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FIN 819
Today’s plan
The capital structure without corporate taxes Valuing risky corporate bonds Capital structure with corporate taxes Two theories for the optimal capital structure
in the real world.
FIN 819
Look at the both sides of a balance sheet
Asset Liabilities and equity
Market value of the asset
V
Market value of equityE
Market value of debt
D
V=E+D
FIN 819
Capital structure
Capital structure refers to the mix of debt and equity of a firm.
Capital structure has two related questions: • Does the capital structure affect the value of a
firm? Or does the amount of debt a firm has affect its value?
• What is the optimal amount of debt a firm should have?
FIN 819
Capital structure
Does the size of a pizza have nothing to do with how it is sliced?
Is the value of a firm also independent of how the firm mixes debt and equity?
FIN 819
Does capital structure affect the firm value?
Equity DebtEquity
Equity
DebtDebt
Govt.Govt.
Slicing the pie doesn’t affect the total amount
available to debt holders and equity holders
Slicing the pie can affect the size of the slice
going to government
Slicing the pie can affect the size of the
wasted slice
wasted
FIN 819
Capital structure without corporate taxes
If there is no corporate tax, we will have the following two famous results• M&M propositions 1 and 2
Pay attention to the condition for these propositions to be valid
Why do we consider such simple, unrealistic situations?
FIN 819
MM’s proposition 1 (without tax)
Modigliani & Miller• If the investment opportunity is fixed, there
are no taxes, and capital markets function well, the market value of a company does not depend on its capital structure.
What is the intuition for this result? Can we use different ways to prove this?
FIN 819
MM’s proposition 2 (without tax)
Modigliani & Miller• If the investment opportunity is fixed, there
are no taxes, and capital markets function well, the expected rate of return on the common stock of a levered firm increases in proportion to the debt-equity ratio (D/E), expressed in market values.
• The WACC is a constant.
FIN 819
Example - River Cruises - All Equity Financed
17.5%12.5%7.5% shares on Return
1.751.25$.75shareper Earnings
175,000125,000$75,000Income Operating
BoomExpectedSlump
Economy theof State Outcome
million 1 $Shares of ValueMarket
$10shareper Price
100,000shares ofNumber
Data
M&M (Debt Policy Doesn’t Matter)
FIN 819
Example
cont.
50% debt
25%15%5% shares on Return
2.501.50$.50shareper Earnings
125,00075,000$25,000earningsEquity
50,00050,000$50,000Interest
175,000125,000$75,000Income Operating
BoomExpectedSlump
Economy theof State Outcome
500,000 $debt of ueMarket val
500,000 $Shares of ValueMarket
$10shareper Price
50,000shares ofNumber
Data
M&M (Debt Policy Doesn’t Matter)
FIN 819
Valuing risky debt
So far, we have learned how to value a risk-free debt. By risk-free debt, we mean that bond investors always get paid for what they are promised when they lend money to firms or governments.
In reality, corporate bonds are not risk-free. When firms borrow money from the bond holders, they may not have enough cash to pay the bond holders in the future.
FIN 819
Valuing risky debt
To illustrate how to value a risky debt, we focus on a simple situation: • Firms have a zero-coupon bond.
More specific, suppose that a firm has issued $K million zero-coupon bonds maturing at time T. Let the market value of the firm asset at time T be V(T).
FIN 819
Valuing risky corporate debts
Using the put-call parity, we have
Where P(K,T) is the value of a European put option with the strike price K and the maturity date T
Please try to derive this formula and understand this situation?
),( TKPKeDTr f
FIN 819
Problem: On march 4, 1994, Chrysler was the eighth largest U.S. firm according to Fortune magazine. It issued 20-years zero-coupon debt with book value of $36.994 billion. The book value of the asset is $43.83 billion and the market value of equity is $21.0468 billions. The risk free rate was 8% and the volatility of the asset return is 30%.
• What is the market value of the debt?
• What is the interest rate charged on Chrysler’s debt?
Example
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Solution
The market value of the debt is $5.98 million
The interest rate charge on Chrysler’s debt is 9.11%.
The market value of the asset is $27.03 million
FIN 819
Capital structure with taxes
If there is corporate tax, we also have two famous results:• M&M propositions 1 and 2
Remember that to make the two propositions valid, we still have to assume that the investment opportunity is fixed and the financial market functions very well.
FIN 819
MM’s propositions withtax
MM’s proposition 1• firm value = value of all equity firm + PV (tax
shield)
• PV(tax shield)=TcD
MM’s proposition 2 • The weighted average cost of capital is decreasing
with the ratio of D/E, and the cost of equity is increasing with D/E.
• Can you prove and understand these results?
FIN 819
Optimal Capital structure with tax
So according to M&M proposition 1 with tax, the optimal capital structure is that firms issue all the debt.
In the real world, very few firms issue all the debt to raise money
What is wrong with M&M propositions?
FIN 819
Capital structure with financial distress cost
Costs of Financial Distress - Costs arising from bankruptcy or distorted business decisions before bankruptcy.
Market Value = Value if all Equity Financed
+ PV Tax Shield
- PV Costs of Financial Distress
FIN 819
Optimal Capital structure
Trade-off Theory - Theory that capital structure is based on a trade-off between tax savings and distress costs of debt.
Pecking Order Theory - Theory stating that firms prefer to issue debt rather than equity if internal finance is insufficient.