fr,,,l

r^'
CAPITAT STRUCTURE
DECISIONS: PART I
/-
t@o
opun its doors, a new business requires capital, and still more capital is
needed if the firm is to expand. The required funds can come from many differ-
ent sources and take many different forms. However, all capital can be classified
into two basic types-debt and equity.
Raising capital as debt has several advantages. First, interest is tax deductible,
which lowers tl're effective cost of debt. Second, debtholders are limiteci to a fixed
return, so stockholders do not have to share profits if the business does excep-
tionally well. Finally, debtholders do not have voting rights, so stockholders can
control a business lvith less money than would otherwise be required.
However, financing with debt also has disadvantages. First, the higher the debt
ratio, the greater the risk and thus the higher the interest rate. At some point, ris-
ing interest rates overwhelm the tax advantages of debt. Second, if a company falls
on hard times, and if its operating income is insufficient to cover interest charges,
then stockholders will have to make up the shortfall, and if they cannot, the com-
pany may be forced into bankruptcy. Good times may be just around the comer,
but too much debt can keep the company from getting there and can wipe out
stockholders in the process.
Crown Cork & Seal Company, an $8.0 billion NYSE company, is a good exam-
ple of a firm that used debt to good advantage. Over a ten-year period, from 1988
to 1998, Crown increased its long-term debt from a minuscule $9 million to a
mighty $4 billion. This pushed its debt ratio up to a still-reasonable 42 percent.
Crown used the borrowed funds to acquire other companies, and, since it earned
more on the acquired assets than its cost of debL that pushed up its ROE and,
consequently, its stock price. Indeed, the'stock price rose from $10 to more than
$50 over the period.
On the other hand, debt financing is causing severe probiems for some air-
lines, including U.S. Airways. In 1998, U.S. Airways had a long-term debt to cap-
italization ratio of almost 100 percent; that is, it was financed almost entirely by
debt. Further, its annual interest expense was more than $200 million, consider-
ably more than the company's operating income during most of the 1990s. U.S.
Airways cannot pay diviclends on its common stock, and its very survival is in
question. The airline industry is extrenrely cyclical, and large amounts of debt
put tremendous pressures on a company when earnings tum south.
Companies can Lrse either debt or equity capital to finance their assets. Is one
form better than the other? If so, should firms be financed either with all debt or all
eqr"rity? Or, if the best clroice is some mix of eiebt and equity, what is the optimal
360 Chapter 9 LONG-TERM FINANCIAL PLANNING
Current ratio
Payout ratio
Operating profit margin after taxes (NOPAT,iSales)
Operating capital requirement (Operating capital/Sales)
Rehrm on invested capital (NOPAT/Operating capital)
Assume that you were recently hired as Simmons'as-
sistant, and youi first major tasli is to help her develop
the forecast. She asked you to begin by answering the fol-
lowing set of questions.
a. Asiume (1) that NWC was oPerating at full capacity in
1998 with respect to all assets, (2) that all assets must
grow proportionally with sales, (3) that accounts
pay4ble and accruals will also grow in proportion to
iales, and (4) that the 1993 profit margin and dividend
payout will be maintained. Under these conditions,
iliat will the company's financial requirements be for
the coming year? Use'the AFN equation to answer this
question.
b. Now estimate the 1999 financial requirements using
the percent of sales approach, making an initial fore-
cast'plus one additio'nil "pass" to ditermine the ef-
fects'of "financing feedbacks." Assume (1) that each
type of asset, as iell as payables, accruals, and 6xed
and variable costs, will be the same
Percent
ot sales m
1999 as in l99S; (2) that the
Payout
ratio is held con-
stant at 30 percent; (3) that extemal funds needed are
financed 50 percent by notes payable and 50 percent
by long+erm debt (nd new common stock will be is-
sued); ind (4) ihat all debt carries an interest rate of 8
percent.
c. Why do the two methods produce somewhat different
AFN forecasts? lAlhich method provides the more ac-
curate forecast?
d. Calculate NWC's forecasted ratios, and compare them
with the company's 1998 ratios and with the industry
averaSes. How dbes NWC compare with the average
fim in its industry, and is the comPany exPected to
improve during the coming year?
e. Calculate NWC's free cash flow for 1999.
f. Suppose NWC exPects sales to grow 15 percent- in
2000. In 2001 and all subsequent years, comPetition
will cause NWC's sales to
Srow
at a constant rate of 5
percent. lf NWC's operations remain the same (i.e., the
items that are a perient of sales will be the sme
Per-
cent of sales in years after 1998 and in 1998), the pro-
iected
free castr flows for 2000 and 2001 are
-$82.50
million and $25.88 million, respectively' After 2001,
free cash flows are expected to
Srow
at 5
Percent Per
year. NWC's weighted average cost of capital i:9 p9I-
ient. What is the value of NWC as of December 31,
1998? (Hint: Find the horizon value at 2001, and then
find the present values of the horizon value and the
free cash flows.)
g. Suppose you now leam that NWC's 1998 receivables
-
and'inventories were in line with required levels,
given the firm's credit and inventory polic-ies,but that
ixcess capacity existed with regard to fixed assets.
2.50
30.00%
3.00%
45.00%
6.67%
3.00
30.00%
5.00%
35.00%
14.N"/"
6f
your answer, show the growth ratt, in in-
,ri* that results from a l0 percent increase in
from a sales level of (a)
$200 and (b) $2,000
I on both the actual regression line and a hy-
tical regression line which is linear and which
through
the origin.
Questions/Problems 361
l. Florv n'ould changes in these items affect the AFN? (1)
Thc dividcnd payout ratio, (2) the profit margin, (3) the
capital intensity ratio, and (4) NWC begins buying from
its suppliers on terms which permit it to pay after 60
days rathcr than after 30 days. (Considr'r each itcm scp-
arately and hold all othcr things constant.)
ng1999? iri
h. Without actually workinB out the numbery
would you expect the ratios to change in the t
where excess capacity in fixed assets exists?
your reasorung.
i.
'Based
on comparisons between NWC's days sal
standing (DSO) md inventory tumover ratios w
Specifically, fixed assets were operated at only
cent of capacity.
'!
(1) What levet of sales could have existed in 1998
the available fixed assets? What would the
assets/sales ratio have been if NWC had
erating at full caPacitY?
(2) How would the existence of excess
fixed assets affect the additional funds needeil
industr! average figures, does it appear that
operating efficiently with resPect to its inventori(
aicounts receivable? If the company were able to
these ratios into line with the industry averages,
effect would this have on its AFN and its
tios? What effect would this have on free cash
lustrate your answer.
Year Sales Inventories
the value of the company? (Note: Inventories
ceivables will be discussed in detail in Chapter
l.
The relationship between sales and the various
assets is imporlant in financial forecasting' The
of sales aouoach, under the assumption that ea of sales approach, under the assumPtion that e
item srowl at the same rate as sales, leads to
forecist that is reasonably close to the forecast r
AFN equation. Explain howeach of the followir
would ;ffect the accuracy of financial forecasts
the AFN equation: (1) excess capacity, (2) base
assets, such as shoes in a shoe store, (3) ecor
scale in the use of assets, and (4) lumPy assets.
k. (i) How could regression analysis be used to
'
the presence oithe situationl described abo
theri to improue the financial forecasts?
I
lraph
of thi following data, which is for a
{
*eli-managed comPany in NWC's industry,
Selected Additional References and Cases
The heart of successfiil
fnancial
planning is the sales
forccast.
On this key urbject, see
Pan,
fudy,
Donald R. Nichols, and O. Maurice
Joy,
"Sales Forecasting Practices of Large
U.S. Industrial Firms, " Iinnnciirl lvld n a ge n c n t, F all 7977, 72-77.
Hirschey, Mark, and
James
L. Pappas, Manngerial Econontics (Fort Worth, Tex.: Dryden
Press, 1996).
Computer modeling is beconing increasitgly itnportnilt. For general references, see
Carleton, Willard T., Charles L. Dick,
Jr,
and David H. Downes, "Financial Policy Mode.ls:
Theory and Practice,"
lournal
of Fhance, December 1973,691-709.
Francis,
Jack
Clark, and Dexter R. Rowell, "A Simultaneous Equation Model of the Firm
for Financial Analysis.-rnd Planning," Financitrl ManLtgcnrcnt, Spring 1978,29-,1,1.
Grinyer, P H., and
J.
\Nooller, Corpornte Models Todny
-A
Neu Tool
for
Finntcial Managenwrt
(London: Institute oI Chartered Accountants, 1978).
Pappas,
James
L., and George P. Huber, "Probabilistic Short-Term Fhancial Planning," Fi
nancial Managentetrr, Autumn 7973, 36 -14.
Traenkle,
].
W., E. B. Cox, and
J.
A. Bullard, Thc Use of Fitnntial Models irr Busiless (Nerv
York: Financial Executives' Research Fomdation, 1975).
Considerable effort las bem e:rpended to dntelop integrated
f,nancial
planning ntodels thut idnrtify
optimal policies. For one exanrple, sae
Myers, Stewart C., and Cerald A. Pogue, "A Programming Approach to Corporate Finan-
cial Management,"
lournal
of Finance , May 1974,579-599.
For an article on eontrol, see
Bierman, Harold, "Beyond Cash Flow ROl," Midlnntl Corporatc Finance
lournal,
W'nter
1988,35-39.
The Drydet Press Cases in Financial Man.rgement: Drydcn Request series contilrs the
fol-
lowhry applicable cases:
Case 37, "Space-Age Materials, lnc.," Case 38, "Automated Banking Management, Inc.,"
Case 38A, "Expert Systems," Case 38B, "lvledical Manag;ement Systems, Inc.," and Case
63, "Dental Ilccords, Inc.," which all focus on using the percent of sales forecasting
method to forecast futurc financing rL'quirenrents.
7996
1997
1998
1999 (est.)
(2) On the same
SraPh
that plots the above data'
' '
a line which ih6ws ho* the regression
line
$1,280
1,600
2,000
2,500
$118
138
162
192
ipp*. t"
i".
fy the use of tf,"'air.r fotmu4
thd percent of iales forecasting procedure'{
354 Chapter 10 CAPITAL STRUCTURE DECISIONS: PART I
mix? In this chapter, we discuss the key facets of the debt-versus-equity, or caDihr
structure, decision. As you read the chapter, think about Crown Cork & Seal'aJ
U.S. Airways, and the ways ihe concepts discussed might aid the.managersj
these and other companies as they make capital structure dccisions.'
One of the most perplexing issues facing financial managers is the relation56;,
between capital structure, which is the mix of debt ancl equity financing,
3,j
stock prices. How does capit.rl structure affect stock prices, and what effectdos
it have on the cost of capital? Should different intlustries, and different
fung
within industries, have different capital structures, and, if so, rvhat factors
lead
5
these differences? Although the optimal capital structure decision is complex
an4
not well understood, the material in this chapter will help you deal with theig
sues involved.
BUSINESS AND FINANCIAL RISK
ln Chapter 2, when we examined risk from the viewpoini of a stock investor,
r'e
distinguished between market rislg which is measured by the firm's beta coeffr
cient, and stand-alone rislg which includes both ni.rrket risk and an elemento{
risk which can be eliminated by diversification. Now we introduce two new &
mensions of risk: (1) business risk, or the riskiness of the firm's stock if it usesm
debt. and (2) financial risk, which is the aCditional risk placed on the commm
stockholders as a result of the firm's decision to use debt.2
Conceptually, the firm has a certain amount of risk inherent in its operationr
this is its business risk. If it uses debt, then, in effect, it partitions its investors inb
two groups and concentrates most of its business risk on one class of investors-
the common stockholders. However, the common stockholders generally de
mand compensation for assuming more risk and thus require a higher rate of rt
I
turn. In this section, we examine business and financial risk within a stand-alor
I risk framework, which ignores the benefits of stockholder diversification.
Business Risk
Business risk in a stand-alone sense is a function of the uncertainty inherentin
projections of a firm's future re!u!! on
lnvgsted
c4p!ta1 (ROIC). defined as follons
Net income to
NOPAT
_
con-rmon stockholders + After-tax intcrest
Pa)'ments
RorC=-:".jr+=
Cap11.11 CapiLrl
Here NOPAT is net operating profit after taxes, or EBIT(I
-
T). If a firm usesto
debt, then its interest payments will be zero, its capital will be alt elluity, andrE
ROIC *'ill equal iis return on equity, ROE:
llolC (zero clebt)
=
ltgp -
Net iticonrc to cor,l.u.n stockholclcrs.
Contmou etlLtitl'
Therefore, the business risk of a b:ocrnse-ft'cc firm can be measttrerl by the
staT
dard deviation of its ROE, oR6g.
rWe
have di\.ided the material on capital structure int(' trvo ch.rptcrs. Chnpter 10 cor t'rs the
Lsril
while Chapter 11 discusses the theor)' of capital structure.
2Preferre.l
stock also adds to fin.rncial risk. Ttr simplifv m.rttr'rs, rr('.qtccntr.rte rrn tlt'L.t ald coflInd
equitv in tlris clrapter.
Busincss antl Financi.rl Risk 3(,5
To illustratt', consitler strilsl,urt Llectronics Conrprlrrv, a dclrt-licc (rrrri.'itn'rl)
firm. Figtrre 10-1 gir.es some cluts about the comparry's business risk. l-he top
graph shows the trc.nc{ in I(OE from 1988 throtrgh 1998; this grapl.r gives both se-
curity analysts antl Strasburgq's m.lnagement arr icioa of the degree to rvhich ROE
has varied in the past and might vary in the fuitrre.
The lou.er graph shorvs tht'bcginning-of-year subjectivcly estimateLl probabil-
ity <listribution of Strasburg's ltOE for 199S, basetl on thc trend line in the top
section of Figure l0-1. As both gr;rphs inclicate, Str..rsburg's actrral IIOE in 199i1
was only 8 pt-rcent, n,ell bclorr, thc expectcd r,:rluc r:f 12 percent- 199E ryas ;r b.rrl
year.
Strasburg's past fltrctuations in liOE rrcre causct{ bv manv factors-booms
ancl recessions in the nation.rl ecr)nom)i succcssful nerr; products intrtlducecl br,
both Str.rsburg and its competitors, latror strikes, a fire in Strasburg's main plani,
and so on. Sintilar events r,vill dorrbtless ctccur in thc futurc, and rvhcn they cio,
the rcalizerl RoE will be higher or lolver than the projcctccl level. Fr.rrther, ihcre
r:j,l:';
;1:t-'l
., i:
-.,..:
..,.
'r i'f)
tl.
1t.'*.
. ili- |
i;'.)tt
ii.
i
BOE
(%)
a. Trend in Belurn on Equity (HOE)
b. Subjeclive Probability Distribution
Probability
Density
of HOE lor 1998
--__-
FtoE (e'.;
Expecled ROE
366 Chaptr'r 10 CAPITAL STRUCTURE DECISIONS: IART I Business and Financial Risk 367
both unit sales and sales prices. However, this stabilization may require spending
a great deal on advertising and/or price concessions to get commitments from
customers to purchase fixed quantities at fixed prices in the future. Similarly,
firms such as Strasburg Electronics can reduce the volatility of future input costs
by negotiating long-term labor and materials supply contracts, but they may
have to pay prices above the current spot price to obtain these contracts. Also,
many firms are using hedging techniques to reduce business risk, as w,e discuss
in Chapter 19.
Operating Leverage
As noted above, business risk depends in part on the extent to rvhich a firm
builds fixed costs into its operationi-if fixed costs are high, even a small decline
in sales can lead to a large decline in ROE. So, other things held constant, the
\igher
a firm's fixed costs, the greater its business risk. Higher fixed costs are
generally associated with more highly automated, capital intensive firms and in-
dustries. However, businesses that employ highly skilled rvorkers who must be
retained and paid even during recessions also have relatively high fixed costs, as
do firms with high product development costs, because the amortization of de-
velopment costs is an element of fixed costs.
If a high percentage of total costs are fixed, then the firm is said to have a high
degree of operating leverage. In physics, Ieverage implies the use of a lever to
raise a heary object with a small force. In politics, if people have leverage, their
smallest word or action can accomplish a lot. /n business terminology, a high degree
,
of operating leaerage, other
factors
held constant, implies tlnt a relatiaely small change
1
ln sales results irr a large change in ROE.
Figure 10-2 illustrates the concept of operating leverage by comparing the re-
sults that Strasburg could expect if it used differe.nt degrees of operating leverage.
Plan A calls for a relatively small amount of fixed costs, $20,000. Here the firm
would not have much automated equipment, so its depreciation, maintenance.
property taxes, and so on would be low, but the total operating costs line has a rel-
atively steep slope, indicating that variable costs per unit are higher than they
would be if the firm used more operating leverage. Plan B calls for a higher level
of fixed costs, $50,000. Here the firm uses automated equipment (with which one
operator can tum out a few or many units at the same labor cost) to a much larger
extent. The breakeven point is higher under Plan B-breakeven occurs at 60,000
units under Plan B versus only 40,000 units under Plan A.
We can calculate the breakeven quantity by recognizing that operating breakeoen
occurs when ROE
=
0, hence when earnings before interest and taxes (EBIT)
=
0:4
EBIT=0=PQ-vQ-F.
Here P is average sales price per unit of output, Q
is units of output, V is variable
cost per unit, and F is fixed operating costs. If we solve for the breakeven quan-
tity,
Qrc,
we get this expression:
is al$,avs the possibility that a long-term,disaster might strike,.permanentlyds
pressing the conrpany's carning poiver; for examplg, a competitor nlight
inho
i.,... n'n.ru prodr,rct that would permanently lower Str.rsbur8's t-arnin8s.
This
uncertainty regarding Strasburg's {uture. ROE,.assunling tly
Ji,rtt
rrsds
'10
debf
f.
ii-rcing, is'tlc'fined as the company's business risk..Since Strasburg uses no dp5q
stockhottlcrs bear all of the company's business risk'
Business risk varies not only from indttstry to industry but also among
firrx1
in i
[iven
industry. Further, business risk can .lo"-8.:.:":t time' For.examPle,
UE
electlic rrtilities were regarded for years as having little business risk, bttt acom-
bination of events in recent years altered the utilities' situation, producing sharp
declincs in their ROEs and greatly increasing the industry's business risk.
Now,
foot-l processors ancl grocery retailers are frequently-given as examples of indw
tries with lorv business risk, *,hile cyclical manufacturin8 industries such
x
autos ancl steel, aS well as marry small startup comPanies, are regarded as having
especially high busint'ss risk.l
'Btrsincss
iisk depencls on a number of factors, the more important of which an
listeci trelorv:
i. Demancl uncertainty. The more
Predictable
the dernand for a firm's prod'
ucts, other things held constant, the lower its business risk'
l. Sales price variability. Firms whose prodr.rcts are sold in highly volatile mar.
kets aie exposetl to more business risk than similar firms whose output
prices are more stable.
). Input cost variability. Firms whose input costs are highly uncertain are er-
posecl to a high degree of business risk.
{. Ability to adjust output prices for changes in input costs' Some firmsan
bctter able than others to raise their olvn ouiPut prices n'hen input cosb
rist,. TI.re greatcr the ability to adfust output prices to reflect cost condition$
the lorver the degree of business risk.
5. Ability to develop new proclucts in a timely, cost-effective manner' Firms
in s.rch l',igh-tech industiies as drugs and compuiers depend on a consta{
stream of ierv proclucts. The faster its products become obsolete, the greatet
a firm's busincss risk.
6. Foreign risk exposure. Firms that generate a l"righ percentage of their earn'
ings .iucrr"n, aic sr-rbic'ct to earninfs declines dtrc. to erchange rate fluctul'
tions. Also, if a firm oPerates in a politically unstable
'rren,
it m'1y be subJeo
b political risks. See Chapter 22 for a further discussion'
7. The extent to which costs are fixed: operating leverage' If a high percenl'
age oi its costs are fixetl, hence do not clecline when dcmantl falls off' tntr
thc firm is exposecl to a relatively high clegrt'e of business risk' This
factot
is ctrllt'r1 up.r,iti,,5 lti'uage, a.rd itis.liscussitl at le.gth in the ne'xt seciior'r'
Each of thr,sr' factors is clett'rminecl partlv by the fi,n's indrrstry char,rcteristiO
but r,.rch of them is also controllablE ttr some extent by m.1l1.1gemL'llt. For
exdr'
ple, most firms can, through their marketing policit'i, take Ictions to stabili'l
\".,,"*r*rt"'.*rt rlisctrssitrn tlf marlL't vtrsLls conlPiny--spccific risk
'n
tn;t
"'t1;t'rr'
\Ve,n'-Tf
(lr rhit .tnv .rclir'n rliriclr in(ro.ts('5 hrlsiniss ri'L irr th.'sl'lt)d-nl(\ne ri\\
(Prrrr't''ill t't'nrrl"' '"-"
:ll.i*': iiilr:\;t:' .,":ii,.i"",, il,,i tiiil,rt
.r prrt.'f busint'cs ri:r s ill gen,trllr he J'n'p'']fl-:tfr
l1(.il,L \ulrle{t k,,'lrnrin.rtirrrr I'r'tli!cr<i[rcrtr,'rr ['r'tlt' iirnr's st()cll1('l(l(rs' Il!i\
Prrltlt
r\
(rrnu*
sr,n\L l( nIlh rrr Cltrpt.'r I I
:
ar.=*
\his definition of breakeven does not include any fixed financial costs because Strasburg is an un-
levered firm. If there were fixed financial costs, the firm rvoulcl suffer an accounting loss at the oper-
ating breakeven point. We will introduce financial costs shortl!'.
368 Chapter 10 CAPITAL STRUCTURE DECISIONS: PAIIT I
Selling price
= $2.00
Fixed costs
= $20,000
Variable costs = $1.50 per unit
Plan A
Thus for Plan A,
and for Plan B,
llusincss .rnri Financi.rl Risk 369
o,, =
r.ffifu
=
4o,ooo L,nits,
Or,=
rffigo
=6o,oo()
units.
r How cloes operating leverage affect br-rsiness risk? Ol/rcr l/rirrgs lcH c(),rslil,rl, f/rcl
'.higher a
firuis
opcrrttirtg lcut:ragc, tltc ltigltr ils lrrrsirrr'ss risl'. This point is rlcnron-f
'strated in Figure 10-3, where rve develop prob.rlrility clistributiorrs for liOE turricr
I'lans A and B.
The left-hand section of Figure 10-3 graphs the. probability distribution of sales
that was presented in tabular form in Figure 10-2. The sales probability distrilru-
tion depends on how demand for the product varies, not on whether the product
is manufactured by Plan A or by Plan B. Therefore, the same sales probability dis-
tribution applies to both production plans; this distribution has expected s.rles of
$220,000, and it ranges from zero to about $450,000, with a standard deviation of
os,r*
= $92,995.
We use the sales probability distribution, together with the operating costs at
each sales level, to develop graphs of the ROE probability distributions under
Plans A and B. Tht'se are shown in the right-hand section of Figure 10-3. Plan B
has a higher expected ROE, but this plan also enLrils a much hight'r probability
of losses. Clearly, Plan B, the one with more fixetl costs and a higher degree of op-
erating Ieverage, is riskier. ln getrcral, htitlitrg otlw
factors
constfifit, tfu higlw the tle-
Sree
of operating leucrogc, tln grcatcr tfu
firnr's
Drsirrt'-ss risk.
To what extent can firms control their opcrating leverage? To a large extent,
operating leverage is determined by technology. Electric utilities, telephone
companies, airlines, steel mills, and chemical companic's simply nrrrsl have large
Selling price
= $2.00
Fixed costs
= $60,000
Variable costs
= $1.00 per unit
Plan B
Prob- Units
ability Sold,
Q
0.03 0 $
0.07 40,000
0.15 60,000
0.50 110,000
0.15 160,000
o.o7 180,000
0.03 220,000
Operating Operating
Sales Costs EBIT NI
Operating Operating
Costs EBIT
$ 60,000 ($ 60,000)
100,000 (20,000)
120,000 0
170,000 50,000
220,000 100,000
240,000 120,000
280,000 160,000
ROE NI R0[
Expectedvalue $220,000
Stmdard deviation $ 92,995
NOTES:
$21,000 12.0%
$13,949 8.0%
($36,000) (2o.6tl
(12,000) (6.9)
0 0.0
30,000 77.1
60,000
y3
72,OOO 41.1
96,000 549
$30,000
17.11
$27,8s8
15'91
0
80,000
120,000
220,000
320,000
360,000
,140,000
$ 2o,ooo ($2o,ooo) ($12,ooo) (6.e%)
80,000 0 0 0.0
110,000 10000 5,000 3.4
185,000 35,000 21,000 12.0
250,000 60,000 36,000 20.6
290.000 70,000 42,000 24.0
350,000 90,000 v,000 30.9
$35,000
923,249
$ 50,000
$ 46,497
',1:;:::.,..
lfti''r
ri.h,1
*il,
,
a. Sales Probability Distribution b. FOE Probability Distribution
Probability Probability
Oensity Oensily
0 Expected Expected BOE (%)
ROEa ROEB
a. Strasburg Electronics has a 40 percent federal-plus-state tax rate.
b. The firm uses no debt financing.
c. For simpliciry we assume assets
=
equity
= $175,000 under both plans.
d. NI
=
EBIT(1
-
T)
=
EBIT(0.6).
rl .
We are using continuous distributions to approximrte the discretc distributions ctrnl,rint'd in Figure 10-2
Plan A
plan
B
lncome and Costs
(Ihousands o, Dollars)
lncome and Costs
(Thousands o, Oollars)
240 240
200
160
120
80
40
200
160
120
80
40
Operating Profit
(EBIT)
Operating
Loss
I
Breakeven Point
|
(EBrr
=
o)
r Fixed Costs
20 40 60 80 100 120
Sales (Thousands ol Units)
20 40 60 80 100 120
Sales (Thousands of Units)
370 Chapter 10 CAPITAL STRUCTURE DECISIONS: PART I
invtstments in fixed assets; this results in high fixed costs and operatins
lpv,
age. Simillrly, clrug, auto, cornputer. anc{ similar complnls5 must spend"heariL
to develop nelv products, and product-development costs incre.rse operati;:
leverage. Grocery stores, on the other h;ind, generalll'have significantly
loruX
fixed costs, hence lower operating leverage. Still. althotrgh irrdLrstry factor.i
exert a n-rajor influence, all firms have some control over their operating
levsl
age. For example, an electric utility can expand its generating capacity bybuil;
ing either a gas-fired or a coal-fired plant. The coal plant wotrld re.lrire
a lam-
investment and would have higher fixed costs, but its vari.rble op.'rating
cfii
would be relatively low. The gas-fired plant, on the other hancl, w,ould requ6,
smaller investment and r,vould have lou'er fixecl costs, but the variable coit
1fq
gas) would be high. Thus, by its capital budgeting decisions, a trtility (or
all
other company) can influence its operating leverage, hence its busirress risk.
'
The concept of operating leverage was originally developed for use in capihl
budgeting. Mutuallv exclusive prujects which involve alternatir.e methodi
fu
producirrB a given pror'luct often have different degrees of operating leveragq
herrce cliifererrt breakeven points and tlifferent dogrees of risk. Str;rsburg
El[.
tronics and many othe,r cor:rpanies regularlv undertakc' a type 6f breakeven
analvsis (the serrsitivity analysis discr.rssed in Clrapter 8) for each proposed pr1+
ect as a part of their regular capital budgeting process. Still, once a corporationi
operating Ievc'rage has been established, this factor exerts a nlajor inf'lr,rence on ib
capit,il structure dr:cisions.
Financial Risk
Financial risk is the additional risk placed on the common stockholders as are
sult of the dc.cision to finance with dcbt. Conceptualll', stockholtlers face a cer-
' tain amount of risk rvhich is inherent in a firm's operations-this is its busines
risk, rvhich is defined as the uncertainty inherent in projections of fuhrre opa-
i
ating income. If a firm uses debt (financial leverage), this concentrates the busi.
ness risk on common stockholders. To illustrate, suppose tc'n people decide b
form a corporation to manufacture disk drives. There is a certain amount d
business risk in the operation. If the firm is capitalized only lvith common 6f
uity, and if each person buys 10 percent of the stock, then each investor shar6
equally in the business risk. However, suppose the firm is capit:rlized with $
percent tlebt and 50 pe'rcent equity, rr,ith five of the invcstors
Futtint
uP ther
capital as debt and the other five putting up their money as equitv In this casQ
the five investors w,ho put up the equity will have to bear all of the' busine$
risk, so the common stoik wiit be twice as risky as it woulcl have been had
th
firm bee'n firranced only rl,ith equity. Thus, the use ofdebt, or financial levera8Q
concentrates the firm's business risk on its stockholders. This concentration
d
business risk occurs because debtholders, who receive fixeit interest
PaymenB
Lrear none of the business risk.
To illustrate. the concentration of business risk, again consiclcr Strasburg
Elec
trr:nics. Strasburg has $175,000 in assets and is all-:equity financed.5 If the
firo
Business and Financial Risk 371
were using Plan A from Figure 10-2, then its expected ROE would be 12.0 percent
with a standard deviation of 8.0 percent. Now suppose the firm decides k>
change its capital structure by issuing $87,500 of debt at k.r
=
10% and using these
funds to reptace $87,500 of equity. Its expected return on equity (which w,ould
now be only $87,500) would rise from 12 to 18 percent:
Expected EBIT (unchanged)
Irrterest (10-ea on $87,500 of debt)
Earnings before taxes
Taxes (40%)
Net income
Expected ROE:
old
(Unleveraged)
Situation
(See Figure 10-2)
$35,000
0
$35,000
1.1,000
s21,000
New
(Leveraged)
Situation
$35,000
8,750
$26,2s0
10,500
91!Zs0
$21,000/$17s,000 = u% $15,750/$87j00 =
18%
Thus, the use of debt would "leverage up" the expccled ROE from 12 percent to
18 percent. Note, holvever, that the expectecl return on invested capital (ROIC) is
[$35,000(0.6)]/$175,000 =
0.12
=
12"/. in both the unleveraged and leveraged cases.
The total dollar return to all investors (both bondholclers and stockholders) is
Net income = $21,000 when no debt is used, but Net income + Interest
= 915,750 +
$8,750 = $2{,500 when $87,500 of debt is used. Thus, thc use of debt allorvs 93,500
more of the $35,000 of EBIT to floli, through ro investors: $2.1,500 - $21,000
--
$3,500. The leverage irnprovement results from interest tax savings-the interest
expense of $8,750 reduced taxes by T(lnterest)
=
0.10($8,750)
= $3,500. Tlurs, tltc
use of rlebt shields n portion of n con+lany's enrnitrys
Jiom .tltt tat collcctor.
Since raising half of its capital as debt would increase the expected dollar re-
tum to investors and leverage up the expected ROE to stockholders, shoulcl the
firm use this amount of, or even more, debt financing? The answer would defi-
rritely be "yes" except for one problem: The use of financial leverage also in-
c'reases the risk facecl by the eqrrity investors, and this higher risk will tend to oft
set the benefits of debt. To illustrate, suppose EBIT actually turned out to be
$5,000 rather than the expected $35,000. If ihe firm uset{ no debt, then ROE woulcl
decline from 12.0 percent to 1.7 percent. However, with debt financing, ROE
would fall from 18.0 to
-2.6
percent:
,ri
Zero Debt
$5,000
0
s5,000
$2,000
$3,000
1.7'.v"
12.09i,
$87,500 of Debt
$s,000
8,750
-53,750
1,500
-q1
)<(l
{-/.\,
18.0'7"
,i. :1..
'ii
+, '
,.,i.'.t".i*n
:.{.1
:11
'
'.:1^1!v.
';
rJ'lir,
.!:i
Aciual EBIT
Interest (10'/d
Earnings bcfore taxes
Taxes (,10'X)
Net incomc
Actual ROE
Expectcd ROE
tA
firrl in busintss for at l(arst tr{ vc;rrs rlorrlti Iiktlv hl'e fnr more lhin 5175,iU0 in nriL'ts
l\k'
purposelv ktcping Strrsbtrrg El.'ctrenics snrall so th.rt rtt'mav focus trn tlrr'conc.,pt. $ith{ul-ttft
ovcrnhelmtcl bv the numtcrs. Also note thnt, to be consistcnt rsith cnpitiL 51s11r111rg
thru)'l
shou[i b., rvorking rsith n].rrLot \2lucs oi s('crtrities ratht,r thrrr [,t ok r rltir,s tri rsrtts. lVe id
S
book rtlucs nt this point to simplifv the illustrnti()n, but tre rtill tliscuss m.rrkr't rtlue relrtionships
later in the chipter lr this re8ard, scc Haim Lely and Robert Brooks, "Fin.rnci.rl Brc.rk-Even An.rly-
sis and thc V.rlue of thc Firn," Fitrucial |ulLilrrt.rrrrrf, A(tun1n l9St, 2?-16.
372 Chapter 10 CAPITAL STRUCTURE DECISIONS: I'ART I
A more complete analysis of the effects of leverage on Strasburg's
f,gg,.,
lustrated in Figure 10-4. The two lines in the top graph show the ROE that
wiJ
exist at different levels of EBIT under the two different capital structurcs.d
greater the use of financial leverage, the more scnsitive ROE is to.t*goi
EBIT.
