26354_l5+capital+structure

1、Capital Structure: Theories and Empirics,References:Brealey, Myers, and AllenChapter 17, and 18Arnold: Chapter 21Brealey, Myers, and Marcus: Chapter 13,1,Concept checkThe value of a firmV = CF/WACC (with per

2、petual constant cash flow)𝑉≡ 𝑉 𝐸 + 𝑉 𝐷 V: value of firm 𝑉 𝐸 : total capitalisation of ordinary shares 𝑉 𝐷 : market value of debt capitalWACC&

3、#119882;𝐴𝐶𝐶= 𝑘 𝐸 𝑊 𝐸 + 𝑘 𝐷 𝑊 𝐷 𝑘 𝐸 :𝑜𝑝𝑝𝑜𝑟𝑡𝑢𝑛

4、9894;𝑡𝑦 𝑐𝑜𝑠𝑡 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 𝑘 𝐷

5、:𝑜𝑝𝑝𝑜𝑟𝑡𝑢𝑛𝑖𝑡𝑦 𝑐𝑜𝑠𝑡 𝑜𝑓 𝑑𝑒𝑏𝑡 𝑐𝑎𝑝

6、;𝑖𝑡𝑎𝑙 𝑊 𝐸 :𝑝𝑟𝑜𝑝𝑜𝑟𝑡𝑖𝑜𝑛 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡w

7、910; 𝑓𝑖𝑛𝑎𝑛𝑐𝑒 𝑊 𝐷 :𝑝𝑟𝑜𝑝𝑜𝑟𝑡𝑖𝑜𝑛 𝑜𝑓 𝑑𝑒&

8、#119887;𝑡 𝑓𝑖𝑛𝑎𝑛𝑐𝑒,Introduction,2,Concept checkingOperating gearingThe fixed/variable cost ratioHigh operating gearing: high fixed cost/low variable cost

9、Car, steel manufacturing, utilitiesFinancial gearingThe proportion of debt in the capital structureLeverage: gearing,Introduction,3,,,4,Measuring firms’ financial gearingCapital gearing (1)Long-term debt/sharehol

10、ders’ funds (D/E)L/T debt: amounts falling due after more than one yearShare holders’ funds: the net assetBoth figure taken from balance sheetRationaleIndicates firm’s ability to sell assets to repay debtsCriticism

11、Book value ? saleable valueHave values between zero and infinity – difficult to compare across firms,Introduction,5,Measuring firms’ financial gearingCapital gearing (2)L/T debt/(L/T debt + Shareholders’ funds)D/(D+

12、E)A fraction of all long-term capital[0%, 100%]Capital gearing (3)All borrowing/(all borrowing + shareholders’ funds)Including short-term debtCommercial papersOver-draft,Introduction,6,Measuring firms’ financial

13、gearingCapital gearing (4)LT/debt/Total market capitalisationMarket-value-based gearing measureCriticismValuation of firm assets is a notoriously difficult taskLiquidation value ? true value of the businesse.g. a

14、dvertising, fashion design, dot-comHence biased measure of firms’ ability to repay debtsIncome gearinginterest charges/EBITExample, Arnold Exhibit 21.3 (omitted),Introduction,7,Given constant future cash flows, can

15、managers increase shareholder value simply by altering debt/equity ratio?i.e. is there an optimal gearing level,Introduction,8,Debt financingCheaper and riskierInterest payments are tax-deductibleLower transaction co

16、stsLenders require lower rate of returnLess risky from lenders’s point of viewPrior claimsSecurity often providedCovenants imposed,Introduction,9,Traditional viewToo little debt: forgone opportunities of cheap de

17、bt capitalToo much debt: higher required rate of return reduces shareholder value,Introduction,10,Modigliani and Miller (1958)Gearing level is inconsequential to firm valuePerfect knowledgeIndividuals can borrow an

18、d lend at the same rate as corporationsZero taxationZero cost of financial distressModigliani and Miller (1963)with taxes, the best gearing level is as high as possibleBut firms tend to avoid very high gearing lev

19、els, hence the capital structure puzzle,Introduction,11,12,The Effect of Gearing with Zero Taxationand Certainty,Pivot plc. needs £1 million. Required return on all-equity firm is 15%. The expected annual cash f

20、low is a constant £150,000 in perpetuity. Three different financing structure:Structure 1: All equity (1 m shares sold at £1 each)Structure 2: 50:50 (half million borrowed at 10% and half million shares sold

21、 at £1)Structure 3: 70:30 (£700K borrowed at 10% and 300K shares sold at £1),13,Effect of Gearing under Certainty:ROE increases proportionately with leverage ratio,14,Effect of Gearing under Certainty:T

