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FIN222 Lecture Notes - Lecture 10: Financial Distress, Retained Earnings, Tax Shield

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rubysea-lion513
27 May 2018
School
UOW
Department
Finance
Course
FIN222
Professor
Aelee Jun

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LECTURE 10.
CAPITAL
STRUCTURE
Capital structure
choices
• Capital Structure is the collection of
securities that a firm issues to raise capital
from investors.
• Equity and Debt are securities most
commonly used by firms.
• Various financing choices will promise
different future amounts to each security
holder in exchange for the cash that is raised
today.
• Managers also need to consider whether the
securities that the firm issues will receive a
fair price in the market, have tax
consequences, entail transaction costs, or
even change its future investment
opportunities.
Capital structure
in perfect capital
markets
Perfect Capital Market
• Securities are fairly priced: equivalent
borrowing costs for investors and firms
• No taxes, no transaction costs, no bankruptcy
costs
• Investment CFs are independent of financing
choices
• Symmetry of market information: firms and
investors have the same information
Financing a new business
(in perfect capital
market)
(1) Equity financing: raising money solely by
selling equity. Equity in a firm w/out debt is
called unlevered equity.
(2) Levered financing: consider borrowing some
needed money to invest. Equity in a firm w
outstanding debt is called levered equity.
**Note: ironically, financing a firm
with leverage can make it more
valuable.
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Owner of a firm should choose the capital
structure that maximises the total value of
the securities issued.
Leverage and Firm Value
(2)
MM Proposition I: In perfect capital market, the
total value of a firm is equal to the market value of
the free cash flows generated by its assets and is not
affected by its choice of capital structure.
𝑉𝐿= 𝐷 + 𝐸 = 𝑉𝑈
When the firm has no debt: CFs paid to
equity holders correspond to the FCFs
generated by the firm’s assets.
When the firm has debt: the CFs are
divided between debt and equity
holders. The total amount, however,
still corresponds to the FCFs generated
by the firm’s assets.
**Notes: WACC is constant for a
given firm, regardless of the capital
structure
Effect of leverage on risk
and return
Leverage increases the risk of equity even when there
is no risk that the firm will default
**Note: the cost of equity rises with
leverage, because the risk to equity
rises with leverage
Homemade Leverage
Home-made Leverage: when investors use leverage
in their own portfolios to adjust the leverage choice
made by a firm.
If investors can borrow/lend at the same interest rates
as the firm (which is true in perfect capital market),
the out-of-pocket cost of securities will be lowered.
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Document Summary

Investment cfs are independent of financing choices: symmetry of market information: firms and investors have the same information (1) equity financing: raising money solely by selling equity. Equity in a firm w/out debt is called unlevered equity. (2) levered financing: consider borrowing some needed money to invest. Equity in a firm w outstanding debt is called levered equity. **note: ironically, financing a firm with leverage can make it more valuable. Owner of a firm should choose the capital structure that maximises the total value of the securities issued. Mm proposition i: in perfect capital market, the total value of a firm is equal to the market value of the free cash flows generated by its assets and is not affected by its choice of capital structure. Leverage increases the risk of equity even when there is no risk that the firm will default.

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Related Questions

F2 Q1-5

1.

The return on equity of a typical firm may change over time because of changes in business and economic conditions, but it is unlikely to change based on the financing or capital structure of the firm.

a. False.

b. True.

2.

Your firm has been plodding along without much attention from the stock market. Your boss insists that he can (a) increase the return on assets to shareholders by taking on more debt, and (b) attract new investors to the firm due to the higher returns.

a. False.

b. Partly true, partly false.

c. True.

3.

Even in a world with no frictions – that is, taxes, costs of bankruptcy, asymmetric information – debt will always be preferred because cost of debt is always lower than cost of equity for a firm.

a. True.

b. False.

c. Partly true, partly false.

4.

In a world with taxes and bankruptcy costs, and in which interest on debt is tax deductible, if a firm has some debt:

a. The return on equity is less than the weighted average cost of capital (WACC).

b. The return on equity is greater than the weighted average cost of capital (WACC).

c. The relationship between return on equity and the WACC cannot be determined because it depends on several factors.