The lower panel of Figure 10-4 shows the effects of lcverage on the fir6'5 g1
probability distribution. With zero debt, expected ROE is 12
Percent,
and
ithai
relatively tight distribution. With 50 percent debt, the expected ROE rixs
Ui
percent, but the ROE distribution is flatter, indicating a more risky situatioti
iact, the standard deviation of ROE is 8.0 percent at zero debt, but exactly
h{
as high, 16.0 percent, at 50 percent debt.
Our conclusions from this analysis are as follows:
1. The use of debt increases a firm's expected ROE, provided the expected
p
turn on invested capiial exceeds the after-tax interest rate.
2. The standard deviation of ROE if the firm Lrses zero financial levenp
6R6s1g1, is a measure of the firm's business risk, and ooor at any debtlag
is a measure of the stand-alone risk borne by stockholders. 6R66
=
opqqLlt
the firm does not use any financial leverage, but if the firm does useddl
then onor > oRoE(u), because business risk is being concentrated on fu
stockholders.
3. The difference between oR6s and os6slr-1y iS a measure of the risk-increast
effects of financial leverage:
In our exampie,
Stand-alone risk
=
onoe.
Business risk
=
op11s1gy.
Financial risk
=
oR66
-
oneslrry.
Financial risk
=
16.0%
-
8.0%
=
8.0%.
1..
'i. :tl
3r
.1.
Operating leverage and financial leverage normally work in the same ttzp
thev both increas! expected ROE, but ttey atso increase the riskbomet!
,tolu,ota"rr.t Operating leverage affects ihe firm's business risk, fharid
leverage affects ihe firir's finaicial risk, and they both affect the 6rnl
stand-alone risk.
Qlry-r,,, uestioils
What is business risk, and how can it be measured?
What are some determinants of business risk?
\44rat is financial risk, and how can it be measured?
What is operating leverage? \A/hat are the similarities between oPeratingle
age and financial leverage?
6Note
that for operatinS leverage to benefit shareholders, the firm must be oPeratinB
^.':r:X,|
rhnrre thp hrp:kovpn noint- and for financial leverase to be of benefit, the after-Lr\ cost
oI sr-'-
above the breakeven
Point,
ects and make related financing decisions, they expict the firm tobe oPerating above
Business and Financial Risk 37-r
BOE
f,,")
60
55
50
45
40
35
30
20
'15
'10
5
ROE with Zero Debl
20 40 60 80 100 EBIT(S)
l0 15 20 25 30 35 40 ROE (e")
point, and they also exPect RO1C to exceed the after-tax cost of debt
37{ Chapter 10 CAPITAL STRUCTUnE DECI-cIONS: Pi\RT I
CAPITAL STRUCTURE THEORY
Capital Struchrre Theory 375
If stock is held until the owner dies, no capital gains tax whatever must be pairl.
So, on bi'rlance, common stock returns are taxed at significantly lower effective
rates thnn debt returns.
Be'cause of the tax situation, investors are willing to accept relatively lorv be-
fore-tax returns on stock vis-ir-vis the before-tax returns on bonds. For example,
an investor might require a return of 10 perce'nt on Firm B's br:nds. and if stock
income rvere taxed at the same rate as bond income, the required rate of return
on Firm B's stock might be 15 percent because of thc stock's greater risk. How-
ever, in vierv of the favorable tax treatment of retrrrns on the stock, investors
might be willing to accept a before-tax return of only 14 percent on the stock.
Thus, as lv{iller pointed out, (1) the dedrrctibility oJ intaresf far.ors the use of delrt
finarrcing, but (2) the/nz,orable tnx trmtnrcnt of irtcotre
front
slocks lowers the re-
quired rate of return on stock and thus favors the use of eqr.rity financing. It is dif-
Iicult to say what the net effect of the'se two factors is. N,lost observers believe that
interest deductibility has the stronger effect, hence that oiriiai system still favors
the corporate use of debt. Howevet that effect is reduced by the lon'er capital
gains tax rate-
One can observe changes in corporate financing patterns following major
changes in tax rates, For example, since 1992 the top personal tax rate on interest
and dividenels was raised sharply, but the capital gains tax rate was lowcrecl.
This resulted in an increased use of equity financing.
The Effect of Bankruptcy Costs
MM's results also depend on the assumption that there are no bankrup_tcy costs.
However, bankruptcy can be quite costly. Firms in bankruptcy have very high le-
gal and accounting expenses, and they also have a hard time retaining customers,
suppliers, and employees. Moreover, bankruptcy often forces a firm to liquiclate
and to sell assets for less than they would be rvorth if the firm were to continue
operating. Assets such as plant and equipment are often illiquid because they are
configurt'd to a company's individual needs, and also because they are difficuli
to disassemble and move.
Note too that the threat ofbankruptcV,
^ot
just bankrupicy per se, brings about
problems. Key employees jump ship, suppliers refuse to grant credit, customers
seek more stable suppliers, and lenders demand higher interest rates or even
refrrse to extend credit.
Bankruptcy-related problems are rnost likely to arise rvhen a firm l'ras a lot of
debt in its capital structure. Therefore, potential bankruptcy costs cliscourage'
firms from pushing their use of debt to excessive levels.
Bankruptcy-related costs depend on three things: (1) the prob.rbility of bank-
ruptcy, (2) the costs the firm will incur if financial distress arises, and (3) the ad-
verse effects that the potential for bankruptcy has on current operations. Firms
whose earnings are more uncertain, all else equal, face a greater chance of bank-
ruptcy and, therefore, should use less debt than nrore stable firms. This is consis-
tent with our earlier point that firms with a high degree of operating leverage,
ancl thus greater business risk, should limit their use of financial let,erage. Lik*
wise, firms w,hicli would face high costs in the event of financial distress shoulcl
rely less heavily orr debt. For example, firms whosc' assets are illitltrict anrl thirs
wotrld have to be sold at "fire sale" prices should limit their use of debt financ-
ing. Finally, firms such as airlines, whose current sales are affectetl by anvthing
that worries potential customers, shoult-l lin'rit their use of debt.
In thc prcvious sectiou, we t-lemonstratecl that the use of financi,rl le!'erage
ryDi.
callv iucreases stockholtlers' expected returns, but, at tht' samt' time, it increaq,
their risk. The question managers face, then, is this: Is the lncre.rse in exPected,*
turn su[[icicnt to colrlPens.rte stockholders for the increase in risk? To help
41
srver this question, it is useful to exantine capital structttre theory. Although
tla.
orv docs not provide all of the answers, it does provide insights into the effe66
oi rit'bt ve'rsus equity financing. Thus, an understanding of capital structure
thF
orv rvill aid managers in establishing their firms'optimal capital structures.T16,
section provides the basics of capital structure theory, while Ch.rpter 1t contains
a more. clctailecl cliscttssion.
Moclcrn capital strr,rcture theory began in 1958, when Professors Franco
Morligliirrri ancl Merton Miiler (hereafter NIM) publishet-l what has be'en called ttp
'mostlirfluential
finance article ever written.T MM proved, but under a veryrs
strictive set of assumptions, that a firm's value is urraffected by its capital s6uc-
-tuie.
Thtrs, Iv'{NI's results sugSest that ii c'loes not matter how a firm financesib
operations, because, at least under thcir assumptions, capital strtlcture is i(ele
vint. One of the assttmptions needc'cl by MM to derive their results was theab
scnce of taxes, both corPorate and personal' With zero taxes, the increase inthe
rL.turn to stockholde'rs resulting from the use of leverage is exactly offset by the
incre.rst, in risk. Thus, at any level of dc.bt, the return to stockholders is
iust
com-
mensurate rvith the risk assumctl, hence there is no net benefit to using financial
leverage.
Dc'qrite the unrealistic assttnrptions, MM's irrelevance result is extremely im'
portaui. By inclicating the conditions under which capital structure is irrelevanl
MM ulrn provider'l us lvith some clttes about what is required for capital skuc'
ture to be reler.ant and l-rence to affect a firm's value.
The Effect of Taxes
MM published a folltrrv-up^paper in which they relaxed the assumPtion tlut
tht-reire no corporate iaxes.E The tax code allows corporations to deduct intercl
payments as an exPense. Holvever, dividend
Payments
to stockholders are nd
iehuctitrle. This difle'rential treatment results in a net benefit to financial leveng3
and thus encourages corporations to trse c1ebt. Incleed. MM clemonstrated thatil
all thr:ir other assirnrptions holtl, this clifferential trcatment leacls to a situation
which calls for 100 porcent debt financing.
Sevt'r.rl years Iati'r, Merton Mille-r (thiJtime withottt Mocligliani) extended
lh
'anall,sis
to incltrcL'personal taxes.e Ht'noted that all of the inconre from bondj
, generallv conlcs as Lrtcrest, rvl'rich is taxecl as personal incontc at ratcs goingrf
in:9.0
lr.-.ce.,t,
rvhilc incon-re from stocks geneially comes partly fronr.dividends
' an.1
;rritlv
from capital girins. Fttrther, capital gains are tarcd at a nraxinrttmlilE
I
of 20
Pcrcent,
irntl this tax is rleferrr'c1 until theitock is sok"l and tlrc. gain realizal
;Frn.co
l\lo.ligliini ,rrrel i\lertr,. H. NIille' "Thc Cost of CaFital, Corprrrrtit,n Finarrco, an.l th.'Th{!
o[ lnrcstnrr,nt,', rlrrnricrrrr [corronric Rrri,,ii,, June
195E. Mociiglilni.rir] Nlrller b(,th \\1)n Nilrelf'rir6
for th('ir h ork.
'F-rnnc(i i\lo.liFlinni nn(l Nl('rtL)rr H. i\lilltr "Corpe1119 lncomc T,rres and thc Cost ot Crpitrl:
ACfi'
rcation," ,,lxr,r'r.r,l I cortllic lirlt a' 53, Jun!'
191)f,, 'l-13-t13.
"\lerton
I l. \lillc., "l).t.t ,rr1!l
-[.r\cs,"
/rrrrrrr/
trfFirarrn'31, i\'li! lq7, ]{'l-175.
$l
li
;l
ii
r.,"r,
1*;
,rit,i
iiil
i,.
'.1;
il,
,i;.,
375 Chapter 10 CAPITAL STRUCTURE
DECISIONS: PART I
I
MM Besult lncorporating the
Ettects of Corporate Taxation:
Price ol the Stock if There
Were No BankruPtcY-Belated
Costs
BankruPtcY-Related Costs'
which Reduce Value
* Actual Price of Stock
Valuo of the Stock
with Zero Debt
=
$20
\
u"'r" ol stock if
the Firm Used No
Financial Leverage
0Dr
I
02
I
Leverage, D/A
Threshold Debt Level Optimal Capital Structure:
wilil'"#ri;;t"v'-
MLislnatTixShetterBonelits:
c;;-dB-e;;;;'Miterial
Mar6inal Bankruptcy-Related costs
Value Added by
A firm whose value
Primarily
is due to growth oPPortunities and not to
asset
in place suffers from both a high cost of financial distress and irom,advslse6.
f"cl on current oPerations. Consider a software developer versus a,hotel
chail
ln the event of diitress or liquidation. the hotel chain can raise funcls by se[ing
DroDertv. In contrast, the software developer cannot sell its assets, which
cons:i
iii,i
uriiy of its employees' intellectual capital. Toavoid defaulting on ioans,
Ur
ioftware developei mlst reduce exPenses, either
-by
laying off emPloyees
or
h
cutting R&D. Sut, uoth these actions have significant negative impacts on
h
"uir""of
the comPany, making bankruptcy ev.en more likeiy' As
1nis,91m'ltc
shows, potential financial distress is an especially serious situation tor high-t61
companies.
Trade-Off Theory
Reqe3rctl
fgr-$91y!g
thq
\aM
p-1p91q
-!a1led.t"- l. Jli9-::efl
jlgory
-o-!!9-v*egge,'lin
*rucn fl.r"l tr;de*off tile banefits of debt fi"l"s,sg
(favorable corPorate tax heat
*;.0 ;grfi*
ryfher-itterest
ialsc aad hankruptcy
-costs'
A summary of tfu
t.ua"-ofitt""ii
ii
"rpt"ts"d
graphically in Figure 10-5' Here are some observ+
tions about the figure:
1. The fact that interest is deductible makes debt.less expensive than coft
*or, o. preferred stock. In effect, the govemment
Pays P1r!
of the co$ d
debt capital, or, to
Put
it another way, debt provides tax shelter benefits' ls
C.rpital Structure Theorr' 377
a result, using debt causes morc of the firrn's operating irrcome (EBIT) to
flow through to investors, so the more debt a company uses, the higher its
value antl stock price. Unt-ler the MM assumptions, rvhen corporate taxes
are considered, a firm's stock price will be maximized if it uses 100 percent
debt. The line labeled "MM Result Incorporating the Effects of Corporate
Taxation" in Figure 10-5 expresses this relationship.
In the real world, firms rarely use 100 percent debt. One reason is because
of the favorable personal tax treatment of income from stocks. However, the
primary reason is that firms limit their use of debt to reduce the probabilitv
of financial distress (bankruptcy). A1so, the interest rate on debt becomes
prohibitively high at high debt levels.
There is some threshold level of debt, labeled D1 in Figure 10-5, belorv
which the probability of bankruptcy is so low as to be immaterial. Be-
yond D1, however, bankruptcy-related costs and rising interest rates be-
come increasingly important, and they reduce the tax benefits of debt at
an increasing rate. in the range from Dl to D2, bankruptcy-related costs
reduce but
.do
not completely offset the tax benefits of debt, so the firn's
stock price rises (but at a decreasing rate) as its debt ratio increases.
However, beyond D2, bankruptcy-related costs exceed the tax benefits, so
from this point on increasing the debi ratio lo*'ers the value of the stock.
Therefore, D2 g the
eptim.a! eapital..slluqtlrLl.
Although it is not shown in Figure 10-5, there is a relationship betrveen the
firm's stock price and its weighted averaBe cost of capital. As a firm uses
more and more debt, its weighted average cost of capital first decreases,
then reaqhes a minimum, and eventually begins to rise. Moreover, the min-
iltglU"qtg-bl"!
:yeI$g
qo,St,Sf,Sap,1t-41--p1-curs.wlrel,e the stock.p"ride.i-s--mril
-rqr?qd-at
Point D2 in Figure 10-5. Thus, the same capital structure that
maximizq thg stogk pfce il:q
f!rygriZSS
t[i:_-oieiiii
coii'of capi-tat
Both theoretical and empirical evidence support the preceding discussion.
However, statistical problems prevent us from precisely identifving Points
D1 and D2. So, while theoretical and empirical work supports the general
shape of the curves in Figure 10-5, these curves must be taken as approxi-
mations, not as precisely defined functions. It is worth noting, horver.er, that
many theoretical models shon'that the maximum value of an optimally ler'
ered firm is from 10 to 20 percent greatcr than an unlevered firrn. These
models also indicate th"rt the optimal arnourlt of leverage is from 30 to 60
percent. These results contrast sharply with il-re case in which bankruptcy
costs are ignored, in which the oprtimal leverage is 100 pt'rcent anci the
value of tire levercd firrn can be more th.rn 70 percent greater thart an un-
levered firm (c-lepending on corporatc tax rates and the firm's IIOIC).
A disturbing empirical contradiction to capital structure theorv as ex-
pressed in Figure 10-5 is the fact that many large, successful firms such as
Intel and Microsoft use far less debt than the theory suggests. This point led
to the development of the signaling theory, t,hich is discussed next.
Signaling Theory
I
One of lvlM's asstrmptions is that investors and managers har.e exactlv the same
!information
about a firm's prospects-this is called symmetric information.
iHo*"r'"r,
managers often have better information than outsicie investors. This is
2.
4.
)
37E Chaptcr 10 CAPITAL STRUCTURE DECISIONS: PART I
Capital Structure Theory 379
This, in turn, suggests that when a mature firm announces a new stock offer-
ring,
the price of its stock should decline. Empirical studies have shown that
this situation does inde.ed exist.12
What is the implication of signaling theory for capital structure decisions?
The answer is ihat firms shoultl, in normal times, maintain a reserrre borrow-
ing capacity which can be used in thc' er.ent that some especially good invest-
ment opportunity comes along. Tltis ntt'ans thnt
firns
slnultl, in nornnl tinrcs, use
less tltbt llian is sriggcstt,d by the tnx Ltcnalit,hankrtryrtctl cost trade-off nodel expressed
itt Figure 10-5.
Using Debt to Constrain Managers
Agency problems may arise if marragers and sha::eholders have differeni objec-
tives. Such conflicis are pariicularly likely when the firm's managers have too
much cash at their disposal. Then managers can use this cash to finance pet proi-
ects or for perquisites such as nicer offices, corporate jet_s-, and tickets to sporting
events, all of which may do little to raise stock prices.'r By contrast, managers
with constraints on free cash flow, such as commitments to make interest and
principal payments, are less able to make wasteful expenditures. This is called
"bonding" the free cash flow
Firms can reduce, or bond, free cash flon, in a variety of ways. One way is to
turn it over to shareholders throttgh higher clividends or stock repurchases. An-
other alternative is to shift the capital structure toward more debt in the hope that
higher debt sen,ice requirements will force managers to become more disci-
plined. If debt is not serviced as required, the finn u,ill be forced into bankruptcy,
in which case its managers u,ould likely lose tireir jobs. Therefore, a manager is
less likely to buy that expensive bui not really necessary new corporate jet if the
firm has large debt service requirements.
Leveraged buyouts (LBOs) bond free cash flow. In an LBO, debt is used to fi-
nance the purchase of a company's shares, after which the firm "goes private."
Many leveraged buyouts, rnhich were especially common during the late 1980s,
were structured specifically to recluce corporate waste.
Of course, increasing debt to bond free cash flow has a downside: lt increases
the risk of bankruptcy, which can be costly. One observer has argued that aclding
debt to a firm's capital structure is likr. putting a dagger pointing at the driver
into the steering wheel of your car.l+ The dagger motivates you to drive more
carefully, but you may get stabbed if someone runs into you, even if you are be-
ing careful. The analogy applies to corporations in the following sense: Higher
debt forces managers to be more careful with shareholders' money, but even
r.l'ell-run firms could face bankruptcy (get stabbed) if some event beyond their
control occurs. To continue the analogy, the capital strucfure decision comes
down to deciding how big a dagger stockholders should employ to keep man-
agers in line.
r:Pnul
Asquith and D.rvitl lV. Ivtullins,
Jr,
"The Impact trf Initlrting Dividentl Pavmcnts on Share-
holrlers' Wcalth,"
lournol o.f Busitttss, Januarv 1983, 77-96.
r3lf
ytru clon't believe corporate managers cin $'nstL. moncy, rc'aL1 Bryan Burrough, Btrltrttitns nt lht
Gotu'(Nov York: Ilarper & Rorv, 1990), thc story of th!, takeover of ll]R-Nabisco.
rrBcn
llcrnake, "ls There Trro Nluch Corporplg Dr.bt?" Federal ll('serve B.rnk of Philarlelphi.r Basir,ss
RcciL'il,, St'ptember/C)ctober'1989, 3-13.
l callecl asymmetric information, and it has an important effect on capital
s6u,.
ture. To ie" *l-ry, consider trl'o situations, one in which,a company's
Tonu'un
knon, that its piospt'cts are extremely good (Firm C) and one in which the r1a,
aucrs knorv th,rt the future looks bad (Firm B)'
Norv suppose Firm C's R&D l.rbs have
iust
discovcred n nonPatentable
cut
fttr th.. conimon colcl. They $'ant to keep the new produci'r secret.as.long as
Pos-
sible to delay competitori'entry
into the markeLTir^.C
T:t:l
build plants5
make the .,ew pro.it,ct, so capitil n"lust be raised' How should Firm C's manage
ment raise the neede'cl capital? If the firm sells stock' then' when profits from61
nen' prodrct start flon'ing in, the price of the stock would rise sharply' and
t[
pr,rcliase.s of the new stock would make a bonanza' The current stockholderr
[i,',.iuai"g
the managers) rvoult] also do well, but not as well as they would ]pv.
i,r". if ,fi" companihaii
not sold stock before the price increased, because thea
thev rvoulcl not^hare hatl to share the benefits of the new product with thenert
,,olkk,ota"...
Thertlorc, one rootrhl exPect a
frnl
toith uery
faaorabk
ptospec.ts.to.trytt
n,r,J t.fl1,g stock inct, rrtther, to raise any reqtrired neu caPital by ttsing debt beyanl
the norttral oytirml caltital slrttcfltrc
l0
'
Nou, k't's consider the bad firm, Firm B suppose its managers have inform+
tion that new orders are off sharply because a comPetitor has installed new tech
nology u'hich has improved its products' quality' Firm B must upgrade its oun
faciliies, at a high cost.
iust
to maintain its current sales' As a resttlt' its retumon
investment willlall (bu[ not by .rs much as if it took no action' which would lead
io a r00 percent loss through tankruptcy). How should Firm B raise the needed
capital? Here the situation is just the ieverse of
.that
fa.cing Firm G' Firm B'becouv
of its trrrf,n'ornl'hj
prosl't'cts, rtoldd tattnt to sell stock' tuhich uortlJ
,lr,L'an
bringing innrr"
,
iirrt'stois lo sltnre llle lossesJlr
Thc conclttsions here are (1) that firms with extremely good
ProsPects Preferb
finance rvith clebt, whereas (2) firms with poor
Prospects
like to linance wur
stock. Horv shoulcl you, as an investor, react to thii conclusion? You orrght tosr
II I see that a company plans to isstte stock, this shott]d
worrv me I know that man-
agement wou)rl not wani iolssue sttrck if future
Pro'putrt
lnJk"d
gooct' btrt it would
*.61 16 i5sue stncf, if tr.in"ss lo;fi;:; Ttt;*iore,'l should louir my.estimateof
it"'fi.*'i"ot"", other thirigs held constant, if it announces a stock offering'
The negative reaction should be stronger if the stock sale t":* bl
3^t::8:;:tt
lishcd iompany such as GlvI or IBM, u'hich has many financing oPtions'
man
u r
*"i" irf . J-"iI, unlisted comPany such as CeneSpiicer'
For Genesplicer'
a stod
sale might signify truly extratrdinary investmeni oPportttnities that cannoth
exnloited without r.rising new equity'
"^!;
;::,
;;;;*iir,'ii
"""u"'"
nnr*"', your views are consistent with thosed
sophisticated Portfolio
*r",g"it
"i
'iistitutions
such as
y":ry
9::H[
Trust, Fidelity-lnvestments,
Prudential Insurance, and so forth' So' itt n tttiu'*
lkllx
ti:,j,,';1,';";t,i-;'l,i:i'i*,:;:l,i;:':':'::,!:';;':,:',,::i:,t;;,:,:;::,ii':,,':::;";'#
"I**,a
"
tr*, frrr Firnr G's miniScrs to personally
FultlY,*ot"
slrtres on the brsisof
dd
i,,.ii.'f.,".f*l*,',rfthcn,'wpn'duct
ihevcrritlrlhosunttoiaiiifthel'dirl'
.-,,,,S
lf
il',',:"ilil::i,:ll'*lllJT,,:
':;I"':Ti'I:,*'"',i:xli'"ii;x'iiil::i:i'H';il;ll'-'"1,1':i1""'
,/
380 ChaPter 10 CAPITAL STRUCTURE DECISIONS: PART I
Setting thc Targct Capital Structurr lthen Cash Florvs Arc Perpetuities 3SI
If you find our discussion of caPital-structure theory
i'"pt:ti::
and somqwh{
u1rruiirfuing, you are not alone. In truth, no one knows how to identify ptec15.5.
a firm,s opt"imal capital structlrre, or how to fireasttre exact]v thc.ettt'cts of capi(1
structure on stock prices and the cost of capital. In practice', capitrl_structu1.6*
cisions must be mide by combining
iudgment
and nunreric.rl ari.-rlysis.
51111,"
understancling of the theoretical issues presented here carl help you makebqlkr
iudgments
oricapital structure issttes.ls
iirl/rir lri' .ilrr't l rl\ r)l i )(1 d/Iltr' -l 1, I :l:).!
Current assets $ 500,000 Debt $ 0
Net fixecl assets 500,000 Comrnon erluity (1.0 million shares outstancling) 1,000,000
Total assets q!!00!00 TLrt.rl claims $1,000,000
.l//.orird ShrfL'rk)rf
.li)r
1998
Sales
Fixed operaling costs
VarLrb)c opcrating cosLs
Earnings before intorest an(l taxcs ([l]lT)
lnterest
Taxablc income
$ 4,000,000
12,000,000
520,000,000
16,000.000
$ 4,000,000
$ 4,000,000
1,600,000
$ 2,100,000
SETTING TI{E
WTIEN CASH
TAITCET CAPITAL STRUCTURE
FLOIVS ARE PERPETUITIES
Capital structure theory suggests that each. firm has an oprtimal capital struc
ture, one that maximiies iis-va1ue and minimizes its o'erall cost of caPitil
However, research on capital structure theory also points out that. there.an
rnany contradictory
issues regarding capital structure decisions' and that the
o.f lu.,r.,o, be .,sei to specif/ u pr"-.ir"iy optimal structure for a firm. In thb
section, we illustrate how a iirm'with pbrpetual cash florvs might_actually
set
its target caPital structure. The exampie will reinforce many of the concepb
discusfed in previous sections, as well as help you understant.l htY
i'll!i.]
deal with reai-world capital structurc dccisions As you will sce' actual caPltx
structure decisions u.e based on
iuclgrnent,
but juclgment supported
by quanb
tative analysis plus an o*ur".,u* oithe theoreiicul irr,r", uu" h..r. discussed'
Hill Software SYstems
Hill Sofware Systems
(HSS) rvas fourrded in 1980 to develop and market
a-ncf,
tyf
"
of g.optti.r roft*u." for personal to,*Pyj::t' The basic.progr"L:".':,].'"lt[
#a putI"t"a by Mark Hill, HSS's fottndcr' Hill owns
'r
n\i]i(\ritv of tlre sto(r'a
though a significant portion is held by institutio.al inr,estors. ilte .ompany
ttr
no debt, and HSS,s key firrancia.I data are slrolvrr irr Table 10-1. Assets are carnol
at a book value of $1 million, so the common
"q"lil' "fttl
hu'' n bolnntt
ths{
FOne
of tl-.* authors
(an rcPort frr'thand the u*fulness r'I finanli".l']l:,:lli.:l','l:.:::l)':l'iflil:';.'S
ijffi'"x:xl:ll'i:'::;lJi:i"iJi::ii,n]:,ltTiii;;til,:;'"iil:lli'lil,l:,iil,'JJl,lx;5
c)n the bJsrs ot un"^* ,i,"olv
""i
in,,iput", m,.iclr rrhi.h sinrrrhtr,J r,'..rrllr rrrrJer,t rrnf,t'ol.rrlt
rions, rhe (ompanr", *";;;;1";;;ciiv
"optimrt cif it,,l srrr.rrrr,,rrrrtcr"
rr itlr.rt l,,r-t r r"rllni,t
deeree of confiden.e Witllout financc thcorv' setting
'r
t'rrget cil'it ll 5trtr(lrlr(' rr ilttl'l lrrt r rfl(
io iittle more than thro\l ing dJrlq'
;tii:'
'
ll:i!-.:i .r
li.,l:$,rr
.i,i;lia; :i
,
fi I
'
ri:::. :
,,' ,:i r,: ;
'
:"i:,)i. r
1r,11i:
,,
,'.fI:
,;.
I
rii:ll
: r:.
'r3l'
;'
f.rjli..r-
Itl'i'
l,,il.
::,,
tili'.
::i';":i::,
:r idi,i:l i
it,','rli ,
*ij.i1ii
i' i!;)Ir',
,.ljlir:rrl
t:r,ri.,
' lii::.i
!
'l;,ji:r
I rilrll
")..,,,
Taxes (.10'11, fecler.rl-pltrs-state)
Net income
Oth,t'L)rtlrt
1. Earnings per share = EPS
= $2,100,000/1,000,000 shares
= $2.40.
2. Diviclenclspersh.lre=DPS=$2,.101.),000/1,000,000sh.rres=$2.,l0.Thus,thecornpany
has a 100 percent payout ratio.
3. Book value per share
= $1,000,000/1,000,000 sh.rres
= 51.
.1. MarketpricePershare=P0=S20.Thus,thestocksellsat20timesitsbookvalue.
5. Price/earnings ratio = P/E = $20/2..10 - 8.33 times.
6. Dividend yield
=
DPS/P0= $2..10 /570 = 12%.
value of $1 million. How.evel these balance sheet figures are not very meaning-
ful because (1) the asset figurcs do not reflect the value of patents ancl (2) the
fixr:d asscts rverc purchased somc yeilrs ago at priccs lower thau today's.
Ivlark Hill pl;rns to retire shortly, and he wants to sell a major part of his
stock to the pr-rblic, using the proceeds to diversify his personal portfolio. As a
p.rrt of the plarrning process, the question of capital structure has arisen.
Should the firm continue its policv of using no debt, or should it recapitaiize?
And if it does decicie to substitllte some debt for equity, how far shouid it go?
As irr all such decisions, the correct answer is that it shorrld clrcose tlrat capitLrl
str.rctLLre titich rnatitni;es tlrc xalte of the stock. If the stock price is maximized,
then the cost of capital rvill simultaneouslv be minimized.
To simplifv the analysis, we asslurle that the lon;;-run demand for I{SS's proti-
r-rcts is not exptcted to grolv, so lls EBIT is c.rpcclcrT to cotttir:.lt e nt $.1 ntillfun irdeft-
rrltclrl. (l-lolvever, futurc s;rlos m.ry trlrn out to t-e cliffercnt frorn the expectecl
levcl, so rellizeri E13IT m.iy bc tnore or less than thc expccted $.1 nrilliorr.) Aiso,
since the cor.npanv h.rs no nccr'l ior ncn' capitai, rrll ()/ils lr.o,rd rt,ill lre prrirl orrl as
Ll ii,iLlnlL{s.
)
TABLE
10.1
d,rrou Qttcstiotrs
In what sense did MM's original theorv produce an "irrelevance of capi61
structure result"?
How do corporate and personal taxes affect firms' capital strllcture decisionsl
Explain horv "asymmetric information" and "signa1s" affect capital struchxl
decisions.
whatismeantby reserueborrowittgcopncity,
and"n,hyisitimPortanttofirms)
How can the use of debt serve to discipline managers?
382 ch;rpter 10 CAPITT\L sTllucTURE
DIlClsloNS:
PART I
Sttting thc Target Capital Structurc lVhcn C.rsh Florvs Are Perpetuities 383
Given the data in Table 10-1, along with those in Figure 10-6, we can determine
HSS's total market value, V, at different capital structures, and we can then use
this information to establish the company's stock price as a function of its capital
structure. These equations are used in ihe analysis:'6
(10-1)
(10-2)
(10-3
)
(10-4)
We first substitute values for k.1, D, and k, into Equation 10-2 to obtain values for
S, the market value of common equity, at each level of debt, D, and we then sum
S and D to find the total value of the firm. Table 10-2 and Fi1;ure 10-Z which
plots selected data from the, table, were developed by this process. The values
shown in Columns 1,2, anC,3 of Table 10-2 were taken from Flgure 10-6, while
those in Column 4 were obtained bv solvinl Equation 10-2 at different debt lev-
els. The values given in Column 5 nere obtained by summing Columns 1 and 4,
D+S=V.
To see how the stock prices shown in Column 6 of Table 10-2 were developed,
visualize this series of events:
1. Initially, HSS has no debt. The firm's value is $20 million, or 920 for each
of its 1 million shares. (See the top line of Table 10-2.)
2.
.1.
Management announces a decision to change the capital strr.rcture; legally,
the firm rnttsl make an explicit announcement or run the risk of having
stockholders sue the directors. Any debt issued will be used to buy back
stock. Because HSS is not growing, it does not require additionai capital.
The values shown in Columns 1 through 5 of Tablel0-2 are estimated as
described previously. The maior institutional investors, and the large
brokerage companies which advise individual investors, have analysts
just as capable of making these estimates as the firm's management.
These analysts would sttrrt making their own estimates as soon as HSS
announced the planned change in leverage, and ihey would presumably
reach conclusions similar to those of the HSS analysts.
4. FISS's stockholders initially orvn the entire company. (There are not yet
any bonclholders.) They see, or are told by their advisor-analysts, that very
shortly the value of the enterprise' will rise from $20 million to some
higher amount, presumably the maximum attainable, r.vhiclr is
$21,727,000. Thus, they anticipate that the value of the firm will increase
by $1,727,000.
5. This additional $1,727,000 u,ill accrr.re to the firm's current stockholders.
Since there are 1 million shares of stock, each share will rise in value by
$1.73, or from $20 to $21.73.
16Note
that Eq(ations 1(]-1 throu8h l0-{ do not stem from a particuLrr c.rpital structure'theorv-thev
do not require acceptance of lvlN'l or anl'other theoq'. Rnther, thcv are de'finitions and basic DCF val-
untir)n equntions for pcrpetual cash flow's.
Firmvaltrc:V=D+S.
