Lecture08 - FIN2101 BUSINESS FINANCE II Module 7 Capital...

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Unformatted text preview: FIN2101 BUSINESS FINANCE II Module 7 Capital Structure Student Activities Student Activities Reading Text, Chapter 13 (pp. 477­96 only) Text Study Guide, Chapter 13 (part only) Study Book, Module 7 Tutorial Activities Tutorial Workbook, Self Assessment Activity 7.1 Text Study Guide, Chapter 13, T/F 1, 7, 8, 9 & 10; MC 5, 6, 7, 12, 14, 15 Introduction Introduction A company may issue several types of securities in varying combinations, but what it tries to do is find the combination that will maximise its overall market value. Capital structure is the proportionate relationship between a company’s debt and equity. Capital structure is the debt vs equity question. Should the company have some debt in its capital structure? Introduction Introduction A financing decision. Investment decisions are critical in determining returns to shareholders. Just how important financing decisions are has been subject to much debate. Introduction Introduction Financing decisions become irrelevant as long as equity holders are happy with their returns. A firm can be highly levered yet no one is concerned as long as dividends are acceptable. Problems arise when returns aren’t enough to cover debt commitments and dividends cease. Capital Structure Dilemma Capital Structure Dilemma Does the manner in which investment proposals are financed matter? If so, what is the optimal capital structure? Does varying the capital structure affect share price? If so, which financing policy maximises share price? How is a choice between alternative financing options made? Which option maximises shareholders’ wealth? Traditional Approach Traditional Approach The RELEVANCE ARGUMENT ­ capital structure is relevant to the market value of the firm and the firm’s cost of capital. There is an optimal debt­to­equity mix that minimises WACC and maximises the market value of the firm to its shareholders. Traditional Approach Traditional Approach A company is able to increase its total market value and decrease its WACC by the use of moderate amounts of debt. There is an optimal level of debt and an optimal capital structure. Traditional Approach Traditional Approach k ks k kd OCS D:E Ratio Traditional Approach Traditional Approach As D:E ratio increases: cost of equity k increases; s cost of debt kd may eventually increase; overall cost of capital k first decreases but then increases; market value maximised and WACC minimised at OCS. Traditional Approach Example Traditional Approach Example A company has $5 000 of 10% debt (MV @ face value). There are 3 000 shares issued (n = 3 000). ks = 15%. Earnings before interest per year = $5 000. Calculate cost of capital, market value, and market value per share. Earnings per year Less Interest ($5 000 × 10%) Earnings available for equity Cost of equity (ks) Market value of equity Plus Market value of debt Market value of firm $ 5000 500 4500 0.15 30000 5000 $35000 Cost of Capital = Earnings/Market Value of Firm = $5000/$35000 14.29% MV Per Share = MV of Equity/No. of Shares = $30000/3000 $10 A Variation A Variation Suppose $5 000 more debt @ 10% is issued to replace equity, with debt proceeds used to repurchase 500 $10 shares, leaving 2 500 shares issued. As a result of increased gearing, ks increases to 20% to compensate investors for greater financial risk. Earnings per year Less Interest ($10 000 × 10%) Earnings available for equity Cost of equity (ks) Market value of equity Plus Market value of debt Market value of firm $ 5000 Cost of Capital = Earnings/Market Value = $5000/$30000 MV Per Share = MV of Equity/No. of Shares = $20000/2500 1000 4000 0.20 20000 10000 $30000 16.67% $8 Summation Summation Before Market Value of Firm $35000 After $30000 Cost of Capital 14.29% 16.67% MV Per Share $10 $8 Change Summation Summation With the introduction of more debt, the equity holders’ perception of the value of the firm has declined to $8. As the return stream has become more risky, the cost of capital has increased from 14.29% to 16.67%. Traditional Approach Assumptions Traditional Approach Assumptions No taxes. 100% dividend payout (ie no R.E.). Perfect markets. Total capital structure won’t change, although components might. The market values assets equally if they have the same risk & generate identical cash flows. Net Operating Income Net Operating Income Approach There is no such thing as an optimal capital structure ­ IRRELEVANT. Should concentrate on investment decisions which are separate from financing decisions. An increase in ks is offset exactly by the cheaper source of finance (debt), with the overall cost of capital remaining constant. N.O.I. Approach N.O.I. Approach k ks k kd D:E Ratio NOI Approach NOI Approach (MM Without Taxes) As D:E ratio increases: cost of equity k increases; s cost of debt kd is unchanged; cost of capital k is unchanged; market value of the firm is unaffected. N.O.I. Approach Example N.O.I. Approach Example Use the data from the earlier example: – $5 000 of debt @ 10% (MV @ face value) – 3 000 shares issued (n = 3000) – earnings of $5 000 Assume an overall cost of capital of 20%. Calculate the cost of equity capital, market value of the firm, and market value per share. Earnings per year Cost of capital (k) Market value of firm - Market value of debt Market value of equity $ 5000 0.20 25000 5000 $20000 Cost of Equity = Earnings-Interest/MV of Equity = $5000-500/$20000 = $4500/$20000 22.5% MV Per Share = MV of Equity/No. of Shares = $20000/3000 $6.67 A Variation A Variation Issue $5 000 additional debt @ 10%. Repurchase $5 000 of