武汉大学公司金融课件(十一)

CAPITAL STRUCTURE AND FINANCIAL LEVERAGEFinancial leverage and M & M propositions I & IILeverage and homemade leverageM & M Propositions I & II with corporate taxesA pecking order or signaling theory of capital structure FINANCIAL LEVERAGENo Corporate TaxM & M Proposition I:The value of a firm is unaffected by its capitalstructure (the debt irrelevance proposition).M & M Proposition II:A firm’s cost of equity capital is a positive linearfunction of its capital structure.Or,The required rate of return on equity increases asthe firm’s debt-equity ratio increases.1. A firm with no debt is called an unlevered company or an all-equity company. After the issuance of debt, it becomes levered.2. RESTRUCTURING:The process of changing the firm’s capital structurewithout changing its assets.Example: p.391, 15.2 RossLeverage can result in higher returns in good times and lower returns in bad time.Leverage increases risk, since the earnings pershare available to the equity holders are moresensitive to the performance of the firm. HOMEMADE LEVERAGE:The use of personal borrowing to change the overallamount of financial leverage to which the individualis exposed.Return on equity( $2000=100shares)Recession Normal ExpansionNo debt 6.25% 12.5% 18.75%D/E = 1 2.5% 15.0% 27.5%$50 $300 $550By homemade leverage:Borrow: $2000 at interest rate of 10%Buy shares: $4000 * $20 = 200 sharesCost: $2000 * 10% = $200ROE: Recession = $50 (4000*6.25%=250250-200=50)Normal = $300 (4000 * 12.5% = 500500 – 200 = 300)Expansion=$550(4000* 18.75%=750750 – 200 = 550)Risk and Cost of EquityWhile changing the capital structure under these conditions does not add value to the firm, it does alter the distribution of that value between bondholders and owners. It also leads to changes in the returns and risks borne by each type of security, the most significant of which is the return to equity.WACC = R A = (D/V) (R D) + (E/V)(R E)R E = R A + (D/E) (R A - R D) [M&M II]Example:p.401 Figure 15.3, p. 400 Table 15.5corporate taxes;bankruptcy;conflicts between bond holders and share holders; and,the interpretation that security markets will place ondifferent financing strategies.M & M PROPOSITIONS I & II WITH CORPORATE TAXESPV interest tax shield = T c * R D * DR DPV interest tax shield = T c * DV L = V U + T c DIn effect, the interest tax shield transfers value from the government to the shareholders and creates value for the owners of the firm. (P.408 Figure 15.4 Ross)The result does suggest that capital structure, for tax paying firms, is very important. Nevertheless, it comes into conflict with the empirical fact that many profitable firms, paying high taxes, have not added leverage by increasing debt. We can deal with that fact, at least partially by adding into our analysis the costs associated with financial distress, to the point of bankruptcy.WACC AND R E with taxes:The additional financial risk created by the leverage can only be accommodated by an increase in the return required by equity holders. In the case with taxation, there is value added (in the amount of T c D) tothe firm by leverage.We can find the required return on equity and therefore the WACC by introducing the concept of unlevered cost of capital, as represesented by R U.Without taxationR E = R A + (R A - R D) (D/E)With taxationR E = R U + (R U – R D)(D/E)(1 – T c)EXAMPLE #1: WACC WITH TAXESCorner Lot Inc. is a mid-sized development corporation with no long-term debt on its balance sheet. The Vice President Finance has determined that the all-in cost of long-term borrowing would be 9.5%. The firm’s marginal tax rate is 32% and its WACC is 16%.The Board of Directors of Corner Lot Inc. has instructed the Vice President to analyze the option of increasing the leverage of the firm.1. What is the current cost of equity for Corner Lot Inc.?2. If the firm borrows long-term funds and buys back shares to endup with 30% debt:a) What will its cost of equity be?b) What will its WACC be?3. If the firm ends up with 50% debt:a) What will its cost of equity be?b) What will its WACC be?EXAMPLE #2: WACC WITH TAXESVeggie Ltd. has developed a small but growing market for vegiburgers.The CEO expects to have an EBIT of $75,000 in 2001, and expects that number to grow by 5% each year thereafter.The firm can borrow at a rate of 9%, currently has no debt, and has a cost of capital of 18%.1) If the marginal tax rate is 35%, what is the value of the firm in2000?2) What would the value of the firm in 2000 be if it borrowed$50,000 and used the proceeds to repurchase common shares?3) What is the cost of equity after the capital restructuring?4) What is the WACC after the capital restructuring?COST OF BANKRUPTCY OR FINANCIAL DISTRESSFinancial distress occurs when promises to creditors are broken or can only be honoured with difficulty.Since investors know that levered firms may fall into financial distress, they take that fact into account in the valuation of the firm.In the same way that the present value of the interest tax shield adds value to a firm, the present value of the costs associated with financial distress (and potentially bankruptcy) reduces the present value of the firm. We can say that the value of a firm is:V L = V U + PV tax shield – PV financial distressAccording to the trade-off theory of capital structure, the theoretical optimum is reached when the present value of the tax savings due to additional leverage is just offset by the present value of the costs of distress due to that additional leverage.(p.432 figure 16.1 Ross)A PECKING ORDER OR SIGNALING THEORY OF CAPITAL STRUCTUREAn alternative approach to capital structure, the pecking order orsignaling theory, is based on asymmetric, or incomplete, information in the market place.It is based on the notion that the market is not entirely efficient so that managers know more about their companies’ prospects, risks, and values than do outside investors.In effect, the theory is based on the concern that different capital structure decisions will be interpreted differently by investors. Given the differences in the costs of debt and of equity, investors, it is argued, interpret the issuing of new equity as a sign that the current price of equity is too high. Managers and existing shareholders are interpreted as trying to take advantage of that fact by selling equity into a hot market. As a result, it is argued, the market price of the shares is likely to fall and there will be a loss of value.On the other hand, issuing new debt is seen to be a signal that the firm has good financial opportunities and that existing shareholders are trying to increase their rate of return by adding leverage to the firm. Rather than basing their decisions on some concept of an optimal capital structure, this theory focuses on the managers’ view of how the market will interpret their actions. Again, the premise has to be that there is not strong form efficiency in the capital markets.So, the PECKING ORDER OR SIGNALING THEORY states that:Firms prefer internal finance, since these funds are raisedwithout sending any adverse signals that may lower thestock price.Firms adapt their target dividend payout ratios to theirinvestment opportunities, while trying to avoid suddenchanges in dividend levels.If external finance is required, firms issue debt first andissue equity only as a last resort. Issuing more debt ispreferred, according to this theory, because it is less likelyto signal to the market that the stock is currentlyoverpriced.In this theory, there is no well-defined debt-equity mix, because there are two sources of equity, one on the top of the pecking order and one on the bottom. The debt equity ratio is more a consequence of the ability of the firm to use internally generated equity to finance available investment opportunities.The pecking order theory explains why the most profitable firms generally borrow less. It is not because they are targeting a low debt-equity ratio, but as a result of a dividend payout strategy that leaves the firm with sufficient internally generated equity to support the profitable investment opportunities.Less profitable firms issue debt before they would issue new equity, if they do not have sufficient internally generated funds to support their profitable investment alternatives.Just as is the case with the trade-off theory, the pecking order theory is less successful in explaining the behavior in some circumstances. For example, many mature stable industries, such as utilities, chose to have high dividend payout ratios with their strong internal cash flow, rather than pay down the debt of the firm.。