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Premium member Presentation Transcript Slide 1: “Capital Structure & Financing ” Abstract : Abstract Corporate-Financing Decisions Long-Term Financing 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: Common Stock Preferred Stock Long-term debt 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. Critiques: - 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 Bankruptcy Cost Agency cost 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. Stock Repurchase - 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 You do not have the permission to view this presentation. In order to view it, please contact the author of the presentation.