Capital Structure
The Big
Debate
Well can you or can’t you?
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Capital Structure
• What do we mean?
• Basically, can we maximise shareholders
wealth by varying the proportions of debt
and equity in a company’s capital make
up?
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Capital Structure
• Notationally
Ko = Ki x (D) + Ke x (E)
(D+E)
(D+E)
Ko = Overall Average cost of Capital
Ki = Cost of Debt
D = Amount of Debt
Ke= Cost of Equity
E = Amount of Equity
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Capital Structure
• As Debt is usually cheaper than equity, why is it
not an open and shut case?
• Consider
Return on a project = 15%
Needs £200-00 of capital
Cash Return
= £30
If all financing is equity then obviously
ROE (return on equity) = 30 = 15%
200
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Capital Structure
• Suppose instead it is financed 50/50
debt/ equity and cost of debt = 10%
• Then: Total Return = 30
Interest cost = 10 (100 x .10)
Net Return
20
ROE = 20
= 20%
100
So far so good, some very happy shareholders
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Capital Structure
• But disaster strikes and the return falls to £15
• Now the returns are
Total returns
= 15
Interest cost
= 10
Net return
= 5
ROE = 5
100
= 5%
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Capital Structure
• Whereas if the shareholders had not been
so bold and had financed all Equity
ROE
= 15 = 7.5%
200
What effect has leverage had?
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Capital Structure
• Results
• Leveraged
• Un-leveraged
Range of ROEs
%
20 - 5
15 – 7.5
• What effect will this have on
expected/required equity returns?
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Capital Structure
Theoretical Positions
• Net Operating Approach (the ‘makes no
difference camp’)
• Traditional Approach (the ‘yes it does camp’)
• Modigliani and Miller (the ‘we can prove it does
not matter camp’)
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Capital Structure
• Net Operating Approach
Net operating income
1,000
Capitalisation rate (cost of Capital)
.15
Total value of firm
6,667
Market value of debt (cost 10%)
1,000
Market value of equity
5,667
Earnings for equity 1,000 – 100 = 900
ROE = 900 =
15.88%
5,667
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Capital Structure
• Now change debt to 3,000
• Operating income still
1,000
Overall capitalisation rate
.15
Total value of firm
6,667
Market value of debt
3,000
Market value of equity
3,667
New equity earnings (1,000 – 300) = 700
ROE = 700 = 19.09
3,667
But note that total value of the firm is constant
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Capital Structure
Traditional approach – assumes there is an optimal structure therefore
judicious use of leverage will increase value of firm
Ke
20
Ko
15
%
Ki
10
0
Leverage
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Capital Structure
Arbitrage Support
• Basically the argument is i) that the
company can do nothing that the
shareholders cannot do for themselves
and ii) that value comes from the cash
flows into the company not from fiddling
about within the company.
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Capital Structure
• Arbitrage Support
Co A
10,000
Net Op Income
Interest on debt (12% pa) nil
Net earnings
10,000
Equity req return
.15
Market Value of equity 66,667
Market value of debt
nil
Total value of the firm 66,667
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Co B
10,000
3,600
6,400
.16
40,000
30,000
70,000
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Capital Structure
• M&M would argue that it would not be
possible for one company to remain ‘more
valuable ‘ than the other, since the over
valued company would be sold and the
under valued company bought, until the
prices equalise’.
• A shareholder in B would do this,
replicating Bs actions
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Capital Structure
• Investor in B (IB) owns 1% of B i.e. 400
• IB sell their shares for 400
Return would have been 64 (1% of 6,400)
• IB borrows 300 (1% of B’s debt) @ 12%
• IB buys 1% of A for 666.7
Net position
• Return on A
100.0
• Less interest
36.0
• Net return
64.0 same as in B but for
33.3 less personal outlay (700 – 666.7)
so could spend on more A
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Capital Structure
• QED
• But the proof relies on a few assumptions
• Capital markets are perfect
(information is costless, no taxes, no
transaction costs and so on)
• And they are not
• So we need to consider the imperfections
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Capital Structure
•
•
•
•
•
Effects of imperfections
Taxes
Financial distress
Bankruptcy
Corporate/private leverage
Non debt tax shields
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Capital Structure
•
Taxes
Co A
2,000
EBIT
Interest*
Profit before tax
2,000
Taxes @ 40%
800
Shareholders income 1,200
Total income to debt and
Shareholders
1,200
Co B
2,000
600
1,400
560
840
1,440
*(5,000 of debt @ 12% in B)
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Capital Structure
• But has this increased shareholder value?
