fr,,,l r^'

CAPITAT STRUCTUREDECISIONS: PART I/-t@o

opun its doors, a new business requires capital, and still more capital isneeded if the firm is to expand. The required funds can come from many differ-ent sources and take many different forms. However, all capital can be classifiedinto two basic types-debt and equity.

Raising capital as debt has several advantages. First, interest is tax deductible,which lowers tl're effective cost of debt. Second, debtholders are limiteci to a fixedreturn, so stockholders do not have to share profits if the business does excep-tionally well. Finally, debtholders do not have voting rights, so stockholders cancontrol a business lvith less money than would otherwise be required.

However, financing with debt also has disadvantages. First, the higher the debtratio, the greater the risk and thus the higher the interest rate. At some point, ris-ing interest rates overwhelm the tax advantages of debt. Second, if a company fallson hard times, and if its operating income is insufficient to cover interest charges,then stockholders will have to make up the shortfall, and if they cannot, the com-pany may be forced into bankruptcy. Good times may be just around the comer,but too much debt can keep the company from getting there and can wipe outstockholders in the process.

Crown Cork & Seal Company, an $8.0 billion NYSE company, is a good exam-ple of a firm that used debt to good advantage. Over a ten-year period, from 1988to 1998, Crown increased its long-term debt from a minuscule $9 million to a

mighty $4 billion. This pushed its debt ratio up to a still-reasonable 42 percent.Crown used the borrowed funds to acquire other companies, and, since it earnedmore on the acquired assets than its cost of debL that pushed up its ROE and,consequently, its stock price. Indeed, the'stock price rose from $10 to more than$50 over the period.

On the other hand, debt financing is causing severe probiems for some air-lines, including U.S. Airways. In 1998, U.S. Airways had a long-term debt to cap-italization ratio of almost 100 percent; that is, it was financed almost entirely bydebt. Further, its annual interest expense was more than $200 million, consider-ably more than the company's operating income during most of the 1990s. U.S.Airways cannot pay diviclends on its common stock, and its very survival is inquestion. The airline industry is extrenrely cyclical, and large amounts of debtput tremendous pressures on a company when earnings tum south.

Companies can Lrse either debt or equity capital to finance their assets. Is oneform better than the other? If so, should firms be financed either with all debt or alleqr"rity? Or, if the best clroice is some mix of eiebt and equity, what is the optimal

360 Chapter 9 LONG-TERM FINANCIAL PLANNING

Current ratio

Payout ratio

Operating profit margin after taxes (NOPAT,iSales)

Operating capital requirement (Operating capital/Sales)

Rehrm on invested capital (NOPAT/Operating capital)

Assume that you were recently hired as Simmons'as-sistant, and youi first major tasli is to help her developthe forecast. She asked you to begin by answering the fol-lowing set of questions.a. Asiume (1) that NWC was oPerating at full capacity in

1998 with respect to all assets, (2) that all assets mustgrow proportionally with sales, (3) that accountspay4ble and accruals will also grow in proportion toiales, and (4) that the 1993 profit margin and dividendpayout will be maintained. Under these conditions,iliat will the company's financial requirements be forthe coming year? Use'the AFN equation to answer thisquestion.

b. Now estimate the 1999 financial requirements usingthe percent of sales approach, making an initial fore-cast'plus one additio'nil "pass" to ditermine the ef-fects'of "financing feedbacks." Assume (1) that eachtype of asset, as iell as payables, accruals, and 6xedand variable costs, will be the same Percent ot sales m1999 as in l99S; (2) that the Payout ratio is held con-stant at 30 percent; (3) that extemal funds needed are

financed 50 percent by notes payable and 50 percentby long+erm debt (nd new common stock will be is-sued); ind (4) ihat all debt carries an interest rate of 8percent.

c. Why do the two methods produce somewhat differentAFN forecasts? lAlhich method provides the more ac-

curate forecast?d. Calculate NWC's forecasted ratios, and compare them

with the company's 1998 ratios and with the industryaveraSes. How dbes NWC compare with the averagefim in its industry, and is the comPany exPected toimprove during the coming year?

e. Calculate NWC's free cash flow for 1999.

f. Suppose NWC exPects sales to grow 15 percent- in2000. In 2001 and all subsequent years, comPetitionwill cause NWC's sales to Srow at a constant rate of 5percent. lf NWC's operations remain the same (i.e., theitems that are a perient of sales will be the sme Per-cent of sales in years after 1998 and in 1998), the pro-

iected free castr flows for 2000 and 2001 are -$82.50million and $25.88 million, respectively' After 2001,

free cash flows are expected to Srow at 5 Percent Peryear. NWC's weighted average cost of capital i:9 p9I-ient. What is the value of NWC as of December 31,

1998? (Hint: Find the horizon value at 2001, and thenfind the present values of the horizon value and thefree cash flows.)

g. Suppose you now leam that NWC's 1998 receivables- and'inventories were in line with required levels,given the firm's credit and inventory polic-ies,but thatixcess capacity existed with regard to fixed assets.

2.50

30.00%

3.00%

45.00%

6.67%

3.00

30.00%

5.00%

35.00%

14.N"/"

6f your answer, show the growth ratt, in in-,ri* that results from a l0 percent increase infrom a sales level of (a) $200 and (b) $2,000

I on both the actual regression line and a hy-tical regression line which is linear and whichthrough the origin.

Questions/Problems 361

l. Florv n'ould changes in these items affect the AFN? (1)Thc dividcnd payout ratio, (2) the profit margin, (3) thecapital intensity ratio, and (4) NWC begins buying fromits suppliers on terms which permit it to pay after 60days rathcr than after 30 days. (Considr'r each itcm scp-arately and hold all othcr things constant.)

ng1999? irih. Without actually workinB out the numbery

would you expect the ratios to change in the t

where excess capacity in fixed assets exists?your reasorung.

i. 'Based on comparisons between NWC's days sal

standing (DSO) md inventory tumover ratios w

Specifically, fixed assets were operated at onlycent of capacity. '!(1) What levet of sales could have existed in 1998

the available fixed assets? What would theassets/sales ratio have been if NWC haderating at full caPacitY?

(2) How would the existence of excessfixed assets affect the additional funds needeil

industr! average figures, does it appear thatoperating efficiently with resPect to its inventori(aicounts receivable? If the company were able to

these ratios into line with the industry averages,

effect would this have on its AFN and itstios? What effect would this have on free cash

lustrate your answer.

Year Sales Inventories

the value of the company? (Note: Inventoriesceivables will be discussed in detail in Chapter

l. The relationship between sales and the variousassets is imporlant in financial forecasting' Theof sales aouoach, under the assumption that eaof sales approach, under the assumPtion that eitem srowl at the same rate as sales, leads toforecist that is reasonably close to the forecast r

AFN equation. Explain howeach of the followirwould ;ffect the accuracy of financial forecaststhe AFN equation: (1) excess capacity, (2) base

assets, such as shoes in a shoe store, (3) ecor

scale in the use of assets, and (4) lumPy assets.

k. (i) How could regression analysis be used to' the presence oithe situationl described abo

theri to improue the financial forecasts? Ilraph of thi following data, which is for a {*eli-managed comPany in NWC's industry,

Selected Additional References and Cases

The heart of successfiil fnancial planning is the sales forccast. On this key urbject, see

Pan, fudy, Donald R. Nichols, and O. Maurice Joy, "Sales Forecasting Practices of LargeU.S. Industrial Firms, " Iinnnciirl lvld n a ge n c n t, F all 7977, 72-77.

Hirschey, Mark, and James L. Pappas, Manngerial Econontics (Fort Worth, Tex.: DrydenPress, 1996).

Computer modeling is beconing increasitgly itnportnilt. For general references, see

Carleton, Willard T., Charles L. Dick, Jr, and David H. Downes, "Financial Policy Mode.ls:Theory and Practice," lournal of Fhance, December 1973,691-709.

Francis, Jack Clark, and Dexter R. Rowell, "A Simultaneous Equation Model of the Firmfor Financial Analysis.-rnd Planning," Financitrl ManLtgcnrcnt, Spring 1978,29-,1,1.

Grinyer, P H., and J. \Nooller, Corpornte Models Todny -A Neu Tool for Finntcial Managenwrt(London: Institute oI Chartered Accountants, 1978).

Pappas, James L., and George P. Huber, "Probabilistic Short-Term Fhancial Planning," Financial Managentetrr, Autumn 7973, 36 -14.

Traenkle, ]. W., E. B. Cox, and J. A. Bullard, Thc Use of Fitnntial Models irr Busiless (NervYork: Financial Executives' Research Fomdation, 1975).

Considerable effort las bem e:rpended to dntelop integrated f,nancial planning ntodels thut idnrtifyoptimal policies. For one exanrple, sae

Myers, Stewart C., and Cerald A. Pogue, "A Programming Approach to Corporate Finan-cial Management," lournal of Finance , May 1974,579-599.

For an article on eontrol, see

Bierman, Harold, "Beyond Cash Flow ROl," Midlnntl Corporatc Finance lournal, W'nter1988,35-39.

The Drydet Press Cases in Financial Man.rgement: Drydcn Request series contilrs the fol-lowhry applicable cases:

Case 37, "Space-Age Materials, lnc.," Case 38, "Automated Banking Management, Inc.,"Case 38A, "Expert Systems," Case 38B, "lvledical Manag;ement Systems, Inc.," and Case63, "Dental Ilccords, Inc.," which all focus on using the percent of sales forecastingmethod to forecast futurc financing rL'quirenrents.

7996

1997

1998

1999 (est.)

(2) On the same SraPh that plots the above data'' ' a line which ih6ws ho* the regression line

$1,280

1,600

2,000

2,500

$118

138

162

192

ipp*. t" i". fy the use of tf,"'air.r fotmu4thd percent of iales forecasting procedure'{

354 Chapter 10 CAPITAL STRUCTURE DECISIONS: PART I

mix? In this chapter, we discuss the key facets of the debt-versus-equity, or caDihr

structure, decision. As you read the chapter, think about Crown Cork & Seal'aJU.S. Airways, and the ways ihe concepts discussed might aid the.managersjthese and other companies as they make capital structure dccisions.'

One of the most perplexing issues facing financial managers is the relation56;,between capital structure, which is the mix of debt ancl equity financing, 3,jstock prices. How does capit.rl structure affect stock prices, and what effectdosit have on the cost of capital? Should different intlustries, and different fungwithin industries, have different capital structures, and, if so, rvhat factors lead 5these differences? Although the optimal capital structure decision is complex an4

not well understood, the material in this chapter will help you deal with theigsues involved.

BUSINESS AND FINANCIAL RISKln Chapter 2, when we examined risk from the viewpoini of a stock investor, r'edistinguished between market rislg which is measured by the firm's beta coeffr

cient, and stand-alone rislg which includes both ni.rrket risk and an elemento{risk which can be eliminated by diversification. Now we introduce two new &mensions of risk: (1) business risk, or the riskiness of the firm's stock if it usesm

debt. and (2) financial risk, which is the aCditional risk placed on the commmstockholders as a result of the firm's decision to use debt.2

Conceptually, the firm has a certain amount of risk inherent in its operationr

this is its business risk. If it uses debt, then, in effect, it partitions its investors inb

two groups and concentrates most of its business risk on one class of investors-the common stockholders. However, the common stockholders generally de

mand compensation for assuming more risk and thus require a higher rate of rtI turn. In this section, we examine business and financial risk within a stand-alorI risk framework, which ignores the benefits of stockholder diversification.

Business Risk

Business risk in a stand-alone sense is a function of the uncertainty inherentin

projections of a firm's future re!u!! on lnvgsted c4p!ta1 (ROIC). defined as follons

Net income to

NOPAT _ con-rmon stockholders + After-tax intcrest Pa)'mentsRorC=-:".jr+=Cap11.11 CapiLrl

Here NOPAT is net operating profit after taxes, or EBIT(I - T). If a firm usesto

debt, then its interest payments will be zero, its capital will be alt elluity, andrE

ROIC *'ill equal iis return on equity, ROE:

llolC (zero clebt) = ltgp - Net iticonrc to cor,l.u.n stockholclcrs.

Contmou etlLtitl'

Therefore, the business risk of a b:ocrnse-ft'cc firm can be measttrerl by the staT

dard deviation of its ROE, oR6g.

rWe have di\.ided the material on capital structure int(' trvo ch.rptcrs. Chnpter 10 cor t'rs the Lsril

while Chapter 11 discusses the theor)' of capital structure.2Preferre.l stock also adds to fin.rncial risk. Ttr simplifv m.rttr'rs, rr('.qtccntr.rte rrn tlt'L.t ald coflInd

equitv in tlris clrapter.

Busincss antl Financi.rl Risk 3(,5

To illustratt', consitler strilsl,urt Llectronics Conrprlrrv, a dclrt-licc (rrrri.'itn'rl)firm. Figtrre 10-1 gir.es some cluts about the comparry's business risk. l-he topgraph shows the trc.nc{ in I(OE from 1988 throtrgh 1998; this grapl.r gives both se-curity analysts antl Strasburgq's m.lnagement arr icioa of the degree to rvhich ROEhas varied in the past and might vary in the fuitrre.

The lou.er graph shorvs tht'bcginning-of-year subjectivcly estimateLl probabil-ity <listribution of Strasburg's ltOE for 199S, basetl on thc trend line in the topsection of Figure l0-1. As both gr;rphs inclicate, Str..rsburg's actrral IIOE in 199i1was only 8 pt-rcent, n,ell bclorr, thc expectcd r,:rluc r:f 12 percent- 199E ryas ;r b.rrlyear.

Strasburg's past fltrctuations in liOE rrcre causct{ bv manv factors-boomsancl recessions in the nation.rl ecr)nom)i succcssful nerr; products intrtlducecl br,both Str.rsburg and its competitors, latror strikes, a fire in Strasburg's main plani,and so on. Sintilar events r,vill dorrbtless ctccur in thc futurc, and rvhcn they cio,the rcalizerl RoE will be higher or lolver than the projcctccl level. Fr.rrther, ihcre

r:j,l:';

;1:t-'l., i:-.,..: ..,.

'r i'f)tl. 1t.'*.

. ili- |i;'.)tt

ii.

i

BOE(%)

a. Trend in Belurn on Equity (HOE)

b. Subjeclive Probability Distribution

ProbabilityDensity

of HOE lor 1998

--__- FtoE (e'.;

Expecled ROE

366 Chaptr'r 10 CAPITAL STRUCTURE DECISIONS: IART I Business and Financial Risk 367

both unit sales and sales prices. However, this stabilization may require spendinga great deal on advertising and/or price concessions to get commitments fromcustomers to purchase fixed quantities at fixed prices in the future. Similarly,firms such as Strasburg Electronics can reduce the volatility of future input costsby negotiating long-term labor and materials supply contracts, but they mayhave to pay prices above the current spot price to obtain these contracts. Also,many firms are using hedging techniques to reduce business risk, as w,e discussin Chapter 19.

Operating Leverage

As noted above, business risk depends in part on the extent to rvhich a firmbuilds fixed costs into its operationi-if fixed costs are high, even a small declinein sales can lead to a large decline in ROE. So, other things held constant, the

\igher a firm's fixed costs, the greater its business risk. Higher fixed costs aregenerally associated with more highly automated, capital intensive firms and in-dustries. However, businesses that employ highly skilled rvorkers who must beretained and paid even during recessions also have relatively high fixed costs, asdo firms with high product development costs, because the amortization of de-velopment costs is an element of fixed costs.

If a high percentage of total costs are fixed, then the firm is said to have a highdegree of operating leverage. In physics, Ieverage implies the use of a lever toraise a heary object with a small force. In politics, if people have leverage, theirsmallest word or action can accomplish a lot. /n business terminology, a high degree

, of operating leaerage, other factors held constant, implies tlnt a relatiaely small change

1 ln sales results irr a large change in ROE.Figure 10-2 illustrates the concept of operating leverage by comparing the re-

sults that Strasburg could expect if it used differe.nt degrees of operating leverage.Plan A calls for a relatively small amount of fixed costs, $20,000. Here the firmwould not have much automated equipment, so its depreciation, maintenance.property taxes, and so on would be low, but the total operating costs line has a rel-atively steep slope, indicating that variable costs per unit are higher than theywould be if the firm used more operating leverage. Plan B calls for a higher levelof fixed costs, $50,000. Here the firm uses automated equipment (with which oneoperator can tum out a few or many units at the same labor cost) to a much largerextent. The breakeven point is higher under Plan B-breakeven occurs at 60,000units under Plan B versus only 40,000 units under Plan A.

We can calculate the breakeven quantity by recognizing that operating breakeoen

occurs when ROE = 0, hence when earnings before interest and taxes (EBIT) = 0:4

EBIT=0=PQ-vQ-F.

Here P is average sales price per unit of output, Q is units of output, V is variablecost per unit, and F is fixed operating costs. If we solve for the breakeven quan-tity, Qrc, we get this expression:

is al$,avs the possibility that a long-term,disaster might strike,.permanentlyds

pressing the conrpany's carning poiver; for examplg, a competitor nlight inho

i.,... n'n.ru prodr,rct that would permanently lower Str.rsbur8's t-arnin8s. This

uncertainty regarding Strasburg's {uture. ROE,.assunling tly Ji,rtt rrsds '10

debf f.ii-rcing, is'tlc'fined as the company's business risk..Since Strasburg uses no dp5q

stockhottlcrs bear all of the company's business risk'

Business risk varies not only from indttstry to industry but also among firrx1

in i [iven industry. Further, business risk can .lo"-8.:.:":t time' For.examPle, UE

electlic rrtilities were regarded for years as having little business risk, bttt acom-

bination of events in recent years altered the utilities' situation, producing sharp

declincs in their ROEs and greatly increasing the industry's business risk. Now,

foot-l processors ancl grocery retailers are frequently-given as examples of indw

tries with lorv business risk, *,hile cyclical manufacturin8 industries such xautos ancl steel, aS well as marry small startup comPanies, are regarded as having

especially high busint'ss risk.l'Btrsincss iisk depencls on a number of factors, the more important of which an

listeci trelorv:

i. Demancl uncertainty. The more Predictable the dernand for a firm's prod'

ucts, other things held constant, the lower its business risk'

l. Sales price variability. Firms whose prodr.rcts are sold in highly volatile mar.

kets aie exposetl to more business risk than similar firms whose output

prices are more stable.

). Input cost variability. Firms whose input costs are highly uncertain are er-

posecl to a high degree of business risk.

{. Ability to adjust output prices for changes in input costs' Some firmsan

bctter able than others to raise their olvn ouiPut prices n'hen input cosb

rist,. TI.re greatcr the ability to adfust output prices to reflect cost condition$

the lorver the degree of business risk.

5. Ability to develop new proclucts in a timely, cost-effective manner' Firms

in s.rch l',igh-tech industiies as drugs and compuiers depend on a consta{

stream of ierv proclucts. The faster its products become obsolete, the greatet

a firm's busincss risk.

6. Foreign risk exposure. Firms that generate a l"righ percentage of their earn'

ings .iucrr"n, aic sr-rbic'ct to earninfs declines dtrc. to erchange rate fluctul'

tions. Also, if a firm oPerates in a politically unstable 'rren, it m'1y be subJeo

b political risks. See Chapter 22 for a further discussion'

7. The extent to which costs are fixed: operating leverage' If a high percenl'

age oi its costs are fixetl, hence do not clecline when dcmantl falls off' tntr

thc firm is exposecl to a relatively high clegrt'e of business risk' This factot

is ctrllt'r1 up.r,iti,,5 lti'uage, a.rd itis.liscussitl at le.gth in the ne'xt seciior'r'

Each of thr,sr' factors is clett'rminecl partlv by the fi,n's indrrstry char,rcteristiO

but r,.rch of them is also controllablE ttr some extent by m.1l1.1gemL'llt. For exdr'

ple, most firms can, through their marketing policit'i, take Ictions to stabili'l

\".,,"*r*rt"'.*rt rlisctrssitrn tlf marlL't vtrsLls conlPiny--spccific risk 'n

tn;t "'t1;t'rr'

\Ve,n'-Tf(lr rhit .tnv .rclir'n rliriclr in(ro.ts('5 hrlsiniss ri'L irr th.'sl'lt)d-nl(\ne ri\\ (Prrrr't''ill t't'nrrl"' '"-":ll.i*': iiilr:\;t:' .,":ii,.i"",, il,,i tiiil,rt .r prrt.'f busint'cs ri:r s ill gen,trllr he J'n'p'']fl-:tfrl1(.il,L \ulrle{t k,,'lrnrin.rtirrrr I'r'tli!cr<i[rcrtr,'rr ['r'tlt' iirnr's st()cll1('l(l(rs' Il!i\ Prrltlt r\ (rrnu*

sr,n\L l( nIlh rrr Cltrpt.'r I I :

ar.=*

\his definition of breakeven does not include any fixed financial costs because Strasburg is an un-levered firm. If there were fixed financial costs, the firm rvoulcl suffer an accounting loss at the oper-ating breakeven point. We will introduce financial costs shortl!'.

368 Chapter 10 CAPITAL STRUCTURE DECISIONS: PAIIT I

Selling price = $2.00

Fixed costs = $20,000

Variable costs = $1.50 per unit

Plan A

Thus for Plan A,

and for Plan B,

llusincss .rnri Financi.rl Risk 369

o,, = r.ffifu = 4o,ooo L,nits,

Or,= rffigo =6o,oo() units.

r How cloes operating leverage affect br-rsiness risk? Ol/rcr l/rirrgs lcH c(),rslil,rl, f/rcl

'.higher a firuis opcrrttirtg lcut:ragc, tltc ltigltr ils lrrrsirrr'ss risl'. This point is rlcnron-f'strated in Figure 10-3, where rve develop prob.rlrility clistributiorrs for liOE turricrI'lans A and B.

The left-hand section of Figure 10-3 graphs the. probability distribution of sales

that was presented in tabular form in Figure 10-2. The sales probability distrilru-tion depends on how demand for the product varies, not on whether the productis manufactured by Plan A or by Plan B. Therefore, the same sales probability dis-tribution applies to both production plans; this distribution has expected s.rles of$220,000, and it ranges from zero to about $450,000, with a standard deviation ofos,r* = $92,995.

We use the sales probability distribution, together with the operating costs ateach sales level, to develop graphs of the ROE probability distributions underPlans A and B. Tht'se are shown in the right-hand section of Figure 10-3. Plan Bhas a higher expected ROE, but this plan also enLrils a much hight'r probabilityof losses. Clearly, Plan B, the one with more fixetl costs and a higher degree of op-erating Ieverage, is riskier. ln getrcral, htitlitrg otlw factors constfifit, tfu higlw the tle-

Sree of operating leucrogc, tln grcatcr tfu firnr's Drsirrt'-ss risk.To what extent can firms control their opcrating leverage? To a large extent,

operating leverage is determined by technology. Electric utilities, telephonecompanies, airlines, steel mills, and chemical companic's simply nrrrsl have large

Selling price = $2.00

Fixed costs = $60,000

Variable costs = $1.00 per unit

Plan B

Prob- Unitsability Sold, Q

0.03 0 $

0.07 40,000

0.15 60,000

0.50 110,000

0.15 160,000

o.o7 180,000

0.03 220,000

Operating OperatingSales Costs EBIT NI

Operating OperatingCosts EBIT

$ 60,000 ($ 60,000)

100,000 (20,000)

120,000 0

170,000 50,000

220,000 100,000

240,000 120,000

280,000 160,000

ROE NI R0[

Expectedvalue $220,000

Stmdard deviation $ 92,995

NOTES:

$21,000 12.0%

$13,949 8.0%

($36,000) (2o.6tl

(12,000) (6.9)

0 0.0

30,000 77.1

60,000 y3

72,OOO 41.1

96,000 549

$30,000 17.11

$27,8s8 15'91

0

80,000

120,000

220,000

320,000

360,000

,140,000

$ 2o,ooo ($2o,ooo) ($12,ooo) (6.e%)

80,000 0 0 0.0

110,000 10000 5,000 3.4

185,000 35,000 21,000 12.0

250,000 60,000 36,000 20.6

290.000 70,000 42,000 24.0

350,000 90,000 v,000 30.9

$35,000

923,249

$ 50,000

$ 46,497

',1:;:::.,..

lfti''rri.h,1

*il, ,

a. Sales Probability Distribution b. FOE Probability Distribution

Probability ProbabilityOensity Oensily

0 Expected Expected BOE (%)ROEa ROEB

a. Strasburg Electronics has a 40 percent federal-plus-state tax rate.

b. The firm uses no debt financing.c. For simpliciry we assume assets = equity = $175,000 under both plans.d. NI = EBIT(1 - T) = EBIT(0.6).

rl . We are using continuous distributions to approximrte the discretc distributions ctrnl,rint'd in Figure 10-2

Plan A plan B

lncome and Costs(Ihousands o, Dollars)

lncome and Costs(Thousands o, Oollars)

240 240

200

160

120

80

40

200

160

120

80

40

Operating Profit(EBIT)

OperatingLoss

I Breakeven Point

| (EBrr = o)

r Fixed Costs

20 40 60 80 100 120

Sales (Thousands ol Units)

20 40 60 80 100 120

Sales (Thousands of Units)

370 Chapter 10 CAPITAL STRUCTURE DECISIONS: PART I

invtstments in fixed assets; this results in high fixed costs and operatins lpv,age. Simillrly, clrug, auto, cornputer. anc{ similar complnls5 must spend"heariLto develop nelv products, and product-development costs incre.rse operati;:leverage. Grocery stores, on the other h;ind, generalll'have significantly loruXfixed costs, hence lower operating leverage. Still. althotrgh irrdLrstry factor.iexert a n-rajor influence, all firms have some control over their operating levslage. For example, an electric utility can expand its generating capacity bybuil;ing either a gas-fired or a coal-fired plant. The coal plant wotrld re.lrire a lam-investment and would have higher fixed costs, but its vari.rble op.'rating cfiiwould be relatively low. The gas-fired plant, on the other hancl, w,ould requ6,smaller investment and r,vould have lou'er fixecl costs, but the variable coit 1fqgas) would be high. Thus, by its capital budgeting decisions, a trtility (or allother company) can influence its operating leverage, hence its busirress risk. '

The concept of operating leverage was originally developed for use in capihlbudgeting. Mutuallv exclusive prujects which involve alternatir.e methodi fuproducirrB a given pror'luct often have different degrees of operating leveragq

herrce cliifererrt breakeven points and tlifferent dogrees of risk. Str;rsburg El[.tronics and many othe,r cor:rpanies regularlv undertakc' a type 6f breakeven

analvsis (the serrsitivity analysis discr.rssed in Clrapter 8) for each proposed pr1+

ect as a part of their regular capital budgeting process. Still, once a corporationioperating Ievc'rage has been established, this factor exerts a nlajor inf'lr,rence on ibcapit,il structure dr:cisions.

Financial Risk

Financial risk is the additional risk placed on the common stockholders as aresult of the dc.cision to finance with dcbt. Conceptualll', stockholtlers face a cer-

' tain amount of risk rvhich is inherent in a firm's operations-this is its busines

risk, rvhich is defined as the uncertainty inherent in projections of fuhrre opa-i ating income. If a firm uses debt (financial leverage), this concentrates the busi.

ness risk on common stockholders. To illustrate, suppose tc'n people decide bform a corporation to manufacture disk drives. There is a certain amount dbusiness risk in the operation. If the firm is capitalized only lvith common 6fuity, and if each person buys 10 percent of the stock, then each investor shar6

equally in the business risk. However, suppose the firm is capit:rlized with $percent tlebt and 50 pe'rcent equity, rr,ith five of the invcstors Futtint uP ther

capital as debt and the other five putting up their money as equitv In this casQ

the five investors w,ho put up the equity will have to bear all of the' busine$

risk, so the common stoik wiit be twice as risky as it woulcl have been had thfirm bee'n firranced only rl,ith equity. Thus, the use ofdebt, or financial levera8Q

concentrates the firm's business risk on its stockholders. This concentration d

business risk occurs because debtholders, who receive fixeit interest PaymenBLrear none of the business risk.

To illustrate. the concentration of business risk, again consiclcr Strasburg Elec

trr:nics. Strasburg has $175,000 in assets and is all-:equity financed.5 If the firo

Business and Financial Risk 371

were using Plan A from Figure 10-2, then its expected ROE would be 12.0 percentwith a standard deviation of 8.0 percent. Now suppose the firm decides k>

change its capital structure by issuing $87,500 of debt at k.r = 10% and using thesefunds to reptace $87,500 of equity. Its expected return on equity (which w,ouldnow be only $87,500) would rise from 12 to 18 percent:

Expected EBIT (unchanged)

Irrterest (10-ea on $87,500 of debt)

Earnings before taxes

Taxes (40%)

Net income

Expected ROE:

old(Unleveraged)

Situation(See Figure 10-2)

$35,000

0

$35,000

1.1,000

s21,000

New(Leveraged)Situation

$35,000

8,750

$26,2s0

10,500

91!Zs0$21,000/$17s,000 = u% $15,750/$87j00 = 18%

Thus, the use of debt would "leverage up" the expccled ROE from 12 percent to18 percent. Note, holvever, that the expectecl return on invested capital (ROIC) is

[$35,000(0.6)]/$175,000 = 0.12 = 12"/. in both the unleveraged and leveraged cases.The total dollar return to all investors (both bondholclers and stockholders) is

Net income = $21,000 when no debt is used, but Net income + Interest = 915,750 +$8,750 = $2{,500 when $87,500 of debt is used. Thus, thc use of debt allorvs 93,500more of the $35,000 of EBIT to floli, through ro investors: $2.1,500 - $21,000 --$3,500. The leverage irnprovement results from interest tax savings-the interestexpense of $8,750 reduced taxes by T(lnterest) = 0.10($8,750) = $3,500. Tlurs, tltcuse of rlebt shields n portion of n con+lany's enrnitrys Jiom .tltt tat collcctor.

Since raising half of its capital as debt would increase the expected dollar re-tum to investors and leverage up the expected ROE to stockholders, shoulcl thefirm use this amount of, or even more, debt financing? The answer would defi-rritely be "yes" except for one problem: The use of financial leverage also in-c'reases the risk facecl by the eqrrity investors, and this higher risk will tend to oftset the benefits of debt. To illustrate, suppose EBIT actually turned out to be$5,000 rather than the expected $35,000. If ihe firm uset{ no debt, then ROE woulcldecline from 12.0 percent to 1.7 percent. However, with debt financing, ROEwould fall from 18.0 to -2.6 percent:

,ri

Zero Debt

$5,000

0

s5,000

$2,000

$3,000

1.7'.v"

12.09i,

$87,500 of Debt

$s,000

8,750

-53,7501,500

-q1 )<(l

{-/.\,18.0'7"

,i. :1..'ii +, ',.,i.'.t".i*n

:.{.1 :11

''.:1^1!v.

'; rJ'lir,

.!:i

Aciual EBIT

Interest (10'/d

Earnings bcfore taxes

Taxes (,10'X)

Net incomc

Actual ROE

Expectcd ROE

tA firrl in busintss for at l(arst tr{ vc;rrs rlorrlti Iiktlv hl'e fnr more lhin 5175,iU0 in nriL'ts l\k'purposelv ktcping Strrsbtrrg El.'ctrenics snrall so th.rt rtt'mav focus trn tlrr'conc.,pt. $ith{ul-ttftovcrnhelmtcl bv the numtcrs. Also note thnt, to be consistcnt rsith cnpitiL 51s11r111rg thru)'lshou[i b., rvorking rsith n].rrLot \2lucs oi s('crtrities ratht,r thrrr [,t ok r rltir,s tri rsrtts. lVe id S

book rtlucs nt this point to simplifv the illustrnti()n, but tre rtill tliscuss m.rrkr't rtlue relrtionshipslater in the chipter lr this re8ard, scc Haim Lely and Robert Brooks, "Fin.rnci.rl Brc.rk-Even An.rly-sis and thc V.rlue of thc Firn," Fitrucial |ulLilrrt.rrrrrf, A(tun1n l9St, 2?-16.

372 Chapter 10 CAPITAL STRUCTURE DECISIONS: I'ART I

A more complete analysis of the effects of leverage on Strasburg's f,gg,.,lustrated in Figure 10-4. The two lines in the top graph show the ROE that wiJexist at different levels of EBIT under the two different capital structurcs.dgreater the use of financial leverage, the more scnsitive ROE is to.t*goiEBIT.

