FIN2101
BUSINESS FINANCE II
Module 7
Capital Structure
Student Activities
Reading
Text,Chapter 13 (pp,477-96 only)
Text Study Guide,Chapter 13 (part only)
Study Book,Module 7
Tutorial Activities
Tutorial Workbook,Self Assessment Activity
7.1
Text Study Guide,Chapter 13,T/F 1,7,8,9
& 10; MC 5,6,7,12,14,15
Introduction
A company may issue several types of
securities in varying combinations,but what
it tries to do is find the combination that will
maximise its overall market value.
Capital structure is the proportionate
relationship between a company’s debt and
equity.
Capital structure is the debt vs equity
question,Should the company have some
debt in its capital structure?
Introduction
A financing decision.
Investment decisions are critical in
determining returns to shareholders.
Just how important financing decisions
are has been subject to much debate.
Introduction
Financing decisions become irrelevant
as long as equity holders are happy
with their returns.
A firm can be highly levered yet no
one is concerned as long as dividends
are acceptable.
Problems arise when returns aren’t
enough to cover debt commitments
and dividends cease.
Capital Structure Dilemma
Does the manner in which investment
proposals are financed matter? If so,
what is the optimal capital structure?
Does varying the capital structure
affect share price? If so,which
financing policy maximises share price?
How is a choice between alternative
financing options made? Which option
maximises shareholders’ wealth?
Traditional Approach
The RELEVANCE ARGUMENT - capital
structure is relevant to the market value of
the firm and the firm’s cost of capital.
There is an optimal debt-to-equity mix
that minimises WACC and maximises the
market value of the firm to its
shareholders.
Traditional Approach
A company is able to increase its total
market value and decrease its WACC
by the use of moderate amounts of
debt.
There is an optimal level of debt and
an optimal capital structure.
Traditional Approach
k
D:E RatioOCS
ks
k
kd
Traditional Approach
As D:E ratio increases:
cost of equity ks increases;
cost of debt kd may eventually
increase;
overall cost of capital k first decreases
but then increases;
market value maximised and WACC
minimised at OCS.
Traditional Approach Example
A company has $5 000 of 10% debt (MV @
face value).
There are 3 000 shares issued (n = 3 000).
ks = 15%.
Earnings before interest per year = $5 000.
Calculate cost of capital,market value,and
market value per share.
Earnings per year $ 5000
Less Interest ($5 000 × 10%) 500
Earnings available for equity 4500
Cost of equity (ks) 0.15
Market value of equity 30000
Plus Market value of debt 5000
Market value of firm $35000
Cost of Capital = Earnings/Market Value of Firm
= $5000/$35000 14.29%
MV Per Share = MV of Equity/No,of Shares
= $30000/3000 $10
A Variation
Suppose $5 000 more debt @ 10% is
issued to replace equity,with debt
proceeds used to repurchase 500 $10
shares,leaving 2 500 shares issued.
As a result of increased gearing,ks
increases to 20% to compensate
investors for greater financial risk.
Earnings per year $ 5000
Less Interest ($10 000 × 10%)
1000
Earnings available for equity 4000
Cost of equity (ks) 0.20
Market value of equity 20000
Plus Market value of debt 10000
Market value of firm $30000
Cost of Capital = Earnings/Market Value
= $5000/$30000 16.67%
MV Per Share = MV of Equity/No,of Shares
= $20000/2500 $8
Summation
Before After Change
Market Value of Firm $35000 $30000
Cost of Capital 14.29% 16.67%
MV Per Share $10 $8
Summation
With the introduction of more debt,
the equity holders’ perception of the
value of the firm has declined to $8.
As the return stream has become
more risky,the cost of capital has
increased from 14.29% to 16.67%.
Traditional Approach Assumptions
No taxes.
100% dividend payout (ie no R.E.).
Perfect markets.
Total capital structure won’t change,
although components might.
The market values assets equally if
they have the same risk & generate
identical cash flows.
Net Operating Income
Approach
There is no such thing as an optimal
capital structure - IRRELEVANT.
