Chapter 17 Capital Structure
Chapter 17 Capital Structure
Chapter 17 Capital Structure
Capital Structure
Determination
17.1 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
After Studying Chapter 17,
you should be able to:
1. Define “capital structure.”
2. Explain the net operating income (NOI) approach to capital
structure and valuation of a firm; and, calculate a firm's value
using this approach.
3. Explain the traditional approach to capital structure and the
valuation of a firm.
4. Discuss the relationship between financial leverage and the cost
of capital as originally set forth by Modigliani and Miller (M&M)
and evaluate their arguments.
5. Describe various market imperfections and other "real world"
factors that tend to dilute M&M’s original position.
6. Present a number of reasonable arguments for believing that an
optimal capital structure exists in theory.
7. Explain how financial structure changes can be used for
financial signaling purposes, and give some examples.
17.2 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Capital Structure
Determination
• A Conceptual Look
• The Total-Value Principle
• Presence of Market Imperfections and
Incentive Issues
• The Effect of Taxes
• Taxes and Market Imperfections
Combined
• Financial Signaling
17.3 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Capital Structure
Assumptions:
• V = B + S = total market value of the firm
• O = I + E = net operating income = interest
paid plus earnings available to common
shareholders
17.7 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Capitalization Rate
B S
ko = ki + ke
B+S B+S
0.20
ke (Required return on equity)
0.15
ko (Capitalization rate)
0.10
ki (Yield on debt)
0.05
0
0 0.25 0.50 0.75 1.0 1.25 1.50 1.75 2.0
Financial Leverage (B/S)
17.13 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Summary of NOI Approach
• Critical assumption is ko remains
constant.
• An increase in cheaper debt funds is
exactly offset by an increase in the
required rate of return on equity.
• As long as ki is constant, ke is a linear
function of the debt-to-equity ratio.
• Thus, there is no one optimal capital
structure.
17.14 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Traditional Approach
17.15 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Optimal Capital Structure:
Traditional Approach
Traditional Approach
ke
0.25
ko
Capital Costs (%)
0.20
0.15
ki
0.10
Optimal Capital Structure
0.05
0
Financial Leverage (B / S)
17.16 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Summary of the
Traditional Approach
• The cost of capital is dependent on the capital
structure of the firm.
• Initially, low-cost debt is not rising and replaces more
expensive equity financing and ko declines.
• Then, increasing financial leverage and the
associated increase in ke and ki more than offsets
the benefits of lower cost debt financing.
• Thus, there is one optimal capital structure
where ko is at its lowest point.
• This is also the point where the firm’s total
value will be the largest (discounting at ko).
17.17 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Total Value Principle:
Modigliani and Miller (M&M)
• Advocate that the relationship between
financial leverage and the cost of capital is
explained by the NOI approach.
• Provide behavioral justification for a constant
ko over the entire range of financial leverage
possibilities.
• Total risk for all security holders of the firm is
not altered by the capital structure.
• Therefore, the total value of the firm is not
altered by the firm’s financing mix.
17.18 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Total Value Principle:
Modigliani and Miller
Market value Market value
of debt ($35M) of debt ($65M)
17.21 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Tax-Shield Benefits
Tax Shield – A tax-deductible expense. The
expense protects (shields) an equivalent dollar
amount of revenue from being taxed by reducing
taxable income.
Present value of
tax-shield benefits (r) (B) (tc)
= = (B) (tc)
of debt* r
= ($5,000) (0.4) = $2,000**
* Permanent debt, so treated as a perpetuity
** Alternatively, $240 annual tax shield / 0.12 = $2,000, where
$240=$600 Interest expense × 0.40 tax rate.
17.22 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Value of the Levered Firm
2. Flexibility
• A decision today impacts the options open to the firm for
future financing options – thereby reducing flexibility.
• Often referred to unused debt capacity.
17.26 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Checklist of Practical and
Conceptual Considerations
• Taxes • EBIT-EPS
• Explicit cost analysis
17.27 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.