6. Capital Structure (Part 1) Flashcards
What are some reasons for why including debt in the capital structure increases the risk (and reduces the value) to shareholders?
- Interest payment obligations reduce the net working capital available to increase firm value or dividends
- Debt creates the possibility of bankruptcy, the costs associated with bankruptcy/financial distress increase with increasing debt
- Shareholders are paid after debtholders in the event of a future liquidation
What is the simplest form of the value of a company equation?
V = D + E
Changes in capital structure benefit the shareholders if…
…the value of the firm increases.
Managers should choose the capital structure that they believe will result in the highest firm value because this capital structure will be most beneficial to shareholders.
What is Modigliani-Miller Theorem Proposition 1 (no taxes)? Explain the reasoning behind it.
The value of the levered firm = The value of the unlevered firm
This is because an investor can use homemade leverage when investing in an unlevered firm to replicate the leverage in a leveraged firm. We can create a levered or unlevered position by adjusting the trading in our own account (homemade leverage). Therefore highly levered firms won’t be valued higher than unlevered firms. The shareholder can achieve a similar outcome by homemade leverage. This suggests that leverage does not affect the value of the firm and capital structure is irrelevant in determining the market value of the firm.
If levered firms are priced too high, rational investors will simply borrow on their personal accounts to buy shares in unlevered firms. The equilibrium result would be that the value of the levered firm would fall and the value of the unlevered firm would rise until they become equal.
What are the key assumptons of MM Propositions (without tax)?
No tax.
Individuals can borrow as cheaply as corporations.
No transaction costs.
What is Modigliani-Miller Proposition 2 (no taxes)? Explain the reasoning behind it.
Leverage increases the risk to shareholders and thus increases the expected return on (cost of) equity.
The firm’s overall cost of capital cannot be reduced as debt is substituted for equity, even though debt appears to be cheaper than equity. Because as the firm adds debt, the remaining equity becomes more risky.
As this risk rises, the cost of equity capital rises as a result, and the increase offsets the decrease in proportion/weighting of equity in the capital structure. As a result, the value of the firm and its overall cost of capital (WACC) is unaffected by changing leverage.
What is Modigliani-Miller Proposition 1 (with taxes)?
Firm value increases with leverage. This is because interest payments are made before tax, therefore, the amount of tax the company pays is decreased. The value of the firm is increased by the amount of tax relief provided by debt.
All equity firm’s V = E - Tax
Levered firm’s V = D + E - Tax
Due to corporate taxing convention, higher D means lower Tax, which means higher V.
The MM propositions assume that debt (when added) replaces an equal value of equity. Thus More D means equally lower E, but the amount of tax is reduced so V increases.
WACC impacts the value of the firm (the more it costs to get financing, the more difficult it is to make a profit), in a scenario with tax, WACC is no longer constant with increasing debt as although cost of equity might still increase with increase of debt, the tax shield outweighs this on WACC.
What is Modigliani-Miller Proposition 2 (with taxes)?
Some of the increase in equity risk and expected return from inclusion of debt in capital structure is offset by the interest tax shield (reduction in tax).
As V increases due to debt, the equity risk (and thus expected return/cost of equity capital) increases but by a lower amount due to the tax shield’s effect on overall firm value (which impacts shareholders).
Why is the optimal amount of debt in capital structure limited?
Interest and prinicipal payments on debt are obligations. This creates the possibility of bankruptcy. If the firm does not have sufficient cash to pay off these obligations it will go into bankruptcy. Bankruptcy and related costs reduce the value of a levered firm. As the amount of debt in a company’s capital structure increases, the present value of bankruptcy costs rise at an increasing rate, eventually (at the optimal amount of debt) at a greater rate than the benefits of the tax shield, implying a reduction in firm value with further leverage beyond this point.
What are the key assumptions of MM Proposition 1 and 2 with taxes?
Corporations are taxed at a fixed rate on earnings after interest.
Individuals can borrow as cheaply as corporations.
No transaction costs.