Dividend Net income
rourrvvalrro:5=-
k. k.
stuck nrice: P, =
Dlg
=
!E.
K\\
Now assume that HSS',s treasurer consults with the firm's investment bankeq
ancl learns that debt can be sold, but the more debt used'.the riskier-the debt
64
oi.nrrc",
the higher its interest rate, k.1. Also, the bankers sllt:
lhll
the
moe
.f"ii HSS'rt"t, tlie greater the riskiness of its stock' hencethe higher,its,requiag
rate of .et.,r,"t on eq;iiy, ks. Estimates of k6, beta' and k' at different ctebt levels
an
fiu"^
i., Figure 10-6, ilong with a graph of the relationshiP between ks and
dU
level.
(EBIT-kdp)(1
-T)
k,
Cost of capital: WACC
=
(D/V)(kJ(1
-
T) + (S/VXk.)
k"r= 12
k*r= 6
Premium for
Financial Risk;
lncreases as Use
of Debt lncreases
Premium for
Business Bisk;
Varies among
Firms. 6% lor HSS.
Risk-Free lnlerest Rate;
Equal to a Real Rate Plus
lnflation Premium
Anrount
Borrorved'
(1)
$0
2,000,000
.1,000,000
6,000,000
8,000,000
10,000,000
12,000,000
1-1,000,000
lnterest Rate
on All Debt,
kr
(2)
8.0"1,
8.3
9.0
10.0
12.0
15.0
18.0
Estimated Beta
Coefficient
of Stock, bb
(3)
1.50
1.55
t.bJ
1.80
2.00
2.30
2.71)
a r(
Required
Rate of Return
on Stock, ki
(4)
1?'.0'/.
1) )
72.6
I )./
1{.0
15.2
16.8
19.0
:!tTl;l:
!:'i-i .
:+t,
"tlSS
is unrt lc to h(rrro$' nrcrt' than $l{ nrillion lrec'rusc o[ limitations on borrorving
in its corF
ch'lrtt'r
---r -.- .r., ,.,-r
^,.-.,,",..,^,r
lr Hrnrnrl.r's t'ouation. Thc
bctrs Fl
iN..tc
th,,t th('t'rt.r.,\'ffi(idlt
L'itim'rh': d() nL)t corr('sPon'l hl Hin1il
hr'rL. .lrr, subicctivt't'stitn.1t('s
furnishcLl bv invcstncrlt lrrtrktrs See Chapter's S nn(] 1l f()r
morP
ctrssionof Ii'rma'l'r'se'1uatiorr
lL-.=1r)'r" Ther.f.re.atzr'rodebt,k.=6'i"+(t0'"-6"i')15'|lr .\\,e.rssunrt,
hcrt'thlt knr, = 6"..rnd krr =
10'r,,. Thercforc. at zt'ro debt,
Othcr valttes oI k,.rre calcrrLtted simihrll''
384 Chapter 10 CAPITAL STRUCTURE DECISIONS: PART I
TABLE 10.2
-=..-
Setting the Target Capital Structurc When Cash Florvs Are
perpetuities
38S
Value of
Debt, D
(in Millions)
(1)
$ 0.0
2.0
4.0
5.0
8.0
10.0
12.0
14.0
NOIFS:
Value of
Value of Firm, V
Stock, S (in Millions) Stock
(in Millions) (1) + (4)
=
Price, Po
(4) (s) (6)
Cost ol Capitat
("/.)
kd k.
(2) (3)
?f
,'t..
Cost o, Equity, ks
Weighted Averaqe
Cos[ ol Capiial, WACC
Alter.Tax Cost of
Debt, k"(1
-
T)
60 Oebwatue Ftario (%)
12.0% $20.000
8.0% 12.2 18.885
8.3 1.2.6 17.467
$20.000 $20.00 0.0olo
Uot
20.885 20.89 9.6
ll5
21.467 21.47 18.6
U2
27.727 21.73 27.6
ll,
27.774 27.77 36.8
ll.l
2r.053 21.05 47.5
tt.{
19.857 19.86 60.4 t2.r
17.158 17.'16 81.6 12J
13.2
12.0
1 t.0
9.0 73.2
10.0 14.0
72.0 15.2
15.0 16.8
18.0 19.0
75.727
'13.714
11.053
7.857
3.158
a. The data in Colums I through3 were taken from FiBure 10{.
b. The values for S in Colum 4 were found by u* of Equation 10-2.
For example, at D
= $0,
-
Netincome (EBIT-kdDxl
-T)
kk
S -
($4.0+(0.6)
-
#
= $zo.o
^lrio.,
o20
Slock Price
($)
27.6
27.6 40
andatD=$6.0,
r
=
@i-gf@
=
E@
= $rs.zz *iuio..
c. ThevaluesforVinColum5wereobtainedasthesumofD+S.Forexample,atD=$6.0,V=!6!'
975.727 = $21.7U millioi.
d. The stock prices shown in Colum 6 are equal to the value of the firm as shown in Colum50
vided by the original number of shares outitanding, which, in this case, is 1 million: The logttr
hind this procedure is explained in the text.
e- Column 7 is found by dividing Colum 1 by Colum 5. For example, at D = $6.0,
D/Yl
$6.O / $21.727 =
27.6"/,.
f. Column 8 is found by use of Equation 10-4. For example, at D
= $6.0,
WACC
=
(D/vxkd)(l
-
r) + (S/v)(ks)
=
(0.276)(eW(0.6) + (o.7241(r3.2h)
=
rr.0"/".
g. At $14.0 miltion of debt EBIT declines from $4 million to $3.52 million due to costs of pototidf
nancial distrss.
h. The row in botdface indicates the optimal amount of debt.
21.73
20.00
6. This price increase wiU occur before the transaction is completed'
To!
why,iuppose the stock price remained at $20 after the annbuncemdils
the'recapitalization plan. Shrervd investors would immediately
recoBII'
that the stock's price will soon
Bo
up to $21.73, and they wouid Pla(gf
ders to brry at any price below $it.zd. rnis trying pressure rvould
quilt!
run the price up i; $21.73,
at which point it wouid remain constant
Tr
g21.ru
i; the eqitilibritun stock prica foi USS once the decision to recapitro'
is announced.
The firm sells
g6
million of bonds at an interest rate of 9 percL.nt. This
ryi:y, t
used to buy stock at the market price, rvhich is now S21.73, so
z/o,tlb shares are repurchased:
Shares repurch.r5q,l
=
$6pq0'9qg
=276,tt6.
60 Oebwalue Ralio (%)
386 Chaptcr 10 C.APII;\L STRUCTURE DECISIONS: PI\RT I
B. The value of the equity aiter the 276,116 shares have been repurchase,l
I
$15,727,000,
as shown in Column 4 of Table 10-2. There are 1,0OO,dl
276,116
=
723,88-l slrares still outstanciing, so the value per share
of the
I
maining stock is
Value pe'r rno..
=
$ffiP
= $21.73.
This confirms our earlier calculation of the equilibrium stock price.
9. The same process was used to find stock prices at other capital strucfux.
these prices are given in Column 6 of Table 10-2 and plotted in the lorri
gr;rph of Figure 10-7. Since t]rc nnxinrum pricc occurs ufun LISS uscs gd
rnrt
liott of daLtt, its olttinnl cdpital stnLcture cnlls
for
$6 rrrillion o/ de&f. \s1g
also
that $6 million of debt corresponds to a firm value of $21.727 milliqr
Thrrs, the optimal market value debt ratio, D/V*, is $6/$21.727 =Zl,tr".
10 In this cxample, we assumed that EBiT woulcl decline from $4 millionb
$3.52 million if the firm's debt rose to $14 million. The re.ason forthed+
cline is that, at tlris very high level of debt, managers ancl employer
rvould bt' rvorrietl .rbout the firm's failing and about losing their
iobs; sup
pliers rvould not sell to the firm on normal credit terms; orders wouldI
lost because of custonrers' fears that the company nright go bankrupt anl
thus be unablt' to deliver; ancl so on. EBIT is independent of financirl
leverage at "reasonable" debt levels, but at extreme clegrees of leveragg
EBIT is adversely affectetl.
Quitc'obviously,
the situation in the real world is much more complex,anl
less cxact, than this example suggests. Most important, different investcs
u,ill have different estimates for EBIT and k., hence they will form diffensrl
e\pectations about the equilibrir-rm stock price. This means that HSS migh
har,e to pay more than $21.73 to repurchase its shares, or perhaps that0r
shares could be bought at a lower price. These changes would cause theop
timal amount of debt to be somewhat higher or lower than $6 million. Stin
$(r million represents our best estimate of the optimal debt level, so it is tk
level we, should rrse as our target capital structure.
12. The WACC for the variotts levels of debt is shown in Column 8 of TabI
10-2. The nrinimum cost of capital, 11.0 percent, corresponL-ls to the leveld
rlcbt at which the value of the firm arrcl its stock price ar.. m.rximized,$6!
million.
The stock price and cost of capital relationships developecl in Tablc 10-2.,tr
graphed in Figure 10-7. F1ere we see that HSS's stock price is maximized,
and6
iveighted or'"ing" cost of capital is minimizecl, at the optimal D/Y ratio,tt
pcrcent.
The Effect of Financial Leverage on EPS
Thr.rs far w,e have focuserl on the inrpact of leverage on a firm's total valuerJ
stock price. Before Ieaving the HSS itlustration, rve shor.rld .rlso t.rke
a lookl
horv ler,c'rage affects eamings per share (EPS); ttris is done in T.rble 10-3'
hdl
of the table gir.,es operatinu income cl.rta. It begins by recoguizing th.rt HsbsI'
trrre EBIT is not knorvn u,ith certaintl,. Exprg6tecl EdlT is i+ nrilii,.,.,, but
tirea
alized EIIIT cor.rltl be [ess than or griater than $-l nriilion. Ttr sirll,lifv
rnitF
11
TABLE
10.3
Setting the Target Capital Structure Whe,n Cash Flows Are
perpetuities
3g7
$,(
ir',
:l
il,l.
lr .
l. Opcrntiug ltcotrrt (EBIT)
Probability of inclicated sales
Sales
Fixecl operating costs
Variable costs (60% of sales)
Total costs (excc,pt
inte,re,st)
Earnings before interest and taxes (EBIT)
II. Ztro Dabt
Less interest
E.rrnings before taxes
Less taxes (40'l,)
Nct income
Eamings per share on I miilion shares (EpS)
Expected EPS
Standard deviation of EpS"
Coefficient of variation of EpS,'
III.510 Million ttf Dilt
Less intercst (0.12 x 910,000,000)
Earnings before taxes
Less taxes (iI0,1,.)b
Net income
Earnings per sltrr.e rn 52-1,9{0 shares (EpS).
Expected EPS
Standard deviation of EpS.,
Coefficient oI variation of EpS"
0.2
$r 0.00
4.00
6.00
$10.00
$0.00
0.00
$ 0.00
0.00
$ 0.00
$ 0.0i)
1.70
($1.20)
(0.48)
190.72)
(
$,1.37)
0.6
$20.00
4.00
12.00
$16.00
$ {.00
__qa
I 4.00
1.60
$ 2.10
s 2.{0
$ 2.{0
$ i.s2
0.63
1.20
$ 2.80
1.'t?
s 1.68
$ 3.20
$ 3.20
$ 2.90
0.91
0.2
$30.00
4.00
18.00
$22.00
$ 8.00
0.00
$ 8.00
3.20
$
-1.80
$ 4.80
7.20
$ 6.80
2.72
5 4.06
i /.//
J;$:#:l'l;'culating
the standattl de'i.rtion antl rht'coefficient
of variation are ctiscussttr in
bAssume
tax crerlit on losses. If cr
higher, at high debt levels.
redits rvt're not dlail'lblc' exPected EPS would be Iorvet and risk
'Shares outstanding is determinecl as follows:
Shares
=
Originai s,.r.",
-
-!!!!- = 1.666.696
-
__pgq!_
whcre rhe sto.k price is tdkcn rrom rabre ,(1lj:Til'."" ,r,,n
$n
^ii[ll,'liio,.
.
=
r,,.0.. ou.,, tlrr rec.rpitrliz,rtion,
5f{,qlU shores,"itt ,,,m.,in o,,r-*t,,n,j;;g,
"'""
"
shares
= 1,000,000
-
_$lgl49[
= s:+ s.,u
EI'5 litrrr,,s c.tn rls,r b!, c.llculitecl using IIlis ,nrnr,,,.r1t'
O'
Eps=_1lu_ll:k,lltttll
ror ex.rnrpre, nt D
= sr0 nriili()n,
( )rigirr'rl
*hrrt's
- I )r't'1 z
1"t'
"
Er)s
ls-l.0tx),000 -
(0.11)(5t0.000.000)l{0.h}
51.h80.0t)r)
l.()00,(rr){l- 5lu,'rilO,pgrt7tli.ti -- -i=t.9tr)
=51.:0
388 Chapter 10 CAPITAL STRUCTURE DECISIONS: PART I
we have assumed a discrete distribution of sales, so EBIT has only three
poiii.
ble outcomes. Notice also that EBIT is assumed not to depend on fiqn6i4
Ieverage.lT
Pari II of Table 10-3 shows the situation that wottld exist if HSS contrnues
h
use no debt. Net income after taxes is divided by the 1 million shares outst66.
ing to calculate EPS. If sales were as low as $10 million, EPS woull be zero,
h{
EPS would rise to $4.80 at sales of $30 million. Next, the EPS at each sales level6
multiplied by the probability oi that sales level to obtain the expected EPS, whidr
is $2.40 if HSS uses no debt. We also calculate the standard deviation of EI5
ard
its coefficient of variation to get an idea of the firm's stand-alone risk at a 46
debt ratio: oeps
= $1.52, and CVr*
=
9.63'
Part III of Table 10-3 shows the financial results that would occur if the coor
pany decided to use $10 million of debt. The interest rate on_ the debt, 12_Percgrl
is taken from Figure 10-6. With $10 million of 12 percent debt outstanding
01
company's interest expense is $1'2 million per year. This is a fixed cost, anditb
deductei from EBIT as calculated in Part I. Next, taxes are taken out, and rt
work on down to the EPS figures that would result at each sales level. With
$10
million of debt, EPS would be
-$1.37
if sales were as low as $10 million; it would
rise to $3.20 if sales were $20 million; and it rvould soar to $7.77 if sales wereas
high as $30 million. The expected EPS is $3.20, osp5
= $2.90, and CV.*
= 9.91.
-Continuous
approximations of the EPS distributions under the two financial
structures are graphed in Figure 10-8. Although expected EPS is much higheril
the firm uses financial leverage, the graph makes it clear that the risk oflow.u
even negative, EPS is also higher if debt is used. Figure 10-8 thus shows thatur
ing leverage involves a risk/return trade-off-higher leverage increases
q'
p"ited
"u..,i.,gs
per share, but it also increases the firm's risk. It is this increar
ing risk that causes k. and k6 to increase at higher amounts of financirl
ie'Jerage.rs
ThJrelationship between expected EPS and financial leverage is plotted in IL
top section of Figure 10-9. Here we see that expected EPS first rises as the use0l
debt increases--interest charges rise, but the decreasing number of shares ot*
standing as debt is substituted for equity still causes EPS to increase. Howe[e(
EPS peJks when $12 million of debt is used. Beyond this amount, interest rats
rise iapidly, and EBIT begins to fall, so EPS is depressed in spite
9f
tn9
ff,li{
number of shares outstanding. Risk as measured by the coefficient of variahonc
EPS shown in the fourth colu"mn of the data in Figure 10-9 rises continuously'ud
at an increasing rate, as debt is substituted for equity.
Does the same amount of debt maximize both price and EPS? The answerr
rro. As we can see from the lower graph in Figure 10-9, HSS's stock
Price
isfi'r
imized with $6 miliion of debi, while the upper graph shows that exPected
uJ
is maximized by using $12 million of debt. Since flanagenlent is primarily
intet*'
in nraxin.rizing tfie ualtt-e of tlre stock, the optimat capital structure calls
Ior
tlrc usc
0l t
nillion of debt.
;.-o*=
oo*o *rlier, capital structure does affect EBIT at very high d.ebt le':,t.t:l:t*Pfi
assumed that HSS's EBIT w6uld fall from $4 million to $3.52 million if the level of debt
rc:;t
million. However, det t in Table 1O-3 is limired to $10 million, so the "e\cessive leverrge
r"'-
EBtT" is not
Present
in this particular example.
rsNote
that financial leverage has a similar effect on the risk of EPS as it dms on that of ROE
F
Figure 10-8 is similar in appearance to the lower
Part
of FiSure 10-'l-
Setting the thrget Capitrl Structurt, \Vhen Cash Florvs Arr
pcrpctuitics
3g9
Tl'rircl, our example' was restrictcd to trre case of a no-growth firm. L.r
'ierr.
of
r inptrt require'ments to model even a sinrprk, n.-gr.*,tii situ.ltion, anrl trlo stirl
the input requirements to ntodel even a sinrpk, no-groh,tl.r situi
Breater
requirements for the grorvth moriel, it is unrearistic to think trrat a prr,cise
optimal capital strr:cture can ever be identifietl.
Problems with the HSS An.rlysis
The Hill softu'arc systcms examplc illustr.rtcd the cffccts of l*,erage on firm
value,,stock prices, earnings
;,er
il.,are, a.cl tlebt values. Flolvever, the cxample
lvas obviously simplified to facilitate trre c-riscussio., ancr rve car.mot o'erc.'m-
phasize the difficulties encounterecl whe. one attempts to use trris type of
a.nalysis in practice. First, the caprtarization ratcs (k.1 ani espr.cially t.l nl"'u...i
difficult to estimate. The cost oi .lebt at different iebt levels can be estimate.i
rvith some confidence, but cost of equitv estimates must be
'ie*,ed
as r.err.
rough approximations.le
Second, the mathematics of the vah.ration proccss make the outcomL-s'erv sen-
sitive to the input estimates. Thus, fairly small errors in thL. estinates of i,r, k,,
and.EBIT can lead to large errors in cstiinatctl EpS anrl stock price.
,lil
l-IT"r]ljl:l:1,-:-].rrio.slr+r
behvcen k and thc rtetrt rario hrs L.rcn studierl (,\te.si\.cl'using
[_oth
cross-sectlonir dnd tim!'series dita..ln thL, cross-s('ctionar studics, a samplc of firnrs i..r,iotrr".il *jitn
multiple rcgression teihniqucs uscr'l in an.rttcmpt to "hold
consiant"
"ir
i"it,,rr,rir,"i'ii,.,;;il;i
tever.lqc_th.rt mlIht inl]uEllce k,. The;encr.rl (Lrn(lusi,\1,rt
thesr'stu.lics is thnt l. ri*,r.1. l,.rIr.rr,, in-
creNrs, but strtistical prolrlenrs
[,r".ir.r"
r,, ir\)m sr(.iir\ il1s tr," i,,n.tirn.,i ,.'r.,ri.,,,ri,i ,r:;il'i,,"i,
(olrllden(c.
In the tinle s.'ries stu.lies, a stn*lc,iirnr'i l. i, rn.rlrzc,l ()\(r tiure in nn itt.lirft tL,.ct hr,rr. L.
th'l:1"1
1n 11rq';,,q.
to (h,rng(s in ris.ir'ht r.rri() r-lcr..ri.rrn. 'oLh,,r
[.rt,,r:" (r!) n(\r r.nr.)r11 ((,n\r.]11t.
sL) It ls Inf\)\srDie tr' sferrlv c\J\tl\ ItorL k. is rir|iterl I,v irnrn.r.rl i$.rr,rEr.
oThese
Yalues are t.rken from Table 10-3. Values at other debt levels rvere calcul.ltcd sinlilrrly
Some Considerations in the Capital Structure Decision 391
I Finally, many firms are not publicly owned, and that causes stiil more difficul-
ties. If a privately held firm's owner does not plan to have his or her firm go pub-
lic, then potential market value data are really irrelevant. However, an analysis
tlased on market values for a privateiy owned firm is useful if the owner is inter-
ested in knowing how the firm's market value would be affected by leverage
should the decision be made to go public.
/)
Urryrrrt
Questions
What are the key assumptions used in the Hill Software example?
Briefly describe the steps involved in finding Hill's optimal capital structure.
14/hat problems occur when the procedures used in the Hill example are used
to estimate real-world optimal capital structures?
Since firms cannot determine their precise optimal capital structures, managers
rnust apply judgment to their quantitative analyses. The judgmental analysis in-
volves several different factors. In one situation a particular factor might have
{reat
importance. In another, that factor might be ielatively unimportlnt. This
section discusses some of the more important
iudgmentai
issues that should be
taken into account.
Managerial Conservatism
Well-diversified investors have eliminated most, if not all, diversifiabie risk
from their portfolios. Therefore, the typical investor can tolerate some chance
of financial distress, because a loss on one stock would probably be r:ffset by
gains on another. Howevet corporate managers generaliy view financial stabil-
ity as being quite important-they are typically not well diversified, and their
careers, and thus the present value of their future earnings, can be seriously af-
t'ected by financial distress. Thus, it is not difficult to imagine that managers
might be more "conservative" in their use of leverage than ihe average stock-
ilolder would desire. If this is true, then managers would set somewhat lower
target debt ratios than the ones which maximize stock prices. The managers of
d publicly owned firm would never admit this, for unless they owned voting
control, they would quickly be removed from office. However, in view of the
uncertainties about what constitutes the value-maximizing structure, manage-
rneni could always say that the target capital structure employed is, in its
judgment, the value-maximizing structure, and it would be difficult to prove
otherwise.20
20lt
is, of course, possible for a particular manager to be less conseryative than his or her firm's aver-
age stockholder. Howevet this condition is less likely to occur than is excessive managerial conser-
vatism, which is just anothe! manifestation of the agency problem. I[ excessive conservatism exists,
then managers, as agents of the stockholders, arc not acting in the best interests of their principals.
Holvever, when managers become the prim.rry orvners of a company, such as in man.rgerial buyouts
(MBOs), they often become very aggressive in their use of financial leverage. By Lrsing extreme
amounts of debt, they take on a great deal of risk, but, in thc, process, they open the tloor for big pay-
offs. Note too that the threat of takeoYers motivatcs underleveraged fims'managels to use more debt
than they otherwise would.
E CONSIDERATIONS IN THE CAPITAL STRUCTURE DECISION
Debt
$0
2,000,000
4,000,000
6,000,000
8,000,000
10,000,000
12,000,000
1{.000,000
Expected EPS
$2.40n
2.55
2.70
2.87
3.01
3.20"
Standard
Deviation
of EPS
$1.52"
1.68
7.87
2.09
2.40
7.90^
Coefficient
of Variation
U.OJ
0.66
0.69
0.73
0.80
0.91'
1.15
1.60
shd
P,id
3.3{ 3.83
3.26 5.20
st
&t
2t-c
21,)
21.:'i
2lt
l!t
l;'r
)
Expected EPS
4.00 Maximum EpS
= 93.34
I
Stock Price
($)
Maximum
, Stock Price
/ =$21.73
22
20
468
t
Optimal Amount
ol Debt
12 Debt (Millions of Dollars)
12 Debt (Miltions of Dollars)
hsttrck
pritr's are fronr T.rhlt' l0-2.
--1. .,t
392 fh3p1g1 19 CAPITAL STRUCTURE DECISIONS: IART I
Lender and Rating Agency Attitudes
Regardless of a manager's own analysis of the propcr leverage for his or her
fm
tl-rere is no question but that lenders' and rating agencies'attittldes nt" fr*q1,*,|
important determinants of firrancial structures. Cenerally, manaBenlent
wiil
dl
cuss the firm's financial structure with lenders and rating agencies
and
;r
much weight to their advice. However, if a particular firm's management
[.
confident of the future that it seeks to use leveragc beyond the norms for
ib;
dustry, its lenders may be unwilling to accePt such debt increases, or may
do5
only at a high price.
Coverage ratios, which were discussed in detail in Chapter 3, often are
..xd
by lenders and rating agencies to neasure the risk of financial distress.
Accod
ingly, managements give considerable weight to such ratios as the times-intepg
eamed (TIE) ratio, which is defined as EBIT divic'led by total interest charg.
The lower this ratio, the higher the probability that a firm will encounter
firin
cial distress.
Table 10-4 shows horv HSS's expected TIE ratio declines as its use of debtin
creases. At zero debt, the TIE ratio is undefined, but it is almost infinitelyhi$r
very low debt levels. lAIhen only $2 million of debt is used, the expected TIE is1
high 25 times, but the interest coverage ratio declines rapidly as debt rises. Noq
howevet that these coverages are expected values
-
the actual TIE will h
higher if sales exceed the expected $20 million level, but Iower if sales fall belr
$20 million.
The variability of the TIE ratio is highlighted in Figure 10-10, which shows 0r
probability distributions of the ratio at $8 million and $12 million of debt. Thea
pected TIE is much higher if only $8 million of debt is usetl. Even more impr
iant, with less debt there is a much lower probability of the actual TIE being ler
than 1.0, the level at which the firm is not earning enough to meet its requirdi,!
terest payments. ,
Another coverage ratio that is often used by lenders and rating agencieli
the fixed charge coverage (FCC) ratio. This ratio recognizes that there are fi'\d
Amount of Debt
(in Millions)
$0
2
4
6
8
l0
12
.TIE
=
EBIT/ Interest. Example
Tabie 10-l and Figure 10-6.
flE = $-1,000,000/$1,200,000 = 3.3 nt $ I0 million of .lct,t. Data
rrtF
Expected TIE"
Undefinec{
25.0
12.L
5.0
3.3
2.2
'lr::Hf.l r
Some Consirlerntions in the CaPiLll 51rr.rur" Dccision 393
+
$12 Million ol Debt
:-.- $A Million of Debl
I
I
TIE
=
1.0
t t
Times tnleresl
I I Earned
Expected TIE
= 2,2 Expected TtE
=
5.0
finarrcial charges other than interest payments r.virich could leacl to financial dis-
tress. The FCC ratio is defined as foilows:
FCC
=
[:BlT + Lcasc payulr'nts
i.l:j,Fi'
,rt.' rL,st J 1
Le,rst'.
i _ iSinkinS
fund palrments
1
\P.rynrenrs/ \
t_T
)
Note that sinking f.nc{ payments reLluce thc debt-thev are not derluctible in-
terest payments. Therefore, sinking funcl paylnents must be
,,grossed
up,, in
recognition of the fact that they must be madc rvitlr after-tax dollais (net inconie).
Interest and lease payments are fully deductible, hcrrce they do not neecl to be
grossed up.
If LISS harl $1 nrillion of leiisc pavrnents.rncl g1
million of sinkinrl furrel pal.
mcnts, its FCC ratio .rt .l dL-bt lcr,cl of $1il rnilliorr ivoulcl be 1.3:
;r-._
5,+,(X)0,00UrS1,00(),0()()
$1,200,000 + $1,000.000 +
51't)tl0'000
0.6
_$5,000,000_1.1
$3,866,667
Thus, the coverage of total fixed charges is consitlerably less than the 3.3
times-interest-e.irned coverage at the s.rme tlebt level.
Reserve Borrowing Capacity and Financing Flexibility
when-n'e discussc'tl asvmmetric information antr signaling, u,e noted tir.rt firms
sl.roult-l nr.rintain some rL'serve l.orrorving capacitr., *']lichJrr".e...cs thcir atrilitr.
39{ chaprer 10 CAPITAL STRUCTURE DECISIONS: PART I
to issue debt on favorable terms. For example, suppose Biotechnjcs Inc.
had i-
successfully completed an R&D program, and its internal projections
a,"'I
much higher earnings in the immediate future. Horvever, the new
"urninr"
I
not yet anticipated by investors, hence are not reflected in the p.ice of its?i.I
Biotechnics would not tvant to issue stock-it would prefer to fin.rnce
withJi
rurrtil thr. higher earnirrgs m;rterialize and are reflected in the stock price,
at wiil
timc it cotrltl sell an issue of common stock, retire the debt, and retum
to ih
il
get capital structure. Similarly,, if the financial manager felt th.rt interest
ni
'rvere tem;rorarily lolv, but were likely b rise fairly soon, he or she nright
wln1l
issue long-term bonds and thus "lock in" tl.re low rates for manv years. To obh;
this financing flexibility, firms gene'rally use less debt rrncler "normal"
cod[
tions, thus presenting a stronger financial picture than they wotrld othenvir
h,i.,.e. This is not suboptimal from a long-run standpoint, although it might
ap
pe.ar so if viewed strictly on a short-run basis.
Note too that firms'debt contracts often specify that no nelv debt canhL
sued unless certain ratios exceed minimum levels. Very frequently, the TIE r+
tio is recluirecl to exceed 2 or 2.5 times as a conclition ior the issuance of addi
tional dcbt. With this in mind, look back at Figure 10-10 and note that, iI it
uscd $12 nrillion of dtbt, HSS's TIE rvould be less than 2.0 almost hatf
gp
time, rvhereas the probability of a coverage less than 2.0 would be quite smal
if it used only $8 million of debt. Thus, if HSS sets a relatively high target d&
ratio, its financing flexibility would be reduced in the sense that it could rut
count on rrsing whatever type of capital it wanted to use at all times.
The emphasis that managers place on flexibility can be summed up by thb
statement made to the authors by a corporate treasurer:
Our companv can earn a lol morc by making good capital budgeting decisions thm
by making goocl financing tle-cisions. lndeed, we are not sure r'xactly horv financing
tlecisions affect our skxk price, but we knorv for sure that forcgoing a promising
capital investment bc'cause func-ls are not available will hurt our stockholders. For
this reason, my primary goal as trcasurer is to always be in a position to raise the
capital necdetl to support operations without having to sell new common stockand
sending out a neBative signal.
Control
The effect of dr:bt on;r management's control position may also influence ihecap
ital structure dt'cision. If nranagement just barely has majority control
(.iust0r.d
50 percent of the stock), but is not in a position to buy any nrore stock, debt ruJ
bc. the choice for new financings. On the other hand, a m.lnagement grouP thatl
ruot conccrnr'rl about voting control nlay decide to use equity ralher than debt!
tht' financial situatiorl is so weak that the use of detrt might subject the companJ
to a serious risk of defhult. If the firm gets into troulrle, cretlik)rs
(throuP
covellnnts in thc debt agreen-rents) may assume control and perhaps force a mrt
ag(,n1ent change. TIris has happenecl to Chryslt'r, Navistar Irrtern.rtirrrr.rl
(formerf
Irrtc.rn.rtional H.rrvt'stt,r), Braniff, Corrtinental Iilinois Blnk, antl a Irttmber
cr
othcr comp.rrries in rcct'nt years. Horvever, if kro little clt'bt is trsetl, managelflell
runs the risk of a takeorer, n'here some othcr company or manilgement
gtot{
persuadL's stockholclc'rs k) turn over control to the neu'gr..trp, nliich pllnsN
iroost earnings and stock prices by using financial levcr.ige. This h.rppcntr3
F
Lr'nox, thc china companl', and to manv Jther firms in recr'nt
],e.rrs.
Control-cto
sitlerations do not nciessirily suggest ihe us.'of tlebt or of eqirit1,, bsl1 thc'effs+
of finarrcing rlecisions ort control must certainly be taken into accoul]t.
Some Considerations in the Capital Structure Decision 395
Business Risk
A firm that has relatively low business risk-small sales variability, lorv operat-
ing leverage, and so on-can take on more debt than can firms with higtr,busi-
ness risk. In essence, firms must limit their total risk, and the higher the business
risk, the less "room" there is to take on financial risk.
Asset Structure
Firms *,hose assets are suitable as security for loans tend to use debt ratht,r heav-
ily. Thus, real estate companies, which have relatively litluid assets, tend to be
highly leveraged. However, companies involved in technological research em-
ploy relatively little debt.
Growth Rate
Other factors the same, faster-growing firms must rely more heavilv on external
capital-slow growth can be financed with retained earnings, but rapid growth
generally requires the use of external funtls. For reasons set forth in our discr-rs-
sion of signaling theory, and also because the floiation costs involved in selling
common stock exceed those incurred when selling tlebt, firms prefer debt to new
stock for meeting external funding neecls. Thus, rapiclly grolving firms tencl to
use somewhat more debt than slower-growth companies.
Profitability
One often observes that firms with'ery high ROEs use relatively little debt. The
reason seems to be that highly profitable firms such as Merck, lntel, and Mi-
crosoft simply do not need io do much debt financing-their high profits enable
them to do rnost of their financing rvith rc'tained earnings.
Taxes
Interest is a deductible expense, while dividends are not decluctible. Therefore,
the higher a firm's corporate tax rate, the greater the advantage of using clebt.
Market Conditions
Conditions in the stock and bond markets undergo both long- and short-run
changes that can affect a firm's optimal capital structure. For example, during a
recent credit crunch, the
iunk
bond market dried up, and it was essentially im-
possible for firms to issue lower-quality debt at "reasonable" interest rates.
Therefore, low-rated companies in need of capital were forced to either issue
stock or use short-term debt, regardless of their target capital structures. As con-
ditions eased, however, such companies were able to sell bonds and move their
capital structures back in line with their targets.
-/?
