% ris& vs' return

eighted average cost o capitala*es and +an&ruptcy costs

Dividend policy


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P0= 100

t = 1

D1= 10

Profit

50 75

25

125 150

-25

Buy Stock

(with payout)

Loss

BUY STOCK (proft/loss diagram)

Future Stock Price (Pt)

Buy Stock(without payout)


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P0= 100

t = 1

r = .15

D1= 10

50 75

25

125 150

-25

Short Stock

(with payout and

with interest on proceeds)

Short Stock

Profit

Loss

SHORT STOCK (proft/loss diagram)

Short Stock(with payout only)



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P0= 100

t = 1

r = .15

50 75

25

125 150

-25

Loss

Profit

LEND CASH(proft/loss diagram)



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P0= 100

t = 1

r = .15

D1= 0

50 75

25

125 150

-25

Additivity Principle: Add vertical distances of dashed lines to the horizontal axis.

Loss

Profit

!" STOCKand !" CASH#Additi$it% &ri'ipl


50%Stock, 50%Cash

Lend Cash

Buy Stock


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P0= 100

t = 1

r = .15

D1= 0

50 75

25

125 150

-25

50%Stock, 50%Cash

(Lending)

100%Stock

150%Stock, -50%Cash

(Borrowing)

Loss

Profit

X%STOCKa'd (100-X)%CASH#&ri'ipl o* +i'a'ial L$rag

Principle of Financial Leverage: More borrowing increases the range of possiblegains and losses.


Question: Suppose the

stock has a higher

expected return than

cash, how doesleverage affect overall

risk and expected

return?


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$aluing an sset

Conceptually, there are two ways you can get the value of

an asset:

Calculate the value of what the asset provides

that is, compute the present value of the expected cash flows

Calculate the value of all claims to the asset

for example, compute the value of a company y adding up all the

claims investors have on the company!s cash flows

Question:"oes the ratio of det to e#uity affect the value

of the corporation$

ssets . !ia+ilities / 0uities


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!a" o the Conservation o#nvestment $alue

If the inest!ent alue of an enterprise as a whole is "y definition the present

worth of all its future distri"utions to security holders, whether on interest or

diidend account, then this alue in no wise depends on what the co!pany#s

capitali$ation is% Clearly, if a single indiidual or a single institutional inestor

owned all the "onds, stocks, and warrants issued "y a corporation, it would not

!atter to this inestor what the co!pany#s capitali$ation was (e&cept for details

concerning the inco!e ta&)% 'ny earnings collected as interest could not "e

collected as diidends% o such an indiidual it would "e perfectly o"ious that

total interest and diidendpaying power was in no wise dependent on the kind

of securities issued to the co!pany#s owner% Further!ore, no change in the

inest!ent alue of the enterprise as a whole would result fro! a change in its

capitali$ation% Bonds could "e retired with stock issues, or two classes of *uniorsecurities (i%e% co!!on stock and warrants) could "e co!"ined into one, without

changing the inest!ent alue of the co!pany as a whole% Such constancy of

inest!ent alue is analogous to the indestructi"ility of !atter and energy+ it

leads us to speak of the Law of the Conseration of Inest!ent alue, *ust as

physicists speak of the Law of the Conseration of -atter, or the Law of the

Conseration of .nergy%/

0 1ohn Burr 2illia!s, The Theory of Investment Value(3456), pp% 7875%


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r+itrage Proo

-odigliani-iller heore!9 he alue of a fir! is independent of

its capital structure (een with uncertainty)%

-odigliani-iller heore!9 he alue of a fir! is independent of

its capital structure (een with uncertainty)%

VU= EU unlevered fir!" VL= DL+ EL levered fir!"

X XU= XL # operating inco!e"

VU= VL VU= VLVU= VL VU= VL

Homemade leverage argument: don$t pa% for so!eone else to !ake

so!ething %ou can !ake %ourself for free.

Current :ate Future :ate

Buy %shares of U EU= VU X

Buy %"onds of L DL min[X rDL!

