Part 4 Capital structure and
Dividend policy
Outline of this part
If a firm seeks to create value with its financing decisions,the
firm must find positive NPV financial arrangements,
We will show that the sources of NPV in financing are taxes,
bankruptcy,and agency costs.
This part is composed by six chapters like,
Chapter 13 Corporate financing decisions and efficient capital
markets
Chapter 14 Long—term financing,an introduction
Chapter 15 Capital structure,basic concepts
Chapter 16 Capital structure,limits to the use of debt
Chapter 17 Valuation and capital budgeting for the levered firm
Chapter 18 Dividend policy,why does it matter?
Part 4 Capital structure and
Dividend policy
Chapter 13 Corporate—financing
decisions and ECM
Chapter 13 Corporate—
financing decisions and ECM
In the past few parts,we have concentrated almost
exclusively on the left—hand side of the balance
sheet(the firm’s capital expenditure decisions),and
now we move to the right—hand side and to the
problems involved in financing the capital
expenditures,
To put it crudely,you have learned hoe to spend
money,now you must to learn how to raise it.
Now we have not totally ignored financing in our
discussion of capital budgeting,But we made the
simplest possible assumption,all—equity financing.
Chapter 13 Corporate—
financing decisions and ECM
What should we do for determine the best financing
strategy?
– Should the firm reinvest most of its earnings in the business,
or should it pay them out as dividends?
– If the firm needs more capital,should it issue more stock or
should it borrow?
– Should it borrow short—term or long—term?
– Should it borrow by issuing a normal long—term bond or a
convertible bond?
……………..
Chapter 13 Corporate—
financing decisions and ECM
13.1 Should financing decisions create value?
In the earlier parts of this book,we have learn how to
evaluate project with NPV,
Typical financing decisions include how much,what type and
when for the debt and equity to sell.
Though the procedure for evaluating financing decisions is
identical to the procedure for evaluating projects,the
results are different,It turns out that the typical firm has
many more capital—expenditure opportunities with
positive NPV,
Though this dearth of profitable financing opportunities will
be examined in detail later,a few remarks are in order now.
Chapter 13 Corporate—
financing decisions and ECM
– Fool investors
– Reduce costs or increase subsidies
– Create a new security
Chapter 13 Corporate—
financing decisions and ECM
Random walking theory
As so often the case with important ideas,the concept of
efficient capital markets stemmed from a chance discovery,
In 1953,Maurice Kendall,a British statistician presented a
controversial paper to the Royal Statistical Society on the
behavior of stock and commodity price.
He had expected to find regular price cycles,but to his
surprise they did not seem to exist,Each series appeared to
be a wandering one,In other words,the prices of stocks
and commodities seemed to follow a random walk,
– The movement of stock prices from day to day DO NOT
reflect any pattern,
Chapter 13 Corporate—
financing decisions and ECM
Coin Toss Game
In this game,if it comes up head,you win 3percent of your invest,
if it tails you lose 2.5 percent of you investment.
100
Head
Tail
103
97.5
head
head
Tail
Tail
106.09
100.43
100.43
95.06
Chapter 13 Corporate—financing
decisions and ECM
13.2 Capital market efficiency
A question that has received particular attention is whether
price adjust quickly and correctly when new information
arrives,A market is said to be ―efficient‖ if this is the case,
In an efficient capital market,current market prices fully
reflect available information,
Efficient capital market is the market in which security price
reflect available information.
– Price behavior in an efficient market
To illustrate how price behavior in an efficient market,
suppose the X corporation has developed a new
production,X’s capital budgeting analysis suggests that
Chapter 13 Corporate—financing
decisions and ECM
launching the new production,That is the NPV is positive,
The key assumption thus far is that X has not released
any information about the new system,so the fact of its
existence is ―inside‖ information only.
Now consider a share of stock in X,in an efficient market,
its price reflects what is known about X current
operations and profitability,and it reflects market
opinion about X’s potential for future growth and
profits.
If the market agree with X’s assessment of the value of the
new project,X’s stock price will rise when the decision
to launch is made public,
Chapter 13 Corporate—financing
decisions and ECM
PriceReaction of
stock
price to new
information in
efficient and
inefficient
market
22
18
14
10
-8 -6 -4 -2 0 +2 +4 +6 +8
Overreaction and
correction
Efficient market reaction
Delayed reaction
Chapter 13 Corporate—
financing decisions and ECM
Efficient market reaction is the price instantaneously
adjusts to and fully reflects new information; there is no
tendency for subsequent increases and decreases.
Delayed reaction is the price partially adjusts to the new
information; 8days elapse before the price completely
reflects the new information.
Overreaction is the price overadjusts to the new
information; it ―overshoots‖ the new price and
subsequently corrects.
– The efficient market hypothesis
A body of theory called the efficient market hypothesis
holds (1) that stocks are always in equilibrium and (2)
that it is impossible for an investor to consistently ―beat
the market.‖
Chapter 13 Corporate—
financing decisions and ECM
Efficient market hypothesis is the hypothesis that securities
are typically in equilibrium – that they are fairly priced in
the sense that the price reflects all publicly available
information on each security.
If a market is efficient,then there is a very important
implication for market participants,All investments in
an efficient market are zero NPV investments,
That is if prices are neither too low nor too high,then the
difference between the market value of an investment
and its cost is zero,
In a efficient market,investors get exactly what they pay
for when they buy securities,and firms receive exactly
what their stocks and bonds are worth when they sell
them.
Chapter 13 Corporate—
financing decisions and ECM
What makes market efficient is competition among
investors,Many individuals spend their entire lives
trying to find misprice stocks,
If you know more about some company than other
investors in the marketplace,you can profit from that
knowledge by investing in the company’s stock if you
have good news and selling it if you have bad news.
The logical consequence of all this information being
gathered and analyzed is that mispriced stocks will
become fewer and fewer,Because of the competition
among investors,the market will become increasingly
efficient,
Chapter 13 Corporate—
financing decisions and ECM
13.3 The form or different types of EMH
Financial theorists generally define three forms,or levels,
of market efficiency:
The weak-form of EMH states
The weak-form of EMH states that all information
contained in past price movements is fully reflected in
current market price,Therefore information about
recent trends in stock prices is of no use in selecting
stocks– the fact that a stock has risen for the past
several days.
t1 e r r o r r a n do mr e t u r n e x p e c t e dtt PP
Chapter 13 Corporate—
financing decisions and ECM
The semistrong-form of EMH
The semistrong-form EMH states that current market
prices reflect all publicly available information,If this
is true,no abnormal returns can be gained by
analyzing stocks,
The strong-form of EMH
The strong-form of EMH states that current market
prices reflect all pertinent information,whether
publicly available or privately held.
Some common misconceptions about the EMH
Chapter 13 Corporate—
financing decisions and ECM
The efficacy of dart throwing
Price fluctuations
Stockholder disinterest
13.4 puzzles and anomalies—what do they mean
for the financial manager?
High returns on the stocks of small firms,Why?
– Do investors respond slowly to new information?
The earnings announcement puzzle
Chapter 13 Corporate—
financing decisions and ECM
In this puzzle,investors underreact to the earnings
announcement and become aware of the full significance
only as further information arrives.
The new—issue puzzle
When the firms issue stock to the public,investors
typically rush to buy,But researchers have found that
these early gains often turn into losses.
– Stock market anomalies and behavioral finance
Attitudes toward risk
Chapter 13 Corporate—
financing decisions and ECM
Attitudes toward risk psychologists have observed that
when making risky decisions,people are particularly
loath to incur losses,even if those losses are small.
Losers tend to regret their actions and kick themselves for
having been so foolish,To avoid this unpleasant
possibility,individuals will tend to avoid those actions
that may result in loss.
Beliefs of about probabilities
Most investors do not have a PhD in probability theory
and may make systematic errors in assessing the
probability of uncertain outcome,
Psychologists have found that when judging the possible
future outcome,individual commonly look back to
Chapter 13 Corporate—
financing decisions and ECM
what has happened in recent periods and then assume
that this is representative of what may occur in the
future,
– Professional investors,irrational exuberance,and
the Dot,Com bubble
Alan Greenspan
Robert Shiller a professor of Yale,he said that as the
bull market developed,it generated optimism about the
future and stimulated demand for stock,Moreover,as
investors racked up profits on their stocks,they became
even more confident in their opinions.
Chapter 13 Corporate—
financing decisions and ECM
– The crash of 1987 and relative efficiency
October 19,1987,was commonly called the Black
Monday,
After the crash,everybody want to know,Who were the
guilty parties? And Do prices reflect fundamental values?
– Index arbitrageurs
– Portfolio insurance
Investors almost always price a common stock relative
to yesterday’s price or today’s price of comparable
securities.
The hypothesis that stock price always equals intrinsic
value is nearly impossible to test,because it is so
Chapter 13 Corporate—
financing decisions and ECM
difficult to calculate intrinsic value without referring to
prices,
However the crash does not undermine the evidence for
market efficiency with respect to relative price.
– Market anomalies and the financial manager
A firm’s financial manager has said that:
Great ! Our stock is clearly overpriced,This means we
can raise capital cheaply and invest in Project X,Our
high stock price gives us a big advantage over our
competitors who could not possibly justify investing in
Project X.
Do he/she is correct? Why?
Chapter 13 Corporate—
financing decisions and ECM
13.5 The six lessons of market efficiency
– Markets have no memory
The weak form of the EMH states that the sequence of
past price changes contains no information about future
changes.
Economists express the same idea more concisely when
they say that the market has no memory.
– Trust market prices
In an efficient market you can trust prices,for they
impound all available information about the value of
each security,,This means that in an efficient market,
there is no way for most investors to achieve consistently
superior rate of return.
Chapter 13 Corporate—
financing decisions and ECM
To do so,you not only need to know more than anyone
else,but also need to know more than everyone else.
– Read the entrails
If the market is efficient,prices impound all available
information,Therefore,if we can only learn to read the
entrails,security prices can tell us a lot about the future.
– There are no financial illusions
In an efficient market there are no financial illusions,
Investors are unromantically concerned with the firm’s
cash flows and the portion of those cash flows to which
they entitled.
Chapter 13 Corporate—
financing decisions and ECM
– The do—it—yourself alternative
In an efficient market investors will not pay others for
what they can do equally well themselves.
As we shall see,many of the controversies in corporate
financing center on how well individuals can replicate
corporate financial decisions,
The financial manager needs to ask the same question
when considering whether it is better to issue debt or
stock.
– Seen one stock,seen them all
Chapter 13 Corporate—
financing decisions and ECM
13.6 An overview of corporate financing
– Patterns of corporate financing
Firms may raise funds from external sources or plow
back profits rather than distribute them to shareholders,
In most years there is a gap between the cash that
companies need and the cash that they generate
internally,This gap is the financial deficit,
Should a firm elect external financing,they may choose
between debt or equity sources.
Dose firms rely too much on internal funds?
Chapter 13 Corporate—
financing decisions and ECM
Has capital structure changed?
We commented that in recent years firms have,in the
aggregate,issued much more debt than equity,But is
there a long—run trend to heavier reliance on debt
finance? This is a hard question to answer in general,
because financing policy varies so much from industry
and from firm to firm,
The next table shows the aggregate balance sheet of all
manufacturing corporations in the US in 2001.
So what is the book debt ratio?
Because financial analysts sometimes focus on the
proportions of debt and equity in long term financing.
Chapter 13 Corporate—
financing decisions and ECM
A g g r e g a t e b a l a n c e s h e e t f o r m a n u f a c t u r i n g c o r p o r a t i o n s
i n t h e U n i t e d S t a t e s,2 0 0 1 ( f i g u r e s i n B i l l i o n s ),
C u r r e n t a s s e t s 1,5 4 7$ C u r r e n t l i a b i l i t i e s 1,2 3 4$
F i x e d a s s e t s 2,3 6 1 L o n g t e r m d e b t 1,0 3 8
L e s s 1,1 6 6 O t h e r l o n g t e r m 679
d e p r e c i c a t i o n l i a b i l i t i e s
N e t f i x e d a s s e t s 1,1 9 5 To t a l l o n g t e r m l i a b i l i t i e s 1,7 1 7
O t h e r l o n g t e r m 2,1 6 0 S t o c k h o l d e r s ' e q u i t y 1,9 5 1
To t a l a s s e t s 4,9 0 3 To t a l l i a b i l i t i e s a n d 4,9 0 3
s t o c k h o l d e r s ' e q u i t y
Chapter 13 Corporate—
financing decisions and ECM
The sum of long—term liabilities and stockholders’
equity is called total capitalization,
– Common stock
– Debt
– Financial market and institutions
60.903,4 717,1234,1a s s e t s T o t a lD e b td e b t r a t i o
47.
951,1717,1
717,1
e q u i t ysl i a b i l i t i e t e r mL o n g
sl i a b i l i t i e t e r mL o n g?
Chapter 13 Corporate—
financing decisions and ECM
Primary
Markets
Secondary
Markets
OTC
Markets
Money
Chapter 13 Corporate—
financing decisions and ECM
Company
Intermediaries
Banks
Insurance Cos.