• Yes
Suppose companies A and B have £8,000
of Capital. Co A would have
8,000 shares of £1-00 each
• Company A’s RoE is 1,200 = 15%
8,000
EPS = 15 pence, suppose PE = 6.66
Share value = 1.00
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Capital Structure
•
•
•
•
Company B’s Capital is:
5,000 debt
3,000 equity
Therefore B’s RoE is 840 = 28%
3,000
EPS = 28 pence, PE is 6.66
Share value = 1.87
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Capital Structure
•
•
•
•
•
•
•
A gift from the Government?
Suppose debt interest was deducted after tax.
Then
EBIT
2,000
Tax at 40%
800
Net after tax
1,200
Deduct debt interest
600
Income for shareholders 600
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Capital Structure
• Where does that leave us?
• RoE =
600 = 20%
3,000
So where does the extra 8% come from?
240 =
3,000
8%
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Capital Structure
Effect of Costs of Bankruptcy & Financial Distress on the
Value of the Firm
company value
a utilising debt
Share price
shield to
maximum
b
c+ b
d+c+b
Optimal Range
0% Leverage
e+d+c+b
100%
b effect of increasing price of debt
c effect of adjustment for risk (including NPV of bankruptcy costs)
d loss of tax shield
Trade off theory
e cost of financial distress
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Capital Structure
Debt
Equity
Prp’tion Cost aftTax Wghtd
0
7
20
7
30
7.5
50
8
70
9.5
80
11.5
Tot
cost %
wghtd
12
100
12.5 80
13
70
14
50
18
30
21
20
Tax Rate 30%
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Capital Structure
Debt
Equity
Prp’tion Cost aftTax Wghtd
0
7
4.9
0
20
7
4.9
.98
30
7.5
5.25 1.575
50
8
5.6
2.8
70
9.5
6.65 4.65
80
11.5
8.05 6.44
Tot
cost %
wghtd
12
100 12
12
12.5 80 10
10.98
13
70
9.1 10.68
14
50
7
9.8
18
30
5.4 10.05
21
20
4.2 10.64
Tax Rate 30%
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Capital Structure
Cost
of 13
Capital
12
11
10
0
50
Gearing/Leverage
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Capital Structure
So how will we decide on leverage level?
• Industry norms
• Coverage ratios
* interest
* interest plus principal
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Capital Structure
Coverage Ratios
• Interest
EBIT
Interest on Debt
Or
7,000,000 = 3.89
1,800,000*
• 8 % of 22,500,000 loan repayable over 10 years
tax rate of 25%
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Capital structure
Coverage Ratios
• Interest plus Principal
•
EBIT
Interest + Principal
1 – Tax Rate
7,000,000
1,800,000 + 2,250,000 = 1.46
1-.25
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Capital Structure
Coverage Ratios
•
But what is a suitable coverage ratio?
Variability
•
Trend Analysis
•
Industry Norms
•
All Commitments
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Capital Structure
• Profitability
* pecking order
• Size
* portfolio effect
* pecking order
• Asset type
• Volatility of earnings
• International / cultural norms
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Capital Structure
• EBIT/EPS Analysis
• Question, what form of financing will result
in the largest EPS?
• Situation (Example from Van Horne)
- Co issued 200,000 shares worth 50 each
- Co needs to borrow a further 5,000,000
- Co may borrow at 12%
- Tax Rate 40%
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Capital Structure
EPS/EBIT
Shares
EBIT
2,400,000
Interest
EBT
2,400,000
Tax @ 40% 960,000
E after T
1,440,000
No of shares 300,000
EPS
4.8
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Debt
2,400,000
600,000
1,800,000
720,000
1,080,000
200,000
5.4
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Capital Structure
EPS/EBIT
• Break Even Point
E 6
P 5
S 4
3
2
1
0
EBIT
*
1
2
3
4
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6 Millions
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Capital Structure
EPS/EBIT
• A Formula may be used
(EBIT* – C1)(1 –t) = (EBIT* – C2)(1-t)
S1
S2
EBIT* = Break Even EBIT
C1, C2 = annual interest expense
T= Corporate tax rate
S1, S2 = Number of shares outstanding after
financing
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Capital Structure
EPS/EBIT
•
(EBIT* - 0)(.6) = (EBIT* - 600,000)(.6)
300,000
200,000
.6(EBIT*)(200,000) = .6(EBIT*)(300,000) –
.6(600,000)(300,000)
60,000EBIT* = 108,000,000,000
EBIT* = 1,800,000
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Cost of Capital
Objective is to minimise cost of capital
Risk Free Rate
Types
Capital
Structure
Debt
Sources
Cost of Capital
Equity
Risk
Return
-Market
- Environment
Dividend
-Business
- Portfolio
Capital growth
-Political
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