CF2 - Chapter 2 Capital Structure - SV
CF2 - Chapter 2 Capital Structure - SV
CF2 - Chapter 2 Capital Structure - SV
CAPITAL STRUCTURE
Dr. Nguyen Quynh Tho
Key Concepts and Skills
2. Patterns of financing
Debt Equity
• Not an ownership interest • Ownership interest
• Creditors do not have voting rights • Common stockholders vote for the
board of directors and other issues
• Interest is considered a cost of
doing business and is tax
deductible • Dividends are not considered a cost
of doing business and are not tax
• Creditors have legal recourse if deductible
interest or principal payments are
missed • Dividends are not a liability of the
firm, and stockholders have no legal
• Excess debt can lead to financial recourse if dividends are not paid
distress and bankruptcy
• An all-equity firm cannot go bankrupt
1. Common Stock
● Proxy voting
● Classes of stock
● Other rights
● Straight Voting
○ Individuals have 1 vote per share.
○ Each share entitles 1 vote for a director seat.
○ Ex. I own 10 shares and 3 directors are up for election. I can vote 10
times for each seat.
● Cumulative Voting
○ Individuals have 1 vote per share
○ Each share entitles to 1 vote for each director seat.
○ You can allocate any number of votes to a single seat.
○ Ex. You can vote all 30 votes for a single director.
Voting Right: Example
The shareholders of Starbuck need to elect seven new directors. There are
960,000 shares outstanding currently trading at $48 per share. You would
like to serve on the board of directors; unfortunately no one else will be
voting for you.
1- How much will it cost you to be certain that you can be elected if
the company uses straight voting?
2- How much will it cost you if the company uses cumulative voting ?
2. Preferred Stock
● Dividends
○ Stated dividend must be paid before dividends can be paid to
common stockholders.
○ Dividends are not a liability of the firm, and preferred dividends
can be deferred indefinitely.
○ Most preferred dividends are cumulative – any missed preferred
dividends have to be paid before common dividends can be
paid.
○ Call provisions
● Security
○ Debentures – unsecured
● Seniority
Required Yields
● Which bonds will have the higher coupon, all else equal?
○ Secured debt versus a debenture
● Income bonds
● Convertible bonds
● Put bonds
International Bonds
● Lines of Credit
○ Provide a maximum amount the bank is willing to lend
○ If guaranteed, referred to as a revolving line of credit
● Syndicated Loan
○ Large banks frequently have more demand for loans than they have supply.
○ Small regional banks are often in the opposite situation.
○ As a result, a larger bank may arrange a loan with a firm or country and then sell
portions of the loan to a syndicate of other banks.
○ A syndicated loan may be publicly traded.
Part 2.
Patterns of Financing
The Long-Term Financial Deficit
Financial
deficit
Net working
capital plus
other uses Long-term debt External cash
and equity flow
Patterns of Financing
● Internally generated cash flow dominates as a source of financing.
●Corporations are redeeming more stocks and bonds than they are
issuing.
Recent Trends in Capital Structure
●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
Current Proposed
Assets $20,000 $20,000
Debt $0 $8,000
Equity $20,000 $12,000
Debt/Equity ratio 0.00 2/3
Interest rate n/a 8%
Shares outstanding 400 240
Share price $50 $50
EPS and ROE Under Current Structure
31
EPS and ROE Under Proposed Structure
32
Financial Leverage and EPS
12.00
10.00 Debt
8.00 No Debt
6.00 Advantage to
Break-even point
EPS
debt
4.00
2.00
0.00
1,000 2,000 3,000
(2.00) EBIT in dollars, no taxes
Disadvantage to debt
Part 4.
Modigliani & Miller Theory
Homemade Leverage: An Example
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.
Recession Expected Expansion
EPS of Levered Firm $1.50 $5.67 $9.83
Earnings for 24 shares $36 $136 $236
Plus interest on $800 (8%) $64 $64 $64
Net Profits $100 $200 $300
ROE (Net Profits / $2,000) 5% 10% 15%
This is the fundamental insight of M&M
MM Proposition I (No Taxes)
VL = VU
Assumptions of the M&M Model
●Homogeneous Expectations
○Perfect competition
○No taxes
MM Proposition II (No Taxes)
●Proposition II
B
R S = R0 + ( R0 − R B )
SL
B S
R0 RW ACC = RB + RS
B+S B+S
RB RB
Debt-to-equity Ratio
B
S
MM Propositions I & II (With Taxes)
B
R S = R0 + (1 − TC ) ( R0 − R B )
SL
R0
B SL
RW ACC = R B (1 − TC ) + RS
B+S L B + SL
RB
Debt-to-equity
ratio (B/S)
Total Cash Flow to Investors
Recession Expected Expansion
EBIT $1,000 $2,000 $3,000
Interest 0 0 0
All Equity
The levered firm pays less in taxes than does the all-equity firm.
Thus, the sum of the debt plus the equity of the levered firm is
greater than the equity of the unlevered firm.
This is how cutting the pie differently can make the pie “larger.”
-the government takes a smaller slice of the pie!
Summary: No Taxes
●In a world of no taxes, the value of the firm is unaffected by capital structure.
VL = VU
●Proposition I holds because shareholders can achieve any pattern of payouts they
desire with homemade leverage.
●In a world of no taxes, M&M Proposition II states that leverage increases the risk and
return to stockholders. B
RS = R0 + (R0 − RB )
SL
Summary: Taxes
●In a world of taxes, but no bankruptcy costs, the value of the firm increases with leverage.
VL = VU + TC B
●Proposition I holds because shareholders can achieve any pattern of payouts they desire with
homemade leverage.
●In a world of taxes, M&M Proposition II states that leverage increases the risk and return to
stockholders.
B
RS = R0 + (1 − TC ) (R0 − RB )
SL
● Describe the basic characteristics of
common and preferred stock.
●Identify the rights of shareholders and
QUICK QUIZ bondholders.