327 - Discussion 5
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Ch13.CapitalStructurePolicy.pptxCapital Structure Policy
Chapter 13
Learning Objectives
Understand the difference between business risk and financial risk.
Use the technique of break-even analysis.
Understand capital structure theories.
Business Risk
Business Risk is the variation in the firm’s expected earnings attributable to the industry in which the firm operates.
Determinants of business risk:
The stability of the domestic economy
The exposure to, and stability of, foreign economies
Sensitivity to the business cycle
Competitive pressures in the firm’s industry
Operating Risk
Operating risk is the variation in the firm’s operating earnings that results from firm’s cost structure (mix of fixed and variable operating costs).
Earnings of firms with higher proportion of fixed operating costs are more vulnerable to change in revenues.
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Operating Leverage
Operating leverage is the change in EBIT caused by a change in quantity sold.
The higher the proportion of fixed costs relative to variable costs, the greater the operating leverage.
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Higher operating leverage leads to more business risk: small sales decline causes a larger EBIT decline.
Sales
$
Rev.
TC
F
QBE
EBIT
}
$
Rev.
TC
F
QBE
Sales
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Operating Breakeven
Q is quantity sold, F is total fixed cost, V is variable cost per unit, TC is total cost, and P is price per unit.
Operating breakeven = QBE
Let EBIT=PQ-VQ-F= 0
QBE = F / (P – V)
Example: F=$200, P=$15, and V=$10:
QBE = $200 / ($15 – $10) = 40.
Financial Risk
Financial Risk is the variation in earnings as a result of firm’s financing mix or proportion of financing that requires a fixed return.
Additional business risk concentrated on common stockholders when financial leverage is used.
Capital Structure Theory
MM theory
Zero taxes
Corporate taxes
Corporate and personal taxes
Trade-off theory
Signaling theory
Pecking order
Debt financing as a managerial constraint
Modigliani-Miller (MM) Theory: Zero Taxes
| Firm U | Firm L | |
| EBIT | $3,000 | $3,000 |
| Interest | 0 | 1,200 |
| NI | $3,000 | $1,800 |
| CF to shareholder | $3,000 | $1,800 |
| CF to debtholder | 0 | $1,200 |
| Total CF | $3,000 | $3,000 |
| Notice that the total CF are identical for both firms. |
MM Results: Zero Taxes
MM assume: (1) no transactions costs; (2) no restrictions or costs to short sales; and (3) individuals can borrow at the same rate as corporations.
MM prove that if the total CF to investors of Firm U and Firm L are equal, then arbitrage is possible unless the total values of Firm U and Firm L are equal:
VL = VU.
Because FCF and values of firms L and U are equal, their WACCs are equal.
Therefore, capital structure is irrelevant.
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MM Theory: Corporate Taxes
Corporate tax laws allow interest to be deducted, which reduces taxes paid by levered firms.
Therefore, more CF goes to investors and less to taxes when leverage is used.
In other words, the debt “shields” some of the firm’s CF from taxes.
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MM Result: Corporate Taxes
MM show that the total value to Firm L’s investors (VL )is equal to the total value to Firm U’s investor (VU )plus an additional amount due to interest deductibility (t*D).
Tax shield of debt= t*D, t=corporate tax rate, D=total debt
VL = VU + t*D
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Value of Firm, V
0
Debt
VL
VU
Under MM with corporate taxes, the firm’s value increases continuously as more and more debt is used.
TD
MM relationship between value and debt when corporate taxes are considered.
Miller’s Theory: Corporate and Personal Taxes
Personal taxes lessen the advantage of corporate debt:
Corporate taxes favor debt financing since corporations can deduct interest expenses.
Personal taxes favor equity financing, since no gain is reported until stock is sold, and long-term gains are taxed at a lower rate.
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Trade-off Theory
Capital structure is based on a trade-off between the tax advantage of debt and the costs of financial distress.
MM theory ignores bankruptcy (financial distress) costs, which increase as more leverage is used.
At low leverage levels, tax benefits outweigh bankruptcy costs.
At high levels, bankruptcy costs outweigh tax benefits.
An optimal capital structure exists that balances these costs and benefits.
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Costs of Financial Distress
What is financial distress?
Bankruptcy
Ch 7: Liquidation
Ch 11: Reorganization
Cost of Financial Distress
Direct Costs
Legal and administrative costs
Indirect Costs
Impaired ability to conduct business
Agency Costs
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Tax Shield vs. Cost of Financial Distress
Value of Firm, V
0
Debt
V = Actual value of firm
VU =Value of firm with no debt
Tax Shield=t*D
Distress Costs
VL=Value of firm with corporate taxes and debt
VL = VU + t*D
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Signaling Theory
MM assumed that investors and managers have the same information.
But, managers often have better information. Thus, they would:
Sell stock if stock is overvalued.
Sell bonds if stock is undervalued.
Investors understand this, so view new stock sales as a negative signal.
Pecking Order Theory
Theory stating that firms prefer to issue debt rather than equity if internal finance is insufficient
Internal equity is first choice, external equity is last
Based on asymmetric information
Rules
Use internal financing
Issue the safest security first (debt before external equity)
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Pecking Order Theory
Consider the following story:
The announcement of a stock issue drives down the stock price because investors believe managers are more likely to issue when shares are overpriced.
Therefore firms prefer internal finance since funds can be raised without sending adverse signals.
If external finance is required, firms issue debt first and equity as a last resort.
The most profitable firms borrow less not because they have lower target debt ratios but because they don't need external finance.
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Pecking Order Theory
Implications
Internal equity is “better” than external equity
Debt is preferred to external equity
Financial slack is valuable
No target debt/equity ratio
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Debt Financing and Agency Costs
One agency problem is that managers can use corporate funds for non-value maximizing purposes.
The use of financial leverage:
Bonds “free cash flow.”
Forces discipline on managers to avoid perks and non-value adding acquisitions.
A second agency problem is the potential for “underinvestment”.
Debt increases risk of financial distress.
Therefore, managers may avoid risky projects even if they have positive NPVs.
