FM2 Assignment_Capital Structure_Tarang Shah_145

Financial Management II

Assignment

On

Prepared By: Submitted to:

Tarang Shah (145) Prof. Bharat Shah

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FM2 Assignment_Capital Structure_Tarang Shah_145

THEORY OF CAPITAL STRUCTURE

Determination of an optimal capital structure has frustrated theoreticians for

decades. The early work made numerous assumptions in order to simplify the problem
and assumed that both the cost of debt and the cost of equity were independent of
capital structure and that the relevant figure for consideration was the net income of the
firm. Under these assumptions, the average cost of capital decreased with the use of
leverage and the value of the firm (the value of the debt and equity combined) increased
while the value of the equity remained constant.

Ks

Ka

Kd

Debt/Equity

Modigliani and Miller showed that this could not be the case. Their contention
was that two identical firms, differing only in their capital structure, must have identical
total values. If they did not, individuals would engage in arbitrage and create the market
forces that would drive the two values to be equal.

Introduction to Capital Structure Theories

There are 4 basic Capital Structure theories. They are:

1. Net Income Approach

2. Net Operating Income Approach
3. Modigliani-Miller (MM) Approach and
4. Traditional Approach

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Their proof of this proposition was based upon several assumptions (many of
which have subsequently been relaxed without changing the results):

• All investors have complete knowledge of what future returns will be

• All firms within an industry have the same risk regardless of capital
structure
• No taxes (we will relax this assumption subsequently)
• No transactions costs
• Individuals can borrow as easily and at the same rate of interest as the
corporation
• All earnings are paid out as dividends (thus, earnings are constant and
there is no growth)
• The average cost of capital is constant

Since no tax has been assumed, the operating income (EBIT) is equivalent to the
net income which is all paid out as dividends. Thus, the value of the firm is equal to

EBIT
V =
ka

Since the value of the firm is equal to the sum of the value of the debt and equity,

V = D+ E
then
k aV = k a ( D + E )
and
E D
ka = k s ( ) + kd ( )
D+ E D+ E

Substituting the last equation into the preceding equation and solving for Ks

D
k s = ka + ( ka − kd )
E

Thus, ks must go up as debt is added to the capital structure.

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%
Ka

Ks

Kd

Debt/Equity

Example: To prove their point, they assumed two identical firms, an unlevered firm (all
equity) and a levered firm with $4 million of debt carrying an interest rate of 7.5%, both
firms generating an operating income (EBIT) of $900,000 annually. They adopted the
assumption that stockholders of both firms would have the same required rate of return
of 10% which, as previously mentioned, was the standard assumption at the time (that
the cost of equity was constant regardless of capital structure).

Unlevered Firm Levered Firm

EBIT $ 900,000 $ 900,000
-Interest 0 300,000
Income $ 900,000 $ 600,000

Since the required rate of return of shareholders is 10% in both cases

Unlevered Firm Levered Firm

$900, 000 $600,000
Value of Equity = = $9 , 000, 000 = $ 6,000,000
.10 .10
Value of Debt = $ 0 $ 4,000,000
Total Value of Firm = $9,000,000 $10,000,000

If this were true, then someone who owns 10% of the levered firm would have
income of $60,000 ($600,000 * 10%) and could sell it for $600,000 ($6 million * 10%).
With this $600,000 the individual could borrow another $300,000 at 7.5% and buy 10%
of the unlevered firm for $900,000 ($9 million * 10%). What would this individual’s
income be now?

EBIT $ 90,000 ($900,000 * 10%)

-Interest 22,500 ($300,000 * 7.5%)
Income $ 67,500

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Thus, the income would be greater by buying the unlevered firm’s stock and borrowing
money to finance the purchase. As other individuals see this opportunity, they also will
sell the stock of the levered firm (driving its price down) and buy the stock of the
unlevered firm (using some borrowed money) and thereby driving the value of the
unlevered firm’s stock up. As the price of the unlevered firm is bid up, the value of the
unlevered firm increases above $9 million dollars, while the selling of the levered firm’s
stock drives the equity value below $6 million (which decreases the total firm value,
including the $4 million of debt, below $10 million) until the two firms’ values, in
equilibrium, are equal and no opportunity to arbitrage the difference exists.
Consequently, if the total value of the two firms is equal, then the average cost of capital
must be equal. And if the average cost of capital is equal, then it must be true that the
cost of equity rises in such a manner as to exactly offset the increased use of cheaper
debt financing (and we end up with the previous graph showing this).

