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Capital Structure MM Theory 1

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Capital Structure “neither a borrower nor a lender be” (Source: Shakespeare`s Hamlet) “The firm`s mix of securities(long term debt & equity) is known as capital structure”. The issues that we seek to address here are: How does a firm select its capital structure (debt-equity ratio)? Shareholders want management to choose capital structure that maximize firm value. Is there an optimal capital structure ? 2

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Value and Capital Structure Consider simple balance sheet, with all entries expresses as current market value. 3 Assets Liabilities and Stockholder’s Equity Value of cash flows from firm’s real assets and operations Market value of debt Market value of equity Value of Firm

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Average Book Debt Ratios 4

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M&M (Debt Policy Doesn’t Matter) Modigliani & Miller ▫When there are no taxes and capital markets function well, the market value of a company does not depend on its capital structure. In other words, financial managers cannot increase value by changing the mix securities used to finance the company. ▫MM`s proposition or MM debt irrelevance proposition states that “under ideal conditions the firm`s debt policy shouldn`t matter to shareholders”. 5

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M&M (Debt Policy Doesn’t Matter) Assumptions Capital markets have to be “well functioning” – Investor can borrow and lend money on the same terms as the firm. – Capital markets are efficient Capital structure does not affect cash flows, if – No taxes – No bankruptcy costs – No effect on management incentives 6

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M&M (Debt Policy Doesn’t Matter) 7 Example - River Cruises - All Equity Financed

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M&M (Debt Policy Doesn’t Matter) 8 50% debt Now restructuring occurs with equal distribution of debt & equity.

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M&M (Debt Policy Doesn’t Matter) 9 Example - River Cruises - All Equity Financed - Debt replicated by investors

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M&M (Debt Policy Doesn’t Matter) 10 Example - River Cruises – Firm debt at 50% - Investor can unwrap debt - $10 invested in share & $10 lend at 10%

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Capital Structure(Definition) Operating Risk (business risk) – Risk in the firm’s operating income. Financial Risk - Risk to shareholders resulting from the use of debt. Financial Leverage - Increase in the variability of shareholder returns that comes from the use of debt. 11

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Cost of Capital a 12 MM`s proposition 1 states that firm`s capital structure does not effect firm`s operating income or value of its asset, but it affects the financial risk of firm. e.g. From previous example following are the returns: With all equity financing return was 1.25/10 =.125 = 12.5% With debt-equity structure return was 1.50/10 =.15 = 15%

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River Cruises`s Return on assets 1.12.5% is the expected return from all equity investment. 2. Expected return on leveraged firm: Expected return on equity = r equity =.15 = 1.50% Return on debt = r debt =.10 = 10% Overall return is: (.5 x.10) + (.5 x.15) =.125 = r asset r assets = ( r debt x D/V ) + ( r equity x E/V ) So total return on both structure remains same. Here is formula for expected return from leveraged firm. r equity = r assets + D/E (r assets -r debt ) 13

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River Cruises`s Cost of Equity River Cruise with all equity r equity = r assets = expected operating income market value of all securities = 125,000/1,000,000 =.125 = 12.5% r equity = r assets + D/E (r assets -r debt ) =.125 + 500,000/500,000 (.125-.10) =.15 = 15% Debt increase the return but also increase the financial risk & cause shareholders to demand higher return on their investment. Once you recognise this cost, debt is no cheaper than equity. 14

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MM’s Proposition II (w/fixed interest rate) 15 r DVDV rDrD rErE rArA Debt-Equity ratio, D/E Rates of return, percentage MM II proposition continues to predict that return on package of debt and equity does not change. However the expected rate of return on equity increases as the firm`s debt equity ratio increases.