Brokerage Firms
Obligations Funds
Chapter 13 Corporate—
financing decisions and ECM
Intermediaries
Investors
Depositors
Policyholders
Investors
Obligations Funds
Chapter 13 Corporate—
financing decisions and ECM
13.7 Implications for corporate finance
– Accounting and efficient market
The accounting profession provides firms with a
significant amount of leeway in their reporting practices,
Companies may choose between the last—in—first—
out(LIFO) or first—in—first—out (FIFO) method on
valuing inventories.
They may choose either the percentage—of—completion
or the completed—contract method for construction
projects,
They may depreciate physical assets by either
accelerated or straight—line depreciation.
Chapter 13 Corporate—
financing decisions and ECM
Accountants have frequently been accused of misusing
this leeway in the hopes of boosting earnings and stock
price,
However,accounting choice should not affect stock
price if two conditions hold,First is enough information
must be provided in the annual report so that financial
analysts can construct earnings under the alternative
accounting method,Second is the market must be
efficient in the semistrong form,the market must
appropriately use all of this accounting information in
determining the market price.
Chapter 13 Corporate—
financing decisions and ECM
– Timing and issuance of financing
Managers of a firm must be choose a perfect date to
issue equity,this is called the timing decision,If
managers believe that their stock is overpriced,they are
likely to issue equity immediately,Conversely they more
select waiting,
However,if market is efficient,securities are always
correctly priced,Since efficiency implies that stock is
always sold for its true worth,the timing decision
become unimportant,The figure shows three possible
stock price adjustments to the issuance of new stock.
If a firm’s stock are undervalued,the firm would like to
repurchase its stock.
Chapter 13 Corporate—
financing decisions and ECM
Three stock—price adjustmentsStock price
-6 –5 –4 –3 –2 –1 0 +1 +2 +3 +4 +5 +6
Issue
day
Stock price movement
if managers have inferior
timing ability
Efficient market
movement
Stock price movement
if managers have superior
timing liability
Months relative
to issue day
Chapter 13 Corporate—
financing decisions and ECM
– Price—pressure effect
Suppose a firm wants to sell a large block of stock,Can
it sell as many shares as it wants without depressing the
price?
If capital market is efficient,a firm should be able to sell
as many shares as it desires without depressing price.
Scholes,which is the first one to examine this question
by empirical analysis,said that the market’s ability to
absorb large blocks of stock was virtually unlimited.
Kraus and stoll had found other thing.
Chapter 13 Corporate—
financing decisions and ECM
Price impacts of block trading
Closing price P-1
Price prior to block
Block price
Closing price P0
Price
Time
End of day -1 End of day 0
Chapter 13 Corporate—
financing decisions and ECM
Summary of EMH
– Does not say
Prices are uncaused
Investors are foolish and stupid to be in the market
All shares of stock have the same expected returns
Investors should throw darts to select stocks
There is no upward trend in stock prices
– Does say
Prices reflect underlying value
Financial managers cannot time stock and bond sales
Sales of stock and bonds will not depress price
Chapter 13 Corporate—
financing decisions and ECM
You cannot cook the books.
– Why doesn’t every body believe it?
There are optical illusions,mirages,and apparent
patterns in charts of stock market returns:
The truth is less interesting
There is evidence against efficiency
– Seasonality
– Insider trading
– Excess stock-price volatility
The tests of market efficiency are weak.
Chapter 13 Corporate—
financing decisions and ECM
13.8 Summary and conclusions
– An efficient financial market processes the information
available to investors and incorporates it into the prices of
securities,This has two general implications,first is in any
given time period,a stock’s abnormal return can depend on
information or news received by the market in that period,
Second is an investor who uses the same information as the
market cannot expect to earn abnormal return,
– What information does the market use to determine price?
– There are several puzzles and anomalies the financial
manager must be solve.
– There are some types of corporate finance to be employed,
– Three implications of efficient markets for corporate finance.
Part 4 Capital structure and
Dividend policy
Chapter 14 Long—term
financing,an introduction
Chapter 14 Long—term
financing,an introduction
14.1 common stock
– Par and no—par stock
– Authorized versus issued common stock
Shares of common stock are the fundamental ownership
units of the corporation,The articles of incorporation of
a new corporation must state the number of shares of
common stock the corporation is authorized to issue.
Although there are no legal limits to authorized shares
of stock,some practical considerations may exist:
– Some states impose taxes based on the number of
authorized shares.
Chapter 14 Long—term
financing,an introduction
– Authorizing a large number of shares may create
concern on the part of investors,because authorized
shares can be issued later with the approval of the
board of directors but without a vote of the
shareholders.
– Capital surplus
Capital surplus usually refers to amounts of directly
contributed equity capital in excess of the par value.
– Retained earnings
The sum of the par value,capital surplus,and
accumulated retained earnings is the common equity of
the firm,which is usually referred to as the firm’s book
value.
Chapter 14 Long—term
financing,an introduction
– Market value,book value,and replacement value
Book value is a backward looking measure,It tells us
how much capital the firm has raised from shareholders
in the past,It does not measure the value that
shareholders place on those shares today,
The market value of the firm is forward looking,it
depends on the future dividends that shareholders
expect to receive,
Replacement value refers to the current cost of
replacing the assets of the firm.
Market,book and replacement value are equal at the
time when a firm purchases an asset.
Chapter 14 Long—term
financing,an introduction
– Shareholders’ rights
Cumulative voting
Straight voting
Proxy voting
Other rights
– The right to share proportionally in dividends paid.
– The right to share proportionally in assets remaining
after liabilities have been paid in a liquidation.
– The right to vote on matters of great importance to
stockholders.
– The right to share proportionally in any new stock
sold,This right also called preemptive right.
Chapter 14 Long—term
financing,an introduction
– Dividends
Dividends paid to shareholders represent a return on
the capital directly or indirectly contributed to the
corporation by the shareholders.
The payment of dividends is at the discretion of the
board of directors,
Here are some important characters of dividends:
– Unless a dividend is declared by the board of
directors of a corporation,it is not a liability of the
corporation,A corporation can’t default on an
undeclared dividends,As a consequence,corporation
can’t become bankrupt because of nonpayment of
dividends.
Chapter 14 Long—term
financing,an introduction
– The payment of dividends by the corporation is not a
business expense,
– Dividends received by individual shareholders are
for the most part considered ordinary income and
must be fully taxable.
– Classes of stock
14.2 Corporate long—term debt,the basics
– Interest versus dividends
– Is it debt or equity?
– Basic features of long—term debt
– Different types of debt
Chapter 14 Long—term
financing,an introduction
Note
Debenture which is an unsecured corporate debt,
whereas a bond is secured by a mortgage on the
corporate property.
Bond,in some ways,long-term bond also called funded
debt.
Consol,some debt is perpetual and has no special
maturity.
– Repayment
Amortization
Sinking funds
Callable debt
Chapter 14 Long—term
financing,an introduction
– Seniority and subordinated
– Security
– Indenture
The written agreement between the corporate debt
issuer and the lender,setting forth maturity date,
interest rate and other terms.
The indenture completely describes the nature of the
indebtedness,
It list all restrictions placed on the firm by the lenders in
restrictive covenants,
14.3 Preferred stock
Chapter 14 Long—term
financing,an introduction
– Stated value
– Cumulative and noncumulative dividends
– Is preferred stock really debt?
When we evaluating preferred stock we should consider
two offsetting taxes effects:
A,Dividends are not deducted from corporate income in
computing the tax ;liability of the issuing corporation.
B,When a corporation purchases preferred stock,70% of
the dividends received are exempt from corporate
taxation.
– The preferred stock puzzle
Effect A above represents a clear tax disadvantage to
the issuance pf preferred stock.
Chapter 14 Long—term
financing,an introduction
Effect B represents a tax advantage,
Both academics and practitioners generally agree that B
does not fully offset A.
But why firm issue preferred stock?
– Because the way utility rates are determined in
regulatory environments,regulated public utilities
can pass the tax disadvantage of issuing preferred
stock on to their customers,So a substantial
preferred amount of stock is issued by utilities.
– Companies reporting losses to the IRS may issue
preferred stock.because they have no taxable income
from which interest on debt can be deducted,
Chapter 14 Long—term
financing,an introduction
preferred stock imposes no tax penalty relative to debt,
In other words,A does not apply,
– firms issuing preferred stock can avoid the threat of
bankruptcy that exists with debt financing,
14.4 Patterns of financing
– Internal financing
Internal financing comes from internally generated cash
flow and it is defined as net income plus depreciation
minus dividends.
Equity versus Debt
Feature Equity Debt
Income Dividends Interest
Tax status Dividends taxed as
personal income,
dividends are not a
business expense.
Interest is taxed as personal
income,Interest is a business
expense,and firms can deduct
interest when computing
corporate tax liability
Control Common stock and
preferred stock
usually have voting
rights.
Control is exercised with loan
agreement
Default Firms can’t become
bankruptcy for
nonpayment of
dividends
Unpaid debt is a liability of the
firm,Nonpayment results in
bankruptcy.
Chapter 14 Long—term
financing,an introduction
– External financing
External financing is net debt and new shares of equity
net of buy—backs.
– Several features of long—term financing
Internally generated cash flow has dominated as a
source of financing.
A financial deficit is created by the different between
uses of financing and internally generated sources.
– Internal or external financing?
The first form of financing used by firm for positive
NPV projects is internally generated cash flows,that is
net income + depreciation - dividends
Chapter 14 Long—term
financing,an introduction
As a last resort a firm will use externally generated cash
flow,First,debt is used,common stock is used last.
14.5 Recent trends in capital structure
14.6 Summary and conclusion
– The basic sources of long—term financing and the essential
features of each.
– The kinds of debt and their features.
– Preferred stock
– Patterns of corporate financing
– Capital structure’s new trends,
Part 4 Capital structure and
Dividend policy
Chapter 15 capital structure,
Basic concepts
Chapter 15 Capital structure:
Basic concepts
In the previous chapters we had examined the capital—
budgeting decisions,
In general,a firm can choose any capital structure that it
wants,It can issue any kinds of securities which it can,
Because the number of instruments is so large,the
variations in capital structures are endless,
We simplify the analysis by considering only common stock
and straight debt in this chapter.
Our results in this chapter are basic,First we discuss the
capital structure decision in a world with neither
taxes nor other capital market imperfections,
Chapter 15 Capital structure:
Basic concepts
15.1 The capital-structure question and the pie
theory
– A firm’s financial managers must to answer the
following questions such as ―How should a firm
choose its debt-equity ratio?‖ or ―what is the best
capital-structure for the firm?‖
– We usually employ a pie model to research those
questions.
Where is the MV of debt or equity
SBV
Chapter 15 Capital structure:
Basic concepts
Equity
Debt
Chapter 15 Capital structure:
Basic concepts
If the goal of the management of the firm is to make the
firm as valuable as possible,then the firm should pick
the debt-equity ratio that makes the pie as big as
possible.
– This discussion begs tow important questions：
Why should the stockholders in the firm care about
maximizing the value of the entire firm? Why should
the stockholders not prefer the strategy that maximize
their interests only?
Why is the ratio of debt to equity that maximizes the
shareholders’ interests?
Chapter 15 Capital structure:
Basic concepts
15.2 Maximizing firm value versus maximizing
stockholder interest
– A firm’s current market value is 1000,and this firm has
100 shares of stock sells for 10,at this time the firm is
unlevered firm,
– Now the firm decided to borrow 500 and pay the 500 to
shareholders as an extra cash dividends of 5 per share,The
firm then became a levered firm,
– What will the value of the firm be after borrow behavior?
Greater? Equal? Or less?
Chapter 15 Capital structure:
Basic concepts
When the firm change its financial plan,the value of the
firm would be change,but the managers believe that the
scale of restructuring should not exceed 250 in either
direction,Then
No debt
(original
capital
structure)
Value of Debt plus Equity after
payment of dividends
1 2 3
Debt 0 500 500 500
Equity 1000 750 500 250
Firm value 1000 1250 1000 750
Chapter 15 Capital structure:
Basic concepts
– Now we would find that the value of equity of the firm is
below 1000 under any of the three possibilities,Why?
First,the chart shows the value of the equity after the
extra cash dividends is paid,Since cash is paid out,a
dividend represents a partial liquidation on the firm,
Second,in the event of a future liquidation,stockholders
will be paid only after bondholders have been paid in
full,
– We now determine the payoff to stockholders under the
above three representative possibilities：
Chapter 15 Capital structure:
Basic concepts
– This example explains why managers should attempt to
maximize the value of the firm,It answers the first question
of 15.1.
Changes in capital structure benefit the stockholders if
and only if the value of the firm increase.
Payoff to shareholders after restructuring
1 2 3
Capital gains -250 -500 -750
Dividends 500 500 500
Net gain or loss 250 0 -250
Chapter 15 Capital structure:
Basic concepts
Conversely,these changes hurt the stockholders if and
only if the value of the firm decreases,
Managers should choose the capital structure that they
believe will have the highest firm value because this
capital structure is most beneficial to the firm’s
stockholders.
15.3 Can an optimal capital structure be
determined?
Modigliani and Miller,proposition Ⅰ （ No taxes）
The previous section shows that the capital structure
producing the highest firm value is the one most
beneficial to the shareholders.