5.

In the real world, where there are taxes and interest on debt is tax deductible, if two firms have the same cash flows as each other in all possible scenarios in the future, the returns on equity of the two firms will:

a. Will depend on the capital structures adopted by the firms.

b. Will depend on the capital structures adopted by the firms and the valuation method used.

c. Always be equal to each other.

d. Will depend on the method of valuation used.

V2 F1 Q1-5

Please give explanations

1) The return on assets of a typical firm may change over time because of changes in business and economic conditions, but it is unlikely to change based on the financing or capital structure of the firm with reasonable amounts of debt.

a) True

b) False

2) Your firm has been plodding along without much attention from the stock market. Your boss insists that he can (a) increase the return on equity to shareholders by taking on more debt, and (b) attract new investors to the firm due to the higher returns.

a) False

b) Partly true, partly false

c) True

Q3) In a world with no frictions – that is, taxes, costs of bankruptcy, asymmetric information - there is no optimal capital structure (that, is no optimal mix of debt and equity).

a) True

b) False

Q4) In a world with taxes and bankruptcy costs, and in which interest on debt is tax deductible, if a firm has some debt:

a) The relationship between return on assets and the WACC is indeterminate and depends on several factors.

b) Its return on assets is always greater than the weighted average cost of capital (WACC).

c) Its return on assets is always is equal to the weighted average cost of capital (WACC).

d) Its return on assets is always less than the weighted average cost of capital (WACC).

Q5) In the real world, where there are taxes and interest on debt is tax deductible, if two firms have the same cash flows as each other in all possible scenarios in the future, their valuation at any point will:

a) Will depend on the capital structures adopted by the firms.

b) Will depend on the method of valuation used.

c) Will depend on the capital structures adopted by the firms and the valuation method used

d) Will be the same as each other regardless of the method of valuation.

Franco Modigliani and Merton Miller (M & M) are two very famous financial economists that both won the Nobel Prize in Economics for their work in the finance area, particularly in capital structure theories (see the Description of this in the box on page 504 of your text). In their famous 1958 article (see footnote on page 490), they argued that with perfect capital markets, the total value of a firm should not depend on its capital structure. In other words, the total value of a frim would be the same with all equity, or financing with 100% debt. This is the basic MM Proposition I stated on p.493. But, as you should see, the "perfect capital markets" assumes 3 key assumptions, including no taxes or transactions costs dealing with equity or debt. Additionally, a key assumption is that individuals and firms can trade the same set of securities at competitive market prices equal to the present value of their future cash flows.

These assumptions are necessary for the M&M theory on capital structure.

For the Proposition M&M II beginning on page 498, still in a perfect capital market which includes no taxes, M&M state that the cost of capital of EQUITY increases with the firm's market value debt-equity ratio. But, when you examine this Proposition more closely, for a new investment the cost of capital will equal the weighted average of the firm's equity and debt costs. What does this mean in practical terms? It means that M&M "loosens" a part of the Proposition I, and admit that the cost of equity does increase as the debt-equity ratio increases. But, if you examine this closely, it means that the OVERALL cost of capital, captured in the WACC stays constant. And, the pre-tax WACC is the same as the after-tax WACC, since there is no tax! If the WACC stays constant while the equity cost increases, this means that the debt costs are going down,relatively; on the contrary, if the equity costs are going down, then the debt costs are going up. This is shown on page 500 in Figure 14.1. And, of course, the weights count.

But, in the real-world, the M&M Propositions do not hold....corporations and individuals do have taxes, and do have transactions costs for debt and equity...buying bonds and stocks, for example.

So, as we have learned, the Beta coefficient for equity does increase as the amount of debt level increases (due to increasing risks of default of interest payments or repayment of the bonds at maturity)...and the costs of debt increase, but as we weight those, the WACC actually varies, based on the real-world that includes taxes....we normally see the WACC being a U-shaped curved that varies as a function of the debt to equity ratio.

That is the background for this Written Assignment. Dr. Steadman

) Discuss the MM Proposition I and MM Proposition II (definition, assumptions, results and implications)? Remember, at the MBA level, more is better. But, to the point, and no "hot air."