Capital Structure Decisions Chapter 15 and 16 Financial Policy and Planning (MB 29) Outline Meaning of Capital Structure Optimal Capital Structure How much should a firm borrow? Does capital structure matter? Does it influence the value of the firm? Limits to the use of debt How companies establish their capital structure? Capital Structure A mix of debt, preferred stock, and common stock with which the firm plans to finance its investments. Objective is to have such a mix of debt, preferred stock, and common equity which will maximize shareholder wealth or maximize market price per share WACC depends on the mix of different securities in the capital structure. A change in the mix of different securities in the capital structure will cause a change in the WACC. Thus, there will be a mix of different securities in the capital structure at which WACC will be the least. An optimal capital structure means a mix of different securities which will maximize the stock price share or minimize WACC. Leverage and Capital Structure Leverage means use of fixed cost source of funds. Generally, it refers to use of debt in the capital structure of the firm How much leverage should be there in a firm? Why is this question important? Two reasons: – a higher debt ratio can enhance the rate of return on equity capital during good economic times – a higher debt ratio also increases the riskiness of the firm’s earnings stream Capital structure decision involves a trade off between risk and return to maximize market price per share Does capital structure matter? Not really; According to Modigliani and Miller (1958) article, in a world without corporate taxes, it mix between debt and equity does not matter Value of the firm is independent of capital structure decisions Value of a firm equals operating income divided by overall cost of capital. Thus, mix between debt and equity is not important. Any benefit of low cost debt is completely offset by an increase in the cost of equity due to use of borrowing. Thus, overall cost of capital remains same and value of the firm does not change if we change the mix between debt and equity. Assumption of a world without taxes is quite unrealistic. M&M revisited their theory in their 1961 article. They assume a world with corporate taxes M&M with corporate taxes If we follow M&M (1958), we should not worry about mixture of debt and equity in the capital structure. These decisions should be relegated to the background because they do not affect the value of the firm. So, financial managers should not worry about these decisions. Still financial managers do show concern for a debt policy, which is carefully developed. And we find a pattern among companies in the use of debt in different industries. M-M’s argument that the value and the cost of capital of a firm remains constant with leverage will not hold when corporate taxes are assumed to exist. In their 1963 article, they recognize that the value of the firm will increase or the cost of capital will decrease with leverage because interest on debt is a tax deductible expense. The value of the levered firm will be greater than the unlevered firm because the return to bondholders escapes taxation at the corporate level. The value of the levered firm will be more than the value of unlevered firm by the amount of the present value of the tax shield due to tax savings given by the tax deductibility of interest expense on debt. Present value of the tax shield is given by Tc D Value of a leverered firm = [(1-Tc)EBIT/re] + TcD Example Firm L has employed a 6 percent debt of $300,000, while firm U is unlevered. Both the firms earn a before tax earnings of $120,000. The pure equity capitalization rate is 10 percent and the corporate tax rate is 34 percent. Find the market value of the firms. (1 - Tc) EBIT (1 - 0.34) $120,000 Vu = --------------- = ----------------------------- = $792,000 re 0.10 VL = VU + Tc D = 792,000 + 0.34 $300,000 = $894,000 M&M Proposition II with corporate taxes Re = rA + D/E (1 - Tc) (rA - rD) Limits to the Use of Debt According to MM theory with taxes, value of levered firm equals the value of unlevered plus the value of the tax shield Accordingly, the more the debt in the capital structure, the higher will be the value of a levered firm. One can always increase firm value by increasing leverage, implying that firms should issue maximum debt. This is inconsistent with the real world, where firms generally employ moderate amount of debt. The answer lies in bankruptcy costs. Debt provides tax benefits to the firm. However, it also puts pressure on the firm, because interest and principal payments are obligations. If these obligations are not met, the firm may risk some sort of financial distress. The possibility of bankruptcy has a negative effect on the value of the firm. However, it is not the risk of bankruptcy itself that lowers value. Rather it is the cost associated with bankruptcy that lowers value. As the proportion of debt in the firm’s capital structure is increased, the probability of bankruptcy also increases. Consequently, the rate of return required by bondholders increases with leverage. The optimal ratio of debt to equity is determined by taking an increasing amounts of debt until the marginal gain from leverage is equal to the marginal expected loss from the bankruptcy costs How Firms Establish Capital Structure? Most corporations have low debt-asset ratios Changes in Financial Leverage affect Firm Value There are differences in the Capital Structures of Different Industries Most companies have a target debt ratio Target debt ratio is dependent on taxes, types of assets, uncertainty of operating income, and pecking order and financial slack.