As we previously uncovered when we looked at financial leverage, this is not a

surprising result. As a firm increases its use of debt, the risk to the stockholder
increases and, as a consequence, the stockholder’s required rate of return will increase.
Modigliani and Miller simply defined how the stockholder’s required rate of return should
increase with increased financial leverage.

The lesson that is intended by this is that value cannot be created by simply
substituting one form of financing for another.

Subsequent to this analysis, it was pointed out that corporate taxes have an
impact on the valuation. Without going through the mathematics (which is in your
textbook), suffice it to say that the result was that the value of the firm increased with
increased leverage. Specifically,
VL = VU + t * D

The fact that the government is a “partner” in the business results in a subsidy when
debt financing is used and a deductible expense (unlike equity payments). When
corporate taxes were taken into account, the average cost of capital was found to
decrease with increased leverage:

%
Ks

Ka before-tax

Ka after tax

Kd before-tax

Kd after-tax

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Debt/Equity

This implies that a firm should use as much debt as possible. Yet, we do not see
companies using 100% debt. It might be pointed out that during the late 1980s there
was a considerable amount of substitution of debt for equity among firms, particularly in
the case of leveraged buyouts. However, many of those firms subsequently failed (for
example, Unocal) and the typical debt/equity ratio today is similar to earlier levels.

So why do we not see more debt employed by companies? The answer to this
question has been sought by many and two primary proposals have been put forth.
First, bankruptcy costs were invoked as a factor. That is, the more debt a firm uses, the
higher the probability that the firm would default and go into bankruptcy. Therefore, the
present value of bankruptcy costs had to be deducted from the value of the firm. A
second factor was that of “agency” costs, such as the necessity of reporting regularly to
lenders (audited financial statements, bank “monitoring” fees, trustees for debt
payments, etc.) that accompany the use of debt. Both of these costs increase in present
value of expected costs terms as the proportion of debt increases. Another way of
viewing these costs is that the risk of receiving full interest and principal payments
increases and thus the required rate of return of lenders increases. (For example, “junk”
bonds often yield higher rates of interest than the required rate of return on equity for
companies with very little debt.) Consequently, the cost of debt increases and the
average cost of capital will ultimately increase.

Ks

Ka after-tax

Kd after-tax

Debt/Equity

As can be observed from the graph, a minimum average cost of capital exists,
but exactly where it should be has yet to be determined within a theoretical framework.

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So what are the insights that we can gain from this theorectical view of capital
structure? First, we should note that, while debt financing is “cheap” in the sense that
required rates of return on equity will always be higher than the interest rate on debt,
there is a “hidden” cost in that the cost of equity rises as we utilize more debt financing.
This is one reason that using the average cost of capital in valuing a project or company
is more appropriate, even if we intend to borrow all of the money to finance it. While we
may use cheap debt to finance a project, the increased risk to shareholders from
increasing our financial leverage results in an increase in the cost of equity. The
average cost of capital reflects both the cost of debt as well as the cost of equity and
thus will reflect the increased cost of equity associated with the use of more debt
financing.

The second important concept is that tax-deductible debt financing results in a

tax subsidy by the government. This subsidy adds value to the firm. For example, what
is the “advantage” of being a home owner with a mortgage rather than leasing a home?
It is the taxes that you will save. The reason that Congress eliminated the deductibility of
credit card interest is that it did not want to encourage, through a tax subsidy, the
financing of purchases purely for consumption. On the other hand, the purchase of a
home (which is still tax-deductible) is an “investment”, not to mention the political
consequences of voting to end the subsidy of the American Dream of home ownership.

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