Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved 1 Chapter 16 Assessing Long-Term Debt, Equity, and Capital Structure McGraw-Hill/Irwin 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