At1-rr*
Questiotts
Is the capital stmcture decision partly objective (made on the Lrasis of numeri-
cal analysis) and partly sr.rbje.ctive (jurlgme'ntal, u,ith manv factors considered)?
List and discuss some factors that manigers consicler tvhen setting the firm's
target capital strllcture.
396
AN
Chapter l0 CAPITAL STRUCTUT{E DECISIONS: PAI{T I
,.
APPROACH TO SETTING THE TARCET CAPITAL STRUCTURE
Thus far in the chapter, we have discussed (1) the basics of busirrr'ss and financirr
risk, (2) several theories of capital stmctlrre, (3) a methorl of .rnalysis based,i
perpetual cash flows, and (.1) a numberof factors that influence the capitals6..
ture decision. In this sectiorr. rve describe a pragmatic approach to scttinB
the
1.,.
get capital structure. Our approach requires
iuclgmental
assumptions, but it
alr
retluires managers to consider how alternative capital strr,lcturL's h,ould affectt$
ture profitability, coverage, and external financing requiremcnts under a variq.
of assumptions.
The starting point for the analysis is a forecasting mor{el set up to test theq[.
fects of capital structure chtrnges. Flere is a brief clcscription of the'spreadshctl
model lve use in consulting assignments. Basically, the model generates
fors
casted data based on inputs srrpplie'd by the firm's financial staff. Each data itql
can be fixed, or it can be allowed to vary from year to ye.rr. The required datail
clucle the most recent balance sheet and income statement, plus the following
items, all of which represent either expectations or managemcnt-cletermined po!
icy variables:
1. Annrral growth rates in an index of unit sales
2. Annual inflation rates for sales prices and input prices
3. CorPorate tax rate
4. Variable costs as a percentage of sales
5. Fixed costs
6. Interest rates on already outstanding (or embedded) debt
7. Marginal component costs of capital
8. Capital structure
Percentages
9. Dividend growth rate
10. Long-term dividend
Payout
ratio
The model uses the input data to forecast balance sheets ancl income statemenE
for future years. Then it calculates and displays such data as external financing
requirements, ROE, EPS, DPS, times-interestlearned, stock price, and WACC
along with a set of keY ratios.
We begin by entering base-year balance sheet and illcome statenlent
valu6
plus data on the expected growth rate, expecterl inflation rates, anLl so on. Thes
inpr1, ,r" used by the model to forecasi operatirlg income and asset requirt
ments. Next, the model brings in the financing mii. It r.rses as inputs both
th
debt/equity mix and the debt maturity structure. By debt maturity structure,tl
mean the proportion of short-term versus long-term debt. Further, rve nlust
eslr
mate as best we can the effects of the firm's iapital stnrcture on its comPondd
costs-a higher clebt ratio will lead to increaser ir-, tl'r" costs of all corrponens
and vice veisa if less debt is used. With all inputs enterecl, the motlel then
foe
casts financial statements and
Senerates
projected stock prices.
The moclel is then usecl to inalyze nit".r.,oti,r" scena;ios. This analysis
trl6
t*'o forms: (1) changing the financing inputs to get an itir'a.rlrout horr'theE
nancing mix affects iireiey o.rtputs uria
1i;
.tlungi"ng tht'oper.rting inputs
to$(
hou' economic conrlitions affect the kev outputs under variolls finarlcing
Strd*
gies. Finall1,, the moclel's outpLrt must be reviervet-l anr-l an.rlvzetl, .rtrl a dectstt'
must be ma.1.- as to the best caprital stnlcturc. W'e
P.ry Pnrticlul.ir
attcntion
tor
Sorlc AcLlitiorr.rl lnsirlrts into C.rFii.rl Strtrctrrre Decisions 397
forecasted EPS, interest coveragc, crtcrrr.rl fr.rnrlirrg retluircmcrrts, and projc'ctctl
stock price.
The nrodel c.rn gcncratc outpr.rt "arrsrvers" rltritc easily, but it is up to the fi-
nrrncirl .rn.rlyst to assign irrPul 1'"1.,"r, t() illtorprct thc output, .'rnri, [inallv, to rcc-
ommend a targct capital stnrcturt.. Thc final dt'cision rvill be r:rarlc bv thc finan-
cial m.rnagt'r antl/or to;r rnarl.rtcnront, consirlcring all tlre factors rr c havc
discusscd. Rcaching a decision is not casl', but a capitrl stnlcturc forcc.rstirrg
moclel such as thc onc wt'trsc tloes ht'lp
p1.1111gg15
analvzc the cffects of altr:rna-
tive courses of irction, rvlrich is csscnti.rl in gootl ttccisiou m.rking.
It should be noted that rty'ri/r' ctltitLrl slnrctrrrc r/cclsiorts Llo itftct sfock
;rli1,'1,'5,
tlrcse t'tftcts nrc gancrolly snrnll itt courPnrlsorr lo tltc clkcts of olteraSillg r/ecisiorr.s. A
company's abilily 1o identify (or crc.rte) markL.t opportLrnities, and 16 prorluce
and sell proclucts or sen,iccs efiicientlv, is tht prirn.rrv determinant of success.
Financial arrangements can facilit.rte or hanrper oper.rtions, btrt the best of fi-
nancial prlarrs cannot overcorre deficiencies in the operations area. This st"rte-
ment is supported by empirical studies, rvhich gr.rrerally fincl a rveak statistical
relatiorrship betlveen capital structure ancl stock prices. It is also supported by
runs of our computer model, which shorv stock
Prices
to bc affectrcl sigrrifi-
cantly by changes in unit sales, sales priccs, fixed costs, anc-l variable costs, but
only slightly by charrges in capital structure.
'lhis
last point carr also be seen
from the HSS example cliscussecl c'arlier. licfer ag.rin to Table 10-2. Hill Soft-
ware Systems' stock price is maxiurized .it a D/V ratio of 27.6 percent. I{orv-
evet at a D/V of 18.6 perccnt, which is one-thirrl lon,r.t the firm's stock
Lrrice
drops onl1, from $21.73 to $21.-17, or bv 1.2 percL.nt, rvhile if D/V riscs to 36.3
percent, HSS's stock price hardly clrops at all.
'[hus,
llSS cor.rld set its tlrget
D/V ratio anvwhere in thr' rrnge from 18 to {0 pr.rcgnl and still come ver;, close
to maximizirrg its stock prict.
Test
Questiotrs
Briefly describe the elements of a fin.-rncial forccasting modcl designed to hr.lp
set the tarBet capit.ll structure.
Horv critical is ihe optimal capital stnrcturc rlecision to the financial perfor-
mance of the firm; that is, horv irnport.int are sm.rll deviations from the opti-
mal structr,rre?
Should thc Lrrsct capital structurc bc thought of .rs .r single poiut or .rs a
rangr'?
E ADDITIONAL INSIGHTS INTO CAPITAL STRUCTURE DECISIONS
At this point, one mirht h.rve an tureasl, fecling rcg.rrding both l.rou' to estalrlish
the target capit.rl structure ancl its effcct on risk,
frrofiLrbilitl',
arrcl stock prricc.s. \\e
can construct mot'lels it'hich generatc projccterl earnings, stock prices, cover.rge
ratios, and so on, uncier clifferent capital strtrcturcs. Flol'ever, our confidence in
these re'sults is lin'ritccl, because' u'r' do not knon for surt hou' k.r and k., hL.nce
stock prices, will reirlly change *'ith ch.rnges in thr. capital structrrrL'. lVe also
knorv that in practice'rnany sr,rbjcctive flctors aiso influcrrce thc dt.cision. Thert'
fore, to gain more insights into capiLrl str!.rcturo tlecisions, it is use[ul to look at
horv uranagtrs say thcy acttrallv csLablish targr't capital stnlciurcs.
398 Chaptor 10 CAPITAL STRUCTUI{E DECISIONS: PART I
Professors David Scott and Dana
Johnson
surveyed a group of firms
to e.,
out horv managers attempt to estimate the optimal capita.l structure,
.])
whether managers really believe that one can be determined.'' Scott and joli
son seni quesiionnaires to the chief financial officer (CFO) of each
Fortrr-
1000 firm. Some 212 financial managers replied, and their answers
providi
useftrl insights into the decision process.
First, the respondents agreed that capital structure decisions do matter-;
general, financial managers believe that the prudent use of debt can lower
hl
firm's overall cost of capital, but that an excessive use of debt will increase gg
6
quired rate of return on equity. Second, the most popular measures of financial
leverage are (1) the long-term debt to total capitalization ratio," (2) the tirnes
interest-earned (TIE) ratio, ancl (3) the long-term debt to common equity
ratio.
Howevet rvhen computing these ratios, accounting (or book) values rather
than
market valnes were virtually always used. Third, 64 percent of the respondinr
managers indicated that their target long-term debt to total capitalization rati{
n,ere in the range of 25 to 40 percent, and the nrost popular reported target rann
was 26 to 30 percent. Because stock market values generally exceed book valu[
the debt ratio measured in market value terms would be quite a bit lower thrn
these reported book value figures.
The strrvey also provided data on how various parties influence the capihl
stnlcture decision. The data indicate that managers give the greatest weight
b
their own internal analyses, but that investment bankers and bond rating agen
cies also have a significant influence. Additionally, firms consider industry awr.
ages rvhen setting their target capital structures, but they are willing to depart
from ihe averages if their own conditions suggest that a departure is warranted
Note that the Scott-Johnson survey was taken in 1982. Since then, many MBfu
have graduatecl, gone into the work force, and now make important financial de
cisions. Otrr grress-supported by our olvn observations-is that if the survel
were repeated today, more companies would report that they give weight b
market value as well as book value capital structures.
Test
Questions
DopracticingfinancialmanagersbelievethatcaPitalStructuresmatter?
Do investment bankers and rating agencies influence the capital shuctun
:rSr,e
D.rvicl F. Scott and Dana
J. Johnson,
"Financing Policies and Practices in Large Corporatial'
Fitrrrrrdal MLttngcntnt, Summer 1982,51-59. .
::Totnl
cnpitatization is clefined as long-term debt plus preferred stock plus common equity.'n6"
fort,.curri'ntlirbilitit'srntltleferredtaresareexcludetl.
SUMMARY This chapter discussed capital structure decisions. The key concepts
listed below:
r Business risk is the inherent riskiness in a firm's operations if it uss
debt. Financial risk is the additional risk that is concentrated on the
holders rvhen debt financing is used.
r Within a stand-alone risk framework, business risk can be
10-1
Questions/Problems 399
financial risk can be measured by Stand-alone risk
-
Business risk
=
onoe
-
onoro.r.
r In 1958, Franco Modigliani and Merton Miller (MM) proved, under a re-
strictive set of assumptions including zero taxes, that capital structure is ir-
relevan! that is, according to ihe original MM article, a firm's value and cost
of capital are not affected by its financing mix.
r \ fhen corporate taxes are added to the MM model, the resuits indicate that
firms should use 100 percent debt financing. Howevet later work by Miller
demonstrated that personal taxes reduce, but do not eliminate, the value of
debt financing.
r The addition of financial distress and agency costs to either the MM corpo-
rate tax model or the Miller model results in a trade-off model. Here the
marginal costs and benefits of debt are balanced against one another, and
the result is an optimal capital strucfure that falls somewhere between zero
and 100 percent debt.
: Unfortunately. capital structure theory does not provide neat, clean answers
to the question of the optimal capital structure. Thus, many factors must be
considered when actually choosing a target capital structure, and the final
decision will be'based on both quantitative analysis and judgment.
r If a firm has perpetual cash flows, then a relatively simple model can be
used to estimate its value under different capital structures. In theory, this
model can be used to find the capital structure that maximizes the stock
price. However, the inputs to the model are very difficult, if not impossible,
to estimate with any degree of precision. Further, most firms are growing, so
they do not have constant cash flows.
r Since one cannot determine the optimal capital structure with quantitative
models, managers must base decisions on analysis plus qualitative factors,
including long-run viability, managerial conservatism, lender and rating
agency attitudes, reserve borrowing capacity, control, asset strucfure. prof-
itability, and taxes.
r Firms generally have computerized planning models which are used in the
financial planning process. These models can be used to get a feel for the im-
pact of capital structure changes on a firm's financial condition.
At this point, you should have a reasonably good idea about how capital struc-
ture affects stock prices and capital costs. In the next chapter, we will examine
some additional issues which provide further insights into the capital stmcture
decision.
Questions
Define each of the following terms:
a. Capital structure
b. Business risk
c. Financial risk
d. Operating leverage
e. Financial leverage
f. Breakeven point
g. Capital structure theory
h. Perpetual cash flow analysis
i. Reseroe borrowing capacity oR6&uy, stand-alone risk to stockholders can be nteasured by oRoe,
400 ChaPter 10 CAPITAL STRUCTURE DIICISIONS: PART I
I
,c
What term refers to the uncedainty inherent in
Projections
of future ROE(U)?
Firms with relatively high nonfinancial fixed costs are said to have a high degrec
of
"OnetypeofleverageaffectsbothEBITandEPS'TheothertypeaffectsonlyEPS"'
this statement.
lVhv is the following statement true? "Other things being the same' firms with
itudt"iot"t are ableio carry relaHvely high debt ratios'"
why do public utility companies usually have capital structures that are differsnl
thoie of reiail firms?
Questions,/Problems 401
Calculate the expectetl value arrcl standrrcl dcviation for Firm C's ROE. ROEA
=
10.0%, on = 5.5%; tlOEn
=
12.0',L, as
=
7 .7Y".
Discuss the relative riskiness of the three firms' rcturns. (Assume that these distribu-
tions are expcctc.d to renrain consLlnt over tim!..)
l0-2
10-3
t0-4
10-s
10-6
70-7
10-8
10-9
10-10
10-11
70-72
a.
b.
c. Now suppose all three firms have tht' sanrc standard deviation of basic carning porver
(EBIT/Total assets), oa = ou = oc = 5.5'l". What can we tell about the tinancial risk of
each firm?
The following data reflect the currt'nt finarrcial conditions of the Levine Corporation: "" 10-3
Structure
Analysis
some economisis believe that swings in business cycles will not be as wide in the
;;il;;-h;;;;"n
in the past' Assuriing that they are correct' what effect miSht this
;iJii/,y h;;";ihe iyp6rof ri""ncing"used by firms i^ the United States? Would yr
Value of debt (book
= market)
Market value of equity
Sales, last 12 months
Variable operating costs (50'2, of sales)
Fixed operating costs
Tax rate, T (federal-plus-state)
$1,000,000
$5,2s7,713
$12,000,000
$6,000,000
$5,000,000
40%
\Arhv is EBIT generally considered to be independent of Jinancial leverage? why
;di+ ;;illy B" inflrinced by financial leverage at high debt levels?
sented in the chaPter?
10-13 \ /hv is the debt level that maximizes a firm's expected EPS
Senerally
higher than
level that maximizes its stock price?
Problems
At the current level of debt, the cost of debt,
Q,
is 8 percent and the cost of equity, k. is
10.5 percent. Management questions whether or not the capital structure is optimal,.so the-
finaricial vice-president has been asked to considcr the possibility of issuing $1 million of
additional debt and using the procceds to repurchasc stock. It is estimated that if thc le'vcr-
age were increased by raising the level of debt to $2 million, the interest rate on new debt
would rise to 9 percent and lq rvould rise to 11.5 percent. The old I percent dcbt is senior
to the new debt, and it would remain outstandirrg, continue to yield I
Percent,
and have a
market value of $1 million. The firm is a zero-growth firn, with all of its eamings paid out
as dividends.
a. Should the firm increase its debt to $2 million?
b. If the firm decided to increase its level of debt to $3 million, its cost of the additional
$2 million of debt would be 12 percent and k, would rise to 15 percent. The original
8 percent of debt would again remain outstanding, and its market value rvould re-
miin at $1 million. What level of debt should the firm choose: $1 million, $2 million,
or $3 million?
c. The market price of the fim's stock was originally $20 per share. Calculate the new
equilibrium stock prices at debt levels of $2 million and $3 million.
d. Cilculate the firm's earnings per share if it uses debt of $1 million, $2 million, and 53
million. Assume that the firm pays out all of its earnings as dividends. If you fincl that
EPS increases with more debt, does this mean drat the firm should choose to increase
its debt to $3 million, or possibly higher?
e. What would happen to the value of the olcl bonds if the fim uses more leverage and
the old bonds are not senior to the new bonds?
The Rivoli Company has no debt outstanding, and its financial
Position
is given by the fol-
lowing data:
swer be true for all firms?
FirmA: ROEI
Firm B: ROEg
Firm C: ROEc
.--
10-4
Analysis
10-1
Operating Leverage and
Bteakeven
Business and Financial Risk
Assets (book
=
nrarket)
EBIT
Cost of equity, k,
Stock price, Po
Shares outstanding, n
Tax rate, T (federal-plus-state)
The firm is considering selling bonds and simultaneously repurchasing some of its stock.
If it uses $900,000 of debL its cost of equity, k., will increase to lL
Percent
to reflect the in-
creased risk, Bonds can be sold at a cost, k3, of 7 percent. Rivoli is a no-grorvth firm.
Hence, all its earnings are paid out as dividends, and earnings are exPectationally constant
over time.
a. What effect woulci this use of leverage have on the value of the firm?
b. What would be the price of Rivoli's stock?
c. What happens to the firm's eamings per sharc'aftcr thc recaPitalization?
$3,000,000
$500,000
70%
$1s
200,000
10"/"
a. Should the firm make the change?
;. iii;ff,h" iTl..:-{:t1l;;,Ei-ug"
i"""u'" or decrease if it made the chanse?
about its breakeven
Point?
c. Would the new situation expose the firm to more or less business risk than the
:rO-Z Here are the estimated ROE distributions for Firms A' B' and C:
ProbabilitY
0.4 0.2
i
10.0% 15.0Y.
12.0 19.0
1s.0 zf.o
0.1
0.0%
(2.0)
(s.0)
0.2
5.0%
5.0
5.0
)
402 Chaptcr 10 CAPiTAL STRUCTURE
DECISIONS: PART I
d. The $500,000
EBIT given previously is actually the exPected value from the
probability distribution:
PtobabilitY
EBIT
($ 100,000)
200,000
500,000
800,000
1,100,000
W1lat is the probability distribution of EPS with zero debt and with $900'000
Vlhich EPS distribution is riskier?
;;;;r*:#-h;;..uruirity
distributions of the times-interest-eamed
ratio for
i"""r. illf."iit tie p.obnb'ility of not covering the interest
Payment
at the $90
Questions/Problems
403
Spreadsheet Problem
Work this problen only if you are using the computerized problem diskette.
Use the model in File C10 to solve this problem. The Norman Corporation is currently all-
equity financed, but the firm is considering a change to 50 percent debt financing. The
debt would cost 12 percent, and would be used to repurchase shares currently selling at
$25 per share. Norman now has 40,000 shares outstanding and $1,000,000 in total assets.
Its pro forma income statement tor 1999, assuming zero debt usage, is as follows:
0.10
0.20
0.40
0.20
0.10
10-7
Structure
Analysis
e.
Sales
Operating costs
EBIT
$900,000
750,000
$150,000
$500,000
700,000
900,000
1,100,000
1,300,000
10-5
Crpital Stmcture AnalYsis
level?
value'of debt to $70 million?
Pettit Printins Company has a total market value of $100 miltion' consisting of 1
li^."" r"iir"""r., 6s'0pl,.irtotu
and $50 million of 10 percent perpetual bonds n
"fi';;;;;
ri";-;iipui,y'' EBIr is $13 2rr *1til"ilJi'.l";l*,ii,:
ff:':*l
:h:;;"ti; ."pirrr .i"r.t'r." by either increasing its debt.to $70 million or decreasir
iio',iirrir".
if it decides to iirrease its use of ieverage' it must call its old bonds I
sue new ones with a 12
Percent
coupon' If it decides=to de1ease its
H:tlq::Ln
i;;; ;;;;
""Jreplacl
them witli new S.percent coupon bonds' The company
;;".$;.h;-;*1i-ui-tt"
."* equilibriim price to complete the capiial
i}li]:i.1'""-atPieeif
-l$2s-*ilii""l
=
0.2. ilnder the assumPtions of Part e' r
iil'I-p"iili
rpi ,"J gg.rt
1'a
(2) expected TIE and orE' assuming an increase
Taxes (40%) 60,000
Net income q J0,000
What is the firm's expected EPS for 1999 using zero debt? At a debt level of $500,000?
Assume that operating costs remain at 83.33 percent of sales over a wide range of sales
levels. Further, the 1999 pro forma income statement is based on expected sales of
$900,000, but the actual sales distribution is as follows:
a.
b.
Probability Sales
0.10
0.15
0.50
0.15
0.10
Find the EPS at each sales level for both zero debt and 50 percent debt financing.
c. Make a plot of EPS versus sales level for both financing alternatives. Place the
Plots
on
the same set of axes. Interpret this graph.
d. At a zero debt level, Norman's expected I{OE
= $90,000/$1,000,000 =
9.0%, while at
$500,000 of deb! expected ROE
= $54,000/$500,000 = 10.8%. Determine the firm's ROE
at each debt level for every possible sales level. Plot the two ROE distributions.
e. Now. assume that the $500,000 debt financing would cost 15 percent. Repeat the Part d
analysis. Is there a significant difference? IAtrhy?
10-6
Subjective Aralysis
you
have been hired as a financial consultant by two firms, Alpha Industries
(fin
Zed Corporation
(Firm Z). r"i,* e"it"i"E" iJst-gro*ing milrocomputer retail
J.rrt.y, *f,if* Firm Z manufactures office tq"iP*gt'.|
:":1,?:!,"T1,:l'3.:1T:;
:il"i;;';il;;;;-t;';;
ii't i' to recommcnd the oPtim;l caDitar stntcture
il: ilHr. ;i;;';;L""i,.i";;tr."t
*""tJ i"n'"n'"
voui
clecision' and specifica
each o[ these factors apply to JJ fit*' Here are so'me additional
Points
Jbout
firms:
i ii fit* n gcnerally leases its stores, whilc Firm- Z purcha*s its nlants'
ii;ii;;ii'i;i;k'ia
;tJ;iy nail *iri.'iii" i"*iiv
'ir
Firm Z's rorinder hords 40
0ase
have.iust been hired as business manager of
, a pizza restaurant located adjacent to cam-
company's EBIT was $500,000 last year, and
u university's enrollment is cappcd, EBIT is ex-
to remain
constant (in real terms) over time. Since
Eltslon
capital will be required, PizzaPalace plans
out all earnings as dividends. The management
rwns
about 50 percent of the stock, and thc stock is
lh the over-the-counter market.
you took your MBA corporate finance coi:rse, your in-
structor stated that most firms' owners would be finan-
cially better off if the firms used some debt. When you
suggested this to your new boss, he encouraged you to
pursue the idea. As a first step, assume ihat you obtained
from the firm's investment banker the following esti
mated costs of debt and equity for the firm at different
debt levels (in thousands of dollars):
i
i
Amount Borrowed kd
$0
k"
t5.o%
250 10.0% 15.5
500 11.0 16.5
)
ffrm
is currently financed with all equity; it has
shares
outstanding; and P0 = $20 per share. When
404 CITAOTET 10 CAPITAL STRUCTURE DECISIONS: PART I
EBIT of $3,000.
(1) Construct partial income statements, which start
' '
",iitiieir.?"i
the t*o firms.
h
(2) Now calculate ROE for both firms.
(3) What does this example illustrate about the impact
of financial leverage on ROE?
b. (1) What is business risk? 14/hat factors influence a
firm's business risk?
(2) What is operating leverage, and how does it affect
a firm's business risk?
c. (1) What is meant by financial leverage and financial
rrska
(2) How does finmcial risk differ from business risk?
d. Now consider the fact that EBIT is not known with cer-
iainty, but rather has the following
Probability
distrib-
ution:
theories be applied directly in this analysis,
1ii
you presented an analysis based on these thqi
how do you think the owners would respond?
(l) Describe briefly, without using any numbeq
sequence of events that would take place if P!
Paiace does recapitalize.
'n
(2) What would be the new stock pace iI Pizzd
recapiialized and used these amounts of
$250,000; $500,000; $750,000?
I
(3) How many shares would remain o
ter recaPitalization under each debt
(4) Considdring only the levels of debt
what is PizraPalace's oPtimal capital s
Sclt'cted Adclitional References and Cases 405
(
For an nrtide on stgrralirrg, scc
Baskin,
ionathon,
"An Empirical Investigation oI the l'ccking Ortlcr Hypothesis," Firrlr,:rirl
Mmagentetrt, Spring 1989, 26-35.
DaJinititte rtfcrentes ou llt cnrpiricol rclrtiorrs/rps bclaucrr cnpital slnlcftr., o,,rl (1) llrL' cosl ry'
daht, (D
the cost of cqtil\, (3) etrnings, nnd (1)
tlta prict of a
frnis
stock are uirtually nonttis-
tcrrt-statistical problnts nmke the
ltrtcisa
estirrtttiott of tlrcse ralaliorsltips xlrnorditmrily tliffi-
cult, if not inrpossible. Ona goorl r(rty t()
Sr't
a
ful for
tfu issrrcs irruo/r,eil is !o obtuiirr rr sd of tltt
cost.oJ capitrtl testitrotries
fled
itt a nnjor utility rnte cnsc-slc,h taslituorry is m,nilnble
Itout'state
public utility conmu-ssiorts, tic FeLlual Conunwticntiorts Connissiotr, the Fcdual Enerly Rtgulrt-
toty Comntission, and utility conpanirc tJrcnrseluts. For an acatlctrtic tliscussion of the r'ssrre.s, sce
Caks,
john, "Corporate Debt Decisions: A Ncw Analytic.rl Framework,",[ournd of Finatcc,
December 197 8, 1297
-1,31,5.
Gordon, Myron
J.,
Tlc Cost of Cayital to t Public Utilily (East Larrsing, lvlich.: Dir.i-
sion of Research, Craduate School of Business Administration, lvlichigan State
University, 1974).
Hamada, Robert S., "The Effect of the Firm's Capital Structure on the Systematic Risk of
Common Stocks,"
Jounnl
of Fhuurcc, Nlay 1972,435-452.
Masulis, Ronald W., "The lmpact of Capital Structure Changc on Firm Value: Some Esti-
mates,"
lournal
of Finance, March 1983, 107-176.
Piper, Thomas R., and Wolf A. Weinhold, "Florv Much Debt Is Right for Your Company?"
Haruard Busirtcss Rtzmr,,
July-August
1982, 106-11{.
Shalit, Sol S., "On the lVlathematics of Financial Leveragt'," Fitnncirrl Nfunngamnt,Spring
1975,57-66.
Shiller, Robert
I.,
and Franco Modigliani, "Coupon and Tax Effecis on New and Seasoned
Bond Yields and the Measurement of thc Cost of Debt Capital,"
,for
nnl of Fbwncial Eco-
nrrrrics, September 1979, 297 -318.
For some htsights into hoto practicing
fntncial
nunagerc oiciL' tle capital slructure drcisiorr, ste
Kamath, Ravindra R., "Long-Term Financing Decisions: Views and Practices of Financial
Managers of NYSE Firms," Fitnncinl Rtziao, May 1997,337-356.
Nortcrn, Edgar, "Factors Affecting Capital Structure Decisions," Fimtncirtl ,lQgl1sar, August
7991,431-446.
Pinegar,
J.
Michat'I, and Lisa Wilbricht, "What Managcrs Think of Capital Structure The-
ory: A Survey," Filnncinl Managetnarl, Winter 1989,82-91,.
Scott, David F., and Dana
J. Johnson,
"Financing Policies and Practices in Large Corpora-
tions," F ina nc ial Ma ilege n rc n l, Summer 1982, 51-59.
To learn nwre Ltbott ilrc link betuccn nnrket risk atul ollcrtlli,B and
ffiancial
leacrngc, xe
Callahan, Carolym M., and Rosame M. Mohr, "The Determinants of Systenatic Risk: A
Synthesis," The Financial Re.'ie'd),May i989, 157-181.
Gahlon, James
M., and
James
A. Gentry,, "On the Relationship between Systematic Risk
and the Degrees of Operating and Financial Leverage," Fimncid Mnlngorcrrl, Srrm-
mer 1982, 15-23.
Prezas, Alexandros P., "Effects of Debt on thc Degrees of Operating and Financial Lever-
age," F inan cial M t nageme n t, Summer 1987, 39
-
U.
Herc are sonrc add.itional articlcs which relnte to tltis chnptcr:
Easterwood, John C., and Palani-Raian Kadapakkam, "The Role of Private and Public Debt
in Corporate Capital Structures," Fitnttcial Nlattngrrre,rl, Autum 1991,
.19-57.
Garvey, Gerald T., "Leveraging the Underinvestment Problem: How High Debt and lvlan-
agement Shareholdings Solve the Agency Costs of Free Cash Flow,"
/olrlai
of Iimnckl
Rtsearclr, Sumrner 7992, 749-766 -
Harris, Milton, and Arttr R.rviv, "Capital Structure .rnd the Inform.rtional Role of Delrt,"
lownnl
of Finnra,
June
1990, 321-3.19.
Israel, Ronen, "Capit11 51.r.,,,te and thc N'larket for Corporalc Control: Thr Dcfrnsive
Role of Debt Financing,"
ltutrnal
of FinLurcc, Septt'nrber 1991, 1391-1+09.
750
1,000
13.0
16.0
18.0
20.0
ple illustrate about the impact of debt financing
and retum?
e. How are financial and business risk measursd
stand-alone risk framework?
f. What does capital structure theory attempt
to
\4/hat lessons can be leamed from capital
shu
theorv?
Withihe above points in mind, now consider
mal capital structure for PizzaPalace.
(1) What valuation equations can you use in the
sis?
(2) Could either the MM or the Miller capital
If the company were to recaPitalize, debt would be is-
sued, and thi fdnds received would be used to repur-
chase stock. PizzaPalace is in the 40
Percent
state-Plus-
federal corporate tax bracket.
a. Now, to develop an example that can be
Pre-sented"
to
PizaPalace's rnanugemeni to illustrate the effects of fi-
nancial leverage, consider two hypothetical firms: Firm
U, which usei no debt financing, and Firm L, which
uses $10,000 of 12 percent debt Boih firms have
$20,000 in assets, a 40
|ercent
tax rate, and an expected
l. lt is also useful to determine the effect of any
recaoitalization on E[5. Calculate the EPS at
ets 6f $0, $250,000, $500,000, and $750,000,
that the firm begins at zero debt and recapital
each level in a aingle step. Is EPS maximized
Economic State ProbabilitY
Bad 0.25
Average 0.50
Good 0.25
EBIT
$Zooo
3,000
4,000
same level that maximizes stock
Price?
i.
Calculate the firm's WACC at elcl qlbt leYe!:
the relationship between the WACC and the
Redo the Part a analysis for Firms U and L, but add ba-
sic eaming power (BEP), retum on investment
(ROI)
[defined
a-s (Net inco*e + Interest)/(Debt + Equity)],
and the times-interest-eamed
(TIE) ratio to the out-
come measures. Find the values for each firm in each
state of the economy, and then calculate the exPected
values. Finally, calculate the standard deviation and
coefficient of variation of ROE. What does this exam-
price?
k. Suppose you discovered that PizzaPalace had
buiiiress iisk than you originally estimated' Dt
how this would afiect the"analfsis. What if th
hid less btsiness risk than origiirally estimated?
l. Is it possible to do an analysis similar to the l
Palacl analvsis for most firmi? Why or why not?
type of anilysis do you think a firm should.at
,i"L to h"tp set its optimal, or target, caPital.stsu
What other factors should mmagers conslder
setting the target caPital structure?
.i
Selected Additional References and Cases
Chapter 77 prouides references that
focus
on the theory of capital stmcture; the references
are orientcd more toward applications than theory.
Donaldson's work on the setting of debt targets is okt brtl still telettant:
Donaldson, Gordon, "New Framework for Corporate Debt Capacily," Haroard
uiezu, March-April 19 62, 717 -137.
'.....-"-.-."._, '//Strategy lbr Financial Emergencies." Haruard Business Reuietu,
ber 1969,6719.
406 Chapter 10 CAPITAL STRUCTURE DECISIONS: PART I
5rr t/rr'.fol/rrilirrg thrL'e arliilL's
l,)rddifiorrnl
irrsigllls irto the relntionshill betit'een
aclcrisfics nnLl
lintttlal
le|erogt:
Bowen, Robert M., Lane A. Daley, and Charles C. Huber,
lr.,
"Evidence
on thg
and Determinants of Inter-lndustry Differences in Leverage," Fhmncial
Mr
Winter 1982, 10-20.
Long, Michael, and Ileen Malitz, "The Investment-Financing Nexus: fume
dence," Midland Corporate Finance
loumal,
FaIl 1985,53-59.
Scott, David F.,
Jr,
and
iohn
D. Martin, "Industry Influence on Fhmcial
nancial Manngemmi, Spring 1975, 67-73.
For a discttssion of tlrc intemational implications of caPital structure, see
Rutterford, Janette,
"An International Perspective on the CaPital Structure Puzzle;
Iand Corporate Finance
lournnl,
FaU 1985, 50-72.
