Tài chính doanh nghiệp - Chapter 17: Capital structure determination

Chapter 17Capital Structure Determination© 2001 Prentice-Hall, Inc.Fundamentals of Financial Management, 11/eCreated by: Gregory A. Kuhlemeyer, Ph.D.Carroll College, Waukesha, WICapital Structure DeterminationA Conceptual LookThe Total-Value PrinciplePresence of Market Imperfections and Incentive IssuesThe Effect of TaxesTaxes and Market Imperfections CombinedFinancial SignalingCapital StructureConcerned with the effect of capital market decisions on security prices.Assume: (1) investment and asset management decisions are held constant and (2) consider only debt-versus-equity financing.Capital Structure -- The mix (or proportion) of a firm’s permanent long-term financing represented by debt, preferred stock, and common stock equity.A Conceptual Look --Relevant Rates of Returnki = the yield on the company’s debtAnnual interest on debtMarket value of debtIB==kiAssumptions:Interest paid each and every yearBond life is infiniteResults in the valuation of a perpetual bondNo taxes (Note: allows us to focus on just capital structure issues.)ESA Conceptual Look --Relevant Rates of Return==ke = the expected return on the company’s equityEarnings available to common shareholdersMarket value of common stock outstandingkeAssumptions:Earnings are not expected to grow100% dividend payoutResults in the valuation of a perpetuityAppropriate in this case for illustrating the theory of the firmESOVA Conceptual Look --Relevant Rates of Return==ko = an overall capitalization rate for the firmNet operating incomeTotal market value of the firmkoAssumptions:V = B + S = total market value of the firmO = I + E = net operating income = interest paid plus earnings available to common shareholdersOVCapitalization RateCapitalization Rate, ko -- The discount rate used to determine the present value of a stream of expected cash flows.kokekiBB + SSB + S=+What happens to ki, ke, and ko when leverage, B/S, increases?Net Operating Income ApproachAssume:Net operating income equals $1,350Market value of debt is $1,800 at 10% interestOverall capitalization rate is 15%Net Operating Income Approach -- A theory of capital structure in which the weighted average cost of capital and the total value of the firm remain constant as financial leverage is changed.Required Rate of Return on EquityTotal firm value = O / ko = $1,350 / .15 = $9,000Market value = V - B = $9,000 - $1,800 of equity = $7,200Required return = E / S on equity* = ($1,350 - $180) / $7,200 = 16.25%Calculating the required rate of return on equity* B / S = $1,800 / $7,200 = .25Interest payments = $1,800 x 10%Total firm value = O / ko = $1,350 / .15 = $9,000Market value = V - B = $9,000 - $3,000 of equity = $6,000Required return = E / S on equity* = ($1,350 - $300) / $6,000 = 17.50%Required Rate of Return on EquityWhat is the rate of return on equity if B=$3,000?* B / S = $3,000 / $6,000 = .50Interest payments = $3,000 x 10% B / S ki ke ko 0.00 --- 15.00% 15% 0.25 10% 16.25% 15% 0.50 10% 17.50% 15% 1.00 10% 20.00% 15% 2.00 10% 25.00% 15%Required Rate of Return on EquityExamine a variety of different debt-to-equity ratios and the resulting required rate of return on equity.Calculated in slides 9 and 10 Required Rate of Return on EquityCapital costs and the NOI approach in a graphical representation.0 .25 .50 .75 1.0 1.25 1.50 1.75 2.0Financial Leverage (B / S).25.20.15.10.050Capital Costs (%)ke = 16.25% and17.5% respectivelyki (Yield on debt)ko (Capitalization rate)ke (Required return on equity)Summary of NOI ApproachCritical assumption is ko remains constant.An increase in cheaper debt funds is exactly offset by an increase in the required rate of return on equity.As long as ki is constant, ke is a linear function of the debt-to-equity ratio.Thus, there is no one optimal capital structure.Traditional ApproachOptimal Capital Structure -- The capital structure that minimizes the firm’s cost of capital and thereby maximizes the value of the firm. Traditional Approach -- A theory of capital structure in which there exists an optimal capital structure and