Financial Management

Session -19

Capital Structure

What is Capital Structure?

• The combination of debt and equity used to finance a firm’s projects is referred to as its capital structure.

• The capital structure of a firm is some mix of debt, internally generated equity, and new equity.

• But what is the right mixture? • Why do some industries tend to have firms with

higher debt ratios than other industries?

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Financial Leverage and Risk

• Equity owners can reap most of the rewards through financial leverage when their firm does well.

• But they may suffer a downside when the firm does poorly.

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Capital Structure and Taxes• Income taxes play an important role in a firm’s capital

structure decision because the payments to creditors and owners are taxed differently.

• The basic framework for the analysis of capital structure and how taxes affect it was developed by two Nobel Prize winning economists, Franco Modigliani and Merton Miller (M&M).

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M&M Hypothesis• M&M reasoned that if the following conditions hold,

the value of the firm is not affected by its capital structure:– Condition #1: Individuals and corporations are able to

borrow and lend at the same terms (referred to as “equal access”).

– Condition #2: There is no tax advantage associated with debt financing (relative to equity financing).

– Condition #3: Debt and equity trade in a perfect market.

– Condition #4: There are no bankruptcy costs

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M&M Hypothesis…Cont’d

• M&M reasoned that if the following conditions hold, the value of the firm is not affected by its capital structure:– Condition #5: All cash flow streams are perpetuities (i.e.,

no growth)

– Condition #6: Corporate insiders and outsiders have the same information (i.e., no signalling opportunities)

– Condition #7: Managers always maximize shareholders’ wealth (i.e., no agency cost)

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Capital Structure and the Pie

• 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

• If the goal of the firm’s management is to make the firm as valuable as possible, then the firm should pick the debt-equity ratio that makes the pie as big as possible.

Value of the Firm

S BS BS BS B

Stockholder InterestsThere are two important questions:1.Why should the stockholders care about maximizing firm value? Perhaps they should be interested in strategies that maximize shareholder value.2.What is the ratio of debt-to-equity that maximizes the shareholder’s value?

As it turns out, changes in capital structure benefit the stockholders if and only if the value of the firm increases.

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$12,000

2/38%240$50

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

EPS and ROE Under Current Structure

Recession Expected ExpansionEBIT $1,000 $2,000 $3,000Interest 0 0 0Net income $1,000 $2,000 $3,000EPS $2.50 $5.00 $7.50ROA 5% 10% 15%ROE 5% 10% 15%Current Shares Outstanding = 400 shares

EPS and ROE Under Proposed StructureRecession Expected Expansion

EBIT $1,000 $2,000 $3,000Interest 640 640 640Net income $360 $1,360 $2,360EPS $1.50 $5.67 $9.83ROA 1.8% 6.8% 11.8%ROE 3.0% 11.3% 19.7%Proposed Shares Outstanding = 240 shares

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

EPS

Debt

No Debt

Break-even point

EBIT in dollars, no taxes

Advantage to debt

Disadvantage to debt

Homemade Leverage: An ExampleRecession Expected Expansion

EPS of Unlevered Firm $2.50 $5.00 $7.50Earnings for 40 shares $100 $200 $300Less interest on $800 (8%) $64 $64 $64Net Profits $36 $136 $236ROE (Net Profits / $1,200) 3.0% 11.3% 19.7%We are buying 40 shares of a $50 stock, using $800 in margin. We get the same ROE as if we bought into a levered firm.

Our personal debt-equity ratio is:3

2200,1$

800$

SB

Homemade (Un)Leverage: An Example

Recession Expected ExpansionEPS of Levered Firm $1.50 $5.67 $9.83Earnings for 24 shares $36 $136 $236Plus interest on $800 (8%) $64 $64 $64Net Profits $100 $200 $300ROE (Net Profits / $2,000) 5% 10% 15%Buying 24 shares of an otherwise identical levered firm along with some of the firm’s debt gets us to the ROE of the unlevered firm.This is the fundamental insight of M&M

MM Proposition I (No Taxes)

• We can create a levered or unlevered position by adjusting the trading in our own account.

