L4 - Capital Structure

Question 1

How is Capital Structure related to firm value?

Answer 1

• The question we ask is this: does it matter how a firm finance its projects? If yes, why?
• The capital structure theories help us understand the factors most important in the relationship between capital structure and firm value.
• In their classic paper, Modigliani and Miller (MM) (1958) show that in perfect capital markets, capital structure decisions are irrelevant. That is, the value of a firm is not related to its capital structure.

Question 2

What is Modigliani-Miller’s proposition I (No Taxes)?

Answer 2

• CAPITAL STRUCTURE IRRELEVANCE
  
  • • Market value of a firm is independent of its capital structure, i.e. different capital structures do not affect the firm value.
  • In other words, a firm cannot change the total value of its outstanding assets by changing the proportions of debt and equity in its capital structure.
• MM Theorem Assumptions:
  
  1. Perfect Capital Markets
     
     • NO Taxation
     • NO bankruptcy costs
     • No agency/information problem
  2. No arbitrage opportunities

Question 3

What is Modigliani-Miller’s Proposition II (No Taxes)?

Answer 3

• Weighted average cost of capital (WACC or R_WACC) is constant and cannot be minimised, regardless of the capital structure.
• But why is it not beneficial to have debt in the capital structure given that the required rate of return on debt is normally lower than that on equity?
• Because when a firm adds debt to its capital structure, the remaining equity becomes more risky. Hence, the cost of equity increases.
• And this increase in the cost of remaining equity exactly offsets the higher proportion of the firm financed by cheap debt.

Question 4

How can we plot Modigliani-Miller’s Proposition II (No Taxes) on a graph?

Answer 4

• When you increase the debt-equity ratio
  
  • cost of equity increases
  • But cost of debt and WACC does not change

Question 5

What is Modigliani-Miller’s proposition I (Corporate Taxes)?

Answer 5

• We assume taxes (relax the assumption) but still hold that there are no bankruptcy or agency costs like before

Question 6

Value of a Levered and unlevered firm under Modigliani-Miller’s Proposition I (Corporate Taxes)?

Example: The company Merlin has a corporation tax rate (Tc ) of 20% and expected earnings before interest and taxes (EBIT) of £1,000,000 each year. Earnings after tax are paid out as dividends. The firm is considering two alternative capital structures: (1) no debt in its capital structure (all-equity financed), (2) £3,000,000 of debt (D) with a cost of 10% (RD).

Answer 6

• Value of levered = value of equity + the tax shield
  
  • (Calculate the first pie)
    
    • Tax shield is the reduction in taxes that comes from owning more debt (the difference on the tax slice in the two pies before)
• REMEMBER –> levered equity –> total firm value - value of debt
  
  • different from normal equity

Question 7

What is Modigliani-Miller’s proposition II (Corporate Taxes)?

Answer 7

• cost of equity with no debt + additional cost to company of using debt * tax shield

Question 8

What is WACC under Modigliani-Miller’s proposition II (Corporate Taxes)?

Answer 8

Question 9

Plot of Modigliani-Miller’s Proposition II (Corporate Taxes)?

Answer 9

• When you increase Debt –> cost of equity still increasing
• But WACC now falls –> due to the advantage of the tax shield

Question 10

Why don’t firms use 100% debt to fund their business?

Answer 10

• So far, we have discussed that in perfect capital markets, capital structure is irrelevant (MM propositions I & II with no taxes).
• However, if there are taxes (in the real world there are always taxes!), then it appears that having more debt is better because it enables the borrowing firm to reduce taxes (MM propositions I & II with corporate taxes).
• But, firms are normally not completely financed with debt in practice. Why?
  
  • • We discussed the advantages of debt. However, a potential disadvantage of debt is that if a firm is unable to pay its debt obligations, then creditors may be able to force the company to stop its operations and sell its assets in order to recover their capital.
  • • Note that dividend payments to shareholders are not obligations of firms, but interest and principle payments to debtholders are legal obligations of firms.
  • • Therefore, for a firm there are dangers from having too much debt. The risk of too much debt is bankruptcy. In other words, if a firm cannot meet its debt obligations, this will lead to financial distress and the ultimate financial distress is .
• Bankruptcy costs tend to offset tax benefits (and hence firms are not completely financed with debt in practice)
• • Therefore, firms have to consider the ‘trade-off’ between tax benefits of debt and bankruptcy costs.
• • In other words, additional debt is good only up to a certain point due to bankruptcy costs.
• • The finance literature pays considerable attention to bankruptcy costs to explain the link between capital structure and the firm value

Question 11

Direct and Indirect costs of bankruptcy?

Answer 11

• Direct costs of bankruptcy:
  
  • • Legal and administrative costs of bankruptcy. For example, fees paid to lawyers, administrators, accountants, etc. that are involved in bankruptcy proceedings.
    
    • • Example: For the Lehman Brother’s bankruptcy, total fees paid to lawyers, administrators, and other parties were around $1.05 billion within two years of bankruptcy.
• Indirect costs of bankruptcy:
  
  • • Lost sales occur because suppliers and customers lose trust and doubt about service quality.
    
    • • It increases the cost of doing business (e.g., tightening credits, lose of key staffs, etc.)
    • • It is difficult to measure the indirect cost of bankruptcy

Question 12

What are Agency Costs?

Answer 12

• • Having debt can lead to conflicts between shareholders and debtholders, especially when financial distress is incurred.
  
  • Shareholders want to keep the cash away from the debtholders for themselves
• • Conflicts of interest between shareholders and debtholders can lead to agency costs on firms. In this case, shareholders can try some strategies to help themselves:
  
  • ➢Taking large risks
  • ➢Underinvestment
  • ➢Milking the property
• • These can impact the capital structure decisions

Question 13

How can we incorporate the effect of Bankruptcy and Agency Costs into the value of a levered firm?

Answer 13

Question 14

Trade-off theory summarised on a graph?

Answer 14

• 1= No corporate taxes
• 2= corporate taxes
• 3= trade off theory

Question 15

Main Theoretical and Empirical Findings?

Answer 15

• Theoretical
  
  • Trade-off theory: Profitable firms and safe firms with valuable tangible assets borrow more.
  • • Pecking order theory: Profitable firms borrow less.
• Empirical
  
  • • Financial leverage is positively related to firm size (bigger firms have a greater capacity to borrow) , asset tangibility (something physical that can be used as collateral), and investment opportunities (value of the future aswell).
  • Financial leverage is negatively related to bankruptcy probability and R&D investments (risky).
  • No consensus, yet, in the empirical capital structure literature.

Question 16

What theory came as a reaction to Trade-off theory?

Answer 16

Question 17

Summary of Capital Structure Theory?

Answer 17