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Capital Structure Determination: Modigliani and Miller Approach

This lecture provides an overview of capital structure determination, including the Modigliani and Miller approach. Topics covered include the relationship between financial leverage and the cost of capital, the total value principle, arbitrage, market imperfections, and agency costs. Examples and illustrations are provided to enhance understanding.

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Capital Structure Determination: Modigliani and Miller Approach

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  1. Business Finance(MGT 232) Lecture 25

  2. Capital Structure Determination

  3. Overview of the Last Lecture • Capital Structure • Required rate of return on debt and equity • Total Capitalization rate • NOI Approach • Traditional Approach

  4. 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 ro 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.

  5. Total Value Principle: Modigliani and Miller • M&M assume an absence of taxes and market imperfections. • Investors can substitute personal for corporate financial leverage. Market value of debt (Rs.65M) Market value of equity (Rs.35M) Total firm market value (Rs.100M) Market value of debt (Rs.35M) Market value of equity (Rs.65M) Total firm market value (Rs.100M) • Total market value is not altered by the capital structure (the total size of the pies are the same).

  6. Arbitrage and Total Market Value of the Firm Arbitrage -- Finding two assets that are essentially the same and buying the cheaper and selling the more expensive. Two firms that are alike in every respect EXCEPT capital structure MUST have the same Market value. Otherwise, arbitrage is possible.

  7. Arbitrage Example • Consider two firms that are identical in every respect EXCEPT: • Company NL -- no financial leverage • Company L -- Rs.30,000 of 12% debt • Market value of debt for Company L equals its par value • Required return on equity -- Company NL is 15% -- Company L is 16% • NOI for each firm is Rs.10,000

  8. Arbitrage Example: Company NL Earnings available to = E = O – I common shareholders = Rs.10,000- Rs.0 = Rs.10,000 Market value = E / re of equity= Rs.10,000/ .15 = Rs.66,667 Total Market value= Rs.66,667+ Rs.0 = Rs.66,667 Overall capitalization rate = 15% Debt-to-equity ratio = 0 Valuation of Company NL

  9. Arbitrage Example: Company L Earnings available to = E = O – I common shareholders = Rs.10,000- Rs.3,600 = Rs.6,400 Market value = E / re of equity= Rs.6,400/ .16 = Rs.40,000 Total Market value= Rs.40,000+ Rs.30,000 = Rs.70,000 Overall capitalization rate = 14.3% Debt-to-equity ratio = .75 Valuation of Company L

  10. Completing an Arbitrage Transaction • Assume you own 1% of the stock of Company L (equity value = Rs.400). • You should: • 1. Sell the stock in Company L for Rs.400. • 2. Borrow Rs.300 at 12% interest (equals 1% of debt for Company L). • 3. Buy 1% of the stock in Company NL for Rs.666.67. This leaves you with Rs.33.33 for other investments (Rs.400 + Rs.300 - Rs.666.67).

  11. Completing an Arbitrage Transaction Original return on investment in Company L Rs.400 x 16% = Rs.64 • Return on investment after the transaction • Rs.666.67 x 16% = Rs.100 return on Company NL • Rs.300 x 12% = Rs.36 interest paid • Rs.64 net return (Rs.100 - Rs.36) AND Rs.33.33 left over. • This reduces the required net investment to Rs.366.67 to earn Rs.64.

  12. Summary of the Arbitrage Transaction • 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. • The investor uses “personal” rather than corporate financial leverage.

  13. Market Imperfections and Incentive Issues • Agency costs • Debt and the incentive to manage efficiently • Institutional restrictions • Transaction costs • Bankruptcy costs

  14. Agency Costs • Monitoring includes bonding of agents, auditing financial statements, and explicitly restricting management decisions or actions. • Costs are borne by shareholders (Jensen & Meckling). • Monitoring costs, lire bankruptcy costs, tend to rise at an increasing rate with financial leverage. 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.

  15. Example of the Effects of Corporate Taxes Consider two identical firms EXCEPT: • Company ND -- no debt, 16% required return • Company D -- Rs.5,000 of 12% debt • Corporate tax rate is 40% for each company • NOI for each firm is Rs.10,000 The judicious use of financial leverage (i.e., debt) provides a favorable impact on a company’s total valuation.

  16. Corporate Tax Example: Company ND Earnings available to = E = O - I common shareholders = Rs.2,000- Rs.0 = Rs.2,000 Tax Rate (T) = 40% Income available to= EACS (1 - T) common shareholders = Rs.2,000(1 - .4) = Rs.1,200 Total income available to = EAT+ I all security holders = Rs.1,200+ 0 = Rs.1,200 Valuation of Company ND (Note: has no debt)

  17. Corporate Tax Example: Company D Earnings available to = E = O - I common shareholders = Rs.2,000- Rs.600 = Rs.1,400 Tax Rate (T) = 40% Income available to= EACS (1 - T) common shareholders = Rs.1,400(1 - .4) = Rs.840 Total income available to = EAT+ I all security holders = Rs.840+ Rs.600 = Rs.1,440* Valuation of Company D(Note: has some debt) * Rs.240 annual tax-shield benefit of debt (i.e., Rs.1,440 - Rs.1,200)

  18. Tax-Shield Benefits Tax Shield -- A tax-deductible expense. The expense protects (shields) an equivalent dollar amount of revenue from being taxed by reducing taxable income. Present value of tax-shield benefits of debt* (r) (B) (tc) = = (B) (tc) r (Rs.5,000) (.4) = Rs.2,000** = * Permanent debt, so treated as a perpetuity ** Alternatively, Rs.240 annual tax shield / .12 = Rs.2,000, where Rs.240=Rs.600 Interest expense x .40 tax rate.

  19. Summary of Corporate Tax Effects • 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 tare on the maximum amount of financial leverage. • This implies a capital structure of almost 100% debt! Yet, this is not consistent with actual behavior. • The greater the amount of debt, the greater the tax-shield benefits and the greater the value of the firm.

  20. Other Tax Issues • 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%. • Uncertainty of tax-shield benefits • Uncertainty increases the possibility of bankruptcy and liquidation, which reduces the value of the tax shield.

  21. Financial Signaling • 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. • A manager may use capital structure changes to convey information about the profitability and risk of the firm.

  22. Summary • The total Value Principal • Arbitrage • Market Imperfections and incentive issues • Effect of taxes

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