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Capital Structure 10

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Capital Structure 10

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krisna fatmawati
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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CAPITAL STRUCTURE

Decision Capital Structure:


1. Debt (Big or Small)
2. Equity (Common Stock)

How should a firm choose its debt-equity ratio? Pie Model

The value of the firm, V, is


V=B+S
B is the market value of the debt
S is the market value of the equity

Figure 15. 1 Two Pie Models of Capital Structure

Value of Firm Value of Firm

Stocks Bonds Stocks Bonds


40% 60% 60% 40%

1
MAXIMIZING FIRM VALUE VERSUS MAXIMIZING
STOCKHOLDER INTERESTS
EXAMPLE
Suppose the market value of the J.J. Sprint company is $1,000. The
company currently has no debt, and each of J.J. Sprint’s 100 shares of
stock sells for $10. A company such as J. J. Sprint with no debt is called
an unlevered company. Further suppose that J. J. Sprint plan to borrow
$500 proceed to shareholder as an extra cash dividend of $5 per share.
After the issuance of debt, the firm becomes levered. The investments of
the firm will not change as result of this transaction. What will the value
of the firm be after the proposed restructuring?
Management recognizes that, by definition, only one of three out comes
can occur restructuring. Firm value after restructuring can be either (1)
greater than the original firm value of $1,000, (2) equal to $1,000, or (3)
less than $1,000.
After consulting with investment bankers, management believes that
restructuring will not change firm value more than $250 in either
direction. Thus, they view firm values of $1,250, and $ 1,000, and $750
as the relevant range. The original capital structure and these possibilities
under the new capital structure and these three possibilities under the
new capital structure are presented next.

2
No Debt Value of Debt plus Equity after
(original Payment of Dividend (three
capital possibilities)
structure)

I II III

Debt $ 0 $ 500 $ 50 0 $ 500


Equity 1,000 750 500 250
Firm value $ 1,000 $ 1,250to Shareholders
Payoff $ 1,000 after$ 750
Restructuring
I II III
Capitan gains -$250 -$500 -$750
Dividends 500 500 500
Net gain or loss to stockholders $250 $ 0 -$250

• Restructuring “Capital Structure” three possibilities:


– Value of the firm increase, constant and decrease
• Managers attempt to maximize the value of the firm: (V increase),
so net gain to stockholders.

3
# FINANCIAL LEVERAGE AND FIRM VALUE: AN EXAMPLE

Trans Am Corporation currently has no debt in its capital structure. The firm is
considering issuing debt to buy back some of its equity. Both its current and
proposed capital structures are presented in Table 15.1. The firm’s assets are
$8,000. There are 400 shares of the all-equity firm,implying a market value per
share of $20. The proposed debt issue is for $4,000, leaving $4,000 in equity. The
interest rate is 10 percent.

Table 15.1 Financial Structure of Trans Am Corporation


Current Proposed
Assets $8,000 $8,000
Debt $0 $4,000
Equity (market and book) $8,000 $4,000
Interest rate 10% 10%
Market value/share $20 $20
Shares outstanding 400 200
The proposed capital structure has leverage, whereas the current structure is all equity.

4
Figure 15.2 Financial Leverage: EPS and EBI
for the Trans Am Corporation
Earning per
share (EPS) in
dollars
5

4 Debt No debt

3 Advantage
to debt

2 Break-even point

1 Disadvantage
to debt
Earning before
0 interest (EBI)
$400 $800 $1,200 $1,600 $2,000
in dollars, no taxes
-1

-2

5
Table 15.2 Trans Am’s Current Capital Structure: No Debt
Recession Expected Expansion
Return on assets (ROA) 5% 15% 25%
Earnings $400 $1,200 $2,000
Return on Equity (ROE) = Earnings/Equity 5% 15% 25%
Earnings per share (EPS) $1.00 $3.00 $5.00

Table 15.3 Trans Am’s Proposed Capital Structure: Debt = $4,000


Recession Expected Expansion
Return on Assets (ROA) 5% 15% 25%

Earnings before interest (EBI) $400 $1,200 $2,000


Interest -400 -400 -400
Earnings after interest $ 0 $ 800 $1,600

Return on equity (ROE)


= Earnings after interest/Equity 0 20% 40%
Earning per share (EPS) 0 $4.00 $8.00

6
The Choice Between Debt and Equity

• Leverage is beneficial, because EPS is expected to be $4.00 with


leverage and only $3.00 without leverage. However, leverage also
creates risk
• Modigliani and Miller (MM) have argument that the value of the firm
is always the same under different capital structures. In other
words, no capital structure is any better or worse than any other
capital structure for the firm’s stockholders.
• MM I Proposition (no taxes) : The value of the levered firm is the
same as the value of the unlevered firm. VLeverage = VUnleverage