The Winter 1995, Winter 1996. and Spring 1'997 isxrcs of the
loumal of Applied
nance all contain
featured
articles pertaining to the capital stntcture decision-
The Dryden Press Cases in Financial Management: Dryden Request serix conlains
the coicepls lpe pruent in Chapters 70 and 11.
Case 9, "Home Security Systems, Inc.," Case 10, "Kleen Kar, Inc.," Case 10A,
Springs, Inc.," and Case 108, "Greta Cosmetics, Inc.," which present a situation
tri the Hill Software Systems example in the text.
CAPITAL STRUCTURE
DECISIONS: PART II
n
phapter 10 presented some basic material on capital structure, including a
brief iniroduction to capital structure theory. We saw that debt concentrates a
firm's business risk on its stockholders, but debt also increases the expected re-
turn on equity. We also saw that there is some optimal level of debt that maxi
mizes a company's stock price, but that it is next to impossible to identify that oP-
timai capitai structure. Now we go into more detail on capital structure theory.
This will give you a deeper understanding of the benefits and costs associated
with debt financing.
AL STRUCTURE THEORY: THE MODIGLIANI.MILLER MODELS
Unll]2Sg-qpijal Etrylstule-theory
cqnsisted of loose assertions about investor
behaviorratGrthancaref ully-.rryqf
f
glCd4@l!r-l6E!-eouH-be-testeali
fg@l1qtEiaila$Iysisiln what liui-bee'" crlled the most influential sei or fi-
"
nancial papers ever published, Franco Modigliani and Merton Miller (MM) ad-
dressed capital structure in a rigorous, scientific fashion, and they set off a
chain of research that continues to this day.1
Assumptions
As we explain in this chapter, MM employed the concePt of arbitrage to develgp
their theory. Arbitrage occursiFtfo Simifar aiseE--in this case, leveraged and
u:nlei;e-raged stocks-sell at different prices. Arbitrageurs will buy the under','al-
ued stock and simultaneously sell the overvalued stock, earning a profit in the
process, and this will continue until the prices of the two assets are equal. For ar-
bitrage to work, the assets must be equivalent, or nearly so. MM show that, un-
der their assumptions, ieveraged and unleveraged stocks are sufficiently similar
for the arbitrage process to operate.
rSee
Franco Modigliani and Merton H. Miller, "The Cost of Capital, Corporation Finance and the The-
ory of Investment," Arnerican Economic Ra,ieu,lune 1958,261197; "The Cost of Capital, CorPoration
Finance and the Theory of Investment: Reply," Anterican Ecouomic Reoiew, September 1958, 655-$69;
"TaxesandtheCostof Capital:ACorrection," AmericanEconouicReuiew,lune1963,43H43tand"Re'
ply," Anterican Econonic Rmiau, lune
7965,52*-527. ln a 1979 survey of Financial Management Asso-
ciation members, the original MM article was judged to have had the greatest impact on the field of
finance of any work ever published.See Philip L. Cooley and J. Louis Heck, "Significant Contribu-
tions to Finance Literature," Fintncial lvlatngenert, Tenth Anniversarv lssue 1981, 23-33. Note that
both Motligliani and Miller won Nobel prizes-Modigliani in 1985 and Miller in 1990.
)
408
Chapter 11 CAPITAL STRUCTURE DECISIONS: PART ll
i,
No one, not even MM, believe that their assumptions are sufficiently
c66pr*.
cause their models to hold exactly in the real world. Howcver, their modehl
show horv much money can be made through arbitrage if one can find
wrl
around prolrlems with the assumptions. Here are the initi.rl MM assumptiff
Note that some of them were later relaxed:
1.
There are no personal or corporate taxes.
2.
Business risk can be measured by oru,r, and firms n,ith the same degreed
business risk are said to be in a homogeneous risk class.
3.
All present and prospective investors have identical estimates of each
firml
future EBIT; that is. investors have honrogeneous expectations about q.
pected future corporate earnings and the riskiness of those earnings.
4. Stocks and bonds are traded in perfect capital markets. This assumptiq
implies, among other things, (a) that there are no brokerage costs and
0)
that investors (both individuals and institutions) can borrow at the sanr
rate as corporations,
5. The debt of firms and individuals is riskless, so the interest rate on all dfi
is the risk-free rate. Further, this situation holds regartlless of how mud
debt a firm (or individual) uses.
6. All cash flows are perpetuities; that is, all firms expect zero growttr, hem
have an "expectationally constant" EBIT, and all bonds are perpetuitic
"Expectationaily constant" means that the best guess is that EBIT willh
constant, but after the fact the realized level could be different from theer.
pected level.
MM without Taxes
MM firsi analyzed leverage under the assumption that there are no corporatetr
personal income taxes. On the basis of their assumptions, they stated and algc
braically proved two propositions:2
Proposition I. The value of any firm is established by capitalizing its expectd
netbperating income (EBIT) at a constant rate (k.g) which is based on the firm}
risk class:
EBIT
YL-YU-wAcc-
Here the subscript L designates a levered firm ancl U designates an unlevend
firm. Both firms are assumed to be in the same business risk class, and lqg istltl
required rate of return for an unlevered, or all-equity, firm. (For our purposetl
is easiest to think in terms of a single firm that has the option of either financt'S
with all equity or using some combination of debt and equity.)
Since V as established by Equation 11-1 is a constant, then untlcr th! tvlVl
til|r:
uhen tlrcre are no taxes, the t'atti of the
firm
is itrdcpcntlent rtf its ltz,crnge. As we sld
see, this also implies that
1. The weighted average cost of capital to the firm is completely independot
of its capital structure.
t"t
*-,, r"tea and proved three propositions, but the third onc is n()t mitcri.rl to our
di<d-
2. The IVACC for the firm, regarrlless of the .rmotrnt of debt it uscs, is etpurl to
the cost of equity it rvould have if it used no debt.
Proposition II. Tho cost of equitl, to a lcvercrl firnr, k.1, is equal to (1) the cost
of erluity to an unlevr.red firnr in thc sante risk cl.iss, k.g, plus (2) a risk premiunr
whose size dtpencis on both the tliffercnti.rl bctrtr'cn an unlevered firmt costs of
debt ant-l equity irntl thc armount of debt uscrl:
k,r_
=
k-u + Ilisk prtn.rium
=
k.t.+ (k.1,
-
k.rXD/S). (11-2)
Here D
=
markt,t varlue of the firm's clcbt, S
=
nr.trkct valuc' of the firm,s eqr-ritr;
and k,
=
const.-rnt cost of dt'bt. Equotiou 11-2 .slrrlcs lltLtt rts tltc
frnis
ust ttf dtbt itt-
cl"(s-r,s, ils cost oJ equity nls0 rlscs, tlnd in 0 nntht,ttrntictlly pr.ccisc rrrirrilrLr:
Taken togethcr, the tu'o MN{ propositions inrprly that the inclusion of more
debt in the capital sh'ucture lvill rrot incrcase thr' valtre of thc fir.m, bec,rusc tlie
benefits of cheaper debt rvill be exactly offsct bv .rrr incre.rse in the riskincss,
lrence in the cost, of its cquity Tlurs, NINI rtrgut: tltnt in n iottrld a,lllroul trr.res, botl
thc taluc of a
Jirn
and its \N,\CC itt)lilll br nn4lcctt'Ll bq its cnpital slrrrcflrc. In the
next sectiorl we lvill present .1 proof of the lvlM Proposition I in thc .rbsence oi
corporatc taxes. A proof of Proposition I rvithor,rt corpor.]tc t.rxes a;rpc..rrs in the
Extension at the end of this chaptet as tlo proofs of Propositiorr I arrd II n.ith cor-
porate taxes.
MM's Arbitrage Proof
MlvI used an orbitroge proo/to support their proprositions.3 They shoned th.tt, un-
der the.ir assumptions, if trvo conrpanies diffcrotl onlv (1) in tl.re w.ry thtv are fi-
nanced and (2) in their total m.rrket valucs, thcn invcstors rvoulti sell sharus of
the higher-valued firm, br.ry thost of the lolver-i..rlucd firr:r, antl continue this
process until the companies had exactly the same urarket value. To illustrate, as-
sume that two firms, L and U, arc identical in all importarrt respL'cts except fi-
nancial structure. Firm L has $.1,000,000 of 7.5 percent debt, while Firm U uses
only equity. Both firms have EBIT
= $900,000, ancl oL3rr is the same for both firms,
so they are in the same business risk class-
lvllvl assumed that all firms are in a zcro-grorvth situation; th.tt is, EBIT is er-
pected to remain constant, and all eamirrgs aro paid out as c'liviclends. Urrc-lcr this
assumption, the total market value of a firnr's colnlnon stock, S, is thc present
value of a perpetuity, lvhich is founcl as follorvs:
"
Dividcntis Nct inconre (l:DlT
-
krD)(1
-
T)
k. k. k.
Equation 11-3 is merclv the valut of a perpq1ui11. rvlrose ntrmer.rtor is thl. nct in-
come availablc to common stockholdcrs, rvhich is all paitl olrt as tlir.idcrrtls, atrtl
whose denontirrator is tht cost of common et1uitr,. ln IVIM's zero-ta\ nor.ltl, tlrt,
tax rate',
I
is zero, so Etltration 1l-3 becomes simplv (EBIT
-
k.rD)/k..
EBIT (11-l)
Capitnl Structure'fhurr1,: Thc Nlotiigliani-lrlillrr ir,lodels
-109
(11-3)
kru
lBv
nrtritrosc rrc nrt'an thc simrrlt,rrreous [ru!ing anrl st'lling ot csscrrti,rllv irlcntical .rssfts \\ hicl] s0ll .tt
diifercnt prices. t hr' buvinE incr('nses tlrc piu:oI the rrnrl..rr.rhrr.l lrrui, ,rrr,l tlrc .ellrrrt rlctrc,r:e, tlre
price of the ovcrl'.rluc.l asset. Art)itr.liir'opLrr.lti(nrs rlill crrntinrrc until p1igq5 hrr-e bticrr rrlju:trtl to
the.point uherr'.the arbitrageur c.rn nrr longer L'irn.1
Lrro[il,
.it !\.hi(h poirlt thl'n]nrkcis,lrli in.qui-
libriun. Irr the aL,scnce of traniiction c()sts, equilil.rium rcquirr'\ thit thc prices oi the t\\ () n:sctr b,!.
erlrral.
'110 Chapter 11 CAPI1AL STRUCTURE DECISIONS: PART II
Assume that initially, ltc.forc anv nrbitray occttrs, both firms h.rve the
sam.-
uitl,capitalization rate: k.g
=
k.r-
=
10%. Under this condition, n..".aing
toEq[
tion 11-3, the followiug situation would exist:
Firm U:
Value of Firm U's stock
=
Su $9,000,m.
Total market vaiue of Firm U
=
Vu
=
Du + Su
= $0 + $9,000,000 = 99,000,000.
Firm L:
Val.e of Firm L's ,,o.U =
t.. =
Et#Q
=ffi=su,ooo,om.
Ttrtal market value of Firm L
=
Vr-
=
DL + SL
= S+,0OO,OOO + $6,000,000 = $10,000,ffi.
Thus, before arbitrage, and assr.rming that k,g
=
k,r- (which inrplies that capi6l
structure has no effect on the cost of equity), the value of the levered Firm Ler.
ceeds that of unlevered Firm U.
Mlvl argued that this is a disequilibrium situation which cannot persist. To sc
rvhv, suppose you owned 10 percent of Ls stock, so the market value of yourin
vestment was 0.10($6,000,000)
= $669,666. According to MM, you could increar
your income without increasing your exposure to risk. For example, suppose yor
(1) sold your stock in L for 5600,000, (2) borrowed an amount equal to 10 percv{
of L's debt ($400,000), and then (3) bought 10 percent of U's stock for $900,ffi
Notice that you wouid receive $1,000,000 from the sale of your 10 percentof[l
stock plus your borrowing, and you would be spending only $900,000 on l.t'i
stock, so you would have an extra $100,000, which MM assumed you would it
vest in riskless debt to yield 7.5 percent, or $7,500 annually.
Now consider your income positions:
$60!m
Capital Structure Thcory: The lvlodigliani-Miller
N{oclels 411
established, gains could be obtainecr by switching from one st.ck to the otrrer,
h.ence the profit motive would force the equality"to be reached. when equirib-
rium is established, the values of Firms Lincr'u, and their weishted arierase
costs of capital, would be equar. Thus, according to Modigtiani ,ria uiu"r, u.?t
a firm's valr.re and its WACC must be inclepenclent of capital structure.
Note that each of the assumptions listed at the beginning of this section is
necessary for.the arbitrage.proof to work. For ex.rmplelif tne".o*pn.ri"s
ao-r.,oi
have identical business risk, or if transactions costs are significant, then the ar-
bitrage process cannot be invoked. we rvill criscuss furthir implications
oi the
assumptions later in the chapter.
Arbitrage with Short Sales
Even if you did not orvn any stock in L, you siill could reap benefits if U and L
do not have ihe same total market value. Now, your first itep would b" ; ;"[
short
9600,000 of stock in L. To do this, vour broker woultl reiyou bo..o* ,to.t
in L from one of tl're broker's other clienis.
your
brokcr would theh ,ur th" ;;;;I
l::
y^o-i^"I^d^qite you the proceeds, or $600,000 in cash.
you
worrlcl ,rppf"-""i
this $600,000 by b9rro11ng $400,000. With thu $1 million total, you *orij Uuy tO
percent of the stock in U for $900,000, and have S100,000 remaining.
-
Your position consists of 9100,000 in cash and trvo portforios. ihe first port-
folio contains $900,000 of stock in u, anci it generates g90,000
in i,rcome. sinc"
vou own the stock, we'll carl it the "long"
portforio. The other portfolio con-
sists of $600,000 of stock in L and $400,000 ln aeut. The value df'this portfolio
is_ $1 million, and it generatt's
$50,000 in cli'idencls and $30,000 in interest.
Howewer, you do not own this second portfolio-you
,,owe,,
it. Since yo, bo._
rowed the ${00,000, you owe the $30,000 in interest. And since you btrrowed
the stock in L, you "owe the stock" to t[-re broker from whom it was borrorved.
ff19fo1e, you must pay your broker the $60,000 of clividends paict by-i,
which the broker would then pass on to the client from whom the stock'was
!]9:r_o-yu1,
So, your net cash flow from the second portfolio is a negative
$90,000. Since you "owe" this portfolio, we,ll call it the
,,short,,
portfoliol
,. Ijur"
areyou going-to get the $90,000 that you musr pay on the short portfo_
lio? The good neus is that this is exactry the amount oriash flow qeneratecr
bv
the long portfolio that you own. The caih flo*'s generated by each portfolio #
the same; in oiher words, the short portfolio
,,repicates,,
the iong portfolio.
Here is the bottom line.
you
stirted out with no *onev of vour own. B,
selt-inq t sf9rt, borrowing
$100,000, ancl purchasing stock in U,
Vou
"na"J
,i
with 9100,000 in cash plus the two portforios. The portforios refricate o.," u.i-
other, so their net cash flow is zero. This is perfect arbitrage,
you
in'est none
of your own money,,you have no risk, you have no future negative cash floq,s,
but you end up with cash in your pociet.
Not surprising, many traders would want to do this. The selling pressure
on L woulcl cause its price to fall, and the br-ryirrg pressllre on U rvoulcl cause
its price to increarse, until the two conrp6nig5,-uni-r"s were equ.rl. To ps.1 11 nr.,_
other wali if tlte.long antl slrort repticotirtg
ltortfolios
lutz,e tltc snitre cailt
jlou]s,
tlrtt
they nutst lutte the sanrc ualue.
This is one of the most important ideas in mocrern finance. Not o.ly croes the
application of this idea give us insights into capital structure, but it is ihe fun.la-
mental building block underlying the Arbitrage
pricing
Theory (Apr) of stock ie-
turns in Chapter 26, the valuation of rear options in Ciiapter ii, ancr the varuation
Ol,l lttconrc:
Ntit, Jrtctrrttc':
10% of L s $600,000 etluity income
10% of U's $900,000 equity income
Less 7.5% interest on $400,000 loan
Plus 7.59'" interest on extra $100,000
Total nerv income
$60,0[
7.it
$67$
Thus, your nc,t income fronr common stock u,ould be exactly the sanre asbeftn'
$60,00b, but you would have $100,000 left over for investment in riskless
dett
which would increase your income by $7,500. Therefore, the total return
onlo!
$600,000 net rvorth wotrld rise to $ei,SOO. Further, your risk, accorr'ling
to lrN
rvotrld be the s.rme as before, because yo, *otild have simply substituh+
S.100.000 of "homemade" leverage for your 10 percent sh.rre of Fi.*'L't ${
millio
of corporate leverage. Thus, neither your "effective" debt nor your risk
wour
h.rve &anged. Ther"efore, you rvoulcl have increased your incomi rl,ithout
rais4
your
risk, u,hich is obviously a desirable thing to do.
Ivllvl argued that tl'ris arbitrage process rvould actually occtrr, *'ith sales.d
L's sbck ririving its price down, and purchases of U's itock clriving;
its
por
up, until the nrarket valucs of the trvo firms *,"."
"ql.,ol.
u.iii ,iir
"qiln,y'"
412Chapter11CAPiTALSTRUCTUREDECISIoNS:PARIli
Vr=Vu+TD'
t=rr=**O
k.r-
=
kuu + (k,u
-
kd)(1
-T)(D/S)
Fredrickson is in a no-growth situation'
of financial options and derivatives as discussed in Chapter 19 ln fact'
withqr
this idea, the bptions and derivatives markets we have today woutd not
exist
MM with CorPorate Taxes
lvIM's original work, published in 1958, assumed zero ta1:::,In 1963'
lhe.yFS
Iished a second article which incorporated corpollle
laxeg
wrth corPorate
incot
taxes, they ioncluded that leverage will increase a firm's value-
'nlt.*:unU'
cause interest is a tax-deductible expense, hence more ot a leveraBed tirm'so*t
ating income flows through to investors. Here are the MM propositions whencq.
porations are subject to income taxes:
Proposition I. The value of a levered firm is equal to the value of an- unleve6
fiini in,f-," same risk class (Vg) plrrs the gain from leverage' The gain fromleru'
aee is the value of the tax savings, found as the product of the corporate taxpl
(f) ti*"t the amount of debt the firm uses (D):
I
C.rpitnl Structurc Theorv: The lvlodigllrni-tr.lillcr lvlodels
.ll3
4. If Freclricksorr begins to use debt, it can borrorv at a rate ka
= 8%. This bor-
ron,ing rate is consLtnt-it doc's not increase regardless of the amount of
debt used. Any money raisecl bv selling debt rvould be used to retire com-
mon skrck, so Fretlricksois asscls ruorr/d rcnnin constant-
5. The business risk inherent in Fredrickson's assets, and thus in its EBI! is
such that its rerluired rate of return, k"Lr, is 12 percent if no debt is used.
With Zero Taxes. To begin, assumc th.-rt thcre are no taxes, so T
=
0%. At any
level of debt, Proposition I (Equation 11-1) can be. used to find Fredrickson's
value in an MNI world, 920 million:
v.
=
vu -
EBIT
-
$2'+
'mi]lion
=
$10.0 mirriou.
k,L 0.12
If Fredrickson uses 910 million of debt, its stock value must be $10 million:
S
=
V
-
D
= $20 million
- 910 million
= $10 million.
We can also find Fredrickson's cost of equity, k,1, and its WACC at a debt level
of $10 million. First, we use Proposition II (Equation 11-2) to find k";, Fredrick-
son's leveraged cost of equity:
k.r- = k.u + (k,Lr *
k.1XD/S)
=
72/, + (12%
-
8%X$10 million/$l0 million)
=12%+4.0"/"=16.0"L.
Nolv we can find the conrpany's lveighted average cost of capital:
WACC
=
(D/v)(k.rx1
-
T) + (S/v)k,
=
($10/$20X89/")(1.0) + (91 0 /920)( 1 6.0%)
=
12.0%.
Fredrickson's value and cost of capital based on the MM model without taxes
at various debt levels are shown in Panel a on the left side of Figure 11-1. Here
we see that in an IVIIv{ world without taxes, financial leverage simply does not
matter: The value of the firm, and its overall cost of capiial, are independent of
the amount of debt.
With Corporate Taxes. To illustrate the MN{ model with corporate taxes, as-
sume that all of the previous conditions hold except these two:
1. Expected EBIT
= $1,000,000.4
2. Fredricksou lras a 40 percent federal-plus-state tax rate, so T
=
40%.
Other thirrgs held constant, the introduction of corporate taxes would lorve'r
Freclrickson's net income, hence its value, so we increased EBIT from $2.4 million
to $4 million to m.rke the comp.rrison betrveen the two modc'ls easier.
rlf
rve had left Fredrickson's EBIT at $2.4 million, the introduction of corporate taxes woulcl have re
drrceel the firm's value from $10 million to 5l? milliort
.. EBIT (1
- Tr Sl I million t0.6)
v'
=::k:- =sl2'omillion
Corlrorrte trxes reducc the anrount of_oPcraiing in.onc a\,iilalrlc to itlvestols irt an unlcur.rtd flim bi
the facbr (1
- T), so the rrlue of tht'firm u,cruld be rcduced br.the same atnount.
r--::T':"----:-:r* ---:----_ -'
The important point here is that when corPorate taxes are introcluced' the valu
oi in" flu""tua firm exceeds that of the unlevered firm by the- amount TD' Sim
ihe eain
from leverage increases as debt increases, in theory a firm's value is nur'
imiied at 100 percent debt financing'
Because all cash flows are urstl^-"d to be perpetuities' the value of the udtn'
"Jfi.r.,
can be found by using Equation 11-4' With zero debt (D
= $0)' the valu
of the firm is its equitY value:
(11.t{
0t-r
0t{
Proposition II. The cost of equity to a levered firm is equal to ( 1) the cost o{ q
uity to an unlevered firm in tlle same risk class plus (2i a risk
Fremium
whd
;a ;;A;t .n the differential between the costs of equity and debt to anrD
i"*r"ifir-,
the amount of financiai leverage used' and the corporate
tax rale
NotethatEquationll-2aisidenticaltothecorrespondirrolvitlrout-taxequab(a
11-2, except for the term tr -ij-i"1i-2"'
Since
(i
-.r)
i!less than
il,llfli
tr*"s .u,rre the cost of equitv to rise less rapid)y with
':li:1i:.illffiH;
the absence of taxes, Proposiiion II, coupled with the fac
fective cost of debt, is *iui p,oa'ces ihe Proposition I result' namc-ly'
thrl
fi
firm's value increases as its leverage increases'
Illustration of the MM Models
To illustrate the MM models, assume that the following clata and conclitiorrsh{
for Fredrickson Wut", Co*iu,ty,
u'tota, established
firm that supplies.n'ag"
residential
customers i., ,"ui,uino-growth
upstate New York conulrrnities
1. Fredrickson currently has no debt; it is an all-equity colnPan\"
-
rin*.f
2. Expected EBIT
= $2,100,000'
EBIT is not expeciecl to incre'lst'ot'e' ""
Fredrickson ls rn a no-growrrt
srruarrult'
,.-.:.tr+ri
Needing no new capital, Fredrickson pavs out all of its intonrt"ls
or\'--'..
- ---"*- rr.s ss. ltMtr
E6BR},
!p9o"i
"
OFHN^
ii e\\in!
NNoEi
a 8Rb
O o6i
-
U
U
,.
E 3BB::
oooo
@ ci N $..l
aaa
> d6i<
O o6ob
o
U
z
u bae
S EEr
,r ERca r
1:9 N
""
*;;:;
E EEEfi!
F
o
o d6
t :;
"
xx
O-
.q
6
cc
o
o:
@6
!
o
o
@
d
iI^
ov
oo
-
t
O-
o;l
o
d
t
o
o:
@6
!
F
I
o
6
F
o
o
o
o
o
t
3*
d o:;
o
o
o
s
F
I
o
3
d
ooo
i'ii6
N r
ei ll
:\en
Capital Structure Theory: The Modigliani-lvliller Models
.115
When Fredrickson has zero debt but pays taxes, Equation 11-4 can be used io
find its value, $20 million:
v.
-
EBIT ( t
-
T)
-
${ million
(0.5)
=
$20.0 minion. vu-
k'u 0.12
-aLt
Now if Fredrickson uses $10 million of debt in a world with taxes, we see by
Proposition I (Equation 11-1a) that its total market value rises to $24 million:
Vs
=
Vu a f!
= $20 million + 0.4($10 million)
= $24 million.
Therefore, the value of Fredrickson's stock must be $14 million:
S
=
V
-
D
= $24 million
- $10 million
=$14
million.
We can also find Fredrickson's cost of equity, k.r, and its Vr'ACC at a debt level
of $10 million. First, we use Proposition II (Equation 11-2a) to find k.p the lever-
aged cost of equity:
k,s
=
k"g + (k'u
-
kdxl
-
T)(D/S)
=
12oh + (12%
-
8%)(0.6)($10 million/$14 million)
=72%+1.77%=73.71%.
The company's weighted average cost of capital is 10 percent:
WACC
=
(D/v)(kJ(1
-r)
+ (S/V)k
=
($10/$24X8%X0.6) + ($14l$24)(1,3.71,%)
=
70.0%.
Fredrickson's vaiue and cost of capital at various debt levels with corporate
taxes are shown in Panei b on the right side of Figure 11-1. In an MM world with
corporate taxes, financial leverage does maiter: The value of the firm is maxi-
mized, and its overall cost of capital is minimized, if it uses almost 100 percent
debt financing. The increase in value is due solely to the tax deductibility of in-
terest payments, which lowers both ihe cost of debt and the equity risk premium
by (1
-
T).s
To conclude this section, compare the "Without Taxes" and "With Corporate
Taxes" sections of Figure 11-1. Without taxes, both WACC and the firm's value
88?
aao
2e?
RFF
5ln
the limiting case, where the firm used 100 percent debt financing, the bondholders would own the
entire company; thus, they would have to bear all the business risk. (Up until this point, MM assume
that the stockholders bear all the risk.) If the bondholders bear all the risk, then the capitalization rate
on the debt should be equal to the equity caPitalization rate at zero debt, ka
= 4u =
12'/".
The income stream to the stockholders in the all-equity case was $4,000,000(1 -
T)
= $2,400,000,
and the value of the firm was
u,
=
&ffi9@
= r2o,ooo,ooo.
lvith all debt, the entire $-1,000,000 of EBIT would be u*d to pay interest charges-k6 would be 12
npr.pnt so T
=
0 l2fDpbt)
=
S,1.000-000. Taxes would he zero- and investors
(bondholders)
would set percent, so I
=
0.12(Debt) = $4,000,000. Taxes would be zero, (bondholders) would get
aa227
Oe
ihe entire S1,000,000 of operating hcome; they would not have to share it with the government. Thus,
at 100 percent debt, the value of the firm would be
"=sH@=t33,333,333=D'
There is, of course, a hansition problem in all this- MN{ assume that kd
=
8'l/o regardless of horv much
debt the firm has until debt reaches 100 p'rcent, at h'hich point kd
iumps
to 12 percent, the cost of eq-
uity. As we shall see Iater in the chaptet k.i realistic.llly rises as the use of financial leverage increases.
)
416
Chapter 11 CAPITAL
STRUCTURE
DECISIONS:
PAITT ll
(v) are constlnt.
with corpordte taxes, welC!
fe*.1es
and. V
,tlllt
ut
*on
),'ra'rnor" debt is used, so the optimal capit'rl structllre' under MM withcq'
porate taxes, is 100
Percent
debt'
What is the optimal capital structure
under the MM zero-tax model?
What is the optimal capital structure under the MM model with corporll
The l-lar:racl.r Nkrtlel: lrrtroducing lvlarkct Risk
{i7
companv rvitir bg
=
1.5 ancl $100,000 of cr}ritr' (S
= $100,000), is considering re-
placing $20,000 of equity with deirt. Asstrming also that krr = 10"/,, krr = 1591,, ancl
T
=
3.1'11", then Firm U's currcnt rrnleverecl retlrrirr'cl ratc of return on equity l\'ould
be 17.5 percent:
k,u = 1i)')i + (15')6
-
10'x,)1.5
=
10,)/,, + 7.5.'/,, = 77.5');.
This shon,s that the businoss risk prcrnium is 7.5 pcrcentagc points. If the tirm
lvere to atltl $20,000 of tlebt to its capital strlrcturL., then its new value, accord-
ing to MM, t,ould be Vr-
=
Vu + TD
= $100,000 + 0.31($20,000)
= $106,E00, and
its k., using Equation 11-5, rvould risr' to 18.(;.1 percerlt:
k,r
=
10% + (159/.
-
10%)1.5 + (159/,
-
109{,)1.5(1
-
0.34X$20,000/$86,300)
=
10% + 7.5"/,' + 1.14')i, = I 8.64'l,.
Thus, adding $20,000 of debt to the capital structure rvould result in a financial
risk premir"rm on the stock of 1.14 percentage points, lvhich would be addcd to
the business risk premitrm of 7.5 pcrccntagc points.
Flamada also sliorved that Equation 11-5 can bc used to clcrir,,e another eqlra-
tion that analyzes the effect of financial leverage on bcta. lVe knorv that the SNIL
can be uscd to estimate a firrn's required rate of rl'turn on e(luity:
SML: k.
=
ko,, + (ku,
-
kon)b.
Nor,v, by equating the SML ecluation rvith Etl,ration 11-5, rve obtain:
knn + (kr'
-
k,.,,;b = k11; + (k'1
-
k11s)b1r + (k,1
-
k11r)LrLr(1
-
TXD/S)
(k\j
-
krir.)b
=
(k',
-
k,.,.)bu + (k'1
-
k111,)Lrg(1
-T)(D/S)
(11-6)
b = bu'r- bu(1
-
T)(D/S),
b
=
bu[1 + (1 rXD/S)l ( 11-5r
)
I Thus, under the MM and CAPNI assumptions, the equity beta of anv firm is
equal to the ecluity beta the firm wor-rld h.rr-c if it used zero delrt, acljustr'd up-
ward by a factor that depends on (1) the corporate tar rate and (2) the amount of
financial leverage employed.' Thercfore, the stock's nrarket risk, which is mca-
sured by b, depends on both the firm's business risk as mcasured by bu and its
financial risk as mcasureLl by b
-
bLr = br(l
-
TXD/S).
To continue our illustration, if Firnr U *'crc to reprl.icc 529,9a, of eLluity w'ith
debt, its equity beta would increase fronr 1.5 to 1.728, accor.lirlg tr: Eqtration 11-[r.r:
b = t,u[1 + (1 TXD/S)]
=
1.5[1 + (1
-
0.3{)(20,000/$S6,800)]
'lf a firm uses preferrcrl stock, thcn l]quntion 11-{r betornts
b=
g.
*O, (p,/S) + t,, 0
_
T)(D/S),
uhere P
=
market v.1hre o[ prcferrccl stocL. llerr thc unlevcreri l,cta is rriirrstcti up*arri l.r'the prc-
icrred sto.k as vloll as tht: dc[.t.
taxes?
Horv does the Proposition
i equation dif{er in the trvo models?
How does the Proposition
1I equation differ in the two mode'ls?
Why do taxes result irr a "gain from leverage" in the MM model with corp
rate taxes?
THE HAMADA
MODEL: II\TRODUCING
MARKET
RISK
In our discussion
of business and financial risk in Chapter 10' we focused m
stand-alone
.isk,
'sit'g
oosE(u) as the measure.of,business
risk and oR6g1u as th
measure of the stand-alonJii"tl
Uot"" by stockholders
if debt is used' Thus' in Sr
stantl_alone
risk sense,-tnoEi;1 -
011691.1, is a.me.rsure of financial risk' Recall,
rh^,,.h th.rt .urt of staJ-"aini"
tittt * be eliminateel
if stockholders
divenill
;il;';il ;;fi.L"'
il il' ;;;tion' we consider business and financial risk ftoo
a market risk standPoint'
Robert Hamada.o*uln.a
the CapitaiAsset
pricins
Modtt
(CAPM) presenttd
in Chapter
2 with the ttil
"ft"t-i"^'-oaa
to obtain this erpression
for kp
0t
."t, ,rilq"itY
to a leveraged firm:6
,.
