Chapter16-CapitalStructure

8/13/2019 Chapter16-CapitalStructure

1/23

Chapter 16 Capital Structure

1. Objectives

1.1 Describe the traditional view of capital structure and its assumptions.

1.2 Describe the views of M&M on capital structure, both without and with

corporate taxation, and their assumptions.

1.3 Identify a rane of capital mar!et imperfections and describe their impact on

the views of M&M on capital structure.

1." #xplain the relevance of pec!in order theory to the selection of sources of

finance.

2. The Traditional View of Capital Structure

3$


2/23

2.1 KE !O"#T

%nder the traditional theor$ of cost of capital, the cost declines initially

and then rises as earin increases. he opti%al capital structurewill bethe point at which '()) is lowest.

2.2 he traditional view of capital structure is that there is an opti%al capital

structureand the company can increase its total value by suitable use of

debt financein its capital structure.

2.3 &SS'(!T"O#S

he assumptions on which this theory is based are as follows*

+a he company pa$s outall its earnin)sas dividends.

+b he )earin) of the company can be chan)ed i%%ediatel$ by

issuin debt to repurchase shares, or by issuin shares to repurchase

debt. here are no transaction costs for issues.

+c he earnins of the company are e*pected to re%ain constant in

perpetuit$ and all investors share the same expectations about

these future earnins.

+d +usiness ris, is also constant, reardless of how the company

invests its funds.

+e Ta*ation, for the timin bein, is i)nored.

2." he traditional view is as follows*

+a (s the level of )earin) increases, the cost of debt remains

unchan)edup to a certain level of earin. -eyond this level, the cost

of debt will increase.

+b he cost of e-uit$rises as the level of )earin) increasesand financial

ris! increases. here is a nonlinear relationship between the cost of

e/uity and earin.

+c he &CCdoes not re%ain constant, but rather falls initially as the

proportion of debt capital increases, and then beins to increase as the

risin cost of e/uity +and possibly of debt becomes more sinificant.

+d he opti%u% level of )earin) is where the co%pan$/s &CC is

%ini%i0ed.

2.$ he traditional view about the cost of capital is illustrated in the followin

fiure. It shows that the '()) will be minimi0ed at a particular level of

3


3/23

earin .

'here eis the cost of e/uity in the eared company

dis the cost of debt

4is the weihted averae cost of capital

2. Conclusion 5 there is an optimal level of earin 5 point . (t point the

overall return re/uired by investors +debt and e/uity is minimised. It follows

that at this point the combined mar!et value of the firm6s debt and e/uity

securities will also be maximised.

2.7 )ompany should ear up until it reaches optimal point and then raise a mix of

finance to maintain this level of earin. 8owever, there is no %ethod, apart

fro% trial and error, available to locate the opti%al point.

. The #et Operatin) "nco%e (odi)liani3(iller (4(55 Viewof &CC

3.1 KE !O"#T

Modiliani and Miller stated that, in the absence of tax, a company6s capital

structurewould have no i%pactupon its '()).

3.2 he net operatin income approach ta!es a different view of the effect of

earin on '()). In their 19$: theory, M&M proposed that the total mar!et

37


4/23

value of a company, in the absence of tax, will be determined only by two

factors*

+a the total earnin)sof the company.

+b thelevel of operatin) business5 ris,

attached to those earnins.

3.3 he total mar!et value would be computed by discountin the total earnins at

a rate that is appropriate to the level of operatin ris!. his rate would

represent the '()) of the company.

3." hus M&M concluded that the capital structure of a co%pan$ would have

no effect on its overall value or &CC.

3.$ &SS'(!T"O#S

M&M made various assumptions in arrivin at this conclusion, includin*

+a ( perfect capital %ar,etexists, in which investors have the same

information, upon which they act rationally, to arrive at the same

expectations about future earnins and ris!s.

+b here are no ta* or transaction costs.

+c ebt is ris,3freeand freely available at the same cost to investors

and companies ali!e.

3. KE !O"#T

If M&M theory holds, it implies*

+a he cost of debt re%ains unchan)ed as the level of earin

increases.

+b he cost of e-uit$ rises in such a way as to !eep the &CC

constant.

3.7 his would be represented on a raph as shown below.