equity (750 shares @ $6.67). n = 2 250 shares (3 000 ­ 750). Earnings per year Cost of capital (k) Market value of firm - Market value of debt Market value of equity $ 5000 0.20 25000 10000 $15000 Cost of Equity = Earnings-Interest/MV of Equity = $5000-1000/$15000 = $4000/$15000 26.67% MV Per Share = MV of Equity/No. of Shares = $15000/2250 $6.67 Summation Summation Before Market Value of Firm $25000 After $25000 Change Nil Cost of Capital 20% 20% Nil MV Per Share $6.67 $6.67 Nil Summation Summation The cost of debt and the overall cost of capital have not changed as a result of the variation in the capital structure. The market value of the firm and the market value of the firm’s shares are unaffected. Summation Summation There is no change in the perception of the market value of the firm. There is no optimal capital structure ­ financing decisions are irrelevant. Modigliani & Miller Modigliani & Miller Seminal paper (1958) on capital structure theory. Supported the NOI approach. Any 2 identical firms would ultimately be perceived by investors as the same in terms of value irrespective of their capital structures. MM(No Taxes) Assumptions MM (No Taxes) Assumptions Perfectly competitive capital market. Business risk of all companies in a particular risk class is the same. No personal or company taxes. Debt is risk­free (no default risk). Borrow and lend at the same rate. No bankruptcy costs. MM MM It is the ultimate return that is important. 3 important propositions. MM Proposition 1 MM Proposition 1 The value of an asset remains the same regardless of how the net cash flows generated by the asset are divided between different classes of investors. In other words, the market value of the company is independent of its capital structure. The investment and financing decisions can be separated. MM Proposition 2 MM Proposition 2 A company’s capital structure has no effect on its overall cost of capital. MM Proposition 3 MM Proposition 3 The appropriate discount rate for a particular investment proposal is independent of how the proposal is to be financed. MM Overall MM Overall In a perfect capital market with no taxes, it is only the investment decision that is important in the pursuit of wealth maximisation. The financing decision is of no consequence. Subject to the underlying assumptions, MM approach has broad acceptance. MM With Taxes MM With Taxes In a world of no taxes, MM say VL = VU. Doesn’t hold true if corporate taxes are introduced. Interest payments are tax deductible, giving an advantage to levered firms. MM (With Corporate Taxes) MM (With Corporate Taxes) k ks k kd k*d D:E Ratio MM (With Corporate Taxes) MM (With Corporate Taxes) As the D:E ratio increases: cost of debt kd is unchanged; cost of equity ks increases; overall cost of capital k decreases; market value of the firm increases. MM With Taxes MM With Taxes VL = VU + (PV of tax savings on interest) T( I ) VL = VU + kd T ( k d )( D ) VL = VU + kd VL = VU + ( T ×D ) MM With Taxes MM With Taxes A levered firm will always be worth more than an equivalent unlevered firm. The more it borrows, the more its value increases. All companies should have 100% debt! However, the tax advantages of debt finance are offset by the costs of debt ­ the costs of financial distress, agency costs and information asymmetry. Personal taxes also complicate things. Personal Taxes Personal Taxes The classical tax system was biased in favour of debt finance. Imputation tax system introduced in 1987/88 tax year. Reduced taxes on equity income. Neutral between debt and equity. Companies now make greater use of equity finance. Dividend Imputation Dividend Imputation Shareholders indifferent to corporate borrowing – tax shield from borrowings irrelevant when shareholders receive franked dividends. Local (resident) shareholders mainly concerned about the availability of franking credits on dividends. This will have some effect on share price. Financial Distress Financial Distress Companies which issue risky debt face the prospect of incurring direct and indirect bankruptcy costs. Direct costs ­ those associated with receivership and liquidation. Indirect costs ­ incurred through loss of sales and management spending too much time on bankruptcy­related matters. Agency Costs Agency Costs Lenders may impose monitoring techniques on borrowers, who consequently incur agency costs. Loan agreements might include provisions (covenants) relating to things like the minimum level of liquidity of the borrower, asset acquisitions by the borrower, executive salaries and dividend payments. Lender can control the risk of the borrower. Asymmetric Information Asymmetric Information Information asymmetry occurs when managers have more information (than investors) about the firm’s activities and future prospects. Results in a pecking order of financial preferences. Retained earnings, debt, external equity. Debt financing is a positive signal – management believes shares are undervalued. Share issue is a negative signal – management thinks that shares are overvalued. Conclusion Conclusion There is little conclusive evidence to support or reject either theory on capital structure. A general conclusion is that primary attention should be paid to investment decisions. Table 13.16 (p. 495) lists factors to consider when making capital structure decisions. Capital Structure in Practice Capital Structure in Practice Two techniques: EBIT­EPS analysis – Assumes a goal of maximising EPS instead of owners’ wealth. – Maximisation of EPS ignores risk. Capacity to service debt – Times interest earned ratio – Fixed­payment coverage ratio ...
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