Capital Structure Cont. Notes

Modigliani and Miller:

• Firm value = Value of debt + Value of equity.

• Combination of debt and equity = Capital structure.

• Can the capital structure affect firm value?

• Is there a value-maximising capital structure? I.e. What is debt-to-equity ratio that maximises firm value.

  • Maximising firm value is important. It makes it significantly more difficult for a bidder to takeover the company and replace management.

The traditional view

• Rate of return on debt < Rate of return on equity.

  • Why is this so?

  • Debt it less risky because it has a higher priority with regards to repayment, and therefore carries a lower rate of return.

  • A debt investor is therefore likely to be willing to invest at a lower rate of return than an equity investor.

• Firm value may thus be maximised by using the right amount of debt.

• The more debt, the more risky and the more expensive the equity.

  • This is because equity lies behind debt in priority.

• The optimum capital structure is obtained where marginal cost of debt = marginal cost of equity.

  • I.e. The addition of one unit of debt increases the cost of equity to an extent that is precisely equal to the cost of the unit of debt.

Example of ABC plc:

• Unleveraged:

  • Expected Earnings = 15,000

  • Debt = 0

  • Interest = 0

  • Rate of return = 0

  • Common shares = 1000

  • Earnings per share = 15

  • Market value per share = 100

  • Rate of return on equity = 15%

  • Market value of the company = 100,000

• Leveraged:

  • Expected Earnings = 15,000

  • Debt = 50,000

  • Interest = 2,500

  • Rate of return = 5%

  • Common shares = 500

  • Earnings per share = 25

  • Market value per share = 115. This increase in share price is due to increase in earnings per share.

  • Rate of return on equity = 21.7%

  • Market value of the company = 107,500

Firm value = Sum of the value of all the financial assets issued by the firm, and these financial assets include both debt and equity (in the form of shares).

Modigliani and Miller

Irrelevance hypothesis:

• In a perfect world (where there is complete information and zero transaction costs) capital structure the irrelevant to firm value.

• Firm value is the same regardless of the mix of debt and equity.

Looking at the balance sheet:

• The value of a firm’s actual assets is unaffected by who owns them.

• Value is affected by changes on the left hand side.

• Only claims to value are affected by changes on the right hand side.

Going back to the example of ABC plc:

• Shares of ABC plc (leveraged) trade at a higher price due to (overall) lower cost of capital (115 vs 100).

• The rational investor then sells the shares in the “overvalued” firm (115 x 500 = 57,500).

• The investor buys, using the proceeds and borrowed funds, shares in ABC plc (unleveraged). This gives us 575 shares for 100 each.

• More shares = More control.

• But earnings per share: 15 < 25.

• ABC plc (leveraged) cash flow: 500 x 25 = 12,500.

  • We need to replicate this cash flow of the leveraged firm in the unleveraged firm.

  • This is achieved through the process of self-leveraging.

• The investor takes out a loan of 38,800 at 5%.

• The investor buys 388 additional shares in ABC plc (unleveraged).

• Overall shareholding in ABC plc (unleveraged): 963.

• Cash flow on shares: 963 x 15 = 14,445.

• Minus the 5% interest on the 38,800 loan = Minus away 1,940.

• Self-leveraging duplicates the returns on shares in the leveraged firm (~12,500).

• In a perfect market, all investors would do the same.

  • The trading leads to increased demand or supply in shares of the unleveraged or leveraged firms (?). This results in an identical price despite the different capital structures.

  • Reaching an equilibrium because supply and demand increase together (?).

Why might capital structure matter in the real world when one leaves out all these assumptions of the perfect world?

• How changes on the right hand side affect values on the left hand side:

  • Taxes:

    • Interest deductible;

    • Dividends non-deductible; and

    • Corporate tax rate, Personal tax rate, and Capital gains tax.

    • This why advise on tax is such an important aspect in all commercial transactions.

  • Signalling effect of capital structure.

    • If management believes they still have profitable projects to pursue, they can issue more debt to finance those projects.

    • This signals to the market that management has a high level of confidence in the profitability of the projects, because they are willing to risk taking on more debt on the company’s balance sheets.

  • Disciplinary effect of debt.

    • Diversifying the firm and making the company more resilient?

    • Making the company more difficult for a bidder to takeover?

    • But shareholders are interested only in a high rate on return on equity, and not diversify; they themselves can hedge against risks by diversifying their own investment portfolio, without the company diversifying its operations.

    • Note the potential conflicts between management protecting their own interests by entrenching the company VS Shareholder interests.

  • Insolvency costs:

    • Increased risk of default = More difficult to trade. This is because suppliers are less willing to supply (and thereby become creditors of the company).

    • This is because debt must always be paid, whilst payment is made on equity only if a profit is made and management declares dividends on shares.

Financial Statements

Essentially = Valuing assets and liabilities, and then presenting them in an accessible way.

• Accounting:

  • A series of processes and techniques used to identify, measure, and communicate economic information.

  • Transparency.

  • Accuracy(?). “Book value” VS “Fair market value”.

    • Book value = Value of the assets as had been entered into the firm’s books.

    • Fair market value = Price at which the assets would sell for on the open market.

• Key Documents:

  • Balance sheet.

  • Profit and loss...

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