Chapter 17 - Yambao - Capital Structure Determination 3a5n4u
This document was ed by and they confirmed that they have the permission to share it. If you are author or own the copyright of this book, please report to us by using this report form. Report 3i3n4
Overview 26281t
& View Chapter 17 - Yambao - Capital Structure Determination as PDF for free.
More details 6y5l6z
- Words: 3,342
- Pages: 43
Chapter 17
Capital Structure Determination Presented By: Meliza D. Yambao
After Studying Chapter 17, you should be able to: 1. 2.
3. 4.
5. 6. 7. 17.2
Define “capital structure.” Explain the net operating income (NOI) approach to capital structure and valuation of a firm; and, calculate a firm's value using this approach. Explain the traditional approach to capital structure and the valuation of a firm. 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. Describe various market imperfections and other "real world" factors that tend to dilute M&M’s original position. Present a number of reasonable arguments for believing that an optimal capital structure exists in theory. Explain how financial structure changes can be used for financial signaling purposes, and give some examples. 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 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
ki
=
I B
=
Annual interest on debt 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 ke
=
E S
=
Earnings available to common shareholders 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 ko
Net operating income
O
=
= 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.
ko = ki
B B+S
+
ke
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 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 17.10
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Required Rate of Return on Equity 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 17.11
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 0.00 0.25 0.50 1.00 2.00
ki — 10% 10% 10% 10%
ke 15.00% 16.25% 17.50% 20.00% 25.00%
ko 15% 15% 15% 15% 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.
Capital Costs (%)
0.25
ke = 16.25% and 17.5% respectively
0.20
ke (Required return on equity)
0.15 ko (Capitalization rate) 0.10 ki (Yield on debt) 0.05 0
0 17.13
0.25
0.50
0.75 1.0 1.25 1.50 Financial Leverage (B/S)
1.75
2.0
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Excel & the NOI Approach NOI Approach You can create this type of analysis in Excel also. You can use some modeling experience to write formulas to calculate the required rates. Refer to “VW13E17.xlsx” on the ‘NOI Approach’ tab
17.14
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-toequity ratio. • Thus, there is no one optimal capital structure.
17.15
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.
17.16
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Optimal Capital Structure: Traditional Approach
ke
Capital Costs (%)
0.25
ko
0.20 0.15
ki 0.10
Optimal Capital Structure 0.05 0
Financial Leverage (B / S) 17.17
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Excel and the Traditional Approach Traditional Approach You can create this type of analysis in Excel also. We use some assumptions in this model built into the formulas. Refer to “VW13E17.xlsx” on the ‘Traditional Approach’ tab
17.18
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Summary of the Traditional Approach • •
• •
17.19
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).
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) •
• • •
17.20
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.
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 of debt ($35M)
Market value of debt ($65M)
Market value of equity ($65M)
Market value of equity ($35M)
Total firm market value ($100M)
17.21
Total firm market 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.
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.
17.22
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Arbitrage Example Consider two firms that are identical in every respect EXCEPT:
• • • •
•
17.23
Company NL – no financial leverage Company L – $30,000 of 12% debt Market value of debt for Company L equals its par value Required return on equity Company NL is 15% – Company L is 16% NOI for each firm is $10,000
–
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Arbitrage Example: Company NL Valuation of Company NL Earnings available to = E = O – I common shareholders = $10,000 - $0 = $10,000 Market value = E / ke of equity = $10,000 / 0 .15 = $66,667 Total market value = $66,667 + $0 = $66,667 Overall capitalization rate = 15% Debt-to-equity ratio =0 17.24
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Arbitrage Example: Company L Valuation of Company L Earnings available to = E = O – I common shareholders = $10,000 – $3,600 = $6,400 Market value = E / ke of equity = $6,400 / 0.16 = $40,000 Total market value = $40,000 + $30,000 = $70,000 Overall capitalization rate = 14.3% Debt-to-equity ratio = 0.75 17.25
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Completing an Arbitrage Transaction Assume you own 1% of the stock of Company L (equity value = $400). You should:
17.26
•
1. Sell the stock in Company L for $400.
•
2. Borrow $300 at 12% interest (equals 1% of debt for Company L).
•
3. Buy 1% of the stock in Company NL for $666.67. This leaves you with $33.33 for other investments ($400 + $300 - $666.67).
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Completing an Arbitrage Transaction Original return on investment in Company L $400 × 16% = $64 Return on investment after the transaction • $666.67 × 16% = $100 return on Company NL • $300 × 12% = $36 interest paid • $64 net return ($100 – $36) AND $33.33 left over.