3:


5/23

3.: E7&(!8E 1

( company has ;$,444 of debt at 14< interest, and earns ;$,444 a year

before interest is paid. here are 2,2$4 issued shares, and the '()) is

24


6/23

'()) 4.2

;

Mar!et value of the company +;$,444 = 4.2 2$,444

>ess* mar!et value of debt +14,444Mar!et value of e/uity 1$,444

(nnual dividends will now be ;$,444 5 ;1,444 interest @ ;",444.

he cost of e/uity has risen to


7/23

"." 8owever, this does not happen in practice due to existence of other %ar,et

i%perfections 5which undermine the tax advantaes of debtfinance.

&5 The proble%s of hi)h )earin)

".$ +an,ruptc$ ris,5 (s earin increases so does the possibility of ban!ruptcy.

If shareholders become concerned, this will increase the '()) of the

company and reduce the share price.

". &)enc$ costs9 restrictive conditions 5 In order to safeuard their

investments, lendersAdebentures holders often impose restrictive conditions in

the loan areements that constrain manaement6s freedom of action, e..

restrictions*

+a on the level of dividends

+b on the level of additional debt that can be raised

+c on manaement from disposin of any maBor fixed assets without the

debenture holders6 areement.

".7 Ta* e*haustion5 (fter a certain level of earin, companies will discover that

they have no tax liability left aainst which to offset interest chares.d+1 5 t simply becomes d.

".: +orrowin);debt capacit$ 5 8ih levels of earin are unusual because

companies run out of suitable assets to offer as security aainst loans.

)ompanies with assets which have an active secondhand mar!et, and with

low levels of depreciation such as property companies, have a hih borrowin

capacity.

".9 ifference ris, tolerance levels between shareholders and directors 5

-usiness failure can have a far reater impact on directors than on a well

diversified investor. It may be arued that directors have a natural tendency to

"1


8/23

be cautious about borrowin.

".14


9/23

realistic than that of the mar!et. If new shares were issued in this situation,

there is a possibility that they would be issued at too low a price, thus

transferrin wealth from existin shareholders to new shareholders. In these

circumstances there miht be a natural preference for internallyenerated

funds over new issues. If additional funds are re/uired over and above

internallyenerated funds, then debt would be the next alternative.

$.7 If manaement is averse to ma!in e/uity issues when in possession of

favourable inside information, mar!et participants miht assume that

manaement will be more li!ely to favour new issues when they are in

possession of unfavourable inside information which leads to the suestion

that new issues miht be rearded as a sinal of bad newsH Manaers may

therefore wish to rely primarily on internallyenerated funds supplemented by

borrowin, with issues of new e/uity as a last resort.

$.: Myers and MaBluf +19:" demonstrated that with asymmetric information,

e/uity issues are interpreted by the mar!et as bad news, since manaers are

only motivated to ma!e e/uity issues when shares are overpriced. -ennett

?tewart +1994 puts it differently* aisin e/uity conveys doubt. Investors

suspect that manaement is attemptin to shore up the firm6s financial

resources for rouh times ahead by sellin overvalued shares.6

$.9 (s/uith and Mullins +19:3 empirically observed that announcements of new

e/uity issues are reeted by sharp declines in stoc! prices. hus, e/uity issues

are comparatively rare amon lare established companies.

$.14 Test $our understandin) 1

-elow is a series of raphs. Identify those that reflect*

+a the traditional view of capital structure

+b M&M without tax

+c M&M with tax.

"3


10/23

$.11 Test $our understandin) 2

(nswer the followin /uestions*

( If a company, in a perfect capital mar!et with no taxes, incorporates

increasin amounts of debt into its capital structure without

chanin its operatin ris!, what will the impact be on its '())J

- (ccordin to M&M why will the cost of e/uity always rise as the

company ears upJ

) In a perfect capital mar!et but with taxes, two companies are

identical in all respects, apart from their levels of earin. ( has

only e/uity finance, - has $4< debt finance. 'hich firm would

M&M arue was worth moreJ

D In practice a firm which has exhausted retained earnins, is li!ely to

select what form of finance nextJ

6. C&!( and (4( Co%bined > ?eared +etas

.1 KE !O"#T

'hen an investment has differin business and finance ris!s from the

existin business, )eared betas may be used to obtain an appropriate

re/uired return.

Keared betas are calculated by*

+a %nearin industry betas

+b )onvertin uneared betas bac! into a eared beta that reflects the

company6s own earin ratio

.2 he earin of a company will affect the ris! of its e/uity. If a company is

eared and its financial ris, is therefore hi)her thanthe ris! of an alle/uity

""


11/23

company, then the L value of the eared company6s e/uity will be hiher than

theL value of a similar uneared company6s e/uity.

