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Intro: What is this topic about?
The name of the game is to add value
Main questions: How can we add value with financing
decisions?
For investment decisions we maximise value by taking all
positive NPV projects.
Therefore the optimal level of finance is to raise enough
funds to take all positive NPV projects.
Two questions:
Does capital structure matter?
Further, is there an optimal capital structure? Can we
create value by selecting the optimal mix of debt and
equity?
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1. Introduction to capital structure decisions
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1. Introduction to capital structure decisions
What is leverage?
The extent to which a Debt-to-value ratio = D / (E + D)
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1. Introduction to capital structure decisions
Why does debt dramatically alter the payoffs to
shareholders?
Firm leverage increases risk.
How does leverage affect payoff to shareholders?
Leverage amplifies the variation in both EPS
and ROE.
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1. Introduction to capital structure decisions
Why does debt dramatically alter the payoffs to
shareholders?
Firm leverage increases risk.
How does leverage affect payoff to shareholders?
Leverage amplifies the variation in both EPS and ROE.
Why?
Leverage increases your commitment to debt holders
In a really good year, we pay our fixed cost and we have
more left over for our shareholders
In a really bad year, we still have to pay our fixed costs and
we have less left over for our shareholders
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1. Introduction to capital structure decisions
What happens when we take on more debt?
EPS= NI / #Shares
ROE = NI / Value of Equity
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1. Introduction to capital structure decisions
What happens when we take on more debt?
EPS= NI / #Shares
ROE = NI / Value of Equity
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1. Introduction to capital structure decisions
What happens when we take on more debt?
EPS= NI / #Shares
ROE = NI / Value of Equity
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1. Introduction to capital structure decisions
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2. Modigliani and Miller propositions
MM Proposition I No taxes
In perfect capital markets, the total value of the
firm should not depend on its capital structure.
The total value of a firm is equal to the market
value of the free cash flows generated by its
assets and is not affected by its choice of capital
structure.
V L= E + D =V U
Value of the Value of the
LEVERED firm UNLEVERED firm
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2. Modigliani and Miller proposition I
MM Proposition I No taxes
The value of a firm is INDEPENDENT of its capital
structure.
N
Value of Firm A Value of Firm B O
Debt T
Equity 40% A
40%
X
Debt E
60% Equity
60% S
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2. Modigliani and Miller proposition I
MM Proposition I No taxes
The value of a firm is INDEPENDENT of its capital
structure.
N
Value of Firm A Value of Firm B
O
T
Equity
40%
Equity
100%
A
X
Debt
60% E
S
> Firm value remains unchanged.
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2. Modigliani and Miller proposition II
MM Proposition II No taxes
Given MMI, what happens to the cost of capital
(WACC) with increasing leverage?
If the cash flows are the same regardless of capital
structure then the required rate of return of the debt equity
portfolio should also be the same.
Since risk remains the same, as leverage increases the
required rate of return to shareholders increases
proportionally so that the total portfolio return remains the
same.
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2. Modigliani and Miller proposition II
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2. Modigliani and Miller proposition II
MM Proposition II No taxes
The cost of capital of levered equity is equal to the
cost of capital of unlevered equity plus a premium
that is proportional to the debt-to-equity ratio
(measured using market values).
Short: The WACC of the firm is not affected by
capital structure.
D
rE = r U + (rU rD)
E
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3. Debt and taxes
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Ass
3. Debt and taxes Example 1 tax ume
of 4 corp
0% ora
te
U L
Income available for distribution 50 50
Interest payments to debtholders Nil 10
Taxable income 50 40
Tax at 40% (to government) 20 16
Income available to shareholders 30 24
Total distribution (SH + DH + Gvt) 50 50
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3. Debt and taxes Example 2
Due to the interest tax shield more of the company's cash
flow is distributed
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3. Debt and taxes
Tax rate
Amount of debt
The higher the debt the higher the tax benefit for the firm
and the smaller the tax payable to the government.
The value of the firm increases with the size of the tax
shield.
This means once taxes are considered capital
structure does matter.
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3. Debt and taxes
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3. Debt and taxes
Should the firm have 100% debt?
With more debt, there is a greater chance that the
firm will be unable to meet interest payments and
will default.
A firm that has trouble meeting its debt obligations is
in financial distress and occurs direct and indirect
costs of bankruptcy.
These costs are borne by shareholders and can
make debt unattractive.
Debtholders also incur expected bankruptcy costs
and potential agency costs of debt.
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3. Debt and taxes
Agency costs: Costs that arise when there are
conflicts of interest between stakeholders e.g.
between investors and managers:
From Topic 1 Managers may make decisions that:
Benefit themselves at investors expense;
Reduce their effort;
Spend excessively on perks such as corporate
jets; or
Undertake wasteful projects that increase the size
of the firm (and their remuneration) at the expense
of shareholder value (empire building).
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3. Debt and taxes
Another example of agency costs
Agency cost of debt:
Conflict of interest between stockholders and
bondholders.
Stockholders are agents of bondholders.
Stockholders make the decisions!
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3. Debt and taxes
Another example of agency costs
Agency cost of debt:
When there is threat of financial distress /bankruptcy
stockholders may pursue selfish strategies:
Take large risks
Underinvest
Payout excessive dividends
These strategies are costly lower the market value
of the firm
Lenders may charge more for debt a cost.
Use of protective covenants may increase the value of the
firm.
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4. The trade-off model
The optimal capital structure can be seen as
a trade-off between tax benefits from debt
and bankruptcy and agency costs.
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4. The trade-off model
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4. The trade-off model
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4. The trade-off model
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4. The trade-off model
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5. The pecking order theory
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In summary
So, in response to the question posed at the start of
the lecture, Does capital structure matter?
The answer seems to be yes but in a number of
complex ways.
There are unlimited gross benefits of using debt
due to the tax system but the net benefits are less
clear-cut.
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End of Topic 9
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