Should concentrate on investment
decisions which are separate from
financing decisions.
An increase in ks is offset exactly by
the cheaper source of finance (debt),
with the overall cost of capital
remaining constant.
N.O.I,Approach
k k
s
k
kd
D:E Ratio
NOI Approach
(MM Without Taxes)
As D:E ratio increases:
cost of equity ks increases;
cost of debt kd is unchanged;
cost of capital k is unchanged;
market value of the firm is unaffected.
N.O.I,Approach Example
Use the data from the earlier example:
– $5 000 of debt @ 10% (MV @ face value)
– 3 000 shares issued (n = 3000)
– earnings of $5 000
Assume an overall cost of capital of
20%.
Calculate the cost of equity capital,
market value of the firm,and market
value per share.
Earnings per year $ 5000
Cost of capital (k) 0.20
Market value of firm 25000
- Market value of debt 5000
Market value of equity $20000
Cost of Equity = Earnings-Interest/MV of Equity
= $5000-500/$20000
= $4500/$20000 22.5%
MV Per Share = MV of Equity/No,of Shares
= $20000/3000 $6.67
A Variation
Issue $5 000 additional debt @ 10%.
Repurchase $5 000 of equity (750
shares @ $6.67).
n = 2 250 shares (3 000 - 750).
Earnings per year $ 5000
Cost of capital (k) 0.20
Market value of firm 25000
- Market value of debt 10000
Market value of equity $15000
Cost of Equity = Earnings-Interest/MV of Equity
= $5000-1000/$15000
= $4000/$15000 26.67%
MV Per Share = MV of Equity/No,of Shares
= $15000/2250 $6.67
Summation
Before After Change
Market Value of Firm $25000 $25000 Nil
Cost of Capital 20% 20% Nil
MV Per Share $6.67 $6.67 Nil
Summation
The cost of debt and the overall cost
of capital have not changed as a result
of the variation in the capital structure.
The market value of the firm and the
market value of the firm’s shares are
unaffected.
Summation
There is no change in the perception
of the market value of the firm.
There is no optimal capital structure -
financing decisions are irrelevant.
Modigliani & Miller
Seminal paper (1958) on capital
structure theory.
Supported the NOI approach.
Any 2 identical firms would ultimately
be perceived by investors as the same
in terms of value irrespective of their
capital structures.
MM (No Taxes) Assumptions
Perfectly competitive capital market.
Business risk of all companies in a
particular risk class is the same.
No personal or company taxes.
Debt is risk-free (no default risk).
Borrow and lend at the same rate.
No bankruptcy costs.
MM
It is the ultimate return that is important.
3 important propositions.
MM Proposition 1
The value of an asset remains the
same regardless of how the net cash
flows generated by the asset are
divided between different classes of
investors.
In other words,the market value of
the company is independent of its
capital structure,The investment and
financing decisions can be separated.
MM Proposition 2
A company’s capital structure has no
effect on its overall cost of capital.
MM Proposition 3
The appropriate discount rate for a
particular investment proposal is
independent of how the proposal is to
be financed.
MM Overall
In a perfect capital market with no
taxes,it is only the investment
decision that is important in the
pursuit of wealth maximisation,The
financing decision is of no
consequence.
Subject to the underlying assumptions,
MM approach has broad acceptance.
MM With Taxes
In a world of no taxes,MM say VL =
VU.
Doesn’t hold true if corporate taxes
are introduced.
Interest payments are tax deductible,
giving an advantage to levered firms.
MM (With Corporate Taxes)
k ks
k
kd
k*d
D:E Ratio
MM (With Corporate Taxes)
As the D:E ratio increases:
cost of debt kd is unchanged;
cost of equity ks increases;
overall cost of capital k decreases;
market value of the firm increases.
MM With Taxes
VL = VU + (PV of tax savings on interest)
D T + V = V
k
DkT
+ V = V
k
IT
+ V = V
UL
d
d
UL
d
UL
MM With Taxes
A levered firm will always be worth more
than an equivalent unlevered firm,The
more it borrows,the more its value
increases.
All companies should have 100% debt!
