Slide 1: “Capital Structure & Financing ” Abstract : Abstract Corporate-Financing Decisions
Basic Concept in Capital Structure
Limits to the Use of Debt
Capital Structure Theories
Recent Empirical Results Related to Capital Structure Issues
Effective factors in Capital Structure Corporate-Financing Decisions : Financing Decisions Operational Decisions Corporate-Financing Decisions Corporate-Financing Decisions : Corporate-Financing Decisions Can Financing Decisions Create Value?
How should a firm choose its capital structure? Corporate-Financing Decisions : How should a firm choose its capital structure?
Changing the capital structure of the firm changes the way the firm pays out its cash flows.
The combined effects of taxes & bankruptcy costs can produce an optimal capital structure. Corporate-Financing Decisions Long-term Financing : Long-term Financing Types of Long-term Financing Basic sources:
Bond Long-term FinancingMain Difference between debt & equity: : Long-term FinancingMain Difference between debt & equity: Basic Concept : Basic Concept PIE Theory
Financial Leverage & Firm Value
- NI Theory
- NOI Theory
- Traditional Approach to cost of capital
- MODIGLIANI & MILLER Basic Concept : Basic Concept Variations in capital structure are endless.
The analysis by considering only common stock & straight debt.
Examine the important factors in the choice of a firm’s debt-to-equity ratio.
Increase in the firm’s value from debt financing leads to: increase in the value of the equity. Basic Concept : Basic Concept PIE Theory & The Capital Structure Question
How should a firm choose its debt-equity ratio?
The value of the firm: the sum of both the debt & the equity
If goal of management of the firm is to make the firm as valuable as possible , the firm should pick the debt-equity ratio that makes the pie -the total value- as big as possible. Basic Concept : Basic Concept PIE Theory Basic Concept : Basic Concept Financial Leverage & Firm Value
- NI Theory
- NOI Theory
- Traditional Approach to cost of capital Basic Concept : Basic Concept Financial Leverage & Firm Value
1. The Irrelevance Proposition (M & M in 1958 ):
They demonstrated :
- ignoring taxes & contracting cost
- the firm’ choice financing policy does not affect the current market value of firm.
- The value of the levered firm equals the value of the un levered firm .VL=Vu
- if corporate financing policies affect the value of the firm, they must do so by changing the probability distribution of firm’s cash flows.
- the cash flow distribution can be affected by the choice of financing policy because there are other important interdependence between the choice of financing policy & the choice of investment policy.
2. Before M& M:
The effect of leverage on the value of the firm was considered complex & convoluted.
3. MM proposition II (no taxes):
The cost of equity rises with leverage, because risk to equity-holders increases with leverage .VL=Vu + t D Basic Concept : Basic Concept Financial Leverage & Firm Value Basic Concept : Basic Concept MM propositions with taxes Limits to the use of debt : Limits to the use of debt Description of Costs
Integration of tax effects & financial distress costs: Trade-Off Model
Personal taxes & Miller Model
The Pecking-order theory Limits to the use of debt : Limits to the use of debt Description of Costs
- Direct Costs of Financial Distress
- Indirect Costs of Financial Distress Slide 18: Bankruptcy Costs
Agency cost Limits to the use of debt Limits to the use of debt : Limits to the use of debt Integration of tax effects & financial distress costs: Trade-Off Model
The Optimal Amount of Debt & Value of the Firm
VL=Vu + tD – Bankruptcy Cost – Agency Cost Limits to the use of debt : Limits to the use of debt Limits to the use of debt : Limits to the use of debt Integration of tax effects & financial distress costs
Pie Model with Real-World Factor Limits to the use of debt : Limits to the use of debt Personal tax & The Miller Model(1977):
Valuation under Personal & Corporate Taxes( Effect of Financial Leverage on Firm Value with both Corporate & Personal Taxes (
The result so far have ignored personal tax. If distributions to equity holders are taxed at a lower effective personal tax rate than are interest payments, the tax advantage to debt at the corporate level is partially offset.
The corporate tax advantage to debt is eliminated if : Limits to the use of debt : Limits to the use of debt Limits to the use of debt : Limits to the use of debt The Pecking-order theory( Donaldsen /1962)
-The pecking-order theory implies that managers prefer internal to external financing. If external financing is required, managers tend to choose the safest securities, such as debt.
- Firms may accumulate slack to avoid external equity. Theories & Capital Structure : Theories & Capital Structure Signaling Theory (Ross/1977)
Theory of Asymmetric Information(Myers/1984)
Static Trade-off Model Recent Empirical Result Related to Capital Structure : Recent Empirical Result Related to Capital Structure Exchange Offers (Masulis/1983)
-The transaction has no effect on the firm’s investment policy & thus should have no effect on firm value if the M & M theorem is applicable.
- measures the effects on the firm’s security prices of a relatively pure financial structure change, providing important evidence on the significance of tax, agency & other hypotheses.
- Significant equity value changes associated with changes in corporate leverage.
- The equity price changes associated with common stock repurchases is consistent with that from exchange offers
- Leverage –increasing events are generally associated with positive stockholder returns. Conclusions : Conclusions Financial economics has progressed through its stage of policy irrelevance propositions of the 1960s to a stage where the theory & evidence have much useful guidance to offer the practicing financial manager.
The theory & evidence are now sufficiently rich that sensible analysis of many detailed problems such as the valuation of contingent claims, optimal bond indenture covenants, & a wide range of contracting problems are emerging. Effective factors in Capital Structure : Effective factors in Capital Structure References : References a) Corporate Finance,
Ross, Westerfield , Jaffe
b) Essentials of Managerial Finance,
Weston & Brigham
c) Intermediate Financial,
Brigham, Ganpenski, Daves
d) The Modern Theory of Corporate Finance ,
Michael C. Jensen & Clifford W. Smith