Cas THEORY OF CAPITAL STRUCTURE pletion of this chapter, students should be able to: Us derstand the concept of an optimal capital structure. indersta Explain the theories of capital structure. Ea understand and be able to graph the theories of capital structure. tpcorporate the concepts of agency costs into a discussion on capital structure management Frauper 1 we discussed Concept of capital structure and financial structure, Capital ‘tmucture is composition of long term sources of financing whereas financial structure is omposition of both short term and long term financing, Financial manager should maintain optimal capital structure at which weighted average cost of capital is minimized and value of the firm is maximized. But there are two schools of thought: one school of thought (relevant theory) argue that capital structure affects the value of the firm and cost of capital whereas another school of thought irrelevant theory argue that it does not affect the value of the firm. This chapter deals with various theories of capital structure viz net income approach, net operating income approach, traditional approach and Modigliani & Miller approach. Finally it presents the financial signaling and pecking order of financing. tia296 Chapter AGEMENT L STRUCTURE MAN: . © CAPITA| Concept oF CAPITAL STRUCTURE — CONCERT OF CARAS ‘The two principal sources of long term financing are equity and debt con CAPITAL STRUCTURE The mx ol ongterm sources ‘al inancing OPTIMAL CAPITAL STRUCTURE The optimal capia sic ‘maximizes the value ol the fim and reduces the cost ol capita 1wo long term financing is known as capita, i st Under normal economic condition, the earnings per share can be inet also increases the financial risk of the gh, °° Wsiy, igher leverage. But leverage ret e rel ies be said whether or not the value of the firm wi d nie with leverage. In other words, a great deal eon has been deve ce whether the capital structure affects value of the firm or not, Tragiy tm argue that capital structure is relevant factor cs valuation ofthe fy, al they say value of the firm can be maximized by adopting optima he, | OPtimal ap, structure. Modigliani and Miller, on the other hand, argue that in Perfect al tal structure does not affect value of the firm. Pita composition of these & market, capi In the first chapter, we have studied that the use of high level of debt ant the capital structure maximizes the earnings per share of shareholders any a increases the risk of insolvency. The shareholders also will demand a higher, 9, of return on their investment to compensate for the risk atising out ia additional amount of debt in the capital structure, Introduction of gy. amount of debt capital in the capital structure reduces the value of the firm ay) increases the cost of capital. The financial manager should Maintain iy optimum capital structure which can maximize the value of the firm, The value ofthe firm and its cost of capital may be affected by the change ing capital structure. Different views have been expressed in this context. In chapter different theories of capital structure have been briefly discussed. fe Common Assumptions and Definitions To explain different theories, following assumptions are made: 1. Two types of capital are employed, long term debt and common stock, 2. The firm's total assets are fixed, but its capital structure can be changed immediately by selling debt to repurchase common stock, or vice versa 3. The net operating income (NOI or EBIT) is not expected to grow or decline over time. 4, All earnings of the firm are paid out in the form of cash dividends, 5. There are no personal and corporate income taxes. (We shall, however, later in the chapter consider the implication of taxes.) 6. The firm is expected to continue indefinitely. In addition to these assumptions, the following symbols are employed: jotal market value of debt total market value of stock (equity) V = total market value of the firm = B + S NOI = net operating income = Earnings before interest and taxes (EBIT) NI =net income I = total rupees of annual interest k = overall capitalization rate or marginal cost of capital k, cost of equity capitalhe Net Inco eo ro inancial Toes tes sorte ae oe THEORY OF CAPITAL STRUCTURE » Chaptor 8 297 _ cost of debt capital before taxes Given these assumptions, the firm’s cost of debt is: I Cost of debt (ks) = 5 ~ (81) while its cost of equity is: ae (8.2) re cost of capital to the firm is equal to the weighted average of the debt and equity costs where: B s kekax y they w= (6.3) ‘The total value of the firm is equal to the combined values of debt and equity, or: 7 2 I NOI-I value of the firm (V)=B+S ii San - (8.4) r EBIT value of the firm (V) = =>1T or NO} = (85) These definitions and equations are used in all discussions of capital structure theory. Our concern is with what happens to ky, ks, and k when the firm’s capital structure (as denoted by the ratio of B/V) changes. several theories of capital structure have been proposed, and we will discuss them in some detail. We begin by looking at three early theories: (1) the net income (NI) approach, (2) the net operating income (NOI) approach, and (3) the traditional approach. Next