The lower panel of Figure 10-4 shows the effects of lcverage on the fir6'5 g1probability distribution. With zero debt, expected ROE is 12 Percent, and ithairelatively tight distribution. With 50 percent debt, the expected ROE rixs Uipercent, but the ROE distribution is flatter, indicating a more risky situatiotiiact, the standard deviation of ROE is 8.0 percent at zero debt, but exactly h{as high, 16.0 percent, at 50 percent debt.

Our conclusions from this analysis are as follows:

1. The use of debt increases a firm's expected ROE, provided the expected pturn on invested capiial exceeds the after-tax interest rate.

2. The standard deviation of ROE if the firm Lrses zero financial levenp6R6s1g1, is a measure of the firm's business risk, and ooor at any debtlagis a measure of the stand-alone risk borne by stockholders. 6R66 = opqqLlt

the firm does not use any financial leverage, but if the firm does useddlthen onor > oRoE(u), because business risk is being concentrated on fustockholders.

3. The difference between oR6s and os6slr-1y iS a measure of the risk-increast

effects of financial leverage:

In our exampie,

Stand-alone risk = onoe.

Business risk = op11s1gy.

Financial risk = oR66 - oneslrry.

Financial risk = 16.0% - 8.0% = 8.0%.

1..

'i.:tl3r

.1. Operating leverage and financial leverage normally work in the same ttzp

thev both increas! expected ROE, but ttey atso increase the riskbomet!

,tolu,ota"rr.t Operating leverage affects ihe firm's business risk, fharid

leverage affects ihe firir's finaicial risk, and they both affect the 6rnl

stand-alone risk.

Qlry-r,,, uestioils

What is business risk, and how can it be measured?

What are some determinants of business risk?

\44rat is financial risk, and how can it be measured?

What is operating leverage? \A/hat are the similarities between oPeratingle€

age and financial leverage?

6Note that for operatinS leverage to benefit shareholders, the firm must be oPeratinB ^.':r:X,|rhnrre thp hrp:kovpn noint- and for financial leverase to be of benefit, the after-Lr\ cost oI sr-'-above the breakeven Point,

ects and make related financing decisions, they expict the firm tobe oPerating above

Business and Financial Risk 37-r

BOEf,,")

60

55

50

45

40

35

30

20

'15

'10

5

ROE with Zero Debl

20 40 60 80 100 EBIT(S)

l0 15 20 25 30 35 40 ROE (e")

point, and they also exPect RO1C to exceed the after-tax cost of debt

37{ Chapter 10 CAPITAL STRUCTUnE DECI-cIONS: Pi\RT I

CAPITAL STRUCTURE THEORY

Capital Struchrre Theory 375

If stock is held until the owner dies, no capital gains tax whatever must be pairl.So, on bi'rlance, common stock returns are taxed at significantly lower effectiverates thnn debt returns.

Be'cause of the tax situation, investors are willing to accept relatively lorv be-fore-tax returns on stock vis-ir-vis the before-tax returns on bonds. For example,an investor might require a return of 10 perce'nt on Firm B's br:nds. and if stockincome rvere taxed at the same rate as bond income, the required rate of returnon Firm B's stock might be 15 percent because of thc stock's greater risk. How-ever, in vierv of the favorable tax treatment of retrrrns on the stock, investorsmight be willing to accept a before-tax return of only 14 percent on the stock.

Thus, as lv{iller pointed out, (1) the dedrrctibility oJ intaresf far.ors the use of delrtfinarrcing, but (2) the/nz,orable tnx trmtnrcnt of irtcotre front slocks lowers the re-quired rate of return on stock and thus favors the use of eqr.rity financing. It is dif-Iicult to say what the net effect of the'se two factors is. N,lost observers believe thatinterest deductibility has the stronger effect, hence that oiriiai system still favorsthe corporate use of debt. Howevet that effect is reduced by the lon'er capitalgains tax rate-

One can observe changes in corporate financing patterns following majorchanges in tax rates, For example, since 1992 the top personal tax rate on interestand dividenels was raised sharply, but the capital gains tax rate was lowcrecl.This resulted in an increased use of equity financing.

The Effect of Bankruptcy Costs

MM's results also depend on the assumption that there are no bankrup_tcy costs.However, bankruptcy can be quite costly. Firms in bankruptcy have very high le-gal and accounting expenses, and they also have a hard time retaining customers,suppliers, and employees. Moreover, bankruptcy often forces a firm to liquiclateand to sell assets for less than they would be rvorth if the firm were to continueoperating. Assets such as plant and equipment are often illiquid because they areconfigurt'd to a company's individual needs, and also because they are difficulito disassemble and move.

Note too that the threat ofbankruptcV, ^ot

just bankrupicy per se, brings aboutproblems. Key employees jump ship, suppliers refuse to grant credit, customersseek more stable suppliers, and lenders demand higher interest rates or evenrefrrse to extend credit.

Bankruptcy-related problems are rnost likely to arise rvhen a firm l'ras a lot ofdebt in its capital structure. Therefore, potential bankruptcy costs cliscourage'firms from pushing their use of debt to excessive levels.

Bankruptcy-related costs depend on three things: (1) the prob.rbility of bank-ruptcy, (2) the costs the firm will incur if financial distress arises, and (3) the ad-verse effects that the potential for bankruptcy has on current operations. Firmswhose earnings are more uncertain, all else equal, face a greater chance of bank-ruptcy and, therefore, should use less debt than nrore stable firms. This is consis-tent with our earlier point that firms with a high degree of operating leverage,ancl thus greater business risk, should limit their use of financial let,erage. Lik*wise, firms w,hicli would face high costs in the event of financial distress shoulclrely less heavily orr debt. For example, firms whosc' assets are illitltrict anrl thirswotrld have to be sold at "fire sale" prices should limit their use of debt financ-ing. Finally, firms such as airlines, whose current sales are affectetl by anvthingthat worries potential customers, shoult-l lin'rit their use of debt.

In thc prcvious sectiou, we t-lemonstratecl that the use of financi,rl le!'erage ryDi.

callv iucreases stockholtlers' expected returns, but, at tht' samt' time, it increaq,

their risk. The question managers face, then, is this: Is the lncre.rse in exPected,*

turn su[[icicnt to colrlPens.rte stockholders for the increase in risk? To help 41srver this question, it is useful to exantine capital structttre theory. Although tla.

orv docs not provide all of the answers, it does provide insights into the effe66

oi rit'bt ve'rsus equity financing. Thus, an understanding of capital structure thF

orv rvill aid managers in establishing their firms'optimal capital structures.T16,

section provides the basics of capital structure theory, while Ch.rpter 1t contains

a more. clctailecl cliscttssion.Moclcrn capital strr,rcture theory began in 1958, when Professors Franco

Morligliirrri ancl Merton Miiler (hereafter NIM) publishet-l what has be'en called ttp'mostlirfluential finance article ever written.T MM proved, but under a veryrs

strictive set of assumptions, that a firm's value is urraffected by its capital s6uc--tuie.

Thtrs, Iv'{NI's results sugSest that ii c'loes not matter how a firm financesib

operations, because, at least under thcir assumptions, capital strtlcture is i(elevint. One of the assttmptions needc'cl by MM to derive their results was theab

scnce of taxes, both corPorate and personal' With zero taxes, the increase inthe

rL.turn to stockholde'rs resulting from the use of leverage is exactly offset by the

incre.rst, in risk. Thus, at any level of dc.bt, the return to stockholders is iust com-

mensurate rvith the risk assumctl, hence there is no net benefit to using financial

leverage.Dc'qrite the unrealistic assttnrptions, MM's irrelevance result is extremely im'

portaui. By inclicating the conditions under which capital structure is irrelevanl

MM ulrn provider'l us lvith some clttes about what is required for capital skuc'

ture to be reler.ant and l-rence to affect a firm's value.

The Effect of Taxes

MM published a folltrrv-up^paper in which they relaxed the assumPtion tlut

tht-reire no corporate iaxes.E The tax code allows corporations to deduct intercl

payments as an exPense. Holvever, dividend Payments to stockholders are nd

iehuctitrle. This difle'rential treatment results in a net benefit to financial leveng3

and thus encourages corporations to trse c1ebt. Incleed. MM clemonstrated thatil

all thr:ir other assirnrptions holtl, this clifferential trcatment leacls to a situation

which calls for 100 porcent debt financing.Sevt'r.rl years Iati'r, Merton Mille-r (thiJtime withottt Mocligliani) extended lh

'anall,sis to incltrcL'personal taxes.e Ht'noted that all of the inconre from bondj

, generallv conlcs as Lrtcrest, rvl'rich is taxecl as personal incontc at ratcs goingrf

in:9.0 lr.-.ce.,t, rvhilc incon-re from stocks geneially comes partly fronr.dividends

' an.1 ;rritlv from capital girins. Fttrther, capital gains are tarcd at a nraxinrttmlilEI of 20 Pcrcent, irntl this tax is rleferrr'c1 until theitock is sok"l and tlrc. gain realizal

;Frn.co l\lo.ligliini ,rrrel i\lertr,. H. NIille' "Thc Cost of CaFital, Corprrrrtit,n Finarrco, an.l th.'Th{!o[ lnrcstnrr,nt,', rlrrnricrrrr [corronric Rrri,,ii,, June 195E. Mociiglilni.rir] Nlrller b(,th \\1)n Nilrelf'rir6for th('ir h ork.

'F-rnnc(i i\lo.liFlinni nn(l Nl('rtL)rr H. i\lilltr "Corpe1119 lncomc T,rres and thc Cost ot Crpitrl: ACfi'

rcation," ,,lxr,r'r.r,l I cortllic lirlt a' 53, Jun!' 191)f,, 'l-13-t13.

"\lerton I l. \lillc., "l).t.t ,rr1!l -[.r\cs,"

/rrrrrrr/ trfFirarrn'31, i\'li! lq7, ]{'l-175.

$l

li

;l

iir.,"r,

1*;,rit,iiiili,.

'.1;

il,,i;.,

375 Chapter 10 CAPITAL STRUCTURE DECISIONS: PART I I

MM Besult lncorporating theEttects of Corporate Taxation:Price ol the Stock if ThereWere No BankruPtcY-BelatedCosts

BankruPtcY-Related Costs'which Reduce Value

* Actual Price of Stock

Valuo of the Stockwith Zero Debt = $20 \ u"'r" ol stock if

the Firm Used NoFinancial Leverage

0DrI

02

ILeverage, D/A

Threshold Debt Level Optimal Capital Structure:wilil'"#ri;;t"v'- MLislnatTixShetterBonelits:c;;-dB-e;;;;'Miterial Mar6inal Bankruptcy-Related costs

Value Added by

A firm whose value Primarily is due to growth oPPortunities and not to asset

in place suffers from both a high cost of financial distress and irom,advslse6.

f"cl on current oPerations. Consider a software developer versus a,hotel chail

ln the event of diitress or liquidation. the hotel chain can raise funcls by se[ing

DroDertv. In contrast, the software developer cannot sell its assets, which cons:i

iii,i uriiy of its employees' intellectual capital. Toavoid defaulting on ioans, Ur

ioftware developei mlst reduce exPenses, either -by

laying off emPloyees or hcutting R&D. Sut, uoth these actions have significant negative impacts on h

"uir""of the comPany, making bankruptcy ev.en more likeiy' As

1nis,91m'ltcshows, potential financial distress is an especially serious situation tor high-t61

companies.

Trade-Off Theory

Reqe3rctl fgr-$91y!g thq \aM p-1p91q -!a1led.t"- l. Jli9-::efl jlgory -o-!!9-v*egge,'lin*rucn fl.r"l tr;de*off tile banefits of debt fi"l"s,sg (favorable corPorate tax heat

*;.0 ;grfi* ryfher-itterest ialsc aad hankruptcy -costs' A summary of tfu

t.ua"-ofitt""ii ii "rpt"ts"d graphically in Figure 10-5' Here are some observ+

tions about the figure:

1. The fact that interest is deductible makes debt.less expensive than coft

*or, o. preferred stock. In effect, the govemment Pays P1r! of the co$ d

debt capital, or, to Put it another way, debt provides tax shelter benefits' ls

C.rpital Structure Theorr' 377

a result, using debt causes morc of the firrn's operating irrcome (EBIT) toflow through to investors, so the more debt a company uses, the higher itsvalue antl stock price. Unt-ler the MM assumptions, rvhen corporate taxesare considered, a firm's stock price will be maximized if it uses 100 percentdebt. The line labeled "MM Result Incorporating the Effects of CorporateTaxation" in Figure 10-5 expresses this relationship.

In the real world, firms rarely use 100 percent debt. One reason is becauseof the favorable personal tax treatment of income from stocks. However, theprimary reason is that firms limit their use of debt to reduce the probabilitvof financial distress (bankruptcy). A1so, the interest rate on debt becomesprohibitively high at high debt levels.

There is some threshold level of debt, labeled D1 in Figure 10-5, belorvwhich the probability of bankruptcy is so low as to be immaterial. Be-

yond D1, however, bankruptcy-related costs and rising interest rates be-come increasingly important, and they reduce the tax benefits of debt atan increasing rate. in the range from Dl to D2, bankruptcy-related costsreduce but .do not completely offset the tax benefits of debt, so the firn'sstock price rises (but at a decreasing rate) as its debt ratio increases.However, beyond D2, bankruptcy-related costs exceed the tax benefits, sofrom this point on increasing the debi ratio lo*'ers the value of the stock.Therefore, D2 g the eptim.a! eapital..slluqtlrLl.Although it is not shown in Figure 10-5, there is a relationship betrveen thefirm's stock price and its weighted averaBe cost of capital. As a firm uses

more and more debt, its weighted average cost of capital first decreases,

then reaqhes a minimum, and eventually begins to rise. Moreover, the min-iltglU"qtg-bl"! :yeI$g qo,St,Sf,Sap,1t-41--p1-curs.wlrel,e the stock.p"ride.i-s--mril

-rqr?qd-at Point D2 in Figure 10-5. Thus, the same capital structure thatmaximizq thg stogk pfce il:q f!rygriZSS t[i:_-oieiiii coii'of capi-tat

Both theoretical and empirical evidence support the preceding discussion.However, statistical problems prevent us from precisely identifving PointsD1 and D2. So, while theoretical and empirical work supports the generalshape of the curves in Figure 10-5, these curves must be taken as approxi-mations, not as precisely defined functions. It is worth noting, horver.er, thatmany theoretical models shon'that the maximum value of an optimally ler'ered firm is from 10 to 20 percent greatcr than an unlevered firrn. Thesemodels also indicate th"rt the optimal arnourlt of leverage is from 30 to 60

percent. These results contrast sharply with il-re case in which bankruptcycosts are ignored, in which the oprtimal leverage is 100 pt'rcent anci thevalue of tire levercd firrn can be more th.rn 70 percent greater thart an un-levered firm (c-lepending on corporatc tax rates and the firm's IIOIC).

A disturbing empirical contradiction to capital structure theorv as ex-pressed in Figure 10-5 is the fact that many large, successful firms such as

Intel and Microsoft use far less debt than the theory suggests. This point ledto the development of the signaling theory, t,hich is discussed next.

Signaling Theory

I One of lvlM's asstrmptions is that investors and managers har.e exactlv the same

!information about a firm's prospects-this is called symmetric information.

iHo*"r'"r, managers often have better information than outsicie investors. This is

2.

4.

)

37E Chaptcr 10 CAPITAL STRUCTURE DECISIONS: PART ICapital Structure Theory 379

This, in turn, suggests that when a mature firm announces a new stock offer-ring, the price of its stock should decline. Empirical studies have shown thatthis situation does inde.ed exist.12

What is the implication of signaling theory for capital structure decisions?The answer is ihat firms shoultl, in normal times, maintain a reserrre borrow-ing capacity which can be used in thc' er.ent that some especially good invest-ment opportunity comes along. Tltis ntt'ans thnt firns slnultl, in nornnl tinrcs, use

less tltbt llian is sriggcstt,d by the tnx Ltcnalit,hankrtryrtctl cost trade-off nodel expresseditt Figure 10-5.

Using Debt to Constrain Managers

Agency problems may arise if marragers and sha::eholders have differeni objec-tives. Such conflicis are pariicularly likely when the firm's managers have toomuch cash at their disposal. Then managers can use this cash to finance pet proi-ects or for perquisites such as nicer offices, corporate jet_s-, and tickets to sportingevents, all of which may do little to raise stock prices.'r By contrast, managerswith constraints on free cash flow, such as commitments to make interest andprincipal payments, are less able to make wasteful expenditures. This is called"bonding" the free cash flow

Firms can reduce, or bond, free cash flon, in a variety of ways. One way is toturn it over to shareholders throttgh higher clividends or stock repurchases. An-other alternative is to shift the capital structure toward more debt in the hope thathigher debt sen,ice requirements will force managers to become more disci-plined. If debt is not serviced as required, the finn u,ill be forced into bankruptcy,in which case its managers u,ould likely lose tireir jobs. Therefore, a manager isless likely to buy that expensive bui not really necessary new corporate jet if thefirm has large debt service requirements.

Leveraged buyouts (LBOs) bond free cash flow. In an LBO, debt is used to fi-nance the purchase of a company's shares, after which the firm "goes private."Many leveraged buyouts, rnhich were especially common during the late 1980s,were structured specifically to recluce corporate waste.

Of course, increasing debt to bond free cash flow has a downside: lt increasesthe risk of bankruptcy, which can be costly. One observer has argued that acldingdebt to a firm's capital structure is likr. putting a dagger pointing at the driverinto the steering wheel of your car.l+ The dagger motivates you to drive morecarefully, but you may get stabbed if someone runs into you, even if you are be-ing careful. The analogy applies to corporations in the following sense: Higherdebt forces managers to be more careful with shareholders' money, but evenr.l'ell-run firms could face bankruptcy (get stabbed) if some event beyond theircontrol occurs. To continue the analogy, the capital strucfure decision comesdown to deciding how big a dagger stockholders should employ to keep man-agers in line.

r:Pnul Asquith and D.rvitl lV. Ivtullins, Jr, "The Impact trf Initlrting Dividentl Pavmcnts on Share-holrlers' Wcalth," lournol o.f Busitttss, Januarv 1983, 77-96.r3lf ytru clon't believe corporate managers cin $'nstL. moncy, rc'aL1 Bryan Burrough, Btrltrttitns nt lhtGotu'(Nov York: Ilarper & Rorv, 1990), thc story of th!, takeover of ll]R-Nabisco.rrBcn llcrnake, "ls There Trro Nluch Corporplg Dr.bt?" Federal ll('serve B.rnk of Philarlelphi.r Basir,ssRcciL'il,, St'ptember/C)ctober'1989, 3-13.

l callecl asymmetric information, and it has an important effect on capital s6u,.

ture. To ie" *l-ry, consider trl'o situations, one in which,a company's Tonu'un

knon, that its piospt'cts are extremely good (Firm C) and one in which the r1a,

aucrs knorv th,rt the future looks bad (Firm B)'

Norv suppose Firm C's R&D l.rbs have iust discovcred n nonPatentable cut

fttr th.. conimon colcl. They $'ant to keep the new produci'r secret.as.long as Pos-

sible to delay competitori'entry into the markeLTir^.C T:t:l build plants5

make the .,ew pro.it,ct, so capitil n"lust be raised' How should Firm C's manage

ment raise the neede'cl capital? If the firm sells stock' then' when profits from61

nen' prodrct start flon'ing in, the price of the stock would rise sharply' and t[pr,rcliase.s of the new stock would make a bonanza' The current stockholderr

[i,',.iuai"g the managers) rvoult] also do well, but not as well as they would ]pv.

i,r". if ,fi" companihaii not sold stock before the price increased, because thea

thev rvoulcl not^hare hatl to share the benefits of the new product with thenert

,,olkk,ota"... Thertlorc, one rootrhl exPect a frnl toith uery faaorabk ptospec.ts.to.trytt

n,r,J t.fl1,g stock inct, rrtther, to raise any reqtrired neu caPital by ttsing debt beyanl

the norttral oytirml caltital slrttcfltrc l0

' Nou, k't's consider the bad firm, Firm B suppose its managers have inform+

tion that new orders are off sharply because a comPetitor has installed new tech

nology u'hich has improved its products' quality' Firm B must upgrade its oun

faciliies, at a high cost. iust to maintain its current sales' As a resttlt' its retumon

investment willlall (bu[ not by .rs much as if it took no action' which would lead

io a r00 percent loss through tankruptcy). How should Firm B raise the needed

capital? Here the situation is just the ieverse of .that

fa.cing Firm G' Firm B'becouv

of its trrrf,n'ornl'hj prosl't'cts, rtoldd tattnt to sell stock' tuhich uortlJ ,lr,L'an bringing innrr"

, iirrt'stois lo sltnre llle lossesJlr

Thc conclttsions here are (1) that firms with extremely good ProsPects Preferb

finance rvith clebt, whereas (2) firms with poor Prospects like to linance wur

stock. Horv shoulcl you, as an investor, react to thii conclusion? You orrght tosr

II I see that a company plans to isstte stock, this shott]d worrv me I know that man-

agement wou)rl not wani iolssue sttrck if future Pro'putrt lnJk"d gooct' btrt it would

*.61 16 i5sue stncf, if tr.in"ss lo;fi;:; Ttt;*iore,'l should louir my.estimateof

it"'fi.*'i"ot"", other thirigs held constant, if it announces a stock offering'

The negative reaction should be stronger if the stock sale t":* bl 3^t::8:;:ttlishcd iompany such as GlvI or IBM, u'hich has many financing oPtions' man u r

*"i" irf . J-"iI, unlisted comPany such as CeneSpiicer' For Genesplicer' a stod

sale might signify truly extratrdinary investmeni oPportttnities that cannoth

exnloited without r.rising new equity'"^!; ;::, ;;;;*iir,'ii """u"'" nnr*"', your views are consistent with thosed

sophisticated Portfolio *r",g"it "i 'iistitutions

such as y":ry 9::H[Trust, Fidelity-lnvestments, Prudential Insurance, and so forth' So' itt n tttiu'*

lkllx ti:,j,,';1,';";t,i-;'l,i:i'i*,:;:l,i;:':':'::,!:';;':,:',,::i:,t;;,:,:;::,ii':,,':::;";'#

"I**,a " tr*, frrr Firnr G's miniScrs to personally FultlY,*ot" slrtres on the brsisof dd

i,,.ii.'f.,".f*l*,',rfthcn,'wpn'duct ihevcrritlrlhosunttoiaiiifthel'dirl' .-,,,,S

lf il',',:"ilil::i,:ll'*lllJT,,: ':;I"':Ti'I:,*'"',i:xli'"ii;x'iiil::i:i'H';il;ll'-'"1,1':i1""'

,/

380 ChaPter 10 CAPITAL STRUCTURE DECISIONS: PART I Setting thc Targct Capital Structurr lthen Cash Florvs Arc Perpetuities 3SI

If you find our discussion of caPital-structure theory i'"pt:ti:: and somqwh{

u1rruiirfuing, you are not alone. In truth, no one knows how to identify ptec15.5.

a firm,s opt"imal capital structlrre, or how to fireasttre exact]v thc.ettt'cts of capi(1

structure on stock prices and the cost of capital. In practice', capitrl_structu1.6*

cisions must be mide by combining iudgment and nunreric.rl ari.-rlysis. 51111,"

understancling of the theoretical issues presented here carl help you makebqlkr

iudgments oricapital structure issttes.ls

iirl/rir lri' .ilrr't l rl\ r)l i )(1 d/Iltr' -l 1, I :l:).!

Current assets $ 500,000 Debt $ 0

Net fixecl assets 500,000 Comrnon erluity (1.0 million shares outstancling) 1,000,000

Total assets q!!00!00 TLrt.rl claims $1,000,000

.l//.orird ShrfL'rk)rf .li)r 1998

Sales

Fixed operaling costs

VarLrb)c opcrating cosLs

Earnings before intorest an(l taxcs ([l]lT)lnterest

Taxablc income

$ 4,000,000

12,000,000

520,000,000

16,000.000

$ 4,000,000

$ 4,000,000

1,600,000

$ 2,100,000

SETTING TI{EWTIEN CASH

TAITCET CAPITAL STRUCTUREFLOIVS ARE PERPETUITIES

Capital structure theory suggests that each. firm has an oprtimal capital struc

ture, one that maximiies iis-va1ue and minimizes its o'erall cost of caPitil

However, research on capital structure theory also points out that. there.an

rnany contradictory issues regarding capital structure decisions' and that the

o.f lu.,r.,o, be .,sei to specif/ u pr"-.ir"iy optimal structure for a firm. In thb

section, we illustrate how a iirm'with pbrpetual cash florvs might_actually set

its target caPital structure. The exampie will reinforce many of the concepb

discusfed in previous sections, as well as help you understant.l htY i'll!i.]deal with reai-world capital structurc dccisions As you will sce' actual caPltx

structure decisions u.e based on iuclgrnent, but juclgment supported by quanb

tative analysis plus an o*ur".,u* oithe theoreiicul irr,r", uu" h..r. discussed'

Hill Software SYstems

Hill Sofware Systems (HSS) rvas fourrded in 1980 to develop and market a-ncf,

tyf "

of g.optti.r roft*u." for personal to,*Pyj::t' The basic.progr"L:".':,].'"lt[#a putI"t"a by Mark Hill, HSS's fottndcr' Hill owns 'r n\i]i(\ritv of tlre sto(r'a

though a significant portion is held by institutio.al inr,estors. ilte .ompany ttr

no debt, and HSS,s key firrancia.I data are slrolvrr irr Table 10-1. Assets are carnol

at a book value of $1 million, so the common "q"lil' "fttl hu'' n bolnntt ths{

FOne of tl-.* authors (an rcPort frr'thand the u*fulness r'I finanli".l']l:,:lli.:l','l:.:::l)':l'iflil:';.'S

ijffi'"x:xl:ll'i:'::;lJi:i"iJi::ii,n]:,ltTiii;;til,:;'"iil:lli'lil,l:,iil,'JJl,lx;5c)n the bJsrs ot un"^* ,i,"olv ""i in,,iput", m,.iclr rrhi.h sinrrrhtr,J r,'..rrllr rrrrJer,t rrnf,t'ol.rrlt

rions, rhe (ompanr", *";;;;1";;;ciiv "optimrt cif it,,l srrr.rrrr,,rrrrtcr" rr itlr.rt l,,r-t r r"rllni,t

deeree of confiden.e Witllout financc thcorv' setting 'r t'rrget cil'it ll 5trtr(lrlr(' rr ilttl'l lrrt r rfl(

io iittle more than thro\l ing dJrlq'

;tii:' 'll:i!-.:i .r

li.,l:$,rr.i,i;lia; :i

, fi I' ri:::. :

,,' ,:i r,: ;' :"i:,)i. r1r,11i:

,,

,'.fI: ,;.I rii:ll : r:.

'r3l' ;'f.rjli..r-

Itl'i'l,,il.::,,

tili'.::i';":i::,

:r idi,i:l iit,','rli ,

*ij.i1iii' i!;)Ir',,.ljlir:rrl

t:r,ri.,' lii::.i !'l;,ji:r

I rilrll

")..,,,

Taxes (.10'11, fecler.rl-pltrs-state)

Net income

Oth,t'L)rtlrt

1. Earnings per share = EPS = $2,100,000/1,000,000 shares = $2.40.

2. Diviclenclspersh.lre=DPS=$2,.101.),000/1,000,000sh.rres=$2.,l0.Thus,thecornpanyhas a 100 percent payout ratio.

3. Book value per share = $1,000,000/1,000,000 sh.rres = 51.

.1. MarketpricePershare=P0=S20.Thus,thestocksellsat20timesitsbookvalue.

5. Price/earnings ratio = P/E = $20/2..10 - 8.33 times.

6. Dividend yield = DPS/P0= $2..10 /570 = 12%.

value of $1 million. How.evel these balance sheet figures are not very meaning-ful because (1) the asset figurcs do not reflect the value of patents ancl (2) thefixr:d asscts rverc purchased somc yeilrs ago at priccs lower thau today's.

Ivlark Hill pl;rns to retire shortly, and he wants to sell a major part of hisstock to the pr-rblic, using the proceeds to diversify his personal portfolio. As a

p.rrt of the plarrning process, the question of capital structure has arisen.Should the firm continue its policv of using no debt, or should it recapitaiize?And if it does decicie to substitllte some debt for equity, how far shouid it go?As irr all such decisions, the correct answer is that it shorrld clrcose tlrat capitLrl

str.rctLLre titich rnatitni;es tlrc xalte of the stock. If the stock price is maximized,then the cost of capital rvill simultaneouslv be minimized.

To simplifv the analysis, we asslurle that the lon;;-run demand for I{SS's proti-r-rcts is not exptcted to grolv, so lls EBIT is c.rpcclcrT to cotttir:.lt e nt $.1 ntillfun irdeft-rrltclrl. (l-lolvever, futurc s;rlos m.ry trlrn out to t-e cliffercnt frorn the expectecl

levcl, so rellizeri E13IT m.iy bc tnore or less than thc expccted $.1 nrilliorr.) Aiso,since the cor.npanv h.rs no nccr'l ior ncn' capitai, rrll ()/ils lr.o,rd rt,ill lre prrirl orrl as

Ll ii,iLlnlL{s.

)

TABLE 10.1

d,rrou Qttcstiotrs

In what sense did MM's original theorv produce an "irrelevance of capi61

structure result"?

How do corporate and personal taxes affect firms' capital strllcture decisionsl

Explain horv "asymmetric information" and "signa1s" affect capital struchxl

decisions.

whatismeantby reserueborrowittgcopncity, and"n,hyisitimPortanttofirms)

How can the use of debt serve to discipline managers?

382 ch;rpter 10 CAPITT\L sTllucTURE DIlClsloNS: PART ISttting thc Target Capital Structurc lVhcn C.rsh Florvs Are Perpetuities 383

Given the data in Table 10-1, along with those in Figure 10-6, we can determineHSS's total market value, V, at different capital structures, and we can then usethis information to establish the company's stock price as a function of its capitalstructure. These equations are used in ihe analysis:'6

(10-1)

(10-2)

(10-3 )

(10-4)

We first substitute values for k.1, D, and k, into Equation 10-2 to obtain values forS, the market value of common equity, at each level of debt, D, and we then sumS and D to find the total value of the firm. Table 10-2 and Fi1;ure 10-Z whichplots selected data from the, table, were developed by this process. The valuesshown in Columns 1,2, anC,3 of Table 10-2 were taken from Flgure 10-6, whilethose in Column 4 were obtained bv solvinl Equation 10-2 at different debt lev-els. The values given in Column 5 nere obtained by summing Columns 1 and 4,D+S=V.

To see how the stock prices shown in Column 6 of Table 10-2 were developed,visualize this series of events:

1. Initially, HSS has no debt. The firm's value is $20 million, or 920 for eachof its 1 million shares. (See the top line of Table 10-2.)

2.

.1.

Management announces a decision to change the capital strr.rcture; legally,the firm rnttsl make an explicit announcement or run the risk of havingstockholders sue the directors. Any debt issued will be used to buy backstock. Because HSS is not growing, it does not require additionai capital.

The values shown in Columns 1 through 5 of Tablel0-2 are estimated as

described previously. The maior institutional investors, and the largebrokerage companies which advise individual investors, have analystsjust as capable of making these estimates as the firm's management.These analysts would sttrrt making their own estimates as soon as HSSannounced the planned change in leverage, and ihey would presumablyreach conclusions similar to those of the HSS analysts.

4. FISS's stockholders initially orvn the entire company. (There are not yetany bonclholders.) They see, or are told by their advisor-analysts, that veryshortly the value of the enterprise' will rise from $20 million to somehigher amount, presumably the maximum attainable, r.vhiclr is

$21,727,000. Thus, they anticipate that the value of the firm will increaseby $1,727,000.

5. This additional $1,727,000 u,ill accrr.re to the firm's current stockholders.Since there are 1 million shares of stock, each share will rise in value by$1.73, or from $20 to $21.73.

