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Graduate School of Business and Law

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BUSM4160 Managerial Finance


Topic 9: Capital Structure
Overview
1. Introduction to capital structure decisions
2. Modigliani and Miller propositions I & II
3. Debt and taxes
4. The trade-off model
Equity
Debt
Firm value

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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

How much debt should a firm have?


What happens to cost of capital, rA, and cost of
equity, rS, as we increase the proportion of debt?
What happens to the value of the firm as we
introduce more and more debt?
Optimal debt-to-equity ratio is reached when rA is
minimised and therefore V maximised
How can we minimise costs of capital & maximise
firm value?

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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)

firm relies on debt.


The higher the
reliance on debt, the
higher the financial
leverage.
Can dramatically alter
the payoffs to
shareholders. Why? Q: Why does the cost of capital go up
with increases in leverage?

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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.

EPS= Net Income (NI) / #Shares


ROE = NI / Value of Equity

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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

So, if capital structure matters:


How should a firm decide on its capital, so that
it can minimise its WACC (i.e. cost of capital)
and maximise the value of the firm (maximise
shareholder value)?
First question to examine:
Does the level of debt in relation to equity have
an impact on the overall value of the firm?

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2. Modigliani and Miller propositions

Theory helps us to answer the capital structure


questions
Capital structure theory was first initiated by
Modigliani and Miller (MM) in 1958, advancing the
irrelevance concept.
Perfect capital markets assumptions by MM:
1. Securities are fairly priced.
2. There are no tax consequences, no asymmetric
information or transactions costs.
3. Investment cash flows are independent of
financing choice.
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2. Modigliani and Miller proposition I

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

In the real world, markets are imperfect, and the


firms capital structure can affect the corporate
taxes it must pay:
Corporations can deduct interest expenses from
their taxable income.
The deduction reduces the taxes paid which
increases the amount available to pay investors
(interest tax shield).
In doing so, the interest tax deduction increases
the value of the corporation.
Interest tax shield = Corporate tax rate * Interest payments

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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

Shareholding 10% 10%


Shareholders dividend income $3.00 $2.40
Debtholding 10% 10%
Debtholders interest income $0.00 $1.00
Total distributed $3.00 $3.40

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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

In the real world, markets are imperfect, and the VL > VU


VL = VU + interest tax shield
VL = VU + ( Tc D)

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

. So, should the firm have 100% debt?


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3. Debt and taxes
Should the firm have 100% debt?
The MM theory can be extended to incorporate
personal taxes, bankruptcy and agency costs.
Cost of equity increases as soon as debt is
included (adding financial risk).
Debt is at first cheaper than equity because of tax
deductibility of interest, but debtholders also incur
costs if the firm is wound up.
Therefore they demand a higher rate to
compensate for expected bankruptcy costs and
agency costs.

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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!

Stockholders may pursue selfish strategies:


Take large risks
Underinvest
Payout excessive dividends

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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.

Here, the total value of a levered firm equals the


value of the firm without leverage plus the present
value of the tax savings from debt, less the present
value of financial distress costs:

VL = VU + PV (interest tax shield) PV (financial distress costs)

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4. The trade-off model

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4. The trade-off model

The trade-off theory states firms should increase their


leverage until it reaches the maximising level.
At this point, the tax savings that result from increasing
leverage are just offset by the increased probability of
incurring the costs of financial distress.
With higher costs of financial distress, it is optimal for the
firm to choose lower leverage.
So, how do we calculate the optimal point? We cannot.
Theory of capital structure does highlight the importance of
taxes and costs associated with financial distress but cannot
precisely estimate the true costs of financial distress.

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4. The trade-off model

The trade-off theory states firms should increase their


leverage until it reaches the maximising level.
The trade-off theory helps to resolve two important facts
about leverage:
1. The presence of financial distress costs can explain why
firms choose debt levels that are too low to fully exploit
the interest tax shield.
2. Differences in the magnitude of financial distress costs
and the volatility of cash flows can explain the differences
in the use of leverage across industries.

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4. The trade-off model

Observed capital structures differ by industry


Differences according to Cost of Capital 2003 Yearbook
by Ibbotson Associates, Inc.:
Lowest levels of debt
Drugs with 2.75% debt
Computers with 6.91% debt
Highest levels of debt
Steel with 55.84% debt
Department stores with 50.53% debt

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5. The pecking order theory

Pecking order theory provides an alternative


explanations as to how observed debt levels can be
explained:
Firms prefer to issue debt than equity if internal finance is
insufficient.
Rule 1: Use internal financing first
Rule 2: Issue debt next, equity last
Pecking-order Theory is at odds with MM trade-off theory:
There is no target B/S ratio
Profitable firms use less debt
Companies like financial slack

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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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