we consider the Modigliani and Miller (MM) analysis of capital structure theory. We then expand the basic MM analysis to include the effects of personal taxes, bankruptcy, and agency costs. me (NI) Approach This approach was developed by David Durand in 1952. According to net income approach, the cost of debt capital and the equity capital remains unchanged when leverage ratio varies. As a result, the weighted average cost of capital declines as the leverage ratio increases. This is because when the leverage ratio increases, the cost of debt, which is lower than the cost of equity, receives a higher weight in calculation of the average cost of capital. Thus, higher leverage results higher value of the firm. Assumptions of this approach are: 1. Change in leverage does not change the risk position/risk perception of investors, as a result, the cost of equity (k;), and cost of debt (ka) remain constant with changes in leverage. 2. Cost of debt (ks) is less than cost of equity (k.). 3. Overall cost of capital (k) decreases as leverage increases. To illustrate the NI approach, assume a firm has NOI of Rs 2,400, ks is 8 percent, and kis 12 percent. If the firm has Rs 4,500 of debt, the value of the common stock is:298 Chapter 8 Oy Net Income Approach: Elect Capital Stuctue on Total Markel Value and Cost of Cepial ¢ CAPITAL STRUCTURE MANAGEMENT NOI-1 ke _ Rs2400- RS 360 _ pe 17,000 . 0.12 Since the value of debt is Rs 4,500, the total value of the firm ig, Vv =B+S = Rs 4,500 + Rs 17,000 =Rs 21,500 While its cost of capital is: B s ko skaxy they Rs4,500_ 55, , R817,000 1, 164, =8%* Reas00 + 12% * Re21.500 = 11-16% Alternatively, the cost of capital can be found by: NOI Rs 2,400 ="V Rs 21,500 Consider what happens if the firm increases its debt from Rs 4.5 and uses the proceeds to repurchase common stock. The common equity is: NOI-I a Rs 2,400 = Rs 960 z 0.12 The total value of the firm is: Vv =B+S Rs 12,000 + Rs 12,000 = Rs 24,000 While the firm’s cost of capital is: wo 0 1.16% 0 to Re 14 vey na = Rs 12,000 Rs12,000 |) Rs Le k = 8% Re 19 + 12% x = 10% Alternatively, NOI Kim ry 3 Rs2,400 Rs 24,000 = 10% as be Financial Leverage E 0% 20.93% 50% Value of debt (8) Rs Rs 4,500 Rs 12,000 Rs 30000 Value of equity (S) 10,000 17,000 12,000 0 Total value (V) Rs 10,000 Rs 21,500 Rs 24,000 Rs 30000 Cost of debt (ke) 8% 8% 8% 8% Cost of equity (ke) 12% 12% 12% 12% Cost of capital (k) 12% 11.16% 10% 8% Under the NI approach, the firm is able to lower its cost of capital as the amout of financial leverage increases. Table 8.1 indicates the values of V and k for various other capital structure proportions.THE! ORY OF CAPITAL stRy, CTURE © Chapter @ 299 Cost of Capital (%4) 50 Financial Leverage, BIV (%) - Total Market Value, V (Rs ) 50 Financial Leverage, B/V (%) e effects on the firm’s cost of capital and its total market value are 8.1. If ka and k, are constant, as is assumed in the NI approach, ortion of cheaper debt funds in the capital structure increases, 1 decreases. Thus, under the NL approach, the firm can lower its aise its total market value through the addition of debt Graphically, the shown in figure then as the prop the cost of capital cost of capital and rr capital. |L STRUCTURE MANAGEMENT # CAPITA .f 300 Chapter 8 as A proach : 0 ee by David Durand in 1952. In this 5 < a italized at an overall capitalization rate to oon, ae As EBIT and overall capitalization Nth, et Tal %, does not affect the market value of the fs Tens Net Operating Income (NOL This approach is a me NET OPERATING NCO? ing income isl APPROACH. pera . Thecoreesroninareal market value of the Ineory nal suggests he fm's pital structure stant, Cay iy S , ci sree cole the equity is computed after deducting market value of dey, Men nismatelyaiaion Vi et value of the firm. Note that in the net operating income ie gl i sien rate and the cost of debt real oda fon aly mS & Jeverage. The required relwen om equity increas early wig leverage. Assumptions ofthis approach are: cl 1. The market uses an overall capitalization rate, k, to pita operating income, k depends on the business risk. I the busing ty | assumed to remain unchanged k is a constant. ine 2. Debt capitalization rate, ka, remains constant. The use of less costly debt funds increases the risk of shareho causes the equity-capitalization rate to increase. Thus, the advan, is offset exactly by the increase in the equity capitalization rate, k, 4. Market value of equity is the residual value. o ders, Ths Be of da Consider the example used before, where the cost of debt is 8 percent a Rs 2,400; but now the cost of capital is assumed to be constant at 10 pe total value of the firm is found by capitalizing NOI by k, so that: EBIT or NO] _ Rs2,400 Value of the firm (V) = =~ 9 q9 = Rs 24,000 nd NOI TONE The With Rs 4,500 in debt, the equity value is a residual subtracting the debt from the total value of the firm: S$ =V-B =Rs 24,000 - Rs 4,500 =Rs 19,500 The implied cost of equity is then determined by: jy -NOl=] _Rs2400-Rs 360 ai. Rs 19,500 The firm’s cost of capital, which was initially assumed to be 10 Percent, the weighted average of the costs of debt and equity: ee BaSt200h Rs 19,500 * Rs 24,000 * 10-46% x R54 999 = 10% hn