16Note that Eq(ations 1(]-1 throu8h l0-{ do not stem from a particuLrr c.rpital structure'theorv-thevdo not require acceptance of lvlN'l or anl'other theoq'. Rnther, thcv are de'finitions and basic DCF val-untir)n equntions for pcrpetual cash flow's.

Firmvaltrc:V=D+S.Dividend Net incomerourrvvalrro:5=-

k. k.

stuck nrice: P, = Dlg

= !E.

K\\

Now assume that HSS',s treasurer consults with the firm's investment bankeq

ancl learns that debt can be sold, but the more debt used'.the riskier-the debt 64oi.nrrc", the higher its interest rate, k.1. Also, the bankers sllt: lhll the moe

.f"ii HSS'rt"t, tlie greater the riskiness of its stock' hencethe higher,its,requiag

rate of .et.,r,"t on eq;iiy, ks. Estimates of k6, beta' and k' at different ctebt levels an

fiu"^ i., Figure 10-6, ilong with a graph of the relationshiP between ks and dU

level.

(EBIT-kdp)(1 -T)k,

Cost of capital: WACC = (D/V)(kJ(1 - T) + (S/VXk.)

k"r= 12

k*r= 6

Premium forFinancial Risk;lncreases as Useof Debt lncreases

Premium forBusiness Bisk;Varies amongFirms. 6% lor HSS.

Risk-Free lnlerest Rate;

Equal to a Real Rate Plus

lnflation Premium

AnrountBorrorved'

(1)

$02,000,000

.1,000,000

6,000,000

8,000,000

10,000,000

12,000,000

1-1,000,000

lnterest Rateon All Debt,

kr(2)

8.0"1,

8.3

9.0

10.0

12.0

15.0

18.0

Estimated BetaCoefficientof Stock, bb

(3)

1.50

1.55

t.bJ

1.80

2.00

2.30

2.71)

a r(

RequiredRate of Return

on Stock, ki(4)

1?'.0'/.

1) )

72.6

I )./

1{.0

15.2

16.8

19.0

:!tTl;l:!:'i-i .

:+t,

"tlSS is unrt lc to h(rrro$' nrcrt' than $l{ nrillion lrec'rusc o[ limitations on borrorving in its corF

ch'lrtt'r ---r -.- .r., ,.,-r ^,.-.,,",..,^,r lr Hrnrnrl.r's t'ouation. Thc bctrs Fl

iN..tc th,,t th('t'rt.r.,\'ffi(idlt L'itim'rh': d() nL)t corr('sPon'l hl Hin1il

hr'rL. .lrr, subicctivt't'stitn.1t('s furnishcLl bv invcstncrlt lrrtrktrs See Chapter's S nn(] 1l f()r morP

ctrssionof Ii'rma'l'r'se'1uatiorr lL-.=1r)'r" Ther.f.re.atzr'rodebt,k.=6'i"+(t0'"-6"i')15'|lr.\\,e.rssunrt, hcrt'thlt knr, = 6"..rnd krr = 10'r,,. Thercforc. at zt'ro debt,

Othcr valttes oI k,.rre calcrrLtted simihrll''

384 Chapter 10 CAPITAL STRUCTURE DECISIONS: PART I

TABLE 10.2-=..-

Setting the Target Capital Structurc When Cash Florvs Are perpetuities 38S

Value ofDebt, D

(in Millions)(1)

$ 0.0

2.0

4.0

5.0

8.0

10.0

12.0

14.0

NOIFS:

Value ofValue of Firm, VStock, S (in Millions) Stock

(in Millions) (1) + (4) = Price, Po

(4) (s) (6)

Cost ol Capitat("/.)

kd k.(2) (3) ?f ,'t.. Cost o, Equity, ks

Weighted AveraqeCos[ ol Capiial, WACC

Alter.Tax Cost ofDebt, k"(1 - T)

60 Oebwatue Ftario (%)

12.0% $20.000

8.0% 12.2 18.885

8.3 1.2.6 17.467

$20.000 $20.00 0.0olo Uot20.885 20.89 9.6 ll521.467 21.47 18.6 U227.727 21.73 27.6 ll,27.774 27.77 36.8 ll.l2r.053 21.05 47.5 tt.{

19.857 19.86 60.4 t2.r

17.158 17.'16 81.6 12J

13.2

12.0

1 t.0

9.0 73.2

10.0 14.0

72.0 15.2

15.0 16.8

18.0 19.0

75.727

'13.714

11.053

7.857

3.158

a. The data in Colums I through3 were taken from FiBure 10{.b. The values for S in Colum 4 were found by u* of Equation 10-2.

For example, at D = $0,

- Netincome (EBIT-kdDxl -T)kk

S - ($4.0+(0.6) - # = $zo.o ^lrio.,

o20Slock Price

($)

27.6

27.6 40

andatD=$6.0,

r = @i-gf@

= E@ = $rs.zz *iuio..

c. ThevaluesforVinColum5wereobtainedasthesumofD+S.Forexample,atD=$6.0,V=!6!'975.727 = $21.7U millioi.

d. The stock prices shown in Colum 6 are equal to the value of the firm as shown in Colum50vided by the original number of shares outitanding, which, in this case, is 1 million: The logttrhind this procedure is explained in the text.

e- Column 7 is found by dividing Colum 1 by Colum 5. For example, at D = $6.0, D/Yl$6.O / $21.727 = 27.6"/,.

f. Column 8 is found by use of Equation 10-4. For example, at D = $6.0,

WACC = (D/vxkd)(l - r) + (S/v)(ks)

= (0.276)(eW(0.6) + (o.7241(r3.2h) = rr.0"/".

g. At $14.0 miltion of debt EBIT declines from $4 million to $3.52 million due to costs of pototidfnancial distrss.

h. The row in botdface indicates the optimal amount of debt.

21.73

20.00

6. This price increase wiU occur before the transaction is completed' To!why,iuppose the stock price remained at $20 after the annbuncemdilsthe'recapitalization plan. Shrervd investors would immediately recoBII'

that the stock's price will soon Bo up to $21.73, and they wouid Pla(gfders to brry at any price below $it.zd. rnis trying pressure rvould quilt!

run the price up i; $21.73, at which point it wouid remain constant Trg21.ru i; the eqitilibritun stock prica foi USS once the decision to recapitro'

is announced.

The firm sells g6 million of bonds at an interest rate of 9 percL.nt. Thisryi:y, t used to buy stock at the market price, rvhich is now S21.73, soz/o,tlb shares are repurchased:

Shares repurch.r5q,l = $6pq0'9qg

=276,tt6.

60 Oebwalue Ralio (%)

386 Chaptcr 10 C.APII;\L STRUCTURE DECISIONS: PI\RT I

B. The value of the equity aiter the 276,116 shares have been repurchase,l I$15,727,000, as shown in Column 4 of Table 10-2. There are 1,0OO,dl276,116 = 723,88-l slrares still outstanciing, so the value per share of the Imaining stock is

Value pe'r rno.. = $ffiP = $21.73.

This confirms our earlier calculation of the equilibrium stock price.

9. The same process was used to find stock prices at other capital strucfux.these prices are given in Column 6 of Table 10-2 and plotted in the lorrigr;rph of Figure 10-7. Since t]rc nnxinrum pricc occurs ufun LISS uscs gd rnrtliott of daLtt, its olttinnl cdpital stnLcture cnlls for $6 rrrillion o/ de&f. \s1g also

that $6 million of debt corresponds to a firm value of $21.727 milliqrThrrs, the optimal market value debt ratio, D/V*, is $6/$21.727 =Zl,tr".

10 In this cxample, we assumed that EBiT woulcl decline from $4 millionb$3.52 million if the firm's debt rose to $14 million. The re.ason forthed+cline is that, at tlris very high level of debt, managers ancl employerrvould bt' rvorrietl .rbout the firm's failing and about losing their iobs; sup

pliers rvould not sell to the firm on normal credit terms; orders wouldIlost because of custonrers' fears that the company nright go bankrupt anl

thus be unablt' to deliver; ancl so on. EBIT is independent of financirl

leverage at "reasonable" debt levels, but at extreme clegrees of leveragg

EBIT is adversely affectetl.

Quitc'obviously, the situation in the real world is much more complex,anlless cxact, than this example suggests. Most important, different investcs

u,ill have different estimates for EBIT and k., hence they will form diffensrl

e\pectations about the equilibrir-rm stock price. This means that HSS migh

har,e to pay more than $21.73 to repurchase its shares, or perhaps that0rshares could be bought at a lower price. These changes would cause theop

timal amount of debt to be somewhat higher or lower than $6 million. Stin

$(r million represents our best estimate of the optimal debt level, so it is tklevel we, should rrse as our target capital structure.

12. The WACC for the variotts levels of debt is shown in Column 8 of TabI

10-2. The nrinimum cost of capital, 11.0 percent, corresponL-ls to the leveld

rlcbt at which the value of the firm arrcl its stock price ar.. m.rximized,$6!million.

The stock price and cost of capital relationships developecl in Tablc 10-2.,tr

graphed in Figure 10-7. F1ere we see that HSS's stock price is maximized, and6

iveighted or'"ing" cost of capital is minimizecl, at the optimal D/Y ratio,ttpcrcent.

The Effect of Financial Leverage on EPS

Thr.rs far w,e have focuserl on the inrpact of leverage on a firm's total valuerJstock price. Before Ieaving the HSS itlustration, rve shor.rld .rlso t.rke a lookl

horv ler,c'rage affects eamings per share (EPS); ttris is done in T.rble 10-3' hdlof the table gir.,es operatinu income cl.rta. It begins by recoguizing th.rt HsbsI'trrre EBIT is not knorvn u,ith certaintl,. Exprg6tecl EdlT is i+ nrilii,.,.,, but tirea

alized EIIIT cor.rltl be [ess than or griater than $-l nriilion. Ttr sirll,lifv rnitF

11

TABLE 10.3

Setting the Target Capital Structure Whe,n Cash Flows Are perpetuities 3g7

$,(ir',:l

il,l.lr .

l. Opcrntiug ltcotrrt (EBIT)

Probability of inclicated sales

Sales

Fixecl operating costs

Variable costs (60% of sales)

Total costs (excc,pt inte,re,st)

Earnings before interest and taxes (EBIT)II. Ztro Dabt

Less interest

E.rrnings before taxes

Less taxes (40'l,)

Nct income

Eamings per share on I miilion shares (EpS)Expected EPS

Standard deviation of EpS"

Coefficient of variation of EpS,'

III.510 Million ttf DiltLess intercst (0.12 x 910,000,000)

Earnings before taxes

Less taxes (iI0,1,.)b

Net income

Earnings per sltrr.e rn 52-1,9{0 shares (EpS).Expected EPS

Standard deviation of EpS.,

Coefficient oI variation of EpS"

0.2

$r 0.00

4.00

6.00

$10.00

$0.00

0.00

$ 0.00

0.00

$ 0.00

$ 0.0i)

1.70

($1.20)

(0.48)

190.72)( $,1.37)

0.6

$20.00

4.00

12.00

$16.00

$ {.00

__qaI 4.00

1.60

$ 2.10

s 2.{0

$ 2.{0

$ i.s2

0.63

1.20

$ 2.80

1.'t?

s 1.68

$ 3.20

$ 3.20

$ 2.90

0.91

0.2

$30.00

4.00

18.00

$22.00

$ 8.00

0.00

$ 8.00

3.20

$ -1.80

$ 4.80

7.20

$ 6.80

2.72

5 4.06

i /.//

J;$:#:l'l;'culating the standattl de'i.rtion antl rht'coefficient of variation are ctiscussttr in

bAssume tax crerlit on losses. If cr

higher, at high debt levels. redits rvt're not dlail'lblc' exPected EPS would be Iorvet and risk

'Shares outstanding is determinecl as follows:

Shares = Originai s,.r.", - -!!!!- = 1.666.696 - __pgq!_whcre rhe sto.k price is tdkcn rrom rabre ,(1lj:Til'."" ,r,,n $n ^ii[ll,'liio,. . = r,,.0.. ou.,,tlrr rec.rpitrliz,rtion, 5f{,qlU shores,"itt ,,,m.,in o,,r-*t,,n,j;;g,

"'"" "

shares = 1,000,000 - _$lgl49[ = s:+ s.,u

EI'5 litrrr,,s c.tn rls,r b!, c.llculitecl using IIlis ,nrnr,,,.r1t' O'

Eps=_1lu_ll:k,lltttllror ex.rnrpre, nt D = sr0 nriili()n,

( )rigirr'rl *hrrt's - I )r't'1 z 1"t' "

Er)s ls-l.0tx),000 - (0.11)(5t0.000.000)l{0.h} 51.h80.0t)r)

l.()00,(rr){l- 5lu,'rilO,pgrt7tli.ti -- -i=t.9tr) =51.:0

388 Chapter 10 CAPITAL STRUCTURE DECISIONS: PART I

we have assumed a discrete distribution of sales, so EBIT has only three poiii.

ble outcomes. Notice also that EBIT is assumed not to depend on fiqn6i4

Ieverage.lTPari II of Table 10-3 shows the situation that wottld exist if HSS contrnues h

use no debt. Net income after taxes is divided by the 1 million shares outst66.

ing to calculate EPS. If sales were as low as $10 million, EPS woull be zero, h{EPS would rise to $4.80 at sales of $30 million. Next, the EPS at each sales level6

multiplied by the probability oi that sales level to obtain the expected EPS, whidr

is $2.40 if HSS uses no debt. We also calculate the standard deviation of EI5 ard

its coefficient of variation to get an idea of the firm's stand-alone risk at a 46debt ratio: oeps = $1.52, and CVr* = 9.63'

Part III of Table 10-3 shows the financial results that would occur if the coor

pany decided to use $10 million of debt. The interest rate on_ the debt, 12_Percgrl

is taken from Figure 10-6. With $10 million of 12 percent debt outstanding 01

company's interest expense is $1'2 million per year. This is a fixed cost, anditb

deductei from EBIT as calculated in Part I. Next, taxes are taken out, and rtwork on down to the EPS figures that would result at each sales level. With $10

million of debt, EPS would be -$1.37 if sales were as low as $10 million; it would

rise to $3.20 if sales were $20 million; and it rvould soar to $7.77 if sales wereas

high as $30 million. The expected EPS is $3.20, osp5 = $2.90, and CV.* = 9.91.-Continuous approximations of the EPS distributions under the two financial

structures are graphed in Figure 10-8. Although expected EPS is much higheril

the firm uses financial leverage, the graph makes it clear that the risk oflow.u

even negative, EPS is also higher if debt is used. Figure 10-8 thus shows thatur

ing leverage involves a risk/return trade-off-higher leverage increases q'

p"ited "u..,i.,gs

per share, but it also increases the firm's risk. It is this increar

ing risk that causes k. and k6 to increase at higher amounts of financirl

ie'Jerage.rsThJrelationship between expected EPS and financial leverage is plotted in IL

top section of Figure 10-9. Here we see that expected EPS first rises as the use0l

debt increases--interest charges rise, but the decreasing number of shares ot*

standing as debt is substituted for equity still causes EPS to increase. Howe[e(

EPS peJks when $12 million of debt is used. Beyond this amount, interest rats

rise iapidly, and EBIT begins to fall, so EPS is depressed in spite 9f tn9 ff,li{number of shares outstanding. Risk as measured by the coefficient of variahonc

EPS shown in the fourth colu"mn of the data in Figure 10-9 rises continuously'ud

at an increasing rate, as debt is substituted for equity.Does the same amount of debt maximize both price and EPS? The answerr

rro. As we can see from the lower graph in Figure 10-9, HSS's stock Price isfi'rimized with $6 miliion of debi, while the upper graph shows that exPected uJ

is maximized by using $12 million of debt. Since flanagenlent is primarily intet*'

in nraxin.rizing tfie ualtt-e of tlre stock, the optimat capital structure calls Ior tlrc usc 0l tnillion of debt.

;.-o*= oo*o *rlier, capital structure does affect EBIT at very high d.ebt le':,t.t:l:t*Pfiassumed that HSS's EBIT w6uld fall from $4 million to $3.52 million if the level of debt rc:;tmillion. However, det t in Table 1O-3 is limired to $10 million, so the "e\cessive leverrge r"'-

EBtT" is not Present in this particular example.rsNote that financial leverage has a similar effect on the risk of EPS as it dms on that of ROE F

Figure 10-8 is similar in appearance to the lower Part of FiSure 10-'l-

Setting the thrget Capitrl Structurt, \Vhen Cash Florvs Arr pcrpctuitics 3g9

Tl'rircl, our example' was restrictcd to trre case of a no-growth firm. L.r 'ierr.

ofr inptrt require'ments to model even a sinrprk, n.-gr.*,tii situ.ltion, anrl trlo stirlthe input requirements to ntodel even a sinrpk, no-groh,tl.r situi

Breater requirements for the grorvth moriel, it is unrearistic to think trrat a prr,ciseoptimal capital strr:cture can ever be identifietl.

Problems with the HSS An.rlysisThe Hill softu'arc systcms examplc illustr.rtcd the cffccts of l*,erage on firmvalue,,stock prices, earnings ;,er il.,are, a.cl tlebt values. Flolvever, the cxamplelvas obviously simplified to facilitate trre c-riscussio., ancr rve car.mot o'erc.'m-phasize the difficulties encounterecl whe. one attempts to use trris type ofa.nalysis in practice. First, the caprtarization ratcs (k.1 ani espr.cially t.l nl"'u...idifficult to estimate. The cost oi .lebt at different iebt levels can be estimate.irvith some confidence, but cost of equitv estimates must be

'ie*,ed as r.err.rough approximations.le

Second, the mathematics of the vah.ration proccss make the outcomL-s'erv sen-sitive to the input estimates. Thus, fairly small errors in thL. estinates of i,r, k,,and.EBIT can lead to large errors in cstiinatctl EpS anrl stock price.

,lil

l-IT"r]ljl:l:1,-:-].rrio.slr+r behvcen k and thc rtetrt rario hrs L.rcn studierl (,\te.si\.cl'using [_othcross-sectlonir dnd tim!'series dita..ln thL, cross-s('ctionar studics, a samplc of firnrs i..r,iotrr".il *jitnmultiple rcgression teihniqucs uscr'l in an.rttcmpt to "hold consiant" "ir

i"it,,rr,rir,"i'ii,.,;;il;itever.lqc_th.rt mlIht inl]uEllce k,. The;encr.rl (Lrn(lusi,\1,rt thesr'stu.lics is thnt l. ri*,r.1. l,.rIr.rr,, in-creNrs, but strtistical prolrlenrs [,r".ir.r" r,, ir\)m sr(.iir\ il1s tr," i,,n.tirn.,i ,.'r.,ri.,,,ri,i ,r:;il'i,,"i,(olrllden(c.

In the tinle s.'ries stu.lies, a stn*lc,iirnr'i l. i, rn.rlrzc,l ()\(r tiure in nn itt.lirft tL,.ct hr,rr. L.th'l:1"1 1n 11rq';,,q.

to (h,rng(s in ris.ir'ht r.rri() r-lcr..ri.rrn. 'oLh,,r [.rt,,r:" (r!) n(\r r.nr.)r11 ((,n\r.]11t.sL) It ls Inf\)\srDie tr' sferrlv c\J\tl\ ItorL k. is rir|iterl I,v irnrn.r.rl i$.rr,rEr.

oThese Yalues are t.rken from Table 10-3. Values at other debt levels rvere calcul.ltcd sinlilrrly

Some Considerations in the Capital Structure Decision 391

I Finally, many firms are not publicly owned, and that causes stiil more difficul-ties. If a privately held firm's owner does not plan to have his or her firm go pub-lic, then potential market value data are really irrelevant. However, an analysistlased on market values for a privateiy owned firm is useful if the owner is inter-ested in knowing how the firm's market value would be affected by leverageshould the decision be made to go public.

/)

Urryrrrt Questions

What are the key assumptions used in the Hill Software example?

Briefly describe the steps involved in finding Hill's optimal capital structure.

14/hat problems occur when the procedures used in the Hill example are usedto estimate real-world optimal capital structures?

Since firms cannot determine their precise optimal capital structures, managersrnust apply judgment to their quantitative analyses. The judgmental analysis in-volves several different factors. In one situation a particular factor might have

{reat importance. In another, that factor might be ielatively unimportlnt. Thissection discusses some of the more important iudgmentai issues that should betaken into account.

Managerial Conservatism

Well-diversified investors have eliminated most, if not all, diversifiabie riskfrom their portfolios. Therefore, the typical investor can tolerate some chanceof financial distress, because a loss on one stock would probably be r:ffset bygains on another. Howevet corporate managers generaliy view financial stabil-ity as being quite important-they are typically not well diversified, and theircareers, and thus the present value of their future earnings, can be seriously af-t'ected by financial distress. Thus, it is not difficult to imagine that managersmight be more "conservative" in their use of leverage than ihe average stock-ilolder would desire. If this is true, then managers would set somewhat lowertarget debt ratios than the ones which maximize stock prices. The managers ofd publicly owned firm would never admit this, for unless they owned votingcontrol, they would quickly be removed from office. However, in view of theuncertainties about what constitutes the value-maximizing structure, manage-rneni could always say that the target capital structure employed is, in itsjudgment, the value-maximizing structure, and it would be difficult to proveotherwise.20

20lt is, of course, possible for a particular manager to be less conseryative than his or her firm's aver-age stockholder. Howevet this condition is less likely to occur than is excessive managerial conser-vatism, which is just anothe! manifestation of the agency problem. I[ excessive conservatism exists,then managers, as agents of the stockholders, arc not acting in the best interests of their principals.Holvever, when managers become the prim.rry orvners of a company, such as in man.rgerial buyouts(MBOs), they often become very aggressive in their use of financial leverage. By Lrsing extremeamounts of debt, they take on a great deal of risk, but, in thc, process, they open the tloor for big pay-offs. Note too that the threat of takeoYers motivatcs underleveraged fims'managels to use more debtthan they otherwise would.

E CONSIDERATIONS IN THE CAPITAL STRUCTURE DECISION

Debt

$02,000,000

4,000,000

6,000,000

8,000,000

10,000,000

12,000,000

1{.000,000

Expected EPS

$2.40n

2.55

2.70

2.87

3.01

3.20"

StandardDeviation

of EPS

$1.52"

1.68

7.87

2.09

2.40

7.90^

Coefficientof Variation

U.OJ

0.66

0.69

0.73

0.80

0.91'

1.15

1.60

shdP,id

3.3{ 3.83

3.26 5.20

st&t2t-c

21,)

21.:'i

2ltl!tl;'r

)

Expected EPS

4.00 Maximum EpS = 93.34

I

Stock Price($)

Maximum, Stock Price

/ =$21.7322

20

468t

Optimal Amountol Debt

12 Debt (Millions of Dollars)

12 Debt (Miltions of Dollars)

hsttrck pritr's are fronr T.rhlt' l0-2. --1..,t

392 fh3p1g1 19 CAPITAL STRUCTURE DECISIONS: IART I

Lender and Rating Agency Attitudes

Regardless of a manager's own analysis of the propcr leverage for his or her fmtl-rere is no question but that lenders' and rating agencies'attittldes nt" fr*q1,*,|important determinants of firrancial structures. Cenerally, manaBenlent wiil dlcuss the firm's financial structure with lenders and rating agencies and ;rmuch weight to their advice. However, if a particular firm's management [.confident of the future that it seeks to use leveragc beyond the norms for ib;dustry, its lenders may be unwilling to accePt such debt increases, or may do5only at a high price.

Coverage ratios, which were discussed in detail in Chapter 3, often are ..xd

by lenders and rating agencies to neasure the risk of financial distress. Accod

ingly, managements give considerable weight to such ratios as the times-intepg

eamed (TIE) ratio, which is defined as EBIT divic'led by total interest charg.

The lower this ratio, the higher the probability that a firm will encounter firincial distress.

Table 10-4 shows horv HSS's expected TIE ratio declines as its use of debtin

creases. At zero debt, the TIE ratio is undefined, but it is almost infinitelyhi$rvery low debt levels. lAIhen only $2 million of debt is used, the expected TIE is1

high 25 times, but the interest coverage ratio declines rapidly as debt rises. Noq

howevet that these coverages are expected values - the actual TIE will hhigher if sales exceed the expected $20 million level, but Iower if sales fall belr

$20 million.The variability of the TIE ratio is highlighted in Figure 10-10, which shows 0r

probability distributions of the ratio at $8 million and $12 million of debt. Thea

pected TIE is much higher if only $8 million of debt is usetl. Even more impr

iant, with less debt there is a much lower probability of the actual TIE being ler

than 1.0, the level at which the firm is not earning enough to meet its requirdi,!terest payments. ,

Another coverage ratio that is often used by lenders and rating agencieli

the fixed charge coverage (FCC) ratio. This ratio recognizes that there are fi'\d

Amount of Debt(in Millions)

$02

4

6

8

l012

.TIE = EBIT/ Interest. Example

Tabie 10-l and Figure 10-6.flE = $-1,000,000/$1,200,000 = 3.3 nt $ I0 million of .lct,t. Data rrtF

Expected TIE"

Undefinec{

25.0

12.L

5.0

3.3

2.2

'lr::Hf.l r

Some Consirlerntions in the CaPiLll 51rr.rur" Dccision 393

+ $12 Million ol Debt

:-.- $A Million of Debl

II

TIE = 1.0

t t Times tnlereslI I EarnedExpected TIE = 2,2 Expected TtE = 5.0

finarrcial charges other than interest payments r.virich could leacl to financial dis-tress. The FCC ratio is defined as foilows:

FCC =[:BlT + Lcasc payulr'nts

i.l:j,Fi'

,rt.' rL,st J 1 Le,rst'. i _ iSinkinS

fund palrments 1

\P.rynrenrs/ \ t_T )Note that sinking f.nc{ payments reLluce thc debt-thev are not derluctible in-terest payments. Therefore, sinking funcl paylnents must be ,,grossed up,, inrecognition of the fact that they must be madc rvitlr after-tax dollais (net inconie).Interest and lease payments are fully deductible, hcrrce they do not neecl to begrossed up.

If LISS harl $1 nrillion of leiisc pavrnents.rncl g1 million of sinkinrl furrel pal.mcnts, its FCC ratio .rt .l dL-bt lcr,cl of $1il rnilliorr ivoulcl be 1.3:

;r-._ 5,+,(X)0,00UrS1,00(),0()()

$1,200,000 + $1,000.000 + 51't)tl0'0000.6

_$5,000,000_1.1$3,866,667

Thus, the coverage of total fixed charges is consitlerably less than the 3.3times-interest-e.irned coverage at the s.rme tlebt level.

Reserve Borrowing Capacity and Financing Flexibilitywhen-n'e discussc'tl asvmmetric information antr signaling, u,e noted tir.rt firmssl.roult-l nr.rintain some rL'serve l.orrorving capacitr., *']lichJrr".e...cs thcir atrilitr.

39{ chaprer 10 CAPITAL STRUCTURE DECISIONS: PART I

to issue debt on favorable terms. For example, suppose Biotechnjcs Inc. had i-successfully completed an R&D program, and its internal projections a,"'Imuch higher earnings in the immediate future. Horvever, the new

"urninr" I

not yet anticipated by investors, hence are not reflected in the p.ice of its?i.IBiotechnics would not tvant to issue stock-it would prefer to fin.rnce withJirurrtil thr. higher earnirrgs m;rterialize and are reflected in the stock price, at wiiltimc it cotrltl sell an issue of common stock, retire the debt, and retum to ih ilget capital structure. Similarly,, if the financial manager felt th.rt interest ni'rvere tem;rorarily lolv, but were likely b rise fairly soon, he or she nright wln1lissue long-term bonds and thus "lock in" tl.re low rates for manv years. To obh;this financing flexibility, firms gene'rally use less debt rrncler "normal" cod[tions, thus presenting a stronger financial picture than they wotrld othenvirh,i.,.e. This is not suboptimal from a long-run standpoint, although it might appe.ar so if viewed strictly on a short-run basis.

Note too that firms'debt contracts often specify that no nelv debt canhLsued unless certain ratios exceed minimum levels. Very frequently, the TIE r+tio is recluirecl to exceed 2 or 2.5 times as a conclition ior the issuance of additional dcbt. With this in mind, look back at Figure 10-10 and note that, iI ituscd $12 nrillion of dtbt, HSS's TIE rvould be less than 2.0 almost hatf gp

time, rvhereas the probability of a coverage less than 2.0 would be quite smal

if it used only $8 million of debt. Thus, if HSS sets a relatively high target d&ratio, its financing flexibility would be reduced in the sense that it could rut

count on rrsing whatever type of capital it wanted to use at all times.The emphasis that managers place on flexibility can be summed up by thb

statement made to the authors by a corporate treasurer:

Our companv can earn a lol morc by making good capital budgeting decisions thmby making goocl financing tle-cisions. lndeed, we are not sure r'xactly horv financingtlecisions affect our skxk price, but we knorv for sure that forcgoing a promisingcapital investment bc'cause func-ls are not available will hurt our stockholders. For

this reason, my primary goal as trcasurer is to always be in a position to raise the

capital necdetl to support operations without having to sell new common stockandsending out a neBative signal.

Control

The effect of dr:bt on;r management's control position may also influence ihecap

ital structure dt'cision. If nranagement just barely has majority control (.iust0r.d

50 percent of the stock), but is not in a position to buy any nrore stock, debt ruJ

bc. the choice for new financings. On the other hand, a m.lnagement grouP thatl

ruot conccrnr'rl about voting control nlay decide to use equity ralher than debt!

tht' financial situatiorl is so weak that the use of detrt might subject the companJ

to a serious risk of defhult. If the firm gets into troulrle, cretlik)rs (throuP

covellnnts in thc debt agreen-rents) may assume control and perhaps force a mrt

ag(,n1ent change. TIris has happenecl to Chryslt'r, Navistar Irrtern.rtirrrr.rl (formerf

Irrtc.rn.rtional H.rrvt'stt,r), Braniff, Corrtinental Iilinois Blnk, antl a Irttmber cr

othcr comp.rrries in rcct'nt years. Horvever, if kro little clt'bt is trsetl, managelflellruns the risk of a takeorer, n'here some othcr company or manilgement gtot{

persuadL's stockholclc'rs k) turn over control to the neu'gr..trp, nliich pllnsN

iroost earnings and stock prices by using financial levcr.ige. This h.rppcntr3 F

Lr'nox, thc china companl', and to manv Jther firms in recr'nt ],e.rrs. Control-ctositlerations do not nciessirily suggest ihe us.'of tlebt or of eqirit1,, bsl1 thc'effs+

of finarrcing rlecisions ort control must certainly be taken into accoul]t.

Some Considerations in the Capital Structure Decision 395

Business Risk

A firm that has relatively low business risk-small sales variability, lorv operat-ing leverage, and so on-can take on more debt than can firms with higtr,busi-ness risk. In essence, firms must limit their total risk, and the higher the businessrisk, the less "room" there is to take on financial risk.

Asset Structure

Firms *,hose assets are suitable as security for loans tend to use debt ratht,r heav-ily. Thus, real estate companies, which have relatively litluid assets, tend to behighly leveraged. However, companies involved in technological research em-ploy relatively little debt.

Growth Rate

Other factors the same, faster-growing firms must rely more heavilv on externalcapital-slow growth can be financed with retained earnings, but rapid growthgenerally requires the use of external funtls. For reasons set forth in our discr-rs-sion of signaling theory, and also because the floiation costs involved in sellingcommon stock exceed those incurred when selling tlebt, firms prefer debt to newstock for meeting external funding neecls. Thus, rapiclly grolving firms tencl touse somewhat more debt than slower-growth companies.

Profitability

One often observes that firms with'ery high ROEs use relatively little debt. Thereason seems to be that highly profitable firms such as Merck, lntel, and Mi-crosoft simply do not need io do much debt financing-their high profits enablethem to do rnost of their financing rvith rc'tained earnings.

Taxes

Interest is a deductible expense, while dividends are not decluctible. Therefore,the higher a firm's corporate tax rate, the greater the advantage of using clebt.

Market Conditions

Conditions in the stock and bond markets undergo both long- and short-runchanges that can affect a firm's optimal capital structure. For example, during arecent credit crunch, the iunk bond market dried up, and it was essentially im-possible for firms to issue lower-quality debt at "reasonable" interest rates.Therefore, low-rated companies in need of capital were forced to either issuestock or use short-term debt, regardless of their target capital structures. As con-ditions eased, however, such companies were able to sell bonds and move theircapital structures back in line with their targets.