7
Table 15.4 Payoff and Cost to Shareholders of Trans Am Corporation under the Proposed
Structure and under the Current Structure with Homemade Leverage
EPS A: Buy 100 Shares of Levered Equity Recession Expected Expansion

EPS of levered eqity (taken from last line of Table 15.3) $0 $ 4 $ 8


Earning per 100 shares $0 $400 $800
Initial cost = 100 shares @ $20/share = $2,000

Strategy B: Homemade Leverage Recession Expected Expansion

Earnings per 200 shares $1 X 200 = $3 X 200 = $5 X 200 =


In current unlevered Trans Am $ 200 $ 600 $1,000

Interest at 10% on $2,000 -200 -200 -200


Net earnings $ 0 $ 400 $ 800

Initial cost = 200 shares @ $20/share - $2,000 = $2,000


Cost of stock Ammount
borrowed
Investor receive the same payoff whether she (1) buy shares in a levered corporation or (2) buys shares in an unlevered firm
and borrows on personal account. Her initial investment is the same in either case. Thus, the firm neither helps nor hurts her
by adding debt to capital structure.

Strategy B : Homemade Leverage


1. Borrow $2,000 from either a bank or brokerage house.
2. Use the borrowed proceeds plus your own investment of $2,000
(a total of $4,000) to buy 200 shares of the current unlevered
equity at $20 per share.

8
MODIGLIANI AND MILLER: PROPOSITION II (NO TAXES)

• Proposition II: Required Return to Equityholders Rises with


Leverage. Rs = Ro + (B/S)(Ro - Rb)
• MM argues that the expected return on equity is positively related
to leverage, because the risk to equityholders increases with
leverages. CAPM, Ri = Rf + Beta(Rm- Rf)
• The firm’s weighted average cost of capital, Rwacc:
B S
 rB   rS
BS BS
Where
rb is the interest rate, also called the cost of debt
rs is the expected return on equity or stock, also called
the cost of equity or the required return on equity
rWACC is the firm’s weighted average cost of capital
B is the value of the firm’s debt or bond
S is the value of the firm’s stock or equity

9
Lets us now define ro to be the cost of capital for an all-equity
firm. For the Trans Am Corp., ro is calculated as:

Expected earnings to unlevered firm $1,200


ro    15%
Unlevered equity $8,000

As can be seen from Table 15.5, rWACC is equal to ro for Trans


Am. In fact, rWACC must always equal ro in a world without
corporate taxes.

10
Table 15.5 Cost of Capital Calculations for Trans Am

B S
rWACC   rB   rS
BS BS

0 $8,000
Unlevered firm: 15%  10% *  15% * *
$8,000 $8,000
$4,000 $4,000
Levered firm: 15%  10% *   20% * * *
$8,000 $8,000
*10% is the interest rate.
** From “Expected” column in Table 15.2, we learn that expected earning after interest for the unlevered firm are
$1,200. From table 15.1, we learn that equity for the unlevered firm is $8,000. Thus, rs for the unlevered firm is:

Expected earnings after interest = $1,200 = 15%


Equity $8,000
***From the “Expected” column in Table 15.2, we learn that expected earning after interest for the levered firm are
$800. From Table 15.1, we learn that equity for levered firm is $4,000. Thus rs for the levered firm is:

Expected earnings after interest = $800 = 20%


Equity $4,000

Proposition II states the expected return of equity, rs, in terms of leverage. The exact relationship, derived by
setting formula (15.2), is
MM Proposition II (no taxes)

B
rs  ro  (ro  rb )
S 11
Example illustrating proposition I and Proposition II

Example:
Luteran Motors, an all-equity firm, has expected earnings of
$10 million per year in perpetuity. The firm pays all of its
earnings out as dividens, so that the $10 million may also be
viewed as the stockholders’ expected cash flow. There are 10
million shares outstanding, implying expected annual cash flow
of $1 per share. The cost of capital for this unlevered firm is
10 percent. In addition, the firm will soon build a new plant for
$4 million. The plant is expected to generate additional cash
flow of $ 1 million per year. These figures can be described as

Current Company New Plant


Cash Flows: $10 million Initial outlay: $4 million
Number of out standing shares: 10 million Additional annual cash flow: $1 million

