Bài giảng Financial Management - Chapter 17: Capital Structure Determination

Chapter 17Capital Structure DeterminationAfter Studying Chapter 17, you should be able to:Define “capital structure.”Explain the net operating income (NOI) approach to capital structure and valuation of a firm; and, calculate a firm's value using this approach. Explain the traditional approach to capital structure and the valuation of a firm. Discuss the relationship between financial leverage and the cost of capital as originally set forth by Modigliani and Miller (M&M) and evaluate their arguments. Describe various market imperfections and other "real world" factors that tend to dilute M&M’s original position. Present a number of reasonable arguments for believing that an optimal capital structure exists in theory.Explain how financial structure changes can be used for financial signaling purposes, and give some examples.A Conceptual LookThe Total-Value PrinciplePresence of Market Imperfections and Incentive IssuesThe Effect of TaxesTaxes and Market Imperfections CombinedFinancial SignalingCapital Structure DeterminationConcerned with the effect of capital market decisions on security prices.Assume: (1) investment and asset management decisions are held constant and (2) consider only debt-versus-equity financing.Capital Structure -- The mix (or proportion) of a firm’s permanent long-term financing represented by debt, preferred stock, and common stock equity.Capital Structureki = the yield on the company’s debtAnnual interest on debtMarket value of debtIB==kiAssumptions:Interest paid each and every yearBond life is infiniteResults in the valuation of a perpetual bondNo taxes (Note: allows us to focus on just capital structure issues.)A Conceptual Look –Relevant Rates of ReturnES==ke = the expected return on the company’s equityEarnings available to common shareholdersMarket value of common stock outstandingkeAssumptions:Earnings are not expected to grow100% dividend payoutResults in the valuation of a perpetuityAppropriate in this case for illustrating the theory of the firmESA Conceptual Look –Relevant Rates of ReturnOV==ko = an overall capitalization rate for the firmNet operating incomeTotal market value of the firmkoAssumptions:V = B + S = total market value of the firmO = I + E = net operating income = interest paid plus earnings available to common shareholdersOVA Conceptual Look –Relevant Rates of ReturnCapitalization Rate, ko – The discount rate used to determine the present value of a stream of expected cash flows.kokekiBB + SSB + S=+What happens to ki, ke, and ko when leverage, B/S, increases?Capitalization RateAssume:Net operating income equals $1,350Market value of debt is $1,800 at 10% interestOverall capitalization rate is 15%Net Operating Income Approach – A theory of capital structure in which the weighted average cost of capital and the total value of the firm remain constant as financial leverage is changed.Net Operating Income ApproachTotal firm value = O / ko = $1,350 / 0.15 = $9,000Market value = V – B = $9,000 – $1,800 of equity = $7,200Required return = E / S on equity* = ($1,350 – $180) / $7,200 = 16.25%Calculating the required rate of return on equity* B / S = $1,800 / $7,200 = 0.25Interest payments = $1,800 × 10%Required Rate of Return on EquityTotal firm value = O / ko = $1,350 / 0.15 = $9,000Market value = V – B = $9,000 – $3,000 of equity = $6,000Required return = E / S on equity* = ($1,350 - $300) / $6,000 = 17.50%What is the rate of return on equity if B=$3,000?* B / S = $3,000 / $6,000 = 0.50Interest payments = $3,000 × 10%Required Rate of Return on Equity B / S ki ke ko 0.00 — 15.00% 15% 0.25 10% 16.25% 15% 0.50 10% 17.50% 15% 1.00 10% 20.00% 15% 2.00 10% 25.00% 15%Examine a variety of different debt-to-equity ratios and the resulting required rate of return on equity.Calculated in slides 9 and 10Required Rate of Return on Equity Capital costs and the NOI approach in a graphical representation.0 0.25 0.50 0.75 1.0 1.25 1.50 1.75 2.0Financial Leverage (B/S)0.250.200.150.100.050Capital Costs (%)ke = 16.25% and17.5% respectivelyki (Yield on debt)ko (Capitalization rate)ke (Required return on equity)Required Rate of Return on EquityNOI ApproachYou can create this type of analysis in Excel also. You can use some modeling experience to write formulas to calculate the required rates. Refer to “VW13E-17.xlsx” on the ‘NOI Approach’ tabExcel & the NOI ApproachCritical assumption is ko remains constant.An increase in cheaper debt funds is exactly offset by an increase in the required rate of return on equity.As long as ki is constant, ke is a linear function of the debt-to-equity ratio.Thus, there is no one optimal