Capital Structure Policy
• Chapter 15: 1,3,7,11,14,19
• Chapter 16: 2,5,6,16
I. Modigliani-Miller (MM) Capital
Structure Propositions
Assumptions include:
Homogeneous expectations
Perpetual cash flows: V = CF/r
Perfect capital markets:
No taxes, transaction costs, costs of distress
Firms and investors borrow and lend at the same rate rB
MM Proposition I:
VL = VU
MM Propositions II:
rS = r0 + B/S(r0 - rB) , where r0 is the cost of
capital for an all equity firm.
The Impact of Financial Leverage: Financial Leverage,
EPS and ROE
Assets
Debt
Equity
Debt/Equity ratio
Share price
Shares outstanding
Interest rate
Current
Proposed
$5,000,000
$5,000,000
$0
$2,500,000
$5,000,000
$2,500,000
0
1
$10
$10
500,000
250,000
na
10%
EPS and ROE under current
capital structure
Recession Expected
EBIT
Expansion
$300,000
$650,000
$800,000
$0
$0
$0
$300,000
$650,000
$800,000
EPS
$0.60
$1.30
$1.60
ROE
6%
13%
16%
Interest
Net Income
EPS and ROE under proposed
capital structure
Recession
Expected Expansion
EBIT
$300,000
$650,000
$800,000
Interest
$250,000
$250,000
$250,000
$50,000
$400,000
$550,000
EPS
$0.20
$1.60
$2.20
ROE
2%
16%
22%
Net Income
Ignoring taxes for the moment, consider
the following 2 alternatives
Firm does not adopt proposed capital structure.
An investor puts up $500 and borrows $500 to buy 100 shares
EPS of
unlevered firm
Earnings for
$0.60
$1.30
$1.60
$60.00
$130.00
$160.00
$50.00
$50.00
$50.00
$10.00
$80.00
$110.00
2%
16%
22%
100 shares
less interest on
$500 at 10%
Net earnings
ROE
The ROE is the same as that of the levered firm.
Firm adopts proposed capital structure.
An investor puts up $500, $250 in stock and $250 in bonds
EPS of
levered firm
$0.20
$1.60
$2.20
Earnings for
25 shares
$5.00
$40.00
$55.00
plus interest on
$250 at 10%
$25.00
$25.00
$25.00
Net earnings
$30.00
$65.00
$80.00
6%
13%
16%
ROE
The ROE is the same as that of the unlevered firm.
M&M Proposition II:
With no taxes, WACC = R0 = (S/V) x RS + (B/V) x RB .
Solving for RS,
RS = R0 + (R0 - RB) x (B/S)
Cost of Capital
RS=R0+(R0-RB) x B/S
R0
RWACC
RB
B/S
(figure 15.3)
15.7
Rayburn Manufacturing is currently an all equity firm.
The firm’s equity is worth $2 million. The cost of that
equity is 18 percent. Rayburn pays no taxes.
Rayburn plans to issue $400,000 in debt and to use the
proceeds to repurchase stock. The cost of debt is 10
percent.
a) After Rayburn repurchases the stock, what will the
firm’s overall cost of capital be?
b) After the repurchase, what will the cost of equity be?
c) Explain you result in (b).
15.9
The Gulf Power Company is an electric utility that is planning to build a
new conventional power plant. The company has traditionally paid out
all earning to the stockholders as dividends, and has financed capital
expenditures with new issues of common stock. There is no debt or
preferred stock presently outstanding. Data on the company and the
new power plant follow. Assume all earnings streams are perpetuities.
Company data:
Current annual earnings: $27 million
# outstanding shares:
$10 million
New Power Plant:
Initial outlay:
$20 million
Added annual earnings:
$3 million
Management considers the power plant to have the same risk as existing
assets. The current required rate of return on equity is 10 percent.
Assume there are no taxes and no costs of bankruptcy.
What will the total market value of Gulf Power be if common stock is
issued to finance the plant?
What will the total market value of the firm be if $20 million in bonds with
an interest rate of 8 percent are issued to finance the plant? Assume
the bonds are perpetuities.
Suppose Gulf Power issues the bonds. Calculate the rate of return
required by stockholders after the financing has occurred and the plant
has been built.
II. Modigliani Miller with Corporate Taxes (Tc)
PV of the interest tax shield = (TC x RB x B)/RB = TC x B.
VL = EBIT*(1-TC)/R0 + TCRBB/RB = VU + TCB
Proposition II becomes:
RS = R0 + (R0 - RB) x (B/S) x (1-TC)
Cost of Capital
RS=R0+(1-TC)(R0-RB) x B/S
R0
RWACC
RB
B/S
(figure 15.6)
15.17
Streiber Publishing Company, an all-equity firm,
generates perpetual earnings before interest
and taxes (EBIT) of $2.5 million per year.
