FIN 351: lecture 12

The Capital Structure Decision

MM propositions

FIN 351: lecture 12

Today’s plan

Review what we have learned about market efficiency• Why is it important?• What are the three-forms of market efficiency?• Can you give me an example for each form of market

efficiency? The capital structure decision

• The capital structure without taxes• MM’s proposition 1• MM’s proposition 2

• The capital structure with taxes• MM’s proposition 1• MM’s proposition 2

FIN 351: lecture 12

What have we learned in the last lecture?

What do we mean by market efficiency? Why is market efficiency important in

corporate finance? What are the three-forms of market

efficiency? Can you give me an example for each

form of market efficiency?

FIN 351: lecture 12

Some true or false questions about market efficiency

1 When securities are priced fairly, then financing at current market rates is a positive NPV transaction.

2 Firms should avoid financing through stock issues, since stock financing is a zero-NPV transaction.

3 If the market is efficient, stock prices should only be expected to react to new information that is released.

4 The intent of technical analysis is to discover patterns in past stock prices.

5 Technical analysts have no effect upon the efficiency of the stock market.

6 Market efficiency implies that security prices impound new information quickly.

FIN 351: lecture 12

Some true or false questions about market efficiency

7. Financing decisions are easier to reverse than investment decisions.

8. In efficient capital markets, all securities are fairly priced. 9. If security prices follow a random walk, then on any particular

day, the odds are that an increase or decrease in price is equally likely.

10. Fundamental analysts attempt to get rich by identifying patterns in stock prices.

11.Strong-form market efficiency implies that one could earn above average returns by examining the history of a firm's stock price.

12. Insider information has nothing to do with historical stock prices

FIN 351: lecture 12

Capital structure

Does the size of a pizza have nothing to do with how it is sliced?

Is the value of a firm also independent of how the firm mixes debt and equity?

FIN 351: lecture 12

Look at the both sides of a balance sheet

Asset Liabilities and equity

Market value of the asset

V

Market value of equityE

Market value of debt

D

V=E+D

FIN 351: lecture 12

Does capital structure affect the firm value?

Equity DebtEquity

Equity

DebtDebt

Govt.Govt.

Slicing the pie doesn’t affect the total amount

available to debt holders and equity holders

Slicing the pie can affect the size of the slice

going to government

Slicing the pie can affect the size of the

wasted slice

wasted

FIN 351: lecture 12

MM’s proposition 1

Modigliani & Miller• If the investment opportunity is fixed, there

are no taxes, and capital markets function well, the market value of a company does not depend on its capital structure.

How can we understand this?• The size of a pizza has nothing to do with

how you slice it.

FIN 351: lecture 12

Example - River Cruises - All Equity Financed

17.5%12.5%7.5% shares on Return

1.751.25$.75shareper Earnings

175,000125,000$75,000Income Operating

BoomExpectedSlump

Economy theof State Outcome

million 1 $Shares of ValueMarket

$10shareper Price

100,000shares ofNumber

Data

M&M (Debt Policy Doesn’t Matter)

FIN 351: lecture 12

Example

cont.

50% debt

25%15%5% shares on Return

2.501.50$.50shareper Earnings

125,00075,000$25,000earningsEquity

50,00050,000$50,000Interest

175,000125,000$75,000Income Operating

BoomExpectedSlump

Economy theof State Outcome

500,000 $debt of ueMarket val

500,000 $Shares of ValueMarket

$10shareper Price

50,000shares ofNumber

Data

M&M (Debt Policy Doesn’t Matter)

FIN 351: lecture 12

Example - River Cruises - All Equity Financed

- Debt replicated by investors

25%15%5% investment$10 on Return

2.501.50$.50investment on earningsNet

1.001.00$1.0010% @Interest :LESS

3.502.50$1.50shares twoon Earnings

BoomExpectedSlump

Economy theof State Outcome

M&M (Debt Policy Doesn’t Matter)

FIN 351: lecture 12

MM’s proposition 2

Modigliani & Miller• If the investment opportunity is fixed, there

are no taxes, and capital markets function well, the expected rate of return on the common stock of a levered firm increases in proportion to the debt-equity ratio (D/E), expressed in market values.

• The WACC is independent of how the firm is financed

FIN 351: lecture 12

r

DV

rD

rE

WACC

WACC without taxes in MM’s view

FIN 351: lecture 12

The use of debt has a lot of implications:• Financial risk- The use of debt will increase the risk to

share holders and thus Increase the variability of shareholder returns.

• Interest tax shield- The savings resulting from deductibility of interest payments.

Capital structure and Corporate Taxes

FIN 351: lecture 12

You own all the equity of Space Babies Diaper Co.. The company has no debt. The company’s annual cash flow is $1,000, before interest and taxes. The corporate tax rate is 40%. You have the option to exchange 1/2 of your equity position for 10% bonds with a face value of $1,000.

Should you do this and why?

An example on Tax shield

FIN 351: lecture 12

All Equity 1/2 Debt

EBIT 1,000

Interest Pmt 0

Pretax Income 1,000

Taxes @ 40% 400

Net Cash Flow $600

C.S. & Corporate Taxes

FIN 351: lecture 12

All Equity 1/2 Debt

EBIT 1,000 1,000

Interest Pmt 0 100

Pretax Income 1,000 900

Taxes @ 40% 400 360

Net Cash Flow $600 $540

C.S. & Corporate Taxes

FIN 351: lecture 12

Capital Structure and Corporate Taxes

All Equity 1/2 Debt

EBIT 1,000 1,000

Interest Pmt 0 100

Pretax Income 1,000 900

Taxes @ 40% 400 360

Net Cash Flow $600 $540

Total Cash Flow

All Equity = 600

*1/2 Debt = 640*1/2 Debt = 640

(540 + 100)

FIN 351: lecture 12

Capital Structure and tax shield

PV of Tax Shield =

D x rD x Tc

rD

= D x Tc

Example:

Tax benefit = 1000 x (.10) x (.40) = $40

PV of 40 perpetuity = 40 / .10 = $400

PV Tax Shield = D x Tc = 1000 x .4 = $400

FIN 351: lecture 12

MM’s proposition 1 with tax

firm value = value of all equity firm + PV(tax shield)

Example,

all equality firm value =600/0.1=6,000

PV( tax shield)=400

firm value=6,400

FIN 351: lecture 12

MM’s proposition 2

The weighted average cost of capital is decreasing with the ratio of D/E, that is

Can you understand this intuitively?

ED

Er

ED

DrTWACC equitydebtc )1(

FIN 351: lecture 12

WACC Graph

FIN 351: lecture 12

Financial Distress

Costs of Financial Distress - Costs arising from bankruptcy or distorted business decisions before bankruptcy.

Market Value = Value if all Equity Financed

+ PV Tax Shield

- PV Costs of Financial Distress

FIN 351: lecture 12

Financial distress

Costs of Financial Distress - Costs arising from bankruptcy or distorted business decisions before bankruptcy.

Market Value = Value if all Equity Financed

+ PV Tax Shield

- PV Costs of Financial Distress

FIN 351: lecture 12

Optimal Capital structure

Trade-off Theory - Theory that capital structure is based on a trade-off between tax savings and distress costs of debt.

Pecking Order Theory - Theory stating that firms prefer to issue debt rather than equity if internal finance is insufficient.

FIN 351: lecture 12

Financial Distress

Debt

Mar

ket V

alue

of

The

Fir

m

Value ofunlevered

firm

PV of interesttax shields

Costs offinancial distress

Value of levered firm

Optimal amount of debt

Maximum value of firm