Chapter 17
Capitalization Rate, ko
- The discount rate used to determine the present value of a stream of expected cash flows.
Capital Structure Determination
-A Conceptual Look -The Total-Value Principle -Presence of Market Imperfections and Incentive Issues -The Effect of Taxes -Taxes and Market Imperfections Combined -Financial Signaling
Flexibility
-A decision today impacts the options open to the firm for future financing options thereby reducing flexibility. -Often referred to unused debt capacity.
Total Value Principle: Modigliani and Miller (M&M)
-Advocate that the relationship between financial leverage and the cost of capital is explained by the NOI approach. -Provide behavioral justification for a constant ko over the entire range of financial leverage possibilities. -Total risk for all security holders of the firm is not altered by the capital structure. -Therefore, the total value of the firm is not altered by the firm's financing mix.
Timing
-After appropriate capital structure determined it is still difficult to decide when to issue debt or equity and in what order -Factors considered include the current and expected health of the firm and market conditions.
Market Imperfections and Incentive Issues
-Bankruptcy costs -Agency costs -Debt and the incentive to manage efficiently -Institutional restrictions -Transaction costs
Agency Costs
-Costs associated with monitoring management to ensure that it behaves in ways consistent with the firm's contractual agreements with creditors and shareholders. -Monitoring includes bonding of agents, auditing financial statements, and explicitly restricting management decisions or actions. -Costs are borne by shareholders (Jensen & Meckling). -Monitoring costs, like bankruptcy costs, tend to rise at an increasing rate with financial leverage.
Corporate plus personal taxes
-Personal taxes reduce the corporate tax advantage associated with debt. -Only a small portion of the explanation why corporate debt usage is not near 100%.
Summary of the Traditional Approach
-The cost of capital is dependent on the capital structure of the firm. -Thus, there is one optimal capital structure where ko is at its lowest point. -This is also the point where the firm's total value will be the largest (discounting at ko).
Summary of Corporate Tax Effects
-The greater the amount of debt, the greater the tax-shield benefits and the greater the value of the firm. -The greater the financial leverage, the lower the cost of capital of the firm. -The adjusted M&M proposition suggests an optimal strategy is to take on the maximum amount of financial leverage. -This implies a capital structure of almost 100% debt! Yet, this is not consistent with actual behavior.
Summary of the Arbitrage Transaction
-The investor uses "personal" rather than corporate financial leverage. -The equity share price in Company NL rises based on increased share demand. -The equity share price in Company L falls based on selling pressures. -Arbitrage continues until total firm values are identical for companies NL and L. -Therefore, all capital structures are equally as acceptable.
Capital Structure
-The mix (or proportion) of a firm's permanent long-term financing represented by debt, preferred stock, and common stock equity -Concerned with the effect of capital market decisions on security prices. -Assume: (1) investment and asset management decisions are held constant and (2) consider only debt-versus-equity financing.
Informational Asymmetry
-is based on the idea that insiders (managers) know something about the firm that outsiders (security holders) do not. -Changing the capital structure to include more debt conveys that the firm's stock price is undervalued -This is a valid signal because of the possibility of bankruptcy.
Tax Shield
A tax-deductible expense. The expense protects (shields) an equivalent dollar amount of revenue from being taxed by reducing taxable income.
Net Operating Income Approach
A theory of capital structure in which the weighted average cost of capital and the total value of the firm remain constant as financial leverage is changed.
Traditional Approach
A theory of capital structure in which there exists an optimal capital structure and where management can increase the total value of the firm through the judicious use of financial leverage.
Summary of NOI Approach
Critical assumption is ko remains constant. An increase in cheaper debt funds is exactly offset by an increase in the required rate of return on equity. As long as ki is constant, ke is a linear function of the debt-to-equity ratio. Thus, there is no one optimal capital structure.
Arbitrage
Finding two assets that are essentially the same and buying the cheaper and selling the more expensive
Checklist of Practical and Conceptual Considerations
Taxes, Explicit cost, cash-flow ability to service debt, agency costs and incentive issues, financial signaling, EBIT-EPS analysis, Capital structure ratios, Security rating, Timing, Flexibity
Optimal Capital Structure
The capital structure that minimizes the firm's cost of capital and thereby maximizes the value of the firm.
Uncertainty of tax-shield benefits
Uncertainty increases the possibility of bankruptcy and liquidation, which reduces the value of the tax shield.