I that is determine 0.46% k he aoe ie a inancial leverage (B/V) ee Neelien 18.75% 50% § Siructue on T 3 12 vane cos Eat Value of debt (B) Rso Rs 4,500 Rs 12,000 Rs 24 , Value of equity (8) 24,000 19,500 12, 00 a Total value (vy) Rs 24,000 Rs 24,000. Rs 24 0 Cost of debt (ke) 8% 8% rl wae Cost of equity (ks) 10% 10.46% a i Cost of capital (k ' a aTHEORY OF CAPiTay STRUCTURE « Chapters 301 (the firm increases its debt to Rs 12,000 ! ommon stock, the overall value of the fir 0 cap! 2V-B =Rs24,000—Rs 12,099 5 + The implied cost of equity is now and uses the proceeds to re purchase < '™ remaing const; tal; so the stock value is: ‘ant, as does its cost of =Rs 12,000 higher th; an before, where: NOI=1 _Rs2400~Rs 960 NOI=1 _Rs2.400—Rs 960 _ area Rs12000 = 12% while the cost of capital is still 19 Percent: Rs 12,000 Rs 12.000 k =8% R524,000 +12 RE74 999 = 10% ks Cost of Capital (%) Financial Leverage, B/V (%) yavevesss wie Neves Torr und Net are Apc V=B+S NO he TS a Total Market Value, V (RS) : Mer Nene = 100 Financial Leverage, B/V (%)302 Chapter o CAPITAL STRUCTURE MANAGEMENT Under the NOI approach, the capital structure selected is 9 mong the value of the firm is independent of the firm's capital struci increases its use of financial leverage by employing more deby, ye offset by an increase in the cost of equity capital. This relationsy figure 82 (a) indicates that as more and more debt is added to ye structure the cot of equity capital rapidly rises. According to the yes ey the cost of debt has two parts; the explicit cost, which is repre PP interest rate, and an implicit or hidden cost, which results from yt by * cost of equity attributable to increases in the degree of financia, Teg extreme degrees of financial leverage, this hidden cost becomag ve hence, the firm’s cost of capital and its total market value are not fn hi is the use of additional cheap debt funds. oe NI and NOI with Corporate Taxes NANO NOI WITH ___conPORATE TAXES ‘Nand NOI wth corporate taxes affect he valve ol the fim. ‘As we saw in the preceding sections, the net income approach sighs | firm should move toward hundred percent debt in order to maximize ly while the NOI theory implies that capital struct simply does nt mah ie, theories are obviously arti and incomplete because, amon 8h simplifications, they assume a zero corporate tax rate. However, they Be Othee | two extreme alternatives for comparison. Provide David Durand also examined the two approaches with corporate ineo Here, under the NOI approach, firm value does increase with leverage oe the tax deductibility of interestjeven though the|cost of debt remaing aq However, firm value under the NI approach increases at an even arn tant, Thus, in a world with corporate taxes, both approaches would indicate gr optimal capital structure calls for virtually hundred percent debt. the To illustrate the NI approach with taxes, assume a firm has NOI of Rs 24qn Pi 8 percent, k. is 12 percent and tax rate is 50 percent: If the firm has Re 4su 5 debt, the value of the common stock is: sf _NOI-I-T _Rs2,400—Rs 360—Rs 1,020 S & 0.12 ts 500) Since the value of debt is Rs 4,500, the total value of the firm, Vi w= BHS = Rs 4,500 + Rs 8,500 = Rs 13,000 While its cost of capital is: B s ko =W0-T)x 7 thx Z Rs 4,500 L Rs 8,500 Rs 13,000 *!2*Rs 13,000 Alternatively, the cost of capital can be found by: _NOIMG=1)_Rs2,400(1-0.50) _ kT GgVnuer aks 13,000, 923% Consider what happens if the firm increases its debt from Rs 4,500 to Rs 12,000 and uses the proceeds to repurchase common stock. The new value of common =4x = 9.23% equity is:NOI-I-T ps9 ee AO S80- 79 2 Vsutie ong ‘The total value ofthe firm jg. ee ot AAG = Rs 12,000 + Rs 6,099 = Rs 18,000 while the firm’s cost of Capital is; Rs 12,000 Rs k =4* Rs18.000 ee See Alternatively, - AOD = 882,400 (1-5) Rs 18,000 = 6.67% 'PProach with taxes, APERENL NOVis Re gop ch SAMPLE Used before, 'SaSslmed tobe constant noe! eis 50 ‘stn su Percent; but capitalizing NOI by k, 55 that Value of unlevered firm (oye Nova -T) ~ 82,400 (1-050) Jo illustrate the NO} a where the cost of debt now the cost of capital hh Rs 4,500 in debt, th oe ae With Rs 4,500 in debt, the value of the leyerca o._. vi =Vu+BTe a = Rs 12,000 + Rs 4,500 x 0.50 Rs 14250 Consider what happens if the firm increases its debt from Rs 4,500 to Rs 12, 000 and uses the proceeds to Tepurchase common stock. The new value of the levered firm is: Ve =Vu+BTe = Rs 12,000 + Rs 12,000 x 0.50 = Rs 18,000 ditional Approach This traditional approach is also developed by David Durand in 1952. The traditional capital structure theory, which is taken as middle ground position is also know as an intermediate approach. It is a compromise between the NI and NOI According to traditional view, which suggested that up to some ‘moderate’ amount of leverage risk, does not increases noticeably on either the debt or equity. So both ks and k, are relatively constant up to some point of leverage. However, beyond this threshold debt ratio, both debt and equity costs begin to rise sharply, and this increases more than offset the advantages of cheaper debt. The result is (i) a 'U' shaped weighted average cost of capital curve and (ii) a value of the firm which first rises, then hits a peak, and finally declines as the debt ratio increases. Thus, according to the traditionalists, there are some capital structures with less than hundred percent debts which maximize the value of the firm.7 |ANAGEMENT BO4iauches eye «CAPITAL STRUCTURE M Here, we can point out main proposition of the traditional approacy pital, ks, remains more or less constant t of debt ca 1, The cos ses thereafter at an increasing rate, degree of leverage but ris ity capital, ks 2. The cost of equity capital, ; gradually up to a.certain degree of leverage and rises sharply there oy adua ! . 