22、he cost of capital is unaffected by leverage ratio,15,Effect of Gearing under Certainty:The value of firm is unaffected by leverage ratio,16,Effect of Gearing with Uncertainty,Business risk The variability of firms’s o

23、perating incomeMeasured by the dispersion of returns for the all-equity capital structureCaused purely by business-related factorse.g. Drop in demand for computer engineering after the millennium buge.g. Volatile pri

24、ces of steel More example?Financial risk The additional variability in returns to shareholders arising from the use of debtHigher the debt, higher the financial risk,,17,,,,,,,,,Financial risk:Increases with LR,Busi

25、ness risk:Independent of LR,Risk-free rate:Time value of money,Level of gearing (e.g. Debt/Equity),Required Return (%),18,The Effect of Gearing with Uncertainty,Two firms, U and L, with the same operating gearing, busi

26、ness risk, and probability distribution of gross income (GI). They only differ with respect to their use of debt (capital structure).Firm UFirm LNo debt£10,000 @ 12%£20,000 equity£10,000

27、equity0% tax rate0% tax rate,19,With Uncertainty: Leverage increases ROE and riskiness of equity investment, but no impact on cost of capital,20,21,,,Cost (%),Debt/Equity,,,,𝒌 𝑬,WACC,𝒌 ү

28、15;,Modigliani and Miller - no taxEffect of gearing on cost of capital,22,Modigliani and Miller - without Tax,Proposition I: Firm value is independent of its capital structure.Proposition II: The expected rate of retur

29、n on equity increases proportionately with the gearing ratio.Proposition III: New projects should be evaluated by WACC - which is constant regardless of gearing.,Modigliani and Miller (1963) with Tax,In a world without

30、tax, the advantage of lower cost of debt capital was exactly offset by the disadvantage of higher required return by equity investorsBut individuals and companies do pay taxeshttp://www.kpmg.com/global/en/services/ta

31、x/tax-tools-and-resources/pages/corporate-tax-rates-table.aspx Most tax regimes permit companies to offset the interest paid on debt against taxable profitThe tax shield effectively reduces the cost of debt capitalHen

32、ce WACC is at its lowest and corporate values at its highest when the capital of the company is almost entirely made up of debt,23,24,Illustration of MM (1963) with Tax,,,Cost (%),Amount of debt in the company(Debt/equi

33、ty),,,,𝒌 𝑬,WACC,𝒌 𝑫,25,3. Modigliani and Miller (1963): with Corporate Tax,Proposition IProposition II: Proposition III:,,Tax saving,Tax saving,,,Tax saving,Example,(see Arnold, Exhi

34、bit 21.17)Glas Cymru announced that it will buy Dwr Cymru (Welsh Water) (2001)The deal was to be fully financed by debtQuestion: Is all-debt indeed the optimal capital structure for Glas Cymru?,26,GI is currently a

35、n all equity firm. EBIT is £1m in perpetuity. The required annual rate of return on the share is 14%. The firm is examining the benefit of a change in its capital structure. It is proposed that the firm issue &#

36、163;2m of bonds at the cost of 8% per annum and use the proceeds to repurchase some of its shares. The corporate tax is 40%.,MM with Tax: Example 3,27,28,QuestionsWhat is the current market value of the firm?What wi

37、ll be the market value of the firm after the capital structure change?What will be the cost of equity capital of the firm after the capital structure change?What will be the WACC after the capital structure change?,4

38、. MM & the Real World,e.g. Average financing of nonfinancial enterprises, as a percentage of total financing sources, 1970 - 1985,Source: Mayer (1990),29,30,4. MM & the Real World,Companies do not gear up as high

39、ly as possible in practiceStewart Myers (1984)“Our theory don’t seem to explain actual financing behaviour, and it seems presumptuous to advise firms on optimal structure when we are so far from explaining actual deci

40、sions.”,4. MM & the Real World,Financial distressAgency costsBorrowing capacity & securityDirectors/owners preferences Ability to respond to opportunitiesGearing levels of similar companiesVolatility

41、of earningsPersonal taxes,31,4. MM & the Real World,Financial distressWhere obligation to creditors are not met or are met with difficultyCost of financial distressReduced liquidityHigher probability of forced

42、liquidationdamage relationship with suppliers, customers, employees, creditorsManagement forced to focus on s/t cash flows rather than l/t shareholder wealth,32,4. MM & the Real World,ExampleNTL, whilst trying to

43、put together a £7.4bn debt-for-equity swap in 2002 lost 73,400 UK customers.In 2003, Fiat put up for sale its most valuable business, Fiat Avio, in order to raise enough cash to service debt.22 Nov 2011, Thomas

