CHAPTER 11

Capital Structure Decisions: Part II

MM and Miller models Hamadas equation Financial distress and agency costs

Trade-off models
Asymmetric information theory
Finance 404 1

Who are Modigliani and Miller (MM)?

They published theoretical papers that changed the way people thought about financial leverage. They won Nobel prizes in economics because of their work. MMs papers were published in 1958 and 1963. Miller had a separate paper in 1977. The papers differed in their assumptions about taxes.

Finance 404

What assumptions underlie the MM and Miller models?

Firms can be grouped into homogeneous classes based on business risk.
Investors have identical expectations about firms future earnings. There are no transactions costs.
(More...)
Finance 404 3

 All cash flows are perpetuities. This implies perpetual debt is issued, firms have zero growth, and expected EBIT is constant over time. In their first paper (1958), MM also assumed that there are no corporate or personal taxes. Later relaxed. The assumptions were necessary in order for MM to use the arbitrage argument to develop and prove their equations.
Finance 404 4

MM with Zero Taxes (1958)

Proposition I: VL = VU. Proposition II: ksL = ksU + (ksU - kd)(D/S).

Finance 404

Given the following data, find V, S, ks, and WACC for Firms U and L.
Firms U and L are in same risk class.
EBITU,L = $500,000. Firm U has no debt; ksU = 14%. Firm L has $1,000,000 debt at kd = 8%. The basic MM assumptions hold. There are no corporate or personal taxes.
From the Mini Case
Finance 404 6

1. Find VU and VL.

VU = EBIT = $500,000 = $3,571,429. ksU 0.14

VL = VU = $3,571,429. Question: Are the MM assumptions required?

Finance 404

2. Find the market value of Firm Ls debt and equity. VL = D + SL = $3,571,429 $3,571,429 = $1,000,000 + SL

SL = $2,571,429.

Finance 404

3. Find ksL.

ksL= ksU + (ksU - kd)(D/S) $1,000,000 = 14.0% + (14.0% - 8.0%) $2,571,429

= 14.0% + 2.33% = 16.33%.

Finance 404

4. Proposition I implies WACC = ksU. Verify for L using WACC formula.

WACC = wdkd + wceks = (D/V)kd + (S/V)ks $1,000,000 = $3,571,429 (8.0%)

( ) $2,571,429 +($3,571,429 )(16.33%)

Finance 404

= 2.24% + 11.76% = 14.00%.

10

Graph the MM relationships between capital costs and leverage as measured by D/V.
Cost of Capital (%) 26 20 14 WACC kd Debt/Value Ratio (%) 100
11

Without taxes
ks

8
0 20 40 60 80

Finance 404

 The more debt the firm adds to its capital structure, the riskier the equity becomes and thus the higher its cost.
Although kd remains constant, ks increases with leverage. The increase in ks is exactly sufficient to keep the WACC constant.

Finance 404

12

Graph value versus leverage.

Value of Firm, V ($) VU 4 VL Firm value ($3.6 million)

3
2 1 0 0.5 1.0 1.5 2.0 2.5 Debt (millions of $)

With zero taxes, MM argue that value is unaffected by leverage.

Finance 404 13

Find V, S, ks, and WACC for Firms U and L assuming a 40% corporate tax rate.
With corporate taxes added, the MM propositions become: Proposition I: VL = VU + TD.

Proposition II: ksL = ksU + (ksU - kd)(1 - T)(D/S).

Finance 404 14

Notes About the New Propositions

1. When corporate taxes are added, VL VU. VL increases as debt is added to the capital structure, and the greater the debt usage, the higher the value of the firm.
2. ksL increases with leverage at a slower rate when corporate taxes are considered.
Finance 404 15

1. Find VU and VL. EBIT(1 - T) = $500,000(0.6) = $2,142,857. VU = ksU 0.14

Note: Represents a 40% decline from the no taxes situation.
VL = VU + TD = $2,142,857 + 0.4($1,000,000) = $2,142,857 + $400,000 = $2,542,857.
Finance 404 16

2. Find market value of Firm Ls debt and equity. VL= D + SL = $2,542,857 $2,542,857= $1,000,000 + SL SL= $1,542,857.

Finance 404

17

3. Find ksL.

ksL = ksU + (ksU - kd)(1 - T)(D/S)

$1,000,000 = 14.0% + (14.0% - 8.0%)(0.6) $1,542,857 = 14.0% + 2.33% = 16.33%.