3, The average cost of capital, k, as a consequence of the above he 3 and ka (a) decreases up to a certain point (b) remain more or jogg fe o, for moderate increases in leverage thereafter, and (6) rises beyonq ty, Certa; Mn P to a Sexy, ain remains more or less constant g os point Ect of Leverage: Tradtonal ‘Approach Cost of capital (percent) Ect of Leverage: Tradtonal ‘aproaen Value of Firm (V) = a eee eee, DebUVelue Ratio (5) The Modigliani-Miller Model (MM Hypothesis without Taxes) Franco Modigliani and Merton Miller (generally referred to as MM) both Nobel price winners in financial economics, have had a profound influence on capital structure theory ever since their seminal paper on capital structure wasTHEORY OF CAPITAL STRUCTURE @ Chapter 6 305 .d in 1958. The Modigliani Miller hypothesis is identical with net ublishe rating income approach. In other words, MM have restated and amplified the NOL ‘Approach. MM argue that, in the absence of taxes, a firm's market value of capital remain invariant to the capital structure changes. In their hey provide analytically sound and logically consistent behavior in favor of their hypothesis. To begin, MM made the following some of which they later relaxed: ope! and the cos article 4 justification assumptions, assumptions perfect eapital markets: Information is costless and readily available to all no transaction costs or government restrictions interfere with capital market transactions; and all securities are infinitely divisible. In addition, both firms and jnaividuals can borrow or lend atthe same rate. ll investors; omogeneous expectations: All present and prospective investors have identical H f expected value of the probability distribution for each firm’s future estimates ©! EBIT. Homogeneous or equivalent return classes of firms: Firms can be classified based on their degree of business risk. Since all firms within a class are equally risky, their expected future earnings are capitalized at the same rate. (This assumption is later relaxed.) hho taxes; There are no taxes on either corporations or individuals. (This assumption is later relaxed.) that there are nO MM first performed their analysis under the assumption in the absence of corporate taxes. Based on the preceding assumptions, and corporate taxes, MM stated and then proved two propositions: izing its expected Proposition I. The value of any firm is established by capital. all cost of capital) 11 net operating income (NOI or EBIT) at a constant rate (i.e. over which is appropriate for the firm's risk class. EBIT _EBIT Vis eae (8.6) (unlevered firm). Since V en under the MM theory also implies that the Here kaw is the required rate of return for an all equity as established by proposition I equation is constant, th the value of the firm is independent of its leverage. This weighted average cost of capital (k) to any firm, leveraged or not, is (1) completely independent of its capital structure (2) Equal to the cost of equity to an unlevered firm in the same risk class. Thus, MM's proposition I is identical to the NOI hypothesis. Proof: MM use an arbitrage proof to support their propositions. The support for this hypothesis. is the arbitrage process. The term arbitrage, as used by MM, refers to the simultaneous buy and sell process investors would enter into if they saw two identical firms selling at different prices because of differences in their capital structures. MM argues that the value of these two firms has to be the same; otherwise investors would profit by selling the shares of the overvalued firm and buying those of the undervalued one, They show that under their assumptions, if two companies differ only (1) in the way they are financed andChapter 8 MANAGEMENT e CAPITAL STRUCTURE investors will sell shares of i rm, and continue this process “Vale until the t values, then dervalued fi Nhe same market value, TO illustrate, We ayy Firm L (Levered) and Firm U (nlevered) sae identical that pt capital structure: Firm L has Rs 6,009 qo al {while firm U is all equity financed. Both fj. ith {4 deviation of EBIT is the same for both i Ve s, (2) in their total markel firm, buy those of un companies have exactly two firms, important respects exe interest rate of 8 percenl EBIT = Rs 1,200, and standar‘ they are in the same risk class: any arbitrage occurs, we assume that b, In the initial situation, before 1e of kyu) = ks = 10%. Under this con, have an equity capitalization rat following situation would exist: Unlevered (U) firm: 0th fr ition, the Rs 1,200 - Rs 0 0.10) EBIT Value of U's stock (Sv) = Kaeo Value of firm U (Vu) = Bu +Su = 