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MM’s Proposition II When the possibility of bankruptcy and its associated costs are considered, the optimal capital structure (optimal debt-equity ratio ) is at the point where the additional tax-shield benefit of taking on one more dollar of debt (marginal benefit) is equal to the cost of bankruptcy (marginal cost). 16

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Capital Structure & Corporate Taxes MM propositions suggest that debt policy should not matter. Then why financial managers do worry about their debt policy? Answer lies in the assumption we made before MM propositions. Debt and Taxes at River Cruises: Interest is tax deductible expense, while equity income is subject to corporate tax. Interest Tax Shield: Tax savings resulting from deductibility of interest payments. 17

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Capital Structure & Corporate Taxes(continued) Zero Debt$500,000 of Debt Expected operating income125,000 Debt interest at 10%050,000 Before tax income125,00075,000 Tax at 35%43,75026,750 After tax income81,25048,750 Combined debt & equity income (debt interest + after tax income) 81,25098,750 18 A clear savings of 17,500 is visible,

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Capital Structure & Corporate Taxes(continued) Annual tax shield = Corporate tax rate X Interest payment = T c x (r debt x D) =.35 x (500,000 x 0.10) = 17,500 T c = Corporate tax r debt = Interest rate D = Amount borrowed 19

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Capital Structure & Corporate Taxes(continued) If tax shield is permanent, we can use the perpetuity formula to calculate present value PV tax shields = annual tax shield r debt = T c x (r debt x D) = T c D r debt =.35 x 500,000 = $175,000 20

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How interest tax shield contribute the value of stockholder`s equity Value of levered firm = value of all equity financed + PV of tax shield In case of permanent debt: Value of levered firm = value of all equity financed + T c D “So borrowing increases the firm value & shareholder`s wealth by the PV of tax savings.” 21

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Financial Distress Costs of Financial Distress - Costs arising from bankruptcy or distorted business decisions before bankruptcy. ▫As the firm assumes more debt, it becomes more risky, i.e., will have a higher chance of defaulting on its debt and investors will therefore demand a higher return. ▫Financial distress based on – probability of distress & the magnitude of costs encountered if it occurs. ▫WorldCom paid $800 M to $1 Billion in fees during 21 months it spent in Chapter 11. Normally it is 3%. Market Value = Value if all Equity Financed + PV Tax Shield - PV Costs of Financial Distress 22

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Financial Distress (Trade-off theory) a 23 Debt Market Value of The Firm Value of unlevered firm PV of interest tax shields Costs of financial distress Value of levered firm Optimal amount of debt Maximum value of firm

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Financial Distress “Borrow $1000 and you`ve got a banker. Borrow $10,000,000 and you`ve got a partner.” 1 st Game: Bet the Bank`s Money – Before bankruptcy as all agree that there is no shareholder equity – so they`ve nothing to lose. So managers of failing firm gamble literally. 2 nd Game: Don`t Bet Your Own Money – If probability of default is high: Managers & shareholders tempted to take high risky project. However, stockholders may refuse to contribute more equity. Stockholders would rather take money out of firm than put new money in. 24

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Financial Choices Trade-off Theory - Theory that capital structure is based on a trade-off between tax savings and financial distress costs of debt. Debt level should be increased till point where value of additional interest tax shield is exactly offset by the additional cost of financial distress. Pecking Order Theory - Theory stating that firms prefer to issue debt rather than equity if internal finance is insufficient. Financial Slack - Reserve of ready cash or unused borrowing capacity. Financing is readily available for positive NPV projects. Too much leads to high perks or ill-advised acquisitions etc. 25

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Pecking Order Theory The pecking order theory suggests that there is an order of preference for the firm of capital sources when funding is needed. The firm will seek to satisfy funding needs in the following order: 1.Internal funds 2.External funds 1.Debt 2.Equity 26

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Pecking Order Theory There are three factors that the pecking order theory is based on and that must be considered by firms when raising capital. 1.Internal funds are cheapest to use (no issuance costs) and require no private information release. 2.Debt financing is cheaper than equity financing. 27

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Pecking Order Theory 3.Managers tend to know more about the future performance of the firm than lenders and investors. Because of this asymmetric information, investors may make inferences about the value of the firm based on the external source of capital the firm chooses to raise. Equity financing inference – firm is currently overvalued Debt financing inference – firm is correctly or undervalued 28

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Pecking Order Theory The pecking order theory suggests that the firm will first use internal funds. More profitable companies will therefore have less use of external sources of capital and may have lower debt-equity ratios. If internal funds are exhausted, then the firm will issue debt until it has reached its debt capacity. Only at this point will firms issue new equity. This theory also suggests that there is no target debt-equity mix for a firm. Peaking order theory work best for mature firms. Fast-growing high tech firms often resort to a series of common stock issues to finance their investments. Here common stock come at the top of peaking order. 29

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