Finance 404

18

4. Find Firm Ls WACC. WACCL= (D/V)kd(1 - T) + (S/V)ks $1,000,000 = $2,542,857 (8.0%)(0.6) $1,542,857 + $2,542,857 (16.33%)

( (

) )

= 1.89% + 9.91% = 11.80%.

When corporate taxes are considered, the WACC is lower for L than for U.
Finance 404 19

MM relationship between capital costs and leverage when corporate taxes are considered.
Cost of Capital (%) 26

ks

20
14 8 WACC kd(1 - T)

20

40

60

80

100

Debt/Value Ratio (%)

20

Finance 404

MM relationship between value and debt when corporate taxes are considered.
Value of Firm, V ($) 4 VL TD

3
2 1

VU
Debt

0.5

1.0

1.5

2.0

2.5 (Millions of $)

Under MM with corporate taxes, the firms value increases continuously as more and more debt is used.
Finance 404 21

Assume investors have the following tax rates: Td = 30% and Ts = 12%. What is the gain from leverage according to the Miller model?
Millers Proposition I: (1 - Tc)(1 - Ts) VL = VU + 1 (1 - Td)

]D.
22

Tc = corporate tax rate. Td = personal tax rate on debt income. Ts = personal tax rate on stock income.
Finance 404

Tc = 40%, Td = 30%, and Ts = 12%. (1 - 0.40)(1 - 0.12) = VU + 1 (1 - 0.30)

VL

]D

= VU + (1 - 0.75)D = VU + 0.25D. Value rises with debt; each $100 increase in debt raises Ls value by $25.
Finance 404 23

How does this gain compare to the gain in the MM model with corporate taxes?
If only corporate taxes, then VL = VU + TcD = VU + 0.40D. Here $100 of debt raises value by $40. Thus, personal taxes lower the gain from leverage, but the net effect depends on tax rates.
(More...)
Finance 404 24

When Miller brought in personal taxes, the value enhancement of debt was lowered. Why?
1. Corporate tax laws favor debt over equity financing because interest expense is tax deductible while dividends are not.

(More...)
Finance 404 25

2. However, personal tax laws favor equity over debt because stocks provide both tax deferral and a lower capital gains tax rate.
3. This lowers the relative cost of equity visa-vis MMs no-personal-tax world and decreases the spread between debt and equity costs. 4. Thus, some of the advantage of debt financing is lost, so debt financing is less valuable to firms.

Finance 404

26

What does capital structure theory prescribe for corporate managers?

1. MM, No Taxes: Capital structure is irrelevant-no impact on value or WACC.

2. MM, Corporate Taxes: Value increases, so firms should use (almost) 100% debt financing.
3. Miller, Personal Taxes: Value increases, but less than under MM, so again firms should use (almost) 100% debt financing.
Finance 404 27

Do firms follow the recommendations of capital structure theory?

Firms dont follow MM/Miller to 100% debt. Debt ratios average about 40%. However, debt ratios did increase after MM. Many think debt ratios were too low, and MM led to changes in financial policies.

Finance 404

28

Define financial distress and agency costs.

Financial distress: As firms use more and more debt financing, they face a higher probability of future financial distress, which brings with it lower sales, EBIT, and bankruptcy costs. Lowers value of stock and bonds.
(More...)
Finance 404 29

Agency costs: The costs of managers not behaving in the best interests of shareholders and the resulting costs of monitoring managers actions. Lowers value of stock and bonds.

