Chapter 14, 15 and 16 – MBA504 1

Capital Structure

Alternative Financial Instruments

Patterns of Financing

Capital-Structure Theory

Modigliani and Miller: No Taxes and With Taxes

Limits to the Use of Debt

Chapter 14, 15 and 16 – MBA504 2

Common Stock (see page 384)• Par Value

• Capital Surplus

• Retained Earnings

• Market Value, Book Value, and Replacement Value

• Shareholders’ Rights

• Dividends

• Classes of Stocks

Chapter 14, 15 and 16 – MBA504 3

Par Value and Capital Surplus• The stated value on a stock certificate is called the

par value. Some stocks have no par value. The total par value (the number of shares multiplied by the par value of each share) is sometimes called the dedicated capital of the corporation.

• Usually refers to amounts of directly contributed equity capital in excess of the par value.– For example, suppose 1,000 shares of common stock

having a par value of $1 each are sold to investors for $8 per share. The capital surplus would be ______.

Chapter 14, 15 and 16 – MBA504 4

Retained Earnings

• The earnings that are not paid out as dividends are referred to as retained earnings.

Chapter 14, 15 and 16 – MBA504 5

Market Value, Book Value, and Replacement Value

• Market Value is the price of the stock multiplied by the number of shares outstanding.

– Also known as Market Capitalization

• Book Value

– The sum of par value, capital surplus, and accumulated retained earnings is the common equity of the firm, usually referred to as the book value of the firm.

• Replacement Value

– The current cost of replacing the assets of the firm.

• At the time a firm purchases an asset, market value, book value, and replacement value are equal.

Chapter 14, 15 and 16 – MBA504 6

Shareholders’ Rights

• The right to elect the directors of the corporation by vote constitutes the most important control device of shareholders.

• Directors are elected each year at an annual meeting by a vote of the holders of a majority of shares who are present and entitled to vote. – The exact mechanism varies across companies.

• The important difference is whether shares are to be voted cumulatively or voted straight.

Chapter 14, 15 and 16 – MBA504 7

Proxy Voting

• A proxy is the legal grant of authority by a shareholder to someone else to vote his or her shares.

• For convenience, the actual voting in large public corporations is usually done by proxy.

• Proxy fight: if shareholders are not satisfied with management, an outside group of shareholders can try to obtain as many votes as possible via proxy. They can vote to replace management by adding enough directors.

Chapter 14, 15 and 16 – MBA504 8

Dividends• Unless a dividend is declared by the board of directors

of a corporation, it is not a liability of the corporation. – A corporation cannot default on an undeclared dividend.

• The payment of dividends by the corporation is not a business expense. – Therefore, they are not tax-deductible.

• Dividends received by individual shareholders are for the most part considered ordinary income by the IRS and are fully taxable.– There is an intra-corporate dividend exclusion: exclude 70% of dividends

if they are corporate shareholders.

Chapter 14, 15 and 16 – MBA504 9

Classes of Stock

• When more than one class of stock exists, they are usually created with unequal voting rights.

• Many companies issue dual classes of common stock. The reason has to do with control of the firm.

• the market prices of stocks with superior voting rights to be about 5 percent higher than the prices of otherwise-identical stocks with inferior voting rights.

Chapter 14, 15 and 16 – MBA504 10

Corporate Long-Term Debt

• Interest versus Dividends

• Hybrid Securities

• Features of Long-Term Debt

Chapter 14, 15 and 16 – MBA504 11

Interest versus Dividends

• Debt is not an ownership interest in the firm. Creditors do not usually have voting power.

• The corporation’s payment of interest on debt is considered a cost of doing business and is fully tax-deductible.

• Dividends are paid out of after-tax dollars.• Unpaid debt is a liability of the firm. If it is not

paid, the creditors can legally claim the assets of the firm.

Chapter 14, 15 and 16 – MBA504 12

Basic Features of Long-Term Debt• The bond indenture usually lists

– Amount of Issue, Date of Issue, Maturity– Denomination (Par value)– Annual Coupon, Dates of Coupon Payments– Security– Sinking Funds– Call Provisions– Covenants

• Features that may change over time– Rating– Yield-to-Maturity– Market price

Chapter 14, 15 and 16 – MBA504 13

Different Types of Debt

• A debenture is an unsecured corporate debt, whereas a bond is secured by a mortgage on the corporate property.

• A note usually refers to an unsecured debt with a maturity shorter than that of a debenture, perhaps under 10 years.

Chapter 14, 15 and 16 – MBA504 14

Repayment• Long-term debt is typically repaid in regular

amounts over the life of the debt. The payment of long-term debt by installments is called amortization.

• Amortization is usually arranged by a sinking fund. Each year the corporation places money into a sinking fund, and the money is used to buy back the bonds.

Chapter 14, 15 and 16 – MBA504 15

Seniority

• Seniority indicates preference in position over other lenders.

• Some debt is subordinated. In the event of default, holders of subordinated debt must give preference other specified creditors who are paid first.

Chapter 14, 15 and 16 – MBA504 16

Security

• Security is a form of attachment to property.– It provides that the property can be sold in

event of default to satisfy the debt for which the security is given.

– A mortgage is used for security in tangible property.

– Debentures are not secured by a mortgage.

Chapter 14, 15 and 16 – MBA504 17

Indenture

• The written agreement between the corporate debt issuer and the lender.

• Sets forth the terms of the loan:– Maturity– Interest rate– Protective covenants.

Chapter 14, 15 and 16 – MBA504 18

Preferred Stock

• Represents equity of a corporation, but is different from common stock because it has preference over common in the payments of dividends and in the assets of the corporation in the event of bankruptcy.