.3 he )(CM is consistent with the propositions of M&M. M&M arue that as

earin rises, the cost of e/uity rises to compensate shareholders for the extra

financial ris! of investin in a eared company. his financial ris! is an aspect

of systematic ris!, and ouht to be reflected in a company6s beta factor.

&5 ?eared betas and un)eared betas

." he connection between M&M theory and the )(CM means that it is possible

to establish a mathematical relationship between the L value of an uneared

company and theL value of a similar, but eared, company. heL value of a

eared company will be hiher than theL value of a company identical in every

respect except that it is alle/uity financed. his is because of the extra

financial ris!. he mathematical relationship between unearedN +or asset

and earedN betas is as follows.

( ) ( )

+

+

+=

d

de

d

e

de

e

a

TVV

TV

TVV

V

,1+

,1+

,1+

'here a is the asset or uneared beta

e is the e/uity or eared beta

d is the beta factor of debt in the eared company

dV is the mar!et value of the debt capital in the eared company

eV is the mar!et value of the e/uity capital in the eared company

is the rate of corporate tax

.$ Debt is often assumed to be ris!free and its beta is then ta!en as 0ero, in

which case the formula above reduces to the followin form.

1+ TVV

V

de

ega

+

= or, without tax,de

e

gaVV

V

+

=

. E7&(!8E 2

wo companies are identical in every respect except for their capital

structure. heir mar!et values are in e/uilibrium, as follows.

Keared %neared

"$


12/23

;444 ;444

(nnual profit before interest and tax 1,444 1,444

>ess* Interest +",444 x :ess* ax O34< 24" 344

Crofit after tax @ dividends "7 744

Mar!et value of e/uity 3,944 ,44

Mar!et value of debt ",1:4 4

otal mar!et value of company :,4:4 ,44

he total value of Keared is hiher than the total value of %neared, which

is consistent with M&M.

(ll profits after tax are paid out as dividends, and so there is no dividend

rowth. he beta value of %neared has been calculated as 1.4. he debt

capital of Keared can be rearded as ris!free.

Calculate9

+a he cost of e/uity in Keared.

+b he mar!et return m.

+c he beta value of Keared.

Solution9

+a ?ince its mar!et value +MF is in e/uilibrium, the cost of e/uity in

Keared can be calculated as*


13/23

+5 'sin) the )eared and un)eared beta for%ula to esti%ate a beta factor

.7 (nother way of estimatin a beta factor for a company6s e/uity is to use data

about the returns of other /uoted companies which have similar operatin

characteristics* that is, to use the beta values of other co%panies/ e-uit$ to

esti%ate a beta value for the co%pan$ under consideration.

.: he beta values estimated for the firm under consideration must be adjusted

to allow for differences in )earin)from the firms whose e/uity beta values

are !nown. he formula for eared and uneared beta values can be applied.

.9 If a company plans to invest in a projectwhich involves diversification into a

new business, the investment will involve a different level of s$ste%atic ris,

from that applyin to the company6s existin business.

.14 ( discount rate should be calculatedwhich is specific to the project, and

which ta!es account of both the proBect6s systematic ris! and the company6s

earin level. he discount rate can be found usin the )(CM.

Step 1 Ket an estimate of the systematic ris! characteristics of the proBect6s

operatin cash flows by obtainin published beta values for

companies in the industry into which the company is plannin to

diversify.

Step 2 (dBust these beta values to allow for the company6s capital earin

level. his adBustment is done in two staes.

+a )onvert the beta values of other companies in the industry to

uneared betas, usin the formula*

1+ TVV

V

de

eea

+

=

+b 8avin obtained an uneared beta value a , convert it bac!

to eared beta e , which reflects the company6s own earin

ratio, usin the formula*

e

deae

VTVV 1+ +=

Step 8avin estimated a proBectspecific eared beta, use the )(CM to

estimate*

+a ( proBectspecific cost of e/uity, and

+b ( proBectspecific cost of capital, based on a weihtin of this

cost of e/uity and the cost of the company6s debt capital.

.11 E7&(!8E

"7


14/23

( company6s debt * e/uity ratio, by mar!et values, is 2 * $. he corporate

debt, which is assumed to be ris!free, yields 11< before tax. he beta

value of the company6s e/uity is currently 1.1. he averae returns on stoc!

mar!et e/uity is 1


15/23

characteristics.