However,the tax advantages of debt finance
are offset by the costs of debt - the costs
of financial distress,agency costs and
information asymmetry.
Personal taxes also complicate things.
Personal Taxes
The classical tax system was biased in
favour of debt finance.
Imputation tax system introduced in
1987/88 tax year.
Reduced taxes on equity income.
Neutral between debt and equity.
Companies now make greater use of
equity finance.
Dividend Imputation
Shareholders indifferent to corporate
borrowing – tax shield from
borrowings irrelevant when
shareholders receive franked dividends.
Local (resident) shareholders mainly
concerned about the availability of
franking credits on dividends,This will
have some effect on share price.
Financial Distress
Companies which issue risky debt face
the prospect of incurring direct and
indirect bankruptcy costs.
Direct costs - those associated with
receivership and liquidation.
Indirect costs - incurred through loss
of sales and management spending
too much time on bankruptcy-related
matters.
Agency Costs
Lenders may impose monitoring techniques
on borrowers,who consequently incur
agency costs.
Loan agreements might include provisions
(covenants) relating to things like the
minimum level of liquidity of the borrower,
asset acquisitions by the borrower,
executive salaries and dividend payments.
Lender can control the risk of the borrower.
Asymmetric Information
Information asymmetry occurs when managers
have more information (than investors) about
the firm’s activities and future prospects.
Results in a pecking order of financial
preferences.
Retained earnings,debt,external equity.
Debt financing is a positive signal –
management believes shares are undervalued.
Share issue is a negative signal – management
thinks that shares are overvalued.
Conclusion
There is little conclusive evidence to
support or reject either theory on
capital structure.
A general conclusion is that primary
attention should be paid to investment
decisions.
Table 13.16 (p,495) lists factors to
consider when making capital
structure decisions.
Capital Structure in Practice
Two techniques:
EBIT-EPS analysis
– Assumes a goal of maximising EPS
instead of owners’ wealth.
– Maximisation of EPS ignores risk.
Capacity to service debt
– Times interest earned ratio
– Fixed-payment coverage ratio
BUSINESS FINANCE II
Module 7
Capital Structure
Student Activities
Reading
Text,Chapter 13 (pp,477-96 only)
Text Study Guide,Chapter 13 (part only)
Study Book,Module 7
Tutorial Activities
Tutorial Workbook,Self Assessment Activity
7.1
Text Study Guide,Chapter 13,T/F 1,7,8,9
& 10; MC 5,6,7,12,14,15
Introduction
A company may issue several types of
securities in varying combinations,but what
it tries to do is find the combination that will
maximise its overall market value.
Capital structure is the proportionate
relationship between a company’s debt and
equity.
Capital structure is the debt vs equity
question,Should the company have some
debt in its capital structure?
Introduction
A financing decision.
Investment decisions are critical in
determining returns to shareholders.
Just how important financing decisions
are has been subject to much debate.
Introduction
Financing decisions become irrelevant
as long as equity holders are happy
with their returns.
A firm can be highly levered yet no
one is concerned as long as dividends
are acceptable.
Problems arise when returns aren’t
enough to cover debt commitments
and dividends cease.
Capital Structure Dilemma
Does the manner in which investment
proposals are financed matter? If so,
what is the optimal capital structure?
Does varying the capital structure
affect share price? If so,which
financing policy maximises share price?
How is a choice between alternative
financing options made? Which option
maximises shareholders’ wealth?
Traditional Approach
The RELEVANCE ARGUMENT - capital
structure is relevant to the market value of
the firm and the firm’s cost of capital.
There is an optimal debt-to-equity mix
that minimises WACC and maximises the
market value of the firm to its
shareholders.
Traditional Approach
A company is able to increase its total
market value and decrease its WACC
by the use of moderate amounts of
debt.
There is an optimal level of debt and
an optimal capital structure.
Traditional Approach
k
D:E RatioOCS
ks
k
kd
Traditional Approach
As D:E ratio increases:
cost of equity ks increases;
cost of debt kd may eventually
increase;
overall cost of capital k first decreases
but then increases;
market value maximised and WACC
minimised at OCS.
