1. Capital Structure Theory Chapter Sixteen

2. Corporate Finance Ch16 1/p17 Prof. Oh, 2012 Choosing a Capital Structure  What is the primary goal of financial managers? Maximize stockholder wealth  We want to choose the capital structure that will maximize stockholder wealth  We can maximize stockholder wealth by maximizing firm value or minimizing WACC

3. Corporate Finance Ch16 2/p17 Prof. Oh, 2012 Capital Structure Theory  Modigliani and Miller Theory of Capital Structure Proposition I – firm value Proposition II – WACC  The value of the firm is determined by the cash flows to the firm and the risk of the assets

4. Corporate Finance Ch16 3/p17 Prof. Oh, 2012 Does Capital Structure Policy Matter?  Suppose that there are two firms that are identical in the assets and the operations but different only in capital structure(Assume that there is no corporate tax).  Do two firms have different firm values?  But, debt has a lower cost of capital(see next slide)  Does this mean that firms should prefer debt to equity?  To answer the question, consider WACC

5. Corporate Finance Ch16 4/p17 Prof. Oh, 2012 Re, Rd and WACC(No Tax Case)

6. Corporate Finance Ch16 5/p17 Prof. Oh, 2012 But, Debt has a Tax Effect Unlevered Firm Levered Firm (D=1,000) EBIT1000 Interest(8%)080 Taxable Income1000920 Taxes (30%)300276 Net Income700644 CFFA700724

7. Corporate Finance Ch16 6/p17 Prof. Oh, 2012 Interest Tax Shield  Annual interest tax shield Tax rate times interest payment Annual tax shield =.30(80) = 24  Present value of annual interest tax shield Assume perpetual debt for simplicity PV = 24 /.08 = 300 PV = D(R D )(T C ) / R D = DT C = 1000(.30) = 300

8. Corporate Finance Ch16 7/p17 Prof. Oh, 2012 Value of the levered firm

9. Corporate Finance Ch16 8/p17 Prof. Oh, 2012 Value of the levered firm  The value of the firm increases by the present value of the annual interest tax shield Value of a levered firm = value of an unlevered firm + PV of interest tax shield  Assuming perpetual cash flows V L = V U + D*T C If V U = 7000, then V L = 7000 + 1000(0.3)=7300 V L = E + D, So E = V L – D= 7300 – 1000=6300

10. Corporate Finance Ch16 9/p17 Prof. Oh, 2012 WACC of levered firm

11. Corporate Finance Ch16 10/p17 Prof. Oh, 2012 Cost of Capital of levered firm  The WACC decreases as D/E increases because of the tax savings on interest payments WACC = (E/V)R E + (D/V)(R D )(1-T C ) R E = R U + (R U – R D )(D/E)(1-T C )  Example Assume R U =10%, R D =8%, D/E=1000/6300 and T C =30%. Then, R E =10+(10-8)(1000/6300)(1-.3)=10.2% WACC=(6300/7300)*10.2+(1000/7300)*8*(1-.3) =8.8%+0.8%=9.6% Check Vu=EBIT(1-t)/Ru = 700/0.1=7,000

12. Corporate Finance Ch16 11/p17 Prof. Oh, 2012 Example  Suppose that the firm changes its capital structure so that the debt-to-equity ratio becomes 1.  What will happen to the cost of equity under the new capital structure? R E =  What will happen to the weighted average cost of capital? WACC =

13. Corporate Finance Ch16 12/p17 Prof. Oh, 2012 But consider Bankruptcy Costs  Now we add bankruptcy costs  As the D/E ratio increases, the probability of bankruptcy increases  This increased probability will increase the expected bankruptcy costs  At some point, the additional value of the interest tax shield will be offset by the expected bankruptcy cost  At this point, the value of the firm will start to decrease and the WACC will start to increase as more debt is added

14. Corporate Finance Ch16 13/p17 Prof. Oh, 2012 Value of Firm with Bankruptcy Costs

15. Corporate Finance Ch16 14/p17 Prof. Oh, 2012 WACC with Bankruptcy Costs

16. Corporate Finance Ch16 15/p17 Prof. Oh, 2012 Observed Capital Structure  Capital structure does differ by industries  Differences according to Cost of Capital 2000 Yearbook by Ibbotson Associates, Inc. Lowest levels of debt  Drugs with 2.75% debt  Computers with 6.91% debt Highest levels of debt  Steel with 55.84% debt  Department stores with 50.53% debt

17. Corporate Finance Ch16 16/p17 Prof. Oh, 2012 WACC with Everything Business Risk

18. Corporate Finance Ch16 17/p17 Prof. Oh, 2012 The Pecking-Order Theory  Theory stating that firms prefer to issue debt rather than equity if internal financing is insufficient. Rule 1: Use internal financing first Rule 2: Issue debt next, new equity last  The pecking-order theory is at odds with the static theory: There is no target D/E ratio Profitable firms use less debt Companies like financial slack