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Capital Structure

Capital Structure. Alternative Financial Instruments Patterns of Financing Capital-Structure Theory Modigliani and Miller: No Taxes and With Taxes Limits to the Use of Debt. Common Stock (see page 384). Par Value Capital Surplus Retained Earnings

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Capital Structure

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  1. Capital Structure Alternative Financial Instruments Patterns of Financing Capital-Structure Theory Modigliani and Miller: No Taxes and With Taxes Limits to the Use of Debt Chapter 14, 15 and 16 – MBA504

  2. Common Stock (see page 384) • Par Value • Capital Surplus • Retained Earnings • Market Value, Book Value, and Replacement Value • Shareholders’ Rights • Dividends • Classes of Stocks Chapter 14, 15 and 16 – MBA504

  3. Par Value and Capital Surplus • The stated value on a stock certificate is called the par value. Some stocks have no par value. The total par value (the number of shares multiplied by the par value of each share) is sometimes called the dedicated capital of the corporation. • Usually refers to amounts of directly contributed equity capital in excess of the par value. • For example, suppose 1,000 shares of common stock having a par value of $1 each are sold to investors for $8 per share. The capital surplus would be ______. Chapter 14, 15 and 16 – MBA504

  4. Retained Earnings • The earnings that are not paid out as dividends are referred to as retained earnings. Chapter 14, 15 and 16 – MBA504

  5. Market Value, Book Value, and Replacement Value • Market Value is the price of the stock multiplied by the number of shares outstanding. • Also known as Market Capitalization • Book Value • The sum of par value, capital surplus, and accumulated retained earnings is the common equity of the firm, usually referred to as the book value of the firm. • Replacement Value • The current cost of replacing the assets of the firm. • At the time a firm purchases an asset, market value, book value, and replacement value are equal. Chapter 14, 15 and 16 – MBA504

  6. Shareholders’ Rights • The right to elect the directors of the corporation by vote constitutes the most important control device of shareholders. • Directors are elected each year at an annual meeting by a vote of the holders of a majority of shares who are present and entitled to vote. • The exact mechanism varies across companies. • The important difference is whether shares are to be voted cumulatively or voted straight. Chapter 14, 15 and 16 – MBA504

  7. Proxy Voting • A proxy is the legal grant of authority by a shareholder to someone else to vote his or her shares. • For convenience, the actual voting in large public corporations is usually done by proxy. • Proxy fight: if shareholders are not satisfied with management, an outside group of shareholders can try to obtain as many votes as possible via proxy. They can vote to replace management by adding enough directors. Chapter 14, 15 and 16 – MBA504

  8. Dividends • Unless a dividend is declared by the board of directors of a corporation, it is not a liability of the corporation. • A corporation cannot default on an undeclared dividend. • The payment of dividends by the corporation is not a business expense. • Therefore, they are not tax-deductible. • Dividends received by individual shareholders are for the most part considered ordinary income by the IRS and are fully taxable. • There is an intra-corporate dividend exclusion: exclude 70% of dividends if they are corporate shareholders. Chapter 14, 15 and 16 – MBA504

  9. Classes of Stock • When more than one class of stock exists, they are usually created with unequal voting rights. • Many companies issue dual classes of common stock. The reason has to do with control of the firm. • the market prices of stocks with superior voting rights to be about 5 percent higher than the prices of otherwise-identical stocks with inferior voting rights. Chapter 14, 15 and 16 – MBA504

  10. Corporate Long-Term Debt • Interest versus Dividends • Hybrid Securities • Features of Long-Term Debt Chapter 14, 15 and 16 – MBA504

  11. Interest versus Dividends • Debt is not an ownership interest in the firm. Creditors do not usually have voting power. • The corporation’s payment of interest on debt is considered a cost of doing business and is fully tax-deductible. • Dividends are paid out of after-tax dollars. • Unpaid debt is a liability of the firm. If it is not paid, the creditors can legally claim the assets of the firm. Chapter 14, 15 and 16 – MBA504

  12. Basic Features of Long-Term Debt • The bond indenture usually lists • Amount of Issue, Date of Issue, Maturity • Denomination (Par value) • Annual Coupon, Dates of Coupon Payments • Security • Sinking Funds • Call Provisions • Covenants • Features that may change over time • Rating • Yield-to-Maturity • Market price Chapter 14, 15 and 16 – MBA504

  13. Different Types of Debt • A debenture is an unsecured corporate debt, whereas a bond is secured by a mortgage on the corporate property. • A note usually refers to an unsecured debt with a maturity shorter than that of a debenture, perhaps under 10 years. Chapter 14, 15 and 16 – MBA504

  14. Repayment • Long-term debt is typically repaid in regular amounts over the life of the debt. The payment of long-term debt by installments is called amortization. • Amortization is usually arranged by a sinking fund. Each year the corporation places money into a sinking fund, and the money is used to buy back the bonds. Chapter 14, 15 and 16 – MBA504

