Capital structure and term structure
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Transcript of Capital structure and term structure
Presentation on capital structure and term structure theories Prepared ByMabruka Mohamed
Outline Capital structure :concepts Net income approach and traditional theories Net operating income approach and
Modigliani and Miller propositions Trade-off, agency cost ,and peking- order
theories Term structure theories
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The Balance-Sheet Model of the Firm
How can the firm raise the money for the required investments?
The Capital Structure Decision
Current Assets
Fixed Assets
1 Tangible
2 IntangibleShareholders’
Equity
Current Liabilities
Long-Term Debt
Capital structure criteria
What is the optimal capital structure? Structure that minimizes overall cost of
financing (WACC) Structure that maximizes value of firm.
Capital Structure and the Pie The value of a firm is defined to be the sum of the
value of the firm’s debt and the firm’s equity.V = B + S
• If the goal of the firm’s management is to make the firm as valuable as possible, then the firm should pick the debt-equity ratio that makes the pie as big as possible.
Value of the Firm
S BS BS BS B
Financial leverageFinancial leverage is the degree to which a company uses fixed-
income securities such as debt . The more debt financing a company uses, the higher its financial leverage.
Measurement • Debt financial ratio D/ (D + E)• Long term debt to capitalization LTD/(LTD+E) (Note: market(not book)values of debt and equity correctly
determine capital structure)
Financial Leverage, EPS, and ROE
CurrentAssets $20,000Debt $0Equity $20,000Debt/Equity ratio 0.00Interest rate n/aShares outstanding 400Share price $50
Proposed$20,000
$8,000$12,000
2/38%240$50
Firm A is unlevered firm currently has no debt . The firm decided to borrow $8,000 by buy back 160 shares at $50 per share.
LeveredRecession ExpectedExpansionEBIT $1,000$2,000 $3,000Interest 640640 640Net income $360$1,360 $2,360EPS $1.50$5.67 $9.83ROA 1.8%6.8% 11.8%ROE 3%11% 20%
Proposed Shares Outstanding = 240 shares
EPS and ROE Under Both Capital StructuresAll-EquityRecession Expected Expansion
EBIT $1,000 $2,000 $3,000Interest 0 0 0Net income $1,000 $2,000 $3,000EPS $2.50 $5.00 $7.50ROA 5% 10% 15%ROE 5% 10% 15%Current Shares Outstanding = 400
Financial Leverage and EPS
(2.00)
0.00
2.00
4.00
6.00
8.00
10.00
12.00
1,000 2,000 3,000
EPS
Debt
No Debt
Break-even point
EBIT in dollars, no taxes
Advantage to debt
Disadvantage to debt
Advantage and Disadvantages of DebtAdvantages of Debt Disadvantages of Debt
Interest is tax deductible Higher debt ratios lead to greater risk and higher required interest rates (to compensate for the additional risk)
Debt-holders are limited to a fixed return
Debt holders do not have voting rights
Capital structure theoriesthere exist conflicting theories on the relationship between capital
structure and the value of a firm. RELEVANCE OF CAPITAL STRUCTURE
IRRELEVANCE OF CAPITAL STRUCTURE
The Net Income approach Net operating income approach
The traditional views M&M Proposition with out tax
M&M Proposition 2with tax
Trade –off ,pecking order and agency cost theories
ASSUMPTIONS OF TRADITIONAL CAPITALSTRUCTURE THEORIES
Firms employ only two types of capital: debt and equity.
The total assets of the firm are given. The degree of leverage can be changed by
selling debt to repurchase shares or selling shares to retire debt.
Investors have the same subjective probability distributions of expected future
operating earnings for a given firm.
The firm has a policy of paying 100 per cent dividends.
The operating earnings of the firm are not expected to grow.
the business risk is assumed to be constant and independent of capital structure and
financial risk.
The corporate and personal income taxes do not exist.
RELEVANCE OF CAPITAL STRUCTURE: THE NET INCOME AND THE TRADITIONAL VIEWS
firm L is a levered firm and it has financed its assets by equity and debt. It hasperpetual expected EBIT or net operating income (NOI) of Rs 1,000 and the
interest payment of Rs 300. The firm’s cost of equity ke, is 9.33 per cent and the cost of debt, kd, is 6 per cent. What is the firm’s value?