• This homemade leverage suggests that capital structure is irrelevant in determining the value of the firm:

VL = VU

MM Proposition II (No Taxes)

• 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 debtSL is the value of levered equity

MM Proposition II (No Taxes)

Debt-to-equity Ratio

R0

RB

SBW ACC RSB

SRSB

BR

)( 00 BL

S RRSBRR

RB

SB

MM Propositions II (With 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 the 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

MM Propositions II (With Taxes)

BTVV CUL

BRTBREBIT BCB )1()(is rsstakeholdealltoflowcash totalThe

The present value of this stream of cash flows is VL

BRTBREBIT BCB )1()(Clearly

The present value of the first term is VU

The present value of the second term is TCB

BRTBRTEBIT BCBC )1()1(BRBTRBRTEBIT BCBBC )1(

The Effect of Financial Leverage

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Cost of capital: R(%)

R0

RB

)()1( 00 BCL

S RRTSBRR

SL

LCB

LW ACC R

SBSTR

SBBR

)1(

)( 00 BL

S RRSBRR

Personal Tax and Capital Structure• If debt income (interest) and equity income (dividends and

capital appreciation) are taxed at the same rate, the interest tax shield is still τD and increasing leverage increases the value of the firm.

• If debt income is taxed at rates higher than equity income, some of the tax advantage to debt is offset by a tax disadvantage to debt income.

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Personal Tax and Capital Structure…Cont’d

• If investors can use the tax laws effectively to reduce to zero their tax on equity income, firms will take on debt up to the point where the tax advantage to debt is just offset by the tax disadvantage to debt income.

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Optimal Capital Structure• The mix of debt and equity that maximizes the value

of the firm is referred to as the optimal capital structure.

• There is a tradeoff between the value of the interest tax shields and the costs of distress.

• Because financial distress is costly, even without legal bankruptcy, the likelihood of financial distress depends on the business risk of the firm, in addition to any risk from financial leverage.

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Capital Structure: Different Industries• The greater the marginal tax rate, the greater the benefit from

the interest deductibility and, hence, the more likely a firm is to use debt in its capital structure.

• The greater the business risk of a firm, the greater the present value of financial distress and, therefore, the less likely the firm is to use debt in its capital structure.

• The greater extent that the value of the firm depends on intangible assets, the less likely it is to use debt in its capital structure.

• Financial slack. The availability of funds to take advantage of profitable investment opportunities is valuable. – Therefore, having cash, marketable securities, and unused debt capacity

is valuable.

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Tax Effects and Financial Distress• There is a trade-off between the tax advantage of debt and the

costs of financial distress.

• It is difficult to express this with a precise and rigorous formula.

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Tax Effects and Financial Distress

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Debt (B)

Value of firm (V)

0

Present value of taxshield on debt

Present value offinancial distress costs

Value of firm underMM with corporatetaxes and debt

VL = VU + TCB

V = Actual value of firmVU = Value of firm with no debt

B*

Maximumfirm value

Optimal amount of debt

The Pie Model Revisited

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• Taxes and bankruptcy costs can be viewed as just another claim on the cash flows of the firm.

• Let G and L stand for payments to the government and bankruptcy lawyers, respectively.

• VT = S + B + G + L

• The essence of the M&M intuition is that VT depends on the cash flow of the firm; capital structure just slices the pie.

S

G

B

L

The Pecking-Order Theory

• Theory stating that firms prefer to issue debt rather than equity if internal financing is insufficient. – Rule 1

• Use internal financing first.– Rule 2

• Issue debt next, new equity last.

• The pecking-order theory is at odds with the tradeoff theory:– There is no target D/E ratio.– Profitable firms use less debt.

