Financial Management

Capital Structure
Concepts

17.1 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Capital Structure

Capital Structure -- The mix (or proportion) of

a firm’s permanent long-term financing
represented by debt, preferred stock, and
common stock equity.
• Concerned 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.
17.2 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 A Conceptual Look –
Relevant Rates of Return
ki = the yield on the company’s debt
I Annual interest on debt
ki =
B
=
Market value of debt
Assumptions:
• Interest paid each and every year
• Bond life is infinite
• Results in the valuation of a perpetual bond
• No taxes (Note: allows us to focus on just
capital structure issues.)
17.3 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 A Conceptual Look –
Relevant Rates of Return
ke = the expected return on the company’s equity
Earnings available to
E
E common shareholders
ke = S =
S Market value of common
stock outstanding
Assumptions:
• Earnings are not expected to grow
• 100% dividend payout
• Results in the valuation of a perpetuity
• Appropriate in this case for illustrating the
theory of the firm
17.4 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 A Conceptual Look –
Relevant Rates of Return

ko = an overall capitalization rate for the firm

O
O Net operating income
ko =
V
V
= Total market value of the firm

Assumptions:
• V = B + S = total market value of the firm
• O = I + E = net operating income = interest
paid plus earnings available to common
shareholders
17.5 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Capitalization Rate

Capitalization Rate, ko – The discount rate

used to determine the present value of a
stream of expected cash flows.

B S
ko = ki + ke
B+S B+S

What happens to ki, ke, and ko

when leverage, B/S, increases?
17.6 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Net Operating
Income Approach
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.
Assume:
• Net operating income equals $1,350
• Market value of debt is $1,800 at 10% interest
• Overall capitalization rate is 15%
17.7 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Required Rate of
Return on Equity
Calculating the required rate of return on equity
Total firm value = O / ko = $1,350 / 0.15
= $9,000
Market value =V–B = $9,000 – $1,800
of equity = $7,200 Interest payments
= $1,800 × 10%
Required return =E/S
on equity* = ($1,350 – $180) / $7,200
= 16.25%
* B / S = $1,800 / $7,200 = 0.25
17.8 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Required Rate of
Return on Equity
What is the rate of return on equity if B=$3,000?
Total firm value = O / ko = $1,350 / 0.15
= $9,000
Market value =V–B = $9,000 – $3,000
of equity = $6,000 Interest payments
= $3,000 × 10%
Required return =E/S
on equity* = ($1,350 - $300) / $6,000
= 17.50%
* B / S = $3,000 / $6,000 = 0.50
17.9 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Required Rate of
Return on Equity
Examine a variety of different debt-to-equity
ratios and the resulting required rate of
return on equity.
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%
Calculated in slides 9 and 10
17.10 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Required Rate of
Return on Equity
Capital costs and the NOI approach in a
graphical representation.
0.25
ke = 16.25% and
17.5% respectively
Capital Costs (%)

0.20
ke (Required return on equity)
0.15
ko (Capitalization rate)
0.10
ki (Yield on debt)
0.05

0
0 0.25 0.50 0.75 1.0 1.25 1.50 1.75 2.0
Financial Leverage (B/S)
17.11 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Summary of NOI Approach
• Critical 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.
17.12 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Traditional Approach

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 – The capital structure

that minimizes the firm’s cost of capital and
thereby maximizes the value of the firm.

17.13 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Optimal Capital Structure:
Traditional Approach
Traditional Approach

ke
0.25
ko
Capital Costs (%)

0.20

0.15
ki
0.10
Optimal Capital Structure
0.05

0
Financial Leverage (B / S)
17.14 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Summary of the
Traditional Approach
• The 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).
17.15 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Total Value Principle:
Modigliani and Miller (M&M)
• Modigliani and Miller approach to capital theory,
devised in the 1950s advocates capital structure
irrelevancy theory. This suggests that the
valuation of a firm is irrelevant to the capital
structure of a company. Whether a firm is highly
leveraged or has lower debt component, it has no
bearing on its market value. Rather, the market
value of a firm is dependent on the operating
profits of the company.

17.16 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Total Value Principle:
Modigliani and Miller

Modigliani and Miller Approach further

states that the market value of a firm
is affected by its operating income
apart from the risk involved in the
investment. The theory stated that the
value of the firm is not dependent on the
choice of capital structure or financing
decision of the firm.

17.17 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Total Value Principle:
Modigliani and Miller
Market value Market value
of debt ($35M) of debt ($65M)

Market value Market value

of equity ($65M) of equity ($35M)

Total firm market Total firm market

value ($100M) value ($100M)

• Assumptions:
• Total market value is not altered by the capital
structure (the total size of the pies are the same).

