Chapter 12 Capital Structure Chapter 12

							              Chapter 12
            Capital Structure
 Quick Review of Capital Markets
 Benefits of Borrowing
 Pecking Order Hypothesis
 Modigliani and Miller Optimal Capital
 Structure Theory
Quick review of Capital Markets
 Capital Markets
   Borrow from more than one year
   Various types of markets
      Bond
      Equity
 Investors return is borrower’s cost
 Not all borrowers get the same rate
   Function of risk to investor
   See Example 12.1, Lucky Larry at 11.11% and
    Sometimes Lucky Sherry at 42.86%
          Benefits of Borrowing
 Using other people’s money
   Financial leverage
   Cost of debt is less than the anticipated return of the
    investment
 Financial leverage benefit measured via EPS
   Owners of the firm can be better off with debt
    financing
   Example 12.2 – Jordan Enterprises
       Adding debt improves EPS if earnings exceed $960,000
       Adding debt hurts EPS if earnings less than $960,000
       Jordan Enterprises will add debt if it believes earnings will be
        greater than $960,000
 Pecking Order Hypothesis (POH)
 Preferred borrowing pattern
   Borrow from cheapest source first
   Asymmetric information
      Firms know more than lenders
      Information is costly to obtain
      Information may be proprietary
 Borrowing pattern from POH
   Internal first
   Avoid swings in dividend payments
   External financing – cheapest first (debt) and equity
    as last resort
 Pecking Order Hypothesis (POH)
 Example 12.3 – Abbot and Costello borrowing
  choices
   Outsiders believe managers only issue equity when
    stock over priced
   Outsiders therefore lower price they will pay for equity
   Managers thus choose to issue debt if possible
 More profitable companies
   Borrow less from external sources
   Therefore have lower debt-equity ratios
  Modigliani and Miller Optimal Capital
            Structure Theory
 Starts with a world of no taxes
 Two Propositions
   Proposition I – It is irrelevant what borrowing pattern a
    firm chooses…the value of the firm remains the same
   Proposition II – cost of equity is a function of three
    things
       Require return on assets
       Cost of debt
       Debt-Equity ratio
 In world of no taxes, WACC is constant and the
  firm is insensitive to the funding choice
  Modigliani and Miller Optimal Capital
            Structure Theory
 Modified to a world of corporate taxes
   Proposition I – all debt financing is optimal
   Proposition II – the WACC of the firm falls as more
    debt is added
 What is happening in this world?
   Government is losing out to equity holders
   Tax shield due to interest payments reduces
    government’s direct share of profits and captured by
    equity holders
 VL = VE + D x T C
  Modigliani and Miller Optimal Capital
            Structure Theory
 One more modification – World of corporate
  taxes and bankruptcy
   Bankruptcy is costly
   When debt payments cannot be made equity holders
    lose company to debt holders
   Must avoid bankruptcy
 Optimal debt-equity ratio arises
   At point where marginal benefits of debt financing
    equal marginal costs of bankruptcy
   At this point WACC is lowest and value of firm highest
              Problems
 Problem 3 – Benefits of Borrowing
 Problem 7 – Pecking Order Hypothesis
 Problem 9 – Finding WACC
 Problem 11 – M&M in World of No Taxes