Buy %shares of L DL m"#[0 X $ rDL!

otal DL+ EL= VL X

Le&icon9 alue of fir!/9 V

alue of stock/9 E

stock price per share/9


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13

Pie heory

Dept

Equity


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11

ssumptions or the Conservation !a"

(1) &'er"tin inome (*rom "ssets) is not "**ete ,"'it" struture (/te tot" 'ie is *i#e):no an%ruptcy costs

no differential transactions costs etween issuing or trading stoc% and onds

no changes in managerial incentives &stoc% options'

no changes in stoc%holder incentives &changes in the ris% of assets'

(2) 3e 'ro'ortion o* te o'er"tin inome t"t is

4oint "o"te to sto "n ,ons is not "**ete, te *irm6s "'it" struture (/on stooers"n ,onoers e"t te 'ie):no differential taxes etween income from stoc% and onds


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1

Pie Chart "ith a*es

Equity

Taxes

Debt


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15

Proo*:

Step 1: t"rt 7it "n une8ere *irm (7it n outst"nin s"res):VU= EU= nU

Step 2: 3e *irm "ters its "'it" struture , ,uin ," m s"res "n

re'"in tem o"r *or o"r 7it ,ons:

VL= EL+ DL= (n $ m)L+ mL= nL

7ere in ener" te sto o* te e8ere *irm m" se "t " i**erent 'rie 'er

s"re o* L.

Step 3: 9o7e8er sine VL= nL "n VU= nU,

i* VL= VU ten L= U

Stoc& Price Constancy

If the alue of a fir! is independent of its capitali$ation structure,

then so too is the fir!#s stock price%

If the alue of a fir! is independent of its capitali$ation structure,

then so too is the fir!#s stock price%

;ote9 &f the fir! starts with debt, for this to hold, the recapitalization cannot affect the !arket value of this debt.


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14

Standard 6allacy

( firm can invest in a pro)ect with an expected rate ofreturn of 10* and orrow money at an interest rate of 5*+hould the pro)ect e funded with det or e#uity$

et the proportion #of the pro)ect e financed y stoc%and 1 $ #y det+ .hen the expected rate of return tostoc%holders E(4)is determined y:

.10 = (1 $ #).05 + #E(4)

; E(4) = .05 + .05


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17

Standard 6allacy (continued)

hat aout ris%$ uppose the annual standard deviation of the returnof the pro)ect is 20*+ .hen

.202= V"r[(1 $ #).05 + #4! = #2V"r(4)

;.20 =#t(4) ; D(4) = .20


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1

eighted verage Cost oCapital (CC)

.he cost of capital is another name for the

discount rate or expected return+

.he ?@AAis the overall expected return ofthe firm as a whole+

.o see why, thin% of the firm as a portfolio

consisting of D


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1

Signifcance o CC

6nder the conditions for the .heorem, for

capital udgeting pro)ects that have the same

8ris%9 as the average firm investment, ?@AAisthe proper discount rate in calculating its present

value+

/f not same ris% as average, then use the C(&to e developed later'+

/f capital structure affects firm value, then still

holds as longs as capital structure is not changed+


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18

9:euired :eturn; on 0uity ora !evered 6irm

.he theorem implies that the ?@AAmust

e the same no matter what the amount of

leverage+

.hin% what would happen if the firm only has one

investor who holds all the det and e#uity+

et 0e the ?@AAof an all e#uity firm+

.he (CCof a levered firm is given y

ED R

ED

ER

ED

DR

+

+

+

=0


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12

:euired :eturn on 0uity(continued)

ultiplying oth sides y (D+E)


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3


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1

6ederal #ncome a*ation

--------- personal tax rates ---------

year corporate interest dividends cap gains4

71-7> >* 70* 70* ?5*

7@->1 A* 70* 70* 2>*

>2->A A* 50* 50* 20*

>7 0* ?@* ?@* 2>*

>>-@0 ?* 2>* 2>* 2>*

@1-@2 ?* ?1* ?1* 2>*

@?-@A ?5* 0* 0* 2>*

@7-00 ?5* 0* 0* 20*

01-02 ?5* ?@* ?@* 20*

0?-05 ?5* ?5* 15* 15*

4 actually much lower in practice due to delay of tax payment until realiBation


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0>ect o a*es

hen the firm pays taxes, you can thin% of thegovernment as )ust another claimant+

.hus there are now three claims on the firm&1' #uity holders

&2' "et holders

&?' .he government &/;'


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5

?ey 6eature o the @S a* Code

/nterest payment on det occurs on a efore-taxasis, whereas as dividends are paid on an after-

tax asis+.o see the general effect, assume that arningsDefore /nterest and .axes &D/.' is constant inperpetuity+

arnings after taxes for the all e#uity firm are:

EBC3(1 $ 3))


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4

ll-0uity 6irm

(ssume earnings after taxes are e#ual to ECE to

e#uity+ .hen, ecause there are no ondholders,

this is also the total cash flow paid out after

taxes+


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7

!evered 6irm

Eirst interest is paid to the ond holders &on a pretax asis':

