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Copyright 1996 by The McGraw-Hill Companies, Inc
Capital Structure
Capital Structure
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Copyright 1996 by The McGraw-Hill Companies, Inc
MODIGLIANIANDMILLER
MODIGLIANIANDMILLER
ANY COMBINATIONOF SECURITIES IS ASGOODAS ANYOTHER
EXAMPLE:TWOFIRMS, SAMEOPERATINGINCOME
DIFFERONLYIN CAPITAL STRUCTURE FIRM U UNLEVERED, VU = EU FIRMLIS LEVERED, EL = VL - DL
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Copyright 1996 by The McGraw-Hill Companies, Inc
MODIGLIANIANDMILLER
MODIGLIANIANDMILLER
TWO STRATEGIES STRATEGY 1
BUY 1% OFFIRM Us EQUITY
DOLLARINVESTMENT .01 VU
DOLLARRETURN .01 PROFITS STRATEGY 2
BUY 1% OFFIRMLs EQUITYANDDEBT
DOLLARINVESTMENT .01DL+ .01EL= .01VL
DOLLARRETURNFROMOWNING01DL .01 INTEREST
FROMOWNING.01EL .01 (PROFITS - INTEREST)
TOTAL .01 PROFITS
BOTH STRATEGIES HAVE SAMEPAYOFF
SAMEPRICE, VU = VL
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Copyright 1996 by The McGraw-Hill Companies, Inc
MODIGLIANIANDMILLER
MODIGLIANIANDMILLER
STRATEGY 3 BUY 1% OFFIRMLs EQUITY
DOLLARINVESTMENT .01 EL= .01(VL - DL) DOLLARRETURN .01 (PROFITS - INTEREST)
STRATEGY 4
BUY 1% OFFIRM Us EQUITY BORROWONYOUROWNACCOUNT.01DL DOLLARINVESTMENT .01(VU - DL) DOLLARRETURN
FROMBORROWING01DL -.01 INTERESTFROMOWNING.01EL .01 (PROFITSTOTAL .01 (PROFITS-INTEREST)
BOTH STRATEGIES AGAINPROMISE SAMEPAYOFF
MUSTHAVE SAME COST
.01(V
L -D
L) = .01(V
U -D
L)ANDV
U =V
L
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Copyright 1996 by The McGraw-Hill Companies, Inc
MODIGLIANIANDMILLER
MODIGLIANIANDMILLER
DOESNTMATTERWHATRISKPREFERENCES AREOFINVESTORS
ONLY CONDITIONIS THATINVESTORSCANBORROWORLENDFORTHEIROWNACCOUNT
UNDOEFFECTOFANY CHANGES INFIRMS CAPITAL STRUCTURE
MMPROPOSITION 1 VALUEOFFIRMINDEPENDENTOFITS
CAPITAL STRUCTURE
CANALSOBEPROVED USING CAPM
(APPENDIX)
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Copyright 1996 by The McGraw-Hill Companies, Inc
VALUEADDITIVITY
VALUEADDITIVITY
WE CAN SLICEA CASHFLOWINTOAS MANYPARTSASWELIKE
SUMOFTHEPRESENTVALUEOFTHEPARTSALWAYS EQUALTOPRESENTVALUEOFTHEORIGINAL STREAM
LAWOF CONSERVATIONOFVALUE
FIRMVALUEIS DETERMINEDBYLEFTHAND SIDEOFBALANCE SHEETBYREALASSETS
REGARDLESS OF CLAIMS AGAINSTIT
SHOULDFIRMISSUEPREFERREDOR COMMONSTOCK?