Chapter 15 Capital structure:
Basic concepts
In this section we will to determine the particular capital
structure that produces the highest firm value,That is
to answer the 2 question of 15.1,But in fact,it’s hard to
do.
Modigliani and Miller have a convincing argument that
a firm con not change the total value of its outstanding
securities by changing the proportions of its capital
structure,
In other words,the value of the firm is always the same
under different capital structures,
In still other words,no capital structure is any better or
worse than any other capital structure for the firm’s
stockholders,
Chapter 15 Capital structure:
Basic concepts
This rather pessimistic result is the famous MM
Proposition Ⅰ
To see how MM Proposition Ⅰ works,consider an
unlevered firm that generates expected earnings of E
per year,,The firm dose not retain any earnings,so its
earnings are all paid out as dividends,The value of this
unlevered firm is denoted as VU,Further consider an
individual buy 15 percent of the firm,He pays 0.15 VU
initially and expects to receive 0.15E as dividends each
year,This transaction can be illustrated as follow:
Strategy I (buy,15 of unlevered firm)
Initial investment Expected dividends per year
0.15 VU 0.15E
Chapter 15 Capital structure:
Basic concepts
Now consider a levered firm,the value of the stock is
denoted by SL,and the value of the bonds is denoted B,
Thus the value of the firm is
VL= SL + B
And this levered firm is expected to generate yearly
earnings before interest payments of E,Now assume
that the bondholders receive interest payment of Int,
then the stockholders expect to receive annual dividends
of (E-Int),An investor buy 0.15 of the stock of this firm
pays 0.15 SL initially and expects to receive 0.15(E-Int)
each year,The transaction can be illustrate as
Strategy II (buy,15 of the stock of levered firm)
Initial investment Expected dividends per year
0.15 SL 0.15(E-Int)
Chapter 15 Capital structure:
Basic concepts
Of course strategy II is more risky than strategy I
because corporate leverage,
Now consider an arbitrageur,who is contemplating a
third and more complex strategy,He wants to,
– Borrow 0.15BL from others.
– Use the borrowed proceeds plus his own funds to
buy 15% of the stock of the unlevered firm.
The strategy could be illustrated as
Strategy III (buy,15 of unlevered firm by one’s mixed assets)
Initial investment Expected dividends per year after Int P
0.15 VU –0.15 BL 0.15E - 0.15 Int
Chapter 15 Capital structure:
Basic concepts
Note that it costs 0.15 VU to buy 15% of the unlevered
firm,However,since our arbitrageur borrow 0.15BL,he
only pays the difference,0.15 VU –0.15 BL,out of his own
pocket,Also his expected net dividends per year is 0.15E -
0.15 Int because he must pay interest on the money he
borrowed.
Now let us compare strategy III,the comparison that MM
use to establish their important capital proposition I,We
compare both the expected net dividends per year and the
initial investments of the tow strategies,Notice that the
expected net dividends each period are equal for the two
strategies.
The initial investments of the two strategies are:
Chapter 15 Capital structure:
Basic concepts
Initial investment of strategy II Initial investment of strategy III
0.15SL 0.15VU –0.15B L
Because the net dividends on the two strategies are identical,
the initial investments must be identical as well,Otherwise,
one investment would be cheaper than the other,and no
rational person would buy the expensive asset,
Consequently,its price would then fall until the two initial
investments became equal,That is VU= SL + BL
Since VL is equal to SL + BL,then VU must equal to VL,
This proves that,
MM proposition I (no taxes),The value of the unlevered firm is
the same as the value of the levered firm,That is VU =VL
Chapter 15 Capital structure:
Basic concepts
– Though this discussion may strike you as mathematical,the
intuition can be explained as follows,
Suppose that our result did not hold,For example,
suppose that the value of the levered firm were actually
greater than the value of the unlevered firm,that it VU
>VL,Our arbitrageur.,could borrow on his own
account and invest in the stock of the unlevered firm,He
would get the same dividend each year as if he had
invested in the levered firm,However,his cost would be
less because VL>VU,The strategy would not be unique to
him,Given VL>VU,no rational individual would ever
invest in the levered firm,Anyone desiring shares in the
levered firm would get the same dollar return more
cheaply by borrowing to finance a purchase of the
unlevered firm’s shares.
Chapter 15 Capital structure:
Basic concepts
The equilibrium result would be,of course,that the
value of the levered firm would fall and the value of the
unlevered firm would rise until VL=VU,At this point,
individuals would be indifferent between strategy II and
strategy III.
This perhaps the most important example in all of
corporate finance,In fact,it is considered the beginning
point of modern managerial finance,Before MM,the
effect of leverage on the value of the firm was
considered complex and convoluted,MM show a
blindingly simple result,if levered firms are priced too
high,rational investors will simply borrow on personal
account to buy shares in unlevered firms,This
substitution is oftentimes called homemade leverage,
Chapter 15 Capital structure:
Basic concepts
As long as individuals borrow (and lend ) on the same
terms as the firm,they can duplicate the effects of
corporate levered on their own.
The above example shows that leverage does not affect the
value of the firm,Since we showed earlier that
stockholders’ welfare is directly related to the firm’s
value,the example indicates that changes in capital
structure can not affect the stockholders’ welfare.
15.4 Financial leverage and firm value,an
example
The corporation currently has no debt in its capital structure,
The chief financial offer is considering issuing debt to buy
Chapter 15 Capital structure:
Basic concepts
back some of its equity,Both its current and proposed capital
structures are presented in table15.1,The firm’s assets are
8,000,000,There are 400,000 share shares of the all-equity
firm,implying a market value per share of 2,The proposed
debt issue is for 4,000,000,leaving 4,000,000 in equity,The
interest rate is 10%.
The financial manager believes the firm’s stockholders will be
better off with a debt issue,He/she concludes from his/her
analysis that:
The effect of financial leverage depends on the
company’s earnings before interest,If earnings before
interest is equal to 1,200,000,the return on equity is
higher under the proposed structure.
Chapter 15 Capital structure:
Basic concepts
Table 15.1 Financial structure of TAC
Current Proposed
Asset 8,000,000 8,000,000
Debt 0 4,000,000
Equity (market and
book)
8,000,000 4,000,000
Interest rate 10% 10%
Market value/share 20 20
Shares outstanding 400,000 200,000
The proposed capital structure has leverage,whereas the
current structures is all equity
Chapter 15 Capital structure:
Basic concepts
If earnings before interest is equal to 400,000,the ROE is
higher under the current structure.
Now consider the slopes of the two lines,The slope of the
dotted line is higher than the slope of the solid line,This
occurs because the levered firm has fewer shares of
stock outstanding than does the unlevered firm,
Therefore,any increase in EBI leads to a great rise of
the levered firm because the earnings increase is
distributed over fewer shares of stock.
Because expected EBI is 1,200,000,the manager reasons
that the stockholders are better off under the proposed
capital structure.
Chapter 15 Capital structure:
Basic concepts
Earnings per share
0
1
2
3
4
5
-2
Break-even
P
Disadvantage
to debt
Advantage to
debt
Debt No Debt
EBI
800,000400,000 1,200,000 1,600,000
Chapter 15 Capital structure:
Basic concepts
But an other financial consultant hired by TAC,argues
that the analysis in point (1) is correct,but the
conclusion in point (2) is incorrect,He states that the
shareholders of the firm can borrow on personal
account if they want to duplicate the firm’s proposed
financial leverage,The consultant considers an investor
who would buy 100 shares of the proposed levered
equity,Alternatively the investor could buy 200 shares
of the unlevered firm,partially financing his purchase
by borrowing 2000,Both the cost and the payoff from
the two strategies will be the same.
In other words,the investor is not receiving anything
from corporate leverage that he could not achieve on his
own.
Payoff and cost to shareholders of TAC under the
proposed structure and under the current structure
with homemade leverage
Strategy I Recession Expected Expansion
EPS 0 4 8
EP 100 shares 0 400 800
Initial cost 2000
Strategy II HL Recession Expected Expansion
Ep 200 share in current 200 （ 1 ） 600（ 3） 1000（ 5）
Interest 10% on debt -200 -200 -200
Net income 0 400 800
Initial cost,stock cost is
4000,debt cost is 2000
Chapter 15 Capital structure:
Basic concepts
Homemade leverage is the use of personal borrowing to
change the overall amount of financial leverage to which
the individual is expected.
Now we could draw some conclusions,
– The effect of financial leverage depends on the
company’s EBI,when EBI is relatively high,the
leverage is beneficial.
– Under the expected scenario,leverage increases the
returns to shareholders.
– Shareholders are exposed to more risk under the
proposed capital structure since the ratios are much
sensitive to change in EBI.
– Because of the impact that financial leverage has on
Chapter 15 Capital structure:
Basic concepts
both the expected return to stockholders and the riskness
of the stock,capital structure is an important
consideration,
– A key assumption
The MM result hinges on the assumption that
individuals can borrow as cheaply as corporations,If,
alternatively,individuals can only borrow at a higher
rate,one can easily show that corporations can increase
firm value by borrowing.
Is this assumption of equal borrowing costs a good one?
Chapter 15 Capital structure:
Basic concepts
15.5 Modigliani and Miller,Proportion II (N o
taxes)
– The levered firm implies more risk for the levered
firm’s stockholders
Levered stockholders have better returns in good times
than do unlevered stockholders but have worse returns
in bad times,
– MM proposition II
A firm’s cost of equity capital is a positive linear
function of its capital structure.
Since levered equity has greater risk,it should have
greater expected return as compensation.
Chapter 15 Capital structure:
Basic concepts
That is the expected return on equity is positively
related to leverage,because the risk of equity increases
with leverage,Now we should recall the weighted
average cost of capital,
Use this equation to calculate the WACC of the levered
and unlevered firm.
An implication of MM Proposition I is that WACC is a
constant for given firm,regardless of the capital
structure.
Now we define r0 to be the cost of capital for an all-equity
firm,
SBW A C C rSB SrSB Br
Chapter 15 Capital structure:
Basic concepts
Proposition II states the expected return on equity,rs,
in terms of leverage,The exact relationship derived by
setting rWACC = r0 and then rearranging
MM proposition II (no taxes)
This equation states the required return on equity is a
linear of the firm’s debt-to-equity ratio,If r0 exceeds the
debt ratio rB,then the cost of equity increases with
increases in the debt-equity ratio,
e q u i t y u n l e v e r e d
f i r m u n l e v e r e d t oe a r n i n g s e x p e c t e d
0?r
)( 00 Bs rrSBrr
Chapter 15 Capital structure:
Basic concepts
The cost of equity,debt,and WACC of capital under M&M II
Cost of capital
r0
Debt-equity ratio
rs
rWACC
rB
rS = r0 + (r0 - rB) B/S
rs is the cost of equity
rB is the cost of debt
r0 is the cost of capital for an all-equity firm
rWACC for a levered firm is equal to r0,
Chapter 15 Capital structure:
Basic concepts
– Example illustrating proposition I and II
An all-equity firm has expected earnings of 10millions
per share in perpetuity,The firm pays all of its earnings
out as dividends and there are 10millions shares
outstanding,Cost of unlevered is 10%.
Now the firm want to build a new plant for 4millions,
The plant is expected to generate additional cash flow of
1million per year,
Current company New plant
Cash flow,10M Initial outlay:4M
Number of outstanding
shares,10 M
Additional annual cash flow,
1M
Chapter 15 Capital structure:
Basic concepts
Then the project’s NPV= -4+ 1/0.1= 6M
Assuming that the project is discounted at the same rate
as the firm as a whole,Before the market knows of the
project,the MV balance sheet of the firm is
Old asset,10/0.1=100M,Equity:100M(10Mshares)
Now the firm want to issue 4M of equity or debt,and we
would consider the effect of equity and debt financing in
turn.
Stock financing
The firm announces that it would raise 4M in equity in
order to build a new plant,The stock price,and
therefore the value of the firm,will rise to reflect the
Chapter 15 Capital structure:
Basic concepts
positive NPV of the plant,At an efficient market,when
the information is announced,the increase occurs
immediately,The MV balance becomes:
Note that the NPV of the plant is included in the MV
balance sheet,Because the new shares have not yet been
issued,the number of outstanding shares remains 10M,
The price per share has now risen to 10.6 to reflect news
concerning of the plant.
Old assets 100M Equity 106M
(10M shares of stock)
NPV of plant 6M
Chapter 15 Capital structure:
Basic concepts
Shortly thereafter,4M of stock is issued or floated,
Because the price is selling at 10.6 per share,377358
shares of stock are issued,Imagine that funds are put in
the bank temporarily before being used to invest,The
MV balance sheet becomes:
Old assets 100M Equity 110M
(10,377358 shares of stock)NPV of plant 6M
New financing 4M
Total assets 110M
Chapter 15 Capital structure:
Basic concepts
The number of shares outstanding is now 10,377,358,The
price per share is 10.60,Note that the price has not
changed,This is consistent with ECM,because stock
pries should only move due to new information.
To avoid problems in discounting,we assume that the
plant is build immediately,The balance sheet becomes:
Old assets 100M Equity 110M
(10,377358 shares of stock)PV of plant 10M
Total assets 110M
Chapter 15 Capital structure:
Basic concepts
Though the total assets do not change,the composition of
the assets does change,The PV of cash flows of 1M a
year from the plant are reflected as an asset worth 10M,
Because the expenditures have already been paid,
According to efficient market,the price per share of
stock remains 10.60.