• M&M assume an absence of taxes and market

imperfections.
17.18 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Total Value Principle:
Modigliani and Miller

 Assumptions:
 There are no taxes.
 Transaction cost for buying and selling securities as well as
bankruptcy cost is nil.
 There is a symmetry of information. This means that an investor
will have access to the same information that a corporation would
and investors would behave rationally.
 The cost of borrowing is the same for investors as well as
companies.
 There is no floatation cost like underwriting commission, payment
to merchant bankers, advertisement expenses, etc.
 There is no corporate dividend tax.

17.19 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Two Propositions without Taxes

1.
With the above assumptions of “no taxes”, the
capital structure does not influence the valuation
of a firm. In other words, leveraging the company
does not increase the market value of the
company. It also suggests that debt holders in
the company and equity shareholders have the
same priority i.e. earnings are split equally
amongst them.

17.20 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 2.
It says that financial leverage is in direct
proportion to the cost of equity. With an increase
in debt component, the equity shareholders
perceive a higher risk to for the company. Hence,
in return, the shareholders expect a higher return,
thereby increasing the cost of equity. A key
distinction here is that proposition 2 assumes
that debt-shareholders have upper-hand as far as
the claim on earnings is concerned. Thus, the
cost of debt reduces.

17.21 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Propositions with Taxes (The
Trade-Off Theory of Leverage)
The Modigliani and Miller Approach assumes that there are
no taxes. But in the real world, this is far from the truth.
Most countries, if not all, tax a company. This theory
recognizes the tax benefits accrued by interest payments.
The interest paid on borrowed funds is tax deductible.
However, the same is not the case with dividends paid on
equity. To put it in other words, the actual cost of debt is
less than the nominal cost of debt because of tax benefits.
The trade-off theory advocates that a company can
capitalize its requirements with debts as long as the cost of
distress i.e. the cost of bankruptcy exceeds the value of tax
benefits. Thus, the increased debts, until a given threshold
value will add value to a company.

17.22 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Propositions with Taxes (The Trade-
Off Theory of Leverage)

This approach with corporate taxes does

acknowledge tax savings and thus infers
that a change in debt-equity ratio has an
effect on WACC (Weighted Average Cost
of Capital). This means higher the debt,
lower is the WACC. This Modigliani and
Miller approach is one of the modern
approaches of Capital Structure Theory.

17.23 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Arbitrage and Total
Market Value of the Firm

Two firms that are alike in every respect

EXCEPT capital structure MUST have
the same market value.
Otherwise, arbitrage is possible.

Arbitrage – Finding two assets that are

essentially the same and buying the
cheaper and selling the more expensive.
17.24 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Arbitrage Example:
Suppose you have $1 million and you are provided with the
following exchange rates:
EUR/USD = 0.8631 EUR/GBP = 1.4600 USD/GBP = 1.6939
Step 1. Sell dollars for euros: $1 million x 0.8631 = €863,100
Step 2. Sell euros for pounds: €863,100/1.4600 = £591,164.40
Step 3. Sell pounds for dollars: £591,164.40 x 1.6939 = $1,001,373
Step 4. Subtract the initial investment from the final amount:
$1,001,373 - $1,000,000 = $1,373

17.25 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Arbitrage Example

Consider two firms that are identical

in every respect EXCEPT:
• Company NL – no financial leverage
• Company L – $30,000 of 12% debt
• Market value of debt for Company L equals its
par value
• Required return on equity
– Company NL is 15%
– Company L is 16%
• NOI for each firm is $10,000
17.26 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Arbitrage Example:
Company NL
Valuation of Company NL
Earnings available to =E =O–I
common shareholders = $10,000 - $0
= $10,000
Market value = E / ke
of equity = $10,000 / 0 .15
= $66,667
Total market value = $66,667 + $0
= $66,667
Overall capitalization rate = 15%
Debt-to-equity ratio =0
17.27 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Arbitrage Example:
Company L
Valuation of Company L
Earnings available to =E =O–I
common shareholders = $10,000 – $3,600
= $6,400
Market value = E / ke
of equity = $6,400 / 0.16
= $40,000
Total market value = $40,000 + $30,000
= $70,000
Overall capitalization rate = 14.3%
Debt-to-equity ratio = 0.75
17.28 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Completing an
Arbitrage Transaction
Assume 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).
17.29 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Completing an
Arbitrage Transaction
Original return on investment in Company L
$400 × 16% = $64

Return on investment after the transaction

• $666.67 × 16% = $100 return on Company NL
• $300 × 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.
17.30 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Summary of the
Arbitrage Transaction
• The investor uses “personal” rather than
corporate financial leverage.
• The 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.
17.31 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.