44、 Cook’s share plummeted to 11.5p when under the pressure to service its debt when its cash flow affected by the Arab Spring.Risk of financial distress raises required return by shareholders and lenders, offsetting the

45、value of tax shield on debt payment,33,34,The Effect of financial distress costs on firm value,,,,,,,,,Value of geared firm with tax effect only,Firm value,Vu,VL,Value of geared firm with tax relief and financial dist

46、ress costs,Cost of financial distress,Optimal structure,,,,Value of tax shield,,4. MM & the Real World,Susceptibility to financial distress varies from company to companyPro-cyclical?High operation gearing?Liquidi

47、ty/marketability of firm’s assets?Regularity of cash flow?ExampleFood retailer Vs. Steel producerReal estate investment firm Vs. Advertising agencyMore example?,35,36,Cost of Financial Distress: empirical evidence,

48、Firms going through bankruptcy have lower salesManagers of bankrupt firms are more likely to lose their jobs ; and their chances of being rehired for similar positions are virtually nilLiquidation costs seem to be re

49、lated to the asset structure of bankrupt firms (e.g. it is less costly to liquidate tangible assets than intangible assets)Firms with higher growth opportunities have lower levels of debt in their capital structures,37

50、,Cost of Financial Distress: empirical evidence,Larger firms are less likely to be liquidated in financial distress and hence can afford to hold more debtFirms with more volatile earnings use less debtCosts of bankru

51、ptcy change from one country to another (e.g. bankruptcy costs are higher in the U.S. than in other developed countries),4. MM & the Real World,Agency costsThe direct and indirect costs of attempting to ensure that

52、agents act in the best interest of principalsCost of monitoringCovenants restricting the firm’s operating freedom and investment flexibilityThe loss resulting from failure to get agents to act in the above mannerHigh

53、er risk not reflected in return to debt holdersDrain the firm’s assets in anticipation of liquidation,38,4. MM & the Real World,Borrowing capacityThe ability to borrow may depend on the firms asset usable as securi

54、tye.g. real estate firm Vs E-publisherManagerial preferenceThe impact of liquidation on managers may be far greater than the impact on investorsAn increase in debt will reduce the ability of managers to pursue waste

55、ful activities more effectively than a dividend increase.,39,40,4. MM & the Real World,Trade-off theoryThe firm’s capital structure is optimised where the marginal subsidy of debt equals the marginal cost.Investor

56、s view debt as a signal of firm value Firms with low (high) anticipated profits will take on a low (high) level of debt.A manager that takes on more debt than is optimal in order to fool investors will pay the cost in

57、 the long run.,4. MM & the Real World,Pecking order theoryMyers (1984) and Myers and Majiluf (1984)Firms prefer to finance with internally generated funds (internal equity ,c.f. L3/slide 5)Debt market is called on

58、 first when internal equity is insufficientRaising external equity financing will be the last resortBad signal, expensiveMyers (1984)“there is no well-defined target debt-equity mix, because there are two kinds of eq

59、uity, one at the top of the pecking order and one at the bottom.”,41,4. MM & the Real World,Personal Taxation (Miller, 1977)There are differences in the personal tax treatment of equity and debt returns. The need

60、to ‘bribe’ investors into holding more debt cancelled out the tax benefits to companies of issuing extra debt finance Conclusion: all combinations of debt and equity finance were optimal.C.f. Lin, Leming and Flannery

61、, Mark J., Do Personal Taxes Affect Capital Structure: Evidence from the 2003 Tax Cut (February 29, 2012). Available at SSRN: http://ssrn.com/abstract=2021333,42,43,Suggested Further Reading:,Modigliani, F. and Miller, M

62、. (1958) The cost of capital, corporation finance and the theory of investment, American Economic Review, 48, 261-297.Harris, M. and Raviv, A. (1991) The theory of capital structure, Journal of Finance, XLVI, 297-355.M

63、iller, M. (1991) Leverage, Journal of Finance, XLVI, 479-488.Miller, M. (1993) The Modigliani-Miller propositions after thirty years, in Chew, D. ed. The new corporate finance-where theory meets practice, McGraw-Hill.M

64、yers, S. (1993) The search for optimal capital structure, in Chew, D. ed. The new corporate finance-where theory meets practice, McGraw-Hill.Barclay, M. J. and Smith, C. W. (2005) The capital structure puzzle: The evide

65、nce revisited, Journal of Applied Corporate Finance 17(1): 8-17Strebulaev, I. A. (2007). "Do tests of capital structure theory mean what they say?" Journal of Finance 62(4): 1747-1787.Al-Najjar, B., Hussainey