FIN 819 The Capital Structure Some classic arguments

FIN 819 Today’s plan The capital structure without corporate taxes Valuing risky corporate bonds Capital structure with corporate taxes Two theories for the optimal capital structure in the real world.

FIN 819 Look at the both sides of a balance sheet AssetLiabilities and equity Market value of the asset V Market value of equity E Market value of debt D V=E+D

FIN 819 Capital structure Capital structure refers to the mix of debt and equity of a firm. Capital structure has two related questions: Does the capital structure affect the value of a firm? Or does the amount of debt a firm has affect its value? What is the optimal amount of debt a firm should have?

FIN 819 Capital structure Does the size of a pizza have nothing to do with how it is sliced? Is the value of a firm also independent of how the firm mixes debt and equity?

FIN 819 Does capital structure affect the firm value? EquityDebt Equity Debt Govt. Slicing the pie doesn’t affect the total amount available to debt holders and equity holders Slicing the pie can affect the size of the slice going to government Slicing the pie can affect the size of the wasted slice wasted

FIN 819 Capital structure without corporate taxes If there is no corporate tax, we will have the following two famous results M&M propositions 1 and 2 Pay attention to the condition for these propositions to be valid Why do we consider such simple, unrealistic situations?

FIN 819 MM’s proposition 1 (without tax) Modigliani & Miller If the investment opportunity is fixed, there are no taxes, and capital markets function well, the market value of a company does not depend on its capital structure. What is the intuition for this result? Can we use different ways to prove this?

FIN 819 MM’s proposition 2 (without tax) Modigliani & Miller If the investment opportunity is fixed, there are no taxes, and capital markets function well, the expected rate of return on the common stock of a levered firm increases in proportion to the debt-equity ratio (D/E), expressed in market values. The WACC is a constant.

FIN 819 Example - River Cruises - All Equity Financed M&M (Debt Policy Doesn’t Matter)

FIN 819 Example cont. 50% debt M&M (Debt Policy Doesn’t Matter)

FIN 819 r DVDV rDrD rErE WACC WACC without taxes in MM’s view

FIN 819 Valuing risky debt So far, we have learned how to value a risk- free debt. By risk-free debt, we mean that bond investors always get paid for what they are promised when they lend money to firms or governments. In reality, corporate bonds are not risk-free. When firms borrow money from the bond holders, they may not have enough cash to pay the bond holders in the future.

FIN 819 Valuing risky debt To illustrate how to value a risky debt, we focus on a simple situation: Firms have a zero-coupon bond. More specific, suppose that a firm has issued $K million zero-coupon bonds maturing at time T. Let the market value of the firm asset at time T be V(T).

FIN 819 Valuing risky corporate debts Using the put-call parity, we have Where P(K,T) is the value of a European put option with the strike price K and the maturity date T Please try to derive this formula and understand this situation?

FIN 819 Problem: On march 4, 1994, Chrysler was the eighth largest U.S. firm according to Fortune magazine. It issued 20-years zero-coupon debt with book value of $ billion. The book value of the asset is $43.83 billion and the market value of equity is $ billions. The risk free rate was 8% and the volatility of the asset return is 30%. What is the market value of the debt? What is the interest rate charged on Chrysler’s debt? Example

FIN 819 Solution The market value of the debt is $5.98 million The interest rate charge on Chrysler’s debt is 9.11%. The market value of the asset is $27.03 million

FIN 819 Capital structure with taxes If there is corporate tax, we also have two famous results: M&M propositions 1 and 2 Remember that to make the two propositions valid, we still have to assume that the investment opportunity is fixed and the financial market functions very well.

FIN 819 MM’s propositions withtax MM’s proposition 1 firm value = value of all equity firm + PV (tax shield) PV(tax shield)=T c D MM’s proposition 2 The weighted average cost of capital is decreasing with the ratio of D/E, and the cost of equity is increasing with D/E. Can you prove and understand these results?

FIN 819 WACC Graph

FIN 819 Optimal Capital structure with tax So according to M&M proposition 1 with tax, the optimal capital structure is that firms issue all the debt. In the real world, very few firms issue all the debt to raise money What is wrong with M&M propositions?

FIN 819 Capital structure with financial distress cost Costs of Financial Distress - Costs arising from bankruptcy or distorted business decisions before bankruptcy. Market Value =Value if all Equity Financed + PV Tax Shield - PV Costs of Financial Distress

FIN 819 Optimal Capital structure Trade-off Theory - Theory that capital structure is based on a trade-off between tax savings and distress costs of debt. Pecking Order Theory - Theory stating that firms prefer to issue debt rather than equity if internal finance is insufficient.

FIN 819 Financial Distress Debt Market Value of The Firm Value of unlevered firm PV of interest tax shields Costs of financial distress Value of levered firm Optimal amount of debt Maximum value of firm