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Principles of Capital
Structure
Copyright 2009 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 10e by Peirson
Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
12-1
Learning Objectives
Explain the effects of financial leverage.
Distinguish between business risk and financial risk.
Understand the capital structure irrelevance theory
of Modigliani and Miller (MM).
Explain the roles of taxes and other factors that may
influence capital structure decisions.
Understand the concept of an optimal capital
structure, based on a trade-off between the benefits
and costs of using debt.
Explain the pecking order theory of capital structure.
Outline Jensens free cash flow theory.
Copyright 2009 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 10e by Peirson
Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
12-2
Introduction
Capital structure:
The mix of debt and equity finance used by a company.
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Financial risk:
The risk involved in using debt as a source of finance.
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MMs Proposition 1
The market value of any firm is independent of its
capital structure.
If a company has a given set of assets, changing
debt to equity will change the way net operating
income is divided between lenders and shareholders
but will not change the value of the company.
Value of a company is given by:
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Proposition 1: Proof
Two companies that have the same assets but
different capital structures are, under the
assumptions, perfect substitutes. As such, perfect
substitutes should have the same value.
There is no reason for investors to pay a premium
for shares of levered companies because investors
can borrow to create home-made leverage.
Home-made leverage is a perfect substitute for
corporate leverage.
The central mechanism in MMs proof is the
substitutability between corporate debt and
personal debt.
Copyright 2009 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 10e by Peirson
Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
12-8
Proposition 1: Proof
If a leveraged company (L) is overvalued compared to
unleveraged (U) company, then an investor in levered
companys shares can replicate his/her risk and return
by investing instead in the shares of an unleveraged
company and adjusting the debtequity ratio by
borrowing personally.
Similarly, if an unleveraged company (U) is overvalued
compared to leveraged (L) company, then an investor in
unleveraged companys shares can replicate his/her
risk and return by investing instead in the shares of a
leveraged company and adjusting the debtequity ratio
(to zero) by lending personally.
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What if
The companies were not selling for the same price?
Arbitrage profits could be earned. An opportunity to
make riskless profits exists and arbitragers will exploit
this.
Arbitrage involves buying an asset and simultaneously
selling it for a higher price, usually in another market,
so as to make a risk-free profit.
An Arbitrage Illustration:
Example: Two firms: U and L. Firm U is unlevered
and Firm L is levered. Firm L has borrowed $400 000
at 7.5%. Both firms make a profit of $900 000.
Required return is 10%. We want to show that these
two companies are equivalent, otherwise there must
be an arbitrage opportunity.
Copyright 2009 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 10e by Peirson
Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
12-10
Firm L (leveraged):
value of equity
$6,000,000
Value of firm = D + E = 4 M + 6 M =$10 000 000
Copyright 2009 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 10e by Peirson
Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
12-11
Return:
10% x net income of L: 10% x 600 000 = $60 000 p.a.
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$400 000
$1 000 000
1, 000, 000
Return
$900, 000
9, 000, 000
$100, 000
This ($100 000) is a gross return and does not factor in costs.
Copyright 2009 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 10e by Peirson
Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
12-13
$100 000
$ 30 000
$ 70 000 p.a.
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MMs Proposition 2
The cost of equity of a levered firm is equal to the cost of
equity of an unlevered firm plus a financial risk premium,
which depends on the degree of financial leverage:
E
D
k0 ke k d
V
V
where:
k0 expected return on assets
ke expected return on equity
kd expected return on debt
E market value of company's equity
D market value of company's debt
V E D market value of company
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MMs Proposition 3
The appropriate discount rate for a particular
investment proposal is independent of how
the proposal is to be financed.
The key factor determining the discount rate
or a proposal is the level of risk associated
with the project.
This is consistent with the irrelevance of the
financing decision: Proposition 1.
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Classical system:
Leverage will increase a firms value because interest
on debt is a tax deductible expense resulting in an
increase in the after-tax net cash flows to investors.
The main implication of Proposition 1 with company tax is
clear but extreme: A company should borrow so much that
its company tax bill is reduced to zero.
Copyright 2009 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 10e by Peirson
Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
12-19
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VL VU
tc k d D
kd
where
tc Drepresents the
VU tc D
interest payments.
1 tc 1 ts
1 t
p
where:
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Millers Analysis
Implications:
There is an optimal debtequity ratio for the corporate
sector as a whole, which will depend on the company
income tax rate and on the funds available to investors
who are subject to different tax rates.
Securities issued by different companies will appeal
to different clienteles of investors. Consequently, in
equilibrium there is no optimal debtequity ratio for
an individual company.
Shareholders of levered companies end up receiving no
benefit from the company tax savings on debt because
the saving is passed on to lenders in the form of a
higher interest rate on debt.
Copyright 2009 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 10e by Peirson
Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
12-22
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VL VU PV of Debt
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Dividend payout:
A company may significantly increase its dividend payout.
This decreases the companys assets and increases the
riskiness of its debt.
Again, this results in a wealth transfer from lenders to
shareholders.
Copyright 2009 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 10e by Peirson
Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
12-27
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VL VU PV of Debt
and
costs
of
increased
debt
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$4.62
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PL
$500,000+$200,000+$17,000
144,444
$4.96
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Ps
$500,000+$200,000+$17,000
140,000
$5.12
Both old and new shareholders benefit as they both gain
12 cents per share in the long run.
Copyright 2009 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 10e by Peirson
Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
12-38
Ps $500,000+$200,000+$17,000
140,000
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In the short term, share price remains $4.50, but in the long
run share price increases from $4.50 to $5.00.
PL $500,000+ $17,000
100,000
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Jensen (1986) argues that free cash flows should be paid out to
investors in order to avoid poor use of funds by managers.
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Summary
Leverage and its effects on financial risk.
Modigliani and Miller capital structure does not
change the value of an entity.
If the company tax saved by borrowing is different
from the extra tax incurred at the investor level,
capital structure can affect the value of companies.
Issue of debt has a range of associated costs and
benefits such as expected bankruptcy costs and
agency costs.
There is a trade-off between costs and benefits in
determining optimal capital structure trade-off theory.
Copyright 2009 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 10e by Peirson
Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
12-44
Summary (cont.)
The trade-off theory suggests that management
should aim to maintain a target debtequity ratio.
An alternative to the trade-off theory is the pecking
order theory:
Information asymmetry can lead managers to have
a preference for debt over equity.
The pecking order approach does not rely on the existence
of a target debtequity ratio.
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