This reduces the required net investment to $366.67 to earn $64.
17.27
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Summary of the Arbitrage Transaction • The investor uses “personal” rather than corporate financial leverage. • The equity share price in Company NL rises based on increased share demand. • The equity share price in Company L falls based on selling pressures. • Arbitrage continues until total firm values are identical for companies NL and L. • Therefore, all capital structures are equally as acceptable.
17.28
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Market Imperfections and Incentive Issues
17.29
•
Bankruptcy costs (Slide 17–30)
•
Agency costs (Slide 17–31)
•
Debt and the incentive to manage efficiently
•
Institutional restrictions
•
Transaction costs
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Required Rate of Return on Equity with Bankruptcy
Required Rate of Return on Equity (ke)
ke with bankruptcy costs
for financial risk
ke with no leverage ke without bankruptcy costs
for business risk
Rf
Risk-free rate
Financial Leverage (B / S) 17.30
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. • Monitoring includes bonding of agents, auditing financial statements, and explicitly restricting management decisions or actions.
• Costs are borne by shareholders (Jensen & Meckling). • Monitoring costs, like bankruptcy costs, tend to rise at an increasing rate with financial leverage.
17.31
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Example of the Effects of Corporate Taxes The judicious use of financial leverage (i.e., debt) provides a favorable impact on a company’s total valuation. Consider two identical firms EXCEPT: • • • •
17.32
Company ND – no debt, 16% required return Company D – $5,000 of 12% debt Corporate tax rate is 40% for each company NOI for each firm is $10,000
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Corporate Tax Example: Company ND Valuation of Company ND (Note: has no debt) Earnings available to = E= O – I common shareholders = $2,000 – $0 = $2,000 Tax Rate (T) = 40% Income available to = EACS (1 – T) common shareholders = $2,000 (1 – 0.4) = $1,200
Total income available to = EAT + I holders = $1,200 + 0
17.33
all security = $1,200
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Corporate Tax Example: Company D Valuation of Company D (Note: has some debt) Earnings available to = E= O – I common shareholders = $2,000 – $600 = $1,400 Tax Rate (T) = 40% Income available to = EACS (1 – T) common shareholders = $1,400 (1 – 0.4) = $840 Total income available to = EAT + I holders = $840 + $600 $1,440*
all security =
* $240 annual tax-shield benefit of debt (i.e., $1,440 - $1,200) 17.34
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 of debt*
=
(r) (B) (tc) r
=
($5,000) (0.4) =
=
(B) (tc) $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.
17.35
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 levered firm
=
Value of firm if unlevered
Value of unlevered firm
+
Present value of tax-shield benefits of debt
= $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 17.36
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.
17.37
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%.
17.38
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Bankruptcy Costs, Agency Costs, and Taxes Value of levered firm = Value of firm if unlevered + Present value of tax-shield benefits of debt - Present value of bankruptcy and agency costs As financial leverage increases, tax-shield benefits increase as do bankruptcy and agency costs.
17.39
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Cost of Capital (%)
Bankruptcy Costs, Agency Costs, and Taxes
Minimum Cost of Capital Point
Taxes, bankruptcy, and agency costs combined
Net tax effect Optimal Financial Leverage
Financial Leverage (B/S) 17.40
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Financial Signaling • A manager may use capital structure changes to convey information about the profitability and risk of the firm.
• Informational Asymmetry is based on the idea that insiders (managers) know something about the firm that outsiders (security holders) do not. • Changing the capital structure to include more debt conveys that the firm’s stock price is undervalued. • This is a valid signal because of the possibility of bankruptcy.
17.41
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Timing and Flexibility 1.
2.
17.42
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.
Flexibility • A decision today impacts the options open to the firm for future financing options – thereby reducing flexibility. • Often referred to unused debt capacity.
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Checklist of Practical and Conceptual Considerations
17.43
•
Taxes
•
EBIT-EPS analysis
•
Explicit cost
•
Capital structure ratios
•
Cash-flow ability to service debt
•
Security rating
•
Timing
•
Flexibility
•
Agency costs and incentive issues
•
Financial signaling
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Capital Structure Determination Presented By: Meliza D. Yambao
After Studying Chapter 17, you should be able to: 1. 2.
3. 4.