PROPOSITION 1 SAYS CHOICEIS IRRELEVANT
IFITDOESNTAFFECTINVESTMENT,
BORROWINGANDOPERATINGPOLICIES
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Copyright 1996 by The McGraw-Hill Companies, Inc
HOWLEVERAGEAFFECTS RETURNSHOWLEVERAGEAFFECTS RETURNS
EXPECTEDRETURNONTHEASSETS OFAFIRMrA = EXPECTEDOPERATINGINCOME
MARKETVALUEOFALL SECURITIES
SUPPOSEINVESTORHOLDS ALLDEBTANDEQUITY
OFTHE COMPANY EXPECTEDRETURNONPORTFOLIO, rA, IS
WEIGHTEDAVERAGEOFEXPECTEDRETURNS ONINDIVIDUAL SECURITIES
rA = (D/D+E)rD + (E/D+E)rErE = rA + (D/E)(rA - rD) MMPROPOSITION 2EXPECTEDRETURNONEQUITY
= EXPECTEDRETURNONASSETS
+ DEBT- EQUITYRATIO x (EXPECTEDRETURNONASSETS
-EXPECTEDRETURNONDEBT)
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Copyright 1996 by The McGraw-Hill Companies, Inc
LEVERAGEANDTHEEXPECTEDRETURNONEQUITYLEVERAGEANDTHEEXPECTEDRETURNONEQUITY
AS LEVERAGE INCREASES, VA
AND rA
ARE UNCHANGED
BUT THE EXPECTED RETURN ON EQUITY INCREASES
FOR RISKY DEBT, rD INCREASES AS LEVERAGE INCREASES
Debt-equity ratio (D/E)
Expected returnrE
rD
rA
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Copyright 1996 by The McGraw-Hill Companies, Inc
rErE
INCREASEINEXPECTEDEQUITYRETURNREFLECTSINCREASEDRISK
INCREASEINLEVERAGEINCREASES AMPLITUDEOFVARIATIONS IN CASHFLOWS AVAILABLETOSHAREHOLDERS
SAME CHANGEINOPERATINGINCOMENOWDISTRIBUTEDAMONGFEWER SHARES
WE CAN UNDERSTANDTHEINCREASEDRISK INTERMS OFFs
WE KNOWTHAT
FA = (D/D + E)FD + (E/D + E)FE
FE =FA + (D/E)(FA -FD)
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Copyright 1996 by The McGraw-Hill Companies, Inc
INTERESTTAX SHIELDINTERESTTAX SHIELD
WHYDIDWE SEEMTODISCOUNTTAXSHIELDBYPRE-TAXINTERESTRATEOF8%?
PERSONALTAXES REDUCETHEVALUEOF
THETAX-SHIELDTOTHEINVESTOR BUTTHEAPPROPRIATEAFTER-TAX
DISCOUNTRATE IS ALSOLOWER
PV (TAX SHIELD = TC (rDD)(1-TP) /rD(1-TP)
=T
CD
WHICHWAS OURORIGINALFORMULA
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Copyright 1996 by The McGraw-Hill Companies, Inc
MMPROPOSITION 1WITHTAXESMMPROPOSITION 1WITHTAXES
VALUEOFFIRM
= VALUEIFALL-EQUITY-FINANCED + PV(TAX SHIELD)
SPECIAL CASEOFPERMANENTDEBT
VALUEOFFIRM = VALUEIFALL-EQUITY-FINANCED +TCD
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Copyright 1996 by The McGraw-Hill Companies, Inc
COSTS OFFINANCIALDISTRESSCOSTS OFFINANCIALDISTRESS
FIRMHAS DIFFICULTYMEETINGITS FINANCIALOBLIGATIONS
OR CANNOTMEETITS OBLIGATIONS
SOMETIMES LEADS TOBANKRUPTCY
INVESTORS MAYBE CONCERNEDTHATLEVEREDFIRMMAYFALLINTOFINANCIALDISTRESS
VALUEOFFIRM
= VALUEIFALLEQUITY-FINANCED
+ PV(TAX SHIELD)
- PV(COSTS OFFINANCIALDISTRESS)
COSTS OFFINANCIALDISTRESS DEPENDON:
PROBABILITYOFDISTRESS
MAGNITUDEOF COSTS ENCOUNTEREDIFDISTRESS OCCURS
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Copyright 1996 by The McGraw-Hill Companies, Inc
COSTS OFFINANCIALDISTRESS REDUCETHEOPTIMALDEBTRATIO
COSTS OFFINANCIALDISTRESS REDUCETHEOPTIMALDEBTRATIO
Firm Value PV Tax Shield
PV Costs Of Distress
Debt Ratio
Optimum
Value of levered firm
Value If All
Equity Financed
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Copyright 1996 by The McGraw-Hill Companies, Inc
OPTIMAL CAPITAL STRUCTUREOPTIMAL CAPITAL STRUCTURE
PVOFTAX SHIELDGRADUALLYINCREASES AS FIRMBORROWS MORE
ATMODERATEDEBTLEVELSPV(FINANCIALDISTRESS) SMALL
TAXADVANTAGES DOMINATE WITHMOREDEBT, PROBABILITYOF
FINANCIALDISTRESS INCREASES
ALSOTAXADVANTAGEOFDEBT
STARTS TODECLINEAS FIRM CANNOLONGERBE SUREOFPROFITINGFROMTHETAX SHIELDINALL STATES OFTHEWORLD
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Copyright 1996 by The McGraw-Hill Companies, Inc
COSTS OFFINANCIALDISTRESSCOSTS OFFINANCIALDISTRESS
