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Maximizing
interest:
Debt
Equity
Firms
Value
Capital gains
Dividends
Net
gain
stockholders
or
loss
to
Here three situations showing that firms value have a positive relation
with shareholders interest.
So we can say, changes in capital structure benefits the stockholders
if and only the value of the firm increase. Conversely, these changes
hurt the stockholders if and only if the value of the firm decreases.
Managers should choose capital structure that has the highest firm
value because this capital structure will be most beneficial to the
firms stockholders.
2. Financial leverage and the firm value:
In this section, we want to determine that optimal capital structure.
Financial leverage can be defined as the degree to which a company
uses fixed-income securities, such as debt and preferred equity. With a
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Asset
Debt
Equity
Interest rate
Share price
Share outstanding
capital
Current
$8000
$0
$8000
10%
$20
400
structures
are
Proposed
$8000
$4000
$4000
10%
$20
200
ROA
Earnings
ROE
EPS
Expected
15%
$1200
15%
$3.00
Expansion
25%
$2000
25%
$5.00
after
Recession
5%
$400
-400
$0
Expected
15%
$1200
-400
$800
Expansion
25%
$2000
-400
$1600
0
$0
20%
$4.00
40%
$8.00
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In the above figure, the solid line represents the case of no leverage. The
line begins at the origin, indicating that EPS would be zero if EBI was zero.
The EPS rises in tandem with a rise in EBI.
The dotted line represents the case of $4000 of debt. Here EPS is negative
if EBI is Zero. This follows because $400 of interest must be paid regardless
of the firms profits.
Here the slope of the dotted line is higher than the slope of the solid line.
This occurs because the levered firm has fewer shares of stock outstanding
than the unlevered firm. Therefore any increase in EBI leads to a greater
rise in EPS for the levered firm because the earnings increase is distributed
over fewer shares of stock.
3. Modigliani and Miller (MM): Proposition II:
This implies that the expected rate of return on equity is positively related
to the firms debt-equity ratio. This makes intuitive sense because the risk of
equity rises with leverage. MM proposition II (no taxes) is expressed by the
following equation:
Rs=R0 +
B
S (R0-RB)
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Fig. MM
corporate
proposition
II
with no
taxes
B
RS+ VL
RB (1-tc)
Where, VL=(S+B)
tc is the corporate tax
In the no taxes case, RWACC is not affected by leverage. However, because
debt is tax advantage relative to equity, it can be shown that RWACC declines
with leverage in a world with corporate taxes.
Summary of Modigliani Miller propositions with corporate taxes:
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B
S (R0-RB) (1-tc)
Here value is positively related to leverage. This result implies that firms
should have a capital structure almost entirely composed of debt. Because
real-world firms select more moderate levels of debt.
Chapter 17
Capital Structure
Limits to the Use of Debt
1. Cost of Financial distress
Cost of financial distress indicates when a firm has debt of capital structure
it has an obligation of Principle and Interest payments, if this obligation are
not met then the firm may face financial distress which may lead to
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Bankruptcy. The more debt a company takes on, the more it risks being
unable to meet its financial obligations to creditors. A highly leveraged firm
is more vulnerable to a decrease in profitability. Therefore, a highly levered
firm has a higher risk of bankruptcy. Bankruptcy costs vary for different
types of firms, but they typically include legal fees and, losses incurred from
selling assets at distressed fire-sale prices, and the departure of valuable
human capital. The way to measure bankruptcy cost is to multiply the
probability of bankruptcy by the expected cost of bankruptcy. A company
should consider the expected cost of bankruptcy when deciding how much
debt to take on.
a. Direct Cost of Financial distress: This is the legal and Administrative cost of Liquidation or Reorganization.
There are also several indirect costs associated with financial distress.
When a company is experiencing financial distress, conservative managers
may cut down on research and development, marketing research, and other
investments to spare cash. The firm may also incur opportunity costs if
trepid managers pass on risky corporate projects. Also, financial distress
can affect a firms reputation. A company in financial distress may lose
customers, be forced to pay a higher cost of capital, receive less
favorable trade credit terms from suppliers, and be vulnerable to tactics
from aggressive industry competitors.
b. Indirect cost of Financial distress
Impaired ability to conduct business.
Any fees or penalties that result from a bankruptcy or liquidation.
An obvious example is thefee one must pay to a bankruptcy attorney. Howev
er, other fees, perhaps broker
fees
resulting from the liquidation of stock, may also be attached. Indirect cost
of financial distress may be the culprit because some of the customers were
demanding cash payment others are halted or canceled shipments.
Agency cost:
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There is an agency cost that exists in every business that has owners or
shareholders and managers who are not necessarily owners. Agency cost
means that shareholders and business managers may not necessarily agree
on the actions that are best for the business firm and that there is an
inherent cost to that disagreement. That leads to what is called the agency
problem. The principal-agent cost problem is complex and usually requires
more than monetary incentives to solve.
(i)
Probability
10%
90%
Payoff
$1,000
$0
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Protective Covenants:
A part of an indenture or loan agreement that limits certain actions
a company may
take
during
the term of
the loan to
protect
the lender's interests. Component of loan agreement or indenture that
imposes restrictions on company actions to protect the lenders. These
restrictions may be in force during the term of the loan. Protective
covenants can be classified into two types:
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(i)
Negative covenant
(ii)
Positive covenant
Negative covenant:
Positive covenant:
3) Signaling:
Financing decision by managers that provide signaling effect to investors
that suggest increase the value of firm. For example; debt signaling,
concerning exchange offers. Firms often change their debt levels through
exchange offers, of which there are two types.
The first type of offer allows stockholders to exchange some of their stock
for debt, thereby increasing leverage.
The second type allows bondholders to exchange some of their debt for
stock, decreasing leverage.
The pecking order theory suggests that there is an order of preference for
the firm of capital sources when funding is needed.
The firm will seek to satisfy funding needs in the following order:
Internal funds
External funds
Debt
Equity
(b) Implications:
The pecking-order Theory is at odds with the trade-off theory:
There is no target D/E ratio.
Profitable firms use less debt.
Companies like financial flexibility
Reference:
1) Corporate Finance Book-By Stephen A. Ross, Randolph W. Westerfield
& Jeffrey Jaffe.
2) www.google.com/images.
3) Website.
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