where management can increase the total value of the firm through the judicious use of financial leverage. Optimal Capital Structure: Traditional ApproachTraditional ApproachFinancial Leverage (B / S).25.20.15.10.050Capital Costs (%)kikokeOptimal Capital StructureSummary of the Traditional ApproachThe cost of capital is dependent on the capital structure of the firm.Initially, low-cost debt is not rising and replaces more expensive equity financing and ko declines.Then, increasing financial leverage and the associated increase in ke and ki more than offsets the benefits of lower cost debt financing.Thus, there is one optimal capital structure where ko is at its lowest point.This is also the point where the firm’s total value will be the largest (discounting at ko).Total Value Principle: Modigliani and Miller (M&M)Advocate that the relationship between financial leverage and the cost of capital is explained by the NOI approach.Provide behavioral justification for a constant ko over the entire range of financial leverage possibilities.Total risk for all security holders of the firm is not altered by the capital structure.Therefore, the total value of the firm is not altered by the firm’s financing mix. Market value of debt ($65M) Market value of equity ($35M)Total firm marketvalue ($100M)Total Value Principle: Modigliani and MillerM&M assume an absence of taxes and market imperfections.Investors can substitute personal for corporate financial leverage. Market value of debt ($35M) Market value of equity ($65M)Total firm marketvalue ($100M)Total market value is not altered by the capital structure (the total size of the pies are the same).Arbitrage and Total Market Value of the FirmArbitrage -- Finding two assets that are essentially the same and buying the cheaper and selling the more expensive. Two firms that are alike in every respect EXCEPT capital structure MUST have the same market value.Otherwise, arbitrage is possible.Arbitrage ExampleConsider two firms that are identical in every respect EXCEPT: Company NL -- no financial leverageCompany L -- $30,000 of 12% debtMarket value of debt for Company L equals its par valueRequired return on equity -- Company NL is 15% -- Company L is 16%NOI for each firm is $10,000Earnings available to = E = O – I common shareholders = $10,000 - $0 = $10,000Market value = E / ke of equity = $10,000 / .15 = $66,667Total market value = $66,667 + $0 = $66,667Overall capitalization rate = 15%Debt-to-equity ratio = 0Arbitrage Example: Company NLValuation of Company NLArbitrage Example: Company LEarnings available to = E = O – I common shareholders = $10,000 - $3,600 = $6,400Market value = E / ke of equity = $6,400 / .16 = $40,000Total market value = $40,000 + $30,000 = $70,000Overall capitalization rate = 14.3%Debt-to-equity ratio = .75Valuation of Company LCompleting an Arbitrage TransactionAssume you own 1% of the stock of Company L (equity value = $400).You should:1. Sell the stock in Company L for $400.2. Borrow $300 at 12% interest (equals 1% of debt for Company L).3. Buy 1% of the stock in Company NL for $666.67. This leaves you with $33.33 for other investments ($400 + $300 - $666.67).Completing an Arbitrage TransactionOriginal return on investment in Company L$400 x 16% = $64Return on investment after the transaction$666.67 x 16% = $100 return on Company NL$300 x 12% = $36 interest paid$64 net return ($100 - $36) AND $33.33 left over.This reduces the required net investment to $366.67 to earn $64.Summary of the Arbitrage TransactionThe equity share price in Company NL rises based on increased share demand.The equity share price in Company L falls based on selling pressures.Arbitrage continues until total firm values are identical for companies NL and L.Therefore, all capital structures are equally as acceptable.The investor uses “personal” rather than corporate financial leverage.Market Imperfections and Incentive IssuesAgency costs (Slide 28)Debt and the incentive to manage efficientlyInstitutional restrictionsTransaction costsBankruptcy costs (Slide 27) Required Rate of Return on Equity with