Expected yearly cash flows from the firm are 11M,the
expected return to stockholders is 0.1
Because this firm is all-equity,rS=r0.
Debt financing
Alternatively the firm want to borrow 4 M at 6 % to build
a new plant,Again the stock price rises immediately to
reflect the positive NPV of the plant.
Chapter 15 Capital structure:
Basic concepts
The value of the firm is the same as in the equity financing
case because (1) the same plant is to be build and (2) MM
prove that debt financing neither better nor worse than
equity financing.
When 4 M debt is issued and placed in the bank,The MV
balance sheet becomes:
Old assets 100M Equity 106M
10 M shares of stockNPV 6M
Total asset 106M
Chapter 15 Capital structure:
Basic concepts
Note that price of stock is still 10.60.
Finally,the contractor receives 4 M and builds the plant,The
market value balance sheet becomes
Old assets 100M Debt 4M
NPV of plant 6M Equity 106M
Proceeds from debt 4M
Total asset 110M Debt plus equity 110M
Old assets 100M Debt 4M
PV of plant 10M Equity 106M
Total asset 110M Debt plus equity 110M
Chapter 15 Capital structure:
Basic concepts
The only change here is that the bank account has been
depleted to pay contractor,The equityholders expected
yearly cash flows after interest of
10,000,000 + 1,000,000 - 240,000=10,760,000
CF on old assets CF on new assets Interest
The equityholders expected to earn a return of
10,760,000/106,000,000=10.115%
This return of 10.15% for levered equityholders is higher
than the 10% return for the unlevered equityholders,
This result is sensible because levered equity is riskier,and
this result should be exactly what MM proposition II
predicts.
Chapter 15 Capital structure:
Basic concepts
This example was useful for two reasons,first,we wanted to
introduce the concept of MV balance sheet,a tool that will
prove useful elsewhere in the text,Second,the example
illustrates three aspects of MM.
The example is consistent with MM proposition I
because the value of the firm is 110M after either equity
or debt financing.
Students are often more interested in stock price than in
firm value,We show that the stock price is always 10.60,
regardless of whether debt or equity financing is used.
％％）＝％（，，,，％ 15.106100 0 00 0 01 0 6 0 0 00 0 0410
Chapter 15 Capital structure:
Basic concepts
The example is consistent with MM proposition II,The
expected return to equityholders rises from 10 to 10.15
percent,just as equation states,This rise occurs because
the equityholders of a levered firm face more risk than
do the equityholders of an unlevered firm.
– MM,An interpretation
The MM results indicate that managers of a firm can’t
change its value by repackaging the firm’s securities,
MM argue that the firm’s overall cost of capital can’t be
reduced as debt is substituted for equity,even though
debt appears to be cheaper than equity,The reason for
this is that,as the firm adds debt,the remaining equity
becomes more risky.
Chapter 15 Capital structure:
Basic concepts
As risk rises,the cost of equity capital rises as a result,
The increase in the cost of the remaining equity capital
offsets the higher proportion of the firm financed by
low-cost debt,
In fact,MM prove that the two effects exactly offset
each other,so that both the value of the firm and the
firm’s overall cost of capital are invariant or leverage,
There are two important unrealistic assumptions in this
theory:
– Taxes were ignored.
– Bankruptcy costs and other agency costs were not
considered,
Chapter 15 Capital structure:
Basic concepts
15.6 Taxes
– The basic insight － EBI versus EBIT
The previous part of this chapter showed that firm is
unrelated to debt in a world without taxes,Now we
show that,in the presence of corporate taxes,the firm’s
value is positively related to its debt,
In selecting between the two capital structures in the
figure,a financial manager should select the one with
the highest value,In other words,in a taxes case,value
is maximized for the capital structure paying the least in
taxes,
Taxes is less for the levered firm than it is for the
unlevered firm.
Chapter 15 Capital structure:
Basic concepts
Equity
Taxes
Equity
Taxes
D e b t
The levered firm pays less than does the all-equity firm,
Thus the sum of the debt plus the equity of the levered
firm is greater than the equity of the unlevered firm.
Chapter 15 Capital structure:
Basic concepts
– The quirk in the tax code
The WPC is evaluating two financing plans,This firm
has a tax rate 0.35 and expected EBIT of 1M,Under
plan I,WPC has no debt in its capital structure,Under
plan II,the firm would have 4,000,000 of debt,the cost
of debt is 10%.
The difference between these two plans is the
140,000,and is exactly the difference between taxes paid.
This difference occurs because the IRS treats interest
differently than it does earnings going to stockholders,
If EBIT is the total CF on the firm,and if we ignore the
effect of depreciation and other items such as taxes,then
Chapter 15 Capital structure:
Basic concepts
Plan I Plan II
EBIT 1,000,000 1,000,000
Interest (rB B) 0 400,000
EBT =(EBIT- rB B ) 1,000,000 600,000
Taxes (T 0.35) 350,000 210,000
Earnings after Taxes
EAT =[(EBIT- rB B ) × （ 1-T） ]
650,000 390,000
Total cash flow to both Equity &
Debt
650,000 790,000
Chapter 15 Capital structure:
Basic concepts
The taxable income of an all-equity firm is simply,EBIT
For an all-equity firm,total taxes are EBIT× T
Earnings after corporate taxes are EBIT× (1-T)
For a levered firm,taxable income is EBIT-rB B
Total taxes in a levered firm are T× (EBIT-rB B)
CF going to the stockholders in a levered firm is
EBIT-rB B- T× (EBIT-rB B) = (EBIT-rB B) × (1-T)
CF going to both the stockholders and the bondholders in a
levered firm is
EBIT× (1-T) +T rB B
Chapter 15 Capital structure:
Basic concepts
The key can be seen by comparing the difference between
EBIT× (1-T) and EBIT× (1-T) +T rB B.
The difference is the extra cash flow going to investors in
the levered firm,And it is also the extra funds not going
to the IRS.
Let us calculate this difference for the example firm:
T rB B= 35% × 10% × 4,000,000= 140,000
This is the same number that we calculated above.
– Value of the tax shield
The discussion above shows a tax advantage to debt or,
equivalently,a tax disadvantage to equity.
Chapter 15 Capital structure:
Basic concepts
We previously said that the CF of the levered firm each
period is greater than the CF of the unlevered firm by T
rB B,That is also called the tax shield from debt,
As long as the firm expects to be in a positive tax
bracket,we can assume that the CF in expression T rB B
has the same risk as the interest on the debt,Thus,its
value can be determined by discounting at the interest
rate rB,Assuming that the CF are perpetual,the value
of the tax shield is
TBr BTr
B
B?
Chapter 15 Capital structure:
Basic concepts
– Value of the levered firm
We have just calculated the PV of the tax shield from
debt,Our next step is to calculate the value of the
levered firm,We showed above that the after-tax CF to
the stockholders in the levered firm is
EBIT× (1-T) +T rB B
The first term is the after-tax CF in the unlevered firm,
The value of an unlevered firm is the PV of EBIT× (1-T),
0
)1(
r
TE B I TV
U
Chapter 15 Capital structure:
Basic concepts
The second part of the CF is the tax shield,To
determined its value,the tax shield should be discounted
at rB,
As a consequence,we have (this relationship holds when
the debt level is assumed to be constant through time,A
different formula would apply if the debt-equity ratio
was assumed to be a constant over time,For a deeper
treatment of this point,J.A,Miles etc,) MM Proposition
I (corporate taxes)
TBV
r
BTr
r
TE B I TV
U
L
B
B
0
)1(
Chapter 15 Capital structure:
Basic concepts
The first term in equation is the value of CF of the firm
with no debt tax shield,In other words,this term is equal
to VU,By raising the debt-equity ratio,the firm can lower
its taxes and thereby increase its total value,The strong
forces that operate to maximize the value of the firm
would seem to push it toward an all-debt capital structure,
– Expected return and leverage under corporate taxes
MM proposition II under no taxes posits a positive
relationship between the expected return on equity and
leverage,This result occurs because the risk of equity
increases with leverage,The same intuition also holds in a
world of corporate taxes,The exact formula is
Chapter 15 Capital structure:
Basic concepts
MM Proposition II (corporate taxes):
We can check this calculation by discounting at rs to
determine the value of the levered equity,The algebraic
formula for levered equity is
)()1( 00 BS rrTSBrr
S
B
r
TBrE B I TS )1()(
Chapter 15 Capital structure:
Basic concepts
The effect of financial leverage on the
cost of debt and equity capital
Cost of capital r
Debt-to-equity ratio
r0 =0.20
0.2351
0.10
0.00
rs
rWACC
rB
Financial leverage adds risk to the firm’s equity,
As compensation,the cost of equity rises the firm’s risk,
Chapter 15 Capital structure:
Basic concepts
– The WACC and corporate taxes
A levered firm will reduce its rWACC from unlevered
position to a more low position on debt financing,When
a firm lowers its rWACC,the firm’s value will increase,
SBW A C C rVSTrVBr
LL
)1(
W A C Cr
TE B I T
V L
)1(
Chapter 15 Capital structure:
Basic concepts
– Stock price and leverage under corporate taxes
Students could be ask some question such as ―Why are
we choosing to maximize the value of the firm?‖ and ―If
managers are looking out for the stockholders interest,
why aren’t they trying to maximize stock price?‖
Our response is twofold,First,we showed in the first
section of this chapter that the capital structure that
maximizes firm’s value is also the one that most benefits
the interests of the stockholders.
Second,we calculate the stock price of a firm both before
and after the exchange of debt for stock.
Chapter 15 Capital structure:
Basic concepts
Balance sheet on all-equity
Physical assets,
153.85/0.2 × (1-0.35)=500
Equity 500
100 shares
Balance sheet upon announcement of debt issue
Physical assets,500 Equity 570
PV of tax shield
T B = 0.35× 200=70
Total assets 570
Chapter 15 Capital structure:
Basic concepts
As we mentioned above,the stock price moves only on the
announcement day,Because the stockholders participating
in the exchange receive a price equal to the market price
per share after the exchange,they do not care whether they
exchange their stock or not.
The example was provided fro two reasons,First,it shows
that an increases in the value of the firm from debt
Balance sheet after exchange has taken place
Physical assets 500 Equity 370
100-200/5.7=64.91
PV of taxes shield 70 Debt 200
Total assets 570 Debt plus equity 570
Chapter 15 Capital structure:
Basic concepts
financing leads to an increase in the price of the stock,In
fact,the stockholders capture the entire tax shield,
Second,we wanted to provide more work with MV
balance sheets.
Modigliani and Miller summary
– The no-tax case
A,Proposition I,the value of the firm levered(VL) is equal
to the value of the firm unlevered (VU).
Implications of Proposition I:
A firm’s capital structure is irrelevant.
A firm’s WACC is the same on matter what mixture of debt
and equity is used to finance the firm.
Chapter 15 Capital structure:
Basic concepts
B,Proposition II,the cost of equity,rS,is rs = r0 + B/S (r0 - rB)
Implications of Proposition II:
The cost of equity rises as the firm increases its use of debt
financing.
The risk of the equity depends on two things,the riskiness
of the firm’s operations (business risk) and the degree of
financing leverage(financial risk).
Chapter 15 Capital structure:
Basic concepts
– The taxes case
A,Proposition I with corporate taxes,the value of the firm
levered is equal to the value of the firm unlevered plus
the PV of the interest tax shield,VL=VU+T× B
Implications of Proposition I:
Debt financing is highly advantageous,and,in the extreme,
a firm’s optimal capital structure is 100% debt.
A firm’s WACC decreases as the firm relies more heavily on
debt financing.
B,Proposition II with taxes,the cost of equity is,
rs = r0 + B/S (1-T)( r0 – rB )
Chapter 15 Capital structure:
Basic concepts
Summary and conclusions
– We began our discussion of capital structure policy by
arguing that the particular capital structure that
maximizes the value of the firm is also the one that
provides the most benefit to the stockholders.
– In a world of no taxes,the famous MM Proposition I
proves that the value of the firm is unaffected by the debt-
to-equity ratio,In other words,financial policy is a matter
of indifference in that world,The result hinges on the
Chapter 15 Capital structure:
Basic concepts
assumption that individuals can borrow at the same rate as
corporations,an assumption we believe to be quite
plausible.
– In a world without taxes,MM Proposition II states
rs = r0 + B/S (r0 - rB)
– While MM is quite elegant,it does not explain the empirical
findings on capital structure very well,MM imply that the
capital structure decision is a matter of indifference,while
the decision appears to be a weighty one in the real world,
To achieve real world applicability,we next considered
corporate taxes.
– In a world with corporate taxes but no bankruptcy costs,
firm value is an increasing function of leverage.
Chapter 15 Capital structure:
Basic concepts
The formula for the value of the firm is
Expected return on levered equity can be expresses as
Here,value is positively related to leverage,This result
implies that firms should have a capital structure almost
entirely composed of debt,Because real world firms select
more moderate levels of debt,the next chapter considers
modifications to the results of this chapter,
)()1( 00 BS rrTSBrr
TBVV UL
Dividend policy
Outline of this part
If a firm seeks to create value with its financing decisions,the
firm must find positive NPV financial arrangements,
We will show that the sources of NPV in financing are taxes,
bankruptcy,and agency costs.