-/?At1-rr* Questiotts

Is the capital stmcture decision partly objective (made on the Lrasis of numeri-cal analysis) and partly sr.rbje.ctive (jurlgme'ntal, u,ith manv factors considered)?List and discuss some factors that manigers consicler tvhen setting the firm'starget capital strllcture.

396

AN

Chapter l0 CAPITAL STRUCTUT{E DECISIONS: PAI{T I ,.

APPROACH TO SETTING THE TARCET CAPITAL STRUCTURE

Thus far in the chapter, we have discussed (1) the basics of busirrr'ss and financirr

risk, (2) several theories of capital stmctlrre, (3) a methorl of .rnalysis based,iperpetual cash flows, and (.1) a numberof factors that influence the capitals6..ture decision. In this sectiorr. rve describe a pragmatic approach to scttinB the 1.,.

get capital structure. Our approach requires iuclgmental assumptions, but it alrretluires managers to consider how alternative capital strr,lcturL's h,ould affectt$

ture profitability, coverage, and external financing requiremcnts under a variq.of assumptions.

The starting point for the analysis is a forecasting mor{el set up to test theq[.

fects of capital structure chtrnges. Flere is a brief clcscription of the'spreadshctl

model lve use in consulting assignments. Basically, the model generates forscasted data based on inputs srrpplie'd by the firm's financial staff. Each data itqlcan be fixed, or it can be allowed to vary from year to ye.rr. The required datailclucle the most recent balance sheet and income statement, plus the following

items, all of which represent either expectations or managemcnt-cletermined po!

icy variables:

1. Annrral growth rates in an index of unit sales

2. Annual inflation rates for sales prices and input prices

3. CorPorate tax rate

4. Variable costs as a percentage of sales

5. Fixed costs

6. Interest rates on already outstanding (or embedded) debt

7. Marginal component costs of capital

8. Capital structure Percentages9. Dividend growth rate

10. Long-term dividend Payout ratio

The model uses the input data to forecast balance sheets ancl income statemenE

for future years. Then it calculates and displays such data as external financing

requirements, ROE, EPS, DPS, times-interestlearned, stock price, and WACC

along with a set of keY ratios.We begin by entering base-year balance sheet and illcome statenlent valu6

plus data on the expected growth rate, expecterl inflation rates, anLl so on. Thes

inpr1, ,r" used by the model to forecasi operatirlg income and asset requirt

ments. Next, the model brings in the financing mii. It r.rses as inputs both th

debt/equity mix and the debt maturity structure. By debt maturity structure,tlmean the proportion of short-term versus long-term debt. Further, rve nlust eslr

mate as best we can the effects of the firm's iapital stnrcture on its comPondd

costs-a higher clebt ratio will lead to increaser ir-, tl'r" costs of all corrponensand vice veisa if less debt is used. With all inputs enterecl, the motlel then foe

casts financial statements and Senerates projected stock prices.The moclel is then usecl to inalyze nit".r.,oti,r" scena;ios. This analysis trl6

t*'o forms: (1) changing the financing inputs to get an itir'a.rlrout horr'theEnancing mix affects iireiey o.rtputs uria 1i; .tlungi"ng tht'oper.rting inputs to$(

hou' economic conrlitions affect the kev outputs under variolls finarlcing Strd*

gies. Finall1,, the moclel's outpLrt must be reviervet-l anr-l an.rlvzetl, .rtrl a dectstt'

must be ma.1.- as to the best caprital stnlcturc. W'e P.ry Pnrticlul.ir attcntion tor

Sorlc AcLlitiorr.rl lnsirlrts into C.rFii.rl Strtrctrrre Decisions 397

forecasted EPS, interest coveragc, crtcrrr.rl fr.rnrlirrg retluircmcrrts, and projc'ctctlstock price.

The nrodel c.rn gcncratc outpr.rt "arrsrvers" rltritc easily, but it is up to the fi-nrrncirl .rn.rlyst to assign irrPul 1'"1.,"r, t() illtorprct thc output, .'rnri, [inallv, to rcc-ommend a targct capital stnrcturt.. Thc final dt'cision rvill be r:rarlc bv thc finan-cial m.rnagt'r antl/or to;r rnarl.rtcnront, consirlcring all tlre factors rr c havcdiscusscd. Rcaching a decision is not casl', but a capitrl stnlcturc forcc.rstirrgmoclel such as thc onc wt'trsc tloes ht'lp p1.1111gg15 analvzc the cffects of altr:rna-tive courses of irction, rvlrich is csscnti.rl in gootl ttccisiou m.rking.

It should be noted that rty'ri/r' ctltitLrl slnrctrrrc r/cclsiorts Llo itftct sfock ;rli1,'1,'5,

tlrcse t'tftcts nrc gancrolly snrnll itt courPnrlsorr lo tltc clkcts of olteraSillg r/ecisiorr.s. Acompany's abilily 1o identify (or crc.rte) markL.t opportLrnities, and 16 prorluceand sell proclucts or sen,iccs efiicientlv, is tht prirn.rrv determinant of success.Financial arrangements can facilit.rte or hanrper oper.rtions, btrt the best of fi-nancial prlarrs cannot overcorre deficiencies in the operations area. This st"rte-ment is supported by empirical studies, rvhich gr.rrerally fincl a rveak statisticalrelatiorrship betlveen capital structure ancl stock prices. It is also supported byruns of our computer model, which shorv stock Prices to bc affectrcl sigrrifi-cantly by changes in unit sales, sales priccs, fixed costs, anc-l variable costs, butonly slightly by charrges in capital structure. 'lhis last point carr also be seenfrom the HSS example cliscussecl c'arlier. licfer ag.rin to Table 10-2. Hill Soft-ware Systems' stock price is maxiurized .it a D/V ratio of 27.6 percent. I{orv-evet at a D/V of 18.6 perccnt, which is one-thirrl lon,r.t the firm's stock Lrricedrops onl1, from $21.73 to $21.-17, or bv 1.2 percL.nt, rvhile if D/V riscs to 36.3percent, HSS's stock price hardly clrops at all. '[hus, llSS cor.rld set its tlrgetD/V ratio anvwhere in thr' rrnge from 18 to {0 pr.rcgnl and still come ver;, closeto maximizirrg its stock prict.

Test Questiotrs

Briefly describe the elements of a fin.-rncial forccasting modcl designed to hr.lpset the tarBet capit.ll structure.

Horv critical is ihe optimal capital stnrcturc rlecision to the financial perfor-mance of the firm; that is, horv irnport.int are sm.rll deviations from the opti-mal structr,rre?

Should thc Lrrsct capital structurc bc thought of .rs .r single poiut or .rs a

rangr'?

E ADDITIONAL INSIGHTS INTO CAPITAL STRUCTURE DECISIONS

At this point, one mirht h.rve an tureasl, fecling rcg.rrding both l.rou' to estalrlishthe target capit.rl structure ancl its effcct on risk, frrofiLrbilitl', arrcl stock prricc.s. \\ecan construct mot'lels it'hich generatc projccterl earnings, stock prices, cover.rgeratios, and so on, uncier clifferent capital strtrcturcs. Flol'ever, our confidence inthese re'sults is lin'ritccl, because' u'r' do not knon for surt hou' k.r and k., hL.nce

stock prices, will reirlly change *'ith ch.rnges in thr. capital structrrrL'. lVe alsoknorv that in practice'rnany sr,rbjcctive flctors aiso influcrrce thc dt.cision. Thert'fore, to gain more insights into capiLrl str!.rcturo tlecisions, it is use[ul to look athorv uranagtrs say thcy acttrallv csLablish targr't capital stnlciurcs.

398 Chaptor 10 CAPITAL STRUCTUI{E DECISIONS: PART I

Professors David Scott and Dana Johnson surveyed a group of firms to e.,out horv managers attempt to estimate the optimal capita.l structure, .])whether managers really believe that one can be determined.'' Scott and jolison seni quesiionnaires to the chief financial officer (CFO) of each Fortrr-1000 firm. Some 212 financial managers replied, and their answers providiuseftrl insights into the decision process.

First, the respondents agreed that capital structure decisions do matter-;general, financial managers believe that the prudent use of debt can lower hlfirm's overall cost of capital, but that an excessive use of debt will increase gg 6quired rate of return on equity. Second, the most popular measures of financialleverage are (1) the long-term debt to total capitalization ratio," (2) the tirnesinterest-earned (TIE) ratio, ancl (3) the long-term debt to common equity ratio.

Howevet rvhen computing these ratios, accounting (or book) values rather than

market valnes were virtually always used. Third, 64 percent of the respondinrmanagers indicated that their target long-term debt to total capitalization rati{n,ere in the range of 25 to 40 percent, and the nrost popular reported target rannwas 26 to 30 percent. Because stock market values generally exceed book valu[the debt ratio measured in market value terms would be quite a bit lower thrnthese reported book value figures.

The strrvey also provided data on how various parties influence the capihl

stnlcture decision. The data indicate that managers give the greatest weight btheir own internal analyses, but that investment bankers and bond rating agen

cies also have a significant influence. Additionally, firms consider industry awr.

ages rvhen setting their target capital structures, but they are willing to depart

from ihe averages if their own conditions suggest that a departure is warranted

Note that the Scott-Johnson survey was taken in 1982. Since then, many MBfu

have graduatecl, gone into the work force, and now make important financial de

cisions. Otrr grress-supported by our olvn observations-is that if the survel

were repeated today, more companies would report that they give weight bmarket value as well as book value capital structures.

Test Questions

DopracticingfinancialmanagersbelievethatcaPitalStructuresmatter?Do investment bankers and rating agencies influence the capital shuctun

:rSr,e D.rvicl F. Scott and Dana J. Johnson, "Financing Policies and Practices in Large Corporatial'Fitrrrrrdal MLttngcntnt, Summer 1982,51-59. .

::Totnl cnpitatization is clefined as long-term debt plus preferred stock plus common equity.'n6"fort,.curri'ntlirbilitit'srntltleferredtaresareexcludetl.

SUMMARY This chapter discussed capital structure decisions. The key conceptslisted below:

r Business risk is the inherent riskiness in a firm's operations if it us€s

debt. Financial risk is the additional risk that is concentrated on the

holders rvhen debt financing is used.

r Within a stand-alone risk framework, business risk can be

10-1

Questions/Problems 399

financial risk can be measured by Stand-alone risk - Business risk =onoe - onoro.r.

r In 1958, Franco Modigliani and Merton Miller (MM) proved, under a re-strictive set of assumptions including zero taxes, that capital structure is ir-relevan! that is, according to ihe original MM article, a firm's value and costof capital are not affected by its financing mix.

r \ fhen corporate taxes are added to the MM model, the resuits indicate thatfirms should use 100 percent debt financing. Howevet later work by Millerdemonstrated that personal taxes reduce, but do not eliminate, the value ofdebt financing.

r The addition of financial distress and agency costs to either the MM corpo-rate tax model or the Miller model results in a trade-off model. Here themarginal costs and benefits of debt are balanced against one another, andthe result is an optimal capital strucfure that falls somewhere between zeroand 100 percent debt.

: Unfortunately. capital structure theory does not provide neat, clean answersto the question of the optimal capital structure. Thus, many factors must beconsidered when actually choosing a target capital structure, and the finaldecision will be'based on both quantitative analysis and judgment.

r If a firm has perpetual cash flows, then a relatively simple model can beused to estimate its value under different capital structures. In theory, thismodel can be used to find the capital structure that maximizes the stockprice. However, the inputs to the model are very difficult, if not impossible,to estimate with any degree of precision. Further, most firms are growing, sothey do not have constant cash flows.

r Since one cannot determine the optimal capital structure with quantitativemodels, managers must base decisions on analysis plus qualitative factors,including long-run viability, managerial conservatism, lender and ratingagency attitudes, reserve borrowing capacity, control, asset strucfure. prof-itability, and taxes.

r Firms generally have computerized planning models which are used in thefinancial planning process. These models can be used to get a feel for the im-pact of capital structure changes on a firm's financial condition.

At this point, you should have a reasonably good idea about how capital struc-ture affects stock prices and capital costs. In the next chapter, we will examinesome additional issues which provide further insights into the capital stmcturedecision.

QuestionsDefine each of the following terms:a. Capital structureb. Business riskc. Financial riskd. Operating leveragee. Financial leveragef. Breakeven pointg. Capital structure theoryh. Perpetual cash flow analysisi. Reseroe borrowing capacityoR6&uy, stand-alone risk to stockholders can be nteasured by oRoe,

400 ChaPter 10 CAPITAL STRUCTURE DIICISIONS: PART II

,c

What term refers to the uncedainty inherent in Projections of future ROE(U)?

Firms with relatively high nonfinancial fixed costs are said to have a high degrec of

"OnetypeofleverageaffectsbothEBITandEPS'TheothertypeaffectsonlyEPS"'this statement.

lVhv is the following statement true? "Other things being the same' firms with

itudt"iot"t are ableio carry relaHvely high debt ratios'"

why do public utility companies usually have capital structures that are differsnl

thoie of reiail firms?

Questions,/Problems 401

Calculate the expectetl value arrcl standrrcl dcviation for Firm C's ROE. ROEA =10.0%, on = 5.5%; tlOEn = 12.0',L, as = 7 .7Y".

Discuss the relative riskiness of the three firms' rcturns. (Assume that these distribu-tions are expcctc.d to renrain consLlnt over tim!..)

l0-210-3

t0-4

10-s

10-6

70-7

10-8

10-9

10-10

10-11

70-72

a.

b.

c. Now suppose all three firms have tht' sanrc standard deviation of basic carning porver(EBIT/Total assets), oa = ou = oc = 5.5'l". What can we tell about the tinancial risk ofeach firm?

The following data reflect the currt'nt finarrcial conditions of the Levine Corporation:"" 10-3

Structure Analysis

some economisis believe that swings in business cycles will not be as wide in the

;;il;;-h;;;;"n in the past' Assuriing that they are correct' what effect miSht this

;iJii/,y h;;";ihe iyp6rof ri""ncing"used by firms i^ the United States? Would yr

Value of debt (book = market)

Market value of equity

Sales, last 12 months

Variable operating costs (50'2, of sales)

Fixed operating costs

Tax rate, T (federal-plus-state)

$1,000,000

$5,2s7,713

$12,000,000

$6,000,000

$5,000,000

40%

\Arhv is EBIT generally considered to be independent of Jinancial leverage? why

;di+ ;;illy B" inflrinced by financial leverage at high debt levels?

sented in the chaPter?

10-13 \ /hv is the debt level that maximizes a firm's expected EPS Senerally higher than

level that maximizes its stock price?

Problems

At the current level of debt, the cost of debt, Q, is 8 percent and the cost of equity, k. is10.5 percent. Management questions whether or not the capital structure is optimal,.so the-

finaricial vice-president has been asked to considcr the possibility of issuing $1 million ofadditional debt and using the procceds to repurchasc stock. It is estimated that if thc le'vcr-age were increased by raising the level of debt to $2 million, the interest rate on new debtwould rise to 9 percent and lq rvould rise to 11.5 percent. The old I percent dcbt is seniorto the new debt, and it would remain outstandirrg, continue to yield I Percent, and have a

market value of $1 million. The firm is a zero-growth firn, with all of its eamings paid outas dividends.a. Should the firm increase its debt to $2 million?b. If the firm decided to increase its level of debt to $3 million, its cost of the additional

$2 million of debt would be 12 percent and k, would rise to 15 percent. The original8 percent of debt would again remain outstanding, and its market value rvould re-

miin at $1 million. What level of debt should the firm choose: $1 million, $2 million,or $3 million?

c. The market price of the fim's stock was originally $20 per share. Calculate the newequilibrium stock prices at debt levels of $2 million and $3 million.

d. Cilculate the firm's earnings per share if it uses debt of $1 million, $2 million, and 53million. Assume that the firm pays out all of its earnings as dividends. If you fincl thatEPS increases with more debt, does this mean drat the firm should choose to increaseits debt to $3 million, or possibly higher?

e. What would happen to the value of the olcl bonds if the fim uses more leverage andthe old bonds are not senior to the new bonds?

The Rivoli Company has no debt outstanding, and its financial Position is given by the fol-lowing data:

swer be true for all firms?

FirmA: ROEI

Firm B: ROEg

Firm C: ROEc

.-- 10-4Analysis

10-1Operating Leverage and

Bteakeven

Business and Financial Risk

Assets (book = nrarket)

EBIT

Cost of equity, k,

Stock price, Po

Shares outstanding, n

Tax rate, T (federal-plus-state)

The firm is considering selling bonds and simultaneously repurchasing some of its stock.If it uses $900,000 of debL its cost of equity, k., will increase to lL Percent to reflect the in-creased risk, Bonds can be sold at a cost, k3, of 7 percent. Rivoli is a no-grorvth firm.Hence, all its earnings are paid out as dividends, and earnings are exPectationally constantover time.a. What effect woulci this use of leverage have on the value of the firm?b. What would be the price of Rivoli's stock?c. What happens to the firm's eamings per sharc'aftcr thc recaPitalization?

$3,000,000

$500,000

70%

$1s

200,000

10"/"

a. Should the firm make the change?;. iii;ff,h" iTl..:-{:t1l;;,Ei-ug" i"""u'" or decrease if it made the chanse?

about its breakeven Point?c. Would the new situation expose the firm to more or less business risk than the

:rO-Z Here are the estimated ROE distributions for Firms A' B' and C:

ProbabilitY

0.4 0.2i

10.0% 15.0Y.

12.0 19.0

1s.0 zf.o

0.1

0.0%

(2.0)

(s.0)

0.2

5.0%

5.0

5.0

)

402 Chaptcr 10 CAPiTAL STRUCTURE DECISIONS: PART I

d. The $500,000 EBIT given previously is actually the exPected value from the

probability distribution:

PtobabilitY EBIT

($ 100,000)

200,000

500,000

800,000

1,100,000

W1lat is the probability distribution of EPS with zero debt and with $900'000

Vlhich EPS distribution is riskier?

;;;;r*:#-h;;..uruirity distributions of the times-interest-eamed ratio for

i"""r. illf."iit tie p.obnb'ility of not covering the interest Payment at the $90

Questions/Problems 403

Spreadsheet Problem

Work this problen only if you are using the computerized problem diskette.

Use the model in File C10 to solve this problem. The Norman Corporation is currently all-equity financed, but the firm is considering a change to 50 percent debt financing. Thedebt would cost 12 percent, and would be used to repurchase shares currently selling at$25 per share. Norman now has 40,000 shares outstanding and $1,000,000 in total assets.Its pro forma income statement tor 1999, assuming zero debt usage, is as follows:

0.10

0.20

0.40

0.20

0.10

10-7

Structure Analysis

e.

Sales

Operating costs

EBIT

$900,000

750,000

$150,000

$500,000

700,000

900,000

1,100,000

1,300,000

10-5

Crpital Stmcture AnalYsis

level?

value'of debt to $70 million?

Pettit Printins Company has a total market value of $100 miltion' consisting of 1

li^."" r"iir"""r., 6s'0pl,.irtotu and $50 million of 10 percent perpetual bonds n"fi';;;;; ri";-;iipui,y'' EBIr is $13 2rr *1til"ilJi'.l";l*,ii,: ff:':*l:h:;;"ti; ."pirrr .i"r.t'r." by either increasing its debt.to $70 million or decreasir

iio',iirrir". if it decides to iirrease its use of ieverage' it must call its old bonds I

sue new ones with a 12 Percent coupon' If it decides=to de1ease its H:tlq::Lni;;; ;;;; ""Jreplacl

them witli new S.percent coupon bonds' The company

;;".$;.h;-;*1i-ui-tt" ."* equilibriim price to complete the capiial

i}li]:i.1'""-atPieeif -l$2s-*ilii""l = 0.2. ilnder the assumPtions of Part e' r

iil'I-p"iili rpi ,"J gg.rt 1'a (2) expected TIE and orE' assuming an increase

Taxes (40%) 60,000

Net income q J0,000

What is the firm's expected EPS for 1999 using zero debt? At a debt level of $500,000?Assume that operating costs remain at 83.33 percent of sales over a wide range of saleslevels. Further, the 1999 pro forma income statement is based on expected sales of$900,000, but the actual sales distribution is as follows:

a.b.

Probability Sales

0.10

0.15

0.50

0.15

0.10

Find the EPS at each sales level for both zero debt and 50 percent debt financing.c. Make a plot of EPS versus sales level for both financing alternatives. Place the Plots on

the same set of axes. Interpret this graph.d. At a zero debt level, Norman's expected I{OE = $90,000/$1,000,000 = 9.0%, while at

$500,000 of deb! expected ROE = $54,000/$500,000 = 10.8%. Determine the firm's ROEat each debt level for every possible sales level. Plot the two ROE distributions.

e. Now. assume that the $500,000 debt financing would cost 15 percent. Repeat the Part danalysis. Is there a significant difference? IAtrhy?

10-6

Subjective Aralysis

you have been hired as a financial consultant by two firms, Alpha Industries (fin

Zed Corporation (Firm Z). r"i,* e"it"i"E" iJst-gro*ing milrocomputer retail

J.rrt.y, *f,if* Firm Z manufactures office tq"iP*gt'.| :":1,?:!,"T1,:l'3.:1T:;:il"i;;';il;;;;-t;';; ii't i' to recommcnd the oPtim;l caDitar stntcture

il: ilHr. ;i;;';;L""i,.i";;tr."t *""tJ i"n'"n'" voui clecision' and specifica

each o[ these factors apply to JJ fit*' Here are so'me additional Points Jbout

firms:i ii fit* n gcnerally leases its stores, whilc Firm- Z purcha*s its nlants'

ii;ii;;ii'i;i;k'ia ;tJ;iy nail *iri.'iii" i"*iiv 'ir

Firm Z's rorinder hords 40

0asehave.iust been hired as business manager of

, a pizza restaurant located adjacent to cam-company's EBIT was $500,000 last year, and

u university's enrollment is cappcd, EBIT is ex-to remain constant (in real terms) over time. SinceEltslon capital will be required, PizzaPalace plansout all earnings as dividends. The management

rwns about 50 percent of the stock, and thc stock islh the over-the-counter market.

you took your MBA corporate finance coi:rse, your in-structor stated that most firms' owners would be finan-cially better off if the firms used some debt. When yousuggested this to your new boss, he encouraged you topursue the idea. As a first step, assume ihat you obtainedfrom the firm's investment banker the following estimated costs of debt and equity for the firm at differentdebt levels (in thousands of dollars):

i

i

Amount Borrowed kd

$0

k"

t5.o%

250 10.0% 15.5

500 11.0 16.5

)

ffrm is currently financed with all equity; it hasshares outstanding; and P0 = $20 per share. When

404 CITAOTET 10 CAPITAL STRUCTURE DECISIONS: PART I

EBIT of $3,000.(1) Construct partial income statements, which start' '

",iitiieir.?"i the t*o firms. h

(2) Now calculate ROE for both firms.(3) What does this example illustrate about the impact

of financial leverage on ROE?

b. (1) What is business risk? 14/hat factors influence afirm's business risk?

(2) What is operating leverage, and how does it affecta firm's business risk?

c. (1) What is meant by financial leverage and financialrrska

(2) How does finmcial risk differ from business risk?d. Now consider the fact that EBIT is not known with cer-

iainty, but rather has the following Probability distrib-ution:

theories be applied directly in this analysis, 1iiyou presented an analysis based on these thqihow do you think the owners would respond?

(l) Describe briefly, without using any numbeqsequence of events that would take place if P!Paiace does recapitalize. 'n

(2) What would be the new stock pace iI Pizzdrecapiialized and used these amounts of$250,000; $500,000; $750,000? I

(3) How many shares would remain o

ter recaPitalization under each debt(4) Considdring only the levels of debt

what is PizraPalace's oPtimal capital s

Sclt'cted Adclitional References and Cases 405

(

For an nrtide on stgrralirrg, scc

Baskin, ionathon, "An Empirical Investigation oI the l'ccking Ortlcr Hypothesis," Firrlr,:rirlMmagentetrt, Spring 1989, 26-35.

DaJinititte rtfcrentes ou llt cnrpiricol rclrtiorrs/rps bclaucrr cnpital slnlcftr., o,,rl (1) llrL' cosl ry'daht, (D the cost of cqtil\, (3) etrnings, nnd (1) tlta prict of a frnis stock are uirtually nonttis-tcrrt-statistical problnts nmke the ltrtcisa estirrtttiott of tlrcse ralaliorsltips xlrnorditmrily tliffi-cult, if not inrpossible. Ona goorl r(rty t() Sr't a ful for tfu issrrcs irruo/r,eil is !o obtuiirr rr sd of tlttcost.oJ capitrtl testitrotries fled itt a nnjor utility rnte cnsc-slc,h taslituorry is m,nilnble Itout'statepublic utility conmu-ssiorts, tic FeLlual Conunwticntiorts Connissiotr, the Fcdual Enerly Rtgulrt-toty Comntission, and utility conpanirc tJrcnrseluts. For an acatlctrtic tliscussion of the r'ssrre.s, sce

Caks, john, "Corporate Debt Decisions: A Ncw Analytic.rl Framework,",[ournd of Finatcc,December 197 8, 1297 -1,31,5.

Gordon, Myron J., Tlc Cost of Cayital to t Public Utilily (East Larrsing, lvlich.: Dir.i-sion of Research, Craduate School of Business Administration, lvlichigan StateUniversity, 1974).

Hamada, Robert S., "The Effect of the Firm's Capital Structure on the Systematic Risk ofCommon Stocks," Jounnl of Fhuurcc, Nlay 1972,435-452.

Masulis, Ronald W., "The lmpact of Capital Structure Changc on Firm Value: Some Esti-mates," lournal of Finance, March 1983, 107-176.

Piper, Thomas R., and Wolf A. Weinhold, "Florv Much Debt Is Right for Your Company?"Haruard Busirtcss Rtzmr,, July-August 1982, 106-11{.

Shalit, Sol S., "On the lVlathematics of Financial Leveragt'," Fitnncirrl Nfunngamnt,Spring1975,57-66.

Shiller, Robert I., and Franco Modigliani, "Coupon and Tax Effecis on New and SeasonedBond Yields and the Measurement of thc Cost of Debt Capital," ,for nnl of Fbwncial Eco-nrrrrics, September 1979, 297 -318.

For some htsights into hoto practicing fntncial nunagerc oiciL' tle capital slructure drcisiorr, ste

Kamath, Ravindra R., "Long-Term Financing Decisions: Views and Practices of FinancialManagers of NYSE Firms," Fitnncinl Rtziao, May 1997,337-356.

Nortcrn, Edgar, "Factors Affecting Capital Structure Decisions," Fimtncirtl ,lQgl1sar, August7991,431-446.

Pinegar, J. Michat'I, and Lisa Wilbricht, "What Managcrs Think of Capital Structure The-ory: A Survey," Filnncinl Managetnarl, Winter 1989,82-91,.

Scott, David F., and Dana J. Johnson, "Financing Policies and Practices in Large Corpora-tions," F ina nc ial Ma ilege n rc n l, Summer 1982, 51-59.

To learn nwre Ltbott ilrc link betuccn nnrket risk atul ollcrtlli,B and ffiancial leacrngc, xeCallahan, Carolym M., and Rosame M. Mohr, "The Determinants of Systenatic Risk: A

Synthesis," The Financial Re.'ie'd),May i989, 157-181.Gahlon, James M., and James A. Gentry,, "On the Relationship between Systematic Risk

and the Degrees of Operating and Financial Leverage," Fimncid Mnlngorcrrl, Srrm-mer 1982, 15-23.

Prezas, Alexandros P., "Effects of Debt on thc Degrees of Operating and Financial Lever-age," F inan cial M t nageme n t, Summer 1987, 39 - U.

Herc are sonrc add.itional articlcs which relnte to tltis chnptcr:

Easterwood, John C., and Palani-Raian Kadapakkam, "The Role of Private and Public Debtin Corporate Capital Structures," Fitnttcial Nlattngrrre,rl, Autum 1991, .19-57.

Garvey, Gerald T., "Leveraging the Underinvestment Problem: How High Debt and lvlan-agement Shareholdings Solve the Agency Costs of Free Cash Flow," /olrlai of IimncklRtsearclr, Sumrner 7992, 749-766 -

Harris, Milton, and Arttr R.rviv, "Capital Structure .rnd the Inform.rtional Role of Delrt,"lownnl of Finnra, June 1990, 321-3.19.

Israel, Ronen, "Capit11 51.r.,,,te and thc N'larket for Corporalc Control: Thr DcfrnsiveRole of Debt Financing," ltutrnal of FinLurcc, Septt'nrber 1991, 1391-1+09.

750

1,000

13.0

16.0

18.0

20.0

ple illustrate about the impact of debt financingand retum?

e. How are financial and business risk measursd

stand-alone risk framework?f. What does capital structure theory attempt to

\4/hat lessons can be leamed from capital shutheorv?Withihe above points in mind, now considermal capital structure for PizzaPalace.(1) What valuation equations can you use in the

sis?(2) Could either the MM or the Miller capital

If the company were to recaPitalize, debt would be is-

sued, and thi fdnds received would be used to repur-chase stock. PizzaPalace is in the 40 Percent state-Plus-federal corporate tax bracket.a. Now, to develop an example that can be Pre-sented" to

PizaPalace's rnanugemeni to illustrate the effects of fi-nancial leverage, consider two hypothetical firms: FirmU, which usei no debt financing, and Firm L, whichuses $10,000 of 12 percent debt Boih firms have

$20,000 in assets, a 40 |ercent tax rate, and an expected

l. lt is also useful to determine the effect of anyrecaoitalization on E[5. Calculate the EPS at

ets 6f $0, $250,000, $500,000, and $750,000,that the firm begins at zero debt and recapital

each level in a aingle step. Is EPS maximized

Economic State ProbabilitY

Bad 0.25

Average 0.50

Good 0.25

EBIT

$Zooo

3,000

4,000

same level that maximizes stock Price?i. Calculate the firm's WACC at elcl qlbt leYe!:

the relationship between the WACC and the

Redo the Part a analysis for Firms U and L, but add ba-

sic eaming power (BEP), retum on investment (ROI)

[defined a-s (Net inco*e + Interest)/(Debt + Equity)],and the times-interest-eamed (TIE) ratio to the out-come measures. Find the values for each firm in eachstate of the economy, and then calculate the exPectedvalues. Finally, calculate the standard deviation andcoefficient of variation of ROE. What does this exam-

price?k. Suppose you discovered that PizzaPalace had

buiiiress iisk than you originally estimated' Dt

how this would afiect the"analfsis. What if th

hid less btsiness risk than origiirally estimated?

l. Is it possible to do an analysis similar to the l

Palacl analvsis for most firmi? Why or why not?

type of anilysis do you think a firm should.at,i"L to h"tp set its optimal, or target, caPital.stsu

What other factors should mmagers conslder

setting the target caPital structure? .i

Selected Additional References and Cases

Chapter 77 prouides references that focus on the theory of capital stmcture; the references

are orientcd more toward applications than theory.

Donaldson's work on the setting of debt targets is okt brtl still telettant:

Donaldson, Gordon, "New Framework for Corporate Debt Capacily," Haroard

uiezu, March-April 19 62, 717 -137.'.....-"-.-."._, '//Strategy lbr Financial Emergencies." Haruard Business Reuietu,

ber 1969,6719.

406 Chapter 10 CAPITAL STRUCTURE DECISIONS: PART I

5rr t/rr'.fol/rrilirrg thrL'e arliilL's l,)rddifiorrnl irrsigllls irto the relntionshill betit'een

aclcrisfics nnLl lintttlal le|erogt:

Bowen, Robert M., Lane A. Daley, and Charles C. Huber, lr., "Evidence on thgand Determinants of Inter-lndustry Differences in Leverage," Fhmncial MrWinter 1982, 10-20.

Long, Michael, and Ileen Malitz, "The Investment-Financing Nexus: fumedence," Midland Corporate Finance loumal, FaIl 1985,53-59.

Scott, David F., Jr, and iohn D. Martin, "Industry Influence on Fhmcialnancial Manngemmi, Spring 1975, 67-73.