5. 6. 7. 17.2
Define “capital structure.” Explain the net operating income (NOI) approach to capital structure and valuation of a firm; and, calculate a firm's value using this approach. Explain the traditional approach to capital structure and the valuation of a firm. 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. Describe various market imperfections and other "real world" factors that tend to dilute M&M’s original position. Present a number of reasonable arguments for believing that an optimal capital structure exists in theory. Explain how financial structure changes can be used for financial signaling purposes, and give some examples. 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 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
ki
=
I B
=
Annual interest on debt 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 ke
=
E S
=
Earnings available to common shareholders 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 ko
Net operating income
O
=
= 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.
ko = ki
B B+S
+
ke
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 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 17.10
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Required Rate of Return on Equity 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 17.11
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 0.00 0.25 0.50 1.00 2.00
ki — 10% 10% 10% 10%
ke 15.00% 16.25% 17.50% 20.00% 25.00%
ko 15% 15% 15% 15% 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.
Capital Costs (%)
0.25
ke = 16.25% and 17.5% respectively
0.20
ke (Required return on equity)
0.15 ko (Capitalization rate) 0.10 ki (Yield on debt) 0.05 0
0 17.13
0.25
0.50
0.75 1.0 1.25 1.50 Financial Leverage (B/S)
1.75
2.0
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Excel & the NOI Approach NOI Approach You can create this type of analysis in Excel also. You can use some modeling experience to write formulas to calculate the required rates. Refer to “VW13E17.xlsx” on the ‘NOI Approach’ tab
17.14
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-toequity ratio. • Thus, there is no one optimal capital structure.
17.15
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.
17.16
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Optimal Capital Structure: Traditional Approach
ke
Capital Costs (%)
0.25
ko
0.20 0.15
ki 0.10
Optimal Capital Structure 0.05 0
Financial Leverage (B / S) 17.17
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Excel and the Traditional Approach Traditional Approach You can create this type of analysis in Excel also. We use some assumptions in this model built into the formulas. Refer to “VW13E17.xlsx” on the ‘Traditional Approach’ tab
17.18
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Summary of the Traditional Approach • •
• •
17.19
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).
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) •
• • •
17.20
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.
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 of debt ($35M)
Market value of debt ($65M)
Market value of equity ($65M)
Market value of equity ($35M)
Total firm market value ($100M)
17.21
Total firm market 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.
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.
17.22
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Arbitrage Example Consider two firms that are identical in every respect EXCEPT:
• • • •
•
17.23
Company NL – no financial leverage Company L – $30,000 of 12% debt Market value of debt for Company L equals its par value Required return on equity Company NL is 15% – Company L is 16% NOI for each firm is $10,000
–
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Arbitrage Example: Company NL Valuation of Company NL Earnings available to = E = O – I common shareholders = $10,000 - $0 = $10,000 Market value = E / ke of equity = $10,000 / 0 .15 = $66,667 Total market value = $66,667 + $0 = $66,667 Overall capitalization rate = 15% Debt-to-equity ratio =0 17.24
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Arbitrage Example: Company L Valuation of Company L Earnings available to = E = O – I common shareholders = $10,000 – $3,600 = $6,400 Market value = E / ke of equity = $6,400 / 0.16 = $40,000 Total market value = $40,000 + $30,000 = $70,000 Overall capitalization rate = 14.3% Debt-to-equity ratio = 0.75 17.25
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Completing an Arbitrage Transaction Assume you own 1% of the stock of Company L (equity value = $400). You should:
17.26
•
1. Sell the stock in Company L for $400.
•
2. Borrow $300 at 12% interest (equals 1% of debt for Company L).
•
3. Buy 1% of the stock in Company NL for $666.67. This leaves you with $33.33 for other investments ($400 + $300 - $666.67).
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Completing an Arbitrage Transaction Original return on investment in Company L $400 × 16% = $64 Return on investment after the transaction • $666.67 × 16% = $100 return on Company NL • $300 × 12% = $36 interest paid • $64 net return ($100 – $36) AND $33.33 left over.
This reduces the required net investment to $366.67 to earn $64.
17.27
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Summary of the Arbitrage Transaction • The investor uses “personal” rather than corporate financial leverage. • The equity share price in Company NL rises based on increased share demand. • The equity share price in Company L falls based on selling pressures. • Arbitrage continues until total firm values are identical for companies NL and L. • Therefore, all capital structures are equally as acceptable.