DD

.hus, remaining income is: EBC3 $ DD.he remaining cash flow &after taxes' to e#uity holders is:

(EBC3 $ DD)(1 $ 3)

.otal cash flow paid out &to det and e#uity' after taxes:

(EBC3 $ DD)(1 $ 3) + DD

EBC3(1 $ 3) + DD3


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Comparison o the otal Cash6lo" paid out

6nlevered firm:

EBC3(1 $ 3)

evered firm:

EBC3(1 $ 3) + DD3

.hus the levered firm pays out higher cash flows to its investors

.he difference, DD3, is the extra cash flow going to e#uityholders that is not going to the government+ .his is the called

the 8tax shield+9 Clearly, the cash flow to investors depends in

this case on the det-to-e#uity ratio+


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Present $alue o the a* Shield

.he extra cash flow to e#uity holders is DD3),

(pplying the perpetuity formulae provides the

present value of this cash flow:

(DD3))


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8


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2

@nlevered 6irm %:eturn on 0uity "ith a*es

hat is the return on e#uity to an unlevered firm

in the constant perpetuity model$

0= EBC3(1 $ 3))


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53

!evered 6irm %:eturn on 0uity "ith a*es

hat is the return on e#uity to a levered firm in

the constant perpetuity model$

E= (EBC3 $ DD)(1 $ 3))


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51

!evered 6irm(continued)

ustituting for VUfrom the .heorem with taxes

gives &VL= VU+ 3D':

E= [(VL$ 3D)0$ DD(1 $ 3)!


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5


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55

Capital Structure PuAAle

(verage G500 firms have ratio:

/nterestHD/. F &aout' ?5*

uBBle: why is this not 100*$


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54

Ban&ruptcy (no ta*es)

Ban&ruptcy process% "or&out Chapter 11 reorganiAation

Chapter liuidationhat costs are associated "ith +an&ruptcy !oss o sales and employees !a"yersccountants gency

@nderinvestment :eputation 6ire sales o assets 0*pert "itnesses (+y ar the most Eustifa+le

e*penseF)


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57

:evised Pie heory

.hese costs areorne y the

stoc%holders+


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5

Caution

3ere we have to e careful, ecause rational

customers should understand that if %eeping the

pro)ects going is a positive IJ investment, thenan%ruptcy cannot affect the decision+

Der%!s .heory:

hy do employees suffer$ hy are they not earningtheir mar%et wages$ ;is%+ #uity holders insure

employees Dan%ruptcy prevents ris% sharing, and

thus is costly+


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5

:evised Pie heory%Ban&ruptcy / a*es


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58

Gther Considerations

(gency costs: moral haBard: ris%y over-

investment

(symmetric information ignaling: leverage indicates CK confidence

(dverse selection: 8lemon!s prolem9 with e#uity

6n)ustified differences of eliefs


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52

Dividend dates

"eclaration date &arch 2@, 1@@@'

"ay the oard of directors ma%es a decision to pay a

dividend

x-dividend date &.hursday, (pril 15, 1@@@'

2 usiness days efore date of record+ (ll ro%erage

houses guarantee that if the stoc% is purchasedbeforethis date, the holder will get the dividend

Kn (pril 15 the stoc% trades ex-dividendwhile on(pril 1 it trades cum-dividend. Lstoc% price 8falls9M


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Dividend dates (continued)

"ate ;ecord &onday, (pril 1@, 1@@@'

ist of stoc%holders of recordwho will get a dividend

ayment "ate &Eriday, ay 2>, 1@@@'

"ay the dividend chec%s are mailed


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#rrelevance o Dividend Policy

.o first order &that is, holding investment policyfixed and ignoring taxes' dividend policy isirrelevant -- it should not affect firm value+

.he reason is any investor can change hispersonal dividend policy y either selling oruying more shares, and the firm can

accomplish the same thing through sharerepurchase+

ince dividend policy is a financial decision,this is really )ust and example of + /n this

context, when might dividend policy matter$


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4

Dividend Policy "ith a*es(in the @S)

ince dividends are usually taxed at higher rate

than capital gains &even today', it would seem

that it is not optimal for a firm to issuedividends+

.hat is, rather than pay dividends firms should

reinvest the money or repurchase its shares and let

shareholders manufacture their personal dividends

y selling stoc%+


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11. Capital Structure.ppt

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