• Preferred shares have a stated liquidating value, usually $100 per share.

• Preferred dividends are either cumulative or noncumulative.

Chapter 14, 15 and 16 – MBA504 19

Sources of Cash Flow (100%)

Internal cash flow (retained earnings plus depreciation)

97%

Long-term debt and

equity 3%

Uses of Cash Flow (100%)

Capital spending

98%

Net working

capital plus other uses

2%

Internal cash flow

External cash flow

Financial deficit

Chapter 14, 15 and 16 – MBA504 20

Definition of Capital Structure

• The value of a firm is defined to be the sum of the value of the firm’s debt and the firm’s equity.

• V = B + S

Value of the Firm

S BS BS BS B

Chapter 14, 15 and 16 – MBA504 21

Financial Leverage, EPS, and ROE

CurrentAssets $20,000Debt $0Equity $20,000Debt/Equity ratio 0.00Interest rate n/aShares outstanding 400Share price $50

Proposed$20,000$8,000

$12,0002/38%

?$50

Consider an all-equity firm that is considering going into debt. (Maybe some of the original shareholders want to cash out.)

Chapter 14, 15 and 16 – MBA504 22

EPS and ROE Under Current Capital Structure

Recession Expected ExpansionEBIT $1,000 $2,000 $3,000Interest 0 0 0Net income $1,000 $2,000 $3,000EPSROAROE

Current Shares Outstanding = 400 shares

Chapter 14, 15 and 16 – MBA504 23

EPS and ROE Under Proposed Capital Structure

Recession Expected ExpansionEBIT $1,000 $2,000 $3,000Interest 640 640 640Net income $360 $1,360 $2,360EPSROAROE

Proposed Shares Outstanding = 240 shares

Chapter 14, 15 and 16 – MBA504 24

Financial Leverage and EPS

(2.00)

0.00

2.00

4.00

6.00

8.00

10.00

12.00

1,000 2,000 3,000

EP

S

Debt

No Debt

Break-even point

EBI

Advantage to debt

Disadvantage to debt

Chapter 14, 15 and 16 – MBA504 25

Assumptions of the Modigliani-Miller Model

• Homogeneous Expectations• Homogeneous Business Risk Classes• Perpetual Cash Flows• Perfect Capital Markets:

– Perfect competition– Firms and investors can borrow/lend at the same rate– Equal access to all relevant information– No transaction costs– No taxes

Chapter 14, 15 and 16 – MBA504 26

MM Propositions I & II (No Taxes)

• Proposition I– Firm value is not affected by leverage

VL = VU

• Proposition II– Leverage increases the risk and return to stockholders

rs = r0 + (B / SL) (r0 - rB)

rB is the interest rate (cost of debt)

rs is the return on (levered) equity (cost of equity)

r0 is the return on unlevered equity (cost of capital)

B is the value of debt

SL is the value of levered equity

Chapter 14, 15 and 16 – MBA504 27

The Cost of Equity, the Cost of Debt, and the Weighted Average Cost of Capital: MM Proposition II with No Corporate Taxes

Debt-to-equity Ratio

Cos

t of

capi

tal:

r (%

)

r0

rB

SBWACC rSB

Sr

SB

Br

)( 00 BL

S rrS

Brr

rB

S

B

Chapter 14, 15 and 16 – MBA504 28

MM Propositions I & II (with Corporate Taxes)

• Proposition I (with Corporate Taxes)– Firm value increases with leverage

VL = VU + TC B• Proposition II (with Corporate Taxes)

– Some of the increase in equity risk and return is offset by interest tax shield

rS = r0 + (B/S)×(1-TC)×(r0 - rB) rB is the interest rate (cost of debt)rS is the return on equity (cost of equity)r0 is the return on unlevered equity (cost of capital)B is the value of debtS is the value of levered equity

Chapter 14, 15 and 16 – MBA504 29

The Effect of Financial Leverage on the Cost of Debt and Equity Capital with Corporate Taxes

Debt-to-equityratio (B/S)

Cost of capital: r(%)

r0

rB

)()1( 00 BCL

S rrTS

Brr

SL

LCB

LWACC r

SB

STr

SB

Br

)1(

)( 00 BL

S rrS

Brr

Chapter 14, 15 and 16 – MBA504 30

Total Cash Flow to Investors Under Each Capital Structure with Corp. Taxes

All-EquityRecession Expected Expansion

EBIT $1,000 $2,000 $3,000Interest 0 0 0EBT $1,000 $2,000 $3,000Taxes (Tc = 35% $350 $700 $1,050Total Cash Flow to S/H $650 $1,300 $1,950

LeveredRecession Expected Expansion

EBIT $1,000 $2,000 $3,000Interest ($800 @ 8% ) 640 640 640EBT $360 $1,360 $2,360Taxes (Tc = 35%) $126 $476 $826Total Cash Flow $234+640 $468+$640 $1,534+$640(to both S/H & B/H): $874 $1,524 $2,174

EBIT(1-Tc)+TCrBB $650+$224 $1,300+$224 $1,950+$224$874 $1,524 $2,174

Chapter 14, 15 and 16 – MBA504 31

Total Cash Flow to Investors Under Each Capital Structure with Corp. Taxes

The sum of the debt plus the equity of the levered firm is greater than the equity of the unlevered firm.

This is how cutting the pie differently can make the pie larger: the government takes a smaller slice of the pie!

S G S G

B

All-equity firm Levered firm

Chapter 14, 15 and 16 – MBA504 32

Limits to the Use of Debt (chapter 16)

• Financial Distress Costs

• Agency costs

-- excessive leverage is costly to shareholders.