-
Risk-free
*
Btrsincss risk
.,
KsL
-
rate
premium
=
k*r + (kiul- kRr)bu + (kr,r
-
kRF)bu(1 -
TXD/S)
Here bg is the beta coefficient
the Jirm woula rril'e,lt
l:,:'::i::"'J:Tii:llj$
:;:,'i"'^I:,;::',"'fi
:'il:':il1"1,ii:;,'^".1'Y.::::::::lll'il1',iJ#
age, anel the other termsate d5 uurrrrtu
-'
-.,,,.,r,rnin,a:
kRf, thcili'
a,?^, ir-.'" rcq,rired rate of return on a.stock into threc tl,_:
.,-,,,-
^f
moneyl
r
;:::' I;,'TilI["
:ff
;':;;';;;h'l;;"
ior the time
::'::..:'.T?liLJ
iim':,I*:il;i ifif 11
;
F"
*'J
iy :,:- ly. J i,' 1t i';', ;,ff
IoX
fiiliill:T".T:1'i'::"::1;il"'h,#;;i*";5!'r',0-"P"/:'J::'m
lx:itrilffiff
i',r J:["ilr
:{il;:; ;ffi:,\.ii
;u.";,:r
i":::::l} has no financl;tI leverage
(D
= SU),
tnen rne Irlrdrl(rdr
"-^
5;;;1.iilo.p.n*rtJ
,"r" ttf."
third terrn woutd drop out) and equity investol
only for business risk
'y
[.r business risk'
' r^r
'.,i]L
-^"h^ra+o r.,\p\ d()eq not holcl exrctlv'dti
il;;";il
see. the MM model with coJP.:rate t"-.:t
1":
-" -- u.-r..,ior T16
,,"TJ:"uXlf
ii:liii"ilffi
i""l
""i
ririy aesc.ibe r.,,e,tor o:n::l1ffi
ffi
"l?;"\TX^'l:
*i"\ti
;lruJ i" i.1,o,i." rr s'
-"'i
u"'" gi*#-:
J#;J1,"".T;:Iiiffi
::Ti::lm#:::*il:T,""'$$di*m:x
appro\imation.
Nevertheless,
the Hamada moclel can
otr""",t;;il'ilj'j.
,"r.ri*
'5il"t;;;
,;ful insights As an illtrstr'rtion' assttnrc tl
;il,ff ',.::*ffi ;,:li$[li.i{1['ii[*TE:rii[^l'q]$[ii:li[[ri$.#
'ii;1::i:',-
"1,'.i
,,' 1".i,,.r.' rislv debt se"-"Di\i'i"n'rl c"'r
"l
(''
Financial risk
premium 01.t
Lil";:;;;;' ri,ui,.;nt lt,,,u,g.r,crrt, spring 1e8s' s'l-st
418 ChaPter 11 CAPITAL STRUCTURE DECISIONS: IART Il
Capit.rl Structure'Theory: The N{iller Model 419
Miller's results can be supported by an arbitrage proof similar to the one rve
presented earlier. However, the alternative proof shown belor,r, is easier to follolv.
To begin, we pariition the levered firnr's annual cash flows, CF;, into those going
to the stockholders and those going to the bondholc'le.rs, after both corporate and
personal taxes:
CFt
=
111"16p to stockholders + Net CF io bondholdt:rs
(11-8)
=
(EBIT
-
I)(1
-
T.)(1
-
T,) + I(i
-
Td).
Here I is the annual interest payment. Equation 11-8 can be rearranged as follows:
CF1
=[EBIT(1 -T.)(1 -T,)] -[I(1 -T.Xl -T,)]
+[I(1
-Ta)].
(11-8a)
The first term in Equation 11-Ba is identical to the after-tax cash flow of an un-
levered firm as shown in Equation 11-7,and its present value is found bv dis-
counting the perpetual cash flow by k,u. The second and third terms, which re-
flect leverage, result from the cash flon,s associatecl lvith debt financing, which
under the MM assumptions is assumed to be riskless. Their present values are
obtained by discounting at the cost of debt, ks. (Remember, these are all perpet-
tral cash flows, so the basic perpetuity valuation model, V
=
CF /k, applies.) Com-
bining ihe present values of the three terms, we obtain this value for the levered
firm:
We can confirm the Equation 11-5 value of ksl =
18'64% by using b
=
1'728
in
6
SML:
k,=knr*(kM-krtF)b
=
10% + (15%
-
10%)1'728 =18'61%'
These relationships can be usecl to hclp estimate a comP'lny's- or a divisio.i
c<ist of er1uit,r,. In both instances, we procec.d by obtaining betas for similar
prg.
licly traclecl iirms anc{ then "levering therr-r up or down" to make them consGtst
wiih o.rr own firm's (or tlivision's) capital structure and tax rate. The resultisU
estimatc'of our firm's (or division's) equity beta, given (1) its business risk6,
measurecl b1, the equity betas of other firms in the same line.of business and p1
its fin.rncial risk as measured by its own capital structure and tax rate.
Qlo-ru, tiotts
Accorrling to FIamac1ir, the requirecl rate of rettlrn on a stock consists of thnt
elemenis. \Mrat are they?
Horv is business risk mt'asured t'ithin a market risk framework?
Horv is financial risk measured within a market risk framework?
what is the relationship between levered and unlevered betas according b
Hamada?
,,
EBrT(1
-T.)(1 -T.)
r(1
-T.Xl -T.) r(1
-Td)
'r'_._-,
l(,u K,; k.1
The first term in Equation 11-9 is identical to Vg as sEt forth in Equation 11-7.
I{ecognizing this, and when we consolidate the second trvo terns, we obtain this
equation:
v,
=
V,, *
J.0--T.r)
f l
-
(l
- T.Xl
-
T.)l
kd
L
(i-Td)
I
(11-e)
CAPITAL STRUCTURE
THEORY: THE MILLER MODEL
Although lvllvl include'r-l corporate taxes in the second version of their modd
tf.ey al'.i not extend the moclel to include personal taxes. Horvever, in his prui
dr.ntial acldress to the American Finance Association, Merton Miller introducedr
*oa"t a".ig.r"a to show how leverage affects firms' values when both personrl
""J.".p".i*
taxes are taken into aciount.8 To explain Miller's model, let usbe
gin by .iefini.,g T. as the corporate tax rate, T. as the personal tax rate on ircort
from'stocks, u",ld-Tu oa the personal tax ratl on income from debt. Note thd
stocks, returns come partly is diviclends and partly as cap-ital gains, so tisl
weighted a\rerage of t'he eifective tax rates on dividends and- capital
g"hl
LY
"rr"'itiulty
all cl"ebt income comes from interest, which is effectively taxed
at [r
vestors' toP rates'
With personal taxes inclucled, nnd tndtr the sante set 0f nssuntPtiorts ttsed
in llt
earlicr triM rrroilels, the value of an unlevered firm is found as follows:
.. EBrT(r -
T.)(1
-
T.)
v ti -
K.l r
0l't'l
(11-9a)
Norv recognize that the after-tax pcrpetual interest payment divided hy the re-
quired rate of return on debt, I(1
-
T,r)/k.t, equals thc. marrket value of the cletrt, D.
Substituting D into the preceding eqtration ancl rearranging, we obtilil-l this ex-
pression, called the Miller model:
Tht, (1
-
T.) tcrm t.tkc's account of pcrsonal taxes' The-rt'fore' the nurnerahr
shorrs hon,"muchof the firm's operatirrg income is left after the ttnlevereo-u"
p.1ys corporatL' itrcome taxes and its stockholtlers subscquently pa{
ry:;
i.i., on iheir c,cluity income. Since the i.troduction of person.rl t.rxes lorvep "',
i.co,re a'ailable to investors,
f",,on'l
taxes reduce th. v'rlue of t5e unle(er'd
firnr, other things heLi collstant'
(11-10)
The Miller model provides an estimate of the vah-re of a levererl flrr:r in a rvorld
with both corporate and personal taxes.
The Miller model has several important implications:
1. The term in brackets,
l,
(1
-
r.x1
-
r.)
I
t'--(1_1i).,'
when multiplied by D, represents the gain from leveragc'. The bracketerl
term thtrs replaces the corporate tax ratc, T irr the earlier MM mociel lvith
corporate taxes, Vy
=
Vu + T'D.
2. If wt' ignore all taxes, that is, if T.
=
T.
=
Tu
=
0, then the bracketc.cl term is
zero, so in that case Eqtration 11-10 is the sarnL'(rs the'original IVr. nrotlel
witlrorrt taxes.
:,:-*:-*-::;:-5'-:-
;--:
"--
..1
Mitter modet: Vr
=
vu'
;,
-
iLf$iDl,
)
rS.'t'
itltrttrn H. \lill.r
"Dcbt anrl T'rrt's"' /ournnl tll Fituttt't' N1'1\' 1977' 261-l;5
420 Chapter 11 CAPIIAL STRUCTURE DICISIONS: PART II
Criticisnrs of tlrc \1\l and Nlillt'r \lotlcls -ll1
Othcrs Ir,rl r. oxtcndcd autl lcstctl Nlillcr's iul.llvsis. Ccntrally, tircst' crtcrrsirrrrs
question lvliller's conclusion th.rt thcrc is no .1d\,.1nt.18C to thc use. of corpor.rtr
cfu'bt. irr the Uniteti States, tlre effective tax ratL'on inconrc fronr stock is less th.rn
on income frorn Lroncls. Thus, it (rppcrrs tl1.rt (t
-
l'.Xl
-
T.) is lcss th.rn (l
-
T.r),
hence there is an advantage to tirc use of corpor.rlc. dL'Lrt. Still, Millcr's rvork does
shor'v that pL.rsonal taxcs offsr't sonrc of thc bcncfits of corpor;rtc rlebt, so tht' tax
at'lvanhrges of corpor.rtc dclrt are lcss tharr rlcrr inrlrlicd b1, thc elrlicr i\lNl
mode l, rvhere only corporate taxes wL.re consirle rccl.
As we note iu the next section, thcrc .rrc ..r uunrbcr of problems n,ith both the
MM and tlre Miller nroclels, so onc shou[1 rcg.rrtl our exirntplcs ;rs ilrrlicating the
gL.ner.rl effects of lever.rgc on firr:rs' r'aluc, not a prccisc relationship.
dr1-rru
euestions
Holv does the Miller nrodel rliffor frorn thc Nfu'l nrodcl rvith corporate taxes?
What are the implications of thc N{illcr rnoclel if 1'.
=
T.
=
f.,
=
gr
What are the inrplications if T.
=
T.r = 0?
Considr'ring the current tax strlrctrlre irt tho Unitecl States, what is thc prirn,iry
implication of the lvliller modol?
THE MM AND MILLER MODELS
, The conclusions of the MM anr'l lv{illtr morlels follon, logically from thcir initial
assumptions. Horvever, both acaclemici.rrrs arrd firr.rncial ex-cutives h;rvc voicr'd
concerns over the validity of tlle MIVI anc] IVIiUer nrociels, ancl virtually no one be-
lieves they hokl precisely. The lvlivl zero-tax ntotlcl learls to the conclusiorr that
capital structure doesn't mattc'r, yet !\'e observe systematic capital structLlre pat-
terns within industries. Further, rvhen used rvith "rcasonable" tax rates, both the
MM model with corporate taxes and the Miller r.rrorlcl lead to the conclusion that
firms should use 100 percent debt financing, but r.irtually no firms deliberatelv
go to that extreme.
People who disagree with the NIM and lvlilltr thr.ories generally attack them on
the grounds that their assumptions are not corrcct. I-lere are the:nain obje,ctions:
1. Both NIM and Miller assume th.rt persorlal anrl corporate leverage are per-
fect substitutc.s. Horvever, an irrclirlicltral irl,c.stir.rg in a lcvcrr.tl [ir]n has lcss
loss exposure .rs a rusult of corPoratr limittJ tiilility than if hc or shc usecl
"honrcmlr-lc" lcverage. For cxample, in txrr tarlicr illustration of tirt Niivl
arbitrage argument, it shor.rlcl tre noterl that only the $600,000 our invcstor
had in Firm L woulcl be lost if that firm r,r,ent b.rnkrupt. I-lorvcve4 if the in-
vestor engaged in arbitrage transactions and employed "homem.rde"
Iever-
age to invest in Firm U, then he. or she cor.rkl Iose $900,000-the origin.-rl
$600,000 in\.estment plus the $100,000 loirn less the $100,000 investment in
riskless bonds. This increased personal risk exposure would tencl to restrain
investors from eng.rging in artritrage, and that could cause tl-re ecluilibrium
values of VL, Vu, k.L, anrl k,g to bc clifferent fronr thosc sirccificd br. NI\1.
I{estrictiorrs on instituticrnal invcstors, u ho t'krminatt'c.rpit.rl markets toriar;
mav also rr,tarcl the arbitragc procrss, LrecaLrsc, nr.rrrv institution.ll in\'ostors
canuot leg.rlll,borrorv to buv stocks, herrce .rrc prohiLritr.rl fnrm cng..rging in
hor.nem.rrle Ievcrage.
3. If w'e ignore personal taxes, that is, if T.
=
T.,
=
0, then the bracketed
teq,
^
duces to
[1 -
(1
-
TJI
=
T., so Equation 11-10 is the sanre as the MM
msd;
with corporate taxes.
4. If the effective personal tax rates on stock and bond incomes were
equrt
that is, if T,
=
T.r, then (1
-
T,) and (1
-
T,1) wotrld cancel, and the bracG
term would agairl reduce to Tc.
5. If (1
-
T.Xi -
T.)
=
(1
-
Td), then the bracketecl term wor'tltl
8o
to zero,ard
the value of using ler.erage would also be zero. This implies tlrat the
tax
ail
vantage of debt to the firm woulci be exactly offset by the
Personal tax.d-
vantage of equity. Undt'r this condition, caPital structure would have
nodt
fect on a finn's value or its cost of capital, so rve lvould be back to lt41r11
original zero-tax theorY.
6. Because taxes on capital gains are both lon'er than on ordinary incomead
can be deferred, the effective iax rate on stock income is normallylessfira
that on bond incomd. This being the case, what would the Miller modelpn
dict as the gain from leverage? To answer this question, assume that the
6
rate on corporate income is T.
=
34'7", the effective rate on bo^nd incomei
Ta=ZBuk, ind the effective rate on stock income is T.
=
15%.e Usingthet
values in the Miller model, rve find that a levered firm's value increasa
over that of an unlevered tirmby 22 percent of the market value of corp
rate debt:
cain rrom re'erage=1, -"++#],
_
f1 _
(1
-0.3.1x1 -
o.l5)lD
I-
(1-o2t3)
l
= [1 -
0.78]D =
0.22D.
Note that the MM model with corPorate taxes would indicate a gain from leter
age of T.(D)
=
0.34D, or 3'l perceni of the amount of corporate debt' Thus' wi$
tiese asiumed tax rates, adding personal taxes to the model lowers but doesrd
eliminate the benefit from corpoiate debt. In general, whenever the effectivettr
rate on income from stock is iess than the effective rate on income from bon&
the N{iller mociel produces a lower gain from leverage than is producedbylh
MM with-tax model.
In his paper, Miller argr.recl that firms in the aggrcgate woulLi issue a mix.d
debt and equity securitiei such that the before-tai"yie"las on corPorate.secuntB
and the p"ito.,ol tax raies of the investors who bought these secttrities.wour
adjust-until an equilibrium was reached. At equilibrium, (1
-
Ta) would.eql'
(1
-
T.Xi
-
T,), so, as rve noted earlier in Poini 5, the tax aclvautage of debl
D
in" fi.* ,uori,l b" exactly offset by personal taxation, and capital
structt!?
wonld have no effett on a firm's ,rui.,* o, its cost tlf capital. Thui, accordinS.r
Miller, the conclttsions derivecl from the original lvlodigliani-Nliller
zert"''
model are correctl
1,* ,rt **'"'r*ller ancl Scholc's clt'scribe'd horv investors cotlld, thcorr'ticallv strette
r or.
{S
conte from stock to thc
Point
\th('re tht' effectil e
licrson'l1
t'1x ratc' trn srrch iutnnt" it t'*"""-''.tt
:ili:"JlliJ,I'11;l
*'l)Hl,i""lill:ii.;?-:lixlil:il.,,l;l:ii;,,{lllll.l:,l.iJi':;li','l:i'.'"[[*#
.rrr.l S.lr.rles Jiscu:scd
ISMS OF
,122 Chapter 1l CAI'}ITAL STIIUCTUIiE DECISIONS: l']AItT II
CapiLrl Slructure Thcory: The Tracle-Off Nlodcls 423
Note, though, that large, diversified corporatiorls can Llse losses in one di-
vision to offset profits in another. Thus, the tax shelter bengfit is more cer-
tain in large, diversified firms than in smaller, single procluct companies.
Firms recognize this, and this factor hirs contributed to an increase. in firm
size.
6. IVIN{ anci Miller assume that there are no costs .rssociatecl witl.r financi;rl dis-
tress, and they ignclre agency costs. Furthcr, thev assume that all market
participants have identical information about firms' prospects, rvhich is also
incorrect. These topics are discussed in the next section.
Note, though, that *'hile limited liability mav
Preserrt
a prohlem
to
indi
vidrurls, it does rlol prescnt a problern to corPorations sct uP to und.rui
-leveraged
buy-outs, or LBOs. Thus, after MM's work becarne
\a;6f
knorvn, Iiterally hundreds of LBO firms were estal'lished, and
tlr+
founclers macle billions recapitalizing unclerlevcragecl tirms "Junk
b6n6.1
lvere createtl to aicl in the process, and the managers of underlevsl4aet
firms that did not want their firms to be taken over recapitalized
on
t[
ot n. Thus, Mlvl's work raised the level of debt in corponte America,
sn6
|
probably raised the level of economic efficiency'
2. If a leveragetl firm's operating income declinccl, it rvould sell assets
a{
takc other measurcs to raise the cash necessary to n'Ieet its iuterest
oblir.
ations ancl thus ar,oid bankruptcy. If the unleveraged firrn experiencf
the samr,' decline in oPeratil-\g income, it woulcl prolrably take the
le$
drastic measure of cutting dividends rather than selling assets. If d11i
ct'ncls w'ere cut, the investor who employed homemacle leverage woul3
not receive cash to pay the interest on his or her debt' Thr'rs, homemadt
lL.verage puts stockholders in greater danger of bankruptcy than does cot.
porate Ievt'rage.
3. Brokerage costs lvere assumed away by MM and N{iller, making the switd
fron L to U costless. However, brokerage ancl other transaction costs (irl
clucling
"market presstrre") do exist, and they too impede the arbitla$
p rocess.
.1.
NIM initially assttmed that corporations and inve'stors can borrow at th
risk-free rate. Although risky debt has been introducec-l into the analysisbl
others, to reacl.r the MM and Miller conclusions it is still necessary t0 a9
sunle that both corporations and investors can borrow at the same raL
While major institutional investors probably can borrorv at the corPora[
rate, many institutions art- not allowed to borrow to truy securities. Furthtt
most individual investors mr"tst borrorv at higher rates than those paidI
large corPorations.
dV-rru
Questiotrs
Shotrld lve accept that one of the models prc'sentecl thus far (MM with zero
taxes, MM with corporate taxes, or Miller) is correct? Why or rvhy not?
Are any of the assumptions used in the modcls n,orrisorne to you, and what
cloes "worrisome" mean in this contcxt?
TAL STRUCTURE THEORY: THE TRADE-OFF MODELS
Sorne of the assumptions inherent in the MM ar.rt-l Miller nrotlels can be relaxecl
without changing the basic IVIM/Miller conclusions.rr Horvever, as we discuss
next, whe.n financial distress and agency costs are considc'rerl, the N{N'I and Miller
results are altered significantly.
Costs of Financial Distress
Fin;.rncial distress inclrrdt's, but is not restrrcied to, bankrr-rptcli ancl n,hen finan-
cial distress occurs, several thirrgs can happen:
Arguments between claimants often clclay the liquiclation of assets. Bank-
ruptcy cases can take many years to settle, antl tluring tl-ris time machinery
rr.rsts, buildings are vandalized, inventories become obsolete, and the like.
Lawyers' fees, court costs, and administrative expenses can absorb a large
part of the firrn's value. Together, the costs of physical deierioration plus le-
gal fees and administrative expenses are called the direct cosls of financial
distress.
Managers and other employees generallv lose their
iotrs
when a firrn f;rils.
Knowing this, the management of a firn-r tlrtrt is ir-r financiaI distress may
take actions that keep it alive in the short run but which also dilute long-run
value. For example, the firm may defcr maintenance of machinery, sell off
valuable assets at bargain prices to raise cash, or cLtt costs so ntttch that the
quality of its products or services is impaired and the firm's long-run mar-
ket position is eroded.
rrFor
exanrpic, sct Robert A. Ilatrgon anrl J.rnrcs L. I'.)plrs, "t:(luilibritrm in the Pricing of Capital As-
sets, llisk-&aring Dcbt lnstftrnlcnts, antl the Question of Optirl.rl Capitdl Strucrure,"
louilutl
of Fi-
iltrtciri nt,l
Qrdriirrlirr'
,4rml-Vsis, JLrnc
1971. 9-13-951; Josr,fih Stiglitz, "A Rc-E\nmin.rtion oF thc
Nlotli;;liani-Nliller
'fheorcn,"
AiltL'ricdtt t-Lrttottlii ,liri'i 4,, [)cct'rnt,er 1969, 7iJ-l 79-] -rrLl Nl'rk E
Rubonstt,in, "A lVlcan-Variance S)'nthcsis oi Corporatt'Financi.rl Thcirrr',"
/L)rrrrrl
r)iFirrd,r.., NInrch
lr7l.16. -181.
5. In his article, Miller concluclecl that an ecluilibrium rvotlkl be reached, butb
reach his equilibrium the tax benefit from corporate debt must be thesart
for all firms, ancl it must be constant for an indiviclual firm regarclless of fr
amount of leverage used. However, lve know that tar berrefits vary frr
firrn to firm: tslig'hly profitable compatries gain the m'lximtrnt tax bened
from leverage, while the benefits to firms that are stmggling are m&i
smaller. Furihcr, some firms have other tax shields such as high deprn?
tion, pension plan contributions, and operating loss cnrry-fonvardt
c-
tl.rese shields ieduce the tax savings from interest pryments
ro
It
1l:0 I
pears simplistic to assume that the expected tax shi':ld is tln'1f fected
Dy u'
amount of clebt usecl. Higher leverage increases the
Probabili[y
that the
fiIr
rvill notbe able to use tlrc full tax shieltl in the fr'rture, bec'-tt'tte higherle\E
are increases thtt probability of future unprofitabilitv and cotlse(luenr:
lorver tax rates. All things crllrsit'lerecl, it appears likely that the interesllr
slrielcl from corporate d"ebt is more valuable to some'Ii'ms than
to othdtl
.',.*
.*"--r*^i the
.
inrprt of tar shie lcls othcr thnn rlcbt iinancin{,, tt
;11;; i:;l,l#
Ronrltt \V. NI.rsulis, "Optimri CaPit,ll StrtlcturL'trllder CorPo'atL''ln'1 11
il.r,rri,rl i ('(,,j, ,rrr,'.. \1.lr, ll t',sl'
'l-ll).
)
42,i Chaptcr 11 CAPITAI- STRUCTURE DICISIONS: PART II
Both customers and suppliers are aware of the problems that can arise,
anr
they often take "evasive action" that further damages the troubled
fir6. pl
cxample, Eastern Airlines, as it struggled to tleal with its unions
and u
avoid liquidation, had trouble selling tickets becarrse potcntial customo-
rvere worried about buying a seat for a future flight and thcn having
dD
company shut down before they could take the trip. Some potentiafqu.
tomers were also worried that the company might cut back on maintenanJ
and Eastern's suppliers were reluctant to grant norm;rl credit terms
or
i
gear up to supply parts and other materials on a long-term basis. Finalt"
Eastern had trouble attracting and retaining the highest-quality worken,I
most workers with a choice preferred employment with a more stable
air.
line to one that might go out of business al any time.
Nonoptimal managerial actions associated with financiaI distress, as wellt
the costs imposed by customers, suppliers, and capital providers, are calle{
the intlirect cosls of financial distress. Of course, these costs may be incuned
by a firm in financial distress even if it does not go into bankruptcy: Banl.
ruptcy is
iust
one point on the continuum of financial distress.
All things considered, the direct and indirect costs associated with fhancial
disiress are high.t'Further, financial distress typically occurs only if a firmhal
debts-debt-free firms usually do not exPerience financial distress. Therefore,llt
greatcr thc use of debt
firttutcirtg,
ttnd tlu ltrger tlrc
fixed
interest clutrgcs, the gteald
tle probobility tlmt a decline in earttitrgs ioill lcad to
ftroncial
distress, hence llt
higlrcr the probability thnt costs associiled ruilhfinancial distress iuill be incurred.
An increase in the probability of future financial distress lowers the cum,l
value of a firm and raises its cost of capital. To see why, stlPPose we estimate tht
Fredrickson Water will incur costs of $7 million if it fails at somL' future date, and
that the preset* aalue of this possible future cost is $5 million. Further, the proba
bility of financial distress increases with leverage, causing the expected presa{
value of the cost of financial distress to rise from zcro at zero debt to $4.75
mil
lion at $30 million of debt as shown in Table 11-1.
These expected costs must be subtracted from the valrtes we previously of
culated in Panel b of Figure l1-1 to find the firm's value at various amounts0l
leverage: They would ieduce the values of V and S and, as a result, would
raise k, and the WACC. For example, at $20 million of debt, we would obain
the values in Table 11-2.13 These ihanges would, of course, then have car4'
through effects on the graphs in Panel b of Figure 11-1. Nlost important,
thei
would (1) reduce the decline of the WACC line and (2) reduce the' slope ol ut
V1 line.
r:Sr'e
Edrvard I. Altman, "A Further Empirical Investig.rtion of the BanlruPlql Cost Qrrdstion,"la'
rcl rr/ Fororrcc, September 198.1, 1067-1089. On the trasis-of a sample of 2o b.rnlrirpt ctrnrP.rntes,
AIIP
found thit bankruptcv costs exceed 20
Percent
of firm value.
'tTo
fir..l k. and the WACC in Table 11-2, simPly transpose Equ,ltion l1-3 .rnel tht'n appll' the d&
tiur for the IVACC:
r.
(EBrr-kJDXl-T)
_ [S] 0.0F(520)l(1-0.1) _1.-,c..
\'
--3-
$s5
- -'
"' '
IVI\CC
=
(D/VXkiXl
-T)
t (S/V)(k.)
=
(92t)/$25.5X8':;X0.6) + ($5.5/$25.5X26. 1s",,)
= 3.76'i; + 5.65')b =
9.ll'r1,.
C.rpital Slructurc
-l-hcrrrr';
Tlrc Tradc-O[[ lvlodcls 425
Arnount oi Dcbl
$5 Nlillion $10 Nlillion $20 Nlillion $30 Nlillion
0.05
,rL'l.{
isl;
r..#'
:.,1;ii
.l.llt,alitlty
or rin" ncial.d istress
$0
0.0
50
0.15
sr50,000 5750,000
0.50
5r,500,000
0.95
9{,750,000
.
i.Vof"rp".t.a
costs of financial elistrcss'
..'.f, lriltion
tinres the incliertt'd pnrt"rtri li t!
The effects of financial distress are also felt by a firn.r's bonclholders. Firms ex-
peliencing financial distress havt'a highcr prtrbalrility of clcfatrlting on clcbt pay-
ments, so the higher the probability of firranci.rl riistrr'ss, the higher the required re-
turn ol1 debt. Thus, as a firm uses nlorc arrcl nrore tlcl,t, hr:rrce incroasing thc
probabilitv of distress, the r'.rluo of k; also incrc.rscs, c.ttsirrg several elerncnts in
P.irrel b of Figr.rre 11-1 to changc.
Agency Costs
We introduced the corlcopt of .rgerrcy costs in Cl.rafrtcr 1. One agc'ncy relationship
is betrveen a firm's stockholders and its bondholclcrs. In the absence of any re-
strictions, m.lnagement lvould be tcnrptecl to iakc actions that would benefit
stockholders at the exprcnse of bonclho[lers. For er.rnr;,1e, i[ Fretlrickson W.rtr'r
were to issue only a srnitll amouul oI clcbt, tircrr this clclrt would h.lve relativelv
little risk, a high boncl rating, and .r lorv intcrcst rate. r\fter it issued the lorv-risk
deLrt, Fredrickson nright issue more rlcbt scclrrtr'l bv thc same assets as the origi-
nal debt. This woultl ririse thc risks facecl by all ltttttdltolLlt
's,
cause k; to rise, anel
conse(luently cause the origin.rl borrt'lhoLlers to suffer caprital losses. Similarll', af-
ter issuing debt Freclrickson might clecidc to restructure its assets, selling ofi
those witl-r lorv br,rsiness risk ancl actluirirrg asscts thilt \^'ere more riskv br.rt
th.rt also had higher expected rates of return. If things u,orked out rvell, the
,:,t
t''
:l*
j'i'p.
it
$:rii
t#
S
k.
lVACC
Values at D
= $20 Nlillion
with Financial Distrcss
Effects Ignored;
Pure NIlt
$2IJ.00
$E.00
1IJ.00",,
\/alues a[ D = S10 Ntillion
with Fin.rncial Distress
Effects Considered:
lllodified illNI
52.ri.00-s2.5=s25.5
S8.0t)*S2.5=55.5
2b. IS",,
9.+1'1"
Tr\BLE
11'1
s.57"
426 Clh,ttrtcr 1l Cr\l'lTA[. SfliUCTLll(E I)I]CISIONS: I'AltT Il
stockl-rolders w'ould get all of the benetit, but if things werrt sotrr, nltrch
of 1\u
1*
woulc-l f;rll on the bonrlholders. So, stockholders rvotrld tre pl,rving a gam;;
"he.rds, I rvin; tails, you lose" with bonriholders.
Because stockholders niight try' to exploit bonclholders in these and
o[n
lvays, Lr6nds are protecte!-l bv restrictive covenants. These covenants hamper
il
corpor.rtion's lcgitinratt' operations to son"te extent. Further, the company
musli
monitored k) L'nsurL'tlrat the coven.rnts are being obeyed,.-tnci the costs of
morJ
toring are passed on to the stockholders in the form of higher debt costs.
The
h{
r'fficicncy plus nronitoring.costs rrc dS(',lcy cdsls that increlse the cost of debtar6
llrrrs rcrluct' its artvant.rge.ll
Value and Cost of Capital
Considering Financial Distress and Agency Costs
If the IvlN{ motlcl with corporatL' taxes were correct, a firm's value would
16.
continrrotrsly as it movet-l from zero tlebt toward 100 percent delrt: The equa[ur
Vr.
=
Vu + TD shows that TD, hence V1., is maximizcd if D is at a maximum.
Re
call that the iucreasing component of r.alue, TD, is a direct result of the taxshl
ter provirlecl bv irrterest on the debt. However, as noted above, financial distpg
and agency costs could cause V1 to decline as the level of clebt rises. Therefoq
the rclatiorrship betu,ecn a firm's value and its use of leverarge has two negatiq
components, so the true equation should look like tl'ris:
(11.lrl
Tl're relationship expressed in Ecluation 11-11 is graphed in Figttre 11-2. The tar
shelter effects totally dominate until the amount of clebt reaches Point A. Aftl
Point A, financial c{istress and agency costs become incre.tsingly important,ofi'
setting some of the tax advantages. At Point B, the marginal tax shelterbenefitd
aclclitional tle'bt is exactly offset by the disadvantages of debt, and beyonel Poit{
B, tht disadvantages outweigh the tax benefit.
Erlr,ratiorr 11-10, thc Milleimodel, can also be modifieci to reflect financialdig
tress anc'l agcncy costs. Thc'equrtion would be ide'ntical to Eqtration 11-11,o'
cept that thc gain front lt'r'erage term, TD, wottlcl reflect the addition ot
P5'
sonal taxes. In either the Mlvl or N4iller models, the gain from leverage cand
least be roughly estimated, but the value reduction resulting from potential
&
nancial distit'si and agency costs is almost entirely subicctive. We knorv
thi
these costs mttst incrcase as leverage rises, br,rt lr'e do not knorv tlre spectr
iunctional rel.rtionships.
The arldilion of finincial rlistress anrl agoncy costs to eithel tl're MM tax mot*l
or the lvlillcr Int'rdel rcsults in a tracle-off moclel of caPital structure. In suchl
/ PVof \
V
=Vu-,,-
(
"ffi:Ti.1
(T,,i,)
\financial /
\
drstress
/
C.rpital Structurc'fheory: The Tracir*Off Models
.127
a "Pure" MM Value ol Firm:
V.=Vu+ l'D
Financial Ciistress and
Agency Costs
Actual Value of Firm
l+ Optimal Amount of Debt
model, the optimal caPital structure can be visualized as a trade-off betwee-n the
benefit of debt (the interest tax shelter) and the costs of debt (financial distress
and agency costs).
Implications of the Trade-Off Ivlodels
The tracle-off models cannot be used to spe6ify a precise optimal capital struc-
tnre, but they do enable us to nrake three statements about Ieverage:
1. Firms witl'r more business risk ought to use less debt than lower-risk firms,
other things being equal, b!-cause the greater the business risk, the greater
the probatrility of financial elistress at anv level of debt, hence the greater
the expecteci costs of distress. Thtrs, firms rvith lower busincss risk can bor-
rolv more before the expc'cte'cl costs of tlistress offset the tax acivatlt.rges of
borrorving (Point B in Figure 11-2).
2. Firms that lrave tangible, rt'atlily r.rrarketable'assets such as real cstate can
use more debt than firms n'hose value is derivecl primarily from intangi-
ble asscis such as patents ancl goocllvill. The costs of financial ciistress de-
pend rrot only on the probability of irrcltrring distress but alstl on lvhat
happerrs i( r-listress occtrrs. Spe'ciirlizr:ci assc'ts anti intani;ible assets are
more likely to lose valr,ro if financial c{istress occurs tlr.ttt arc stancl.lrdized,
tarrgible assets.
