CAPITAL STRUCTURE POLICY Chapter 15
Principles Applied in This Chapter Principle 2: There is a Risk-Return Tradeoff Principle 3: Cash Flows Are the Source of Value Principle 5: Investors Respond to Incentives
Learning Objectives Describe a firm's capital structure. 1. Explain why firms have different capital structures 2. and how capital structure influences a firm's weighted average cost of capital. Describe some fundamental differences in 3. industries that drive differences in the way they finance their investments. Use the basic tools of financial analysis to analyze 4. a firm's financing decision.
Capital Structure Choices in Practice The primary objective of capital structure management is to maximize the total value of the firm's outstanding debt and equity. The resulting financing mix that maximizes this combined value is called the optimal capital structure .
Defining a Firm's Capital Structure Capital structure = owner's equity + interest bearing debt Financial structure = Capital structure + non- interest bearing liabilities (such as accounts payable). It is also described using a firm's debt ratio .
Defining the Firm's Capital Structure The Debt to Enterprise Value ratio is commonly used to describe a firm's capital structure.
Defining the Firm's Capital Structure The book value of interest bearing debt includes: Short-term notes payable (e.g., bank loans), Current portion of long-term debt, and Long-term debt.
Financial and Capital Structures for Selected Firms, Year-End 2015 Blank
Defining the Firm's Capital Structure Table 15-1 shows that debt ratio is always higher than the debt-to-enterprise value because: Debt ratio is based on book value and book value of equity is always lower than its market value. Debt to value ratio excludes non-interest bearing debt in the numerator resulting in a lower value.
Defining the Firm's Capital Structure Table 15-1 also reports the Times Interest Earned Ratio, which measures the firm's ability to pay the interest on its debt out of operating earnings.
Financial Leverage By borrowing a portion of firm's capital at a fixed rate of interest, firm can “leverage” the rate of return it earns on its total capital into an even higher rate of return on the firm's equity. For example, if the firm is earning 17% on its investments and paying only 8% on borrowed money, the 9% differential goes to the firm's owners. This is known as favorable financial leverage . If it earns less than 8%, it will be unfavorable financial leverage .
How Do Firms Finance Their Assets? Debt-to-Enterprise-Value Ratios for Selected I ndustries
A First Look at the Modigliani and Miller Capital Structure Theorem Modigliani-Miller Capital Structure Theorem (M&M) explains what determines capital structure Logic: If Assumptions 1 and 2 hold, then capital structure does not matter (does not affect enterprise value) We know capital structure does matter. Therefore, Assumption 1or 2 (or both) does not hold What was assumed away determine capital structure
M&M Capital Structure Theorem M&M showed that, under idealistic conditions, the level of debt in its capital structure does not matter. The theory relies on two basic assumptions: Firm’s cash flows are not affected by financing. 1. Financial markets are perfect. 2.
M&M Capital Structure Theorem Assumption 2 of perfect market implies that the packaging of cash flows, that is whether they are distributed to investors as dividends or interest payments, is not important. When the two assumptions hold, the value of the firm is not affected by how it is financed.
Capital Structure, the Cost of Equity, and WACC When there are no taxes, the firm's weighted average cost of capital is also unaffected by its capital structure.
Capital Structure, the Cost of Equity, and WACC For simplicity, we are valuing a firm whose cash flows are a level perpetuity.
Capital Structure, the Cost of Equity, and WACC Since firm value and firm cash flows are unaffected by the capital structure, the firm's weighted average cost of capital is also unaffected.
Figure 15.3 Cost of Capital and Capital Structure: M&M Theory
Why Capital Structure Matters in Reality? Financial managers care a great deal about how their firms are financed. Indeed, there can be negative consequences for firms that select an inappropriate capital structure, which means that, in reality, at least one of the two M&M assumptions is violated.
Violation of Assumption 2 Transaction costs can be important and because of these costs, the rate at which investors can borrow may differ from the rate at which firms can borrow. When this is the case, firm values may depend on how they are financed.