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Multiple Choice Question - 1

A Company increases amount of debt finance in itscapital structure keeping total amount of capitalemployed the same. Capital market is perfect withno taxes. Will the company’s WACC :a) remain the sameb) fallc) rised) fall to a minimum and then rise

Multiple Choice Question - 1

Ans. (a)

Multiple Choice Question - 2

As a company goes from zero debt to successively higher levels of debt, whathappens to the value of the company?a) steadily risesb) steadily fallsc) rises to a maximum and then fallsd) remains the same

Multiple Choice Question - 2

Ans. (c)

Multiple Choice Question - 3A Company is planning its target capital structure. It has estimated after-tax costs of debt and equity at differentlevels of debt as follows :Total assets/Debt ratio Cost of equity Cost of debt0 12.0 % -0.10 12.0 % 8.0 %0.20 12.0 % 8.0 %0.30 13.0 % 8.5 %0.40 13.5 % 9.0 %0.50 14.0 % 9.5 %0.60 14.5 % 10.0 %

What is the target debt-equity ratio for the company?a) 0.25, b) 0.50, c) 1.00, d) 1.50

Multiple Choice Question - 3Ans. (a)

Solution:

Debt to Total assets ratio WACC0 12.0 %0.10 9 * 12 + 0.1 * 8 = 11.6 %0.20 8 * 12 + 0.2 * 8 = 11.2 %0.30 7 * 13 + 0.3 * 8.5 = 11.65 %0.40 6 * 13.5 + 0.4 * 9.0 = 11.7 %0.50 5 * 14 + 0.5 * 9.5 = 11.75 %0.60 4 * 14.5 + 0.6 * 10.0 = 11.8 %

So, target debt to total assets ratio = 0.2And debt to equity ratio = 0.2/0.8

= 0.25

Multiple Choice Question - 4A Company has some unused land, which, it hasbeen recently discovered, contains huge quantitycrude oil. The company needs additional funds toextract the oil. The information has been keptconfidential. How should the company raise theadditional capital?a) Issue bondsb) Issue equityc) Issue convertible bondsd) Issue bonds and equity in 50 : 50 ratio

Multiple Choice Question - 4Ans. (a)Solution: The existing shareholders will benefit the most if bonds are issued.

Multiple Choice Question - 5A Company borrows money at 12 % but onlyhalf the interest expense is allowed as a taxdeduction. The corporate tax rate is 40 %. What is the post-tax cost of debt?a) 12 %b) 9.6 %c) 4.8 %d) 7.2 %

Multiple Choice Question - 5Ans. (b)Solution: Pre-tax cost of debt for total borrowings = 12 %Post-tax cost of debt for 50 % of borrowings

= 12 * (1-0.4) = 7.2 %Post tax cost of debt for the balance 50 % of the

borrowings = 12 % So, post-tax cost of debt

= 0.5 * 7.2 + 0.5 * 12 = 9.6 %

ProblemA Company needs Rs.10 million capital for its new green field project. The net operating earnings is expected to be30 % of investment and the corporate tax rate is 40 %. The

company expects the following alternatives for raising the capital.a) 100 % equity at Rs.20 per shareb) 40 % debt at 12 % interest and 60 % equity at Rs.16 per sharec) 30 % debt at 11 % interest, 20 % 12 % preference shares and

50 % equity at Rs.18 per share.Which is the best alternative for the company for raising the

capital?

Problem

Ans. Alternative (c)Solution: We will undertake EBIT-EPS analysis

for the three alternatives.

ProblemEBIT-EPS Analysis

(Fig. in Rs. Million)Alternatives

(a) (b) (c)Value of equity 10 6 5Value of pref. shares - - 2Value of debt - 4 3No. of shares (million) 0.5 0.375 0.278EBIT 3.0 3.0 3.0Interest - 0.48 0.33 EBT 3.0 2.52 2.67

Problem

EBT 3.0 2.52 2.67Taxes 1.2 1.01 1.07EAT 1.8 1.51 1.60Preference dividend - - 0.24Earnings available to 1.8 1.51 1.36

Equity holdersEPS 3.60 4.03 4.89Alternative (c) is the best since EPS is maximized in this case.

Thank You!

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