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    Capital Structure CH 16 CFA Slides

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    Mrinal Bajaj

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    Capital Structure CH 16 CFA Slides

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    capital structure Ch 16 CFA slides

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    59 views20 pages

    Capital Structure CH 16 CFA Slides

    Uploaded by

    Mrinal Bajaj

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    © All Rights Reserved
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    of 20

    CAPITAL STRUCTURE

    RWJ, CHAPTER 16 (read 16.1 through 16.4)


    CAPITAL RESTRUCTURING

    • Capital restructuring involves changing the amount of leverage a firm has


    without changing the firm’s assets.

    • We are going to look at how changes in capital structure affect the value of the
    firm, all else equal.

    • The firm can increase leverage by issuing debt and repurchasing outstanding
    shares.

    • The firm can decrease leverage by issuing new shares and retiring outstanding
    debt.
    CHOOSING A CAPITAL STRUCTURE
    • What is the primary goal of financial managers?
    - Maximize stockholder wealth

    • We want to choose the capital structure that will maximize stockholder wealth

    • We can maximize stockholder wealth by maximizing the value of the firm or


    minimizing the WACC
    THE WEIGHTED AVERAGE COST OF CAPITAL
    The weighted average cost of capital (WACC) is the marginal cost of raising
    additional capital and is affected by the costs of capital and the proportion of
    each source of capital:
    𝐷𝐷 𝐸𝐸
    WACC = rWACC = 𝑟𝑟 1 − 𝑡𝑡 + 𝑟𝑟
    𝑉𝑉 𝑑𝑑 𝑉𝑉 𝑒𝑒

    where
    rd is the before-tax marginal cost of debt
    re is the marginal cost of equity
    t is the marginal tax rate
    D is the market value of debt
    E is the market value of equity

    V=D+E

    Copyright © 2013 CFA Institute


    CAPITAL STRUCTURE THEORY
    The capital structure theory helps us understand
    the factors most important in the relationship
    between capital structure and the value of the
    company.

    Copyright © 2013 CFA Institute


    THE CAPITAL STRUCTURE DECISION

    Development of the theory of capital structure, beginning with the capital


    structure theory of Miller and Modigliani:

    Costs of
    Asymmetric
    Agency Information
    Costs
    Costs of
    Financial
    Benefit from Distress
    Tax
    Capital Deductibility
    Structure of Interest
    Irrelevance

    Copyright © 2013 CFA Institute


    PROPOSITION I WITHOUT TAXES:
    CAPITAL STRUCTURE IRRELEVANCE
    • Franco Modigliani and Merton Miller (MM) developed a theory that helps us
    understand how taxes and financial distress affect a company’s capital
    structure decision.
    • The assumptions of their model are unrealistic, but they help us work through
    the effects of the capital structure decision:
    1. Investors have homogeneous expectations regarding future cash flows.
    2. Bonds and stocks trade in perfect markets.
    3. Investors can borrow and lend at the same rate.
    4. There are no agency costs.
    5. Investment and financing decisions are independent of one another.

    Copyright © 2013 CFA Institute


    PROPOSITION I WITHOUT TAXES:
    CAPITAL STRUCTURE IRRELEVANCE

    MM Proposition I
    The market value of a company is not affected by the capital structure of
    the company.

    • Based on the assumptions that there are no taxes, costs of financial distress,
    or agency costs, so investors would value firms with the same cash flows as
    the same, regardless of how the firms are financed.
    • Reasoning: There is no benefit to borrowing at the firm level because there is
    no interest deductibility. Firms would be indifferent to the source of capital and
    investors could use financial leverage if they wish.
    • It does not matter to the investor if the debt is held by the company or by the
    investor herself. The latter case is termed homemade leverage.
    • Bottom line: There is no benefit to using debt versus equity.

    Copyright © 2013 CFA Institute


    PROPOSITION II WITHOUT TAXES:
    HIGHER FINANCIAL LEVERAGE

    MM Proposition II:
    The cost of equity is a linear function of the company’s debt/equity ratio.

    • Because creditors have a claim to income and assets that has preference over
    equity, the cost of debt will be less than the cost of equity.
    • As the company uses more debt in its capital structure, the cost of equity increases
    because of the seniority of debt:
    𝐷𝐷
    𝑟𝑟𝑒𝑒 = 𝑟𝑟0 + (𝑟𝑟0 −𝑟𝑟𝑑𝑑 )
    𝐸𝐸
    where r0 is the cost of equity if there is no debt financing.
    • The WACC is constant because as more of the cheaper source of capital is used
    (that is, debt), the cost of equity increases.
    - In other words, the increase in the cost of equity is balanced out by the increased
    use of the cheaper source of capital, debt.
    • Bottom line: There is no benefit to using debt versus equity.

    Copyright © 2013 CFA Institute


    INTRODUCING TAXES INTO THE MM THEORY
    When taxes are introduced (specifically, the tax deductibility of interest by the
    firm), the value of the firm is enhanced by the tax shield provided by this interest
    deduction. The tax shield:
    - Lowers the cost of debt.
    - Lowers the WACC as more debt is used.
    - Increases the value of the firm by tD (that is, marginal tax rate times debt)
    Bottom line: The optimal capital structure is 99.99% debt.