17.28
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Market Imperfections and Incentive Issues
17.29
•
Bankruptcy costs (Slide 17–30)
•
Agency costs (Slide 17–31)
•
Debt and the incentive to manage efficiently
•
Institutional restrictions
•
Transaction costs
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Required Rate of Return on Equity with Bankruptcy
Required Rate of Return on Equity (ke)
ke with bankruptcy costs
for financial risk
ke with no leverage ke without bankruptcy costs
for business risk
Rf
Risk-free rate
Financial Leverage (B / S) 17.30
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. • Monitoring includes bonding of agents, auditing financial statements, and explicitly restricting management decisions or actions.
• Costs are borne by shareholders (Jensen & Meckling). • Monitoring costs, like bankruptcy costs, tend to rise at an increasing rate with financial leverage.
17.31
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Example of the Effects of Corporate Taxes The judicious use of financial leverage (i.e., debt) provides a favorable impact on a company’s total valuation. Consider two identical firms EXCEPT: • • • •
17.32
Company ND – no debt, 16% required return Company D – $5,000 of 12% debt Corporate tax rate is 40% for each company NOI for each firm is $10,000
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Corporate Tax Example: Company ND Valuation of Company ND (Note: has no debt) Earnings available to = E= O – I common shareholders = $2,000 – $0 = $2,000 Tax Rate (T) = 40% Income available to = EACS (1 – T) common shareholders = $2,000 (1 – 0.4) = $1,200
Total income available to = EAT + I holders = $1,200 + 0
17.33
all security = $1,200
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Corporate Tax Example: Company D Valuation of Company D (Note: has some debt) Earnings available to = E= O – I common shareholders = $2,000 – $600 = $1,400 Tax Rate (T) = 40% Income available to = EACS (1 – T) common shareholders = $1,400 (1 – 0.4) = $840 Total income available to = EAT + I holders = $840 + $600 $1,440*
all security =
* $240 annual tax-shield benefit of debt (i.e., $1,440 - $1,200) 17.34
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 of debt*
=
(r) (B) (tc) r
=
($5,000) (0.4) =
=
(B) (tc) $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.
17.35
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 levered firm
=
Value of firm if unlevered
Value of unlevered firm
+
Present value of tax-shield benefits of debt
= $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 17.36
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.
17.37
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%.
17.38
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Bankruptcy Costs, Agency Costs, and Taxes Value of levered firm = Value of firm if unlevered + Present value of tax-shield benefits of debt - Present value of bankruptcy and agency costs As financial leverage increases, tax-shield benefits increase as do bankruptcy and agency costs.
17.39
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Cost of Capital (%)
Bankruptcy Costs, Agency Costs, and Taxes
Minimum Cost of Capital Point
Taxes, bankruptcy, and agency costs combined
Net tax effect Optimal Financial Leverage
Financial Leverage (B/S) 17.40
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Financial Signaling • A manager may use capital structure changes to convey information about the profitability and risk of the firm.
• Informational Asymmetry is based on the idea that insiders (managers) know something about the firm that outsiders (security holders) do not. • Changing the capital structure to include more debt conveys that the firm’s stock price is undervalued. • This is a valid signal because of the possibility of bankruptcy.
17.41
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Timing and Flexibility 1.
2.
17.42
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.
Flexibility • A decision today impacts the options open to the firm for future financing options – thereby reducing flexibility. • Often referred to unused debt capacity.
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Checklist of Practical and Conceptual Considerations
17.43
•
Taxes
•
EBIT-EPS analysis
•
Explicit cost
•
Capital structure ratios
•
Cash-flow ability to service debt
•
Security rating
•
Timing
•
Flexibility
•
Agency costs and incentive issues
•
Financial signaling
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Related Documents 3h463d
Chapter 17 - Yambao - Capital Structure Determination 3a5n4u
April 2022 0
Chapter # 17: Raising Capital 5v4k2d
April 2021 0
Chapter 17. Multinational Cost Of Capital And Capital Structure 4575g
December 2021 0
Capital Structure 146h2y
January 2021 0
Capital Structure 146h2y
January 2023 0
Chapter 13 Capital Structure And Leverage 122ai
November 2019 52More Documents from "Aiza Lopez Colorado" 1x2a1m
Chapter 17 - Yambao - Capital Structure Determination 3a5n4u
April 2022 0
Credit Card Fees Letter 45i25
December 2021 0
Audit Program Prepaid Expenses 2e2y1g
December 2019 54
Harga Perkhidmatan Service Aircond 3h2b22
November 2019 249
Kumpulan 2-kesan Pembuangan Bahan Sisa Industri 715a8
December 2019 55