Chapter 19 CAPITAL STRUCTURE AND FIRM VALUE  Centre for

Chapter 19 CAPITAL STRUCTURE AND FIRM VALUE Centre for Financial Management , Bangalore

OUTLINE Assumptions and Definitions Net Income Approach Net Operating Income Approach Traditional Position Modigliani and Miller Position Taxation and Capital Structure Tradeoff Theory Signaling Theory Centre for Financial Management , Bangalore

ASSUMPTIONS To examine the relationship between capital structure and cost of capital, the following simplifying assumptions are commonly made: No income tax 100 percent dividend payout Identical subjective probability distributions of operating income No growth Centre for Financial Management , Bangalore

FOCUS OF ANALYSIS Annual interest charges I rD Market value of debt D Equity earnings P rE Market value of equity E Operating income O rA V Market value of the firm D r A rD D E E rE D E What happens to rD, rE, and rA when financial leverage, D/E, changes? Centre for Financial Management , Bangalore

NET INCOME APPROACH According to this approach, rD and rE remain unchanged when D/E varies. The constancy of rD and rE with respect to D/E means that rA declines as D/E increases. Rates of return rE rA rD D/E Centre for Financial Management , Bangalore

NET OPERATING INCOME APPROACH According to this approach the overall capitalisation rate (rA) and the cost of debt (rD) remain constant for all degrees of leverage. Hence rE rA (rA – rD) (D/E) Rates of return rE rA rD Centre for Financial Management , Bangalore D/E

TRADITIONAL POSITION Rates of rE return rA rD D/E Centre for Financial Management , Bangalore

MODIGLIANI AND MILLER (MM) POSITION Perfect Capital Market Rational Investors and Managers Homogenous Expectations Equivalent Risk Classes Absence of Taxation Centre for Financial Management , Bangalore

MM PROPOSITION I The value of a firm is equal to its expected operating income divided by the discount rate appropriate to its risk class. It is independent of its capital structure. V D E O/r where V market value of the firm D market value of debt E market value of equity O expected operating income r discount rate applicable to the risk class to which the firm belongs Centre for Financial Management , Bangalore

MM PROPOSITION II The expected return on equity is equal to the expected rate of return on assets, plus a premium. The premium is equal to the debt-equity ratio times the difference between the expected return on assets and the expected return on debt rE rA (rA – rD) (D/E) Centre for Financial Management , Bangalore

THE RISK-RETURN TRADEOFF As leverage increases, equity shareholders require a higher return because equity beta increases. E A D/E ( A - D) where E equity beta A asset beta D/E debt-equity ratio D debt beta Centre for Financial Management , Bangalore

CRITICISMS OF MM THEORY Firms and investors pay taxes Bankruptcy costs can be high Agency costs exist Managers tend to prefer a certain sequence of financing Informational asymmetry exists Personal and corporate leverage are not perfect substitutes Centre for Financial Management , Bangalore

CORPORATE TAXES When taxes are applicable to corporate income, debt financing is advantageous as interest on debt is a tax-deductible expense. In general O ( 1 - tC ) V where V O tC r D tC D r value of the firm operating income corporate tax rate capitalisation rate applicable to the unlevered firm market value of debt It means: Value of levered firm Value of unlevered firm Gain from leverage VL VU Centre for Financial Management , Bangalore tC D

CORPORATE TAXES AND PERSONAL TAXES When personal taxes are considered along with corporate taxes, the tax advantage of a rupee of debt is: (1 – tc) (1 – tpe) 1– (1 – tpd) where tc corporate tax rate tpd personal tax rate on debt income tpe personal tax rate on equity income Example : Suppose tc 50 percent, tpe 5 percent, and tpd 30 percent. The tax advantage of every rupee of debt is: (1 – 0.5) (1 – 0.05) 1– 0.32 rupee (1 – 0.3) Centre for Financial Management , Bangalore

LEVERAGE AND FIRM VALUE IN THE PRESENCE OF TAXES Centre for Financial Management , Bangalore

COST OF FINANCIAL DISTRESS A high level of debt may lead to financial distress that entails certain costs: Direct Costs Delay in liquidation may diminish asset value Distress sale fetches lower price Legal and administrative costs are high Indirect Costs Managers become myopic Stakeholders dilute their commitment Centre for Financial Management , Bangalore

AGENCY COSTS There is an agency relationship between the shareholders and creditors of firms that have substantial amounts of debt. Hence lenders impose restrictive covenants and monitor the behaviour of the firm. The loss in efficiency on account of restrictions on operational freedom plus the cost of monitoring (which are almost invariably passed on to shareholders) represent agency costs associated with debt. Centre for Financial Management , Bangalore

TRADEOFF MODEL Value of the firm Value of the firm considering the tax advantage of debt Financial distress costs and agency costs Value of the firm considering the tax advantage and financial distress and agency costs Value of the unlevered firm D/E Centre for Financial Management , Bangalore

PECKING ORDER OF FINANCING There is a pecking order of financing which goes as follows: Internal finance (retained earnings) Debt finance External equity finance Given the pecking order of financing, there is no welldefined target debt-equity ratio, as there are two kinds of equity, internal and external. While the internal equity is at the top of the pecking order, the external equity is at the bottom. Centre for Financial Management , Bangalore

SIGNALING THEORY Noting the inconsistency between trade-off theory and the pecking order of financing, Myers proposed a new theory, called the signaling, or asymmetric information, theory of capital structure. A critical premise of the the trade-off theory is that all parties have the same information and homogeneous expectations. Myers argued that there is asymmetric information and divergent expectations which explains the pecking order of financing observed in practice. Centre for Financial Management , Bangalore

SUMMING UP Several positions have been taken on the relationship between capital structure and firm value (or cost of capital) According to the net income approach the average cost of capital declines as the leverage ratio increases According to the net operating income approach, the cost of capital does not vary with capital structure According to the traditional approach, the cost of capital decreases upto a point, remains more or less unchanged for moderate increases in leverage thereafter, and rises beyond that at an increasing rate Modigliani and Miller (MM) restated and amplified the net operating income approach in terms of two basic propositions: (a) the value of a firm is independent of its capital structure. (b) The expected return on equity is equal to the expected return on assets, plus a premium. The premium is equal to the debt-equity ratio times the difference between the expected return on assets and the expected return on debt Centre for Financial Management , Bangalore

The beta of a firm’s equity may be expressed as: E A D/E ( A – D) The imperfections in the real world cast their shadow over the leverage irrelevance theorem of MM The value of a firm, when corporate taxation is considered, is : V [O (1 – tc) tcD]/r When personal taxes are considered, along with corporate taxes, the gain in the value per rupee of debt is equal to : [1 – (1 – tc) (1 – tpe) / (1 – tpd)] Considering the tax effect and financial distress and agency costs, the value of a levered firm is: Value of the unlevered firm Tax advantage of debt - Financial distress and agency cost In the real world, firms seem to follow a pecking order of financing which goes as follows; internal finance, debt finance, and external equity. Myers explains this with the help of the signaling theory Centre for Financial Management , Bangalore