1. Chapter 9 Theory of Capital Structure

2. Introduction to the Theory
Capital structure is the proportions of
Debt
Preferred stock
Common stock
Assumptions
Definitions
NOI approach
Traditional approach

3. Assumptions No taxes & no bankruptcy costs No transaction costs
Pay all earnings in dividends
Same expected future operating earnings for all investors
No growth of earnings

4. Definitions ki is the yield on the company’s debt
ke is the earnings/price ratio
Required rate of return for investors
k0 is an overall capitalization rate for the firm
Weighted average cost of capital (WACC)

5. Calculating NOI ApproachX
Overall capitalization rate =
Total value of firm –
Market value of debt
Market value of stock

6. NOI Approach
Required return on equity increases linearly with leverage
Total valuation of the firm unaffected by it capital structure

7. Important Assumptions of NOI Approach
k0 is constant
Regardless of the degree of leverage
Breakdown between debt and equity unimportant
If ki remains constant, ke is a constant linear function of the debt-to-equity ratio
k0 cannot be altered through leverage
No one optimal capital leverage

8. Traditional Approach There is an optimal capital structure
Increase the total value of the firm through leverage
Cost of capital is independent of the capital structure
Optimal capital structure exists

9. Modigliani-Miller (MM) Position
Assumptions are important
Capital structure is irrelevant
Total investment value of a corporation depends on profitability and risk
Value is the same regardless of financing mix
Homemade leverage
Arbitrage efficiency

10. Irrelevance in a CAPM Framework
As leverage increases
Expected return and beta increase proportionally
The change in expected return and beta offset each other with respect to share price
Share price is invariant with respect to leverage

11. Taxes and Capital Structure
Important market imperfections
Corporate taxes
Components of overall value
Value if levered + Value of tax shield
Optimal strategy is to maximize leverage
Not consistent with corporate behavior

12. Uncertainty of Tax Shield
Income is consistently low or negative
Bankruptcy
Change in the corporate tax rate
Redundancy

13. New Value Equation Value of Value if Pure value Value lost
firm = Unlevered + of corporate – through tax
tax shield shield
uncertainty

14. Corporate Plus Personal Taxes
Personal taxes can reduce the corporate tax advantage
Dividends versus capital gains
Debt or stock income

15. Merton Miller’s Equilibrium
In market equilibrium personal and corporate tax effects cancel out
Investor clienteles and market equilibrium
Completing the market
Counterarguments
Zero personal tax on stock income is suspect
Disturbing relationship between
Corporate debt
Stock returns
Returns on tax-exempt municipal bonds

16. Recapitulation Tax advantage to borrowing Moderate amounts of debt
Tax shield uncertainty is not great
Some lessening of the corporate tax effect
Owing to personal taxes
Greater the tax wedge
Lower the overall tax shield

17. Effects of Bankruptcy Costs
Less than perfect capital markets
Administrative costs to bankruptcy
Assets liquidated at < economic value
Relationship to leverage
Deadweight loss to suppliers of capital
Taxes and bankruptcy costs
Trade-off between
Tax effects of leverage
Bankruptcy costs associated with high leverage
Most important imperfections

18. Other Imperfections
Corporate and homemade leverage not being perfect substitutes
Advantage to corporation borrowing
Arbitrage process
Institutional restrictions
Adverse effects on market value
Greater the importance of imperfections
Less effective MM arbitrage process
Greater the case for an optimal capital structure

19. Incentive Issues and Agency Costs
Stakeholders monitoring
Equity holders
Debt holders
Management
Other stakeholders

20. Debt Holders Versus Equity Holders
Equity of a firm
Call option on the firm’s total value
Debtholders are the writers of the option

21. Effect of Variance and the Riskiness of Assets
By increasing the riskiness of the company
Stockholders increase the value of their stock
At the direct expense of the debt holders

22. Changing the Proportion of Debt
Will affect the relative valuation
Of debt
Of equity
Relationship between the proportion of debt and valuation
Increasing the proportion of debt
Results in a decline in the price of debt
Results in an increase in share price

23. Protective Covenants Restrict the stockholders’ ability
To increase the assets riskiness
To increase leverage
MM argument
“Me-first” rules

24. The Underinvestment Problem
Result of equity holders not wishing to invest when the rewards favor debt holders
Disappears when
Investors own both stocks and bonds
By contracting between debt holders and stockholders

25. Agency Costs More Broadly Defined
Monitoring
Cost is born by stockholders
Debt holders charge more interest
May limit the optimal amount of debt
Optimal balance between
Monitoring costs
Interest rate charged on debt

26. Organizational Incentives to Manage Efficiently
Leveraged companies
May be lean because management cuts the fat
Running scared
Debt brings capital-market discipline to management
Company with little debt
Significant free cash flow
Have a tendency to squander funds

27. Asymmetric Information
Signaling effect
Assumes there is information asymmetry
Credibility of a financial signal depends on asymmetric information
The greater the asymmetry in information the greater the likely stock reaction to a financing announcement
What is significant?
The signal conveyed by a changed capital structure