capital structure.Summary of NOI ApproachOptimal Capital Structure – The capital structure that minimizes the firm’s cost of capital and thereby maximizes the value of the firm. Traditional Approach – A theory of capital structure in which there exists an optimal capital structure and where management can increase the total value of the firm through the judicious use of financial leverage.Traditional Approach Traditional ApproachFinancial Leverage (B / S)0.250.200.150.100.050Capital Costs (%)kikokeOptimal Capital StructureOptimal Capital Structure: Traditional ApproachTraditional ApproachYou can create this type of analysis in Excel also. We use some assumptions in this model built into the formulas. Refer to “VW13E-17.xlsx” on the ‘Traditional Approach’ tabExcel and the Traditional ApproachThe cost of capital is dependent on the capital structure of the firm. Initially, low-cost debt is not rising and replaces more expensive equity financing and ko declines.Then, increasing financial leverage and theassociated increase in ke and ki more than offsetsthe benefits of lower cost debt financing.Thus, there is one optimal capital structure where ko is at its lowest point.This is also the point where the firm’s totalvalue will be the largest (discounting at ko).Summary of the Traditional ApproachAdvocate that the relationship betweenfinancial leverage and the cost of capital is explained by the NOI approach.Provide behavioral justification for a constantko over the entire range of financial leverage possibilities.Total risk for all security holders of the firm isnot altered by the capital structure.Therefore, the total value of the firm is notaltered by the firm’s financing mix.Total Value Principle: Modigliani and Miller (M&M) Market value of debt ($65M) Market value of equity ($35M)Total firm marketvalue ($100M)M&M assume an absence of taxes and market imperfections.Investors can substitute personal for corporate financial leverage. Market value of debt ($35M) Market value of equity ($65M)Total firm marketvalue ($100M)Total market value is not altered by the capital structure (the total size of the pies are the same).Total Value Principle: Modigliani and MillerArbitrage – Finding two assets that are essentially the same and buying the cheaper and selling the more expensive.Two firms that are alike in every respect EXCEPT capital structure MUST have the same market value.Otherwise, arbitrage is possible.Arbitrage and Total Market Value of the Firm Consider two firms that are identical in every respect EXCEPT: Company NL – no financial leverageCompany L – $30,000 of 12% debtMarket value of debt for Company L equals its par valueRequired return on equity – Company NL is 15% – Company L is 16%NOI for each firm is $10,000Arbitrage ExampleEarnings available to = E = O – I common shareholders = $10,000 - $0 = $10,000Market value = E / ke of equity = $10,000 / 0 .15 = $66,667Total market value = $66,667 + $0 = $66,667Overall capitalization rate = 15%Debt-to-equity ratio = 0Valuation of Company NLArbitrage Example: Company NLEarnings available to = E = O – I common shareholders = $10,000 – $3,600 = $6,400Market value = E / ke of equity = $6,400 / 0.16 = $40,000Total market value = $40,000 + $30,000 = $70,000Overall capitalization rate = 14.3%Debt-to-equity ratio = 0.75Valuation of Company LArbitrage Example: Company LAssume you own 1% of the stock of Company L (equity value = $400).You should:1. Sell the stock in Company L for $400.2. Borrow $300 at 12% interest (equals 1% of debt for Company L).3. Buy 1% of the stock in Company NL for $666.67. This leaves you with $33.33 for other investments ($400 + $300 - $666.67).Completing an Arbitrage TransactionOriginal return on investment in Company L$400 × 16% = $64Return on investment after the transaction$666.67 × 16% = $100 return on Company NL$300 × 12% = $36 interest paid$64 net return ($100 – $36) AND $33.33 left over.This reduces the required net investment to $366.67 to earn $64.Completing an Arbitrage TransactionThe equity share price in Company NL rises based on increased share demand.The equity share price in Company L falls based on selling pressures.Arbitrage continues until total firm values are identical for companies NL and L.Therefore, all capital structures are equally as acceptable.The investor uses “personal” rather than corporate financial leverage.Summary of the Arbitrage TransactionAgency costs (Slide 17–31)Debt and the incentive to manage efficientlyInstitutional restrictionsTransaction costsBankruptcy costs (Slide 17–30)Market Imperfections and Incentive Issues Financial Leverage (B / S)RfRequired Rate of Returnon Equity (ke)ke with no leverageke without bankruptcy