Capital

Capital Structure
Structure
Determination
Determination

17.1 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Capital Structure
Determination
• A Conceptual Look
• The Total-Value Principle
• Presence of Market Imperfections and
Incentive Issues
• The Effect of Taxes
• Taxes and Market Imperfections
Combined
• Financial Signaling
17.2 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Capital Structure

Capital Structure -- The mix (or proportion) of

a firm’s permanent long-term financing
represented by debt, preferred stock, and
common stock equity.
• Concerned with the effect of capital market
decisions on security prices.
• Assume: (1) investment and asset
management decisions are held constant and
(2) consider only debt-versus-equity financing.
17.3 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Traditional Approach

Traditional Approach – A theory of capital

structure in which there exists an optimal capital
structure and where management can increase
the total value of the firm through the judicious
use of financial leverage.

Optimal Capital Structure – The capital structure

that minimizes the firm’s cost of capital and
thereby maximizes the value of the firm.

17.4 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Optimal Capital Structure:
Traditional Approach
Traditional Approach

ke
0.25
ko
0.20
Capital Costs (%)

0.15
ki
0.10
Optimal Capital Structure
0.05

0
Financial Leverage (B / S)
17.5 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Excel and the
Traditional Approach
Traditional
Approach

You can create this

type of analysis in
Excel also. We use
some assumptions
in this model built
into the formulas.

Refer to “VW13E-
17.xlsx” on the
‘Traditional
Approach’ tab

17.6 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Summary of the
Traditional Approach
• The cost of capital is dependent on the capital
structure of the firm.
• Initially, low-cost debt is not rising and replaces more
expensive equity financing and ko declines.
• Then, increasing financial leverage and the
associated increase in ke and ki more than offsets
the benefits of lower cost debt financing.
• Thus, there is one optimal capital structure
where ko is at its lowest point.
• This is also the point where the firm’s total
value will be the largest (discounting at ko).
17.7 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Total Value Principle:
Modigliani and Miller (M&M)
• Advocate that the relationship between
financial leverage and the cost of capital is
explained by the NOI approach.
• Provide behavioral justification for a constant
ko over the entire range of financial leverage
possibilities.
• Total risk for all security holders of the firm is
not altered by the capital structure.
• Therefore, the total value of the firm is not
altered by the firm’s financing mix.
17.8 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Total Value Principle:
Modigliani and Miller
Market value Market value
of debt ($35M) of debt ($65M)

Market value Market value

of equity ($65M) of equity ($35M)

Total firm market Total firm market

value ($100M) value ($100M)

• Total market value is not altered by the capital

structure (the total size of the pies are the same).
• M&M assume an absence of taxes and market
imperfections.
• Investors can substitute personal for corporate
financial leverage.
17.9 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Required Rate of Return
on Equity with Bankruptcy
ke with bankruptcy costs
Required Rate of Return

Premium
ke with no leverage for financial
on Equity (ke)

risk
ke without bankruptcy costs

Premium
for business
risk
Rf
Risk-free
rate

Financial Leverage (B / S)
17.10 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Agency Costs

Agency Costs -- Costs associated with monitoring

management to ensure that it behaves in ways
consistent with the firm’s contractual agreements
with creditors and shareholders.
• Monitoring includes bonding of agents, auditing
financial statements, and explicitly restricting
management decisions or actions.
• Costs are borne by shareholders (Jensen & Meckling).
• Monitoring costs, like bankruptcy costs, tend to rise at
an increasing rate with financial leverage.
17.11 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Example of the Effects
of Corporate Taxes

The judicious use of financial leverage

(i.e., debt) provides a favorable impact
on a company’s total valuation.
Consider two identical firms EXCEPT:
EXCEPT
• Company ND – no debt, 16% required return
• Company D – $5,000 of 12% debt
• Corporate tax rate is 40% for each company
• NOI for each firm is $10,000
17.12 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Tax-Shield Benefits
Tax Shield – A tax-deductible expense. The
expense protects (shields) an equivalent dollar
amount of revenue from being taxed by reducing
taxable income.
Present value of
tax-shield benefits = (r) (B) (tc) = (B) (tc)
of debt*
debt r
= ($5,000)
$5,000 (0.4)
0.4 = $2,000**
$2,000
* Permanent debt, so treated as a perpetuity
** Alternatively, $240 annual tax shield / 0.12 = $2,000, where
$240=$600 Interest expense × 0.40 tax rate.
17.13 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Value of the Levered Firm

Value of Value of Present value

of
levered = firm if + tax-shield
benefits
Value
firm of unlevered firm
unlevered = $1,200of/ 0.16
debt
(Company ND) = $7,500*
$7,500

Value of levered firm = $7,500 +

$2,000 (Company D) = $9,500
* Assuming zero growth and 100% dividend payout
17.14 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Summary of
Corporate Tax Effects
• The greater the amount of debt, the greater the tax-
shield benefits and the greater the value of the
firm.
• The greater the financial leverage, the lower the
cost of capital of the firm.
• The adjusted M&M proposition suggests an
optimal strategy is to take on the maximum
amount of financial leverage.
leverage
• This implies a capital structure of almost 100%
debt! Yet, this is not consistent with actual
behavior.
17.15 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Other Tax Issues
• Uncertainty of tax-shield benefits
Uncertainty increases the possibility of
bankruptcy and liquidation, which reduces
the value of the tax shield.
• Corporate plus personal taxes
Personal taxes reduce the corporate tax
advantage associated with debt.
Only a small portion of the explanation why
corporate debt usage is not near 100%.
17.16 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Bankruptcy Costs,
Agency Costs, and Taxes
Value of levered firm
= Value of firm if unlevered
+ Present value of tax-shield benefits
of debt
- Present value of bankruptcy and
agency costs
As financial leverage increases, tax-shield
benefits increase as do bankruptcy and
agency costs.
costs
17.17 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Bankruptcy Costs,
Agency Costs, and Taxes
Cost of Capital (%)

Minimum Cost Taxes, bankruptcy, and

of Capital Point agency costs combined

Net tax effect

Optimal Financial Leverage

Financial Leverage (B/S)

17.18 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Financial Signaling
• A manager may use capital structure changes to
convey information about the profitability and risk
of the firm.
• Informational Asymmetry is based on the idea that
insiders (managers) know something about the firm
that outsiders (security holders) do not.
• Changing the capital structure to include more debt
conveys that the firm’s stock price is undervalued.
undervalued
• This is a valid signal because of the possibility of
bankruptcy.
17.19 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Timing and Flexibility
1. Timing
• After appropriate capital structure determined it is still difficult
to decide when to issue debt or equity and in what order
• Factors considered include the current and expected health of
the firm and market conditions.

2. Flexibility
• A decision today impacts the options open to the firm for
future financing options – thereby reducing flexibility.
• Often referred to unused debt capacity.

17.20 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Checklist of Practical and
Conceptual Considerations
• Taxes • EBIT-EPS
analysis
• Explicit cost
• Capital structure
• Cash-flow ability to
ratios
service debt
• Security rating
• Agency costs and
incentive issues • Timing
• Financial signaling • Flexibility

17.21 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Pecking Order Theory
 First Preference  Second Preference
Internal financing External Financing
- Debt
- Hybrid
- Equity

17.22 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.