Chapter 16
McGraw-Hill/Irwin
Assessing Long-Term Debt,
Equity, and Capital Structure
Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.
1
Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved
Introduction
• Capital structure
– Mix of debt and equity that finances firm’s
operations
• Funding decision factors
– debt interest payments’ tax deductibility
– risks posed by increased debt
16-2
Active vs. Passive Capital Structure
Changes
Active management
– Selling one type of capital to fund the retirement
of other kinds of capital
Passive management
– Waiting for additional incoming capital
– Adjust financing mix (debt or equity) over time
16-3
Active vs. Passive
Choice depends on three factors
–
How quickly the firm is growing
–
The flotation costs under the active management
approach
–
The need for changes to the firm’s capital structure
16-4
Capital Structure Theory: The Effect of
Financial Leverage
• Debt is referred to as “leverage”
• Debt magnifies potential risk and returns
16-5
Modigliani and Miller
The Modigliani and Miller (M&M) Theorem is a
tool for examining the effects of various
variables on choice of optimal capital
structure for firm.
16-6
Modigliani and Miller’s Perfect World
• No taxes
• No chance of bankruptcy
• Perfectly efficient markets
• Symmetric information sets for all participants
16-7
M&M Theorem’s Main
Propositions
• Proposition I
– The value of a levered firm is equal to the value of
unlevered firm (all-equity financed)
16-8
M&M Theorem’s Main
Propositions
• Proposition II
– The cost of equity increases with the use of debt
in a capital structure
16-9
Effect of Leverage on Cost of
Equity
• Cost of Equity increases as debt increases
• Weighted Average Cost of Capital (WACC)
does not change
16-10
Effect of Leverage on WACC
• Debt less expensive than equity
• Proposition IIa:
16-11
M&M with Corporate Taxes
• Proposition I
– Assumes debt is perpetual and tax-deductible
16-12
M&M with Taxes
• Proposition II
– Assumes debt is perpetual and tax-deductible
16-13
Choice to Re-leverage
• Increased debt increases
– Cash flows to equity holders
– Volatility of cash flows to equity
16-14
Break-Even EBIT
• Solving for EPS creates investor indifference
between capital structures
– Express EPS as function of EBIT for each capital
structure
– Set them equal to each other
– Solve for the break-even EBIT
16-15
M&M with Corporate Taxes
and Bankruptcy
• Assumes firm may go bankrupt
– Bondholders bear some of firm risk
– Bondholders demand higher compensation in
return for risk
16-16
Types of Bankruptcies in the U.S.
• Chapter 7
– Business liquidation
– Immediate cessation of business operations
• Chapter 7 Claimant payout order
•
•
•
•
•
•
Secured lenders (including bondholders)
Lawyers
Employees
Government
Unsecured debt holders
Equity holders
16-17
Types of Bankruptcies in the U.S.
• Chapter 11
– Firm remains in operation
– May reorganize under court supervision
– Creditors register with the bankruptcy court
– Firm may emerge from bankruptcy
16-18
Costs of Financial Distress
• Loss of consumer and supplier confidence
• May face tighter credit and higher rates
• Declining partnership opportunities with
other firms
• Potential loss of best employees
16-19
Value of Firm with Taxes
and Bankruptcy
Optimal Debt/Equity (DE) ratio depends on tax rate and
financial distress costs due to debt
16-20
Capital Structure
Theory vs. Reality
• Factors affecting capital structures
– Firms with high taxes should use more debt
– Firms with stable, predictable income streams can
use more debt
16-21
Observed Capital Structures
• Economic sectors with lowest D/E ratios tend
to have low or variable income streams
• Economic sectors with highest D/E ratios tend
to have high, stable income streams
16-22