NOI – interest = 1,000 – 300 = Rs 700, and the cost of equity is 9.33 per cent.
Cost of capital
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Value of the firm (NI approach)
The cost of equity is 10%
The effect of leverage on the cost of capital under NI approach
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The Traditional View The traditional view has emerged as a compromise to the extreme position
taken by the NI approach. According to this view, the mix of debt and equity capital can increase the
value of the firm by reducing the weighted average cost of capital up to certain level of debt.
Exp ;firm is expecting a perpetual net operating income of Rs 150 crore on assets, (the cost of equity) is 10 percent.
It is considering substituting equity capital by issuing perpetual debentures of Rs 300 at 6 percent. The cost of equity is expected to increase to 10.56 per cent.
firm is also considering the alternative of raising perpetual debentures of Rs 600 crore and replace equity, The debt-holders will charge interest of 7 per cent, and the cost of equity will rise to 12.5 per cent to compensate shareholders for higher financial risk. 17
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Modigliani and Miller (MM) (1958) propositions1
Proposition I The value of the firm is NOT affected by changes in
the capital structure The cash flows of the firm do not change; therefore, value doesn’t change.
Firms with identical net operating income and business (operating) risk,but differing capital structure, should have same total value.
Firm value is not affected by leverageVL = VU
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Case I – MM Propositions II with out tax same with (net operating income approach )
Proposition II The WACC of the firm is NOT affected by capital structure.
RE = RA +D/E(RA-RD)RD is the interest rate (cost of debt)RE is the return on equity (cost of equity)RA is the return on unlevered equity (cost of capital)B is the value of debtE is the value of equity
the cost of equity rises with leverage ,because the risk to equity rises with leverage .
Taxes were ignored Bankruptcy costs and other agency cost were not considerered
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The CAPM Proposition II How does financial leverage affect systematic risk? The systematic risk of the stock depends on:
Systematic risk of the assets RA, (business risk) Level of leverage, D/E, (financial risk) RE = RA +(RA-RD)D/E
business risk Financial risk an increase in financial leverage should increase systematic risk since changes in
interest rates are a systematic risk factor and will have more impact the higher the financial leverage.
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Case II – Corporate taxes Interest is tax deductible when a firm adds debt, it reduces taxes, all
else equal The reduction in taxes increases the cash flow
of the firm.
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Case II – Example(interest tax shield)
Unlevered Firm
Levered Firm
EBIT 5,000 5,000
Interest 0 500
Taxable Income 5,000 4,500
Taxes (34%) 1,700 1,530
Net Income 3,300 2,970
CFFA 3,300 3,470
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Interest Tax Shield
Annual interest tax shield Tax rate times interest payment $6,250 in 8% debt = $500 in interest expense Annual tax shield = .34($500) = $170
Present value of annual interest tax shield Assume perpetual debt for simplicity PV = $170 / .08 = $2,125 PV = D(RD)(TC) / RD = D*TC = $6,250(.34) =
$2,125 26
Case II – Proposition II
The value of the firm increases by the present value of the annual interest tax shield Value of a levered firm = value of an
unlevered firm + PV of interest tax shield Value of equity = Value of the firm – Value of
debt
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Case II – Proposition II
The WACC decreases as D/E increases because of the government subsidy on interest payments
WACC= Ke* E/V+ Kd*D/V(1-Tc)
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Case III (trade-off theory)
Now they add bankruptcy costs As the D/E ratio increases, the probability of bankruptcy
increases This increased probability will increase the expected
bankruptcy costs At some point, the additional value of the interest tax shield
will be offset by the expected bankruptcy costs At this point, the value of the firm will start to decrease and
the WACC will start to increase as more debt is added
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Bankruptcy Costs Direct costs
Legal and administrative costs Ultimately cause bondholders to incur additional losses
Financial distress Significant problems in meeting debt obligations
Indirect bankruptcy costs Larger than direct costs, but more difficult to measure and
estimate Assets lose value as management spends time worrying
about avoiding bankruptcy instead of running the business Also have lost sales, interrupted operations, and loss of
valuable employees 31
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Agency cost of capital structure theory Jensen and Meckling 1976 There are agency problems between managers and shareholders
and between debt and equity holders These parties are not equal access to information . The agency cost because there is conflict between shareholders
and mangers and between the shareholders and bond holders. agency cost of shareholders :the costs incurred if the agent uses to
company's resources for his own benefit; orB) the cost of techniques that principals use to prevent the agent from prioritizing his interests over the shareholders
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agency cost of debt managers may want to engage in risky actions they hope will benefit shareholders, who seek a high rate of return. Bondholders, who are typically interested in a safer investment, may want to place restrictions on the use of their money to reduce their risk.
