FIN 351: lecture 12 The Capital Structure Decision MM propositions

FIN 351: lecture 12 Today’s plan Review what we have learned about market efficiency Why is it important? What are the three-forms of market efficiency? Can you give me an example for each form of market efficiency? The capital structure decision The capital structure without taxes MM’s proposition 1 MM’s proposition 2 The capital structure with taxes MM’s proposition 1 MM’s proposition 2

FIN 351: lecture 12 What have we learned in the last lecture? What do we mean by market efficiency? Why is market efficiency important in corporate finance? What are the three-forms of market efficiency? Can you give me an example for each form of market efficiency?

FIN 351: lecture 12 Some true or false questions about market efficiency 1 When securities are priced fairly, then financing at current market rates is a positive NPV transaction. 2 Firms should avoid financing through stock issues, since stock financing is a zero-NPV transaction. 3 If the market is efficient, stock prices should only be expected to react to new information that is released. 4 The intent of technical analysis is to discover patterns in past stock prices. 5 Technical analysts have no effect upon the efficiency of the stock market. 6 Market efficiency implies that security prices impound new information quickly.

FIN 351: lecture 12 Some true or false questions about market efficiency 7. Financing decisions are easier to reverse than investment decisions. 8. In efficient capital markets, all securities are fairly priced. 9. If security prices follow a random walk, then on any particular day, the odds are that an increase or decrease in price is equally likely. 10. Fundamental analysts attempt to get rich by identifying patterns in stock prices. 11.Strong-form market efficiency implies that one could earn above average returns by examining the history of a firm's stock price. 12. Insider information has nothing to do with historical stock prices

FIN 351: lecture 12 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 351: lecture 12 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 351: lecture 12 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 351: lecture 12 MM’s proposition 1 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. How can we understand this? The size of a pizza has nothing to do with how you slice it.

FIN 351: lecture 12 Example - River Cruises - All Equity Financed M&M (Debt Policy Doesn’t Matter)

FIN 351: lecture 12 Example cont. 50% debt M&M (Debt Policy Doesn’t Matter)

FIN 351: lecture 12 Example - River Cruises - All Equity Financed - Debt replicated by investors M&M (Debt Policy Doesn’t Matter)

FIN 351: lecture 12 MM’s proposition 2 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 independent of how the firm is financed

FIN 351: lecture 12 r DVDV rDrD rErE WACC WACC without taxes in MM’s view

FIN 351: lecture 12 The use of debt has a lot of implications: Financial risk- The use of debt will increase the risk to share holders and thus Increase the variability of shareholder returns. Interest tax shield- The savings resulting from deductibility of interest payments. Capital structure and Corporate Taxes

FIN 351: lecture 12 You own all the equity of Space Babies Diaper Co.. The company has no debt. The company’s annual cash flow is $1,000, before interest and taxes. The corporate tax rate is 40%. You have the option to exchange 1/2 of your equity position for 10% bonds with a face value of $1,000. Should you do this and why? An example on Tax shield

FIN 351: lecture 12 All Equity1/2 Debt EBIT1,000 Interest Pmt 0 Pretax Income1,000 40% 400 Net Cash Flow$600 C.S. & Corporate Taxes

FIN 351: lecture 12 All Equity1/2 Debt EBIT1,0001,000 Interest Pmt Pretax Income1, % Net Cash Flow$600$540 C.S. & Corporate Taxes

FIN 351: lecture 12 Capital Structure and Corporate Taxes All Equity1/2 Debt EBIT1,0001,000 Interest Pmt Pretax Income1, % Net Cash Flow$600$540 Total Cash Flow All Equity = 600 *1/2 Debt = 640 ( )

FIN 351: lecture 12 Capital Structure and tax shield PV of Tax Shield = D x r D x Tc r D = D x Tc Example: Tax benefit = 1000 x (.10) x (.40) = $40 PV of 40 perpetuity = 40 /.10 = $400 PV Tax Shield = D x Tc = 1000 x.4 = $400

FIN 351: lecture 12 MM’s proposition 1 with tax firm value = value of all equity firm + PV(tax shield) Example, all equality firm value =600/0.1=6,000 PV( tax shield)=400 firm value=6,400

FIN 351: lecture 12 MM’s proposition 2 The weighted average cost of capital is decreasing with the ratio of D/E, that is Can you understand this intuitively?

FIN 351: lecture 12 WACC Graph

FIN 351: lecture 12 Financial Distress 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 351: lecture 12 Financial distress 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 351: lecture 12 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 351: lecture 12 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