0+ Rs 12,000 = Rs 12,000 EBIT __Rs1200, U's cost of capital (k) =e = Rs 12,000 =0.10 or 10% =Rs 12,000 Levered (L) firm: EBI Rs 1,200- Rs 480 Value of Lie stock (Si) —=smiqmg = aneeaO:10) meen Value of firm L (Vi) = Bu + Si =Rs 6,000 + Rs 7,200 = Rs 13,200 EBIT 200 Lscost of capital (k) ="y, = Rs 13,200 = 0.0909 or 9.09% The total market value of firm L, Rs 13,200, is greater than that of firm U, whi is Rs 12,000. MM maintain this situation will not continue, since a investors can increase their return without increasing their risk by engagin, af an arbitrage process. a To illustrate this process, suppose you owned 15 percent of L’s stock, so that your investment was Rs 1,080 (0.15 x Rs 7,200). By substituting personal leverage for corporate leverage, you can increase your return as follows: 2 Step 1. Sell your stock in L for Rs 1,080. Step 2. Borrow an amount equal to your previous proportional participation in the leverage of firm L. Thus, you borrow an amount equal to Rs 900 (0.15 x Rs 6,000) at 8 percent interest. Step 3. Buy 15 percent of the shares of firm U for Rs 1,800 (0.15 = Rs 12,000), Note: You have money left over since the sum of the funds from steps 1 and 2is greater than your investment in step 3 by Rs 180 (Rs 1,080 + 900 — Rs 1,800). Now let us consider what happened to your income: Income in L firm, i “Income in Ufirm ‘SIOCK: 0.10 x RS 1,080 van sssnsunnenrene RS 108 Stock: 0.10 x Rs 1,800 as 180 Less interest on loan : 0.08 x 900 ......un- S72 Total income «RS 108 Total income... Rs 108si al Jig class plus (2) risk premium whose size depends on bo! THEORY OF CAPITAL STRUCTURE « Chapter 8 307 ince the firm L paid all its earnings out in the form of dividends, your income ior to the arbitrage process was Rs 108, After the arbitrage prone your return is till Rs 108, but you have an additional Rs 180 still available for investment; peing a rational investor, you will therefore prefer to invest in firm U. In essence; your return has increased while your risk, according to MM, is the same. MM argue that this arbitrage process would actually occur, with sales of L's stock driving its price down, and purchases of U’s stock driving its price UP, until the market values of the two firms were equal. Until this equality was established, there would be gains to be had from switching from one stock to the other, so the profit motive would force the equality to be reached. When equilibrium was established, the NOI conditions would be fulfilled, and the es and average costs of capital of Firms L and U would be equal. Thus, valu of capital according to Modigliani and Miller, V and k must be independent Structure under equilibrium conditions, proposition II. MM's proposition defines the cost of equity. The cost of equity to levered firm is equal to (1) the cost of equity to an unlevered firm in the same th the differential between the costs of equity and debt to an unlevered firm and the amount of leverage used. kay =k + Risk premium (8.7) = kay + (kau -ke) (B/S) ‘ +. 8.7) in a given Here the subscripts L and U designate levered and unlevered firms risk class. Proposition II states that as the firm's use of debt increases, its cost of equity also rises, and in an exactly specified manner. ‘Taken together, the first two-MM propositions imply that the inclusion of more debt in the capital structure will not increase the value of the firm because the benefits of cheaper debt will be exactly offset by an increase in the cost of equity. ‘Thus, the basic MM theory states that in a world without taxes, both the value of a firm and its cost of capital are completely unaffected by its capital structure. Proof: The cost of equity for a zero growth company is as follows: BIT — ka = eet (8.8) From proposition I, plus the fact that V = S + B, we can write (8.8) This equation can be rearranged as follows: EBIT = kau (B +8) +» (8.86) ‘Now substitute this expression for EBIT in equation 8.8: ku(B + S)-1 += (8.8¢) ka eS w+ (8.8)308 Chapter MM with Corporate Taxes M derive a new set of propositions Market Value ofthe Firm as Function of Capta Structure STRUCTURE MANAGEMENT 8 © CAPITAL Simplify to obtain this expression” ka = kev + (kev ka) (B/S) a MM set forth in Proposition IL This is the equatior When taxes are introduced, M corporate income taxes, they conclude th With because interest on deb is a deductible expens®; hence, more of the ope, Value Faaeete trisase rough’ (o" investors. ere [are thelt Oyo) Poy ions subject to income taxes S for an unlevered firm is the firm's after tax opera ting at leverage will increase a firny, s corporati Proposition I. The value of income divided by its cost of equity. _EpiTa=T) Setar to ee ~-(8.9) 1m is equal to (1) the value of a unlevered firm j ain from leverage, which is the present value = the porate tax rate times the amount of a 7‘ e The value of a levered fir same risk class plus (2) the §: tax saving and which equals the cor firm uses. Vi Vu + BTc Gin Where, Vi =value of levered firm Vu = value of unlevered firm BTc = present value of debt tax shield corporate tax rate It is noted that when corporate taxes are introduced, the value of the levered firm exceeds that of the unlevered firm. Additionally, the