Capital Structure The Big Debate Well can you or can’t you? copyright anbirts 1 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? copyright anbirts 2 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 copyright anbirts 3 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 copyright anbirts 4 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 copyright anbirts 5 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% copyright anbirts 6 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? copyright anbirts 7 Capital Structure • Results • Leveraged • Un-leveraged Range of ROEs % 20 - 5 15 – 7.5 • What effect will this have on expected/required equity returns? copyright anbirts 8 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’) copyright anbirts 9 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 copyright anbirts 10 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 copyright anbirts 11 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 copyright anbirts 12 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. copyright anbirts 13 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 copyright anbirts Co B 10,000 3,600 6,400 .16 40,000 30,000 70,000 14 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 copyright anbirts 15 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 copyright anbirts 16 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 copyright anbirts 17 Capital Structure • • • • • Effects of imperfections Taxes Financial distress Bankruptcy Corporate/private leverage Non debt tax shields copyright anbirts 18 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) copyright anbirts 19 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 copyright anbirts 20 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 copyright anbirts 21 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 copyright anbirts 22 Capital Structure • Where does that leave us? • RoE = 600 = 20% 3,000 So where does the extra 8% come from? 240 = 3,000 8% copyright anbirts 23 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 copyright anbirts 24 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% copyright anbirts 25 copyright anbirts 26 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% copyright anbirts 27 Capital Structure Cost of 13 Capital 12 11 10 0 50 Gearing/Leverage copyright anbirts 100 28 Capital Structure So how will we decide on leverage level? • Industry norms • Coverage ratios * interest * interest plus principal copyright anbirts 29 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% copyright anbirts 30 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 copyright anbirts 31 Capital Structure Coverage Ratios • But what is a suitable coverage ratio? Variability • Trend Analysis • Industry Norms • All Commitments copyright anbirts 32 Capital Structure • Profitability * pecking order • Size * portfolio effect * pecking order • Asset type • Volatility of earnings • International / cultural norms copyright anbirts 33 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% copyright anbirts 34 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 copyright anbirts Debt 2,400,000 600,000 1,800,000 720,000 1,080,000 200,000 5.4 35 Capital Structure EPS/EBIT • Break Even Point E 6 P 5 S 4 3 2 1 0 EBIT * 1 2 3 4 copyright anbirts 5 6 Millions 36 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 copyright anbirts 37 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 copyright anbirts 38 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 copyright anbirts 39
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