Streiber’s after tax, all-equity discount rate is 20
percent. The company’s tax rate is 34 percent.
a) What is the value of Streiber Publishing?
b) If Streiber adjusts its capital structure to include
$600,000 of debt, what is the value of the firm?
c) What assumptions are you making when you
are valuing Streiber?
III. Limits to use of debt: bankruptcy & distress costs.
An optimal capital structure will balance the valuable interest tax
shield against the higher probability of facing bankruptcy costs.
Expected costs of distress = probability of distress x distress
costs
Direct costs of financial distress
Indirect costs of financial distress
Agency costs of debt & equity
Agency costs of debt:
Overinvestment in risky projects
•
•
•
•
Tri-State Paving, Inc.
– Owners-managers literally took all of the company’s cash to Las Vegas in an
attempt to win enough money “to pay the corporate-debtor’s creditors and
solve the financial problems of all three debtors ...”
Continental Airlines.
– Frank Lorenzo’s Texas Air purchased a controlling interest in Continental
Airlines cheaply when the latter was already in serious financial difficulty.
Continental filed Chapter 11, locked the union out, and attempted to hire a
new, non-union labor force while selling tickets to anywhere in the US for $49.
Creditors opposed the scheme. Had it been unsuccessful, they would have
born most of the cost
Sambo’s Restaurants.
– While In Chapter 11, Sambo’s Restaurants borrowed against its
unencumbered assets and invested the money in changing the name, look,
and concept of its restaurants. The gamble failed, the money was lost, and
unsecured creditors ended up with only about 11 cents on the dollar
Storage Technology
– Storage Technology brought a new data-storage device to the market during
its Chapter 11 case. The produce was so successful that the company was
solvent with a substantial cushion of equity by the time it emerged.
IV. Empirical Implications of Capital Structure Theories
Effects of changing capital structure
Stock repurchases
Debt/equity swaps
Factors to consider in establishing a capital structure:
Taxes
Type of assets
Uncertainty of operating income
Pecking order and financial slack
Example: Optimal capital structure
Firm invests $500,000 in PPE, WC; generates EBIT of $120,000 in perpetuity
100% dividend payout; capex = depreciation; no sales growth; tax rate = .5
1
Debt in capital
structure
0%
10%
20%
30%
40%
50%
2
EBIT
$120,000
$120,000
$120,00
0
$120,000
$120,000
$120,000
3
Interest
0
4,125
8,750
14,625
22,000
31,250
4
Profit before tax
120,000
115,875
111,250
105,375
98,000
88,750
5
Tax
60,000
57,938
55,625
52,688
49,000
44,375
6
Profit after tax
60,000
57,938
55,625
52,688
49,000
44,375
7
Dividends
60,000
57,938
55,625
52,688
49,000
44,375
8
Total pmts to
security holders
60,000
62,063
64,375
67,313
71,000
75,625
9
Cost of debt
8.00%
8.25%
8.75%
9.75%
11.00%
12.50%
12.00%
12.50%
13.00%
13.50%
14.50%
16.00%
0
50,000
100,000
150,000
200,000
250,000
10
Cost of equity
11
Market value of debt
12
Market value of
equity
500,000
463,500
427,885
390,278
337,931
277,344
13
Market value of firm
500,000
513,500
527,885
540,278
537,931
527,344
14.
Book value of debt
0
50,000
100,000
150,000
200,000
250,000
15.
Book value of equity
500,000
450,000
400,000
350,000
300,000
250,000
16.
Book value of firm
500,000
500,000
500,000
500,000
500,000
500,000
17.
Return on total capital
12.0%
12.4%
12.9%
13.5%
14.2%
15.1%
18.
Return on equity
12.0%
12.9%
13.9%
15.1%
16.3%
17.8%
19.
Number of shares
outstanding
5,000
4,513
4,053
3,612
3,141
2,630
20.
Price per share
$100.00
$102.70
$105.58
$108.06
$107.59
$105.47
21.
EPS
$12.00
$12.84
$13.73
$14.59
$15.60
$16.88
22.
PE ratio
$8.33
$8.00
$7.69
$7.41
$6.90
$6.25
23.
Book value debt ratio
0.0%
10.0%
20.0%
30.0%
40.0%
50.0%
24.
Market value debt ratio
0.0%
9.7%
18.9%
27.8%
37.2%
47.4%
25.
WACC
12.0%
11.7%
11.4%
11.1%
11.2%
11.4%
26.
FCF
$60,000
$60,000
$60,000
$60,000
$60,000
$60,000
27.
Market value of firm
$500,000
$513,500
$527,885
$540,278
$537,931
$527,344
V. Implementing capital structure models.
Operating income approach
Cost of capital approach**
APV (adjusted present value) approach**
Comparables approach