For a discttssion of tlrc intemational implications of caPital structure, see

Rutterford, Janette, "An International Perspective on the CaPital Structure Puzzle;

Iand Corporate Finance lournnl, FaU 1985, 50-72.

The Winter 1995, Winter 1996. and Spring 1'997 isxrcs of the loumal of Appliednance all contain featured articles pertaining to the capital stntcture decision-

The Dryden Press Cases in Financial Management: Dryden Request serix conlains

the coicepls lpe pruent in Chapters 70 and 11.

Case 9, "Home Security Systems, Inc.," Case 10, "Kleen Kar, Inc.," Case 10A,

Springs, Inc.," and Case 108, "Greta Cosmetics, Inc.," which present a situation

tri the Hill Software Systems example in the text.

CAPITAL STRUCTUREDECISIONS: PART IInphapter 10 presented some basic material on capital structure, including a

brief iniroduction to capital structure theory. We saw that debt concentrates a

firm's business risk on its stockholders, but debt also increases the expected re-turn on equity. We also saw that there is some optimal level of debt that maximizes a company's stock price, but that it is next to impossible to identify that oP-timai capitai structure. Now we go into more detail on capital structure theory.This will give you a deeper understanding of the benefits and costs associatedwith debt financing.

AL STRUCTURE THEORY: THE MODIGLIANI.MILLER MODELSUnll]2Sg-qpijal Etrylstule-theory cqnsisted of loose assertions about investorbehaviorratGrthancaref ully-.rryqf f glCd4@l!r-l6E!-eouH-be-testealifg@l1qtEiaila$Iysisiln what liui-bee'" crlled the most influential sei or fi-

" nancial papers ever published, Franco Modigliani and Merton Miller (MM) ad-dressed capital structure in a rigorous, scientific fashion, and they set off a

chain of research that continues to this day.1

Assumptions

As we explain in this chapter, MM employed the concePt of arbitrage to develgptheir theory. Arbitrage occursiFtfo Simifar aiseE--in this case, leveraged andu:nlei;e-raged stocks-sell at different prices. Arbitrageurs will buy the under','al-ued stock and simultaneously sell the overvalued stock, earning a profit in theprocess, and this will continue until the prices of the two assets are equal. For ar-bitrage to work, the assets must be equivalent, or nearly so. MM show that, un-der their assumptions, ieveraged and unleveraged stocks are sufficiently similarfor the arbitrage process to operate.

rSee Franco Modigliani and Merton H. Miller, "The Cost of Capital, Corporation Finance and the The-ory of Investment," Arnerican Economic Ra,ieu,lune 1958,261197; "The Cost of Capital, CorPorationFinance and the Theory of Investment: Reply," Anterican Ecouomic Reoiew, September 1958, 655-$69;"TaxesandtheCostof Capital:ACorrection," AmericanEconouicReuiew,lune1963,43H43tand"Re'ply," Anterican Econonic Rmiau, lune 7965,52*-527. ln a 1979 survey of Financial Management Asso-ciation members, the original MM article was judged to have had the greatest impact on the field offinance of any work ever published.See Philip L. Cooley and J. Louis Heck, "Significant Contribu-tions to Finance Literature," Fintncial lvlatngenert, Tenth Anniversarv lssue 1981, 23-33. Note thatboth Motligliani and Miller won Nobel prizes-Modigliani in 1985 and Miller in 1990.

)

408 Chapter 11 CAPITAL STRUCTURE DECISIONS: PART lli,

No one, not even MM, believe that their assumptions are sufficiently c66pr*.cause their models to hold exactly in the real world. Howcver, their modehlshow horv much money can be made through arbitrage if one can find wrlaround prolrlems with the assumptions. Here are the initi.rl MM assumptiffNote that some of them were later relaxed:

1. There are no personal or corporate taxes.

2. Business risk can be measured by oru,r, and firms n,ith the same degreedbusiness risk are said to be in a homogeneous risk class.

3. All present and prospective investors have identical estimates of each firmlfuture EBIT; that is. investors have honrogeneous expectations about q.pected future corporate earnings and the riskiness of those earnings.

4. Stocks and bonds are traded in perfect capital markets. This assumptiqimplies, among other things, (a) that there are no brokerage costs and 0)that investors (both individuals and institutions) can borrow at the sanr

rate as corporations,

5. The debt of firms and individuals is riskless, so the interest rate on all dfiis the risk-free rate. Further, this situation holds regartlless of how muddebt a firm (or individual) uses.

6. All cash flows are perpetuities; that is, all firms expect zero growttr, hemhave an "expectationally constant" EBIT, and all bonds are perpetuitic"Expectationaily constant" means that the best guess is that EBIT willhconstant, but after the fact the realized level could be different from theer.

pected level.

MM without Taxes

MM firsi analyzed leverage under the assumption that there are no corporatetr

personal income taxes. On the basis of their assumptions, they stated and algc

braically proved two propositions:2

Proposition I. The value of any firm is established by capitalizing its expectd

netbperating income (EBIT) at a constant rate (k.g) which is based on the firm}

risk class:

EBITYL-YU-wAcc-

Here the subscript L designates a levered firm ancl U designates an unlevend

firm. Both firms are assumed to be in the same business risk class, and lqg istltl

required rate of return for an unlevered, or all-equity, firm. (For our purposetlis easiest to think in terms of a single firm that has the option of either financt'S

with all equity or using some combination of debt and equity.)Since V as established by Equation 11-1 is a constant, then untlcr th! tvlVl til|r:

uhen tlrcre are no taxes, the t'atti of the firm is itrdcpcntlent rtf its ltz,crnge. As we sld

see, this also implies that

1. The weighted average cost of capital to the firm is completely independot

of its capital structure.

t"t *-,, r"tea and proved three propositions, but the third onc is n()t mitcri.rl to our di<d-

2. The IVACC for the firm, regarrlless of the .rmotrnt of debt it uscs, is etpurl tothe cost of equity it rvould have if it used no debt.

Proposition II. Tho cost of equitl, to a lcvercrl firnr, k.1, is equal to (1) the costof erluity to an unlevr.red firnr in thc sante risk cl.iss, k.g, plus (2) a risk premiunrwhose size dtpencis on both the tliffercnti.rl bctrtr'cn an unlevered firmt costs ofdebt ant-l equity irntl thc armount of debt uscrl:

k,r_ = k-u + Ilisk prtn.rium = k.t.+ (k.1, - k.rXD/S). (11-2)

Here D = markt,t varlue of the firm's clcbt, S = nr.trkct valuc' of the firm,s eqr-ritr;and k, = const.-rnt cost of dt'bt. Equotiou 11-2 .slrrlcs lltLtt rts tltc frnis ust ttf dtbt itt-cl"(s-r,s, ils cost oJ equity nls0 rlscs, tlnd in 0 nntht,ttrntictlly pr.ccisc rrrirrilrLr:

Taken togethcr, the tu'o MN{ propositions inrprly that the inclusion of moredebt in the capital sh'ucture lvill rrot incrcase thr' valtre of thc fir.m, bec,rusc tliebenefits of cheaper debt rvill be exactly offsct bv .rrr incre.rse in the riskincss,lrence in the cost, of its cquity Tlurs, NINI rtrgut: tltnt in n iottrld a,lllroul trr.res, botlthc taluc of a Jirn and its \N,\CC itt)lilll br nn4lcctt'Ll bq its cnpital slrrrcflrc. In thenext sectiorl we lvill present .1 proof of the lvlM Proposition I in thc .rbsence oicorporatc taxes. A proof of Proposition I rvithor,rt corpor.]tc t.rxes a;rpc..rrs in theExtension at the end of this chaptet as tlo proofs of Propositiorr I arrd II n.ith cor-porate taxes.

MM's Arbitrage Proof

MlvI used an orbitroge proo/to support their proprositions.3 They shoned th.tt, un-der the.ir assumptions, if trvo conrpanies diffcrotl onlv (1) in tl.re w.ry thtv are fi-nanced and (2) in their total m.rrket valucs, thcn invcstors rvoulti sell sharus ofthe higher-valued firm, br.ry thost of the lolver-i..rlucd firr:r, antl continue thisprocess until the companies had exactly the same urarket value. To illustrate, as-sume that two firms, L and U, arc identical in all importarrt respL'cts except fi-nancial structure. Firm L has $.1,000,000 of 7.5 percent debt, while Firm U usesonly equity. Both firms have EBIT = $900,000, ancl oL3rr is the same for both firms,so they are in the same business risk class-

lvllvl assumed that all firms are in a zcro-grorvth situation; th.tt is, EBIT is er-pected to remain constant, and all eamirrgs aro paid out as c'liviclends. Urrc-lcr thisassumption, the total market value of a firnr's colnlnon stock, S, is thc presentvalue of a perpetuity, lvhich is founcl as follorvs:

" Dividcntis Nct inconre (l:DlT - krD)(1 - T)k. k. k.

Equation 11-3 is merclv the valut of a perpq1ui11. rvlrose ntrmer.rtor is thl. nct in-come availablc to common stockholdcrs, rvhich is all paitl olrt as tlir.idcrrtls, atrtlwhose denontirrator is tht cost of common et1uitr,. ln IVIM's zero-ta\ nor.ltl, tlrt,tax rate', I is zero, so Etltration 1l-3 becomes simplv (EBIT - k.rD)/k..

EBIT (11-l)

Capitnl Structure'fhurr1,: Thc Nlotiigliani-lrlillrr ir,lodels -109

(11-3)

kru

lBv nrtritrosc rrc nrt'an thc simrrlt,rrreous [ru!ing anrl st'lling ot csscrrti,rllv irlcntical .rssfts \\ hicl] s0ll .ttdiifercnt prices. t hr' buvinE incr('nses tlrc piu:oI the rrnrl..rr.rhrr.l lrrui, ,rrr,l tlrc .ellrrrt rlctrc,r:e, tlreprice of the ovcrl'.rluc.l asset. Art)itr.liir'opLrr.lti(nrs rlill crrntinrrc until p1igq5 hrr-e bticrr rrlju:trtl tothe.point uherr'.the arbitrageur c.rn nrr longer L'irn.1 Lrro[il, .it !\.hi(h poirlt thl'n]nrkcis,lrli in.qui-libriun. Irr the aL,scnce of traniiction c()sts, equilil.rium rcquirr'\ thit thc prices oi the t\\ () n:sctr b,!.erlrral.

'110 Chapter 11 CAPI1AL STRUCTURE DECISIONS: PART II

Assume that initially, ltc.forc anv nrbitray occttrs, both firms h.rve the sam.-uitl,capitalization rate: k.g = k.r- = 10%. Under this condition, n..".aing toEq[tion 11-3, the followiug situation would exist:

Firm U:

Value of Firm U's stock = Su $9,000,m.

Total market vaiue of Firm U = Vu = Du + Su = $0 + $9,000,000 = 99,000,000.

Firm L:

Val.e of Firm L's ,,o.U = t.. = Et#Q

=ffi=su,ooo,om.

Ttrtal market value of Firm L = Vr- = DL + SL = S+,0OO,OOO + $6,000,000 = $10,000,ffi.

Thus, before arbitrage, and assr.rming that k,g = k,r- (which inrplies that capi6l

structure has no effect on the cost of equity), the value of the levered Firm Ler.ceeds that of unlevered Firm U.

Mlvl argued that this is a disequilibrium situation which cannot persist. To scrvhv, suppose you owned 10 percent of Ls stock, so the market value of yourinvestment was 0.10($6,000,000) = $669,666. According to MM, you could increaryour income without increasing your exposure to risk. For example, suppose yor(1) sold your stock in L for 5600,000, (2) borrowed an amount equal to 10 percv{

of L's debt ($400,000), and then (3) bought 10 percent of U's stock for $900,ffiNotice that you wouid receive $1,000,000 from the sale of your 10 percentof[lstock plus your borrowing, and you would be spending only $900,000 on l.t'i

stock, so you would have an extra $100,000, which MM assumed you would itvest in riskless debt to yield 7.5 percent, or $7,500 annually.

Now consider your income positions:

$60!m

Capital Structure Thcory: The lvlodigliani-Miller N{oclels 411

established, gains could be obtainecr by switching from one st.ck to the otrrer,h.ence the profit motive would force the equality"to be reached. when equirib-rium is established, the values of Firms Lincr'u, and their weishted arierasecosts of capital, would be equar. Thus, according to Modigtiani ,ria uiu"r, u.?ta firm's valr.re and its WACC must be inclepenclent of capital structure.

Note that each of the assumptions listed at the beginning of this section isnecessary for.the arbitrage.proof to work. For ex.rmplelif tne".o*pn.ri"s ao-r.,oihave identical business risk, or if transactions costs are significant, then the ar-bitrage process cannot be invoked. we rvill criscuss furthir implications oi theassumptions later in the chapter.

Arbitrage with Short Sales

Even if you did not orvn any stock in L, you siill could reap benefits if U and Ldo not have ihe same total market value. Now, your first itep would b" ; ;"[short 9600,000 of stock in L. To do this, vour broker woultl reiyou bo..o* ,to.tin L from one of tl're broker's other clienis. your brokcr would theh ,ur th" ;;;;Il:: y^o-i^"I^d^qite you the proceeds, or $600,000 in cash. you worrlcl ,rppf"-""ithis $600,000 by b9rro11ng $400,000. With thu $1 million total, you *orij Uuy tOpercent of the stock in U for $900,000, and have S100,000 remaining.

- Your position consists of 9100,000 in cash and trvo portforios. ihe first port-folio contains $900,000 of stock in u, anci it generates g90,000 in i,rcome. sinc"vou own the stock, we'll carl it the "long" portforio. The other portfolio con-sists of $600,000 of stock in L and $400,000 ln aeut. The value df'this portfoliois_ $1 million, and it generatt's $50,000 in cli'idencls and $30,000 in interest.Howewer, you do not own this second portfolio-you ,,owe,, it. Since yo, bo._rowed the ${00,000, you owe the $30,000 in interest. And since you btrrowedthe stock in L, you "owe the stock" to t[-re broker from whom it was borrorved.ff19fo1e, you must pay your broker the $60,000 of clividends paict by-i,which the broker would then pass on to the client from whom the stock'was!]9:r_o-yu1, So, your net cash flow from the second portfolio is a negative$90,000. Since you "owe" this portfolio, we,ll call it the ,,short,, portfoliol,. Ijur" areyou going-to get the $90,000 that you musr pay on the short portfo_lio? The good neus is that this is exactry the amount oriash flow qeneratecr bvthe long portfolio that you own. The caih flo*'s generated by each portfolio #the same; in oiher words, the short portfolio ,,repicates,,

the iong portfolio.Here is the bottom line. you stirted out with no *onev of vour own. B,

selt-inq t sf9rt, borrowing $100,000, ancl purchasing stock in U, Vou "na"J ,i

with 9100,000 in cash plus the two portforios. The portforios refricate o.," u.i-other, so their net cash flow is zero. This is perfect arbitrage, you in'est noneof your own money,,you have no risk, you have no future negative cash floq,s,but you end up with cash in your pociet.

Not surprising, many traders would want to do this. The selling pressureon L woulcl cause its price to fall, and the br-ryirrg pressllre on U rvoulcl causeits price to increarse, until the two conrp6nig5,-uni-r"s were equ.rl. To ps.1 11 nr.,_other wali if tlte.long antl slrort repticotirtg ltortfolios lutz,e tltc snitre cailt jlou]s, tlrttthey nutst lutte the sanrc ualue.

This is one of the most important ideas in mocrern finance. Not o.ly croes theapplication of this idea give us insights into capital structure, but it is ihe fun.la-mental building block underlying the Arbitrage pricing Theory (Apr) of stock ie-turns in Chapter 26, the valuation of rear options in Ciiapter ii, ancr the varuation

Ol,l lttconrc:

Ntit, Jrtctrrttc':

10% of L s $600,000 etluity income

10% of U's $900,000 equity income

Less 7.5% interest on $400,000 loan

Plus 7.59'" interest on extra $100,000

Total nerv income

$60,0[

7.it$67$

Thus, your nc,t income fronr common stock u,ould be exactly the sanre asbeftn'

$60,00b, but you would have $100,000 left over for investment in riskless dett

which would increase your income by $7,500. Therefore, the total return onlo!$600,000 net rvorth wotrld rise to $ei,SOO. Further, your risk, accorr'ling to lrNrvotrld be the s.rme as before, because yo, *otild have simply substituh+

S.100.000 of "homemade" leverage for your 10 percent sh.rre of Fi.*'L't ${ millio

of corporate leverage. Thus, neither your "effective" debt nor your risk wour

h.rve &anged. Ther"efore, you rvoulcl have increased your incomi rl,ithout rais4your risk, u,hich is obviously a desirable thing to do.

Ivllvl argued that tl'ris arbitrage process rvould actually occtrr, *'ith sales.d

L's sbck ririving its price down, and purchases of U's itock clriving; its por

up, until the nrarket valucs of the trvo firms *,"." "ql.,ol.

u.iii ,iir "qiln,y'"

412Chapter11CAPiTALSTRUCTUREDECISIoNS:PARIli

Vr=Vu+TD'

t=rr=**O

k.r- = kuu + (k,u - kd)(1 -T)(D/S)

Fredrickson is in a no-growth situation'

of financial options and derivatives as discussed in Chapter 19 ln fact' withqr

this idea, the bptions and derivatives markets we have today woutd not exist

MM with CorPorate Taxes

lvIM's original work, published in 1958, assumed zero ta1:::,In 1963' lhe.yFS

Iished a second article which incorporated corpollle laxeg wrth corPorate incot

taxes, they ioncluded that leverage will increase a firm's value- 'nlt.*:unU'

cause interest is a tax-deductible expense, hence more ot a leveraBed tirm'so*t

ating income flows through to investors. Here are the MM propositions whencq.

porations are subject to income taxes:

Proposition I. The value of a levered firm is equal to the value of an- unleve6

fiini in,f-," same risk class (Vg) plrrs the gain from leverage' The gain fromleru'

aee is the value of the tax savings, found as the product of the corporate taxpl

(f) ti*"t the amount of debt the firm uses (D):

I C.rpitnl Structurc Theorv: The lvlodigllrni-tr.lillcr lvlodels .ll3

4. If Freclricksorr begins to use debt, it can borrorv at a rate ka = 8%. This bor-ron,ing rate is consLtnt-it doc's not increase regardless of the amount ofdebt used. Any money raisecl bv selling debt rvould be used to retire com-mon skrck, so Fretlricksois asscls ruorr/d rcnnin constant-

5. The business risk inherent in Fredrickson's assets, and thus in its EBI! issuch that its rerluired rate of return, k"Lr, is 12 percent if no debt is used.

With Zero Taxes. To begin, assumc th.-rt thcre are no taxes, so T = 0%. At anylevel of debt, Proposition I (Equation 11-1) can be. used to find Fredrickson'svalue in an MNI world, 920 million:

v. = vu - EBIT - $2'+ 'mi]lion = $10.0 mirriou.k,L 0.12

If Fredrickson uses 910 million of debt, its stock value must be $10 million:

S = V - D = $20 million - 910 million = $10 million.

We can also find Fredrickson's cost of equity, k,1, and its WACC at a debt levelof $10 million. First, we use Proposition II (Equation 11-2) to find k";, Fredrick-son's leveraged cost of equity:

k.r- = k.u + (k,Lr * k.1XD/S)

= 72/, + (12% - 8%X$10 million/$l0 million)

=12%+4.0"/"=16.0"L.

Nolv we can find the conrpany's lveighted average cost of capital:

WACC = (D/v)(k.rx1 - T) + (S/v)k,

= ($10/$20X89/")(1.0) + (91 0 /920)( 1 6.0%) = 12.0%.

Fredrickson's value and cost of capital based on the MM model without taxesat various debt levels are shown in Panel a on the left side of Figure 11-1. Herewe see that in an IVIIv{ world without taxes, financial leverage simply does notmatter: The value of the firm, and its overall cost of capiial, are independent ofthe amount of debt.

With Corporate Taxes. To illustrate the MN{ model with corporate taxes, as-sume that all of the previous conditions hold except these two:

1. Expected EBIT = $1,000,000.4

2. Fredricksou lras a 40 percent federal-plus-state tax rate, so T = 40%.

Other thirrgs held constant, the introduction of corporate taxes would lorve'rFreclrickson's net income, hence its value, so we increased EBIT from $2.4 millionto $4 million to m.rke the comp.rrison betrveen the two modc'ls easier.

rlf rve had left Fredrickson's EBIT at $2.4 million, the introduction of corporate taxes woulcl have redrrceel the firm's value from $10 million to 5l? milliort

.. EBIT (1 - Tr Sl I million t0.6)v' =::k:- =sl2'omillion

Corlrorrte trxes reducc the anrount of_oPcraiing in.onc a\,iilalrlc to itlvestols irt an unlcur.rtd flim bithe facbr (1 - T), so the rrlue of tht'firm u,cruld be rcduced br.the same atnount.

r--::T':"----:-:r* ---:----_ -'

The important point here is that when corPorate taxes are introcluced' the valu

oi in" flu""tua firm exceeds that of the unlevered firm by the- amount TD' Sim

ihe eain from leverage increases as debt increases, in theory a firm's value is nur'

imiied at 100 percent debt financing'

Because all cash flows are urstl^-"d to be perpetuities' the value of the udtn'

"Jfi.r., can be found by using Equation 11-4' With zero debt (D = $0)' the valu

of the firm is its equitY value:

(11.t{

0t-r

0t{

Proposition II. The cost of equity to a levered firm is equal to ( 1) the cost o{ q

uity to an unlevered firm in tlle same risk class plus (2i a risk Fremium whd

;a ;;A;t .n the differential between the costs of equity and debt to anrD

i"*r"ifir-, the amount of financiai leverage used' and the corporate tax rale

NotethatEquationll-2aisidenticaltothecorrespondirrolvitlrout-taxequab(a11-2, except for the term tr -ij-i"1i-2"' Since (i -.r) i!less than il,llflitr*"s .u,rre the cost of equitv to rise less rapid)y with ':li:1i:.illffiH;the absence of taxes, Proposiiion II, coupled with the fac

fective cost of debt, is *iui p,oa'ces ihe Proposition I result' namc-ly' thrl fi

firm's value increases as its leverage increases'

Illustration of the MM Models

To illustrate the MM models, assume that the following clata and conclitiorrsh{

for Fredrickson Wut", Co*iu,ty, u'tota, established firm that supplies.n'ag"

residential customers i., ,"ui,uino-growth upstate New York conulrrnities

1. Fredrickson currently has no debt; it is an all-equity colnPan\" - rin*.f

2. Expected EBIT = $2,100,000' EBIT is not expeciecl to incre'lst'ot'e' ""

Fredrickson ls rn a no-growrrt srruarrult' ,.-.:.tr+ri

Needing no new capital, Fredrickson pavs out all of its intonrt"ls or\'--'..

- ---"*- rr.s ss. ltMtr

E6BR},!p9o"i

" OFHN^ii e\\in!NNoEi

a 8RbO o6i -

UU

,. E 3BB::

oooo@ ci N $..l

aaa> d6i<

O o6ob

o

U

z

u baeS EEr

,r ERca r

1:9 N

"" *;;:;

E EEEfi!

F

o

o d6

t :;" xx

O-

.q6cco

o:@6

!oo@

diI^ovoo -t

O-o;lodto

o:@6

!

FI

o6Fo

oooo€t3*d o:;

oo

osFIo

3d

oooi'ii6 N rei ll

:\en

Capital Structure Theory: The Modigliani-lvliller Models .115

When Fredrickson has zero debt but pays taxes, Equation 11-4 can be used iofind its value, $20 million:

v. - EBIT ( t - T) - ${ million (0.5) = $20.0 minion.vu- k'u 0.12 -aLt

Now if Fredrickson uses $10 million of debt in a world with taxes, we see byProposition I (Equation 11-1a) that its total market value rises to $24 million:

Vs = Vu a f! = $20 million + 0.4($10 million) = $24 million.

Therefore, the value of Fredrickson's stock must be $14 million:

S = V - D = $24 million - $10 million =$14 million.

We can also find Fredrickson's cost of equity, k.r, and its Vr'ACC at a debt levelof $10 million. First, we use Proposition II (Equation 11-2a) to find k.p the lever-aged cost of equity:

k,s = k"g + (k'u - kdxl - T)(D/S)

= 12oh + (12% - 8%)(0.6)($10 million/$14 million)

=72%+1.77%=73.71%.

The company's weighted average cost of capital is 10 percent:

WACC = (D/v)(kJ(1 -r) + (S/V)k

= ($10/$24X8%X0.6) + ($14l$24)(1,3.71,%) = 70.0%.

Fredrickson's vaiue and cost of capital at various debt levels with corporatetaxes are shown in Panei b on the right side of Figure 11-1. In an MM world withcorporate taxes, financial leverage does maiter: The value of the firm is maxi-mized, and its overall cost of capital is minimized, if it uses almost 100 percentdebt financing. The increase in value is due solely to the tax deductibility of in-terest payments, which lowers both ihe cost of debt and the equity risk premiumby (1 - T).s

To conclude this section, compare the "Without Taxes" and "With CorporateTaxes" sections of Figure 11-1. Without taxes, both WACC and the firm's value

88?aao

2e?RFF

5ln the limiting case, where the firm used 100 percent debt financing, the bondholders would own theentire company; thus, they would have to bear all the business risk. (Up until this point, MM assumethat the stockholders bear all the risk.) If the bondholders bear all the risk, then the capitalization rateon the debt should be equal to the equity caPitalization rate at zero debt, ka = 4u = 12'/".

The income stream to the stockholders in the all-equity case was $4,000,000(1 - T) = $2,400,000,and the value of the firm was

u, = &ffi9@ = r2o,ooo,ooo.

lvith all debt, the entire $-1,000,000 of EBIT would be u*d to pay interest charges-k6 would be 12npr.pnt so T = 0 l2fDpbt) = S,1.000-000. Taxes would he zero- and investors (bondholders) would setpercent, so I = 0.12(Debt) = $4,000,000. Taxes would be zero, (bondholders) would get

aa227Oe

ihe entire S1,000,000 of operating hcome; they would not have to share it with the government. Thus,at 100 percent debt, the value of the firm would be

"=sH@=t33,333,333=D'There is, of course, a hansition problem in all this- MN{ assume that kd = 8'l/o regardless of horv muchdebt the firm has until debt reaches 100 p€'rcent, at h'hich point kd iumps to 12 percent, the cost of eq-uity. As we shall see Iater in the chaptet k.i realistic.llly rises as the use of financial leverage increases.

)

416 Chapter 11 CAPITAL STRUCTURE DECISIONS: PAITT ll

(v) are constlnt. with corpordte taxes, welC! fe*.1es and. V ,tlllt ut *on

),'ra'rnor" debt is used, so the optimal capit'rl structllre' under MM withcq'

porate taxes, is 100 Percent debt'

What is the optimal capital structure under the MM zero-tax model?

What is the optimal capital structure under the MM model with corporll

The l-lar:racl.r Nkrtlel: lrrtroducing lvlarkct Risk {i7

companv rvitir bg = 1.5 ancl $100,000 of cr}ritr' (S = $100,000), is considering re-placing $20,000 of equity with deirt. Asstrming also that krr = 10"/,, krr = 1591,, anclT = 3.1'11", then Firm U's currcnt rrnleverecl retlrrirr'cl ratc of return on equity l\'ouldbe 17.5 percent:

k,u = 1i)')i + (15')6 - 10'x,)1.5

= 10,)/,, + 7.5.'/,, = 77.5');.

This shon,s that the businoss risk prcrnium is 7.5 pcrcentagc points. If the tirmlvere to atltl $20,000 of tlebt to its capital strlrcturL., then its new value, accord-ing to MM, t,ould be Vr- = Vu + TD = $100,000 + 0.31($20,000) = $106,E00, andits k., using Equation 11-5, rvould risr' to 18.(;.1 percerlt:

k,r = 10% + (159/. - 10%)1.5 + (159/, - 109{,)1.5(1 - 0.34X$20,000/$86,300)

= 10% + 7.5"/,' + 1.14')i, = I 8.64'l,.

Thus, adding $20,000 of debt to the capital structure rvould result in a financialrisk premir"rm on the stock of 1.14 percentage points, lvhich would be addcd tothe business risk premitrm of 7.5 pcrccntagc points.

Flamada also sliorved that Equation 11-5 can bc used to clcrir,,e another eqlra-tion that analyzes the effect of financial leverage on bcta. lVe knorv that the SNILcan be uscd to estimate a firrn's required rate of rl'turn on e(luity:

SML: k. = ko,, + (ku, - kon)b.

Nor,v, by equating the SML ecluation rvith Etl,ration 11-5, rve obtain:

knn + (kr' - k,.,,;b = k11; + (k'1 - k11s)b1r + (k,1 - k11r)LrLr(1 - TXD/S)

(k\j - krir.)b = (k', - k,.,.)bu + (k'1 - k111,)Lrg(1 -T)(D/S) (11-6)

b = bu'r- bu(1 - T)(D/S),

b = bu[1 + (1 rXD/S)l ( 11-5r )

I Thus, under the MM and CAPNI assumptions, the equity beta of anv firm isequal to the ecluity beta the firm wor-rld h.rr-c if it used zero delrt, acljustr'd up-ward by a factor that depends on (1) the corporate tar rate and (2) the amount offinancial leverage employed.' Thercfore, the stock's nrarket risk, which is mca-sured by b, depends on both the firm's business risk as mcasured by bu and itsfinancial risk as mcasureLl by b - bLr = br(l - TXD/S).

To continue our illustration, if Firnr U *'crc to reprl.icc 529,9a, of eLluity w'ithdebt, its equity beta would increase fronr 1.5 to 1.728, accor.lirlg tr: Eqtration 11-[r.r:

b = t,u[1 + (1 TXD/S)]

= 1.5[1 + (1 - 0.3{)(20,000/$S6,800)]

'lf a firm uses preferrcrl stock, thcn l]quntion 11-{r betornts

b= g. *O, (p,/S) + t,, 0 _ T)(D/S),

uhere P = market v.1hre o[ prcferrccl stocL. llerr thc unlevcreri l,cta is rriirrstcti up*arri l.r'the prc-icrred sto.k as vloll as tht: dc[.t.

taxes?

Horv does the Proposition i equation dif{er in the trvo models?

How does the Proposition 1I equation differ in the two mode'ls?

Why do taxes result irr a "gain from leverage" in the MM model with corp

rate taxes?