This part is composed by six chapters like,
Chapter 13 Corporate financing decisions and efficient capital
markets
Chapter 14 Long—term financing,an introduction
Chapter 15 Capital structure,basic concepts
Chapter 16 Capital structure,limits to the use of debt
Chapter 17 Valuation and capital budgeting for the levered firm
Chapter 18 Dividend policy,why does it matter?
Part 4 Capital structure and
Dividend policy
Chapter 13 Corporate—financing
decisions and ECM
Chapter 13 Corporate—
financing decisions and ECM
In the past few parts,we have concentrated almost
exclusively on the left—hand side of the balance
sheet(the firm’s capital expenditure decisions),and
now we move to the right—hand side and to the
problems involved in financing the capital
expenditures,
To put it crudely,you have learned hoe to spend
money,now you must to learn how to raise it.
Now we have not totally ignored financing in our
discussion of capital budgeting,But we made the
simplest possible assumption,all—equity financing.
Chapter 13 Corporate—
financing decisions and ECM
What should we do for determine the best financing
strategy?
– Should the firm reinvest most of its earnings in the business,
or should it pay them out as dividends?
– If the firm needs more capital,should it issue more stock or
should it borrow?
– Should it borrow short—term or long—term?
– Should it borrow by issuing a normal long—term bond or a
convertible bond?
……………..
Chapter 13 Corporate—
financing decisions and ECM
13.1 Should financing decisions create value?
In the earlier parts of this book,we have learn how to
evaluate project with NPV,
Typical financing decisions include how much,what type and
when for the debt and equity to sell.
Though the procedure for evaluating financing decisions is
identical to the procedure for evaluating projects,the
results are different,It turns out that the typical firm has
many more capital—expenditure opportunities with
positive NPV,
Though this dearth of profitable financing opportunities will
be examined in detail later,a few remarks are in order now.
Chapter 13 Corporate—
financing decisions and ECM
– Fool investors
– Reduce costs or increase subsidies
– Create a new security
Chapter 13 Corporate—
financing decisions and ECM
Random walking theory
As so often the case with important ideas,the concept of
efficient capital markets stemmed from a chance discovery,
In 1953,Maurice Kendall,a British statistician presented a
controversial paper to the Royal Statistical Society on the
behavior of stock and commodity price.
He had expected to find regular price cycles,but to his
surprise they did not seem to exist,Each series appeared to
be a wandering one,In other words,the prices of stocks
and commodities seemed to follow a random walk,
– The movement of stock prices from day to day DO NOT
reflect any pattern,
Chapter 13 Corporate—
financing decisions and ECM
Coin Toss Game
In this game,if it comes up head,you win 3percent of your invest,
if it tails you lose 2.5 percent of you investment.
100
Head
Tail
103
97.5
head
head
Tail
Tail
106.09
100.43
100.43
95.06
Chapter 13 Corporate—financing
decisions and ECM
13.2 Capital market efficiency
A question that has received particular attention is whether
price adjust quickly and correctly when new information
arrives,A market is said to be ―efficient‖ if this is the case,
In an efficient capital market,current market prices fully
reflect available information,
Efficient capital market is the market in which security price
reflect available information.
– Price behavior in an efficient market
To illustrate how price behavior in an efficient market,
suppose the X corporation has developed a new
production,X’s capital budgeting analysis suggests that
Chapter 13 Corporate—financing
decisions and ECM
launching the new production,That is the NPV is positive,
The key assumption thus far is that X has not released
any information about the new system,so the fact of its
existence is ―inside‖ information only.
Now consider a share of stock in X,in an efficient market,
its price reflects what is known about X current
operations and profitability,and it reflects market
opinion about X’s potential for future growth and
profits.
If the market agree with X’s assessment of the value of the
new project,X’s stock price will rise when the decision
to launch is made public,
Chapter 13 Corporate—financing
decisions and ECM
PriceReaction of
stock
price to new
information in
efficient and
inefficient
market
22
18
14
10
-8 -6 -4 -2 0 +2 +4 +6 +8
Overreaction and
correction
Efficient market reaction
Delayed reaction
Chapter 13 Corporate—
financing decisions and ECM
Efficient market reaction is the price instantaneously
adjusts to and fully reflects new information; there is no
tendency for subsequent increases and decreases.
Delayed reaction is the price partially adjusts to the new
information; 8days elapse before the price completely
reflects the new information.
Overreaction is the price overadjusts to the new
information; it ―overshoots‖ the new price and
subsequently corrects.
– The efficient market hypothesis
A body of theory called the efficient market hypothesis
holds (1) that stocks are always in equilibrium and (2)
that it is impossible for an investor to consistently ―beat
the market.‖
Chapter 13 Corporate—
financing decisions and ECM
Efficient market hypothesis is the hypothesis that securities
are typically in equilibrium – that they are fairly priced in
the sense that the price reflects all publicly available
information on each security.
If a market is efficient,then there is a very important
implication for market participants,All investments in
an efficient market are zero NPV investments,
That is if prices are neither too low nor too high,then the
difference between the market value of an investment
and its cost is zero,
In a efficient market,investors get exactly what they pay
for when they buy securities,and firms receive exactly
what their stocks and bonds are worth when they sell
them.
Chapter 13 Corporate—
financing decisions and ECM
What makes market efficient is competition among
investors,Many individuals spend their entire lives
trying to find misprice stocks,
If you know more about some company than other
investors in the marketplace,you can profit from that
knowledge by investing in the company’s stock if you
have good news and selling it if you have bad news.
The logical consequence of all this information being
gathered and analyzed is that mispriced stocks will
become fewer and fewer,Because of the competition
among investors,the market will become increasingly
efficient,
Chapter 13 Corporate—
financing decisions and ECM
13.3 The form or different types of EMH
Financial theorists generally define three forms,or levels,
of market efficiency:
The weak-form of EMH states
The weak-form of EMH states that all information
contained in past price movements is fully reflected in
current market price,Therefore information about
recent trends in stock prices is of no use in selecting
stocks– the fact that a stock has risen for the past
several days.
t1 e r r o r r a n do mr e t u r n e x p e c t e dtt PP
Chapter 13 Corporate—
financing decisions and ECM
The semistrong-form of EMH
The semistrong-form EMH states that current market
prices reflect all publicly available information,If this
is true,no abnormal returns can be gained by
analyzing stocks,
The strong-form of EMH
The strong-form of EMH states that current market
prices reflect all pertinent information,whether
publicly available or privately held.
Some common misconceptions about the EMH
Chapter 13 Corporate—
financing decisions and ECM
The efficacy of dart throwing
Price fluctuations
Stockholder disinterest
13.4 puzzles and anomalies—what do they mean
for the financial manager?
High returns on the stocks of small firms,Why?
– Do investors respond slowly to new information?
The earnings announcement puzzle
Chapter 13 Corporate—
financing decisions and ECM
In this puzzle,investors underreact to the earnings
announcement and become aware of the full significance
only as further information arrives.
The new—issue puzzle
When the firms issue stock to the public,investors
typically rush to buy,But researchers have found that
these early gains often turn into losses.
– Stock market anomalies and behavioral finance
Attitudes toward risk
Chapter 13 Corporate—
financing decisions and ECM
Attitudes toward risk psychologists have observed that
when making risky decisions,people are particularly
loath to incur losses,even if those losses are small.
Losers tend to regret their actions and kick themselves for
having been so foolish,To avoid this unpleasant
possibility,individuals will tend to avoid those actions
that may result in loss.
Beliefs of about probabilities
Most investors do not have a PhD in probability theory
and may make systematic errors in assessing the
probability of uncertain outcome,
Psychologists have found that when judging the possible
future outcome,individual commonly look back to
Chapter 13 Corporate—
financing decisions and ECM
what has happened in recent periods and then assume
that this is representative of what may occur in the
future,
– Professional investors,irrational exuberance,and
the Dot,Com bubble
Alan Greenspan
Robert Shiller a professor of Yale,he said that as the
bull market developed,it generated optimism about the
future and stimulated demand for stock,Moreover,as
investors racked up profits on their stocks,they became
even more confident in their opinions.
Chapter 13 Corporate—
financing decisions and ECM
– The crash of 1987 and relative efficiency
October 19,1987,was commonly called the Black
Monday,
After the crash,everybody want to know,Who were the
guilty parties? And Do prices reflect fundamental values?
– Index arbitrageurs
– Portfolio insurance
Investors almost always price a common stock relative
to yesterday’s price or today’s price of comparable
securities.
The hypothesis that stock price always equals intrinsic
value is nearly impossible to test,because it is so
Chapter 13 Corporate—
financing decisions and ECM
difficult to calculate intrinsic value without referring to
prices,
However the crash does not undermine the evidence for
market efficiency with respect to relative price.
– Market anomalies and the financial manager
A firm’s financial manager has said that:
Great ! Our stock is clearly overpriced,This means we
can raise capital cheaply and invest in Project X,Our
high stock price gives us a big advantage over our
competitors who could not possibly justify investing in
Project X.
Do he/she is correct? Why?
Chapter 13 Corporate—
financing decisions and ECM
13.5 The six lessons of market efficiency
– Markets have no memory
The weak form of the EMH states that the sequence of
past price changes contains no information about future
changes.
Economists express the same idea more concisely when
they say that the market has no memory.
– Trust market prices
In an efficient market you can trust prices,for they
impound all available information about the value of
each security,,This means that in an efficient market,
there is no way for most investors to achieve consistently
superior rate of return.
Chapter 13 Corporate—
financing decisions and ECM
To do so,you not only need to know more than anyone
else,but also need to know more than everyone else.
– Read the entrails
If the market is efficient,prices impound all available
information,Therefore,if we can only learn to read the
entrails,security prices can tell us a lot about the future.
– There are no financial illusions
In an efficient market there are no financial illusions,
Investors are unromantically concerned with the firm’s
cash flows and the portion of those cash flows to which
they entitled.
Chapter 13 Corporate—
financing decisions and ECM
– The do—it—yourself alternative
In an efficient market investors will not pay others for
what they can do equally well themselves.
As we shall see,many of the controversies in corporate
financing center on how well individuals can replicate
corporate financial decisions,
The financial manager needs to ask the same question
when considering whether it is better to issue debt or
stock.
– Seen one stock,seen them all
Chapter 13 Corporate—
financing decisions and ECM
13.6 An overview of corporate financing
– Patterns of corporate financing
Firms may raise funds from external sources or plow
back profits rather than distribute them to shareholders,
In most years there is a gap between the cash that
companies need and the cash that they generate
internally,This gap is the financial deficit,
Should a firm elect external financing,they may choose
between debt or equity sources.
Dose firms rely too much on internal funds?
Chapter 13 Corporate—
financing decisions and ECM
Has capital structure changed?
We commented that in recent years firms have,in the
aggregate,issued much more debt than equity,But is
there a long—run trend to heavier reliance on debt
finance? This is a hard question to answer in general,
because financing policy varies so much from industry
and from firm to firm,
The next table shows the aggregate balance sheet of all
manufacturing corporations in the US in 2001.
So what is the book debt ratio?
Because financial analysts sometimes focus on the
proportions of debt and equity in long term financing.
Chapter 13 Corporate—
financing decisions and ECM
A g g r e g a t e b a l a n c e s h e e t f o r m a n u f a c t u r i n g c o r p o r a t i o n s
i n t h e U n i t e d S t a t e s,2 0 0 1 ( f i g u r e s i n B i l l i o n s ),
C u r r e n t a s s e t s 1,5 4 7$ C u r r e n t l i a b i l i t i e s 1,2 3 4$
F i x e d a s s e t s 2,3 6 1 L o n g t e r m d e b t 1,0 3 8
L e s s 1,1 6 6 O t h e r l o n g t e r m 679
d e p r e c i c a t i o n l i a b i l i t i e s
N e t f i x e d a s s e t s 1,1 9 5 To t a l l o n g t e r m l i a b i l i t i e s 1,7 1 7
O t h e r l o n g t e r m 2,1 6 0 S t o c k h o l d e r s ' e q u i t y 1,9 5 1
To t a l a s s e t s 4,9 0 3 To t a l l i a b i l i t i e s a n d 4,9 0 3
s t o c k h o l d e r s ' e q u i t y
Chapter 13 Corporate—
financing decisions and ECM
The sum of long—term liabilities and stockholders’
equity is called total capitalization,
– Common stock
– Debt
– Financial market and institutions
60.903,4 717,1234,1a s s e t s T o t a lD e b td e b t r a t i o
47.
951,1717,1
717,1
e q u i t ysl i a b i l i t i e t e r mL o n g
sl i a b i l i t i e t e r mL o n g?
Chapter 13 Corporate—
financing decisions and ECM
Primary
Markets
Secondary
Markets
OTC
Markets
Money
Chapter 13 Corporate—
financing decisions and ECM
Company
Intermediaries
Banks
Insurance Cos.
