Financial Leverage and Capital Structure Policy

Chapter 16

Created by David Moore, PhD

Topics

  • Capital Structure Theory
    • M&M Proposition I and II
      • Case I: No taxes
      • Case II: taxes no bankruptcy
      • Case III: taxes and bankruptcy
    • Optimal Capital Structure
      • Static Theory of Capital Structure
    • Pecking Order
    • Bankruptcy
      • Costs
      • Process

Why does Capital Structure Matter? Or does it?

  • Goal of financial manager?
    • Maximize Stockholder Wealth
  • Choose debt-equity ratio that maximizes shareholder wealth
  • How do we maximize shareholder wealth?
    • Maximize firm value
    • Minimize the WACC
  • Caveat: This is a brief and basic introduction to capital structure theory

Modigliani and Miller (M&M)Theory of Capital Structure

Case I: No taxes and No bankruptcy costs

M&M Proposition I

The proposition that the value of the firm is independent of the firm's capital structure.

  • Think of firm as pie
  • How you slice pie is irrelevant
  • Only size of pie matters.
  • The cash flows of the firm do not change; therefore, value doesn't change

Two Pie Model of Capital Structure

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M&M Proposition II

The proposition that a firm's cost of equity capital is a positive linear function of the firm's capital structure.

$WACC=R_A=\frac{E}{V}R_E+\frac{D}{V}R_D$

$R_E=R_A+(R_A-R_D)\frac{D}{E}$, where:
$(R_A-R_D)\frac{D}{E}$ is the financial risk (risk of capital structure)
$R_A$ is the business risk (risk of assets)

Case I: Cost of Capital

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Case I: Takeaways

In the absence of taxes and bankruptcy costs:

  • Cash flow of the firm does not change
  • Risk of cash flows has not changed
  • How we divide cash flows between bondholders and stockholders does not matter
  • Value of firm unchanged
  • No optimal capital structure

Modigliani and Miller (M&M)Theory of Capital Structure

Case II: Taxes and No bankruptcy costs

M&M Proposition I

The Value of the levered firm is equal to the value of the unlevered firm plus the present value of the interest tax shield.

$V_L=V_U+T_CD$

  • Interest is tax deductible
  • Debt reduces taxes (government subsidizes interest payment)
  • Cash flow increases (by tax shield)
  • Value of firm changes with present value of interest tax shield

M&M Proposition I: Graph

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M&M Proposition II

The WACC decreases as D/E increases because of the government subsidy on interest payments

$WACC=R_A=\frac{E}{V}R_E+\frac{D}{V}R_D(1-T_C)$

$R_E=R_U+(R_U-R_D)\frac{D}{E}(1-T_C)$

  • Cost of equity is increasing with debt
  • WACC is decreasing with debt.

Case II: Cost of Capital

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Case II: Takeaways

In a world of taxes and no bankruptcy costs:

  • Government subsidizes interest payment
  • Cash flows increase with value of tax shield (amount of debt)
  • Firm Value increase with leverage
  • WACC decreases with leverage
  • Optimal capital structure: 100% debt

Modigliani and Miller (M&M)Theory of Capital Structure

Case III: Taxes and bankruptcy costs

Bankruptcy costs

  • Direct Costs
    • Legal and administrative costs
  • Indirect Costs
    • Costs of avoiding a bankruptcy filing incurred by financially distressed firm.
    • Larger than direct costs and harder to measure.


Financial Distress costs: Direct and indirect costs associated with going bankrupt or experiencing financial distress.

Optimal Capital Structure

  • Taxes: As D/E ratio increases, cash flows increase
  • Bankruptcy: As D/E ratio increase, the probability of bankruptcy increases (expected cost increases)


Static theory of Capital Structure: The theory that the firm borrows up to the point where the tax benefit from an extra dollar in debt is exactly equal to the cost that comes from the increased probability of financial distress.

Case III: Optimal Capital Structure: Value

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Case III: Optimal Capital Structure: WACC

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Case III: Takeaways

In a world of taxes and bankruptcy costs:

  • Capital structure is a trade-off
  • Firms trade value of tax shield and expected cost of bankruptcy created by debt
  • Optimal is point where marginal cost=marginal benefit

Capital Structure Theory Review

Firm Value

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WACC

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The Pie: Revisited

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Pecking Order Theory

1. Cash 2. Debt 3. Equity
  • Implications:
    1. No target capital structure
    2. Profitable firms use less debt
    3. Companies will build financial slack

Static vs Pecking

  • Static takes long-run focus
  • Pecking: Short-run


Likely true that firms have long-run target capital structure (static theory) but deviate from target as needed to avoid issuing new equity (pecking-order theory)

Bankruptcy Process

Types of Financial Distress

  1. Business Failure
  2. Legal Bankruptcy
  3. Technical Insolvency
  4. Accounting Insolvency

Bankruptcy

A legal proceeding for liquidating or reorganizing a business.
  • When a firm cannot meet credit obligations
  • The firm has two legal options
    1. Liquidation: Chapter 7
    2. Reorganization: Chapter 11

Liquidation: Chapter 7

Termination of the firm as a going concern
  1. A petition is filed in federal court
  2. Trustee-in-bankruptcy takes over assets
  3. Assets are liquidated. Proceeds (after expenses) are distributed to creditors in order of priority.
  4. If anything is left, distributed to shareholders

Reorganization: Chapter 11

Financial restructuring of a failing firm to attempt to continue operations as a going concern.
  1. A petition is filed and approved by judge
  2. Corporation continues to run and submits reorganization plan
  3. Creditors and shareholders must agree to plan and plan must be confirmed by court
  4. Payments are made pursuant to the plan
  5. Business operates according to plan for a fixed period of time.

Recent Examples

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Key Learning Outcomes

  • Capital Structure Theory
    • Case I: Prop I and II
    • Case II: Prop I and II
    • Case III: Static Theory
  • Bankruptcy
    • Costs
    • Process
      • Chapter 7 and 11

Next time

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