    Copyright © 2013 CFA Institute


    INTRODUCING COSTS OF
    FINANCIAL DISTRESS
    • Costs of financial distress are costs associated with a company that is
    having difficulty meeting its obligations.
    • The expected cost of financial distress increases as the relative use of debt
    financing increases.
    - This expected cost reduces the value of the firm, offsetting, in part, the
    benefit from interest deductibility.
    - The expected cost of distress affects the cost of debt and equity.
    - When there are bankruptcy costs, a high debt ratio increases the risk of
    bankruptcy.

    Bottom line: There is an optimal capital structure at which the value of the
    firm is maximized and the cost of capital is minimized.

    Copyright © 2013 CFA Institute


    BANKRUPTCY COSTS
    FINANCIAL DISTRESS
    • Direct costs
     Legal and administrative costs
     Ultimately cause bondholders to incur additional losses
     Disincentive to debt financing

    • Financial distress
     Significant problems in meeting debt obligations
     Firms that experience financial distress do not
    necessarily file for bankruptcy.
    THE STATIC THEORY OF CAPITAL STRUCTURE
    • According to the static trade-off theory of capital structure, in choosing a capital
    structure, a company balances the value of the tax benefit from deductibility of
    interest with the present value of the costs of financial distress.
    • At the optimal target capital structure, the incremental tax shield benefit is
    exactly offset by the incremental costs of financial distress.
    • A company may identify its target capital structure, but its capital structure at
    any point in time may not be equal to its target for many reasons.

    Copyright © 2013 CFA Institute 13


    MANAGERIAL RECOMMENDATIONS
    • The tax benefit is only important if the firm has a
    large tax liability.

    • Risk of financial distress


     The greater the risk of financial distress, the less debt will
    be optimal for the firm.

     The cost of financial distress varies across firms and


    industries, and as a manager you need to understand the
    cost for your industry.

    Copyright © 2019 McGraw-Hill


    Education. All rights reserved. No
    reproduction or distribution without the prior
    AGENCY COSTS
    • Agency costs are the costs associated with the separation of owners and
    management.
    • The better the corporate governance, the lower the agency costs.
    • Agency costs increase the cost of equity and reduce the value of the firm.
    • The higher the use of debt relative to equity, the greater the monitoring of the
    firm and, therefore, the lower the cost of equity.
    • Using more debt in a company’s capital structure reduces the net agency costs
    of equity.

    Copyright © 2013 CFA Institute


    COSTS OF ASYMMETRIC INFORMATION
    • Asymmetric information is the situation in which different parties have
    different information.
    - In a corporation, managers will have a better information set than investors.
    - The degree of asymmetric information varies among companies and
    industries.
    • The pecking order theory argues that the capital structure decision is affected
    by management’s choice of a source of capital that gives higher priority to
    sources that reveal the least amount of information.
    - The key element in the pecking order theory is that firms prefer to use
    internal financing whenever possible.
    - The costs of asymmetric information increase as more equity is used
    versus debt, suggesting the pecking order theory of leverage, in which new
    equity issuance is the least preferred method of raising capital.

    Copyright © 2013 CFA Institute


    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.
     Companies like financial slack.
    OBSERVED CAPITAL STRUCTURE
    • Capital structure does differ by industry.

    • Differences according to Cost of Capital 2010 Yearbook by Ibbotson


    Associates, Inc.
     Lowest levels of debt
    - Drugs with 8.46% debt-to-equity
    - Computer equipment with 10.02% debt-to-equity
     Highest levels of debt
    - Cable television with 193.88% debt-to-equity
    - Airlines with 177.19% debt-to-equity
    SUMMARY
    • The goal of the capital structure decision is to determine the financial leverage
    that maximizes the value of the company (or minimizes the weighted average
    cost of capital).
    • In the Modigliani and Miller theory developed without taxes, capital structure is
    irrelevant and has no effect on company value.
    • The deductibility of interest lowers the cost of debt and the cost of capital for
    the company as a whole. Adding the tax shield provided by debt to the
    Modigliani and Miller framework suggests that the optimal capital structure is
    all debt.
    • In the Modigliani and Miller propositions with and without taxes, increasing a
    company’s relative use of debt in the capital structure increases the risk for
    equity providers and, hence, the cost of equity capital.

    Copyright © 2013 CFA Institute


    SUMMARY (CONTINUED)
    • Many companies have goals for maintaining a certain credit rating, and these
    goals are influenced by the relative costs of debt financing among the different
    rating classes.
    • In evaluating a company’s capital structure, the financial analyst must look at
    the capital structure of the company over time, the capital structure of
    competitors that have similar business risk, and company-specific factors that
    may affect agency costs.
    • Good corporate governance and accounting transparency should lower the net
    agency costs of equity.

    Copyright © 2013 CFA Institute

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