BANKRUPTCY COSTS
CORPORATEBANKRUPTCYOCCURS WHENSTOCKHOLDERS EXERCISETHEIRRIGHTTODEFAULT
VALUABLERIGHTWHENAFIRMGETS INTOTROUBLE,
STOCKHOLDERS CANWALK AWAY
FORMER CREDITORS BECOMETHENEW
STOCKHOLDERS
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Copyright 1996 by The McGraw-Hill Companies, Inc
COSTS OFDISTRESS VARYWITHTYPEOFASSETCOSTS OFDISTRESS VARYWITHTYPEOFASSET
YOUR COMPANYOWNS ELECTRONICS COMPANY STOCKHOLDERS MAYBE UNWILLINGTOPROVIDE
MORE CAPITALINFINANCIALDISTRESS
MORE SERIOUS THANFORHOTEL
IF COMPANYGOES BANKRUPT CREDITORWOULDHAVEDIFFICULTY SELLING
OFFASSETS
MANYASSETS INTANGIBLE
ALSODIFFICULTIN CARRYINGONAS GOINGCONCERN
ODDS OFDEFECTIONS BY KEYEMPLOYEES
ASSURANCES TO CUSTOMERS THATFIRMWILLBEAROUNDTO SERVICEITS PRODUCTS
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Copyright 1996 by The McGraw-Hill Companies, Inc
PECKINGORDEROFFINANCING CHOICESPECKINGORDEROFFINANCING CHOICES
MANAGERS KNOWMOREABOUTTHEIRFIRMTHANOUTSIDERS
PROSPECTS, RISKS
ASYMMETRIC INFORMATION
MANAGERS KNOWMORETHANINVESTORS
DIVIDEND SIGNALING
INVESTORS INTERPRETINCREASEIN
DIVIDENDAS SIGNOFMANAGEMENT CONFIDENCE
ASYMMETRIC INFORMATIONAFFECTSCHOICEBETWEEN
INTERNALVS EXTERNALFINANCING
ISSUINGDEBTVS E UITY
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Copyright 1996 by The McGraw-Hill Companies, Inc
PECKINGORDERPECKINGORDER
LEADS TOFOLLOWINGPECKINGORDER
INVESTMENTS FIRSTFINANCEDWITH
INTERNALFUNDS
NEWDEBT
NEWEQUITY
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Copyright 1996 by The McGraw-Hill Companies, Inc
Financial Choices
Trade-off Theory - Theory that capital structure is based on atrade-off between tax savings and distress costs of debt.
Pecking Order Theory - Theory stating that firms prefer toissue debt rather than equity if internal finance is
insufficient.
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Copyright 1996 by The McGraw-Hill Companies, Inc
Trade Off Theory &PricesTrade Off Theory &Prices
1. Stock-for-debt Stock price
exchange offers falls
Debt-for-stock Stock price
exchange offers rises
2. Issuing common stock drives down stock prices;repurchase increases stock prices.
3. Issuing straight debt has a small negative impact.
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Copyright 1996 by The McGraw-Hill Companies, Inc
Issues and Stock PricesIssues and Stock Prices
Why do security issues affect stock price? The demandfor a firms securities oughtto be flat.
Any firm is a drop in the bucket.
Plenty of close substitutes.
Large debt issues dont significantly depress the stockprice.
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Copyright 1996 by The McGraw-Hill Companies, Inc
PeckingOrder TheoryPeckingOrder Theory
Consider the following story:
The announcement of a stock issue drives down the stock price becauseinvestors believe managers are more likely to issue when shares areoverpriced.
Therefore firms prefer internal finance since funds can beraised without sending adverse signals.
If external finance is required, firms issue debt first and equity as a lastresort.
The most profitable firms borrow less not because they have lower target
debt ratios but because they don't need external finance.
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Copyright 1996 by The McGraw-Hill Companies, Inc
PeckingOrder TheoryPeckingOrder Theory
Some Implications:
Internal equity may be better than external equity.
Financial slack is valuable.
If external capital is required, debt is better. (There is less
room for difference in opinions about what debt is worth).