Brokerage Firms
Obligations Funds
Chapter 13 Corporate—
financing decisions and ECM
Intermediaries
Investors
Depositors
Policyholders
Investors
Obligations Funds
Chapter 13 Corporate—
financing decisions and ECM
13.7 Implications for corporate finance
– Accounting and efficient market
The accounting profession provides firms with a
significant amount of leeway in their reporting practices,
Companies may choose between the last—in—first—
out(LIFO) or first—in—first—out (FIFO) method on
valuing inventories.
They may choose either the percentage—of—completion
or the completed—contract method for construction
projects,
They may depreciate physical assets by either
accelerated or straight—line depreciation.
Chapter 13 Corporate—
financing decisions and ECM
Accountants have frequently been accused of misusing
this leeway in the hopes of boosting earnings and stock
price,
However,accounting choice should not affect stock
price if two conditions hold,First is enough information
must be provided in the annual report so that financial
analysts can construct earnings under the alternative
accounting method,Second is the market must be
efficient in the semistrong form,the market must
appropriately use all of this accounting information in
determining the market price.
Chapter 13 Corporate—
financing decisions and ECM
– Timing and issuance of financing
Managers of a firm must be choose a perfect date to
issue equity,this is called the timing decision,If
managers believe that their stock is overpriced,they are
likely to issue equity immediately,Conversely they more
select waiting,
However,if market is efficient,securities are always
correctly priced,Since efficiency implies that stock is
always sold for its true worth,the timing decision
become unimportant,The figure shows three possible
stock price adjustments to the issuance of new stock.
If a firm’s stock are undervalued,the firm would like to
repurchase its stock.
Chapter 13 Corporate—
financing decisions and ECM
Three stock—price adjustmentsStock price
-6 –5 –4 –3 –2 –1 0 +1 +2 +3 +4 +5 +6
Issue
day
Stock price movement
if managers have inferior
timing ability
Efficient market
movement
Stock price movement
if managers have superior
timing liability
Months relative
to issue day
Chapter 13 Corporate—
financing decisions and ECM
– Price—pressure effect
Suppose a firm wants to sell a large block of stock,Can
it sell as many shares as it wants without depressing the
price?
If capital market is efficient,a firm should be able to sell
as many shares as it desires without depressing price.
Scholes,which is the first one to examine this question
by empirical analysis,said that the market’s ability to
absorb large blocks of stock was virtually unlimited.
Kraus and stoll had found other thing.
Chapter 13 Corporate—
financing decisions and ECM
Price impacts of block trading
Closing price P-1
Price prior to block
Block price
Closing price P0
Price
Time
End of day -1 End of day 0
Chapter 13 Corporate—
financing decisions and ECM
Summary of EMH
– Does not say
Prices are uncaused
Investors are foolish and stupid to be in the market
All shares of stock have the same expected returns
Investors should throw darts to select stocks
There is no upward trend in stock prices
– Does say
Prices reflect underlying value
Financial managers cannot time stock and bond sales
Sales of stock and bonds will not depress price
Chapter 13 Corporate—
financing decisions and ECM
You cannot cook the books.
– Why doesn’t every body believe it?
There are optical illusions,mirages,and apparent
patterns in charts of stock market returns:
The truth is less interesting
There is evidence against efficiency
– Seasonality
– Insider trading
– Excess stock-price volatility
The tests of market efficiency are weak.
Chapter 13 Corporate—
financing decisions and ECM
13.8 Summary and conclusions
– An efficient financial market processes the information
available to investors and incorporates it into the prices of
securities,This has two general implications,first is in any
given time period,a stock’s abnormal return can depend on
information or news received by the market in that period,
Second is an investor who uses the same information as the
market cannot expect to earn abnormal return,
– What information does the market use to determine price?
– There are several puzzles and anomalies the financial
manager must be solve.
– There are some types of corporate finance to be employed,
– Three implications of efficient markets for corporate finance.
Part 4 Capital structure and
Dividend policy
Chapter 14 Long—term
financing,an introduction
Chapter 14 Long—term
financing,an introduction
14.1 common stock
– Par and no—par stock
– Authorized versus issued common stock
Shares of common stock are the fundamental ownership
units of the corporation,The articles of incorporation of
a new corporation must state the number of shares of
common stock the corporation is authorized to issue.
Although there are no legal limits to authorized shares
of stock,some practical considerations may exist:
– Some states impose taxes based on the number of
authorized shares.
Chapter 14 Long—term
financing,an introduction
– Authorizing a large number of shares may create
concern on the part of investors,because authorized
shares can be issued later with the approval of the
board of directors but without a vote of the
shareholders.
– Capital surplus
Capital surplus usually refers to amounts of directly
contributed equity capital in excess of the par value.
– Retained earnings
The sum of the par value,capital surplus,and
accumulated retained earnings is the common equity of
the firm,which is usually referred to as the firm’s book
value.
Chapter 14 Long—term
financing,an introduction
– Market value,book value,and replacement value
Book value is a backward looking measure,It tells us
how much capital the firm has raised from shareholders
in the past,It does not measure the value that
shareholders place on those shares today,
The market value of the firm is forward looking,it
depends on the future dividends that shareholders
expect to receive,
Replacement value refers to the current cost of
replacing the assets of the firm.
Market,book and replacement value are equal at the
time when a firm purchases an asset.
Chapter 14 Long—term
financing,an introduction
– Shareholders’ rights
Cumulative voting
Straight voting
Proxy voting
Other rights
– The right to share proportionally in dividends paid.
– The right to share proportionally in assets remaining
after liabilities have been paid in a liquidation.
– The right to vote on matters of great importance to
stockholders.
– The right to share proportionally in any new stock
sold,This right also called preemptive right.
Chapter 14 Long—term
financing,an introduction
– Dividends
Dividends paid to shareholders represent a return on
the capital directly or indirectly contributed to the
corporation by the shareholders.
The payment of dividends is at the discretion of the
board of directors,
Here are some important characters of dividends:
– Unless a dividend is declared by the board of
directors of a corporation,it is not a liability of the
corporation,A corporation can’t default on an
undeclared dividends,As a consequence,corporation
can’t become bankrupt because of nonpayment of
dividends.
Chapter 14 Long—term
financing,an introduction
– The payment of dividends by the corporation is not a
business expense,
– Dividends received by individual shareholders are
for the most part considered ordinary income and
must be fully taxable.
– Classes of stock
14.2 Corporate long—term debt,the basics
– Interest versus dividends
– Is it debt or equity?
– Basic features of long—term debt
– Different types of debt
Chapter 14 Long—term
financing,an introduction
Note
Debenture which is an unsecured corporate debt,
whereas a bond is secured by a mortgage on the
corporate property.
Bond,in some ways,long-term bond also called funded
debt.
Consol,some debt is perpetual and has no special
maturity.
– Repayment
Amortization
Sinking funds
Callable debt
Chapter 14 Long—term
financing,an introduction
– Seniority and subordinated
– Security
– Indenture
The written agreement between the corporate debt
issuer and the lender,setting forth maturity date,
interest rate and other terms.
The indenture completely describes the nature of the
indebtedness,
It list all restrictions placed on the firm by the lenders in
restrictive covenants,
14.3 Preferred stock
Chapter 14 Long—term
financing,an introduction
– Stated value
– Cumulative and noncumulative dividends
– Is preferred stock really debt?
When we evaluating preferred stock we should consider
two offsetting taxes effects:
A,Dividends are not deducted from corporate income in
computing the tax ;liability of the issuing corporation.
B,When a corporation purchases preferred stock,70% of
the dividends received are exempt from corporate
taxation.
– The preferred stock puzzle
Effect A above represents a clear tax disadvantage to
the issuance pf preferred stock.
Chapter 14 Long—term
financing,an introduction
Effect B represents a tax advantage,
Both academics and practitioners generally agree that B
does not fully offset A.
But why firm issue preferred stock?
– Because the way utility rates are determined in
regulatory environments,regulated public utilities
can pass the tax disadvantage of issuing preferred
stock on to their customers,So a substantial
preferred amount of stock is issued by utilities.
– Companies reporting losses to the IRS may issue
preferred stock.because they have no taxable income
from which interest on debt can be deducted,
Chapter 14 Long—term
financing,an introduction
preferred stock imposes no tax penalty relative to debt,
In other words,A does not apply,
– firms issuing preferred stock can avoid the threat of
bankruptcy that exists with debt financing,
14.4 Patterns of financing
– Internal financing
Internal financing comes from internally generated cash
flow and it is defined as net income plus depreciation
minus dividends.
Equity versus Debt
Feature Equity Debt
Income Dividends Interest
Tax status Dividends taxed as
personal income,
dividends are not a
business expense.
Interest is taxed as personal
income,Interest is a business
expense,and firms can deduct
interest when computing
corporate tax liability
Control Common stock and
preferred stock
usually have voting
rights.
Control is exercised with loan
agreement
Default Firms can’t become
bankruptcy for
nonpayment of
dividends
Unpaid debt is a liability of the
firm,Nonpayment results in
bankruptcy.
Chapter 14 Long—term
financing,an introduction
– External financing
External financing is net debt and new shares of equity
net of buy—backs.
– Several features of long—term financing
Internally generated cash flow has dominated as a
source of financing.
A financial deficit is created by the different between
uses of financing and internally generated sources.
– Internal or external financing?
The first form of financing used by firm for positive
NPV projects is internally generated cash flows,that is
net income + depreciation - dividends
Chapter 14 Long—term
financing,an introduction
As a last resort a firm will use externally generated cash
flow,First,debt is used,common stock is used last.
14.5 Recent trends in capital structure
14.6 Summary and conclusion
– The basic sources of long—term financing and the essential
features of each.
– The kinds of debt and their features.
– Preferred stock
– Patterns of corporate financing
– Capital structure’s new trends,
Part 4 Capital structure and
Dividend policy
Chapter 15 capital structure,
Basic concepts
Chapter 15 Capital structure:
Basic concepts
In the previous chapters we had examined the capital—
budgeting decisions,
In general,a firm can choose any capital structure that it
wants,It can issue any kinds of securities which it can,
Because the number of instruments is so large,the
variations in capital structures are endless,
We simplify the analysis by considering only common stock
and straight debt in this chapter.
Our results in this chapter are basic,First we discuss the
capital structure decision in a world with neither
taxes nor other capital market imperfections,
Chapter 15 Capital structure:
Basic concepts
15.1 The capital-structure question and the pie
theory
– A firm’s financial managers must to answer the
following questions such as ―How should a firm
choose its debt-equity ratio?‖ or ―what is the best
capital-structure for the firm?‖
– We usually employ a pie model to research those
questions.
Where is the MV of debt or equity
SBV
Chapter 15 Capital structure:
Basic concepts
Equity
Debt
Chapter 15 Capital structure:
Basic concepts
If the goal of the management of the firm is to make the
firm as valuable as possible,then the firm should pick
the debt-equity ratio that makes the pie as big as
possible.
– This discussion begs tow important questions：
Why should the stockholders in the firm care about
maximizing the value of the entire firm? Why should
the stockholders not prefer the strategy that maximize
their interests only?
Why is the ratio of debt to equity that maximizes the
shareholders’ interests?
Chapter 15 Capital structure:
Basic concepts
15.2 Maximizing firm value versus maximizing
stockholder interest
– A firm’s current market value is 1000,and this firm has
100 shares of stock sells for 10,at this time the firm is
unlevered firm,
– Now the firm decided to borrow 500 and pay the 500 to
shareholders as an extra cash dividends of 5 per share,The
firm then became a levered firm,
– What will the value of the firm be after borrow behavior?
Greater? Equal? Or less?
Chapter 15 Capital structure:
Basic concepts
When the firm change its financial plan,the value of the
firm would be change,but the managers believe that the
scale of restructuring should not exceed 250 in either
direction,Then
No debt
(original
capital
structure)
Value of Debt plus Equity after
payment of dividends
1 2 3
Debt 0 500 500 500
Equity 1000 750 500 250
Firm value 1000 1250 1000 750
Chapter 15 Capital structure:
Basic concepts
– Now we would find that the value of equity of the firm is
below 1000 under any of the three possibilities,Why?
First,the chart shows the value of the equity after the
extra cash dividends is paid,Since cash is paid out,a
dividend represents a partial liquidation on the firm,
Second,in the event of a future liquidation,stockholders
will be paid only after bondholders have been paid in
full,
– We now determine the payoff to stockholders under the
above three representative possibilities：
Chapter 15 Capital structure:
Basic concepts
– This example explains why managers should attempt to
maximize the value of the firm,It answers the first question
of 15.1.
Changes in capital structure benefit the stockholders if
and only if the value of the firm increase.
Payoff to shareholders after restructuring
1 2 3
Capital gains -250 -500 -750
Dividends 500 500 500
Net gain or loss 250 0 -250
Chapter 15 Capital structure:
Basic concepts
Conversely,these changes hurt the stockholders if and
only if the value of the firm decreases,
Managers should choose the capital structure that they
believe will have the highest firm value because this
capital structure is most beneficial to the firm’s
stockholders.
15.3 Can an optimal capital structure be
determined?
Modigliani and Miller,proposition Ⅰ （ No taxes）
The previous section shows that the capital structure
producing the highest firm value is the one most
beneficial to the shareholders.