Violation of Assumption 1 Capital structure affects the total cash flows available Interest is a tax-deductible expense, while dividends 1. are not. Thus, after taxes, firms have more money to distribute to their debt and equity holders if they use debt financing. Debt financing creates a fixed legal obligation. If the 2. firm defaults on its payments, the firm will incur the added cost that the bankruptcy process entails. The threat of bankruptcy can influence the behavior 3. of a firm's executives as well as its employees and customers.
Corporate Taxes and Capital Structure Since interest payments are tax deductible (and dividends are not), the after-tax cash flows will be higher if the firm's capital structure includes more debt.
Bankruptcy and Financial Distress Costs Even though debt provides valuable tax savings, a firm cannot keep on increasing debt. If the firm's debt obligations (i.e. interest expense) exceed it's ability to generate cash, it will be forced into bankruptcy and incur financial distress costs.
The Tradeoff Theory and the Optimal Capital Structure Thus two factors can have material impact on the role of capital structure in determining firm value and firms must tradeoff the pluses and minuses of both these factors: Interest expense is tax deductible. Debt makes it more likely that firms will experience financial distress costs.
Figure 15.5 The Cost of Capital and the Tradeoff Theory
Capital Structure Decisions and Agency Costs Debt financing can help reduce agency costs. For example, debt financing by creating fixed dollar obligations will reduce the firm's discretionary control over cash and thus reduce wasteful spending.
Making Financing Choices When Managers are Better Informed than Shareholders When firms issue new shares, it is perceived that the firm's stock is overpriced and accordingly share price generally falls. This provides an added incentive for firms to prefer debt.
Making Financing Choices When Managers are Better Informed than Shareholders Stewart Myers suggested that because of the information issues that arise when firms issue equity, firms tend to adhere to the following pecking order when they raise capital: Internal sources of financing Marketable securities Debt Hybrid securities Equity
Managerial Implications Higher levels of debt can benefit the firm due to 1. tax savings and potential to reduce agency costs. Higher levels of debt increase the probability of 2. financial distress costs and offset tax and agency cost benefits of debt.
Figure 15.6 Capital Structure and Firm Value with Taxes, Agency Costs, and Financial Distress Costs
Why Do Capital Structures Differ Across Industries? Firms in some industries (such as utilities) tend to generate relatively more taxable income and can benefit more from tax savings on debt. Financial distress can be fatal for some companies (like computer and software firms like Apple) as consumers will be very reluctant to buy the product if there is a possibility of bankruptcy. Thus such firms will tend to have lower levels of debt.
Benchmarking the Firm's Capital Structure By benchmarking a firm's capital structure, we compare the firm's current and proposed capital structures to firms that are in similar lines of business and consequently subject to the same types of risks. Table 15.3 provides a simple template for benchmarking.
Table 15.3 Worksheet for Benchmarking a Capital Structure Decision
The Problem Under the debt financing alternative, what will Sister Sarah's financial ratios look like in just two years after the firm has repaid $4 million of the loan (assuming nothing else changes)?
Step 1: Picture the Problem The pro-forma balance sheet after $4 million in long- term debt has been paid off will change and is given on the next slide.
Step 1: Picture the Problem Balance Sheet Before After $ 4 m illion paid off Accounts Payable $4,500,000 $4,500,000 Short-term Debt $3,200,000 $3,200,000 Total Current $ 7 ,7 0 0 ,0 0 0 $ 7 ,7 0 0 ,0 0 0 Liabilities Long-term Debt $12,800,000 $8,800,000 Total Liabilities $ 2 0 ,5 0 0 ,0 0 0 $ 1 6 ,5 0 0 ,0 0 0 Common Equity $19,300,000 $19,300,000 Total Liabilities and $ 3 9 ,8 0 0 ,0 0 0 $ 3 5 ,8 0 0 ,0 0 0 Equity
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