+b Esti%ates of beta values fro% share price infor%ation are not

wholl$ accurate.hey are based on statistical analysis of historical

data, and as the previous example shows, estimates usin one firm6s

data will differ from estimates usin another firm6s data.

+c here may be differences in beta valuesbetween firms caused by*

+i Different cost structures +e,, the ratio of fixed costs to variable

costs

+ii ?i0e differences between firms

+iii Debt capital not bein ris!free

+d If the firm for which an e/uity beta is bein estimated has

opportunities for )rowththat are reconi0ed by investors, and which

will affect its e/uity beta, estimates of the e/uity beta based on other

firm6s data will be inaccurate, because the opportunities for rowth will

not be allowed for.

.13 Test $our understandin)

-ac!woods is a maBor international company with its head office in the %,

wantin to raise ;1$4 million to establish a new production plant in the

eastern reion of Kermany. -ac!woods evaluates its investments usin

ECF, but is not sure what cost of capital to use in the discountin process

for this proBect evaluation.

he company is also proposin to increase its e/uity finance in the near

future for % expansion, resultin overall in little chane in the company6s

mar!etweihted capital earin.

he summari0ed financial data for the company before expansion are shown

below.

Income statement for the year ended 31 December 244:

;m

evenue 1,9:"

Kross profit "32

Crofit after tax :1

Dividends 37

etained earnins ""

"9


16/23

-alance sheet as at 31 December 244:

Eoncurrent assets :"

'or!in capital 3$4

1,19Medium term and lon term loans +see note below 214

9:

?hareholders6 funds

Issued ordinary shares of ;4.$4 each nominal value 22$

eserves 71

9:

Eotes on borrowins

hese include ;7$m 1"< fixed rate bonds due to mature in five years time

and redeemable at par. he current mar!et price of these bonds is ;124.44

and they have an aftertax cost of debt of 9I-S plus 1


17/23

E*a%ination St$le @uestions

@uestion 1

Droxfol )o is a listed company that plans to spend ;14m on expandin its existin

business. It has been suested that the money could be raised by issuin 9< loan

notes redeemable in ten years6 time. )urrent financial information on Droxfol )o is as

follows.

"nco%e state%ent infor%ation for the last $ear

;444

Crofit before interest and tax 7,444

Interest +$44

Crofit before tax ,$44

ax +1,9$4

Crofit for the period ",$$4

State%ent of financial position for the last $ear ;444 ;444

Eoncurrent assets 24,444

)urrent assets 24,444

Total assets "4,444

E-uit$ and liabilities

Srdinary shares, par value ;1 $,444

etained earnins 22,$44

Total e-uit$ 27,$44

14< loan notes $,444

9< preference shares, par value ;1 2,$44

Total non3current liabilities 7,$44

)urrent liabilities $,444Total e-uit$ and liabilities "4,444

he current ex div ordinary share price is ;".$4 per share. (n ordinary dividend of 3$

cents per share has Bust been paid and dividends are expected to increase by "< per

year for the foreseeable future. he current ex div preference share price is 7.2 cents.

he loan notes are secured on the existin noncurrent assets of Droxfol )o and are

redeemable at par in eiht years6 time. hey have a current ex interest mar!et price of

;14$ per ;144 loan note. Droxfol )o pays tax on profits at an annual rate of 34


18/23

he expansion of business is expected to increase profit before interest and tax by

12< in the first year. Droxfol )o has no overdraft.

&vera)e sector ratios9Tinancial earin* "$< +prior chare capital divided by e/uity capital on a boo! value

basis

Interest coverae ratio* 12 times


19/23

-ond ( will be redeemed at par in ten years6 time and pays annual interest of 9


20/23


21/23


22/23

(verae share price +cents Dividend per share +cents

2443 193 9.23

244" 149 14.4

244$ 9 14.97

244 11 11.9$

2447 134 13.43

he cost of capital is


23/23

+b Discuss which of your revised estimates 'emere should use as the discount rate

for capital investment appraisal. +" mar!s

+c Discuss whether discounted cash flow techni/ues includin discounted paybac!

are useful to small unlisted companies. +7 mar!s

+otal 2$ mar!s

$7

Date post:	04-Jun-2018
Category:	Documents
Upload:	samueldwumfour
View:	215 times
Download:	0 times

Chapter16-CapitalStructure

Documents