Traditional Approach Example
A company has $5 000 of 10% debt (MV @
face value).
There are 3 000 shares issued (n = 3 000).
ks = 15%.
Earnings before interest per year = $5 000.
Calculate cost of capital,market value,and
market value per share.
Earnings per year $ 5000
Less Interest ($5 000 × 10%) 500
Earnings available for equity 4500
Cost of equity (ks) 0.15
Market value of equity 30000
Plus Market value of debt 5000
Market value of firm $35000
Cost of Capital = Earnings/Market Value of Firm
= $5000/$35000 14.29%
MV Per Share = MV of Equity/No,of Shares
= $30000/3000 $10
A Variation
Suppose $5 000 more debt @ 10% is
issued to replace equity,with debt
proceeds used to repurchase 500 $10
shares,leaving 2 500 shares issued.
As a result of increased gearing,ks
increases to 20% to compensate
investors for greater financial risk.
Earnings per year $ 5000
Less Interest ($10 000 × 10%)
1000
Earnings available for equity 4000
Cost of equity (ks) 0.20
Market value of equity 20000
Plus Market value of debt 10000
Market value of firm $30000
Cost of Capital = Earnings/Market Value
= $5000/$30000 16.67%
MV Per Share = MV of Equity/No,of Shares
= $20000/2500 $8
Summation
Before After Change
Market Value of Firm $35000 $30000
Cost of Capital 14.29% 16.67%
MV Per Share $10 $8
Summation
With the introduction of more debt,
the equity holders’ perception of the
value of the firm has declined to $8.
As the return stream has become
more risky,the cost of capital has
increased from 14.29% to 16.67%.
Traditional Approach Assumptions
No taxes.
100% dividend payout (ie no R.E.).
Perfect markets.
Total capital structure won’t change,
although components might.
The market values assets equally if
they have the same risk & generate
identical cash flows.
Net Operating Income
Approach
There is no such thing as an optimal
capital structure - IRRELEVANT.
Should concentrate on investment
decisions which are separate from
financing decisions.
An increase in ks is offset exactly by
the cheaper source of finance (debt),
with the overall cost of capital
remaining constant.
N.O.I,Approach
k k
s
k
kd
D:E Ratio
NOI Approach
(MM Without Taxes)
As D:E ratio increases:
cost of equity ks increases;
cost of debt kd is unchanged;
cost of capital k is unchanged;
market value of the firm is unaffected.
N.O.I,Approach Example
Use the data from the earlier example:
– $5 000 of debt @ 10% (MV @ face value)
– 3 000 shares issued (n = 3000)
– earnings of $5 000
Assume an overall cost of capital of
20%.
Calculate the cost of equity capital,
market value of the firm,and market
value per share.
Earnings per year $ 5000
Cost of capital (k) 0.20
Market value of firm 25000
- Market value of debt 5000
Market value of equity $20000
Cost of Equity = Earnings-Interest/MV of Equity
= $5000-500/$20000
= $4500/$20000 22.5%
MV Per Share = MV of Equity/No,of Shares
= $20000/3000 $6.67
A Variation
Issue $5 000 additional debt @ 10%.
Repurchase $5 000 of equity (750
shares @ $6.67).
n = 2 250 shares (3 000 - 750).
Earnings per year $ 5000
Cost of capital (k) 0.20
Market value of firm 25000
- Market value of debt 10000
Market value of equity $15000
Cost of Equity = Earnings-Interest/MV of Equity
= $5000-1000/$15000
= $4000/$15000 26.67%
MV Per Share = MV of Equity/No,of Shares
= $15000/2250 $6.67
Summation
Before After Change
Market Value of Firm $25000 $25000 Nil
Cost of Capital 20% 20% Nil
MV Per Share $6.67 $6.67 Nil
Summation
The cost of debt and the overall cost
of capital have not changed as a result
of the variation in the capital structure.
The market value of the firm and the
market value of the firm’s shares are
unaffected.
Summation
There is no change in the perception
of the market value of the firm.
There is no optimal capital structure -
financing decisions are irrelevant.
