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Lecture # 5

Capital Structure Decisions Presentation

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22 views9 pages

Lecture # 5

Capital Structure Decisions Presentation

Uploaded by

ishfaque ahmed
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

Decisions
Lecture # 08
Introduction
Introduction
Economic bankruptcy: The market value of a company’s assets is less than the amount owed
to creditors
Legal bankruptcy: A company files in bankruptcy court for protection from its creditors until
it can arrange an orderly reorganization or liquidation
Liquidity crisis: A company doesn’t have access to enough cash to make payments to
creditors as the payments come due in the near future
Free cash flow (FCF): The money a company has left over after paying its operating expenses
and capital expenditures
• A firm’s financing choices obviously have a direct effect on the WACC
• It also indirectly affect the costs of debt & equity (due to risk change)
• Financing choices can also affect free cash flows
• This chapter focuses on the debt–equity choice and its effect on value
An Overview of Capital Structure
• A firm’s operations is the present value of its expected future FCF
discounted at WACC:

Where as, WACC of a corporate firm is financed by debt and common


stock with respect to its percentage( and ), the cost of debt (), the cost of
stock (), and the corporate tax rate ():

• The decision can change the value of operations is by changing either


expected free cash flows or the cost of capital
See Self Test Problem no. 1 (ST-1)
Business Risk and Financial Risk
• Business risk and Financial risk combine to determine the total risk of a firm’s future
return on equity
Business Risk and Operating Leverage
• Business risk is the risk a firm’s common stockholders would face if the firm had no
debt
• Business risk depends on a number of factors, i.e. demand and production costs
• A high degree of operating leverage implies that a relatively small change in sales
results in a relatively large change in Profitability. i.e. EBIT, NOPAT, ROIC, ROA, ROE
• The higher a firm’s fixed costs the greater its operating leverage
• Fixed cost includes: capital intensive firms, highly skilled workers (highly paid), R&D projects
Financial Risk and Financial Leverage
• Financial risk is the additional risk placed on the common stockholders as a result of
the decision to finance with debt (financial leverage)
Capital Structure Theory
Modigliani and Miller (MM Theorem) 1958: No Taxes
• MM published the most influential finance article ever written
• It was based on some strong assumptions:
• There are no brokerage costs
• There are no taxes
• There are no bankruptcy costs
• Investors can borrow at the same rate as corporations
• All investors & managers have the same information about firm’s future
• EBIT is not affected by the use of debt
“It states that the market value of a company is correctly calculated as the present
value of its future earnings and its underlying assets, and is independent of its
capital structure”
Capital Structure Theory
Trade-Off Theory
• The bankruptcy can be quite costly i.e. High legal and accounting expenses
• It often forces a firm to sell assets for less than they worth
• It states that “the value of a levered firm is equal to the value of an
unlevered firm plus the value of any side effects”
• Side effects include the tax shield and the expected costs due to
financial distress
Capital Structure Theory
Signaling Theory
• It originates from information asymmetries between management and
shareholders
• It claims that “Insiders generally have better information about the company's
condition and future prospects than outsiders”
• If managers believe that their firms are undervalued, they will issue debt first
and then issue equity as a last resort (and other way around)
The Pecking Order Hypothesis
• The presence of flotation costs and asymmetric information may cause a firm
to raise capital according to a pecking order
Retained Earning > selling short-term securities > debt > preferred stock > common stock
Capital Structure Theory
The Market Timing Theory (hypothesis)
• If markets are efficient, then security prices should reflect all available
information (hence prices are correct)
• It states that “managers don’t believe this and supposes instead that
stock prices and interest rates are sometimes either too low or too high
relative to their true fundamental values”
• The theory suggests that managers issue equity when they believe
stock market prices are abnormally high and issue debt when they
believe interest rates are abnormally low (They time the market)

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