THE HAMADA MODEL: II\TRODUCING MARKET RISK

In our discussion of business and financial risk in Chapter 10' we focused m

stand-alone .isk, 'sit'g oosE(u) as the measure.of,business risk and oR6g1u as th

measure of the stand-alonJii"tl Uot"" by stockholders if debt is used' Thus' in Sr

stantl_alone risk sense,-tnoEi;1 - 011691.1, is a.me.rsure of financial risk' Recall,

rh^,,.h th.rt .urt of staJ-"aini" tittt * be eliminateel if stockholders divenill

;il;';il ;;fi.L"' il il' ;;;tion' we consider business and financial risk ftoo

a market risk standPoint'Robert Hamada.o*uln.a the CapitaiAsset pricins Modtt (CAPM) presenttd

in Chapter 2 with the ttil "ft"t-i"^'-oaa to obtain this erpression for kp 0t

."t, ,rilq"itY to a leveraged firm:6

,. - Risk-free * Btrsincss risk .,KsL - rate premium

= k*r + (kiul- kRr)bu + (kr,r - kRF)bu(1 - TXD/S)

Here bg is the beta coefficient the Jirm woula rril'e,lt l:,:'::i::"'J:Tii:llj$:;:,'i"'^I:,;::',"'fi :'il:':il1"1,ii:;,'^".1'Y.::::::::lll'il1',iJ#age, anel the other termsate d5 uurrrrtu -' -.,,,.,r,rnin,a:

kRf, thcili'a,?^, ir-.'" rcq,rired rate of return on a.stock into threc tl,_:

.,-,,,- ^f moneyl r

;:::' I;,'TilI[" :ff ;':;;';;;h'l;;" ior the time ::'::..:'.T?liLJiim':,I*:il;i ifif 11

; F"

*'J iy :,:- ly. J i,' 1t i';', ;,ff IoXfiiliill:T".T:1'i'::"::1;il"'h,#;;i*";5!'r',0-"P"/:'J::'mlx:itrilffiff i',r J:["ilr :{il;:; ;ffi:,\.ii ;u.";,:r i":::::l}has no financl;tI leverage (D = SU), tnen rne Irlrdrl(rdr "-^ 5;;;1.iilo.p.n*rtJ,"r" ttf." third terrn woutd drop out) and equity investol

only for business risk'y [.r business risk' ' r^r '.,i]L -^"h^ra+o r.,\p\ d()eq not holcl exrctlv'dtiil;;";il see. the MM model with coJP.:rate t"-.:t 1": -" -- u.-r..,ior T16

,,"TJ:"uXlf ii:liii"ilffi i""l ""i ririy aesc.ibe r.,,e,tor o:n::l1ffiffi "l?;"\TX^'l:

*i"\ti ;lruJ i" i.1,o,i." rr s' -"'i u"'" gi*#-:J#;J1,"".T;:Iiiffi ::Ti::lm#:::*il:T,""'$$di*m:xappro\imation. Nevertheless, the Hamada moclel can otr""",t;;il'ilj'j. ,"r.ri*'5il"t;;; ,;ful insights As an illtrstr'rtion' assttnrc tl

;il,ff ',.::*ffi ;,:li$[li.i{1['ii[*TE:rii[^l'q]$[ii:li[[ri$.#'ii;1::i:',-

"1,'.i ,,' 1".i,,.r.' rislv debt se"-"Di\i'i"n'rl c"'r "l

(''

Financial riskpremium 01.t

Lil";:;;;;' ri,ui,.;nt lt,,,u,g.r,crrt, spring 1e8s' s'l-st

418 ChaPter 11 CAPITAL STRUCTURE DECISIONS: IART Il Capit.rl Structure'Theory: The N{iller Model 419

Miller's results can be supported by an arbitrage proof similar to the one rvepresented earlier. However, the alternative proof shown belor,r, is easier to follolv.To begin, we pariition the levered firnr's annual cash flows, CF;, into those goingto the stockholders and those going to the bondholc'le.rs, after both corporate andpersonal taxes:

CFt = 111"16p to stockholders + Net CF io bondholdt:rs(11-8)

= (EBIT - I)(1 - T.)(1 - T,) + I(i - Td).

Here I is the annual interest payment. Equation 11-8 can be rearranged as follows:

CF1 =[EBIT(1 -T.)(1 -T,)] -[I(1 -T.Xl -T,)] +[I(1 -Ta)]. (11-8a)

The first term in Equation 11-Ba is identical to the after-tax cash flow of an un-levered firm as shown in Equation 11-7,and its present value is found bv dis-counting the perpetual cash flow by k,u. The second and third terms, which re-flect leverage, result from the cash flon,s associatecl lvith debt financing, whichunder the MM assumptions is assumed to be riskless. Their present values areobtained by discounting at the cost of debt, ks. (Remember, these are all perpet-tral cash flows, so the basic perpetuity valuation model, V = CF /k, applies.) Com-bining ihe present values of the three terms, we obtain this value for the leveredfirm:

We can confirm the Equation 11-5 value of ksl = 18'64% by using b = 1'728 in 6SML:

k,=knr*(kM-krtF)b

= 10% + (15% - 10%)1'728 =18'61%'

These relationships can be usecl to hclp estimate a comP'lny's- or a divisio.i

c<ist of er1uit,r,. In both instances, we procec.d by obtaining betas for similar prg.

licly traclecl iirms anc{ then "levering therr-r up or down" to make them consGtst

wiih o.rr own firm's (or tlivision's) capital structure and tax rate. The resultisU

estimatc'of our firm's (or division's) equity beta, given (1) its business risk6,

measurecl b1, the equity betas of other firms in the same line.of business and p1

its fin.rncial risk as measured by its own capital structure and tax rate.

Qlo-ru, tiotts

Accorrling to FIamac1ir, the requirecl rate of rettlrn on a stock consists of thnt

elemenis. \Mrat are they?

Horv is business risk mt'asured t'ithin a market risk framework?

Horv is financial risk measured within a market risk framework?

what is the relationship between levered and unlevered betas according b

Hamada? ,, EBrT(1 -T.)(1 -T.) r(1 -T.Xl -T.) r(1 -Td)'r'_._-, l(,u K,; k.1

The first term in Equation 11-9 is identical to Vg as sEt forth in Equation 11-7.I{ecognizing this, and when we consolidate the second trvo terns, we obtain thisequation:

v, = V,, * J.0--T.r) f l - (l - T.Xl - T.)l

kd L (i-Td) I

(11-e)

CAPITAL STRUCTURE THEORY: THE MILLER MODEL

Although lvllvl include'r-l corporate taxes in the second version of their modd

tf.ey al'.i not extend the moclel to include personal taxes. Horvever, in his prui

dr.ntial acldress to the American Finance Association, Merton Miller introducedr

*oa"t a".ig.r"a to show how leverage affects firms' values when both personrl

""J.".p".i* taxes are taken into aciount.8 To explain Miller's model, let usbe

gin by .iefini.,g T. as the corporate tax rate, T. as the personal tax rate on ircort

from'stocks, u",ld-Tu oa the personal tax ratl on income from debt. Note thd

stocks, returns come partly is diviclends and partly as cap-ital gains, so tislweighted a\rerage of t'he eifective tax rates on dividends and- capital g"hl LY"rr"'itiulty

all cl"ebt income comes from interest, which is effectively taxed at [r

vestors' toP rates'With personal taxes inclucled, nnd tndtr the sante set 0f nssuntPtiorts ttsed in llt

earlicr triM rrroilels, the value of an unlevered firm is found as follows:

.. EBrT(r - T.)(1 - T.)v ti - K.l r

0l't'l

(11-9a)

Norv recognize that the after-tax pcrpetual interest payment divided hy the re-quired rate of return on debt, I(1 - T,r)/k.t, equals thc. marrket value of the cletrt, D.Substituting D into the preceding eqtration ancl rearranging, we obtilil-l this ex-pression, called the Miller model:

Tht, (1 - T.) tcrm t.tkc's account of pcrsonal taxes' The-rt'fore' the nurnerahr

shorrs hon,"muchof the firm's operatirrg income is left after the ttnlevereo-u"

p.1ys corporatL' itrcome taxes and its stockholtlers subscquently pa{ ry:;i.i., on iheir c,cluity income. Since the i.troduction of person.rl t.rxes lorvep "',

i.co,re a'ailable to investors, f",,on'l taxes reduce th. v'rlue of t5e unle(er'd

firnr, other things heLi collstant'

(11-10)

The Miller model provides an estimate of the vah-re of a levererl flrr:r in a rvorldwith both corporate and personal taxes.

The Miller model has several important implications:

1. The term in brackets,

l, (1 - r.x1 - r.) It'--(1_1i).,'

when multiplied by D, represents the gain from leveragc'. The bracketerlterm thtrs replaces the corporate tax ratc, T irr the earlier MM mociel lvithcorporate taxes, Vy = Vu + T'D.

2. If wt' ignore all taxes, that is, if T. = T. = Tu = 0, then the bracketc.cl term iszero, so in that case Eqtration 11-10 is the sarnL'(rs the'original IVr. nrotlelwitlrorrt taxes.

:,:-*:-*-::;:-5'-:- ;--: "-- ..1

Mitter modet: Vr = vu' ;,

- iLf$iDl,

)

rS.'t' itltrttrn H. \lill.r "Dcbt anrl T'rrt's"' /ournnl tll Fituttt't' N1'1\' 1977' 261-l;5

420 Chapter 11 CAPIIAL STRUCTURE DICISIONS: PART II Criticisnrs of tlrc \1\l and Nlillt'r \lotlcls -ll1

Othcrs Ir,rl r. oxtcndcd autl lcstctl Nlillcr's iul.llvsis. Ccntrally, tircst' crtcrrsirrrrsquestion lvliller's conclusion th.rt thcrc is no .1d\,.1nt.18C to thc use. of corpor.rtrcfu'bt. irr the Uniteti States, tlre effective tax ratL'on inconrc fronr stock is less th.rnon income frorn Lroncls. Thus, it (rppcrrs tl1.rt (t - l'.Xl - T.) is lcss th.rn (l - T.r),hence there is an advantage to tirc use of corpor.rlc. dL'Lrt. Still, Millcr's rvork doesshor'v that pL.rsonal taxcs offsr't sonrc of thc bcncfits of corpor;rtc rlebt, so tht' taxat'lvanhrges of corpor.rtc dclrt are lcss tharr rlcrr inrlrlicd b1, thc elrlicr i\lNlmode l, rvhere only corporate taxes wL.re consirle rccl.

As we note iu the next section, thcrc .rrc ..r uunrbcr of problems n,ith both theMM and tlre Miller nroclels, so onc shou[1 rcg.rrtl our exirntplcs ;rs ilrrlicating thegL.ner.rl effects of lever.rgc on firr:rs' r'aluc, not a prccisc relationship.

dr1-rru euestions

Holv does the Miller nrodel rliffor frorn thc Nfu'l nrodcl rvith corporate taxes?

What are the implications of thc N{illcr rnoclel if 1'. = T. = f., = gr

What are the inrplications if T. = T.r = 0?

Considr'ring the current tax strlrctrlre irt tho Unitecl States, what is thc prirn,iryimplication of the lvliller modol?

THE MM AND MILLER MODELS, The conclusions of the MM anr'l lv{illtr morlels follon, logically from thcir initial

assumptions. Horvever, both acaclemici.rrrs arrd firr.rncial ex€-cutives h;rvc voicr'dconcerns over the validity of tlle MIVI anc] IVIiUer nrociels, ancl virtually no one be-lieves they hokl precisely. The lvlivl zero-tax ntotlcl learls to the conclusiorr thatcapital structure doesn't mattc'r, yet !\'e observe systematic capital structLlre pat-terns within industries. Further, rvhen used rvith "rcasonable" tax rates, both theMM model with corporate taxes and the Miller r.rrorlcl lead to the conclusion thatfirms should use 100 percent debt financing, but r.irtually no firms deliberatelvgo to that extreme.

People who disagree with the NIM and lvlilltr thr.ories generally attack them onthe grounds that their assumptions are not corrcct. I-lere are the:nain obje,ctions:

1. Both NIM and Miller assume th.rt persorlal anrl corporate leverage are per-fect substitutc.s. Horvever, an irrclirlicltral irl,c.stir.rg in a lcvcrr.tl [ir]n has lcssloss exposure .rs a rusult of corPoratr limittJ tiilility than if hc or shc usecl"honrcmlr-lc" lcverage. For cxample, in txrr tarlicr illustration of tirt Niivlarbitrage argument, it shor.rlcl tre noterl that only the $600,000 our invcstorhad in Firm L woulcl be lost if that firm r,r,ent b.rnkrupt. I-lorvcve4 if the in-vestor engaged in arbitrage transactions and employed "homem.rde" Iever-age to invest in Firm U, then he. or she cor.rkl Iose $900,000-the origin.-rl$600,000 in\.estment plus the $100,000 loirn less the $100,000 investment inriskless bonds. This increased personal risk exposure would tencl to restraininvestors from eng.rging in artritrage, and that could cause tl-re ecluilibriumvalues of VL, Vu, k.L, anrl k,g to bc clifferent fronr thosc sirccificd br. NI\1.I{estrictiorrs on instituticrnal invcstors, u ho t'krminatt'c.rpit.rl markets toriar;mav also rr,tarcl the arbitragc procrss, LrecaLrsc, nr.rrrv institution.ll in\'ostorscanuot leg.rlll,borrorv to buv stocks, herrce .rrc prohiLritr.rl fnrm cng..rging inhor.nem.rrle Ievcrage.

3. If w'e ignore personal taxes, that is, if T. = T., = 0, then the bracketed teq, ^duces to [1 - (1 - TJI = T., so Equation 11-10 is the sanre as the MM msd;with corporate taxes.

4. If the effective personal tax rates on stock and bond incomes were equrt

that is, if T, = T.r, then (1 - T,) and (1 - T,1) wotrld cancel, and the bracGterm would agairl reduce to Tc.

5. If (1 - T.Xi - T.) = (1 - Td), then the bracketecl term wor'tltl 8o to zero,ard

the value of using ler.erage would also be zero. This implies tlrat the tax ailvantage of debt to the firm woulci be exactly offset by the Personal tax.d-

vantage of equity. Undt'r this condition, caPital structure would have nodtfect on a finn's value or its cost of capital, so rve lvould be back to lt41r11

original zero-tax theorY.

6. Because taxes on capital gains are both lon'er than on ordinary incomead

can be deferred, the effective iax rate on stock income is normallylessfirathat on bond incomd. This being the case, what would the Miller modelpn

dict as the gain from leverage? To answer this question, assume that the 6rate on corporate income is T. = 34'7", the effective rate on bo^nd incomei

Ta=ZBuk, ind the effective rate on stock income is T. = 15%.e Usingthet

values in the Miller model, rve find that a levered firm's value increasa

over that of an unlevered tirmby 22 percent of the market value of corp

rate debt:

cain rrom re'erage=1, -"++#],_ f1 _ (1 -0.3.1x1 - o.l5)lDI- (1-o2t3) l

= [1 - 0.78]D = 0.22D.

Note that the MM model with corPorate taxes would indicate a gain from leter

age of T.(D) = 0.34D, or 3'l perceni of the amount of corporate debt' Thus' wi$

tiese asiumed tax rates, adding personal taxes to the model lowers but doesrd

eliminate the benefit from corpoiate debt. In general, whenever the effectivettr

rate on income from stock is iess than the effective rate on income from bon&

the N{iller mociel produces a lower gain from leverage than is producedbylhMM with-tax model.

In his paper, Miller argr.recl that firms in the aggrcgate woulLi issue a mix.d

debt and equity securitiei such that the before-tai"yie"las on corPorate.secuntB

and the p"ito.,ol tax raies of the investors who bought these secttrities.wour

adjust-until an equilibrium was reached. At equilibrium, (1 - Ta) would.eql'(1 - T.Xi - T,), so, as rve noted earlier in Poini 5, the tax aclvautage of debl D

in" fi.* ,uori,l b" exactly offset by personal taxation, and capital structt!?

wonld have no effett on a firm's ,rui.,* o, its cost tlf capital. Thui, accordinS.r

Miller, the conclttsions derivecl from the original lvlodigliani-Nliller zert"''

model are correctl

1,* ,rt **'"'r*ller ancl Scholc's clt'scribe'd horv investors cotlld, thcorr'ticallv strette r or. {Sconte from stock to thc Point \th('re tht' effectil e licrson'l1 t'1x ratc' trn srrch iutnnt" it t'*"""-''.tt

:ili:"JlliJ,I'11;l *'l)Hl,i""lill:ii.;?-:lixlil:il.,,l;l:ii;,,{lllll.l:,l.iJi':;li','l:i'.'"[[*#.rrr.l S.lr.rles Jiscu:scd

ISMS OF

,122 Chapter 1l CAI'}ITAL STIIUCTUIiE DECISIONS: l']AItT II CapiLrl Slructure Thcory: The Tracle-Off Nlodcls 423

Note, though, that large, diversified corporatiorls can Llse losses in one di-vision to offset profits in another. Thus, the tax shelter bengfit is more cer-tain in large, diversified firms than in smaller, single procluct companies.Firms recognize this, and this factor hirs contributed to an increase. in firmsize.

6. IVIN{ anci Miller assume that there are no costs .rssociatecl witl.r financi;rl dis-tress, and they ignclre agency costs. Furthcr, thev assume that all marketparticipants have identical information about firms' prospects, rvhich is alsoincorrect. These topics are discussed in the next section.

Note, though, that *'hile limited liability mav Preserrt a prohlem to individrurls, it does rlol prescnt a problern to corPorations sct uP to und.rui-leveraged

buy-outs, or LBOs. Thus, after MM's work becarne \a;6fknorvn, Iiterally hundreds of LBO firms were estal'lished, and tlr+founclers macle billions recapitalizing unclerlevcragecl tirms "Junk b6n6.1

lvere createtl to aicl in the process, and the managers of underlevsl4aet

firms that did not want their firms to be taken over recapitalized on t[ot n. Thus, Mlvl's work raised the level of debt in corponte America, sn6 |probably raised the level of economic efficiency'

2. If a leveragetl firm's operating income declinccl, it rvould sell assets a{takc other measurcs to raise the cash necessary to n'Ieet its iuterest oblir.

ations ancl thus ar,oid bankruptcy. If the unleveraged firrn experiencf

the samr,' decline in oPeratil-\g income, it woulcl prolrably take the le$

drastic measure of cutting dividends rather than selling assets. If d11i

ct'ncls w'ere cut, the investor who employed homemacle leverage woul3

not receive cash to pay the interest on his or her debt' Thr'rs, homemadt

lL.verage puts stockholders in greater danger of bankruptcy than does cot.

porate Ievt'rage.

3. Brokerage costs lvere assumed away by MM and N{iller, making the switd

fron L to U costless. However, brokerage ancl other transaction costs (irl

clucling "market presstrre") do exist, and they too impede the arbitla$

p rocess.

.1. NIM initially assttmed that corporations and inve'stors can borrow at th

risk-free rate. Although risky debt has been introducec-l into the analysisbl

others, to reacl.r the MM and Miller conclusions it is still necessary t0 a9

sunle that both corporations and investors can borrow at the same raL

While major institutional investors probably can borrorv at the corPora[

rate, many institutions art- not allowed to borrow to truy securities. Furthtt

most individual investors mr"tst borrorv at higher rates than those paidI

large corPorations.

dV-rru Questiotrs

Shotrld lve accept that one of the models prc'sentecl thus far (MM with zerotaxes, MM with corporate taxes, or Miller) is correct? Why or rvhy not?

Are any of the assumptions used in the modcls n,orrisorne to you, and whatcloes "worrisome" mean in this contcxt?

TAL STRUCTURE THEORY: THE TRADE-OFF MODELSSorne of the assumptions inherent in the MM ar.rt-l Miller nrotlels can be relaxeclwithout changing the basic IVIM/Miller conclusions.rr Horvever, as we discussnext, whe.n financial distress and agency costs are considc'rerl, the N{N'I and Millerresults are altered significantly.

Costs of Financial Distress

Fin;.rncial distress inclrrdt's, but is not restrrcied to, bankrr-rptcli ancl n,hen finan-cial distress occurs, several thirrgs can happen:

Arguments between claimants often clclay the liquiclation of assets. Bank-ruptcy cases can take many years to settle, antl tluring tl-ris time machineryrr.rsts, buildings are vandalized, inventories become obsolete, and the like.

Lawyers' fees, court costs, and administrative expenses can absorb a largepart of the firrn's value. Together, the costs of physical deierioration plus le-gal fees and administrative expenses are called the direct cosls of financialdistress.

Managers and other employees generallv lose their iotrs when a firrn f;rils.Knowing this, the management of a firn-r tlrtrt is ir-r financiaI distress maytake actions that keep it alive in the short run but which also dilute long-runvalue. For example, the firm may defcr maintenance of machinery, sell offvaluable assets at bargain prices to raise cash, or cLtt costs so ntttch that thequality of its products or services is impaired and the firm's long-run mar-ket position is eroded.

rrFor exanrpic, sct Robert A. Ilatrgon anrl J.rnrcs L. I'.)plrs, "t:(luilibritrm in the Pricing of Capital As-sets, llisk-&aring Dcbt lnstftrnlcnts, antl the Question of Optirl.rl Capitdl Strucrure," louilutl of Fi-iltrtciri nt,l Qrdriirrlirr' ,4rml-Vsis, JLrnc 1971. 9-13-951; Josr,fih Stiglitz, "A Rc-E\nmin.rtion oF thcNlotli;;liani-Nliller 'fheorcn," AiltL'ricdtt t-Lrttottlii ,liri'i 4,, [)cct'rnt,er 1969, 7iJ-l 79-] -rrLl Nl'rk E

Rubonstt,in, "A lVlcan-Variance S)'nthcsis oi Corporatt'Financi.rl Thcirrr'," /L)rrrrrl r)iFirrd,r.., NInrchlr7l.16. -181.

5. In his article, Miller concluclecl that an ecluilibrium rvotlkl be reached, butb

reach his equilibrium the tax benefit from corporate debt must be thesart

for all firms, ancl it must be constant for an indiviclual firm regarclless of framount of leverage used. However, lve know that tar berrefits vary frrfirrn to firm: tslig'hly profitable compatries gain the m'lximtrnt tax bened

from leverage, while the benefits to firms that are stmggling are m&i

smaller. Furihcr, some firms have other tax shields such as high deprn?

tion, pension plan contributions, and operating loss cnrry-fonvardt c-

tl.rese shields ieduce the tax savings from interest pryments ro It 1l:0 I

pears simplistic to assume that the expected tax shi':ld is tln'1f fected Dy u'

amount of clebt usecl. Higher leverage increases the Probabili[y that the fiIr

rvill notbe able to use tlrc full tax shieltl in the fr'rture, bec'-tt'tte higherle\E

are increases thtt probability of future unprofitabilitv and cotlse(luenr:

lorver tax rates. All things crllrsit'lerecl, it appears likely that the interesllr

slrielcl from corporate d"ebt is more valuable to some'Ii'ms than to othdtl

.',.* .*"--r*^i the . inrprt of tar shie lcls othcr thnn rlcbt iinancin{,, tt

;11;; i:;l,l#Ronrltt \V. NI.rsulis, "Optimri CaPit,ll StrtlcturL'trllder CorPo'atL''ln'1 11

il.r,rri,rl i ('(,,j, ,rrr,'.. \1.lr, ll t',sl' 'l-ll).

)

42,i Chaptcr 11 CAPITAI- STRUCTURE DICISIONS: PART II

Both customers and suppliers are aware of the problems that can arise, anrthey often take "evasive action" that further damages the troubled fir6. plcxample, Eastern Airlines, as it struggled to tleal with its unions and uavoid liquidation, had trouble selling tickets becarrse potcntial customo-

rvere worried about buying a seat for a future flight and thcn having dDcompany shut down before they could take the trip. Some potentiafqu.tomers were also worried that the company might cut back on maintenanJand Eastern's suppliers were reluctant to grant norm;rl credit terms or igear up to supply parts and other materials on a long-term basis. Finalt"

Eastern had trouble attracting and retaining the highest-quality worken,Imost workers with a choice preferred employment with a more stable air.

line to one that might go out of business al any time.

Nonoptimal managerial actions associated with financiaI distress, as welltthe costs imposed by customers, suppliers, and capital providers, are calle{

the intlirect cosls of financial distress. Of course, these costs may be incuned

by a firm in financial distress even if it does not go into bankruptcy: Banl.

ruptcy is iust one point on the continuum of financial distress.

All things considered, the direct and indirect costs associated with fhancial

disiress are high.t'Further, financial distress typically occurs only if a firmhaldebts-debt-free firms usually do not exPerience financial distress. Therefore,llt

greatcr thc use of debt firttutcirtg, ttnd tlu ltrger tlrc fixed interest clutrgcs, the gteald

tle probobility tlmt a decline in earttitrgs ioill lcad to ftroncial distress, hence llthiglrcr the probability thnt costs associiled ruilhfinancial distress iuill be incurred.

An increase in the probability of future financial distress lowers the cum,lvalue of a firm and raises its cost of capital. To see why, stlPPose we estimate thtFredrickson Water will incur costs of $7 million if it fails at somL' future date, and

that the preset* aalue of this possible future cost is $5 million. Further, the proba

bility of financial distress increases with leverage, causing the expected presa{

value of the cost of financial distress to rise from zcro at zero debt to $4.75 mil

lion at $30 million of debt as shown in Table 11-1.

These expected costs must be subtracted from the valrtes we previously ofculated in Panel b of Figure l1-1 to find the firm's value at various amounts0l

leverage: They would ieduce the values of V and S and, as a result, would

raise k, and the WACC. For example, at $20 million of debt, we would obain

the values in Table 11-2.13 These ihanges would, of course, then have car4'

through effects on the graphs in Panel b of Figure 11-1. Nlost important, thei

would (1) reduce the decline of the WACC line and (2) reduce the' slope ol ut

V1 line.

r:Sr'e Edrvard I. Altman, "A Further Empirical Investig.rtion of the BanlruPlql Cost Qrrdstion,"la'rcl rr/ Fororrcc, September 198.1, 1067-1089. On the trasis-of a sample of 2o b.rnlrirpt ctrnrP.rntes, AIIPfound thit bankruptcv costs exceed 20 Percent of firm value.

'tTo fir..l k. and the WACC in Table 11-2, simPly transpose Equ,ltion l1-3 .rnel tht'n appll' the d&tiur for the IVACC:

r. (EBrr-kJDXl-T) _ [S] 0.0F(520)l(1-0.1) _1.-,c..\' --3-

$s5 - -' "' '

IVI\CC = (D/VXkiXl -T) t (S/V)(k.)

= (92t)/$25.5X8':;X0.6) + ($5.5/$25.5X26. 1s",,)

= 3.76'i; + 5.65')b = 9.ll'r1,.

C.rpital Slructurc -l-hcrrrr'; Tlrc Tradc-O[[ lvlodcls 425

Arnount oi Dcbl

$5 Nlillion $10 Nlillion $20 Nlillion $30 Nlillion

0.05

,rL'l.{isl;r..#':.,1;ii

.l.llt,alitlty or rin" ncial.d istress

$0

0.0

50

0.15

sr50,000 5750,000

0.50

5r,500,000

0.95

9{,750,000. i.Vof"rp".t.a costs of financial elistrcss'

..'.f, lriltion tinres the incliertt'd pnrt"rtri li t!

The effects of financial distress are also felt by a firn.r's bonclholders. Firms ex-peliencing financial distress havt'a highcr prtrbalrility of clcfatrlting on clcbt pay-ments, so the higher the probability of firranci.rl riistrr'ss, the higher the required re-turn ol1 debt. Thus, as a firm uses nlorc arrcl nrore tlcl,t, hr:rrce incroasing thcprobabilitv of distress, the r'.rluo of k; also incrc.rscs, c.ttsirrg several elerncnts inP.irrel b of Figr.rre 11-1 to changc.

Agency Costs

We introduced the corlcopt of .rgerrcy costs in Cl.rafrtcr 1. One agc'ncy relationshipis betrveen a firm's stockholders and its bondholclcrs. In the absence of any re-strictions, m.lnagement lvould be tcnrptecl to iakc actions that would benefitstockholders at the exprcnse of bonclho[lers. For er.rnr;,1e, i[ Fretlrickson W.rtr'rwere to issue only a srnitll amouul oI clcbt, tircrr this clclrt would h.lve relativelvlittle risk, a high boncl rating, and .r lorv intcrcst rate. r\fter it issued the lorv-riskdeLrt, Fredrickson nright issue more rlcbt scclrrtr'l bv thc same assets as the origi-nal debt. This woultl ririse thc risks facecl by all ltttttdltolLlt 's, cause k; to rise, anel

conse(luently cause the origin.rl borrt'lhoLlers to suffer caprital losses. Similarll', af-ter issuing debt Freclrickson might clecidc to restructure its assets, selling ofithose witl-r lorv br,rsiness risk ancl actluirirrg asscts thilt \^'ere more riskv br.rt

th.rt also had higher expected rates of return. If things u,orked out rvell, the

,:,t t'':l*j'i'p.

it$:rii

t#S

k.

lVACC

Values at D = $20 Nlillionwith Financial Distrcss

Effects Ignored;Pure NIlt

$2IJ.00

$E.00

1IJ.00",,

\/alues a[ D = S10 Ntillionwith Fin.rncial Distress

Effects Considered:lllodified illNI

52.ri.00-s2.5=s25.5

S8.0t)*S2.5=55.5

2b. IS",,

9.+1'1"

Tr\BLE 11'1

s.57"

426 Clh,ttrtcr 1l Cr\l'lTA[. SfliUCTLll(E I)I]CISIONS: I'AltT Il

stockl-rolders w'ould get all of the benetit, but if things werrt sotrr, nltrch of 1\u 1*woulc-l f;rll on the bonrlholders. So, stockholders rvotrld tre pl,rving a gam;;"he.rds, I rvin; tails, you lose" with bonriholders.

Because stockholders niight try' to exploit bonclholders in these and o[nlvays, Lr6nds are protecte!-l bv restrictive covenants. These covenants hamper ilcorpor.rtion's lcgitinratt' operations to son"te extent. Further, the company muslimonitored k) L'nsurL'tlrat the coven.rnts are being obeyed,.-tnci the costs of morJtoring are passed on to the stockholders in the form of higher debt costs. The h{r'fficicncy plus nronitoring.costs rrc dS(',lcy cdsls that increlse the cost of debtar6llrrrs rcrluct' its artvant.rge.ll

Value and Cost of CapitalConsidering Financial Distress and Agency Costs

If the IvlN{ motlcl with corporatL' taxes were correct, a firm's value would 16.

continrrotrsly as it movet-l from zero tlebt toward 100 percent delrt: The equa[ur

Vr. = Vu + TD shows that TD, hence V1., is maximizcd if D is at a maximum. Re

call that the iucreasing component of r.alue, TD, is a direct result of the taxshlter provirlecl bv irrterest on the debt. However, as noted above, financial distpg

and agency costs could cause V1 to decline as the level of clebt rises. Therefoq

the rclatiorrship betu,ecn a firm's value and its use of leverarge has two negatiq

components, so the true equation should look like tl'ris:

(11.lrl

Tl're relationship expressed in Ecluation 11-11 is graphed in Figttre 11-2. The tar

shelter effects totally dominate until the amount of clebt reaches Point A. AftlPoint A, financial c{istress and agency costs become incre.tsingly important,ofi'

setting some of the tax advantages. At Point B, the marginal tax shelterbenefitdaclclitional tle'bt is exactly offset by the disadvantages of debt, and beyonel Poit{

B, tht disadvantages outweigh the tax benefit.Erlr,ratiorr 11-10, thc Milleimodel, can also be modifieci to reflect financialdig

tress anc'l agcncy costs. Thc'equrtion would be ide'ntical to Eqtration 11-11,o'

cept that thc gain front lt'r'erage term, TD, wottlcl reflect the addition ot P5'

sonal taxes. In either the Mlvl or N4iller models, the gain from leverage cand

least be roughly estimated, but the value reduction resulting from potential &

nancial distit'si and agency costs is almost entirely subicctive. We knorv thi

these costs mttst incrcase as leverage rises, br,rt lr'e do not knorv tlre spectr

iunctional rel.rtionships.The arldilion of finincial rlistress anrl agoncy costs to eithel tl're MM tax mot*l

or the lvlillcr Int'rdel rcsults in a tracle-off moclel of caPital structure. In suchl

/ PVof \

V =Vu-,,- ( "ffi:Ti.1 (T,,i,)\financial /\ drstress /

C.rpital Structurc'fheory: The Tracir*Off Models .127

a "Pure" MM Value ol Firm:V.=Vu+ l'D

Financial Ciistress andAgency Costs

Actual Value of Firm

l+ Optimal Amount of Debt

model, the optimal caPital structure can be visualized as a trade-off betwee-n the

benefit of debt (the interest tax shelter) and the costs of debt (financial distress

and agency costs).

Implications of the Trade-Off Ivlodels

The tracle-off models cannot be used to spe6ify a precise optimal capital struc-tnre, but they do enable us to nrake three statements about Ieverage:

1. Firms witl'r more business risk ought to use less debt than lower-risk firms,other things being equal, b!-cause the greater the business risk, the greater

the probatrility of financial elistress at anv level of debt, hence the greater

the expecteci costs of distress. Thtrs, firms rvith lower busincss risk can bor-rolv more before the expc'cte'cl costs of tlistress offset the tax acivatlt.rges ofborrorving (Point B in Figure 11-2).

2. Firms that lrave tangible, rt'atlily r.rrarketable'assets such as real cstate can

use more debt than firms n'hose value is derivecl primarily from intangi-ble asscis such as patents ancl goocllvill. The costs of financial ciistress de-

pend rrot only on the probability of irrcltrring distress but alstl on lvhathapperrs i( r-listress occtrrs. Spe'ciirlizr:ci assc'ts anti intani;ible assets are

more likely to lose valr,ro if financial c{istress occurs tlr.ttt arc stancl.lrdized,tarrgible assets.