Modigliani & Miller
Seminal paper (1958) on capital
structure theory.
Supported the NOI approach.
Any 2 identical firms would ultimately
be perceived by investors as the same
in terms of value irrespective of their
capital structures.
MM (No Taxes) Assumptions
Perfectly competitive capital market.
Business risk of all companies in a
particular risk class is the same.
No personal or company taxes.
Debt is risk-free (no default risk).
Borrow and lend at the same rate.
No bankruptcy costs.
MM
It is the ultimate return that is important.
3 important propositions.
MM Proposition 1
The value of an asset remains the
same regardless of how the net cash
flows generated by the asset are
divided between different classes of
investors.
In other words,the market value of
the company is independent of its
capital structure,The investment and
financing decisions can be separated.
MM Proposition 2
A company’s capital structure has no
effect on its overall cost of capital.
MM Proposition 3
The appropriate discount rate for a
particular investment proposal is
independent of how the proposal is to
be financed.
MM Overall
In a perfect capital market with no
taxes,it is only the investment
decision that is important in the
pursuit of wealth maximisation,The
financing decision is of no
consequence.
Subject to the underlying assumptions,
MM approach has broad acceptance.
MM With Taxes
In a world of no taxes,MM say VL =
VU.
Doesn’t hold true if corporate taxes
are introduced.
Interest payments are tax deductible,
giving an advantage to levered firms.
MM (With Corporate Taxes)
k ks
k
kd
k*d
D:E Ratio
MM (With Corporate Taxes)
As the D:E ratio increases:
cost of debt kd is unchanged;
cost of equity ks increases;
overall cost of capital k decreases;
market value of the firm increases.
MM With Taxes
VL = VU + (PV of tax savings on interest)
D T + V = V
k
DkT
+ V = V
k
IT
+ V = V
UL
d
d
UL
d
UL
MM With Taxes
A levered firm will always be worth more
than an equivalent unlevered firm,The
more it borrows,the more its value
increases.
All companies should have 100% debt!
However,the tax advantages of debt finance
are offset by the costs of debt - the costs
of financial distress,agency costs and
information asymmetry.
Personal taxes also complicate things.
Personal Taxes
The classical tax system was biased in
favour of debt finance.
Imputation tax system introduced in
1987/88 tax year.
Reduced taxes on equity income.
Neutral between debt and equity.
Companies now make greater use of
equity finance.
Dividend Imputation
Shareholders indifferent to corporate
borrowing – tax shield from
borrowings irrelevant when
shareholders receive franked dividends.
Local (resident) shareholders mainly
concerned about the availability of
franking credits on dividends,This will
have some effect on share price.
Financial Distress
Companies which issue risky debt face
the prospect of incurring direct and
indirect bankruptcy costs.
Direct costs - those associated with
receivership and liquidation.
Indirect costs - incurred through loss
of sales and management spending
too much time on bankruptcy-related
matters.
Agency Costs
Lenders may impose monitoring techniques
on borrowers,who consequently incur
agency costs.
Loan agreements might include provisions
(covenants) relating to things like the
minimum level of liquidity of the borrower,
asset acquisitions by the borrower,
executive salaries and dividend payments.
Lender can control the risk of the borrower.
Asymmetric Information
Information asymmetry occurs when managers
have more information (than investors) about
the firm’s activities and future prospects.
Results in a pecking order of financial
preferences.
Retained earnings,debt,external equity.
Debt financing is a positive signal –
management believes shares are undervalued.
Share issue is a negative signal – management
thinks that shares are overvalued.
Conclusion
There is little conclusive evidence to
support or reject either theory on
capital structure.
A general conclusion is that primary
attention should be paid to investment
decisions.
Table 13.16 (p,495) lists factors to
consider when making capital
structure decisions.
Capital Structure in Practice
Two techniques:
EBIT-EPS analysis
– Assumes a goal of maximising EPS
instead of owners’ wealth.
– Maximisation of EPS ignores risk.
Capacity to service debt
– Times interest earned ratio
– Fixed-payment coverage ratio
