Capital Structure: Part 1

Transcription

1 Capital tructure: Part 1 For 9.220, Term 1, 2002/03 02_Lecture19.ppt tudent Version Outline 1. Introduction 2. Theories of Capital tructure a Modigliani and Miller No tax b M&M with Corporate Tax 3. ummary and Conclusions (so far 1

2 Introduction Definition: Capital tructure is the mix of financial securities used to finance the firm. Our goal is to see if there is an optimal way for firms to finance. hould a firm have a higher or lower D/E ratio. What factors affect the optimal D/E choice? In order to optimize the D/E ratio, our overall goal is to maximize the total value of the firm and thus maximize expected shareholder wealth. Modigliani and Miller No Tax Case M&M began looking at capital structure in a very simplified world so that we would know what does or does not matter. Assume no taxes No transaction costs Including no bankruptcy costs Investors can borrow/lend at the same rate (the same as the firm. No information asymmetries A fixed investment policy by the firm 2

3 M&M No Tax: Result A change in capital structure does not matter to the overall value of the firm. The total cash flows produced are the same, thus the total value of the cash flows is the same. It doesn t matter if the cash flows from the firm to its security holders are called debt or equity cash flows. M&M No Tax Case $1,000, 100% Debt, $300, 30% $700, 70% $400, 40% Debt, $600, 60% 3

4 The M&M Propositions I & II (No Taxes Proposition I Firm value is not affected by leverage V L = V U Proposition II Leverage increases the risk and return to stockholders r s = r 0 + ( / L (r 0 - r r is the interest rate (cost of debt r s is the return on (levered equity (cost of equity r 0 is the return on unlevered equity (cost of capital is the value of debt L is the value of levered equity M&M Proposition I (No Taxes The derivation is straightforward: hareholders in a levered firm receive ( EIT r + r EIT r Thus, the total cash flow to all stakeholders is V = L V U ondholders receive The present value of this stream of cash flows is V L Clearly ( EIT r + r = EIT r The present value of this stream of cash flows is V U 4

5 M&M Proposition II (No Taxes The derivation is straightforward: r + + Then set r WACC = r WACC = r + r 0 + r + r = r 0 multiply both sides by r + + r + r = + + r + r 0 + = r 0 r + r = r 0 + r 0 r = r 0 + ( r 0 r Exercise uppose the firm is currently all equity financed and the total value of the firm is $90 million. E[R equity ] is 18%. Also, suppose R f = 4% and E[R M ] = 14%. 1. What is the value of the equity and the total value of the firm if the capital structure is changed to include $30 million of debt? If E[R debt ] is 6%, then what is the new E[R equity ]? What is the WACC? Compare the beta of the levered equity to the unlevered equity. What is the weighted beta of the firms securities? 2. Redo 1 with $60 million of debt. 5

6 The Cost of Equity & Debt, and the WACC: M&M Proposition II with No Corporate Taxes Cost of capital: r (% r 0 r = r 0 + ( r 0 r L r WACC = r + r + + r r Debt-to-equity Ratio M&M with Corporate Taxes When corporate taxes are introduced, then debt financing causes a positive benefit to the value of the firm. The reason for this is that debt interest payments reduce taxable income and thus reduce taxes. Thus with debt, there is more after-tax cash flow available to security holders (equity and debt than there is without debt. Thus the value of the equity and debt securities combined is greater. 6

7 M&M with Corporate Taxes T C = 40% in this example Tax, $400, 40% $600, 60% $420, 42% Tax, $280, 28% $240, 24% Tax, $160, 16% Debt, $300, 30% Debt, $600, 60% M&M Proposition I (with Corporate Taxes Proposition I (with Corporate Taxes Firm value increases with leverage V L = V U + T C 7

8 M&M Proposition I (with Corp. Taxes hareholders in a levered firm receive ( EIT r (1 T C Thus, the total cash flow to all stakeholders is ( EIT r (1 TC + r The present value of this stream of cash flows is V L Clearly ( EIT r (1 TC + r = The present value of the first term is V U The present value of the second term is T C ondholders receive r = EIT (1 TC r (1 TC + r = EIT (1 T r + r T r C C + VL = VU + T C M&M Proposition II (with Corp. Taxes Proposition II (with Corporate Taxes This proposition is similar to Prop. II in the no tax case, however, now the risk and return of equity does not rise as quickly as the debt/equity ratio is increased because low-risk tax cash flows are saved. ome of the increase in equity risk and return is offset by interest tax shield r = r 0 + (/ (1-T C (r 0 -r r is the interest rate (cost of debt r is the return on equity (cost of equity r 0 is the return on unlevered equity (cost of capital is the value of debt is the value of levered equity 8

9 Exercise uppose the firm is currently all equity financed and the total value of the firm is $90 million. E[R equity ] is 18%. Also, suppose that T C = 40%, R f = 4% and E[R M ] = 14%. 1. What is the value of the equity and the total value of the firm if the capital structure is changed to include $30 million of debt? If E[R debt ] is 6%, then what is the new E[R equity ]? What is the new WACC? 2. Redo 1 with $60 million of debt. The Effect of Financial Leverage on the Cost of Debt and Equity Capital Cost of capital: r (% r = r0 + ( 1 TC ( r0 r L r 0 r L r WACC = (1 C + + L + L T r r Debt-to-equity ratio (/ 9

10 ummary and Conclusions At this point, it appears clear that an increase in the debt/equity ratio increases the risk of the equity. With corporate taxes, it also appears that the value of the firm increases as the amount of debt used increases (due to taxes being saved. However, in reality, we don t see 100% debt financing, so there must be other factors that affect the firm s optimal capital structure. The next lecture addresses these other factors and extends the theory. 10