BankruptcyFinancial Leverage (B / S)RfRequired Rate of Returnon Equity (ke)ke with no leverageke without bankruptcy costske with bankruptcy costsPremiumfor financialriskPremiumfor businessriskRisk-freerateAgency CostsMonitoring includes bonding of agents, auditing financial statements, and explicitly restricting management decisions or actions.Costs are borne by shareholders (Jensen & Meckling).Monitoring costs, like bankruptcy costs, tend to rise at an increasing rate with financial leverage.Agency Costs -- Costs associated with monitoring management to ensure that it behaves in ways consistent with the firm’s contractual agreements with creditors and shareholders.Example of the Effects of Corporate TaxesConsider two identical firms EXCEPT: Company ND -- no debt, 16% required returnCompany D -- $5,000 of 12% debtCorporate tax rate is 40% for each companyNOI for each firm is $10,000The judicious use of financial leverage (i.e., debt) provides a favorable impact on a company’s total valuation.Earnings available to = E = O - I common shareholders = $2,000 - $0 = $2,000Tax Rate (T) = 40%Income available to = EACS (1 - T) common shareholders = $2,000 (1 - .4) = $1,200Total income available to = EAT + I all security holders = $1,200 + 0 = $1,200Corporate Tax Example: Company NDValuation of Company ND (Note: has no debt)Earnings available to = E = O - I common shareholders = $2,000 - $600 = $1,400Tax Rate (T) = 40%Income available to = EACS (1 - T) common shareholders = $1,400 (1 - .4) = $840Total income available to = EAT + I all security holders = $840 + $600 = $1,440*Corporate Tax Example: Company DValuation of Company D (Note: has some debt)* $240 annual tax-shield benefit of debt (i.e., $1,440 - $1,200)Tax-Shield BenefitsTax Shield -- A tax-deductible expense. The expense protects (shields) an equivalent dollar amount of revenue from being taxed by reducing taxable income.Present value oftax-shield benefitsof debt*=(r) (B) (tc)r= (B) (tc)* Permanent debt, so treated as a perpetuity** Alternatively, $240 annual tax shield / .12 = $2,000, where $240=$600 Interest expense x .40 tax rate.=($5,000) (.4) = $2,000**Value of the Levered FirmValue of unlevered firm = $1,200 / .16 (Company ND) = $7,500*Value of levered firm = $7,500 + $2,000 (Company D) = $9,500 Value of Value of Present value of levered = firm if + tax-shield benefits firm unlevered of debt* Assuming zero growth and 100% dividend payoutSummary of Corporate Tax EffectsThe greater the financial leverage, the lower the cost of capital of the firm.The adjusted M&M proposition suggests an optimal strategy is to take on the maximum amount of financial leverage.This implies a capital structure of almost 100% debt! Yet, this is not consistent with actual behavior.The greater the amount of debt, the greater the tax-shield benefits and the greater the value of the firm.Other Tax IssuesCorporate plus personal taxesPersonal taxes reduce the corporate tax advantage associated with debt.Only a small portion of the explanation why corporate debt usage is not near 100%.Uncertainty of tax-shield benefitsUncertainty increases the possibility of bankruptcy and liquidation, which reduces the value of the tax shield.Bankruptcy Costs, Agency Costs, and TaxesAs financial leverage increases, tax-shield benefits increase as do bankruptcy and agency costs.Value of levered firm = Value of firm if unlevered + Present value of tax-shield benefits of debt - Present value of bankruptcy and agency costsBankruptcy Costs, Agency Costs, and TaxesOptimal Financial LeverageTaxes, bankruptcy, andagency costs combinedNet tax effectFinancial Leverage (B/S)Cost of Capital (%)Minimum Costof Capital PointFinancial SignalingInformational Asymmetry is based on the idea that insiders (managers) know something about the firm that outsiders (security holders) do not.Changing the capital structure to include more debt conveys that the firm’s stock price is undervalued.This is a valid signal because of the possibility of bankruptcy.A manager may use capital structure changes to convey information about the profitability and risk of the firm.