Chapter 15 Capital structure:
Basic concepts
In this section we will to determine the particular capital
structure that produces the highest firm value,That is
to answer the 2 question of 15.1,But in fact,it’s hard to
do.
Modigliani and Miller have a convincing argument that
a firm con not change the total value of its outstanding
securities by changing the proportions of its capital
structure,
In other words,the value of the firm is always the same
under different capital structures,
In still other words,no capital structure is any better or
worse than any other capital structure for the firm’s
stockholders,
Chapter 15 Capital structure:
Basic concepts
This rather pessimistic result is the famous MM
Proposition Ⅰ
To see how MM Proposition Ⅰ works,consider an
unlevered firm that generates expected earnings of E
per year,,The firm dose not retain any earnings,so its
earnings are all paid out as dividends,The value of this
unlevered firm is denoted as VU,Further consider an
individual buy 15 percent of the firm,He pays 0.15 VU
initially and expects to receive 0.15E as dividends each
year,This transaction can be illustrated as follow:
Strategy I (buy,15 of unlevered firm)
Initial investment Expected dividends per year
0.15 VU 0.15E
Chapter 15 Capital structure:
Basic concepts
Now consider a levered firm,the value of the stock is
denoted by SL,and the value of the bonds is denoted B,
Thus the value of the firm is
VL= SL + B
And this levered firm is expected to generate yearly
earnings before interest payments of E,Now assume
that the bondholders receive interest payment of Int,
then the stockholders expect to receive annual dividends
of (E-Int),An investor buy 0.15 of the stock of this firm
pays 0.15 SL initially and expects to receive 0.15(E-Int)
each year,The transaction can be illustrate as
Strategy II (buy,15 of the stock of levered firm)
Initial investment Expected dividends per year
0.15 SL 0.15(E-Int)
Chapter 15 Capital structure:
Basic concepts
Of course strategy II is more risky than strategy I
because corporate leverage,
Now consider an arbitrageur,who is contemplating a
third and more complex strategy,He wants to,
– Borrow 0.15BL from others.
– Use the borrowed proceeds plus his own funds to
buy 15% of the stock of the unlevered firm.
The strategy could be illustrated as
Strategy III (buy,15 of unlevered firm by one’s mixed assets)
Initial investment Expected dividends per year after Int P
0.15 VU –0.15 BL 0.15E - 0.15 Int
Chapter 15 Capital structure:
Basic concepts
Note that it costs 0.15 VU to buy 15% of the unlevered
firm,However,since our arbitrageur borrow 0.15BL,he
only pays the difference,0.15 VU –0.15 BL,out of his own
pocket,Also his expected net dividends per year is 0.15E -
0.15 Int because he must pay interest on the money he
borrowed.
Now let us compare strategy III,the comparison that MM
use to establish their important capital proposition I,We
compare both the expected net dividends per year and the
initial investments of the tow strategies,Notice that the
expected net dividends each period are equal for the two
strategies.
The initial investments of the two strategies are:
Chapter 15 Capital structure:
Basic concepts
Initial investment of strategy II Initial investment of strategy III
0.15SL 0.15VU –0.15B L
Because the net dividends on the two strategies are identical,
the initial investments must be identical as well,Otherwise,
one investment would be cheaper than the other,and no
rational person would buy the expensive asset,
Consequently,its price would then fall until the two initial
investments became equal,That is VU= SL + BL
Since VL is equal to SL + BL,then VU must equal to VL,
This proves that,
MM proposition I (no taxes),The value of the unlevered firm is
the same as the value of the levered firm,That is VU =VL
Chapter 15 Capital structure:
Basic concepts
– Though this discussion may strike you as mathematical,the
intuition can be explained as follows,
Suppose that our result did not hold,For example,
suppose that the value of the levered firm were actually
greater than the value of the unlevered firm,that it VU
>VL,Our arbitrageur.,could borrow on his own
account and invest in the stock of the unlevered firm,He
would get the same dividend each year as if he had
invested in the levered firm,However,his cost would be
less because VL>VU,The strategy would not be unique to
him,Given VL>VU,no rational individual would ever
invest in the levered firm,Anyone desiring shares in the
levered firm would get the same dollar return more
cheaply by borrowing to finance a purchase of the
unlevered firm’s shares.
Chapter 15 Capital structure:
Basic concepts
The equilibrium result would be,of course,that the
value of the levered firm would fall and the value of the
unlevered firm would rise until VL=VU,At this point,
individuals would be indifferent between strategy II and
strategy III.
This perhaps the most important example in all of
corporate finance,In fact,it is considered the beginning
point of modern managerial finance,Before MM,the
effect of leverage on the value of the firm was
considered complex and convoluted,MM show a
blindingly simple result,if levered firms are priced too
high,rational investors will simply borrow on personal
account to buy shares in unlevered firms,This
substitution is oftentimes called homemade leverage,
Chapter 15 Capital structure:
Basic concepts
As long as individuals borrow (and lend ) on the same
terms as the firm,they can duplicate the effects of
corporate levered on their own.
The above example shows that leverage does not affect the
value of the firm,Since we showed earlier that
stockholders’ welfare is directly related to the firm’s
value,the example indicates that changes in capital
structure can not affect the stockholders’ welfare.
15.4 Financial leverage and firm value,an
example
The corporation currently has no debt in its capital structure,
The chief financial offer is considering issuing debt to buy
Chapter 15 Capital structure:
Basic concepts
back some of its equity,Both its current and proposed capital
structures are presented in table15.1,The firm’s assets are
8,000,000,There are 400,000 share shares of the all-equity
firm,implying a market value per share of 2,The proposed
debt issue is for 4,000,000,leaving 4,000,000 in equity,The
interest rate is 10%.
The financial manager believes the firm’s stockholders will be
better off with a debt issue,He/she concludes from his/her
analysis that:
The effect of financial leverage depends on the
company’s earnings before interest,If earnings before
interest is equal to 1,200,000,the return on equity is
higher under the proposed structure.
Chapter 15 Capital structure:
Basic concepts
Table 15.1 Financial structure of TAC
Current Proposed
Asset 8,000,000 8,000,000
Debt 0 4,000,000
Equity (market and
book)
8,000,000 4,000,000
Interest rate 10% 10%
Market value/share 20 20
Shares outstanding 400,000 200,000
The proposed capital structure has leverage,whereas the
current structures is all equity
Chapter 15 Capital structure:
Basic concepts
If earnings before interest is equal to 400,000,the ROE is
higher under the current structure.
Now consider the slopes of the two lines,The slope of the
dotted line is higher than the slope of the solid line,This
occurs because the levered firm has fewer shares of
stock outstanding than does the unlevered firm,
Therefore,any increase in EBI leads to a great rise of
the levered firm because the earnings increase is
distributed over fewer shares of stock.
Because expected EBI is 1,200,000,the manager reasons
that the stockholders are better off under the proposed
capital structure.
Chapter 15 Capital structure:
Basic concepts
Earnings per share
0
1
2
3
4
5
-2
Break-even
P
Disadvantage
to debt
Advantage to
debt
Debt No Debt
EBI
800,000400,000 1,200,000 1,600,000
Chapter 15 Capital structure:
Basic concepts
But an other financial consultant hired by TAC,argues
that the analysis in point (1) is correct,but the
conclusion in point (2) is incorrect,He states that the
shareholders of the firm can borrow on personal
account if they want to duplicate the firm’s proposed
financial leverage,The consultant considers an investor
who would buy 100 shares of the proposed levered
equity,Alternatively the investor could buy 200 shares
of the unlevered firm,partially financing his purchase
by borrowing 2000,Both the cost and the payoff from
the two strategies will be the same.
In other words,the investor is not receiving anything
from corporate leverage that he could not achieve on his
own.
Payoff and cost to shareholders of TAC under the
proposed structure and under the current structure
with homemade leverage
Strategy I Recession Expected Expansion
EPS 0 4 8
EP 100 shares 0 400 800
Initial cost 2000
Strategy II HL Recession Expected Expansion
Ep 200 share in current 200 （ 1 ） 600（ 3） 1000（ 5）
Interest 10% on debt -200 -200 -200
Net income 0 400 800
Initial cost,stock cost is
4000,debt cost is 2000
Chapter 15 Capital structure:
Basic concepts
Homemade leverage is the use of personal borrowing to
change the overall amount of financial leverage to which
the individual is expected.
Now we could draw some conclusions,
– The effect of financial leverage depends on the
company’s EBI,when EBI is relatively high,the
leverage is beneficial.
– Under the expected scenario,leverage increases the
returns to shareholders.
– Shareholders are exposed to more risk under the
proposed capital structure since the ratios are much
sensitive to change in EBI.
– Because of the impact that financial leverage has on
Chapter 15 Capital structure:
Basic concepts
both the expected return to stockholders and the riskness
of the stock,capital structure is an important
consideration,
– A key assumption
The MM result hinges on the assumption that
individuals can borrow as cheaply as corporations,If,
alternatively,individuals can only borrow at a higher
rate,one can easily show that corporations can increase
firm value by borrowing.
Is this assumption of equal borrowing costs a good one?
Chapter 15 Capital structure:
Basic concepts
15.5 Modigliani and Miller,Proportion II (N o
taxes)
– The levered firm implies more risk for the levered
firm’s stockholders
Levered stockholders have better returns in good times
than do unlevered stockholders but have worse returns
in bad times,
– MM proposition II
A firm’s cost of equity capital is a positive linear
function of its capital structure.
Since levered equity has greater risk,it should have
greater expected return as compensation.
Chapter 15 Capital structure:
Basic concepts
That is the expected return on equity is positively
related to leverage,because the risk of equity increases
with leverage,Now we should recall the weighted
average cost of capital,
Use this equation to calculate the WACC of the levered
and unlevered firm.
An implication of MM Proposition I is that WACC is a
constant for given firm,regardless of the capital
structure.
Now we define r0 to be the cost of capital for an all-equity
firm,
SBW A C C rSB SrSB Br
Chapter 15 Capital structure:
Basic concepts
Proposition II states the expected return on equity,rs,
in terms of leverage,The exact relationship derived by
setting rWACC = r0 and then rearranging
MM proposition II (no taxes)
This equation states the required return on equity is a
linear of the firm’s debt-to-equity ratio,If r0 exceeds the
debt ratio rB,then the cost of equity increases with
increases in the debt-equity ratio,
e q u i t y u n l e v e r e d
f i r m u n l e v e r e d t oe a r n i n g s e x p e c t e d
0?r
)( 00 Bs rrSBrr
Chapter 15 Capital structure:
Basic concepts
The cost of equity,debt,and WACC of capital under M&M II
Cost of capital
r0
Debt-equity ratio
rs
rWACC
rB
rS = r0 + (r0 - rB) B/S
rs is the cost of equity
rB is the cost of debt
r0 is the cost of capital for an all-equity firm
rWACC for a levered firm is equal to r0,
Chapter 15 Capital structure:
Basic concepts
– Example illustrating proposition I and II
An all-equity firm has expected earnings of 10millions
per share in perpetuity,The firm pays all of its earnings
out as dividends and there are 10millions shares
outstanding,Cost of unlevered is 10%.
Now the firm want to build a new plant for 4millions,
The plant is expected to generate additional cash flow of
1million per year,
Current company New plant
Cash flow,10M Initial outlay:4M
Number of outstanding
shares,10 M
Additional annual cash flow,
1M
Chapter 15 Capital structure:
Basic concepts
Then the project’s NPV= -4+ 1/0.1= 6M
Assuming that the project is discounted at the same rate
as the firm as a whole,Before the market knows of the
project,the MV balance sheet of the firm is
Old asset,10/0.1=100M,Equity:100M(10Mshares)
Now the firm want to issue 4M of equity or debt,and we
would consider the effect of equity and debt financing in
turn.
Stock financing
The firm announces that it would raise 4M in equity in
order to build a new plant,The stock price,and
therefore the value of the firm,will rise to reflect the
Chapter 15 Capital structure:
Basic concepts
positive NPV of the plant,At an efficient market,when
the information is announced,the increase occurs
immediately,The MV balance becomes:
Note that the NPV of the plant is included in the MV
balance sheet,Because the new shares have not yet been
issued,the number of outstanding shares remains 10M,
The price per share has now risen to 10.6 to reflect news
concerning of the plant.
Old assets 100M Equity 106M
(10M shares of stock)
NPV of plant 6M
Chapter 15 Capital structure:
Basic concepts
Shortly thereafter,4M of stock is issued or floated,
Because the price is selling at 10.6 per share,377358
shares of stock are issued,Imagine that funds are put in
the bank temporarily before being used to invest,The
MV balance sheet becomes:
Old assets 100M Equity 110M
(10,377358 shares of stock)NPV of plant 6M
New financing 4M
Total assets 110M
Chapter 15 Capital structure:
Basic concepts
The number of shares outstanding is now 10,377,358,The
price per share is 10.60,Note that the price has not
changed,This is consistent with ECM,because stock
pries should only move due to new information.
To avoid problems in discounting,we assume that the
plant is build immediately,The balance sheet becomes:
Old assets 100M Equity 110M
(10,377358 shares of stock)PV of plant 10M
Total assets 110M
Chapter 15 Capital structure:
Basic concepts
Though the total assets do not change,the composition of
the assets does change,The PV of cash flows of 1M a
year from the plant are reflected as an asset worth 10M,
Because the expenditures have already been paid,
According to efficient market,the price per share of
stock remains 10.60.