costske with bankruptcy costsPremiumfor financialriskPremiumfor businessriskRisk-freerateRequired Rate of Return on Equity with BankruptcyMonitoring includes bonding of agents, auditing financial statements, and explicitly restricting management decisions or actions.Costs are borne by shareholders (Jensen & Meckling).Monitoring costs, like bankruptcy costs, tend to rise at an increasing rate with financial leverage.Agency Costs -- Costs associated with monitoring management to ensure that it behaves in ways consistent with the firm’s contractual agreements with creditors and shareholders.Agency CostsConsider two identical firms EXCEPT: Company ND – no debt, 16% required returnCompany D – $5,000 of 12% debtCorporate tax rate is 40% for each companyNOI for each firm is $10,000The judicious use of financial leverage (i.e., debt) provides a favorable impact on a company’s total valuation.Example of the Effects of Corporate TaxesEarnings available to = E = O – I common shareholders = $2,000 – $0 = $2,000Tax Rate (T) = 40%Income available to = EACS (1 – T) common shareholders = $2,000 (1 – 0.4) = $1,200Total income available to = EAT + I all security holders = $1,200 + 0 = $1,200Valuation of Company ND (Note: has no debt)Corporate Tax Example: Company NDEarnings available to = E = O – I common shareholders = $2,000 – $600 = $1,400Tax Rate (T) = 40%Income available to = EACS (1 – T) common shareholders = $1,400 (1 – 0.4) = $840Total income available to = EAT + I all security holders = $840 + $600 = $1,440*Valuation of Company D (Note: has some debt)* $240 annual tax-shield benefit of debt (i.e., $1,440 - $1,200)Corporate Tax Example: Company DTax Shield – A tax-deductible expense. The expense protects (shields) an equivalent dollar amount of revenue from being taxed by reducing taxable income.Present value oftax-shield benefitsof debt*=(r) (B) (tc)r= (B) (tc)* Permanent debt, so treated as a perpetuity** Alternatively, $240 annual tax shield / 0.12 = $2,000, where $240=$600 Interest expense × 0.40 tax rate.=($5,000) (0.4) = $2,000**Tax-Shield BenefitsValue of unlevered firm = $1,200 / 0.16 (Company ND) = $7,500*Value of levered firm = $7,500 + $2,000 (Company D) = $9,500 Value of Value of Present value of levered = firm if + tax-shield benefits firm unlevered of debt* Assuming zero growth and 100% dividend payoutValue of the Levered FirmThe greater the financial leverage, the lower the cost of capital of the firm.The adjusted M&M proposition suggests an optimal strategy is to take on the maximum amount of financial leverage.This implies a capital structure of almost 100% debt! Yet, this is not consistent with actual behavior.The greater the amount of debt, the greater the tax-shield benefits and the greater the value of the firm.Summary of Corporate Tax EffectsCorporate plus personal taxesPersonal taxes reduce the corporate tax advantage associated with debt.Only a small portion of the explanation why corporate debt usage is not near 100%.Uncertainty of tax-shield benefitsUncertainty increases the possibility of bankruptcy and liquidation, which reduces the value of the tax shield.Other Tax IssuesAs financial leverage increases, tax-shield benefits increase as do bankruptcy and agency costs.Value of levered firm = Value of firm if unlevered + Present value of tax-shield benefits of debt - Present value of bankruptcy and agency costsBankruptcy Costs, Agency Costs, and TaxesOptimal Financial LeverageTaxes, bankruptcy, andagency costs combinedNet tax effectFinancial Leverage (B/S)Cost of Capital (%)Minimum Costof Capital PointBankruptcy Costs, Agency Costs, and TaxesInformational Asymmetry is based on the idea that insiders (managers) know something about the firm that outsiders (security holders) do not.Changing the capital structure to include more debt conveys that the firm’s stock price is undervalued.This is a valid signal because of the possibility of bankruptcy.A manager may use capital structure changes to convey information about the profitability and risk of the firm.Financial SignalingFlexibilityA decision today impacts the options open to the firm for future financing options – thereby reducing flexibility.Often referred to unused debt capacity.TimingAfter appropriate capital structure determined it is still difficult to decide when to issue debt or equity and in what orderFactors considered include the current and expected health of the firm and market conditions.Timing and FlexibilityTaxesExplicit costCash-flow ability to service debtAgency costs and incentive issuesFinancial signalingEBIT-EPS analysisCapital structure ratiosSecurity ratingTimingFlexibilityChecklist of Practical and Conceptual Considerations