differential increas; as the use of debt increases, so a firm's value is maximized at virtually Men percent debt financing Market valve of levered firm Market Value of Firm (Rs) Present value of tax shield (BTc) Market Value of Unievered Firm ‘Amount of Debt (Rs)EN UV THEORY OF CAPITAL STRUCTURE « Chapter 8 309 proof: MM originally used an arbitrage proof similar to that presented to prove proposition I without corporat : '¢ taxes, Assume that two firms are identical in all respects except capital structure. Firm U has no debt in its capital structure, while L uses debt. Expected EBIT and ogy; are identical for each firm. under these assumptions the operating cash flows av (Cfo) are cry =EBIT(-To ailable to firm U's investors (8.11) while the cash flows to Firm L’s investors (stockholders and bondholders) are ch = (EBIT-1)0-To +1 w+ (8.12) = (EBIT — kgB) (1- To) + kyB . (8.12a) Equation (8.12a) can be rearranged as follows: CF. = EBIT Q-To) —keB + TdegB + kB ++» (8.12b) = EBIT (1-To) + TekgB = (8.120) The first term in equation 8.12c, EBIT (1 - To), is identical to Firm U’s income, while the second term, T:ksB, represents the tax savings, hence the additional operating income that is available to Firm L’s investors because of the fact that interest is deductible. The value of the unlevered firm, Vy, may be determined by capitalizing its annual net income after corporate taxes at its cost of equity. CFu _EBIT(1-T,) (8.13) Vue anon ku 5 The value of the levered firm, on the other hand, is found by capitalizing both parts of its after tax cash flows as expressed in equation 8.12c. MM argue that because L’s regular earnings stream is precisely as risky as the income of Firm U, it should be capitalized at the same rate (ku). However, they argue that the tax savings are more certain ~ these savings will occur so long as interest on the debt is paid, so the tax savings are exactly as risky as the firm’s debt, which MM assume to be riskless. Therefore, the cash flows represented by the tax savings should be discounted at the risk free rate (kj). Thus, Firm L’s value: EBITG-To | TksB Veod Single aneaabe ey = (8.14) a _ EBIT 2 To), BT. ++ (8.-14a) Since the first term is identical to Vu, we may also express Vi as follows: Vi=Vu+BTc Thus, we see that the value of the levered firm exceeds that of the unlevered company, and the differential increases as the use of debt (B), goes up. Proposition II. The cost of equity of a levered firm is equal to (1) the cost of equity of an unlevered firm in the same risk class, plus (2) a risk premium whoseTHEORY OF CAPITAL STRUCTURE © Chapter 8 311 This last expression is the equation set forth in MM’s Proposition II; hence, we have proved the proposition. MM with Personal Taxes Although MM included corporate taxes in the second version of their model, they did not extend the model to include personal taxes. However, in his 1976 presidential address to the American Finance Association, Merton Miller did introduce a mode designed to show how leverage affects the firm value when both personal and corporate taxes are taken into account. The presence of taxes on personal income, however, may reduce the advantage associated with debt financing. If the returns to investors from purchasing debt instruments are taxed ata higher rate than the returns on common stock, the overall advantage of debt financing in the economy is reduced. In the MM approach, with corporate taxes {and ignoring bankruptcy and agency costs), the net gain from leverage is the difference between the value of the levered and an unlevered firm is: (8.17) erage is equal to the debt subsidy, BLT and bonds (Tro) are recognized, Gain = V.-Vu=BiTe Which shows that the gain from lev However, once personal taxes on stocks (Tis), the gain from leverage is as follows: (8.18) Bh (To) ta!) Gain =B bb eT) The value of the levered firm is given by following equation: G-Td) (=T, >| + (8.19) ~ _ (-Te) (1=Tpa) Vi =Vu+ [2 (= Tpa) When the personal tax rates on set equal to zero, the gain from leverage is equal to the same as originally specified by MM with corporate taxes. If there are no personal taxes, or if personal taxes on stocks are equal to personal taxes on bonds, we are back to the MM approach with corporate taxes. However, if the tax on stocks is less than the tax on bonds, the gain from leverage when personal taxes are considered is then less than the gain from the MM with corporate taxes. If the personal tax on stocks is less than the personal tax on bonds, the before tax return on bonds has to be high enough to offset this disadvantages to investors; otherwise, they would not want to hold the bonds. Proof: With personal taxes included, the value of an unlevered firm with a constant cash flow is found as follows: EBIT (1 To) (1 —Trs) ku The (1 - Trs) term adjusts for personal taxes, leading to a reduction in the value of unlevered firm. Ws (8.20) For the levered firm, we first partition its annual cash flows, CF,, between the stockholders and bondholders as follows: CF, = Net CF to stockholders + Net CF to bondholders312 Chapter 6 ® CAPITAL STRUCTURE MANAGEMENT = (EBIT=1) (1=T)(1- Tyo) + 1 = Tra? G2) Here I is the annual interest payment. Equation 8.21 