Capital Structure Flashcards
why capital structure is irrelevant in Modigliani and Miller world
MM propositions assert that financial leverage has no effect on shareholder wealth: Shareholders’ expected return increases as the firm’s debt-equity ratio increases, to compensate for the extra equity risk.
- perfect markets (no transaction costs, perfect information)
- law of one price: assets with the same payoff have the same price
- investors can borrow and lend at the same rates as the firm and can do or undo a firm’s financing decisions
- no taxes
- payout policy (dividends, repurchases) is ignored
- capital structure choice does not affect investment and operating policies
MM Proposition 1
“With perfect capital markets and no taxes the value of the firm is independent of its capital structure”
- investors can undo a firm’s financing policy
- if the value of 2 assets is the same when combining them, this also holds when splitting them
- the value is determined by PVs of cash flows generated by a firm’s assets, not by the securities issued to buy the assets
- absent taxes and bankruptcy risk, the weighted average cost of capital doesn’t depend on the ratio between debt and equity
MM Proposition 2
“The expected return on equity of a levered firm increases with the D/E ratio. The rate of increase depends on the spread between the expected return on assets and the return on debt
MM Proposition 1 vs 2
1 states that the value of the company is independent of its capital structure, 2 states that increasing leverage increases the expected return on equity
- both are right: the fact that the expected return on equity increases with leverage doesn’t mean that shareholders are better off. Rather, the expected return on equity must increase to compensate shareholders for the increase in risk brought about by the increase in leverage. This premium is equal to rE
Any increase in expected return is exactly offset by an increase in risk and the required rate of return
MM debt and equity risk (no taxes)
Equity becomes riskier as leverage increases.
The change in financial structure doesn’t affect the amount or risk of the cash flows on the total package of debt and equity.
Increasing the amount of debt also increases debt holder risk - debt holders are likely to ask for higher returns.
As the firm borrows more, more of the business is transferred from stockholders to bondholders.
More borrowing also increases equity risk and the required return on equity increases as well.
The weighted average return on debt and equity is unaffected.
MM summary
- capital structure is irrelevant in a world with perfect capital markets and no taxes. Firm value is determined by a firm’s real
assets and not by the type of securities issued. If a firm increases the fraction of debt, equity becomes riskier. - to compensate shareholders for the increase in risk, the firm must offer them a higher rate of return. This increase in the firm’s cost of equity capital offsets any potential benefit from substituting “cheaper” debt for “more expensive” equity, leaving the firm’s weighted average cost of capital and its market value unchanged.
- MM’s propositions are a starting point. However, what is important in reality in determining optimal capital structure are market imperfections and taxes!
what are the real-world limitations to the MM propositions are
We observe various market imperfections. Considering the costs of bankruptcy, conflicts of interest, information problems, and incentive effects, debt policy does matter.
- firms incur costs for issuing securities
- firms and investors do not face identical borrowing and lending costs
- pooling single investors’ interests reduces transaction costs
- corporate bond schemes allow circumventing regulatory constraints
- the set of securities available to investors is incomplete
- credit risk can lead to conflicts of interest between debt investors, equity investors, and management
how taxes and bankruptcy costs affect capital structure choice
The trade-off theory relaxes assumptions of no taxes and no costs of financial distress.
The third claimant of CF (in addition to debt and equity holders): government taxes CF to equity and debt differently - interest paid on a firm’s borrowing = deductible, but dividends aren’t, since they’re a return to the firm’s owners. This difference creates a bias toward debt. Debt finance reduces a firm’s taxable income, resulting in higher after-tax CF.
- According to the trade-off theory, the manager chooses a capital structure by weighting benefits (tax shield) and costs (expected costs of financial distress) of debt finance.
Trade-off theory: costs of financial distress
in reality, debt ratios are low (30-40%) - so, there must be costs to debt financing.
Trade-off theory proposes bankruptcy costs, and costs of financial distress as main costs of debt finance
- in MM world: when the value of equity = 0, debt holders take over the firm - no costs to bankruptcy since no reduction in CF generated by the company.
In practice: sizeable costs of bankruptcy - make debt less attractive because they reduce expected value of CF
Trade-off theory: direct and indirect costs of bankruptcy
Direct: e.g. lawyers and bankruptcy judges (relatively small costs)
Indirect: managerial attention diverted from managing assets to managing liabilities (loss of flexibility, assets sold in fire sales, intangible assets may be destroyed when the firm is broken up or sold)
why signal is conveyed to the market by announcing different types of financing (e.g. internal financing, debt and equity issuances)
the pecking order theory accounts for the signaling effect (resulting from asymmetric information = that managers know more about companies’ prospects, risks, and value than outsiders)
- asymmetric information affects the choice between internal and external financing - leading to Pecking order:
1. internal financing
2. debt
3. equity (last resort, when the company runs out of debt capacity, because of costs of financial distress)
Pecking order and its complications
When external financing is needed: the safest security is issued first = debt
- observed debt ratios show the firm’s cumulative requirement for external financing
- profitable firms borrow less since they’re less dependent on outside financing (attraction of interest tax shields not as important) - size, tangible assets, profitability, and market to books have an impact
Pecking order theory explains the inverse relationship between profitability and financial leverage