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Packed order theoriesMyers and Majluf (1984) .Pecking Order Theory - Theory stating that firms prefer to issue debt rather than
equity if internal finance is insufficientThe announcement of a stock issue drives down the stock price because investors believe managers are more likely to issue when shares are overpriced.
Therefore firms prefer internal finance since funds can be raised without sending adverse signals.
If external finance is required, firms issue debt first and equity as a last resort.
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The term structure of interest rates The term structure of interest rates compares
the interest rates on securities, assuming that all characteristics (i.e., default risk, liquidity risk) except maturity are the same.
Bonds with identical risk, liquidity, and tax characteristics may have different interest rates because the time remaining to maturity is differ
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Term Structure of Interest Rates
Yield curve: a plot of the yield on bonds with differing terms to maturity but the same risk. Upward-sloping: long-term rates are above
short-term rates Flat: short- and long-term rates are the same Inverted: long-term rates are below short-term
rates
Term Structure of Interest Rates:the Yield Curve
Yield toMaturity
Time to Maturity
(a)
(b)
(c)
(a) Upward sloping(b) Inverted or downward sloping(c) Flat
Term Structure Facts Fact 1: Interest rates for different maturities tend
to move together over time. Fact 2: Yields on short-term bond more volatile
than yields on long-term bonds.
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Fact 3: Long-term yield tends to be higher than short term yields (i.e. yield curves
usually are upward sloping).
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The Expectations Theory The key assumption behind this theory is that buyers of bonds do not prefer
bonds of one maturity over another, so they will not hold any quantity of a bond if its expected return is less than that of another bond with a different maturity.
interest rate on the long bond is the average of the interests on short bonds expected over the life of the long bond. More generally, for n-period bonds
interest rates of different maturities will move together (Fact 1)If the current short term rate changes so it will have very little impact on long
term yield (fact2)This theory can not explain the third fact
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Expectations Theory
Long-term interest rates are geometric averages of current and expected future short-term interest rates
(EXAMPLE)
1))](1))...((1)(1[( /1112111 N
NN rErERR
Segmented Markets Theory Bonds of different maturities are completely segmented The interest rate for each bond with a different maturity is
determined by the demand for and supply of that bond longer bonds that have associated with them inflation and interest
rate risks are completely different assets than the shorter bonds so the expected returns from a bond of one maturity has no effect on the demand for a bond of another maturity.
Investors have preferences for bonds of one maturity over another If investors generally prefer bonds with shorter maturities that have
less interest-rate risk, then this explains why yield curves usually slope upward (fact 3)
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Liquidity Premium Theory
Long-term interest rates are geometric averages of current and expected future short-term interest rates plus liquidity risk premiums that increase with maturity
Lt = liquidity premium for period tL2 < L3 < …<LN
1)])(1)...()(1)(1[( /11212111 N
NNN LrELrERR
Liquidity Premium ( Preferred Habitat) Theories Interest rates on different maturity bonds move together over time. Yield curves typically slope upward; explained
by a larger liquidity premium as the term to maturity lengthens.
Investors have a preference for bonds of one maturity over another They will be willing to buy bonds of different maturities only if
they earn a somewhat higher expected return Investors are likely to prefer short-term bonds over longer-term
bonds
Thank You
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