Expected yearly cash flows from the firm are 11M,the
expected return to stockholders is 0.1
Because this firm is all-equity,rS=r0.
Debt financing
Alternatively the firm want to borrow 4 M at 6 % to build
a new plant,Again the stock price rises immediately to
reflect the positive NPV of the plant.
Chapter 15 Capital structure:
Basic concepts
The value of the firm is the same as in the equity financing
case because (1) the same plant is to be build and (2) MM
prove that debt financing neither better nor worse than
equity financing.
When 4 M debt is issued and placed in the bank,The MV
balance sheet becomes:
Old assets 100M Equity 106M
10 M shares of stockNPV 6M
Total asset 106M
Chapter 15 Capital structure:
Basic concepts
Note that price of stock is still 10.60.
Finally,the contractor receives 4 M and builds the plant,The
market value balance sheet becomes
Old assets 100M Debt 4M
NPV of plant 6M Equity 106M
Proceeds from debt 4M
Total asset 110M Debt plus equity 110M
Old assets 100M Debt 4M
PV of plant 10M Equity 106M
Total asset 110M Debt plus equity 110M
Chapter 15 Capital structure:
Basic concepts
The only change here is that the bank account has been
depleted to pay contractor,The equityholders expected
yearly cash flows after interest of
10,000,000 + 1,000,000 - 240,000=10,760,000
CF on old assets CF on new assets Interest
The equityholders expected to earn a return of
10,760,000/106,000,000=10.115%
This return of 10.15% for levered equityholders is higher
than the 10% return for the unlevered equityholders,
This result is sensible because levered equity is riskier,and
this result should be exactly what MM proposition II
predicts.
Chapter 15 Capital structure:
Basic concepts
This example was useful for two reasons,first,we wanted to
introduce the concept of MV balance sheet,a tool that will
prove useful elsewhere in the text,Second,the example
illustrates three aspects of MM.
The example is consistent with MM proposition I
because the value of the firm is 110M after either equity
or debt financing.
Students are often more interested in stock price than in
firm value,We show that the stock price is always 10.60,
regardless of whether debt or equity financing is used.
％％）＝％（，，,，％ 15.106100 0 00 0 01 0 6 0 0 00 0 0410
Chapter 15 Capital structure:
Basic concepts
The example is consistent with MM proposition II,The
expected return to equityholders rises from 10 to 10.15
percent,just as equation states,This rise occurs because
the equityholders of a levered firm face more risk than
do the equityholders of an unlevered firm.
– MM,An interpretation
The MM results indicate that managers of a firm can’t
change its value by repackaging the firm’s securities,
MM argue that the firm’s overall cost of capital can’t be
reduced as debt is substituted for equity,even though
debt appears to be cheaper than equity,The reason for
this is that,as the firm adds debt,the remaining equity
becomes more risky.
Chapter 15 Capital structure:
Basic concepts
As risk rises,the cost of equity capital rises as a result,
The increase in the cost of the remaining equity capital
offsets the higher proportion of the firm financed by
low-cost debt,
In fact,MM prove that the two effects exactly offset
each other,so that both the value of the firm and the
firm’s overall cost of capital are invariant or leverage,
There are two important unrealistic assumptions in this
theory:
– Taxes were ignored.
– Bankruptcy costs and other agency costs were not
considered,
Chapter 15 Capital structure:
Basic concepts
15.6 Taxes
– The basic insight － EBI versus EBIT
The previous part of this chapter showed that firm is
unrelated to debt in a world without taxes,Now we
show that,in the presence of corporate taxes,the firm’s
value is positively related to its debt,
In selecting between the two capital structures in the
figure,a financial manager should select the one with
the highest value,In other words,in a taxes case,value
is maximized for the capital structure paying the least in
taxes,
Taxes is less for the levered firm than it is for the
unlevered firm.
Chapter 15 Capital structure:
Basic concepts
Equity
Taxes
Equity
Taxes
D e b t
The levered firm pays less than does the all-equity firm,
Thus the sum of the debt plus the equity of the levered
firm is greater than the equity of the unlevered firm.
Chapter 15 Capital structure:
Basic concepts
– The quirk in the tax code
The WPC is evaluating two financing plans,This firm
has a tax rate 0.35 and expected EBIT of 1M,Under
plan I,WPC has no debt in its capital structure,Under
plan II,the firm would have 4,000,000 of debt,the cost
of debt is 10%.
The difference between these two plans is the
140,000,and is exactly the difference between taxes paid.
This difference occurs because the IRS treats interest
differently than it does earnings going to stockholders,
If EBIT is the total CF on the firm,and if we ignore the
effect of depreciation and other items such as taxes,then
Chapter 15 Capital structure:
Basic concepts
Plan I Plan II
EBIT 1,000,000 1,000,000
Interest (rB B) 0 400,000
EBT =(EBIT- rB B ) 1,000,000 600,000
Taxes (T 0.35) 350,000 210,000
Earnings after Taxes
EAT =[(EBIT- rB B ) × （ 1-T） ]
650,000 390,000
Total cash flow to both Equity &
Debt
650,000 790,000
Chapter 15 Capital structure:
Basic concepts
The taxable income of an all-equity firm is simply,EBIT
For an all-equity firm,total taxes are EBIT× T
Earnings after corporate taxes are EBIT× (1-T)
For a levered firm,taxable income is EBIT-rB B
Total taxes in a levered firm are T× (EBIT-rB B)
CF going to the stockholders in a levered firm is
EBIT-rB B- T× (EBIT-rB B) = (EBIT-rB B) × (1-T)
CF going to both the stockholders and the bondholders in a
levered firm is
EBIT× (1-T) +T rB B
Chapter 15 Capital structure:
Basic concepts
The key can be seen by comparing the difference between
EBIT× (1-T) and EBIT× (1-T) +T rB B.
The difference is the extra cash flow going to investors in
the levered firm,And it is also the extra funds not going
to the IRS.
Let us calculate this difference for the example firm:
T rB B= 35% × 10% × 4,000,000= 140,000
This is the same number that we calculated above.
– Value of the tax shield
The discussion above shows a tax advantage to debt or,
equivalently,a tax disadvantage to equity.
Chapter 15 Capital structure:
Basic concepts
We previously said that the CF of the levered firm each
period is greater than the CF of the unlevered firm by T
rB B,That is also called the tax shield from debt,
As long as the firm expects to be in a positive tax
bracket,we can assume that the CF in expression T rB B
has the same risk as the interest on the debt,Thus,its
value can be determined by discounting at the interest
rate rB,Assuming that the CF are perpetual,the value
of the tax shield is
TBr BTr
B
B?
Chapter 15 Capital structure:
Basic concepts
– Value of the levered firm
We have just calculated the PV of the tax shield from
debt,Our next step is to calculate the value of the
levered firm,We showed above that the after-tax CF to
the stockholders in the levered firm is
EBIT× (1-T) +T rB B
The first term is the after-tax CF in the unlevered firm,
The value of an unlevered firm is the PV of EBIT× (1-T),
0
)1(
r
TE B I TV
U
Chapter 15 Capital structure:
Basic concepts
The second part of the CF is the tax shield,To
determined its value,the tax shield should be discounted
at rB,
As a consequence,we have (this relationship holds when
the debt level is assumed to be constant through time,A
different formula would apply if the debt-equity ratio
was assumed to be a constant over time,For a deeper
treatment of this point,J.A,Miles etc,) MM Proposition
I (corporate taxes)
TBV
r
BTr
r
TE B I TV
U
L
B
B
0
)1(
Chapter 15 Capital structure:
Basic concepts
The first term in equation is the value of CF of the firm
with no debt tax shield,In other words,this term is equal
to VU,By raising the debt-equity ratio,the firm can lower
its taxes and thereby increase its total value,The strong
forces that operate to maximize the value of the firm
would seem to push it toward an all-debt capital structure,
– Expected return and leverage under corporate taxes
MM proposition II under no taxes posits a positive
relationship between the expected return on equity and
leverage,This result occurs because the risk of equity
increases with leverage,The same intuition also holds in a
world of corporate taxes,The exact formula is
Chapter 15 Capital structure:
Basic concepts
MM Proposition II (corporate taxes):
We can check this calculation by discounting at rs to
determine the value of the levered equity,The algebraic
formula for levered equity is
)()1( 00 BS rrTSBrr
S
B
r
TBrE B I TS )1()(
Chapter 15 Capital structure:
Basic concepts
The effect of financial leverage on the
cost of debt and equity capital
Cost of capital r
Debt-to-equity ratio
r0 =0.20
0.2351
0.10
0.00
rs
rWACC
rB
Financial leverage adds risk to the firm’s equity,
As compensation,the cost of equity rises the firm’s risk,
Chapter 15 Capital structure:
Basic concepts
– The WACC and corporate taxes
A levered firm will reduce its rWACC from unlevered
position to a more low position on debt financing,When
a firm lowers its rWACC,the firm’s value will increase,
SBW A C C rVSTrVBr
LL
)1(
W A C Cr
TE B I T
V L
)1(
Chapter 15 Capital structure:
Basic concepts
– Stock price and leverage under corporate taxes
Students could be ask some question such as ―Why are
we choosing to maximize the value of the firm?‖ and ―If
managers are looking out for the stockholders interest,
why aren’t they trying to maximize stock price?‖
Our response is twofold,First,we showed in the first
section of this chapter that the capital structure that
maximizes firm’s value is also the one that most benefits
the interests of the stockholders.
Second,we calculate the stock price of a firm both before
and after the exchange of debt for stock.
Chapter 15 Capital structure:
Basic concepts
Balance sheet on all-equity
Physical assets,
153.85/0.2 × (1-0.35)=500
Equity 500
100 shares
Balance sheet upon announcement of debt issue
Physical assets,500 Equity 570
PV of tax shield
T B = 0.35× 200=70
Total assets 570
Chapter 15 Capital structure:
Basic concepts
As we mentioned above,the stock price moves only on the
announcement day,Because the stockholders participating
in the exchange receive a price equal to the market price
per share after the exchange,they do not care whether they
exchange their stock or not.
The example was provided fro two reasons,First,it shows
that an increases in the value of the firm from debt
Balance sheet after exchange has taken place
Physical assets 500 Equity 370
100-200/5.7=64.91
PV of taxes shield 70 Debt 200
Total assets 570 Debt plus equity 570
Chapter 15 Capital structure:
Basic concepts
financing leads to an increase in the price of the stock,In
fact,the stockholders capture the entire tax shield,
Second,we wanted to provide more work with MV
balance sheets.
Modigliani and Miller summary
– The no-tax case
A,Proposition I,the value of the firm levered(VL) is equal
to the value of the firm unlevered (VU).
Implications of Proposition I:
A firm’s capital structure is irrelevant.
A firm’s WACC is the same on matter what mixture of debt
and equity is used to finance the firm.
Chapter 15 Capital structure:
Basic concepts
B,Proposition II,the cost of equity,rS,is rs = r0 + B/S (r0 - rB)
Implications of Proposition II:
The cost of equity rises as the firm increases its use of debt
financing.
The risk of the equity depends on two things,the riskiness
of the firm’s operations (business risk) and the degree of
financing leverage(financial risk).
Chapter 15 Capital structure:
Basic concepts
– The taxes case
A,Proposition I with corporate taxes,the value of the firm
levered is equal to the value of the firm unlevered plus
the PV of the interest tax shield,VL=VU+T× B
Implications of Proposition I:
Debt financing is highly advantageous,and,in the extreme,
a firm’s optimal capital structure is 100% debt.
A firm’s WACC decreases as the firm relies more heavily on
debt financing.
B,Proposition II with taxes,the cost of equity is,
rs = r0 + B/S (1-T)( r0 – rB )
Chapter 15 Capital structure:
Basic concepts
Summary and conclusions
– We began our discussion of capital structure policy by
arguing that the particular capital structure that
maximizes the value of the firm is also the one that
provides the most benefit to the stockholders.
– In a world of no taxes,the famous MM Proposition I
proves that the value of the firm is unaffected by the debt-
to-equity ratio,In other words,financial policy is a matter
of indifference in that world,The result hinges on the
Chapter 15 Capital structure:
Basic concepts
assumption that individuals can borrow at the same rate as
corporations,an assumption we believe to be quite
plausible.
– In a world without taxes,MM Proposition II states
rs = r0 + B/S (r0 - rB)
– While MM is quite elegant,it does not explain the empirical
findings on capital structure very well,MM imply that the
capital structure decision is a matter of indifference,while
the decision appears to be a weighty one in the real world,
To achieve real world applicability,we next considered
corporate taxes.
– In a world with corporate taxes but no bankruptcy costs,
firm value is an increasing function of leverage.
Chapter 15 Capital structure:
Basic concepts
The formula for the value of the firm is
Expected return on levered equity can be expresses as
Here,value is positively related to leverage,This result
implies that firms should have a capital structure almost
entirely composed of debt,Because real world firms select
more moderate levels of debt,the next chapter considers
modifications to the results of this chapter,
)()1( 00 BS rrTSBrr
TBVV UL