The project’s net present value is


$1 million
 $4 million   $6 million
0.1
12
Assuming that the project is discounted at the same rate as the
firm as a whole. Before the market knows of the project, the
market-value balance sheet of the firm is
LUTERAN MOTORS
Balance Sheet (all equity)

$10 million
Old assets :  $100 million Equty: $100 million
0 .1
(10 million shares of stock)

Stock Financing. Imagine that the firm announces that, in


the near future, it will raise $4 million in equity in order to
build a new plant. The stock price, and therefore the value of
the firm, will rise to reflect the positive net present value of the
plant. According to efficient market, the increase occurs
immediately. That is, the rise occurs on the day of the
announcement, not on the date of either the onset of
construction of the power plant of the forthcoming stock
offering. The market-value balance sheet becomes

13
LUTERAN MOTOR
Balance Sheet
(upon announcement of equity issue to construct plant
Old assets $100 million Equity $106 million
NPV of plant: (10 million shares of stock)
$1 million 6 million
 4 million  
0 .1
Total assets $106 million

Debt Financing. Alternatively, imagine that the firm announces


that, in the near future, it will borrow $4 million at 6 percent to
build a new plant. This implies yearly interest payments of
$240,000 ($4,000,000 X 6%). Again the stock price rises
immediately to reflect the positive net present value of the plant.
Thus, we have

LUTERAN MOTOR
Balance Sheet
(upon announcement of equity issue to construct plant
Old assets $100 million Equity $106
NPV of plant: million
$1 million 6 million (10 million shares of
 4 million  
0 .1 stock)
Total assets $106 million

14
The Quirk in the Tax Code

Example
The Water Products Company has a corporate tax rate, TC, of
35 percent and expected earnings before interest and taxes
(EBIT) of $1 million each year, its entire earnings after taxes
are paid out of dividends.
The firm is considering two alternative capital structures.
Under plan I, Water Products would have no debt in its capital
structure. Under plan II, the company would have $4,000,000
of debt,B. The cost of debt, rb, is 10 percent.

The chief financial officer for Water Products makes the following
calculation:
Plan I Plan II
Earning before interest and corporation taxes (EBIT) $1,000,000 $1,000,000
Interest (rbB) 0 (400,000)

Earnings before taxes (EBIT) = (EBIT – rbB) 1,000,000 600,000


Taxes (Tc = 0.35) (350,000) (210,000)

Earnings after corporate taxes 650,000 390,000


(EAT) = [(EBIT – rbB) X (1 – Tc)]
Total cash flow to both stockholders and bondholders $ 650,000 $ 790,000
[EBIT X (1 – Tc) + TcrbB]
15
Example
Divided Airlines is currently an unlevered firm. The company expects
to generate $153,85 in earnings before interest and taxes (EBIT), in
perpetuity. The corporate tax rate is 35 percent, implying after-tax
earnings of $100. All earnings after tax are paid out as dividends.
The firm is considering a capital restructuring to allow $200 of debt.
Its cost of debt capital is 10 percent. Unlevered firms in the same
industry have a cost of equity capital of 20 percent. What will the new
value of Devided Airlaines be? VL =

The value of Devided Airlines will equal to


EBIT  (1  TC )
VL   TC B
ro
$100
  (0.35  $200)
0.20
 $500  $70
 $570
The value of the levered firm is $570, which is greater than the unlevered
value of $500. Because VL = B + S, the value od levered equity, S, is equal to
$570 - $200 = $370. The value of Devided Airlines as a function of leverage is
illustrated in Figure 15.5
16
Figure 15.5 The Effect of Financial Leverage on Firm Value: MM
with Corporate Taxes in the Case of Divided Airlines
Value of firm (V)

VL
570 

VU = 500

Debt (B)
0 200

VL = VU + TCB
= $500 + (0.35 X $200)
= $570

MM Proposition II (corporate taxes):


B
rS  ro  ( ro  rb )(1  Tc )
SL

17
The Weighted Average Cost of Capital rWACC and Corporate Taxes

In chapter 12, we defined the weighted average cost of capital (with


corporate taxes) as
B S
rWACC  rB (1  TC )  rS
VL VL

For Divided Airlines, rWACC is equal to

 200   370 
rWACC    0.10  0.65     0.2351
 570   570 
 0.1754

Devided Airlines has reduced its rWACC from 0.20 (with no debt) to 0.1754
with reliance on debt. This result is intuitively pleasing because it suggest,
when a firm lowers its rWACC, the firm’s value will increase. Using the rWACC
approach, we can confirm that the value of Divided Airlines is $570
EBIT  (1  TC ) $100
VL  
rWACC 0.1754
 $570
18

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