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
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
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.
Value of firm changes with present value of interest tax shield
M&M Proposition I: Graph
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
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
Case III: Optimal Capital Structure: WACC
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
WACC
The Pie: Revisited
Pecking Order Theory
1. Cash 2. Debt 3. Equity
Implications:
No target capital structure
Profitable firms use less debt
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
Business Failure
Legal Bankruptcy
Technical Insolvency
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
Liquidation: Chapter 7
Reorganization: Chapter 11
Liquidation: Chapter 7
Termination of the firm as a going concern
A petition is filed in federal court
Trustee-in-bankruptcy takes over assets
Assets are liquidated. Proceeds (after expenses) are distributed to creditors in order of priority.
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.
A petition is filed and approved by judge
Corporation continues to run and submits reorganization plan
Creditors and shareholders must agree to plan and plan must be confirmed by court
Payments are made pursuant to the plan
Business operates according to plan for a fixed period of time.
Recent Examples
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
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