can be Tearrangeq RB follows: CFL =EBIT (1- TJ -Tp)-1 (= Td (1- Tp) +11 Thad (621 The first term in equation 8.21a is merely the after tax cash flow of an Unevereg term, and the present value of this term is found by discounting the perpey, cash flow by kou. The second term and third terms, which reflect leverage, esi from the cash flows produced by interest payments. These two cash flows 4, assumed to be of equal risk as the basic interest rate stream; hence their Present values are obtained by dividing by the cost of debt (k.). Combining the presen values of the three terms, we obtain this value for the levered firm: y EBIT (1-To) (1-Tys) 11 =Tc) (1-Tys) = 1(1-Tya) aa ku oi Ka Ka (8.2%) The first term in equation 8.22 is equal to Vu as set forth in equation 8.20. We cay consolidate the second two terms as follows: 1a—Tra) [, (=Td O-Tyo vi mut [oper “= (6.229) Now recognize that the after tax perpetual interest payment divided by the required rate of return on debt, I (1 ~ Tra)/ks, equals the market value of the debt, B. Substituting B into the preceding equation, and putting it at the end, we obtain this expression: (1-To) =Tp) eS je Geo) To) vi = vor [1 Ta) | This equation is the equation of Miller model Effects of Bankruptcy Costs Bankruptcy costs refer to direct costs such as trustee fees, legal fees, and other BANKRUPTCY COSTS costs of reorganization or bankruptcy that are deducted before investors are Thecosswhchare paid, plus indirect costs such as the opportunity cost of funds being tied up associated win banpcy, PC ‘ichasinaleies ee) during bankruptcy proceedings, lost profits created by decreased sales in lees ndaéninstaive anticipation of bankruptcy, disruptions in production during bankruptcy, lost epeses investment opportunities due to their economic lives being longer than the expected life of the firm, and so on. Once bankruptcy costs are considered, optimal or target capital structures appear to exist for firms. In the event of bankruptcy, security holders as a whole receive less than they would otherwise. Thus, the losses associated with bankruptcy cause the value of the firm to be less than the discounted present value of the expected cash flows from operations. To the extent that levered firms have a greater probability of bankruptcy, their value will be less than that of unlevered ones. If the firm recognizes the cost associated with the risk of bankruptcy, the value of the firm with recognizing both the tax advantage associated with debt and bankruptcy costs is:jssue THEORY OF CAPITAL STRUCTURE « cunt oe ype Vu + BTe PV of bankruptcy moo hus, the cobbler is that in a world of both corporate taxes and bankruptcy costs, it appears that firms have optimal capital structures, even if all the other tenets of he MM approach hold. 5 and Agency Costs ‘an agency felationship is defined as a contract under which one or more principals engage agents to perform some service on their behalf by delegating some decision making authority to the agent, The costs associated with the agency agreement consist of monitoring expenditures by the principal, bonding expenditures by the agent, and other residual losses that arise because the agent's decisions often are not the decisions that would maximize the wealth of the principal. Given the separation ownership and control that exists for virtually all corporations, and the use of both external debt and equity, the firm js involved in numerous agency relationships. On the one hand, there are monitoring costs associated with the firm’s use of equity. If a firm is owned exclusively by a single individual, he/she will obviously make only those decisions that are wealth maximizing. However, if some of the ownership rights are sold to new stockholders, obvious conflicts in interest may arise. The new stockholders will have to incur monitoring costs in one form or another to ensure that the co-owner-manager makes decisions that are in the stockholders’ best interests. These costs are borne by the firm's stockholders as a reduction of the value of the firm. Market value of levered firm with taxes, financial distress, and agency costs Market value of levered Present Value firm with taxes of Financial Distress and ose cos Present Value Optimal ‘Amount of of Tax Shield Debt, 8° | Market Value of Firm (RS) Market Value of Unlevered Firm Bre Financial Leverage (Debt to Equity Ratio) There is a problem associated with the issuance of debt. The interests of owner may lead to investment decisions that are in the stockholders’ interests but at the expense of the bondholders’ interests. This happens because the set of investments that maximize the firm’s total value is not the same as the set of investments that maximizes share value. The value of the firm should be less than the discounted present value of the expected cash flows from operations.314 Chapter Asymmetric Information and Financial Signaling SYMMETRIC INFORMATION. The station in which Investors and managers have IGentcalintormaton about the firm's prospects uation in which managers have diferent (Cater information about tht fim’ prospects than do investors, ‘Hierarchy o ong term financing strategies in which Using internally generated ‘cash is atthe top and issuing ‘new equiy is al the bottom, ‘ © CAPITAL STRUCTURE MANAGEMENT Vi = Vu + BT. PV of bankruptcy - PV of agency costs i at an even lower det “8, Thus the optimal capital structure occurs T debt ratio for») ‘Agency costs reinforce the conclusion that firms have optimal capj fj I struc Tey, MM asstumed that investors have the same information about a firm», as its managers ~ this is called symmetric information. However, p'Peq, often have better information than outside investors. This is called gq" ™'Beq, information, and it has an important effect on optimum capital structyn, he In reality managers will posses intimate inside knowledge abou | operations. As insiders they will have access to more information aboyy “is than its shareholders and they can share information with sharehoiqa {tm other stakeholders. This unequal access to and distribution of ings" Sha between managers and owners are known as information asymmetry ang j ation, agency cost borne by the shareholders. isan In the context of capital structure, the role of information asymmetry can illustrated by an example. Suppose that a biotechnology company made 4 breakthrough in. genetic engineering which could be deemed jp pot considerable benefit in the prevention of coronary heart disease, In this a of only management is aware of the breakthrough and that the comet"? prospects are very favourable (asymmetric information) Pany’s The company needs to raise substantial funds for the manufacturing, marke; and distribution of its new product. If the financial manager considers current capital structure as optimal how should the funds be raised, thy debt or equity? IE new equity isu is made the share price will rise when the company stats, generate the net cash flows from the investment. Thus the new and exisin shareholders will have benefited from the financial windfall. 8 throug, However, the existing shareholders will be less wealthy than if the funds hag been raised by an issue of debt, The creation of new shareholders had dilute the wealth of the existing shareholders, With a debt issue, existing shareholder, would not have to share the new wealth. From the existing shareholders standpoint, issuing debt to fund the development would be the preferred option, By issuing debt the company would be signaling to investors and current shareholders that the future outlook for the company is bright, Issuing debt would be interpreted as a positive signal about the company’s future, In contrast the decision by a company to issue equity would generally be interpreted by shareholders and investors as a negative signal, indicating that the company’s future prospects are not so good and that its equity is currently overvalued. A Pecking Order of Financing —FECKING ORDERTHEORY In the theory of firm’s capital structure and financing decisions, the Pecking Order Theory or Pecking Order Model was developed by Stewart C. Myers in 1984. It states that companies prioritize their sources of financing (from internalTHEORY OF CAPITAL STRUCTURE © Ch apter 8 315 financing to equity) according to the la WwW preteting vo raids equi gel rnoneRe vs ee or of least resistance, r ‘of last ue i funds are used first, and when that is depleted, debt is ee are er sensible to issue any more debt, equity is issued. ae Maa e ace ued. This theory maintains that be See of financing sources and prefer internal >, AN i 7. is required. lebt is preferred over equity if external financing Tests of the Pecking Order Theory have not been able to show that it is of first- order importance in determining a firm's capital structure. However, several authors have found that there are instances where it is a good approximation of reality. On the one hand, Fama and French [1], and also Myers and Shyam- Sunder [2] find that some features of the data are better explained by the Pecking Order than by the Trade-Off Theory. Goyal and Frank show, among other things, that Pecking Order theory fails where it should hold, namely for small firms where information asymmetry is presumably an important problem. [3] The Pecking Order Theory explains the profitability and debt ratios 1. Firms prefer internal financing. | 2. They adapt their target dividend payout ratios opportunities, while trying to avoid sudden changes in dividends. 3. Sticky dividend policies, plus unpredictable fluctuations in profits and investment opportunities, mean that internally generated cash flow is sometimes more than capital expenditures and at other times less. If it is more, the firm pays off the debt or invests in marketable securities. If it is less, the firm first draws down its cash balance or sells its marketable securities, rather than reduce dividends. 4, If external financing is required, firms is they start with debt, then possibly hybrid securities su bonds, then perhaps equity a . In addition, issue costs are least is a last resor' for internal funds, low for debt and highest for equity. There is also the ing to the sto d with issuing equity, inverse relationship between | to their investment sue the safest security first. That is, ch as convertible ck market associate negative signali positive signaling associated with debt.