3. Firms that arr. currently p,lvirrg taxcs at the highest rate, ancl th.lt are likelvt.6a so in the futrtre, slrott[l ttse nlore debt tlr.rn firms lt'ith ltxver t(]\ r<rtes.

''\ li.h.r.l C. l('r\cn .il\(l \\'illir m l l. i\ld.klinA lroint o(tt th.lt th('re irc .rl',, 1g111. 1' (r,sts bcts'ts d

sirlc c uitr lrolJcr: rr.l nrrnrgt,nr.rrt. Sct "iltitrl oi tht' l:irnt: l\lrn'rgtrirl Rthitir.r, AgencvaTrnrl ()rrrrcrship Stnr(lurt'," lonnil oi FittttttiLtl I.or{r,ri(j, C)chrber l')7o, ltl5 lbl) Thtrr sluo!''u...srrgil('sts thrt il) trnrlholdu.rgencv cttsts irrcrclse.rs tlrr'cielrt r,lti() in.ren{\, t tlt (:) oulsidcPhol.lcr.rgcncl co\ts nl(rvr'irt rt'r'crst'f.rshitn, i.rllirrg rvith incrt.rsotl ttsc oi tlcht.

)

rtGuRE 17-2

428 Chapter 1l CAPITAL STITUCTURE DECISIONS: PART II

stiot s

Describe some types of financial distress and agency costs.

How are these costs relatecl to the use of financial leverage?

How are the basic MM with corporate taxes ancl Miller moclels affectecl by ilrinclusion of financial distress and agency crrsts?

What is a trade-off model of capital structure?

What irnplications clo the trade-off models have regarcling capital structure?

Does the empirical evidence support the trade<lff modcls?

riFor ex.rmples of thc' empiric.rl research in this area, sce Robr'rt A. Trg*rrt, lr., .\ \lo.Jct of GII'rateFinancingDecisions,'ilrrrrnrrlpfFinurct.D('ccnber1977,l-167-1.181:in.lIi,rrl\l.rr*1,. Ih"Ct*t'betlveen Equitv.rnd Debt: An Enll.irical Sttrrlr;" ltrrrrrri crlFird,rrr, Nl,rrcli l9Sl. 1ll-l-ll.

High corporate taxes lead to greater benefits from dcbt, other factors harconstant, so more debt can be rrsed before the tax slrield ls offset by firrzicial distress and agency costs.

According to tl're trade-off models, each firm should set its t.rrget capital stnr..ture such that tl-re costs antl benefits of leverage are balanccd .rt the margiri,il,cause such a structLrre lvill maximize its value. 'lf the trade-off models are ioirnrwe shoulcl find actual target strllctures that are consistent rvith the three poirijust noted. Further, we should find that firms within a given inrlustry huue sirjlar capital structures, because such firms should htrve rrughly the same typeso{assets, busincss risk, and profitability.

The Empirical Evidence

The trade-off models have intuitive appeal because' ihey lead to the' conclusiqlthat both no-debt and all-debt are bad, while a "moderate" debt level is gm4However, we must ask ourselves whether these moclels explain actual behaviqIf they do not, then we must search for other explanations.

ln fnct, the trade-0ff nndds lrLtue uery litnited et4tiricttl srrpporl.rs Ii cloes tum out

that firms which invest primarily in tangible assets do tend to borrow more

heavily than firms whose value stems from intangibles. H_owe-rger, empiricaler.idence refutes other aspects of the trade-off models. First, se.,'eral studies havt

examined models of fiirancing belravior to see if fiimi' financing clecisions an

consistent with a target capital structure. There is some eviclence that this a.curs, but the explanatory power of the models is very low, suggesting liuttrade-off models capture only a part of actual behavior. Second, studies halr

not consistently demonstrated thit a firrn's tax rate has i'pic.iictable, material

effect on its capital structure. Indee.d, firms used about as much cielrtbeforecor.porate income taxes even existcd as they do today.-Finally, actual debt ratio

tend to vary widely across apparently similar firms within given induskies,

whereas the trade-off models s!.lggest that similar firms should have similu

debt ratios.A11 in all, the empirical support for the trade-off models is weak, whichsug'

Bests that factors not incorporated into these models are' alscl at lvork. In otits

words, the trade-off models do not tell the full story.

C.rpital Struttrrrc Thctrrr': Thc Signaling itlodcl {29

ITAL STRUCTURE THEORY: THE SIGNALINC MODEL

Some time ago, Profcssor Cordon Dorraklson of llarvartl concluctetl an extcnsivr'' stuclv of horv corpor.rtiorls actu.rlly cstalrlish tlicir capital structurcs.l6 Here is a

snllunarv of lris firrdings:

'[. Firnrs prefcr to fiuance lvith interrrallv gcncrnte.l fturrls. that is, tith rc-tained earnings anri clepreciation cash flolr,.

2. Firms set targct divitlerrd payout r.rtios b.rserl on e\Lrccted fr,rture invest-mr.nt opportunities and expcctccl futurc cash fltlvs. The tartct payout ratiois set at a level that c.luscs rL.taincd earnirrgs plus deprr.ciation to covor cap-ital cxpcrrri itrrrcs urrtl or rrorma l corrtl i tiorrs.

3. Divirlentls arc "sticky" irr the short rrrn-firnrs are relttctant to raisc divi-dcrrtls unless they.rrc conficlcnt that thc higher divielend can be main-tairred, ancl thcy arr: cspccinllv relucLrnt to cut the clivitlcnil. lntiectl, thc'v

generally rlo not rerluce the cliviclcnd trnlcss things aro so bad that they sim-ply havc to.

4. lf .r firm has morr' internirl c.rsh florv than is ncctlerl to cover its capital ex-pr'nditures, then it rvill invest in m.rrket.rble securities, usc the funds to re-

tire debt, incroase dividends, repurchase stock, or acrluire other firms. Ontht'other lrancl, if it has irrsufiicient intcrn.rl c.rsh floh, to finance nonpost-

Fonable neh, projects, it rvill first clraw' r'lorvn its marketable securities porFfolio, tl-ren go to the external capit.rl markets. If it has to Bo io the e'xtern.rlmarkets, it rvill first issuc r1ebt, therr corrvr.rtible bonds, ancl thcn conlmonstock only as a last resort. Tltls, Dtrrrrt/ristrrr ol,sclit',1 tlutt tltra is rr ";t'l.li,1g p1-

dcr" oJJitrottcittg, tl()t 0 ltttlitt.L'tl ipltrL)ntlr rrs ii,or/r/ rcsilt iJ tlte troi*oJf nnttltls

at c u ro t c h1 riescriDrri rcnl -ittn' lrl bL'l tni' i o r.

Professor Stewart Myers rrotetl the inconsistcncy betlveen DonaLisorr's furd-irrgs.rnd the traclc-ofi morlcls, ancl that incorrsistr'rrct'led N{yers to propose a nervtlrcory.r' First, M1'crs notcrl that Donalclson's pccking-order findings lcd arvavfrom, rather than torvar(i, a rvell-clefinerl capital structurc. Equity is raised in hvoforms-retirined earnings and ne'rv stock. lletaincd trrrnirrgs arc at thL'top of the

pecking order, lvhile nc!\' cornmon stock is at thc bottom. Thercfore, if retainr'rlearnirrgs are. high rclrtive to investment requiremcnts, the equity ratio u'ill in-cre.rse, lvhile if rehrined eamings are insufficient, thr'firm will borro*' rather thanissue stock, cirusing the delrt ratio to incrc.rse. Thc trade-off mot{els, on the otherhand, assume that equity from the sale of stock is etltrivalcnt to that from retainede;rrnings, ant'l they suggest that the delrt/ecitritv ratio shoulcl renlain constantor.er time.

Next, IVIyers notc'c1 that a critical assumption in thc tradc-off modc.ls is that alimirrket participants hirve hornotL'rleoLls t'xLrcctatiotrs. rvliich implies (1) th.rt allparticipants have the sarrre infomrirtion aud (2) th.rl an1, changcs in opcr.r1j11g 111-

come arL. purcly r.rntlorn as opposcd to Lrcirrg anticip.ltcrl bv sotnc'but rrot all p.rr-ties. Mt,c.rs had the insight to sce th.rt if exlroct.rtions are not honrogoneous,

rhCordon Donalrlstrn, CdrlrrLllf Dd'l Crlrrritv:.1 Sfrrrlv tr/ C(,ryr,r.rif Dal,l I'0licv ar,l tlt{ DrtL'rililtiltlit)r o.f

Corlurilr'D.lrl Crrlu.ill (l]osk)rr: I-1.1r\'.1rd CrnLlu.rtc Sclrotrl o[ Busintss r\(imirtistrition, 19bl).

'tSt.'rtart C. Nllcrs, "The Capit,rl Structure I1!/Aa," lt\tt,ilil t1f Firrtrrcr. Jul! l9E-1, 575-59:. lt is intr'r-esting tr) n()t!'th,rt, lilc thc lvlillcr n1o(['1, NIrr'rs's 1.a1-1'r rr'.rs iirst prt'stntetl .rs a l,rr'sitirntirl.rddrr'ssto the Anreri(.ln FinJncc Associnti!)rr.

Test

.130 Chaptcr 11 CAPITAL STRUCTURE DECISIONS: PART Il

nlearlirlg that difft'rent grouprs 6f mirrket participants have asvntmc'tric (o1 6;11-

ent) infr)rmation, thcn Donaldson's restllts can be explained in a logical 63,j[Nlyers's *,ork resultctl in what is norv callecl the-signaling, or asymmetrichf;nration, theory of caPital.structtlre..To

illustrate, assume that a firm has 10,000 comnron shares outstan6i*

Thcy st-ll at a price of $19 per sharc, so the market valtte of its equityl$190,000. Horvevr'r, its rnanagers have better itrformation rt'garrling the fi'rifuttrre than stockholclers, arrcl the managers believe that tlre actual value ush;rre bascd orr existing assets is $21, giving the eqtrity a total "intrinsic" yj|of $210,000. Such an information asymmetry (or difference) cotrld easily erLtfor managers often knorv more about their firms'Prospects than do currentarjpotenti;rl investors.Is

Strppose further that managelnent now iclentifies a new proje'ct which would

require 9100,000 o[ extL'rnal financing and which has an estiuatetl NPV of $5,m

[Remember that a project's NPV represents economic value added (EVA), atg

that it accrucs to thc shareholclers.l This proiect is trnanticipatecl by the firmtbvestors, so the $5,000 NPV has not been incorporated into tlre $190,000 eqrrity

m.rrkct value. Shoulc{ the firm accept the proiect? To begin, strPPose the firmbslres nelv stock to raise the $100,000 to finance the project. Scverirl possibilifu

exist:

1. Symmetric information. First, as a point of departttre, consider thesihra

tion in rvhich management can convey all the information to the publia

hence all investors have the same information as management regardinga.

isting asset values. Under ihese conditions, the stock woulcl immediatdy

rise to its 921 intrinsic v;rlue. Then, lvht'n the new project comes alongard

is financed, the firm wottld have to sell $100,000/$21 = 4,762 new shara

Acceptrncc of the projt'ct would then increase the stock price from $21 b

$21.3-l:

New stock P.,." = Original shares + New shares

_ $210,000 + $100,000 + $5,000 =

$315,000 = szt.gl.

10,000 + {,762 11,761

Both olcl ancl nerv sharcholtlers rvould benefit if the proiect lvere accePted;

cach grouP wotrL{ gaiu $21.31 - $21.00 = $0.3'l per sh.irc as.1 rcsttltof tlt

nelv Projcct.2. Asynrnretric infomration prior to stock isstle' Nort' srtpPo5s Inanagemdt

is unable'to inform investors about the stock's intrinsic r'.rlue. Perhapsii6

necessarv to trolcl back such information to maint.lin a comPetitive dFor pslhap5 SEC regtrlations cause man;lgement to refraiu from "touhnt

the stock prior to ti.c n"r" isstre (if thin[s cticl rrot notk out.1s exPe(tel

nerv shartihol.L'rs might sr.te the n,,,,,n["r. who had Ptrvidcd the^r0{

forecast). lrr this situation, nerv stock tuoiil,l f"t.l-t the cuirclrt price, $19 Fsharc, so tht'comPatrv *'oultl have to sell 5100,000/$19 = 5,263 sharctlt

orcltr to raisc thi' reqr.rirec-l 5100,000. If this rvere clorrc', this lletv Prra

rr'1[l5.rssunrPtion is contrarv to th!'strL)n$-forn] L'fiicicnt nl,lrkcts hrPt,llre'is ([Nlll) lrcst'd{:Ch.rnlt.rls.['ilti\r\*r1()t.lh('rc,h'rv,)[1st'r\er:- intlutiingpcol'lt'rr]r,rstrt'nIlr:(rfl')ris'eJ^-.til(i reilri.lrr\nq-h,rtr] rltr.rr.n(\'-nrt NillinA h) di.elt str(nll:'i(rril1 ulti.ir'rlc\'

C.rpital Structure Thc'ory: The Signaling Motlel ,131

would result after the. proiect was acccpted and the information asymme-try was removed:

. Nelt, markct value + New monev raised + NPVNew stock p.,." =

$210.000 + $100.000 + $5.000 =ffi=sro.u*.Under this condition, the project shoulcl not bc ttndertaken. If the projectwere not accepted. so no ne$'shares rvere sold, then the price of the stockwould rise to its $21 intrinsic value when the information as!'mmetry waseventually removed. The sale of new stock at $19 per share wotrld lead to a$0.36 per share loss to the firm's existing shareholders. There u,oulcl be a

$1.64 gain to the new shareholders, but management lvants to maximize thevalue of curlenl siockholders, not new onL.s.

3. A more profitable project. Norv suppose the project had an NPV of $2O000rather than $5,000, the stock solcl for $19, and otl-rer conditions in Scenario 2

were unchanged. Now the firm's stock price would rise to $21.62 if it un-dertook the project:

$210.000 + $100.000 + $20.000=

$330,000 = szr.ez.

15.263

Under these conditions, the firm should take on the proiect. Note, though,that most of the positive NPV would go to the new stockholders, whowould pay $19 per share and thus enjoy a capital gain of $2.62 versus a gainof only $0.62 for the original stockholders.

4. Dark clouds on the horizon. Now sr.rppose an errtirely different-andbad-situation faced the firm. Stockholders think the firm is worth $19 pershare, but managers know (a) that outside investors are entirely too optimistic about growth opportunities, (b) that investors have not factored inproposed legislation which will require large, nonearning investments inpollution control equipment, and (c) that the current stock price does not re-flect the need for new R&D expenditures that will be required to keep thefirm's products competitive. If all of these bacl events materialize, profitmargins ',r'ill be under pressure, cash flows will fall, and the company willhave difficulty servicing its debt.

Faced wiih these conditions, management might well conclude that the

stock's intrinsic value is only $17 pcr share, and then decide to sell a nelv is-sue of 10,000 shares at the current price of $19, raising $190,000 and usingthe fur-rds to retire debt or to support this year's capital budget. This actionwould increase the intrinsic value of the stock from $17 to 918:

New intrilrsic value =Old intrinsic market value + New

Original shares + New sharcs

$170.000 + S190.000

10,000 + 10,000

Current stockholders u'il[, if management's expectations comL] true, suffer a

Ioss when the bad nelvs becomes knorvn, br:t thc' sale of nerv stock rvoult-lret{uce that loss. (Note: Managemerrt n'ortltl h;rve to careftrllv rvord theprospectus for the nerv issue, pointing out the potenti.il problenrs. Horvever,

10,000 + 5,263

Nen,stock price =10,000 + 5,263

lr,

' .!vE.': ;i.qlr

,,iii-\.i,:\,ia+,

l$'-:i;,;,eli

. lili.';-,ira

= $i3lj33o

= s" *

432 Chapter 11 CAPITA L STRUCTURE DECISTONS: I)AI{T II

Nelv stock price =

virtuallv all prospectuses are filled with car:tionarv langttage, So hv*-have.liificuliy teiling frorn them what managoment rcally expects.l "\

5. Finance the original $5,000 NPV project with debt. lf the firm used dehrfinance the original $100,000 Project (Scenario 2), and llrt'tt tlte ilrt'orwiasynililetry ilarc

.renuttcLl,^lhe new stock price would be $21.50 uarrurf

$20.64 we found under Sccnario 2:

C.r[.ital Strtrctrrrc -IhcLrrt;

Otrr Vicrr' {33

-Test Questiotrs

Brieflv expl.rin the rrsvrlmetric infornration (sigrraling) tht'orr'.

Wh.rt does this thcorv strggest about c.rpital structure tlt.cisions?

Is tht'signaling thcory t'qu.rl11'apPlir;;1blq' to all [irnis?

L STRUCTURE THEORY: OUR VIEWTl're great contribution of tht' tr.rtlc-off nlol'lels dcvclolrecl by MN'1, Millc'r, ancl

tlieir followers is that thesr'motlels idcrrtifierl thc spr'cific benefits and costs of us-ing dt'bt-the tax benefits, financial distress costs, and so on. Prior to ivlivl, no

capiial structure thcory existetl, so rve had uo systematic n ay of analYzitrg the ef-iects of debt financing.

The trade-off models are suumarizecl graphicallv in Figure 11-3. The topgraph shorvs the relationsltips betrvccn the del,t r.rtio arrd thl'cost of dcbt, thecost of ecluitv, ancl the WACC. Both k. arrrl k.i(1 - T,.) rist' sto.rclily with increasesin leverage, but the rate of incrcase accelcratcs at higher debt levels, reflectingagency costs and thc incrcased probability of finirncial t-listress. The WACC firstdeclines, then hits a minimtrm at D/V*, and then begins to risc. Note' that thevalue of D in D/V* in the uppcr gr.rph is D", the lcvel of debt in thc lorver graphthat maximizes thc' firm's valtte. Thus, a film's WACC is urinimizerl .1nd its valllt.is maximized at thr' santc cnpit.ll structurc. Notc also tl.rLrt thc gener.rl sh.rL.es ofthe cunes apply regardless of n'hctht'r ir'o.rre trsing the r.r.rotlific'cl irli\l u'ith cor-

por.rte taxes morlel, the lvlillcr modcl, or .r r'.rri,rnt of thcse motlels.Unfortunately- it is improssiblt' to quantiiy accuratcly thc costs anrl bencfits of

debt financing, so it is imp<.rssible kr pinpoint D/V-, thc capit.rl structure thatmarimizes a firm's value. N{ost experts believt' sr.rch a structure exists for everyfirm, but that it changes over time as firms' oper.rtions and investors' preferenceschange. Most experts also bclicve th.rt, as shown irr Figure 11-3, the rel.rtionshipbetween value and leverage is relatively flat over a fairly broad range, so largedeviations from the optimal capital structure can occur lvithout materialh'affect-ing the stock price.

Novv consider the signalirrg theory. Becar,rse of asymmetric infcrmation, in-vestors knorv less alrout a firm's prtrsPccts thirn its rtraltcrgers knolv. FurtltL'r, mnn-agers try to nraxirnize valut'for crtrttttl stockhoklcts, not nclv oncs. Thcrcfore, ifthe firnr has excellerrt prospccts, managclnent n'ill not rvant to isstte trcrv sharr:s,

but if things look bleak, thon a ncw stock offcring would bcrtefit crtrrcnt stock-holtlers. Consequcntly, investors take a stock offc'ring to be a signal of [rat] netvs,so stock prices terrtl to rlecline *'hcn ncrv issrtes art'annottncetl. As a resttlt, netr'

ctluity financirrgs .rrc rt'lativcly t'rpctrsivc, The nct t'ffcct of sign.rling cffccts is kr

motivatt'firms to maintairr a resen'e Lrorrorving capacity designcd to perruit fr.tturt-

investmL.nt opportunities to be financt'rl Lrv debt if internal furrr'ls are not arvailat le.

By combinirrg tlre trircle-off and asvnrmetric iuform;rtiou thcories, rl'e obt.rinthis exLrlanation for firms' Lrch.tvior: (1) Debt iin.rncing provirlcs trenr'fits Lrt'caLtse

of thc tax cledr.rctibility of irrterest, sr-r fimrs shoLrlcl havc srure dc'bt in their capi-tal strtrctures. (2) Hon,ever, fin.rncial rlislress arrrl .rgertcv costs pl.rce Iimits olrdebt usage

-be.\'oncl some Point, these costs offsot the t.rx advantagr'of dc'Lrt.

The costs of finarrcial distress.rre espccinllv h.rrnrfrrl to iirurs rvhose value's con-sist primarily of intirngiblc grorvth oprtiorrs, such .rs Il&D. Srrch firms shoultl lr.tvc

New market value + NPVOriginal shares

_ $210,000 + $5,000 _ $215,000 = S21.5010,000 10,000

Thus, if debt were used, all of the intrinsic l'alue of the firm's exishng&

sets, plus the NPV of the new Project, woulcl accrue to the original sii6lholtlers. If stock were used, we saw earlier that the value of the origirul

stock would end up at $20.64 rather than $21, the intrinsic value wigrou

the nelv investment.le

What does alt this suggest about corporate financial policy? First, in a.wor!

where asymmetric information exists, corporations should issue new shaE'

only in the unlikely event that they have extraordinarily profitable investmst

that cannot be either postponed, signaled to invcstors, or financed by debt,c

in situations where management thinks the shares are overvalued' Second, i+

vestors recognize all this, so selling Pressure drives down a company's siun

price when it announces plans to issue new shares- Third, the pecking ordert}l

bonalclson observed is rational when asymmetric information exists-it palsh

rejtain a large fraction of earnings, and also to keep the etlttity ratio up and th

debt ratio do*.,, so as to maintain a reserve borrowing capacity which canh

used to support the capital budget if and when an unusually large number.d

positive Ni'V projects iome along, or if problems arise which require outsil

capital.20Note that signaling effects, and their impact on investors' perceptions, difia

substantially across firms. To illustrate, asymmetry is typicalty much greatun

the drug and semiconductor industries thin in the retailing and trucking indrr

tries, be"cause success in the drug and semiconciuctor inclustries depends on se

cretive proprietary research anddevelopment' Tlrtrs, managers in these.indrr'

tries have iignifiiantly more information about their firnrs' ProsPects thand0

outsic{e inveslors. Also, emerging firms with limited capital btit good Srowth0tportunities are recognizecl uJhruirlg to use external financing, so the announG

ment of new stock offerings by a new comPany is not vierved lvith .ls muchc(t

cern by investors as are offerings by mature firms rvith linritt'tl grotru'

opportirnities. Thus, altl'rough signiting'affects all firms, its i,-rpract yaries fns

firm to firrn.

\' *' ."raitt**c['t wcre n(,t proportionrllv m.rtchctl uith retiin.(l enrlrings, issuirrE ncr'Jd

rvoulrl incrc.rse tlre firm s ri.k rtrci'conseqtrcntly its require.l rntc of reltlrll on elluit\" SinllLrrl! "-sulncc of ne$' c(']uitv in the Prcvi()tls scenarioi rnighI reduct' risk antl thus lorttr

.tlrc. iost-rx t,[

tve abstract frcrm thrise effects because (1) thev arc o[ second orcler imporLrntr'nnd (]) lrlfor]*"-'thsr into the an.rll sis rroultl unnc(css.lrih conrPliqllg the er.rnrplcs.r"Flot.rti()n costs .1lso play' a role itr c.iPital structurc thcorv. ln gt'ne'ral tltrtrtiort ro:t' ":" :i'ly.idc.bt ihdn on e('luitv issues, anrl this prolidts .rn atltlitional rntionale it)r rtsitrg .ic['t ritllcl r"""

sirle cquitr'. Wc rlill rliscrrss this issrtc in more qlct.ril in Chapter 13.

i:3;.

,jr,,:fr:

,,".,

':;r.1

434 Ch.rptr.r 1l CAPITAL STRUCTURE DECISIONS: PART Il Varlrtions in Capital Structures 435

I tions may run out of internally Benerated cash, but they should emphasize stocki rather than debt due to the severe problems that financial distress imposes oni such firms. (4) Finally, because of asy;metric information, firms should maintaini a reserve of borrowing capaci$/ in order to be able to take advantage of good in-I vestment opportunities without having to issue stock at low prices, and this re-

i serve will cause the actual debt ratio to be lower than that suggested by theItrade-off models.

'-Test

Summarize the trade-off and signaling theories of capital structure.

Are the trade-off and signaling theories mutually exclusive; that is, might bothbe correct?

Does capital structure theory provide managers with a model that can be usedto set a precise optimal capital shucture?

CAPITAL STRUCTURES

As might be expected, wide variations in the use of financial leverage occur boihacross industries and among individual firms in each industry. Table 11-3 illus-trates differences for selected industries; the ranking is in descending order ofcommon equity ratios, as shown in Column 1.t'

?rlnformation on capital structures and financial strength is available from a multitude of sources. Weused tlre Cotrrptrsra, data tapes to develop Table 1l-3, but published rcurces include The Value Linc ln-aFhilent Suruey, Robert Morris Associales Annunl Studics, and Dtrr Cl Brodslreet Key Business Ratiu,

0

Value of Firm, V($)

Debwalue Ratio (./")

RIATIONS IN

)osite (averagcindustries, n;t

those listed

Common PreferredEquity Stock

(1) (2')

74.4%

58.4

53.6

46.9

37.7y"

a.o% 25.6"/.

0.0 31.6

1.0 45.i1

s.3 47.8

Total Long-Tem Short-Term Times-Interest- Return onDebt Debt Debt Eamed Ratio Equity(3) (4) (5) (6) (71

18.7"/" 6.9v" 77.7x 26.4Y"

lou,er levels of dcbt than firms whose asset birses cor.rsist nrostly of tangiblerrscts. (3) Bc'cause of problems due to asymmetric informatiorr ancl flotation cosb

Iorr,-grorvth firms shotrltl follow a pecking order, with capit.rl r.risecl first fromin

\ t.'rnal sources, tlrt'n by borrorving, and fiially by issuinjnerv stock. In fact,sud

\ ltu'-pSowth firms r.rrely need to issue external equity. High-gro*.th firms rvhas

1 grorvth is occtrrring primarily through iucreases in tangiblc asscts slrorrld four

\ tht'same pr'cking, orcler, bLrt usually thcy will neccl to iis,,o noru stock as lvell,I dcbt. High-grorvth firnrs rvhose r.alues consist primarily of intarrgible grorvthf

These ratios are barcl on accounting (or btxrk) values. Statr'd on a m.rrket-rirluc b.rsis, thc equity percentages would rise, becausesttks sell al prices that are t!\,o hr t"hree timc,s higher than their brxrk values.

t.5"1 60.8v" 38.7%

24.5

39.1

43.8

7.7

5.0

4.0

22.1"t,

5.1

2.5

71..7

16.2

5.6

3.?x 17.7')'"

Coxrflrslrt Inelustriat Data Tapre, 1995.

Chapter 11 CAPITAL STI{UCTUItE DECISIONS: I'ART ll

Drug and electronics companies use relatively little debt-the uncertaih(_inherent in industries that are cyclical, oriented toward research, or subi-J}huge product liability suits render the heavy use of debt trnwise. Also, thesi-*rpanies are generally quite profitable, hence are able to finance t.r.g"ly witt"ftained earrrings. Utility and retailinB companies, on the other hand, usedebrJ-atively hcavily. The utilities have traditionally usecl large amounts of d"[particularly long-term debt-tlieir fixed assets make good security for mort#bonds, and their relatively stable sales has made it safe for them to .u.ry inl,debt than would be true for firms with more business risk. Note, though, ihat tiutilities are rapidly being deregulaied, hence they face rapidly increasing comJtition. As a result, r,irtually every utility has revised its target capital structu{5include less debt. This demonstrates that firms change their target capital stn*-tures as their business risks change.

Particular attention should be given to the times-intercst-earncd (TIE) raiiohcause it gives an indication of how safe the dt'bt is and how vulnerable thecoo.panv is to financial distress. TIE ratios depend on three factors: (1) the percentr'of debt, (2) the interest rate on the debt, and (3) the company's profitability. G;erally, the least leveraged industries, such as the drug industry, have the higlrucoverage ratios, whereas the utility industry, which finances heavily with detlhas a low average coverage ratio. Again, it should be noted that both Mood/land Standard & Poor recently changed their "guidelines" for the utility industtraising the coverage ratios (and lortering the debt ratios) that are necessary t0rF

ceive high bond ratings.Wide variations also exist among firms within given industric,s. For examplc

although the average debt ratio in 1995 for the drug industry was 25.6 perca{,

Merck's ratio rvas only 7 percent, while that of .American Home Products was0

percent. Two particularly important factors in explaining such variation in leve.

age ratios are the stability of earnings and the presence of growth opportunitieEmpirical studies show that firms with more stability in their earnings tyPical,

have higher than average leverage ratios when compare'd with the industryar'erage. Also, firms with greater than average investment growth opportunitictypically have lower than average leverage ratios. Thus, factors unique to indi

vidual firms, inclrrding managerial attitudes, play an important role in xttitgtarget capital structures.

Professor Ravindra R: Kamath recently surveyed a large number of CFG'About one-third of the CFOs said they try to maintain a target capital structult

when raising new capital, antl about two-thirr-ls saicl that they folkrw a "hierar

chy in which the most advarrtageous sources of funds are exhausted before ou6

sources are used." The hierarch-y usually followed the pecking order of intemall,r

generated cash flow, external debt, and external equity. But there were occasitf!

in which common equity was the first source of financing. This probablyisttcause the firm had so much leverage that additional de'ht rvould be a more co{source of financing than equity. In-ottrerlvorcls, the firm was far above theoFmal clegree of leve'iage, soit iis,re.l equity to get closer to the optimal, or ta$rt

level oflebt. Tht'refo-re, many firms ao .,ot "rfti.itty

state tllat thcy have a urScapital structure, but their actions imply that a target capital structure doeseDfor the firm.

r:See Ravindra R. K.rm.rth, "l-ongjlerm Fin.lncing Dccisions: Viervs anrl Practiccs of FinanciJ Il!agers of NYSE Firms," T/rc' l'irarrcirl/ Rf ir'ir', Mnv 1997, 3-50-35tr.

Dcbt 5 50

Equity 50

Total ryq

Book \\'cights lersus lv{arket lveiBhts 437

IVIarket Value

$ 50 33,/.

100 67

s150 100%

50']i,

50

100%

.l'l"l*'lt i;r,i';i:.4'ii...-, ,4,l

:;!iir.',,r1;'

i,,]l;I

dry-rrr, Qttcstiotr

Why do wide vari.-rtions in the usc of financial lcvcr.rgc occr,rr Lroth across in-dustries and amorrg the indiviclrr.il ftrrrs in caclr industry?

WEIGHTS VERSUS MARI(ET WEIGHTSIn Chapter 5, ',ve calculateri the rveightetl avcrate cost of capital rvitl.r marketvalue rather than book value' lveights. Fr.rrther, irr or.rr cliscussions of capital struc-ttrre thus f;rr in Chapters 10 arrd 11, n,e have focused primarily on market values,not book values. However, survey data inclicate. thirt financial managers generallyfocus orr book valtre structures. Thus, there seents to be a conflict betlveen acad-emic theory and brrsiness practice. Here are son.re thoughts on this issue:

1. If stocks and bonds tio not sell exactly at book value-and they almostnever do-then it w,oultl bc impossible for a growing firm to establishand maintairr at constant levels both a targct book valuc and a target mar-ket value capital structure. The firm coultl stay on its book value target oron its markc't value iarget, but not on both. Tcl illustrate, assume th.tt a

comp.lny has, at book val,re, $50 million of deLrt and $50 nrillion of equity,for a total book value of $100 million. l{oivr.r,er, its stock sells at 2.0 timesbook, so the market value of its equity is 5100. Here is the capital structuresituation, with dollars in millions:

Book Value

Now suppose the companv needs to raise an additional $100 million. If itsells $50 million of tlebt and S50 million of common stock, it will add theseamounts to its balance sheet, so its book value capital structure rvill remainconstant. However, adding $50 million to both debt and equity n,ill causeits market value capital structure to change. On the other hand, if it raises

$33 million .rs debt anrl $67 million as L'quity, its n-rarkct value capitalstructure lvill remain constarlt, Lrut its book value structure will changc.Thus, it can maintain eitht'r its book valtre or its market vah-re capitalstructure, but not both.

