Chapter 17 Capital structure Determination 17-1
17-1 Chapter 17 Capital Structure Determination
Capital Structure Determination A Conceptual Look The Total-value Principle Presence of Market Imperfections and Incentive Issues The effect of taxes Taxes and Market Imperfections Combined Financial Signaling 17-2
17-2 Capital Structure Determination A Conceptual Look The Total-Value Principle Presence of Market Imperfections and Incentive Issues The Effect of Taxes Taxes and Market Imperfections Combined Financial Signaling
Capital Structure Capital Structure The mix (or proportion) of a firm's permanent long-term financing represented by debt, preferred stock, and common stock equity. Concerned with the effect of capital market decisions on security prices Assume:(1)investment and asset management decisions are held constant and (2)consider only debt-versus-equity financing 17-3
17-3 Capital Structure Concerned with the effect of capital market decisions on security prices. Assume: (1) investment and asset management decisions are held constant and (2) consider only debt-versus-equity financing. Capital Structure -- The mix (or proportion) of a firm’s permanent long-term financing represented by debt, preferred stock, and common stock equity
A Conceptual Look Relevant Rates of return ki= the yield on the company's debt Annual interest on debt B Market value of debt Assumptions Interest paid each and every year · Bond life is infinite Results in the valuation of a perpetual bond No taxes(Note: allows us to focus on just capital structure issues. 17-4
17-4 A Conceptual Look -- Relevant Rates of Return ki = the yield on the company’s debt Annual interest on debt Market value of debt I B ki = = Assumptions: • Interest paid each and every year • Bond life is infinite • Results in the valuation of a perpetual bond • No taxes (Note: allows us to focus on just capital structure issues.)
A Conceptual Look Relevant Rates of return Ke= the expected return on the company's equity Earnings available to common shareholders = e s Market value of common stock outstanding Assumptions: Earnings are not expected to grow 100%dividend payout Results in the valuation of a perpetuity Appropriate in this case for illustrating the theory of the firm 17-5
17-5 E S A Conceptual Look -- Relevant Rates of Return = = ke = the expected return on the company’s equity Earnings available to common shareholders Market value of common stock outstanding ke Assumptions: • Earnings are not expected to grow • 100% dividend payout • Results in the valuation of a perpetuity • Appropriate in this case for illustrating the theory of the firm
A Conceptual Look Relevant Rates of return Ko E an overall capitalization rate for the firm Net operating income Total market value of the firm Assumptions: VEB+S=total market value of the firm o=1+E=net operating income interest paid plus earnings available to common shareholders 17-6
17-6 O V A Conceptual Look -- Relevant Rates of Return = = ko = an overall capitalization rate for the firm Net operating income Total market value of the firm ko Assumptions: • V = B + S = total market value of the firm • O = I + E = net operating income = interest paid plus earnings available to common shareholders
Capitalization Rate Capitalization rate, Ko, -- the discount rate used to determine the present value of a stream of expected cash flows B B+ s e B+S What happens to Ki, Ke, and k when leverage, B/s, increases? 17-7
17-7 Capitalization Rate Capitalization rate, ko , -- the discount rate used to determine the present value of a stream of expected cash flows. ko ki ke B B + S S B + S = + What happens to ki , ke , and ko when leverage, B/S, increases?
Net Operating Income Approach Net Operating Income Approach -a theory of capital structure in which the weighted average cost of capital and the total value of the firm remain constant as financial leverage is changed Assume: Net operating income equals $1, 350 Market value of debt is $1, 800 at 10% interest Overall capitalization rate is 15% 17-8
17-8 Net Operating Income Approach Assume: Net operating income equals $1,350 Market value of debt is $1,800 at 10% interest Overall capitalization rate is 15% Net Operating Income Approach -- A theory of capital structure in which the weighted average cost of capital and the total value of the firm remain constant as financial leverage is changed
Required Rate of Return on Equity Calculating the required rate of return on equity Total firm value=o/k =$1,350 /.15 =$9,000 Market value =V-B $93000-$1,800 of equity =$7,200 Interest payments =$1,800*10% Required return =E/S on equity =(51,350-$180)/$7200 =16.25% 17-9 *B/S=$1,800/$7,200=25
17-9 Required Rate of Return on Equity Total firm value= O / ko = $1,350 / .15 = $9,000 Market value = V - B = $9,000 - $1,800 of equity = $7,200 Required return = E / S on equity* = ($1,350 - $180) / $7,200 = 16.25% Calculating the required rate of return on equity * B / S = $1,800 / $7,200 = .25 Interest payments = $1,800 * 10%
Required Rate of Return on Equity What is the rate of return on equity if B=$3,000? Total firm value=o/k =$1,350 /.15 =$9,000 Market value =V-B $93000-$3,000 of equity =$6,000 Interest payments =$3,000*10% Required return =E/S on equity =(51,350-$300)/$6,000 =17.50% 17-10 *B/S=$3,000/$6,000=50
17-10 Total firm value= O / ko = $1,350 / .15 = $9,000 Market value = V - B = $9,000 - $3,000 of equity = $6,000 Required return = E / S on equity* = ($1,350 - $300) / $6,000 = 17.50% Required Rate of Return on Equity What is the rate of return on equity if B=$3,000? * B / S = $3,000 / $6,000 = .50 Interest payments = $3,000 * 10%
