Chapter 17

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

Capital Structure -- The mix (or proportion) of

a firm’s permanent long-term financing
represented by debt, preferred stock, and
common stock equity.
• Concerned with the effect of capital market
decisions on security prices.
• Assume: (1) investment and asset
management decisions are held constant and
(2) consider only debt-versus-equity financing.
17.4 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 A Conceptual Look –
Relevant Rates of Return
ki = the yield on the company’s debt
I Annual interest on debt
ki =
B
=
Market value of debt
Assumptions:
• Interest paid each and every year
• Bond life is infinite
• Results in the valuation of a perpetual bond
• No taxes (Note: allows us to focus on just
capital structure issues.)
17.5 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 A Conceptual Look –
Relevant Rates of Return
ke = the expected return on the company’s equity
Earnings available to
E
E common shareholders
ke = S =
S Market value of common
stock outstanding
Assumptions:
• Earnings are not expected to grow
• 100% dividend payout
• Results in the valuation of a perpetuity
• Appropriate in this case for illustrating the
theory of the firm
17.6 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 A Conceptual Look –
Relevant Rates of Return

ko = an overall capitalization rate for the firm

O
O Net operating income
ko =
V
V
= Total market value of the firm

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

Capitalization Rate, ko – The discount rate

used to determine the present value of a
stream of expected cash flows.

B S
ko = ki + ke
B+S B+S

What happens to ki, ke, and ko

when leverage, B/S, increases?
17.8 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Net Operating
Income Approach
Net Operating Income Approach – A theory of
capital structure in which the weighted average
cost of capital and the total value of the firm
remain constant as financial leverage is changed.
Assume:
• Net operating income equals $1,350
• Market value of debt is $1,800 at 10% interest
• Overall capitalization rate is 15%
17.9 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Required Rate of
Return on Equity
Calculating the required rate of return on equity
Total firm value = O / ko = $1,350 / 0.15
= $9,000
Market value =V–B = $9,000 – $1,800
of equity = $7,200 Interest payments
= $1,800 × 10%
Required return =E/S
on equity* = ($1,350 – $180) / $7,200
= 16.25%
* B / S = $1,800 / $7,200 = 0.25
17.10 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Required Rate of
Return on Equity
What is the rate of return on equity if B=$3,000?
Total firm value = O / ko = $1,350 / 0.15
= $9,000
Market value =V–B = $9,000 – $3,000
of equity = $6,000 Interest payments
= $3,000 × 10%
Required return =E/S
on equity* = ($1,350 - $300) / $6,000
= 17.50%
* B / S = $3,000 / $6,000 = 0.50
17.11 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Required Rate of
Return on Equity
Examine a variety of different debt-to-equity
ratios and the resulting required rate of
return on equity.
B/S ki ke ko
0.00 — 15.00% 15%
0.25 10% 16.25% 15%
0.50 10% 17.50% 15%
1.00 10% 20.00% 15%
2.00 10% 25.00% 15%
Calculated in slides 9 and 10
17.12 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Required Rate of
Return on Equity
Capital costs and the NOI approach in a
graphical representation.
0.25
ke = 16.25% and
17.5% respectively
Capital Costs (%)

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

Traditional Approach – A theory of capital

structure in which there exists an optimal capital
structure and where management can increase
the total value of the firm through the judicious
use of financial leverage.

Optimal Capital Structure – The capital structure

that minimizes the firm’s cost of capital and
thereby maximizes the value of the firm.

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)

Market value Market value

of equity ($65M) of equity ($35M)

Total firm market Total firm market

value ($100M) value ($100M)

• Total market value is not altered by the capital

structure (the total size of the pies are the same).
• M&M assume an absence of taxes and market
imperfections.
• Investors can substitute personal for corporate
financial leverage.
17.19 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Arbitrage and Total
Market Value of the Firm

Two firms that are alike in every respect

EXCEPT capital structure MUST have
the same market value.
Otherwise, arbitrage is possible.

Arbitrage – Finding two assets that are

essentially the same and buying the
cheaper and selling the more expensive.
17.20 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Agency Costs

Agency Costs -- Costs associated with

monitoring management to ensure that it behaves
in ways consistent with the firm’s contractual
agreements with creditors and shareholders.

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

Value of Value of Present value of

levered = firm if + tax-shield benefits
firm unlevered of debt

Value of unlevered firm = $1,200 / 0.16

(Company ND) = $7,500*

Value of levered firm = $7,500 + $2,000

(Company D) = $9,500
* Assuming zero growth and 100% dividend payout
17.23 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Summary of
Corporate Tax Effects
• The greater the amount of debt, the greater the tax-
shield benefits and the greater the value of the
firm.
• The greater the financial leverage, the lower the
cost of capital of the firm.
• The adjusted M&M proposition suggests an
optimal strategy is to take on the maximum
amount of financial leverage.
• This implies a capital structure of almost 100%
debt! Yet, this is not consistent with actual
behavior.
17.24 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Other Tax Issues
• Uncertainty of tax-shield benefits
Uncertainty increases the possibility of
bankruptcy and liquidation, which reduces
the value of the tax shield.
• Corporate plus personal taxes
Personal taxes reduce the corporate tax
advantage associated with debt.
Only a small portion of the explanation why
corporate debt usage is not near 100%.
17.25 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Timing and Flexibility
1. Timing
• After appropriate capital structure determined it is still
difficult to decide when to issue debt or equity and in
what order
• Factors considered include the current and expected
health of the firm and market conditions.

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

• Cash-flow ability to • Capital structure

service debt ratios

• Agency costs and • Security rating

incentive issues • Timing
• Financial signaling • Flexibility

17.27 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.