2. Book values as reportecl on b.rlance shcets reflect the historical costs of as-sets. Horvever, historical costs have little to do with the actual vaiue of as-sets or n'ith their ability to produce casl.r tlorvs. Nlarket valrres rvould al-most always better reflt'ct cash generation and debt service abilitr'.

3. As we have repeatecill,noted throughout this chapter and the last one, thepoint of capital structure analysis is to finti that capital stmcture rvhichmaximizes the firm's market value, hencr. its stock price. Since this opt!mum is defined in terms of sbck pricr's, it c.rn orrly be cletermined by anan.rlysis of nrarket valur's.

4. Nolv suppose a firm found its optin.ral m.trket value structure, but then fi-nanced so as to maintairr a constant book value strllcture. This lvould lead

438 Chapter 11 CAPITAL STRUCTURE DECISIONS: IART Il

7.

to a deprarture from value maximizaiion. Therefore, if a firm is sr^,,r-must finance so as to holcl constant its market value rtr".tu.u. fiullrlli-twe saw above, normally lead to changes in the book value struchlls.'*(

5. Since the firm should, to keep its vallre at a maximum, finance so,..holcl its market value structure constant, the weighted ou"rog".oriit:oital, WACC, should be found using market value weights.

6. Business executives prefer stability and predictabiliiy to volatility andurcertainty. Book values are far more predictable than market values. Fl-ther, a financial manager can set a target book vah-re capital structure aithen attain it, right on the money. It would be virtually impossible to sriat a target market value structure because of bond and stock price fluOiations. This is one reason executives focus on book value structures rath'than on the more logical market value structures. Also, many financial.'.ecutives have accounting backgrounds, and accouniants focus on accoq.

Summary 439

it would be impossible to keep the actual capital structure on target at all times,but this fact in no way detracts from the validity of market value targets.

Test Questions

Should the target capital structure be expressed in book valtte or market valueweights?

Why do practicing financial managers prefer to work with book weights?

In this chapter, we discussed a variety of topics relaied to capital structure deci.sions. The key concepts covered are listed below:

r In 1958, Franco Modigliani and Merton Miller (MM) proved, under a re-strictive set of assumptions including zero taxes, that capital structure is ir-relevan[ that is, according to ihe original MM article, a firm's vaiue is not af-.fected by its financing mix.

r MM later added corporate taxes to their model and reached the conclusionthat capital structure does matter. Indeed, their model led to the conclttsionthat firms should use 100 percent debt financing.

r MM's model with corporate taxes demonstraied that the primary benefit ofdebt stems from the tax deductibility of interest Payments.

I Much later, Miller extended the theory to include personal taxes. The in-troduction of personal taxes reduces, but does not eliminate, the benefitsof debt financing. Thus, the Miller model also leads to 100 percent debtfinancing.

r The addition of financial distress and agency costs to either the MM corpo-rate tax model or ihe Miller model results in a trade-off model. I-Iere themarginal costs and benefits of debt are balanced against one another, andthe result is an optimal capital struchlre that falls somewhere between zeroand 100 percent debt.

r The Hamada equation combines the CAPM with the MM with corPoratetaxes model:

k,r = knr + (kM - kRF)bu + (kpt - kRr)bu(1 - TXD/S)'

This equation shows that the required rate of return on a levered comPany'sstock is equal to the risk-free rate, which comPensates investors for the timevalue of money, plus premiums for business risk and financial risk.

r Within a market risk framework, business risk can be measured by bg, mar-ket risk can be measured by b, and financial risk can be measured by b - bu =bu(1 - TXD/S).

r The asymmetric information, or signaling, theory which recognizes thatmanagers have better information than most investors, postrrlates that thereis a preferred "pecking order" of financing: first retained earnings (and de-preciation), then debt, and then, as a last resort only, new common stock.

I The signaling theory leads to the conclusion that firms should maintain a re-serve borrowing capacity so that tlley can ahvays issue debt on reasonableterms rather than have to issne new erluity at tl"re lvrong time.

I

ARY

ing numbers. However, as financial executives gain a knowledge of finaricial (as opposed to accounting) theory, the focus is shifting more towallimarket values.

For purposes of developing the weighted average cost of capital, *pstrongly recommend the use of market value weights. However, if a co6.

pany focuses on a book value capital structlrre, seeks to maintah th1structure, and finances in.accordance with book value weights, then(rveighted average cost of c.\pital should be based on book weights.

Some executives have argued against the use of market value weightsod'

the grounds that as stock prices change, so would capitalrveights, with the result being a volatile cost of capital. This argummtlincorrect. The cost of capital shotrld be based on inr3cf weil;hts, not onth'actual capital structure, and there is no reason to think that a target mqket value stnrcture would be any less stable than a targei book vaiue shsture. in fact. as we discuss in Point 9 below, target market valueare probably more stable than target book weights. il

9. Now consider a fairly typical situation. Firm X currently has a

tlebt/equiiy ratio at book, and a 33/67 ratio at markei. It t.rrgets on lhbook value ratio. Several years go by. The company takes on proiectswttr.

positive NPVs, and that raises iis market value above its book value.AIsQ

inflation occurs, so new assets cost more. Output prices are based on mi''

ginal costs, which have risen because of inflation. With the new hi$f[rices, the rate of return on old assets increases, as does the valueoftrold assets, ancl the firm's stock price rises. Book values per share arert'b

tively stable, so the increasing stock price leads io an increase in the ml'

even to increasc, even thirugh thr' firm finances on a 50/50 book basis ,'

10. Note also thirt, untler our sce'ntrrio, the rising ROE n,ill lead to impmrd

kr.t/-book ratio. DeLrt values, 6n the oiher hand, remain close to book. Rt

ing stock prices, whc'n combiuec-l with stable boncl prices, coLIItl cause.th

nrarkct valrr.. tlebt/c.tluity ratio to remain constani at the 33/67 lerel,d

coverage ratios. This faci, together with a'nalysts' knorvletlge th.rl tlt

firm's book values arc' un.lerstitecl, lvill support an incrc..rse in ihe debr rrtirr me.rsurecl at Lrook

What can rve concluclt from all this? We are absoltrtelv conr ir.tcr'ti th.lt firtr'

shoulcl focus on nrarkct lalue capital structures arrd has.' thcir cost of caPY,

)

calctrl.rtions on target market 'n'al,te rveights. Bec.ruse m.rrket valttt's clt-r

440 Chapter 11 CAPITAL STRUCTURE DECISIONS: PART It

managed fim.

essary in the arbitrage proof.

in the chapter support or refute Gordon's position?

Problems

Tampa's ownere expeit that the total bo6k and markei value of the firin,s stoit , if itzero debt, would be $10 million.a. Estimate the beta of an unleveraged firm in the comuter airline brrsiness

faxair's market-determined beta. (Hine Jaxair's market-determined beta is abeta. Use Equation 11-6a and solve for br.)

r There are clearly benefits to dett financing, but firms should useamounts of debt depending on their tax rates, asset structures, x11irisks.

r Wide variations in capital structure exist, both across industries anaiindividual firms within industries. The variations across industriliexplained to a- large extent by the economic fundamentals of thelVariations within industries also reflect fundamental differences, Iadditionally reflect differences in managers' attitudes toward debi

r The optimal capital structure should be thought of in market valuethan book value terms, even though nranagers often focus on book v

Questions11-1 Define each of the following terms.

a. MM Proposition I without taxes; with corporate taxesb. MM Proposition II without taxes; with coiporate taxesc. Miller modeld. Financial distress costse. Agency costsf. Trade-off modelg. 4rymmetric information, or signaling, theoryh. Hamada equationi. Reserve borrowing capacity

7l-Z Explain why agency costs would probably be more of a problem for a larqe,owned firm that uses both debt anil equity capital than for'a small, unteverafe

Qtrcstions/Probhms {{1

d. Calculote Air Tamp.r'5 k and financill risk lrronriurn at $(r rlillion tlcLrt lssumin$ itst'ederal-plus-state tax rate is norv .l0 p!'rccnt. Conr[r.rrt this rvith vour corrcspondinganswer to Part c. (Hint: The incroasc irr the tax rnte c.rus!.s Vy to drop to $ti million.)

Complnics U antl L are itlcrrtical in cvr,rv resprct c\dcpt thit U is urrlclcrag,rd s'hilc L h.rsti10 million of 5 pcrcent bontls outsLrntliug. Assumt' (l ) lh.rt .rll of tlrr MM assurrptions .rremet, (2) that thcre are no corporatc or pcrson.rl t.rxes, (3) that Etll't is $2 million, .rntl(4) th.rt thc cost of t'quity to Conrp.rny U is 10 perccnt.a. What value lvould MM cstimatr. for orclr firnr?b. What is k. for Firm U? For Firm L?c. Fincl Sl, and thcn show th.rt Ss + D = Vr = $20 nrillion.d, What is the WACC for Firm U? For Firnr L?e. Suppose Vu = $20 million anrl Vl_ = $22 million. According to NIiII, do thcse r'.rluc.s

represent an eqtrilibriunr? If not, cxpl.rin thc prroccss bv rvhich eqrrilil,rirrm rvouH berestored.

Refer to Problem ll-2. Assume that all the facts lrolcl, c\ccpt that both firnrs.rrr subject toa 40 percent federal-plus-statc corporatc tax ratc.a. What value woultl MM nolv estim.rte for e.rch firnr? (Use Proposition I.)b. What is k for Firm U? Firm L?c. Find Sp and then show that SL + D = VL rcsults in thc samr. valuc as obt.rincd in I'.rrt a.

d. What is the WACC for Firm U? For Firm L?

Refer to Problems 11-2 and l1-3. Assunlo tlrat all facts irold, c-xcept th.rt both corpr:rrte ancipersonal taxes apply. Assume that both firms nrust pJ)'.r fericral-plus-st.rte corporrtc taxrate of T. = 40%, and th.rt investors in both firms facr' .r tax rate of TJ = 28'li, on dr.bt incomr.and T. = 20')r", on average, on stock inconre.a. What is the value of thc unleveragcri firm, Vg? (Notc that Vg is norv rctluced [ry tht

personal tax on stock income, henct Vu + $12 million as in Problem 11-3.)b. \4trhat is the value of Vs?c. What is the Bain from leverage in this situation? Conrpare. this u,ith the g.rin from lc'r'er-

age in Problem 11-3,

d. Set T. = T" = Ta = 0. What is the value of the leveraged firm? The' gain from lererage?e. Now suppose \ = Tu = 0. What aro the value of the levcragcd firm and the gain from

Ieverage?f. Assume that T,l = 28"i", T, = 269l, and T. = {09;. Nrrrv rvhat are the value of the lei.er-

aged firm and the gain from leverage?

International Associates (tA) is just about to com,rcnce operations as an intemation.rltrading company. The firm will have book assets of $10 million, arrd it expects to earn a 16percent return on these assets before taxes. Horvevcr, because o[ certain tilx arr.rngementswith foreign governments, IA rvill not p.ry any taxr.s; th.rt is, its tax rate will bc zero. irlan-agement is trying to dccide hou' to r.risc the' rc.cluirr'r1 510 rnillion. lt is knou'n that the cap-italization rate for an all-equity firm irr this business is l1 pcrcent, that is, ku = 119;. Fur-thec IA can borrow at a rate kd = 6')/.. Assume that thL' lvlM assunrptions apply.a. According to MM. wh.rt rvill be the r'.rlue of lA if it uses no ciebt? If it ust's 56 milliur

of 6 percent debt?b. What are the values of the WACC and k. .rt c{cbt le'r'els of D = $0, D = $6 million, and

D = $10 million? Wlrat effect docs lcverage havc on firm value? Why?c. Assume the initial facts of the problem (k.r = 6'i1,, EBIT = $1.6 million, k.u = 11'li,), but norv

assume th.rt a +0 percent federal-plrrs-state corpor.rte tax rate cxists. Find tlrc nerv mar-ket values for IA with zero debt anrl with $6 nrillitrr of dcbt, using the NINI formulrs.

d. What are the values of the IVACC arrd k, at debt levels of D = $0, D= 56 million, antl D =$10 million, assunring a 40 percerrt corporate lax r.rtc'? Plot the rel.rtionships brtrveen thevalue of the firm and the debt ratio, and betrveen cal,ilal costs and the debt ratio.

e. lVhat is the maximum dollar amount of debt firrarrcing that can be usecl? lVh.rt is thevalue of the firm at this rlebt level? What is the. cost of this tlcht?

f. Horv lvoult{ each of the foliowing f.rctors tend to ch.rnge the valrrcs vou plotted in vourgraph?(1) The intercst rate on deLrt increases.rs the tlc.bt ratio rises.(2) At hiBllcr levels of clcbt, thc prob.rlrilitt, ol iinancial clistress riscs.

Until recently, d1e PreskrFino Conrpaly carrieci a triple-A bturl r.rting .rnd 6'.15 5t1png inevery rcspr'ct. Horvcvcr, a serics trf pr()hl('nls h.rs aftlictt'tl tlrr' firm: It is ctrrrtrrtlv irr sc-vere financial distrcss, and its ability to m.rke itrturc Fnvnrcnts on outst.rndinr del)t is

11-3 . Explain,.verbally, howlvlM use the arbikage process to prove the validity ofI. Also, list the maior MM assumptions and explain why lach of these assump

17-Z

without Taxes

11-3

CorPorate Taxes

11-4Miller Model

11-5ild without Taxes

t7-5At€,ncy Costs

l1-4 A utility company is supposed to be allowed to charge prices high enouqh to ()rcosts, including its cost of capital. Public sen'ice commiisions are slpposed-to take ato.stimulate companies-to operate as efficiently as possible in ordei-to keep cosb,prices, a.s low as-po-ssible. Some time ago, AI&T's debt ratio was about 33 i:ercmtpe_o{e (Myron J. Gordon, in particulai) argued that a higher debt ratio'wouldAT&T's cost of.capital-and permit it to charge lower rates ior telephone service. Gthought an optimal debt ratio for AT&T waiabout 50 percent. Do'the theories pre

7t-1Business and Financial

Risk: Market

Air Tampa has justteen incorporated, and its board of directors is currently graplwith the question of optimal capital structure. The company plans to offer commuttservices between Tampa and smaller surrounding cities. Jaxiii has been around forayears, and it has about the same basic businessiisk as Air Tampa would have,markeFdetermined beta is 1.8, and it has a current market value debt ratio (totaltal assets) of 50 percent and a federal-plus-state tax rate of 40 percent. Air Tampa exlonly to.be marginally profitade at startup, hence its tax rate woutcl only be 25 p;rcent

b

c

Now assume that ksp = 197. xn6 Ltrr = 15%. Find the required rate of rL.trlrn onan unleveraged commuter airline. What is the businesi risk premium for thisAir Tampa is considering three capital structures: (1) $2 nrillion cl(,bt, (2) $l n

debt, and (3) 95 million debt. Estimate Air Tanrpa's k for thcse delrt lcvcls. lVhatfinancial risk premium at e.tch level?

{42 Chapter 11 CAPI'IAL STRUCTURE DECISIONS: PART Il

questionable. If the firm were forced into bankruptcy at this time, the common

liolders would almost certainly tre wiped out. Although the.firm has limited finan,

sources, its cash flows (primaiily from depreciation) are sufficient to suPPort one

mutuallv exclusive inveitments, each costing $150 million and having a l0-year erI;f. rhmp nrnip.ts have the same market risk, but different total risk as measurp.llife. Thele proiects have the same market risk, but different total risk as measured

variance ofrefu*r. Each proiect has the following after-tax cash inflows for 10 yr

Questions/Problems 443

Spreadsheet Problem

Work this probletu only if you are using the computerized problem diskette.

TJse the model in File C11 to solve this problem. The Brandt Corporation is an mleveragedfirm, and it has constant expected operating earnings (EBIT) of $2 million per year.Brandt's federal-plus-state tax rate is 40 percent, its cost of equity is 10 percent, and itsmarket value is V = S = $12 million. Management is considering the use of debt whichtrvould cost the firm 8 percent regardless of the amount used. (Debt wotdd be issued andrrsed to buy back stock, so the size of the firm would remain constant.) Since interest ex-pense is tax deductible, the value of the firm would tend to increase as'debt is added toihe capital structure, but there would be an offset in the fom of rising risk of financial dis-tress. The firm's analysts have estimaied, as an approximation, that the present value ofany future financial distress costs is $8 million, and that the probability of diskess wouldincrease with leverage according to the following schedule:

Value of Debt Probability of Distress

$ 0 0.0%

2,500,000 2..5

5,000,000 s.0

7,500,000 10.0

10,000,000 25.0

12,500,000 50.0

15,000,000 75.0

a. According to the "pure" MM with corporate taxes model. what is the optimal level ofdebt? (Consider only those debt values listed in the table.)

b. What is the optimal capital structure when financial distress costs are included?c. Plot ihe value of the firm, with and without financial distress costs, as a function of the

level of debt.d. Assume that the firm's unleveraged cost of equity is 8 perceni. What is the firm's opti-

mal capital stmcture now? (From this point on, include financial distress costs in allyour malyses.)

e. Return to the base-case lqg of 10 percent. Now assume that the firm's tax rate increasesto 60 percent. What effect does this change have on lhe firm's optimal capiial structure?

f. Reiurn to the base-case tax rate of 40 percent. Assume that the estimated present valueof financial distress costs is only $5 million. Now what is the firm's optimal capitalstructure?

Annual Cash Inflows

Project A Prcject B

$30.000,000 $10,000,000

35,000,000 50,000,000

11-8

MM with FinancialDistress Costs

makint a decision that is contrary to their interests?f. Who biars the cost of this "proteition"? How is this cost related to leverage and

timal capital structure?

Probability

0.5

0.5

analvses:

Interest rate (%) 8.0 8.3

Cost of equity (%) 12.0 1?.25 12.75

71-7MM with Financial

Distress Costs

Federal-plus-state tax rate = 407o.

Dividend paYout ratio = 100%

Cunent required rate of return on eqtity = 12'1".

The cost of capital schedule predicted by Mr. Harris follows:

At a Debt Level of (Millions of Dollars)

$2 $4 $6 $s $10 $12

EBIT = $4 million per year, in perpehrity.

9.0 10.0 11.0 13.0

i3.0 13.15 13.4 14.659ase

.Cheney, the CEO of Cheney Electronics, is con-about his firm's level of debI financing. The com-Ms. Broske estimated the Present value of financial distress costs at $8 million'

ally, she estimated the following probabilities of fhancial distress: short-term debt to finance its temporary work-tal needs. but it does not use any permanentm) debt. Other electronics comp.mies averagePercent debt, and Mr. Cheney wonders why thet occurs, and what its effects are on stock prices.some insights into the matter, he poses the !ol-

questions t6 vou, his rccently hired issistant:ress-lVerk reiently ran an irticle on companies'

(MM) were mentioned several times as leading re-searchers on the theory of capital structure. Briefly,who are MM, and what assumptions are embedded inthe MM and Miller models?

b. Assume that Firms U and L are in the same risk class,and that both have EBIT = $500,000. Firm U uses nodebt financing, and its cost of equity is lq, = 14%. FirmL has $1 million of debt outstanding at a cost of k3 =8%. There are no taxes. Assume that the MM assunip-tions hold, and then:(1) Find V, S, k., and WACC for Firms U antl L.

At a Debt Level of (Millions of Dollars)

$0 $2 $4 $6 $8 $10 $12

Probability of financial clistress 0 0 0.05 0-07 0.10 0.77 0'47

a. What level of debt would Mr. Harris and Ms. Broske recommencl as oPtimal?

b. Comment on the similarities and differences in their recommendations'

)

policies, and the names Modiglirni and-Miller

4114 Chapter 11 CAPITAL STRUCTUITE DECISIONS: I,ART II

d. Now suppose investors are subiect to the following taxrates: T6 = 30% and T,=12%.(1) What is the gain from leverage according to dre

Miller model?(2) How does this gain compare to the gain in the MM

model with corporate taxes?(3) What does the Miller model imply about the effect

of corporate debt on the value of the firm, that is,how do personal taxes affect the situation?

l,llhat capital structure policy recommendatirthree theories (MM without taxes, MM withtaxes. and Miller) suggest to financial manapirically, do firms appear to fottow any onJoiguidelines?What are financial distress and agency costs?

does the addition of these costs change theMiller models? (Express your ansrver in w61equation form, and in graphical form.) ^iHow are financial and business risk measuptmarket risk framework?

i Selectcd A(.lditionnl llcf!.rcucL,s arrrl Cascs 445

Ghosh, -Dilip

K., "Optimum Capital Stnrcture llctlcfincrl,,, Firrrrrrci,rl llcuir,1,, Autust 1992,117429.

Kelly, william A- Jr, a.d James A. Miles, "Capital structurt'Theory and thc Fisrrer Effect,,,The Fiutncial Rei,ictl Fcbruary 1989, 5!73.

Lee, Wayne Y- arll H:,].y H. Barker, -Bankruptcy Costs a.d thc Firm,s Optimal Debt Ca_pa-cityj A_Positivr Tht'ory of Capitar stmcturri," soutrvnt Er:onouic lttuittrr, April 1977,1{53-1{55.

IVackie-Maso., Jeffrey K., "Do Taxrs Affcct Corptrratc Firr.rncirrg Decisions,,'/orr,nr o/Financ?, December 1990, 1.171-1493.

Martin, John D., and Davi.l F.,Sr-otr, ,,Dcbt Clpacill a1d rhe Capital Budgering Decision:A Revisitation," Finmcinl Managtrnrlt, Spring 19-g0, 23_26.

,t,i1:..r:,Y::l:l I, "The Modigtimi-Millu^propositir>ns aftcr Thirty years,,. lournot of Ap_

Ittt&l Lorporntu tl,xil,cc, Spring 19S9, GtS...........'...._. "Leverage," lournnl of Fimtcc, Junt, 1991, 429-{Sg.Pincgar, J.-Michael, a.d Lis.r wilbricht, "wh,rt Nl.rnagcrs Think of Capital structure Thc-

ory: A Survey," Fittttrciil Managctrrcrrl, Winter l9g9;S2-91.scherr, rrederick C., "A l\'lultiperiod Mean-Variancc Mode I of optimal Capital structurc,,,

Tht Fintttcinl R(?,i(io Fcbruary 19S7, l-31.Schncller, Meir 1., "Taxcs antl thc optimal Capital stnrctur!. of the Firm," /olrrnn I of Fittrutct',

March 1980, 119-127.

Tag_gart, Robert A., Jr, "Taxcs and Corporatc Capital St^tcturc in .rn Incomplttc Market,,,lournnl of Finance, June 1980, 6.1'659.

Tlrakor, Anjan V, "Stratt'gic Issues in FinancLrl Contr.rcting: An Ov.rvicw,,, Fbnncial Matrcgenrcrl, Summer 1989, 39-58.

TharL, hts bct cotrsitlrtblt rlisclssirrr in llt littnturt corrccrrrlt n fitnucinl leterate tlitnlclc cf-Jtct. Mntry theorists po;tulltt thnt lirns ruith loLu lq,t'rny rt 1ni,irt,i by ltgi,-r,i* rrrn",*.i iri,,rrir'r,and oicc larsil. Ttoo articlcs ott this strbjtct nrtHarris, John1V1., Ir.,. Ro_lyy L. Roenfcldt, anci philip L. Coolev ,,Evidcnce of Financial

Leverage Clienteles," louuul ol Fitnncc, Scprernbei 1993, 1125_1132.Kim, E. Han,,"Millcr's Equilibrium, Slrarclroklcr Lc'rr.rgc Clic.teles, and Optirn.rl Capital

Leverage," lourntl of Finutte, May i9ti2, 301-319.

For a aery readablc tliscussion of tlu: nnny issrps irndz,.d itt (ttlital structure thaory, sce"A Discussion of Corporate Capital Structure,,, M,./la nd Coipornle Finnnce lournil, Fal) 19g5,

19-48.

The Drydcn Press Cases in Financial Ma.agement: Dryden Request serias hns tha fottoiuirscasas tlnt apply to this clutpter:

Case Z "Seattle Steel Prod'cts," Case 9, "Kleen Kar, Inc.,,, Case 10, ,,Aspeon Sparkline Wa-ter," Case 10A, "Mountain Springs," Case 108, ,,Gret;r Cosmetics,,.'and iase +5.Y,Thcter," Case 10A, "Mountain Springs," Case 108, ,,Gret;r Cosmetics,/and C^ase +S,",,fneWcstcm Company," focus on capit.tl stnrcture the()r)..Westem Company," focus on capit.tl stnrcture theory

Case 8, "Jolmso'Window Company," and Case 8A, ,,lsh Marine Boat Comparry,,, cor.croperating and financial leverage.

(2) Graph (a) the relationships between caPital.costs e'

and-leverage as measured by D/V and (b) the re-lationship between value and D.

c. Using the dita given in Part b, but norv assunring thatFirms L and U are both subiect to a 40 perccnt corpo-rate tax rate, rePeat the analysis called for in b(1) and f.b(2) under the MM with-tax model"

h. What is the asymmetric information, orory of capital structure?

i. What is the "pecking order" theory oIture?

Selected Additional References and Cases

The botlv of literature on capitnl stnrcture -and the nurubcr of potential referatces

Tlwet'oie, only a sanrpling can be giz,en here. Fot an extensit'e rertiezo of tlrc recent lizuell as .t,letailed bibliography, sce

Beranek, William, "Research Directions in Finance," Quartcrly Reoieto of Btrsinrrs

norrics, Spring 1981, 6-24.

Tle nmjor tlrcoretical u,ork on capital structure tlrcory are discussed in an integrated

Copelanct, Thomas E., and l. Fred Weston, Financial Thaoty and Corpornte Policy (l

Mass.: Addison-Wesley, 1988).

Harris, Milton, and Artur Raviv "The Theory of Capital Structure," Journal olMarch 1991, 297-355.

The Falt L988 rssue o/The ]ournal of Economic Perspectives and tlrc Swmut 7989 inancial Managemeit esch contain seaeral intetcsting and oery readable articles wlichMM proposit'to7s after 30 years of debate and teslins. iIn addition to Mitler's wotk, the effect of personal taxes on capital strtrcture decisions

dressecl by

Gordon, Myron J., and Lawrence I. Gould, "The Cost of Equity CaPital with Perso

come Taxes and Flotation Costs," l ow nal of F i nan c e, Stp tembcr 797 8' 1707-1ZlL

Bradlev, Michael, Cregg A. Jarrell, and E. Han Kim, "On the Existence of an O

ital 'itructure: Theo-r-y ancl Evidence," lournal of Finnnce, Jily 1984, 857-a78'

Conine, Thomas E., Jr, "Debt Capacity and the Capital Budgeting Decision:F inarcial Manage,rtenf, SPring 7980, 2W22.

Flath, David, and Charles R. Knoebec "Taxes, Failure'Costs, and OPtinlaltal Structure," lournnl of Finmce, March 1980,89-117.

Crutchley, Claire E., and Robert S. Hansen, "A Test of the fSelcy ]lreory 9lOu*.drship, Corporate Leverage, and Corporate Dividends," Finnncinl )

Winter 1989,36-46.

Dugan, Michael T., and Keith A. Sfuiver, "An EmPirical Comparison of Altemative,'3dr'fo. Estimaiing the Degree of Operating L""utog","'Fittrtncial ReeicitL l"lll

309-321.Ferri, Michael, and Wesley H. Jones,-"Deteminants of Financial Structure: A---M"ti-aoto[i.alApproai'h,"]oirnnlofFimnce,lune1979,631-6{{.'i

446 Chapter 11 CAPITAL STRUCTURE DECISIONS: PART II

6,rtensionsADDITIONAL MMPROOFSIn Chapter 11, rve presented the proof for MM's Proposition I inder the assumption of no corporate taxes. How-ever, the remaining propositions were presented withoutproofs. We present those proofs in this extension.

PROOF OF MM PROPOSITION II WITHOUTCORPORATE TAXES We noted in Chapter 11 thatEquation 11-3 could be used to find the value of a firm'scommon stock for a zero growth comPany. Here is Equa-tion 11-3 rearranged to solve for \ with T = 0, and substi-trrting k.1 for k" to denote the use of leverage:

, EBIT - k.,D*"t=-- S

(

g, we obtain

, (EBrT - kdDxl - T)*,,_ = -- s. -

y, =!EJI0-J).*1p.Ku

be rewritten as

Vrlqu = EBIT(1 - T) + LiuTD,

as

. EBrT(1 - T) - kdD(1 - T)k,=ffi. (11E-5)

be rewritten as

I, Equation 11E-4, we know that

Extensions 447

and recognize that V1 = $ n p, nnd substitute for V1 in thepreceding equation:

n., _ (S + D)k.u - TD\,u - kaD + TDko"- sL

_ Sk"u + Dksu - TDk"u - kdD + mkdS

_ Sku . Dk.u - TDk,u - kdD + TDkrSS

= lq, + (lqg - Tk,u - ka + TkJP,5

or

Lr = k,u + (lcu - krxl - TXD/S). (11-2a)

This last expression is the equation set forth in MNl'sProposition II, hence we have proved the proposition.

(11-3b)

(11-3a)

From the Proposition I equation, plus the fact that V = S +D, we can write

v=s*P=EBITk.u

This equation can be rearrdnged as follows:

P311= lqr(S + D).

Now substitute this expression for EBIT in Equation 11-3a:

. k, (s - D) - kdD KuS . k,uD k"Dcr=---- s-= s * s - s.Simplifying, we obtain this cxpression:

k'r= k,u + (}cu - kaxD/s). (11-2)

This is the Proposition II equation we sought to Prove.

PROOF OT MM PROPOSITION I WITHCORPORATE TAXES MM originally used an arbi-trage proof similar to the one we gave in Chapter 11 toprove Proposition I without corPorate taxes, but theirpoints can'be confirmed with a dimpler alternate proof.First, assume that th'o firms are identical in all respects

except capital structure. Firm U has no debt in its caPitalsrruitrrre, lvhile L uses debt. Expected EBIT and 66s11 nra

identical for each firm.Under these assumptions, the operathg cash flows

available to Firm U's investors, CFrr are

CFr= t31111 -t,.and the cash florvs to Firm Us investors (stockholders andbr:ndholders) are

CF1. = (EBIT - fuD)(1 - T) + krD (11E-2)

Equation 11E-2 can be rearranged as follows:

CFt= 531111 - T) - kdD + kdD +TkdD

= EBIT(I - T) + TkdD

Tk6D, represents the tax savings, and hence the;operating income, that is available to Firm Usbecause of the fact that interest is iax deductible.

The value of the unl,evered firm, Vg, may bemined by capitalizing its amual net income afterrate taxes, CFu = EBIT(I - 1), at its cost of equity:

., CFu EBIT(I -T)" k.u k.u

,, EBIT(I - T) Tk.,D EBIT(I - T) . _^vI =.----:-f -;-=-f tU.- k., kd krr

. (EBrT - k.1DX1 - T)JL=--_- .-

EBIT(1 -T) = (VL- TD)lqu.

substitute this expression for EBIT(1 - T) in77E-5:

, (vL - TD)ksu - k.,D(l - T)qt= s

_ V.k.r - TDlqr - k.D + TOk.S

pressed in Equation 11E-2a. MM argue that becaus"regular" eamings stream is precisely as risky as tlcome of Firm U, it should be capitalized at the sam{i

The value of the levered fim, on the other hand, isby capitalizing both parts of its after-tax cash flows

k.u. However, they argue that the tax savings arecertain-these savings will occur as long as intrthe debt is paid, so the tax savings are exactly as

the firm's debt, which MM assume to be risklessfore, the cash flows represented by the iax savingsbe discormted at the risk-free rate, k6. Thus, weEquation 11E-4 for Firm L"s value:

Since the first term in Equation 11E-4, EBIT(I -identical to Vu in Equation 11E-3, we may alsoas follows:

Vr= Vu+TD.

Equation 11E-4a is MM's Proposition I with (

taies. Thus, we see that the value of the leveredceeds thai of the unlevered company, and theincreases as the use of debt, D, Boes up.

PROOF OF MM PROPOSITION II W(11E-1) CORPORATE TAXES The value of a levered

equity may be found using of Equation 11-3 inas follows:

)

= CFu + TkuD. i

The first term in Equation 11E-2a, EBIT(I - T), is idio Firm U's net income, CFu, while the second