3. Firms that arr. currently p,lvirrg taxcs at the highest rate, ancl th.lt are likelv
t.6a so in the futrtre, slrott[l ttse nlore debt tlr.rn firms lt'ith ltxver t(]\ r<rtes.
''\ li.h.r.l C. l('r\cn
.il\(l \\'illir m l l. i\ld.klinA
lroint
o(tt th.lt th('re irc .rl',, 1g111. 1' (r,sts bcts'ts
d
sirlc c uitr lrolJcr: rr.l nrrnrgt,nr.rrt. Sct "iltitrl
oi tht' l:irnt: l\lrn'rgtrirl Rthitir.r, AgencvaT
rnrl
()rrrrcrship Stnr(lurt',"
lonnil
oi FittttttiLtl I.or{r,ri(j, C)chrber l')7o, ltl5 lbl) Thtrr sluo!''u...
srrgil('sts thrt il) trnrlholdu.rgencv cttsts irrcrclse.rs tlrr'cielrt r,lti() in.ren{\, t tlt (:) oulsidcP
hol.lcr.rgcncl co\ts nl(rvr'irt rt'r'crst'f.rshitn, i.rllirrg rvith incrt.rsotl ttsc oi tlcht.
)
rtGuRE
17-2
428 Chapter 1l CAPITAL STITUCTURE DECISIONS: PART II
stiot s
Describe some types of financial distress and agency costs.
How are these costs relatecl to the use of financial leverage?
How are the basic MM with corporate taxes ancl Miller moclels affectecl
by ilr
inclusion of financial distress and agency crrsts?
What is a trade-off model of capital structure?
What irnplications clo the trade-off models have regarcling capital structure?
Does the empirical evidence support the trade<lff modcls?
riFor
ex.rmples of thc' empiric.rl research in this area, sce Robr'rt A. Trg*rrt, lr., .\ \lo.Jct
of GII'
rateFinancingDecisions,'ilrrrrnrrlpfFinurct.D('ccnber1977,l-167-1.181:in.lIi,rrl\l.rr*1,.
Ih"Ct*t'
betlveen Equitv.rnd Debt: An Enll.irical Sttrrlr;" ltrrrrrri crlFird,rrr, Nl,rrcli l9Sl. 1ll-l-ll.
High corporate taxes lead to greater benefits from dcbt, other factors
har
constant, so more debt can be rrsed before the tax slrield ls offset
by
firrzi
cial distress and agency costs.
According to tl're trade-off models, each firm should set its t.rrget capital
stnr..
ture such that tl-re costs antl benefits of leverage are balanccd .rt the margiri,il,
cause such a structLrre lvill maximize its value.
'lf
the trade-off models are ioirnr
we shoulcl find actual target strllctures that are consistent rvith the three poiri
just noted. Further, we should find that firms within a given inrlustry huue
sirj
lar capital structures, because such firms should htrve rrughly the same typeso{
assets, busincss risk, and profitability.
The Empirical Evidence
The trade-off models have intuitive appeal because' ihey lead to the' conclusiql
that both no-debt and all-debt are bad, while a "moderate" debt level is gm4
However, we must ask ourselves whether these moclels explain actual behaviq
If they do not, then we must search for other explanations.
ln
fnct,
the trade-0ff nndds lrLtue uery litnited et4tiricttl srrpporl.rs Ii cloes tum out
that firms which invest primarily in tangible assets do tend to borrow more
heavily than firms whose value stems from intangibles. H_owe-rger, empiricaler.
idence refutes other aspects of the trade-off models. First, se.,'eral studies havt
examined models of fiirancing belravior to see if fiimi' financing clecisions an
consistent with a target capital structure. There is some eviclence that this a.
curs, but the explanatory power of the models is very low, suggesting liut
trade-off models capture only a part of actual behavior. Second, studies halr
not consistently demonstrated thit a firrn's tax rate has i'pic.iictable, material
effect on its capital structure. Indee.d, firms used about as much cielrtbeforecor.
porate income taxes even existcd as they do today.-Finally, actual debt ratio
tend to vary widely across apparently similar firms within given induskies,
whereas the trade-off models s!.lggest that similar firms should have similu
debt ratios.
A11 in all, the empirical support for the trade-off models is weak, whichsug'
Bests
that factors not incorporated into these models are' alscl at lvork. In otits
words, the trade-off models do not tell the full story.
C.rpital Struttrrrc Thctrrr': Thc Signaling itlodcl {29
ITAL
STRUCTURE THEORY: THE SIGNALINC MODEL
Some time ago, Profcssor Cordon Dorraklson of llarvartl concluctetl an extcnsivr'
'
stuclv of horv corpor.rtiorls actu.rlly cstalrlish tlicir capital structurcs.l6 Here is a
snllunarv of lris firrdings:
'[.
Firnrs prefcr to fiuance lvith interrrallv gcncrnte.l fturrls. that is, tith rc-
tained earnings anri clepreciation cash flolr,.
2. Firms set targct divitlerrd payout r.rtios b.rserl on e\Lrccted fr,rture invest-
mr.nt opportunities and expcctccl futurc cash fltlvs. The tartct payout ratio
is set at a level that c.luscs rL.taincd earnirrgs plus deprr.ciation to covor cap-
ital cxpcrrri itrrrcs urrtl or rrorma l corrtl i tiorrs.
3. Divirlentls arc "sticky" irr the short rrrn-firnrs are relttctant to raisc divi-
dcrrtls unless they.rrc conficlcnt that thc higher divielend can be main-
tairred, ancl thcy arr: cspccinllv relucLrnt to cut the clivitlcnil. lntiectl, thc'v
generally rlo not rerluce the cliviclcnd trnlcss things aro so bad that they sim-
ply havc to.
4. lf .r firm has morr' internirl c.rsh florv than is ncctlerl to cover its capital ex-
pr'nditures, then it rvill invest in m.rrket.rble securities, usc the funds to re-
tire debt, incroase dividends, repurchase stock, or acrluire other firms. On
tht'other lrancl, if it has irrsufiicient intcrn.rl c.rsh floh, to finance nonpost-
Fonable
neh, projects, it rvill first clraw' r'lorvn its marketable securities porF
folio, tl-ren go to the external capit.rl markets. If it has to
Bo
io the e'xtern.rl
markets, it rvill first issuc r1ebt, therr corrvr.rtible bonds, ancl thcn conlmon
stock only as a last resort. Tltls, Dtrrrrt/ristrrr ol,sclit',1 tlutt tltra is rr
";t'l.li,1g p1-
dcr" oJJitrottcittg, tl()t 0 ltttlitt.L'tl ipltrL)ntlr rrs ii,or/r/ rcsilt iJ tlte troi*oJf nnttltls
at c u ro t c h1 riescriDrri rcnl -ittn' lrl bL'l tni' i o r.
Professor Stewart Myers rrotetl the inconsistcncy betlveen DonaLisorr's furd-
irrgs.rnd the traclc-ofi morlcls, ancl that incorrsistr'rrct'led N{yers to propose a nerv
tlrcory.r' First, M1'crs notcrl that Donalclson's pccking-order findings lcd arvav
from, rather than torvar(i, a rvell-clefinerl capital structurc. Equity is raised in hvo
forms-retirined earnings and ne'rv stock. lletaincd trrrnirrgs arc at thL'top of the
pecking order, lvhile nc!\' cornmon stock is at thc bottom. Thercfore, if retainr'rl
earnirrgs are. high rclrtive to investment requiremcnts, the equity ratio u'ill in-
cre.rse, lvhile if rehrined eamings are insufficient, thr'firm will borro*' rather than
issue stock, cirusing the delrt ratio to incrc.rse. Thc trade-off mot{els, on the other
hand, assume that equity from the sale of stock is etltrivalcnt to that from retained
e;rrnings, ant'l they suggest that the delrt/ecitritv ratio shoulcl renlain constant
or.er time.
Next, IVIyers notc'c1 that a critical assumption in thc tradc-off modc.ls is that ali
mirrket participants hirve hornotL'rleoLls t'xLrcctatiotrs. rvliich implies (1) th.rt all
participants have the sarrre infomrirtion aud (2) th.rl an1, changcs in opcr.r1j11g 111-
come arL. purcly r.rntlorn as opposcd to Lrcirrg anticip.ltcrl bv sotnc'but rrot all p.rr-
ties. Mt,c.rs had the insight to sce th.rt if exlroct.rtions are not honrogoneous,
rhCordon
Donalrlstrn, CdrlrrLllf Dd'l Crlrrritv:.1 Sfrrrlv tr/ C(,ryr,r.rif Dal,l I'0licv ar,l tlt{ DrtL'rililtiltlit)r o.f
Corlurilr'D.lrl Crrlu.ill (l]osk)rr: I-1.1r\'.1rd CrnLlu.rtc Sclrotrl o[ Busintss r\(imirtistrition, 19bl).
'tSt.'rtart
C. Nllcrs, "The Capit,rl Structure I1!/Aa,"
lt\tt,ilil
t1f Firrtrrcr.
Jul!
l9E-1, 575-59:. lt is intr'r-
esting tr) n()t!'th,rt, lilc thc lvlillcr n1o(['1, NIrr'rs's
1.a1-1'r
rr'.rs iirst prt'stntetl .rs a
l,rr'sitirntirl.rddrr'ss
to the Anreri(.ln FinJncc Associnti!)rr.
Test
.130
Chaptcr 11 CAPITAL STRUCTURE DECISIONS: PART Il
nlearlirlg that difft'rent grouprs 6f mirrket participants have asvntmc'tric (o1
6;11-
ent) infr)rmation, thcn Donaldson's restllts can be explained in a logical
63,j[
Nlyers's *,ork resultctl in what is norv callecl the-signaling, or asymmetrichf;
nration, theory of caPital.structtlre.
.To
illustrate, assume that a firm has 10,000 comnron shares outstan6i*
Thcy st-ll at a price of $19 per sharc, so the market valtte of its equityl
$190,000. Horvevr'r, its rnanagers have better itrformation rt'garrling the
fi'ri
futtrre than stockholclers, arrcl the managers believe that tlre actual value
u
sh;rre bascd orr existing assets is $21, giving the eqtrity a total "intrinsic"
yj|
of $210,000. Such an information asymmetry (or difference) cotrld easily
erLt
for managers often knorv more about their firms'Prospects than do currentarj
potenti;rl investors.Is
Strppose further that managelnent now iclentifies a new proje'ct which
would
require 9100,000
o[ extL'rnal financing and which has an estiuatetl NPV of $5,m
[Remember
that a project's NPV represents economic value added (EVA),
atg
that it accrucs to thc shareholclers.l This proiect is trnanticipatecl by the firmtb
vestors, so the $5,000 NPV has not been incorporated into tlre $190,000 eqrrity
m.rrkct value. Shoulc{ the firm accept the proiect? To begin, strPPose the firmb
slres nelv stock to raise the $100,000 to finance the project. Scverirl possibilifu
exist:
1. Symmetric information. First, as a point of departttre, consider thesihra
tion in rvhich management can convey all the information to the publia
hence all investors have the same information as management regardinga.
isting asset values. Under ihese conditions, the stock woulcl immediatdy
rise to its 921 intrinsic v;rlue. Then, lvht'n the new project comes alongard
is financed, the firm wottld have to sell $100,000/$21 =
4,762 new shara
Acceptrncc of the projt'ct would then increase the stock price from $21 b
$21.3-l:
New stock
P.,."
=
Original shares + New shares
_
$210,000 + $100,000 + $5,000
=
$315,000
=
szt.gl.
10,000 + {,762 11,761
Both olcl ancl nerv sharcholtlers rvould benefit if the proiect lvere accePted;
cach grouP wotrL{ gaiu $21.31 - $21.00 = $0.3'l per sh.irc as.1 rcsttltof
tlt
nelv
Projcct.
2. Asynrnretric infomration prior to stock isstle' Nort' srtpPo5s Inanagemdt
is unable'to inform investors about the stock's intrinsic r'.rlue. Perhapsii6
necessarv to trolcl back such information to maint.lin a comPetitive
dF
or pslhap5 SEC regtrlations cause man;lgement to refraiu from
"touhnt
the stock prior to ti.c n"r" isstre (if thin[s cticl rrot notk out.1s exPe(tel
nerv shartihol.L'rs might sr.te the n,,,,,n["r. who had
Ptrvidcd
the^r0{
forecast). lrr this situation, nerv stock tuoiil,l f"t.l-t the cuirclrt price, $19 F
sharc, so tht'comPatrv *'oultl have to sell 5100,000/$19 =
5,263 sharctlt
orcltr to raisc thi' reqr.rirec-l 5100,000. If this rvere clorrc', this lletv Prra
rr'1[l5.rssunrPtion
is contrarv to th!'strL)n$-forn] L'fiicicnt nl,lrkcts hrPt,llre'is ([Nlll)
lrcst'd{:
Ch.rnlt.rls.['ilti\r\*r1()t.lh('rc,h'rv,)[1st'r\er:-
intlutiingpcol'lt'rr]r,rstrt'nIlr:(rfl')ris'eJ^-
.til(i reilri.lrr\nq-h,rtr] rltr.rr.n(\'-nrt NillinA h) di.elt str(nll:'i(rril1 ulti.ir'rlc\'
C.rpital Structure Thc'ory: The Signaling Motlel
,131
would result after the. proiect was acccpted and the information asymme-
try was removed:
. Nelt, markct value + New monev raised + NPV
New stock p.,."
=
$210.000 + $100.000 + $5.000
=ffi=sro.u*.
Under this condition, the project shoulcl not bc ttndertaken. If the project
were not accepted. so no ne$'shares rvere sold, then the price of the stock
would rise to its $21 intrinsic value when the information as!'mmetry was
eventually removed. The sale of new stock at $19 per share wotrld lead to a
$0.36 per share loss to the firm's existing shareholders. There u,oulcl be a
$1.64 gain to the new shareholders, but management lvants to maximize the
value of curlenl siockholders, not new onL.s.
3. A more profitable project. Norv suppose the project had an NPV of $2O000
rather than $5,000, the stock solcl for $19, and otl-rer conditions in Scenario 2
were unchanged. Now the firm's stock price would rise to $21.62 if it un-
dertook the project:
$210.000 + $100.000 + $20.000
=
$330,000
=
szr.ez.
15.263
Under these conditions, the firm should take on the proiect. Note, though,
that most of the positive NPV would go to the new stockholders, who
would pay $19 per share and thus enjoy a capital gain of $2.62 versus a gain
of only $0.62 for the original stockholders.
4. Dark clouds on the horizon. Now sr.rppose an errtirely different-and
bad-situation faced the firm. Stockholders think the firm is worth $19 per
share, but managers know (a) that outside investors are entirely too opti
mistic about growth opportunities, (b) that investors have not factored in
proposed legislation which will require large, nonearning investments in
pollution control equipment, and (c) that the current stock price does not re-
flect the need for new R&D expenditures that will be required to keep the
firm's products competitive. If all of these bacl events materialize, profit
margins
',r'ill
be under pressure, cash flows will fall, and the company will
have difficulty servicing its debt.
Faced wiih these conditions, management might well conclude that the
stock's intrinsic value is only $17 pcr share, and then decide to sell a nelv is-
sue of 10,000 shares at the current price of $19, raising $190,000 and using
the fur-rds to retire debt or to support this year's capital budget. This action
would increase the intrinsic value of the stock from $17 to 918:
New intrilrsic value =
Old intrinsic market value + New
Original shares + New sharcs
$170.000 + S190.000
10,000 + 10,000
Current stockholders u'il[, if management's expectations comL] true, suffer a
Ioss when the bad nelvs becomes knorvn, br:t thc' sale of nerv stock rvoult-l
ret{uce that loss. (Note: Managemerrt n'ortltl h;rve to careftrllv rvord the
prospectus for the nerv issue, pointing out the potenti.il problenrs. Horvever,
10,000 + 5,263
Nen,stock price
=
10,000 + 5,263
lr,
' .!vE.'
: ;i.qlr
,,iii-\.i
,:\,ia+,
l$'
-:i;,;
,eli
. lili.'
;-,ira
=
$i3lj33o
= s" *
432 Chapter 11 CAPITA L STRUCTURE DECISTONS: I)AI{T II
Nelv stock price =
virtuallv all prospectuses are filled with car:tionarv langttage, So
hv*-
have.liificuliy teiling frorn them what managoment rcally expects.l
"\
5. Finance the original $5,000 NPV project with debt. lf the firm used
dehr
finance the original $100,000
Project
(Scenario 2), and llrt'tt tlte ilrt'orwi
asynililetry ilarc
.renuttcLl,^lhe
new stock price would be $21.50 uarrurf
$20.64 we found under Sccnario 2:
C.r[.ital Strtrctrrrc
-IhcLrrt;
Otrr Vicrr' {33
-Test
Questiotrs
Brieflv expl.rin the rrsvrlmetric infornration (sigrraling) tht'orr'.
Wh.rt does this thcorv strggest about c.rpital structure tlt.cisions?
Is tht'signaling thcory t'qu.rl11'apPlir;;1blq' to all [irnis?
L STRUCTURE THEORY: OUR VIEW
Tl're great contribution of tht' tr.rtlc-off nlol'lels dcvclolrecl by MN'1, Millc'r, ancl
tlieir followers is that thesr'motlels idcrrtifierl thc spr'cific benefits and costs of us-
ing dt'bt-the tax benefits, financial distress costs, and so on. Prior to ivlivl, no
capiial structure thcory existetl, so rve had uo systematic n ay of analYzitrg the ef-
iects of debt financing.
The trade-off models are suumarizecl graphicallv in Figure 11-3. The top
graph shorvs the relationsltips betrvccn the del,t r.rtio arrd thl'cost of dcbt, the
cost of ecluitv, ancl the WACC. Both k. arrrl k.i(1
-
T,.) rist' sto.rclily with increases
in leverage, but the rate of incrcase accelcratcs at higher debt levels, reflecting
agency costs and thc incrcased probability of finirncial t-listress. The WACC first
declines, then hits a minimtrm at D/V*, and then begins to risc. Note' that the
value of D in D/V* in the uppcr gr.rph is D", the lcvel of debt in thc lorver graph
that maximizes thc' firm's valtte. Thus, a film's WACC is urinimizerl .1nd its valllt.
is maximized at thr' santc cnpit.ll structurc. Notc also tl.rLrt thc gener.rl sh.rL.es of
the cunes apply regardless of n'hctht'r ir'o.rre trsing the r.r.rotlific'cl irli\l u'ith cor-
por.rte taxes morlel, the lvlillcr modcl, or .r r'.rri,rnt of thcse motlels.
Unfortunately- it is improssiblt' to quantiiy accuratcly thc costs anrl bencfits of
debt financing, so it is imp<.rssible kr pinpoint D/V-, thc capit.rl structure that
marimizes a firm's value. N{ost experts believt' sr.rch a structure exists for every
firm, but that it changes over time as firms' oper.rtions and investors' preferences
change. Most experts also bclicve th.rt, as shown irr Figure 11-3, the rel.rtionship
between value and leverage is relatively flat over a fairly broad range, so large
deviations from the optimal capital structure can occur lvithout materialh'affect-
ing the stock price.
Novv consider the signalirrg theory. Becar,rse of asymmetric infcrmation, in-
vestors knorv less alrout a firm's prtrsPccts thirn its rtraltcrgers knolv. FurtltL'r, mnn-
agers try to nraxirnize valut'for crtrttttl stockhoklcts, not nclv oncs. Thcrcfore, if
the firnr has excellerrt prospccts, managclnent n'ill not rvant to isstte trcrv sharr:s,
but if things look bleak, thon a ncw stock offcring would bcrtefit crtrrcnt stock-
holtlers. Consequcntly, investors take a stock offc'ring to be a signal of [rat] netvs,
so stock prices terrtl to rlecline *'hcn ncrv issrtes art'annottncetl. As a resttlt, netr'
ctluity financirrgs .rrc rt'lativcly t'rpctrsivc, The nct t'ffcct of sign.rling cffccts is kr
motivatt'firms to maintairr a resen'e Lrorrorving capacity designcd to perruit fr.tturt-
investmL.nt opportunities to be financt'rl Lrv debt if internal furrr'ls are not arvailat le.
By combinirrg tlre trircle-off and asvnrmetric iuform;rtiou thcories, rl'e obt.rin
this exLrlanation for firms' Lrch.tvior: (1) Debt iin.rncing provirlcs trenr'fits Lrt'caLtse
of thc tax cledr.rctibility of irrterest, sr-r fimrs shoLrlcl havc srure dc'bt in their capi-
tal strtrctures. (2) Hon,ever, fin.rncial rlislress arrrl .rgertcv costs pl.rce Iimits olr
debt usage
-be.\'oncl
some
Point,
these costs offsot the t.rx advantagr'of dc'Lrt.
The costs of finarrcial distress.rre espccinllv h.rrnrfrrl to iirurs rvhose value's con-
sist primarily of intirngiblc grorvth oprtiorrs, such .rs Il&D. Srrch firms shoultl lr.tvc
New market value + NPV
Original shares
_
$210,000 + $5,000
_
$215,000
=
S21.50
10,000 10,000
Thus, if debt were used, all of the intrinsic l'alue of the firm's exishng&
sets, plus the NPV of the new
Project,
woulcl accrue to the original
sii6l
holtlers. If stock were used, we saw earlier that the value of the origirul
stock would end up at $20.64 rather than $21, the intrinsic value wigrou
the nelv investment.le
What does alt this suggest about corporate financial policy? First, in a.wor!
where asymmetric information exists, corporations should issue new shaE'
only in the unlikely event that they have extraordinarily profitable investmst
that cannot be either postponed, signaled to invcstors, or financed by debt,c
in situations where management thinks the shares are overvalued' Second, i+
vestors recognize all this, so selling
Pressure
drives down a company's siun
price when it announces plans to issue new shares- Third, the pecking ordert}l
bonalclson observed is rational when asymmetric information exists-it palsh
rejtain a large fraction of earnings, and also to keep the etlttity ratio up and th
debt ratio do*.,, so as to maintain a reserve borrowing capacity which canh
used to support the capital budget if and when an unusually large number.d
positive Ni'V projects iome along, or if problems arise which require outsil
capital.20
Note that signaling effects, and their impact on investors' perceptions, difia
substantially across firms. To illustrate, asymmetry is typicalty much greatun
the drug and semiconductor industries thin in the retailing and trucking indrr
tries, be"cause success in the drug and semiconciuctor inclustries depends on se
cretive proprietary research anddevelopment' Tlrtrs, managers in these.indrr'
tries have iignifiiantly more information about their firnrs'
ProsPects
thand0
outsic{e inveslors. Also, emerging firms with limited capital btit good
Srowth0t
portunities are recognizecl uJhruirlg to use external financing, so the announG
ment of new stock offerings by a new comPany is not vierved lvith .ls muchc(t
cern by investors as are offerings by mature firms rvith linritt'tl
grotru'
opportirnities. Thus, altl'rough signiting'affects all firms, its i,-rpract
yaries fns
firm to firrn.
\' *' ."raitt**c['t wcre n(,t proportionrllv m.rtchctl uith retiin.(l enrlrings, issuirrE
ncr'Jd
rvoulrl incrc.rse tlre firm s ri.k rtrci'conseqtrcntly its require.l rntc of reltlrll on elluit\" SinllLrrl! "-
sulncc of ne$' c(']uitv in the
Prcvi()tls
scenarioi rnighI reduct' risk antl thus lorttr
.tlrc.
iost-rx
t,[
tve abstract frcrm thrise effects because (1) thev arc o[ second orcler imporLrntr'nnd (]) lrlfor]*"-'
thsr into the an.rll sis rroultl unnc(css.lrih conrPliqllg the er.rnrplcs.
r"Flot.rti()n
costs .1lso play' a role itr c.iPital structurc thcorv. ln gt'ne'ral tltrtrtiort ro:t'
":" :i'ly.i
dc.bt ihdn on e('luitv issues, anrl this prolidts .rn atltlitional rntionale it)r rtsitrg .ic['t ritllcl
r"""
sirle cquitr'. Wc rlill rliscrrss this issrtc in more qlct.ril
in Chapter 13.
i:3;.
,jr,,:fr:
,,".,
':;r.1
434 Ch.rptr.r 1l CAPITAL STRUCTURE DECISIONS: PART Il
Varlrtions in Capital Structures 435
I
tions may run out of internally
Benerated
cash, but they should emphasize stock
i rather than debt due to the severe problems that financial distress imposes on
i
such firms. (4) Finally, because of asy;metric information, firms should maintain
i a reserve of borrowing capaci$/ in order to be able to take advantage of good in-
I
vestment opportunities without having to issue stock at low prices, and this re-
i
serve will cause the actual debt ratio to be lower than that suggested by the
Itrade-off
models.
'-Test
Summarize the trade-off and signaling theories of capital structure.
Are the trade-off and signaling theories mutually exclusive; that is, might both
be correct?
Does capital structure theory provide managers with a model that can be used
to set a precise optimal capital shucture?
CAPITAL STRUCTURES
As might be expected, wide variations in the use of financial leverage occur boih
across industries and among individual firms in each industry. Table 11-3 illus-
trates differences for selected industries; the ranking is in descending order of
common equity ratios, as shown in Column 1.t'
?rlnformation
on capital structures and financial strength is available from a multitude of sources. We
used tlre Cotrrptrsra, data tapes to develop Table 1l-3, but published rcurces include The Value Linc ln-
aFhilent Suruey, Robert Morris Associales Annunl Studics, and Dtrr Cl Brodslreet Key Business Ratiu,
0
Value of Firm, V
($)
Debwalue Ratio (./")
RIATIONS
IN
)osite (averagc
industries,
n;t
those
listed
Common Preferred
Equity Stock
(1) (2')
74.4%
58.4
53.6
46.9
37.7y"
a.o% 25.6"/.
0.0 31.6
1.0 45.i1
s.3 47.8
Total Long-Tem Short-Term Times-Interest- Return on
Debt Debt Debt Eamed Ratio Equity
(3) (4) (5) (6) (71
18.7"/" 6.9v" 77.7x 26.4Y"
lou,er levels of dcbt than firms whose asset birses cor.rsist nrostly of tangiblerr
scts. (3) Bc'cause of problems due to asymmetric informatiorr ancl flotation
cosb
Iorr,-grorvth firms shotrltl follow a pecking order, with capit.rl r.risecl first fromin
\
t.'rnal sources, tlrt'n by borrorving, and fiially by issuinjnerv stock. In fact,sud
\
ltu'-pSowth firms r.rrely need to issue external equity. High-gro*.th firms
rvhas
1
grorvth is occtrrring primarily through iucreases in tangiblc asscts slrorrld
four
\
tht'same pr'cking, orcler, bLrt usually thcy will neccl to iis,,o noru stock as lvell,
I
dcbt. High-grorvth firnrs rvhose r.alues consist primarily of intarrgible grorvthf
These
ratios are barcl on accounting (or btxrk) values. Statr'd on a m.rrket-rirluc b.rsis, thc equity percentages would rise, because
sttks
sell al prices that are t!\,o hr t"hree timc,s higher than their brxrk values.
t.5"1 60.8v" 38.7%
24.5
39.1
43.8
7.7
5.0
4.0
22.1"t,
5.1
2.5
71..7
16.2
5.6
3.?x 17.7')'"
Coxrflrslrt
Inelustriat Data Tapre, 1995.
Chapter 11 CAPITAL STI{UCTUItE DECISIONS: I'ART ll
Drug and electronics companies use relatively little debt-the uncertaih(_
inherent in industries that are cyclical, oriented toward research, or subi-J}
huge product liability suits render the heavy use of debt trnwise. Also, thesi-*r
panies are generally quite profitable, hence are able to finance t.r.g"ly
witt"f
tained earrrings. Utility and retailinB companies, on the other hand, usedebrJ-
atively hcavily. The utilities have traditionally usecl large amounts
of
d"[
particularly long-term debt-tlieir fixed assets make good security for
mort#
bonds, and their relatively stable sales has made it safe for them to .u.ry
inl,
debt than would be true for firms with more business risk. Note, though,
ihat
ti
utilities are rapidly being deregulaied, hence they face rapidly increasing
comJ
tition. As a result, r,irtually every utility has revised its target capital structu{5
include less debt. This demonstrates that firms change their target capital
stn*-
tures as their business risks change.
Particular attention should be given to the times-intercst-earncd (TIE)
raiioh
cause it gives an indication of how safe the dt'bt is and how vulnerable thecoo.
panv is to financial distress. TIE ratios depend on three factors: (1) the percentr'
of debt, (2) the interest rate on the debt, and (3) the company's profitability.
G;
erally, the least leveraged industries, such as the drug industry, have the higlru
coverage ratios, whereas the utility industry, which finances heavily with detl
has a low average coverage ratio. Again, it should be noted that both Mood/l
and Standard & Poor recently changed their "guidelines" for the utility industt
raising the coverage ratios (and lortering the debt ratios) that are necessary t0rF
ceive high bond ratings.
Wide variations also exist among firms within given industric,s. For examplc
although the average debt ratio in 1995 for the drug industry was 25.6 perca{,
Merck's ratio rvas only 7 percent, while that of .American Home Products was0
percent. Two particularly important factors in explaining such variation in leve.
age ratios are the stability of earnings and the presence of growth opportunitie
Empirical studies show that firms with more stability in their earnings tyPical,
have higher than average leverage ratios when compare'd with the industryar'
erage. Also, firms with greater than average investment growth opportunitic
typically have lower than average leverage ratios. Thus, factors unique to indi
vidual firms, inclrrding managerial attitudes, play an important role in xttitg
target capital structures.
Professor Ravindra R: Kamath recently surveyed a large number of CFG'
About one-third of the CFOs said they try to maintain a target capital structult
when raising new capital, antl about two-thirr-ls saicl that they folkrw a "hierar
chy in which the most advarrtageous sources of funds are exhausted before
ou6
sources are used." The hierarch-y usually followed the pecking order of intemall,r
generated cash flow, external debt, and external equity. But there were occasitf!
in which common equity was the first source of financing. This probablyistt
cause the firm had so much leverage that additional de'ht rvould be a more
co{
source of financing than equity. In-ottrerlvorcls, the firm was far above theoF
mal clegree of leve'iage, soit iis,re.l equity to get closer to the optimal, or ta$rt
level oflebt. Tht'refo-re, many firms ao .,ot
"rfti.itty
state tllat thcy have
a urS
capital structure, but their actions imply that a target capital structure doeseD
for the firm.
r:See
Ravindra R. K.rm.rth, "l-ongjlerm Fin.lncing Dccisions: Viervs anrl Practiccs of FinanciJ
Il!
agers of NYSE Firms," T/rc' l'irarrcirl/ Rf ir'ir', Mnv 1997, 3-50-35tr.
Dcbt 5 50
Equity 50
Total
ryq
Book \\'cights lersus lv{arket lveiBhts 437
IVIarket Value
$ 50 33,/.
100 67
s150 100%
50']i,
50
100%
.l'l"l*
'lt i;r,i
';i:.4
'ii...-
, ,4,l
:;!iir.'
,,r1;'
i,,]l;I
dry-rrr,
Qttcstiotr
Why do wide vari.-rtions in the usc of financial lcvcr.rgc occr,rr Lroth across in-
dustries and amorrg the indiviclrr.il ftrrrs in caclr industry?
WEIGHTS
VERSUS MARI(ET WEIGHTS
In Chapter 5,
',ve
calculateri the rveightetl avcrate cost of capital rvitl.r market
value rather than book value' lveights. Fr.rrther, irr or.rr cliscussions of capital struc-
ttrre thus f;rr in Chapters 10 arrd 11, n,e have focused primarily on market values,
not book values. However, survey data inclicate. thirt financial managers generally
focus orr book valtre structures. Thus, there seents to be a conflict betlveen acad-
emic theory and brrsiness practice. Here are son.re thoughts on this issue:
1. If stocks and bonds tio not sell exactly at book value-and they almost
never do-then it w,oultl bc impossible for a growing firm to establish
and maintairr at constant levels both a targct book valuc and a target mar-
ket value capital structure. The firm coultl stay on its book value target or
on its markc't value iarget, but not on both. Tcl illustrate, assume th.tt a
comp.lny has, at book val,re, $50 million of deLrt and $50 nrillion of equity,
for a total book value of $100 million. l{oivr.r,er, its stock sells at 2.0 times
book, so the market value of its equity is 5100. Here is the capital structure
situation, with dollars in millions:
Book Value
Now suppose the companv needs to raise an additional $100 million. If it
sells $50 million of tlebt and S50 million of common stock, it will add these
amounts to its balance sheet, so its book value capital structure rvill remain
constant. However, adding $50 million to both debt and equity n,ill cause
its market value capital structure to change. On the other hand, if it raises
$33 million .rs debt anrl $67 million as L'quity, its n-rarkct value capital
structure lvill remain constarlt, Lrut its book value structure will changc.
Thus, it can maintain eitht'r its book valtre or its market vah-re capital
structure, but not both.
2. Book values as reportecl on b.rlance shcets reflect the historical costs of as-
sets. Horvever, historical costs have little to do with the actual vaiue of as-
sets or n'ith their ability to produce casl.r tlorvs. Nlarket valrres rvould al-
most always better reflt'ct cash generation and debt service abilitr'.