Finance 404

30

How do financial distress and agency costs change the MM and Miller models?
MM/Miller ignored these costs, hence those models show firm value increasing continuously with leverage. Since financial distress and agency costs increase with leverage, such costs reduce the value of debt financing.
Finance 404 31

Heres a valuation model which includes financial distress and agency costs:
PV of agency PV of expected VL = VU + XD . costs fin. distress costs

X represents either Tc in the MM model or the more complex Miller term. Now, optimal leverage involves a tradeoff between the tax benefits of debt and the costs associated with financial distress and agency.
Finance 404 32

Relationships between capital costs and leverage when financial distress and agency costs are considered.
Cost of Capital (%) ks WACC or ka kd(1 - T) 4 D*
Finance 404

14

Debt/Value Ratio (%)

33

Relationship between value and leverage.

Value of Firm V ($) 4 Note that value is maximized and WACC is minimized at the same capital structure.

3
2 1 D*
Finance 404

Debt ($)
34

Tradeoff theory (Static Tradeoff Theory):

The optimal capital structure involves a balance between: the tax-shield benefits of leverage and the costs associated with financial distress and agency problems. rationalizes moderate borrowing mature firms with tangible assets should borrow more than growth firms

Finance 404

35

Implications of Tradeoff Theory

Firms with more business risk ought to use less debt than lower risk firms Firms that have tangible, readily marketable assets such as real estate can use more debt than firms whose value is derived from intangible assets. Firms that are currently paying taxes at the highest rate should use more debt than firms with lower current/ or prospective tax rates.
Finance 404 36

Reality
Firms prefer to finance with internally generated funds - retained earnings and depreciation. Firms set their target payout ratios based on their expected future investment opportunities and expected future cash flows Dividends are sticky in the short run. There is a pecking order of financing, not the balanced approach that is called for under the tradeoff theory.
Finance 404 37

How are financial and business risk measured in a market risk framework? ksL= kRF + (kM-kRF)bU + (kM - kRF)bU(1 - T)(D/S)
ksL =

Business Pure time + risk + premium value

Financial risk . premium

(Hamadas equation)
Finance 404 38

Hamadas equation for beta:

b= bU + bU(1 - T)(D/S)

Unlevered Increased beta, which volatility of reflects the the returns + business to equity risk of the due to the use firm of debt

Business risk

Financial risk
39

Finance 404

What is the asymmetric information, or signaling, theory of capital structure?

Theory recognizes that market participants do not have homogeneous expectations--managers typically have better information than investors. Thus, financing actions are interpreted by investors as signals of managerial expectations for the future.
(More...)
Finance 404 40

 Managers will issue new common stock only when no other alternatives exist or when the stock is overvalued. Investors recognize this, so new stock sales are treated as negative signals and stock price falls. Managers do not want to trigger a price decline, so firms maintain a reserve borrowing capacity. Managers act in the best interests of current shareholders.

Finance 404

41

Important implication:
Because managers are reluctant to take actions which lower their firms stock price, they try to maintain a reserve borrowing capacity which can be tapped if external equity is needed. They do not want to be forced into a new equity issue at the wrong time.

Finance 404

42

What is the pecking order theory of capital structure?

Results of a survey by Donaldson and the asymmetric information theory.
Firms follow a specific financing order:

First use internal funds. Next, draw on marketable securities. Then, issue new debt. Finally, and only as a last resort, issue new common stock.

Finance 404

43

Does the pecking order theory make sense? Explain. Is the pecking order theory consistent with the trade-off theory?
It is consistent with the asymmetric information theory, in which managers avoid issuing equity. Especially true for mature companies which go to the markets infrequently. It is not consistent with trade-off theory.
Finance 404 44

Organizational Theory of Capital Structure

Maximize Corporate Wealth

Organizations act in their own interest

The most profitable firms borrow the least Some regard the substitution of Debt for Equity as a Good Change
Finance 404 45

Conclusion
MM and Miller models
Financial Distress and Agency Costs

Hamada Equation Tradeoff Theory Asymmetric Information Theory Pecking Order Theory
Finance 404 46