3. As we have repeatecill,noted throughout this chapter and the last one, the
point of capital structure analysis is to finti that capital stmcture rvhich
maximizes the firm's market value, hencr. its stock price. Since this opt!
mum is defined in terms of sbck pricr's, it c.rn orrly be cletermined by an
an.rlysis of nrarket valur's.
4. Nolv suppose a firm found its optin.ral m.trket value structure, but then fi-
nanced so as to maintairr a constant book value strllcture. This lvould lead
438 Chapter 11 CAPITAL STRUCTURE DECISIONS: IART Il
7.
to a deprarture from value maximizaiion. Therefore, if a firm is sr^,,r-
must finance so as to holcl constant its market value rtr".tu.u. fiullrlli-t
we saw above, normally lead to changes in the book value struchlls.'*(
5. Since the firm should, to keep its vallre at a maximum, finance
so,..
holcl its market value structure constant, the weighted ou"rog".oriit:o
ital, WACC, should be found using market value weights.
6. Business executives prefer stability and predictabiliiy to volatility
andur
certainty. Book values are far more predictable than market values.
Fl-
ther, a financial manager can set a target book vah-re capital structure
ai
then attain it, right on the money. It would be virtually impossible
to sri
at a target market value structure because of bond and stock price
fluOi
ations. This is one reason executives focus on book value structures
rath'
than on the more logical market value structures. Also, many financial.'.
ecutives have accounting backgrounds, and accouniants focus on accoq.
Summary 439
it would be impossible to keep the actual capital structure on target at all times,
but this fact in no way detracts from the validity of market value targets.
Test
Questions
Should the target capital structure be expressed in book valtte or market value
weights?
Why do practicing financial managers prefer to work with book weights?
In this chapter, we discussed a variety of topics relaied to capital structure deci.
sions. The key concepts covered are listed below:
r In 1958, Franco Modigliani and Merton Miller (MM) proved, under a re-
strictive set of assumptions including zero taxes, that capital structure is ir-
relevan[ that is, according to ihe original MM article, a firm's vaiue is not af-.
fected by its financing mix.
r MM later added corporate taxes to their model and reached the conclusion
that capital structure does matter. Indeed, their model led to the conclttsion
that firms should use 100 percent debt financing.
r MM's model with corporate taxes demonstraied that the primary benefit of
debt stems from the tax deductibility of interest
Payments.
I Much later, Miller extended the theory to include personal taxes. The in-
troduction of personal taxes reduces, but does not eliminate, the benefits
of debt financing. Thus, the Miller model also leads to 100 percent debt
financing.
r The addition of financial distress and agency costs to either the MM corpo-
rate tax model or ihe Miller model results in a trade-off model. I-Iere the
marginal costs and benefits of debt are balanced against one another, and
the result is an optimal capital struchlre that falls somewhere between zero
and 100 percent debt.
r The Hamada equation combines the CAPM with the MM with corPorate
taxes model:
k,r
=
knr + (kM
-
kRF)bu + (kpt
-
kRr)bu(1
-
TXD/S)'
This equation shows that the required rate of return on a levered comPany's
stock is equal to the risk-free rate, which comPensates investors for the time
value of money, plus premiums for business risk and financial risk.
r Within a market risk framework, business risk can be measured by bg, mar-
ket risk can be measured by b, and financial risk can be measured by b
-
bu
=
bu(1
-
TXD/S).
r The asymmetric information, or signaling, theory which recognizes that
managers have better information than most investors, postrrlates that there
is a preferred "pecking order" of financing: first retained earnings (and de-
preciation), then debt, and then, as a last resort only, new common stock.
I The signaling theory leads to the conclusion that firms should maintain a re-
serve borrowing capacity so that tlley can ahvays issue debt on reasonable
terms rather than have to issne new erluity at tl"re lvrong time.
I
ARY
ing numbers. However, as financial executives gain a knowledge of finari
cial (as opposed to accounting) theory, the focus is shifting more towalli
market values.
For purposes of developing the weighted average cost of capital,
*p
strongly recommend the use of market value weights. However, if a co6.
pany focuses on a book value capital structlrre, seeks to maintah th1
structure, and finances in.accordance with book value weights, then(
rveighted average cost of c.\pital should be based on book weights.
Some executives have argued against the use of market value weightsod'
the grounds that as stock prices change, so would capital
rveights, with the result being a volatile cost of capital. This argummtl
incorrect. The cost of capital shotrld be based on inr3cf weil;hts, not onth'
actual capital structure, and there is no reason to think that a target mq
ket value stnrcture would be any less stable than a targei book vaiue shs
ture. in fact. as we discuss in Point 9 below, target market value
are probably more stable than target book weights.
il
9. Now consider a fairly typical situation. Firm X currently has a
tlebt/equiiy ratio at book, and a 33/67 ratio at markei. It t.rrgets on lh
book value ratio. Several years go by. The company takes on proiectswttr.
positive NPVs, and that raises iis market value above its book value.AIsQ
inflation occurs, so new assets cost more. Output prices are based on mi''
ginal costs, which have risen because of inflation. With the new hi$f
[rices,
the rate of return on old assets increases, as does the valueoftr
old assets, ancl the firm's stock price rises. Book values per share arert'b
tively stable, so the increasing stock price leads io an increase in the ml'
even to increasc, even thirugh thr' firm finances on a 50/50 book basis ,'
10. Note also thirt, untler our sce'ntrrio, the rising ROE n,ill lead to impmrd
kr.t/-book ratio. DeLrt values, 6n the oiher hand, remain close to book.
Rt
ing stock prices, whc'n combiuec-l with stable boncl prices, coLIItl cause.th
nrarkct valrr.. tlebt/c.tluity ratio to remain constani at the 33/67
lerel,d
coverage ratios. This faci, together with a'nalysts' knorvletlge
th.rl
tlt
firm's book values arc' un.lerstitecl, lvill support an incrc..rse in ihe debr
rr
tirr me.rsurecl at Lrook
What can rve concluclt from all this? We are absoltrtelv conr ir.tcr'ti th.lt
firtr'
shoulcl focus on nrarkct lalue capital structures arrd has.' thcir cost of caPY,
)
calctrl.rtions on target market 'n'al,te rveights. Bec.ruse m.rrket valttt's clt-r
440 Chapter 11 CAPITAL STRUCTURE DECISIONS: PART It
managed fim.
essary in the arbitrage proof.
in the chapter support or refute Gordon's position?
Problems
Tampa's ownere expeit that the total bo6k and markei value of the firin,s stoit ,
if it
zero debt, would be $10 million.
a. Estimate the beta of an unleveraged firm in the comuter airline brrsiness
faxair's
market-determined beta. (Hine
Jaxair's market-determined beta is a
beta. Use Equation 11-6a and solve for br.)
r There are clearly benefits to dett financing, but firms should
use
amounts of debt depending on their tax rates, asset structures,
x11i
risks.
r Wide variations in capital structure exist, both across industries
anai
individual firms within industries. The variations across industrili
explained to a- large extent by the economic fundamentals
of thel
Variations within industries also reflect fundamental differences,
I
additionally reflect differences in managers' attitudes toward
debi
r The optimal capital structure should be thought of in market value
than book value terms, even though nranagers often focus on book
v
Questions
11-1 Define each of the following terms.
a. MM Proposition I without taxes; with corporate taxes
b. MM Proposition II without taxes; with coiporate taxes
c. Miller model
d. Financial distress costs
e. Agency costs
f. Trade-off model
g.
4rymmetric
information, or signaling, theory
h. Hamada equation
i. Reserve borrowing capacity
7l-Z Explain why agency costs would probably be more of a problem for a larqe,
owned firm that uses both debt anil equity capital than for'a small, unteverafe
Qtrcstions/Probhms {{1
d. Calculote Air Tamp.r'5 k and financill risk
lrronriurn
at $(r rlillion tlcLrt lssumin$ its
t'ederal-plus-state tax rate is norv
.l0
p!'rccnt. Conr[r.rrt this rvith vour corrcsponding
answer to Part c. (Hint: The incroasc irr the tax rnte c.rus!.s Vy to drop to $ti million.)
Complnics U antl L are itlcrrtical in cvr,rv resprct c\dcpt thit U is urrlclcrag,rd s'hilc L h.rs
ti10 million of 5 pcrcent bontls outsLrntliug. Assumt' (l
)
lh.rt .rll of tlrr MM assurrptions .rre
met, (2) that thcre are no corporatc or pcrson.rl t.rxes, (3) that Etll't is $2 million, .rntl
(4) th.rt thc cost of t'quity to Conrp.rny U is 10 perccnt.
a. What value lvould MM cstimatr. for orclr firnr?
b. What is k. for Firm U? For Firm L?
c. Fincl Sl, and thcn show th.rt Ss + D =
Vr
= $20 nrillion.
d, What is the WACC for Firm U? For Firnr L?
e. Suppose Vu
= $20 million anrl Vl_
= $22 million. According to NIiII, do thcse r'.rluc.s
represent an eqtrilibriunr? If not, cxpl.rin thc prroccss bv rvhich eqrrilil,rirrm rvouH be
restored.
Refer to Problem ll-2. Assume that all the facts lrolcl, c\ccpt that both firnrs.rrr subject to
a 40 percent federal-plus-statc corporatc tax ratc.
a. What value woultl MM nolv estim.rte for e.rch firnr? (Use Proposition I.)
b. What is k for Firm U? Firm L?
c. Find Sp and then show that SL + D
=
VL rcsults in thc samr. valuc as obt.rincd in I'.rrt a.
d. What is the WACC for Firm U? For Firm L?
Refer to Problems 11-2 and l1-3. Assunlo tlrat all facts irold, c-xcept th.rt both corpr:rrte anci
personal taxes apply. Assume that both firms nrust pJ)'.r fericral-plus-st.rte corporrtc tax
rate of T.
=
40%, and th.rt investors in both firms facr' .r tax rate of TJ =
28'li, on dr.bt incomr.
and T.
=
20')r", on average, on stock inconre.
a. What is the value of thc unleveragcri firm, Vg? (Notc that Vg is norv rctluced [ry tht
personal tax on stock income, henct Vu + $12 million as in Problem 11-3.)
b. \4trhat is the value of Vs?
c. What is the
Bain
from leverage in this situation? Conrpare. this u,ith the g.rin from lc'r'er-
age in Problem 11-3,
d. Set T.
=
T"
=
Ta
=
0. What is the value of the leveraged firm? The' gain from lererage?
e. Now suppose
\ = Tu
=
0. What aro the value of the levcragcd firm and the gain from
Ieverage?
f. Assume that T,l
=
28"i", T,
=
269l, and T.
=
{09;. Nrrrv rvhat are the value of the lei.er-
aged firm and the gain from leverage?
International Associates (tA) is just about to com,rcnce operations as an intemation.rl
trading company. The firm will have book assets of $10 million, arrd it expects to earn a 16
percent return on these assets before taxes. Horvevcr, because o[ certain tilx arr.rngements
with foreign governments, IA rvill not p.ry any taxr.s; th.rt is, its tax rate will bc zero. irlan-
agement is trying to dccide hou' to r.risc the' rc.cluirr'r1 510 rnillion. lt is knou'n that the cap-
italization rate for an all-equity firm irr this business is l1 pcrcent, that is, ku =
119;. Fur-
thec IA can borrow at a rate kd
=
6')/.. Assume that thL' lvlM assunrptions apply.
a. According to MM. wh.rt rvill be the r'.rlue of lA if it uses no ciebt? If it ust's 56 milliur
of 6 percent debt?
b. What are the values of the WACC and k. .rt c{cbt le'r'els of D
= $0, D
= $6 million, and
D
= $10 million? Wlrat effect docs lcverage havc on firm value? Why?
c. Assume the initial facts of the problem (k.r
=
6'i1,, EBIT
= $1.6 million, k.u
=
11'li,), but norv
assume th.rt a +0 percent federal-plrrs-state corpor.rte tax rate cxists. Find tlrc nerv mar-
ket values for IA with zero debt anrl with $6 nrillitrr of dcbt, using the NINI formulrs.
d. What are the values of the IVACC arrd k, at debt levels of D
= $0, D= 56 million, antl D =
$10 million, assunring a 40 percerrt corporate lax r.rtc'? Plot the rel.rtionships brtrveen the
value of the firm and the debt ratio, and betrveen cal,ilal costs and the debt ratio.
e. lVhat is the maximum dollar amount of debt firrarrcing that can be usecl? lVh.rt is the
value of the firm at this rlebt level? What is the. cost of this tlcht?
f. Horv lvoult{ each of the foliowing f.rctors tend to ch.rnge the valrrcs vou plotted in vour
graph?
(1) The intercst rate on deLrt increases.rs the tlc.bt ratio rises.
(2) At hiBllcr levels of clcbt, thc prob.rlrilitt, ol iinancial clistress riscs.
Until recently, d1e PreskrFino Conrpaly carrieci a triple-A bturl r.rting .rnd 6'.15 5t1png in
every rcspr'ct. Horvcvcr, a serics trf pr()hl('nls h.rs aftlictt'tl tlrr' firm: It is ctrrrtrrtlv irr sc-
vere financial distrcss, and its ability to m.rke itrturc
Fnvnrcnts
on outst.rndinr del)t is
11-3
.
Explain,.verbally, howlvlM use the arbikage process to prove the validity of
I. Also, list the maior MM assumptions and explain why lach of these assump
17-Z
without
Taxes
11-3
CorPorate
Taxes
11-4
Miller Model
11-5
ild without Taxes
t7-5
At,ncy Costs
l1-4 A utility company is supposed to be allowed to charge prices high enouqh to ()r
costs, including its cost of capital. Public sen'ice commiisions are slpposed-to take a
to.stimulate companies-to operate as efficiently as possible in ordei-to keep cosb,
prices, a.s low as-po-ssible. Some time ago, AI&T's debt ratio was about 33
i:ercmt
pe_o{e (Myron
J.
Gordon, in particulai) argued that a higher debt ratio'would
AT&T's cost of.capital-and permit it to charge lower rates ior telephone service. G
thought an optimal debt ratio for AT&T waiabout 50 percent. Do'the theories pre
7t-1
Business and Financial
Risk: Market
Air Tampa has justteen incorporated, and its board of directors is currently grapl
with the question of optimal capital structure. The company plans to offer commutt
services between Tampa and smaller surrounding cities.
Jaxiii has been around fora
years, and it has about the same basic businessiisk as Air Tampa would have,
markeFdetermined beta is 1.8, and it has a current market value debt ratio (total
tal assets) of 50 percent and a federal-plus-state tax rate of 40 percent. Air Tampa
exl
only to.be marginally profitade at startup, hence its tax rate woutcl only be 25 p;rcent
b
c
Now assume that ksp
=
197. xn6 Ltrr
=
15%. Find the required rate of rL.trlrn on
an unleveraged commuter airline. What is the businesi risk premium for this
Air Tampa is considering three capital structures: (1) $2 nrillion cl(,bt, (2) $l
n
debt, and (3) 95 million debt. Estimate Air Tanrpa's k for thcse delrt lcvcls. lVhat
financial risk premium at e.tch level?
{42 Chapter 11 CAPI'IAL STRUCTURE DECISIONS: PART Il
questionable. If the firm were forced into bankruptcy at this time, the common
liolders would almost certainly tre wiped out. Although the.firm has limited finan,
sources, its cash flows (primaiily from depreciation) are sufficient to suPPort
one
mutuallv exclusive inveitments, each costing $150 million and having a l0-year
er
I;f. rhmp nrnip.ts have the same market risk, but different total risk as measurp.l
life. Thele proiects have the same market risk, but different total risk as measured
variance ofrefu*r. Each proiect has the following after-tax cash inflows for 10 yr
Questions/Problems
443
Spreadsheet Problem
Work this probletu only if you are using the computerized problem diskette.
TJse the model in File C11 to solve this problem. The Brandt Corporation is an mleveraged
firm, and it has constant expected operating earnings (EBIT) of $2 million per year.
Brandt's federal-plus-state tax rate is 40 percent, its cost of equity is 10 percent, and its
market value is V
=
S
= $12 million. Management is considering the use of debt which
trvould cost the firm 8 percent regardless of the amount used. (Debt wotdd be issued and
rrsed to buy back stock, so the size of the firm would remain constant.) Since interest ex-
pense is tax deductible, the value of the firm would tend to increase as'debt is added to
ihe capital structure, but there would be an offset in the fom of rising risk of financial dis-
tress. The firm's analysts have estimaied, as an approximation, that the present value of
any future financial distress costs is $8 million, and that the probability of diskess would
increase with leverage according to the following schedule:
Value of Debt Probability of Distress
$ 0 0.0%
2,500,000 2..5
5,000,000 s.0
7,500,000 10.0
10,000,000 25.0
12,500,000 50.0
15,000,000 75.0
a. According to the "pure" MM with corporate taxes model. what is the optimal level of
debt? (Consider only those debt values listed in the table.)
b. What is the optimal capital structure when financial distress costs are included?
c. Plot ihe value of the firm, with and without financial distress costs, as a function of the
level of debt.
d. Assume that the firm's unleveraged cost of equity is 8 perceni. What is the firm's opti-
mal capital stmcture now? (From this point on, include financial distress costs in all
your malyses.)
e. Return to the base-case lqg of 10 percent. Now assume that the firm's tax rate increases
to 60 percent. What effect does this change have on lhe firm's optimal capiial structure?
f. Reiurn to the base-case tax rate of 40 percent. Assume that the estimated present value
of financial distress costs is only $5 million. Now what is the firm's optimal capital
structure?
Annual Cash Inflows
Project A Prcject B
$30.000,000 $10,000,000
35,000,000 50,000,000
11-8
MM with Financial
Distress Costs
makint a decision that is contrary to their interests?
f. Who biars the cost of this "proteition"? How is this cost related to leverage and
timal capital structure?
Probability
0.5
0.5
analvses:
Interest rate (%) 8.0 8.3
Cost of equity (%) 12.0 1?.25 12.75
71-7
MM with Financial
Distress Costs
Federal-plus-state tax rate =
407o.
Dividend paYout ratio
=
100%
Cunent required rate of return on eqtity =
12'1".
The cost of capital schedule predicted by Mr. Harris follows:
At a Debt Level of (Millions of Dollars)
$2 $4 $6 $s $10 $12
EBIT
= $4 million per year, in perpehrity.
9.0 10.0 11.0 13.0
i3.0 13.15 13.4 14.65
9ase
.Cheney, the CEO of Cheney Electronics, is con-
about
his firm's level of debI financing. The com- Ms. Broske estimated the
Present
value of financial distress costs at $8 million'
ally, she estimated the following probabilities of fhancial distress: short-term debt to finance its temporary work-
tal needs. but it does not use any permanent
m) debt. Other electronics comp.mies average
Percent debt, and Mr. Cheney wonders why the
t occurs,
and what its effects are on stock prices.
some
insights into the matter, he poses the !ol-
questions
t6 vou, his rccently hired issistant:
ress-lVerk
reiently ran an irticle on companies'
(MM) were mentioned several times as leading re-
searchers on the theory of capital structure. Briefly,
who are MM, and what assumptions are embedded in
the MM and Miller models?
b. Assume that Firms U and L are in the same risk class,
and that both have EBIT = $500,000. Firm U uses no
debt financing, and its cost of equity is lq,
=
14%. Firm
L has $1 million of debt outstanding at a cost of k3
=
8%. There are no taxes. Assume that the MM assunip-
tions hold, and then:
(1) Find V, S, k., and WACC for Firms U antl L.
At a Debt Level of (Millions of Dollars)
$0 $2 $4 $6 $8 $10 $12
Probability of financial clistress 0 0 0.05 0-07 0.10 0.77 0'47
a. What level of debt would Mr. Harris and Ms. Broske recommencl as oPtimal?
b. Comment on the similarities and differences in their recommendations'
)
policies,
and the names Modiglirni and-Miller
4114 Chapter 11 CAPITAL STRUCTUITE DECISIONS: I,ART II
d. Now suppose investors are subiect to the following tax
rates: T6
=
30% and T,=12%.
(1) What is the gain from leverage according to dre
Miller model?
(2) How does this gain compare to the gain in the MM
model with corporate taxes?
(3) What does the Miller model imply about the effect
of corporate debt on the value of the firm, that is,
how do personal taxes affect the situation?
l,llhat capital structure policy recommendatir
three theories (MM without taxes, MM with
taxes. and Miller) suggest to financial mana
pirically, do firms appear to fottow any onJoi
guidelines?
What are financial distress and agency costs?
does the addition of these costs change the
Miller models? (Express your ansrver in w61
equation form, and in graphical form.)
^i
How are financial and business risk measupt
market risk framework?
i
Selectcd A(.lditionnl llcf!.rcucL,s arrrl Cascs 445
Ghosh,
-Dilip
K., "Optimum
Capital Stnrcture llctlcfincrl,,, Firrrrrrci,rl llcuir,1,, Autust 1992,
117429.
Kelly, william A-
Jr,
a.d
James
A. Miles, "Capital structurt'Theory and thc Fisrrer Effect,,,
The Fiutncial Rei,ictl Fcbruary 1989, 5!73.
Lee, Wayne Y- arll H:,].y H. Barker,
-Bankruptcy
Costs a.d thc Firm,s Optimal Debt Ca_
pa-cityj A_Positivr Tht'ory of Capitar stmcturri," soutrvnt Er:onouic
lttuittrr, April 1977,
1{53-1{55.
IVackie-Maso.,
Jeffrey K., "Do Taxrs Affcct Corptrratc Firr.rncirrg Decisions,,'/orr,nr o/Fi
nanc?, December 1990, 1.171-1493.
Martin,
John
D., and Davi.l F.,Sr-otr,
,,Dcbt
Clpacill a1d rhe Capital Budgering Decision:
A Revisitation," Finmcinl Managtrnrlt, Spring 19-g0, 23_26.
,t,i1:..r:,Y::l:l
I,
"The Modigtimi-Millu^propositir>ns
aftcr Thirty
years,,.
lournot
of Ap_
Ittt&l
Lorporntu tl,xil,cc, Spring 19S9, GtS.
..........'...._.
"Leverage,"
lournnl of Fimtcc,
Junt,
1991, 429-{Sg.
Pincgar,
J.-Michael,
a.d Lis.r wilbricht, "wh,rt Nl.rnagcrs Think of Capital structure Thc-
ory: A Survey," Fittttrciil Managctrrcrrl, Winter l9g9;S2-91.
scherr, rrederick C., "A l\'lultiperiod Mean-Variancc Mode I of optimal Capital structurc,,,
Tht Fintttcinl R(?,i(io Fcbruary 19S7, l-31.
Schncller, Meir 1., "Taxcs antl thc optimal Capital stnrctur!. of the Firm,"
/olrrnn
I of Fittrutct',
March 1980, 119-127.
Tag_gart, Robert A.,
Jr,
"Taxcs and Corporatc Capital St^tcturc in .rn Incomplttc Market,,,
lournnl
of Finance,
June 1980, 6.1'659.
Tlrakor, Anjan V, "Stratt'gic Issues in FinancLrl Contr.rcting: An Ov.rvicw,,, Fbnncial Matr
cgenrcrl, Summer 1989, 39-58.
TharL, hts bct cotrsitlrtblt rlisclssirrr in llt littnturt corrccrrrlt n fitnucinl leterate tlitnlclc cf-
Jtct.
Mntry theorists po;tulltt thnt
lirns
ruith loLu lq,t'rny rt
1ni,irt,i
by ltgi,-r,i* rrrn",*.i iri,,rrir'r,
and oicc larsil. Ttoo articlcs ott this strbjtct nrt
Harris,
John1V1., Ir.,.
Ro_lyy L. Roenfcldt, anci
philip
L. Coolev
,,Evidcnce
of Financial
Leverage Clienteles,"
louuul ol Fitnncc, Scprernbei 1993, 1125_1132.
Kim, E. Han,,"Millcr's Equilibrium, Slrarclroklcr Lc'rr.rgc Clic.teles, and Optirn.rl Capital
Leverage,"
lourntl
of Finutte, May i9ti2, 301-319.
For a aery readablc tliscussion of tlu: nnny issrps irndz,.d itt (ttlital
structure thaory, sce
"A Discussion of Corporate Capital Structure,,, M,./la nd Coipornle Finnnce
lournil, Fal) 19g5,
19-48.
The Drydcn Press Cases in Financial Ma.agement: Dryden Request serias hns tha
fottoiuirs
casas tlnt apply to this clutpter:
Case Z
"Seattle Steel Prod'cts," Case 9, "Kleen Kar, Inc.,,, Case 10,
,,Aspeon
Sparkline Wa-
ter," Case 10A, "Mountain Springs," Case 108,
,,Gret;r
Cosmetics,,.'and iase +5.Y,Thc
ter," Case 10A, "Mountain Springs," Case 108,
,,Gret;r
Cosmetics,/and C^ase +S,",,fne
Wcstcm Company," focus on capit.tl stnrcture the()r)..
Westem Company," focus on capit.tl stnrcture theory
Case 8, "Jolmso'Window Company," and Case 8A,
,,lsh
Marine Boat Comparry,,, cor.cr
operating and financial leverage.
(2) Graph (a) the relationships between caPital.costs e'
and-leverage as measured by D/V and (b) the re-
lationship between value and D.
c. Using the dita given in Part b, but norv assunring that
Firms L and U are both subiect to a 40 perccnt corpo-
rate tax rate, rePeat the analysis called for in b(1) and f.
b(2) under the MM with-tax model"
h. What is the asymmetric information, or
ory of capital structure?
i. What is the "pecking order" theory oI
ture?
Selected Additional References and Cases
The botlv of literature on capitnl stnrcture
-and
the nurubcr of potential referatces
Tlwet'oie, only a sanrpling can be giz,en here. Fot an extensit'e rertiezo of tlrc recent li
zuell as .t,letailed bibliography, sce
Beranek, William, "Research Directions in Finance," Quartcrly
Reoieto of Btrsinrrs
norrics, Spring 1981, 6-24.
Tle nmjor tlrcoretical u,ork on capital structure tlrcory are discussed in an integrated
Copelanct, Thomas E., and
l.
Fred Weston, Financial Thaoty and Corpornte Policy (l
Mass.: Addison-Wesley, 1988).
Harris, Milton, and Artur Raviv "The Theory of Capital Structure,"
Journal
ol
March 1991, 297-355.
The Falt L988 rssue o/The
]ournal
of Economic Perspectives and tlrc Swmut 7989 i
nancial Managemeit esch contain seaeral intetcsting and oery readable articles wlich
MM proposit'to7s after 30 years of debate and teslins.
i
In addition to Mitler's wotk, the effect of personal taxes on capital strtrcture decisions
dressecl by
Gordon, Myron J., and Lawrence I. Gould, "The Cost of Equity CaPital with Perso
come Taxes and Flotation Costs," l
ow nal of F i nan c e, Stp tembcr 797 8' 1707-1ZlL
Bradlev, Michael, Cregg A. Jarrell, and E. Han Kim, "On the Existence of an O
ital
'itructure:
Theo-r-y ancl Evidence,"
lournal
of Finnnce,
Jily
1984, 857-a78'
Conine, Thomas E.,
Jr,
"Debt Capacity and the Capital Budgeting Decision:
F inarcial Manage,rtenf, SPring 7980, 2W22.
Flath, David, and Charles R. Knoebec "Taxes, Failure'Costs, and OPtinlal
tal Structure," lournnl
of Finmce, March 1980,89-117.
Crutchley, Claire E., and Robert S. Hansen, "A Test of the
fSelcy ]lreory 9l
Ou*.drship, Corporate Leverage, and Corporate Dividends," Finnncinl )
Winter 1989,36-46.
Dugan, Michael T., and Keith A. Sfuiver, "An EmPirical Comparison of Altemative,
'3dr'fo.
Estimaiing the Degree of Operating L""utog","'Fittrtncial ReeicitL
l"lll
309-321.
Ferri, Michael, and Wesley H.
Jones,-"Deteminants
of Financial Structure:
A
---M"ti-aoto[i.alApproai'h,"]oirnnlofFimnce,lune1979,631-6{{.'i
446 Chapter 11 CAPITAL STRUCTURE DECISIONS: PART II
6,rtensions
ADDITIONAL MM
PROOFS
In Chapter 11, rve presented the proof for MM's Proposi
tion I inder the assumption of no corporate taxes. How-
ever, the remaining propositions were presented without
proofs. We present those proofs in this extension.
PROOF OF MM PROPOSITION II WITHOUT
CORPORATE TAXES We noted in Chapter 11 that
Equation 11-3 could be used to find the value of a firm's
common stock for a zero growth comPany. Here is Equa-
tion 11-3 rearranged to solve for
\
with T
=
0, and substi-
trrting k.1 for k" to denote the use of leverage:
, EBIT
-
k.,D
*"t=--
S
(
g, we obtain
,
(EBrT
-
kdDxl
-
T)
*,,_ =
-- s.
-
y,
=!EJI0-J).*1p.
Ku
be rewritten as
Vrlqu =
EBIT(1
-
T) + LiuTD,
as
. EBrT(1 -
T)
-
kdD(1
-
T)
k,=ffi.
(11E-5)
be rewritten as
I, Equation 11E-4, we know that
Extensions 447
and recognize that V1
= $ n
p,
nnd substitute for V1 in the
preceding equation:
n.,
_
(S + D)k.u
-
TD\,u
-
kaD + TDko
"-
sL
_
Sk"u + Dksu
-
TDk"u
- kdD + mkd
S
_
Sku
.
Dk.u
-
TDk,u
-
kdD + TDkr
SS
= lq, + (lqg
-
Tk,u
-
ka + TkJP,
5
or
Lr = k,u + (lcu
-
krxl
-
TXD/S). (11-2a)
This last expression is the equation set forth in MNl's
Proposition II, hence we have proved the proposition.
(11-3b)
(11-3a)
From the Proposition I equation, plus the fact that V
=
S +
D, we can write
v=s*P=EBIT
k.u
This equation can be rearrdnged as follows:
P311= lqr(S + D).
Now substitute this expression for EBIT in Equation 11-3a:
. k,
(s - D)
-
kdD
KuS .
k,uD k"D
cr=----
s-= s
*
s
-
s.
Simplifying, we obtain this cxpression:
k'r= k,u + (}cu
-
kaxD/s). (11-2)
This is the Proposition II equation we sought to
Prove.
PROOF OT MM PROPOSITION I WITH
CORPORATE TAXES MM originally used an arbi-
trage proof similar to the one we gave in Chapter 11 to
prove Proposition I without corPorate taxes, but their
points can'be confirmed with a dimpler alternate proof.
First, assume that th'o firms are identical in all respects
except capital structure. Firm U has no debt in its caPital
srruitrrre, lvhile L uses debt. Expected EBIT and 66s11 nra
identical for each firm.
Under these assumptions, the operathg cash flows
available to Firm U's investors, CFrr are
CFr= t31111
-t,.
and the cash florvs to Firm Us investors (stockholders and
br:ndholders) are
CF1.
=
(EBIT
- fuD)(1 -
T) + krD (11E-2)
Equation 11E-2 can be rearranged as follows:
CFt= 531111
-
T)
-
kdD + kdD +TkdD
=
EBIT(I
-
T) + TkdD
Tk6D, represents the tax savings, and hence the;
operating income, that is available to Firm Us
because of the fact that interest is iax deductible.
The value of the unl,evered firm, Vg, may be
mined by capitalizing its amual net income after
rate taxes, CFu =
EBIT(I
-
1), at its cost of equity:
., CFu EBIT(I
-T)
" k.u k.u
,,
EBIT(I
-
T) Tk.,D EBIT(I
-
T)
. _^
vI
=.----:-f -;-=-f tU.
-
k., kd krr
.
(EBrT
-
k.1DX1
-
T)
JL=--_-
.-
EBIT(1
-T) =
(VL- TD)lqu.
substitute
this expression for EBIT(1
-
T) in
77E-5:
,
(vL
-
TD)ksu
-
k.,D(l
-
T)
qt=
s
_
V.k.r
-
TDlqr
-
k.D + TOk.
S
pressed in Equation 11E-2a. MM argue that becaus
"regular" eamings stream is precisely as risky as tl
come of Firm U, it should be capitalized at the sam{i
The value of the levered fim, on the other hand, is
by capitalizing both parts of its after-tax cash flows
k.u. However, they argue that the tax savings are
certain-these savings will occur as long as intr
the debt is paid, so the tax savings are exactly as
the firm's debt, which MM assume to be riskless
fore, the cash flows represented by the iax savings
be discormted at the risk-free rate, k6. Thus, we
Equation 11E-4 for Firm L"s value:
Since the first term in Equation 11E-4, EBIT(I
-
identical to Vu in Equation 11E-3, we may also
as follows:
Vr= Vu+TD.
Equation 11E-4a is MM's Proposition I with
(
taies. Thus, we see that the value of the levered
ceeds thai of the unlevered company, and the
increases as the use of debt, D,
Boes
up.
PROOF OF MM PROPOSITION II W
(11E-1) CORPORATE TAXES The value of a levered
equity may be found using of Equation 11-3 in
as follows:
)
=
CFu + TkuD.
i
The first term in Equation 11E-2a, EBIT(I
-
T), is id
io Firm U's net income, CFu, while the second