  15. Seniority • Seniority indicates preference in position over other lenders. • Some debt is subordinated. In the event of default, holders of subordinated debt must give preference other specified creditors who are paid first. Chapter 14, 15 and 16 – MBA504

  16. Security • Security is a form of attachment to property. • It provides that the property can be sold in event of default to satisfy the debt for which the security is given. • A mortgage is used for security in tangible property. • Debentures are not secured by a mortgage. Chapter 14, 15 and 16 – MBA504

  17. Indenture • The written agreement between the corporate debt issuer and the lender. • Sets forth the terms of the loan: • Maturity • Interest rate • Protective covenants. Chapter 14, 15 and 16 – MBA504

  18. Preferred Stock • Represents equity of a corporation, but is different from common stock because it has preference over common in the payments of dividends and in the assets of the corporation in the event of bankruptcy. • Preferred shares have a stated liquidating value, usually $100 per share. • Preferred dividends are either cumulative or noncumulative. Chapter 14, 15 and 16 – MBA504

  19. Uses of Cash Flow (100%) Sources of Cash Flow (100%) Capital spending 98% Internal cash flow (retained earnings plus depreciation) 97% Internal cash flow Financial deficit Net working capital plus other uses 2% Long-term debt and equity 3% External cash flow Chapter 14, 15 and 16 – MBA504

  20. S S B B Definition of Capital Structure • The value of a firm is defined to be the sum of the value of the firm’s debt and the firm’s equity. • V =B + S S S B B Value of the Firm Chapter 14, 15 and 16 – MBA504

  21. Financial Leverage, EPS, and ROE Consider an all-equity firm that is considering going into debt. (Maybe some of the original shareholders want to cash out.) Current Assets $20,000 Debt $0 Equity $20,000 Debt/Equity ratio 0.00 Interest rate n/a Shares outstanding 400 Share price $50 Proposed $20,000 $8,000 $12,000 2/3 8% ? $50 Chapter 14, 15 and 16 – MBA504

  22. EPS and ROE Under Current Capital Structure Recession Expected Expansion EBIT $1,000 $2,000 $3,000 Interest 0 0 0 Net income $1,000 $2,000 $3,000 EPS ROA ROE Current Shares Outstanding = 400 shares Chapter 14, 15 and 16 – MBA504

  23. EPS and ROE Under Proposed Capital Structure Recession Expected Expansion EBIT $1,000 $2,000 $3,000 Interest 640 640 640 Net income $360 $1,360 $2,360 EPS ROA ROE Proposed Shares Outstanding = 240 shares Chapter 14, 15 and 16 – MBA504

  24. Financial Leverage and EPS 12.00 Debt 10.00 8.00 No Debt Advantage to debt 6.00 Break-even point EPS 4.00 Disadvantage to debt 2.00 EBI 0.00 1,000 2,000 3,000 (2.00) Chapter 14, 15 and 16 – MBA504

  25. Assumptions of the Modigliani-Miller Model • Homogeneous Expectations • Homogeneous Business Risk Classes • Perpetual Cash Flows • Perfect Capital Markets: • Perfect competition • Firms and investors can borrow/lend at the same rate • Equal access to all relevant information • No transaction costs • No taxes Chapter 14, 15 and 16 – MBA504

  26. MM Propositions I & II (No Taxes) • Proposition I • Firm value is not affected by leverage VL = VU • Proposition II • Leverage increases the risk and return to stockholders rs = r0 + (B / SL) (r0 - rB) rB is the interest rate (cost of debt) rs is the return on (levered) equity (cost of equity) r0 is the return on unlevered equity (cost of capital) B is the value of debt SL is the value of levered equity Chapter 14, 15 and 16 – MBA504

  27. The Cost of Equity, the Cost of Debt, and the Weighted Average Cost of Capital: MM Proposition II with No Corporate Taxes Cost of capital: r (%) r0 rB rB Debt-to-equity Ratio Chapter 14, 15 and 16 – MBA504

  28. MM Propositions I & II (with Corporate Taxes) • Proposition I (with Corporate Taxes) • Firm value increases with leverage VL = VU + TC B • Proposition II (with Corporate Taxes) • Some of the increase in equity risk and return is offset by interest tax shield rS = r0 + (B/S)×(1-TC)×(r0 - rB) rB is the interest rate (cost of debt) rS is the return on equity (cost of equity) r0 is the return on unlevered equity (cost of capital) B is the value of debt S is the value of levered equity Chapter 14, 15 and 16 – MBA504

  29. The Effect of Financial Leverage on the Cost of Debt and Equity Capital with Corporate Taxes Cost of capital: r(%) r0 rB Debt-to-equityratio (B/S) Chapter 14, 15 and 16 – MBA504

  30. Total Cash Flow to Investors Under Each Capital Structure with Corp. Taxes All-EquityRecession Expected Expansion EBIT $1,000 $2,000 $3,000 Interest 0 0 0 EBT $1,000 $2,000 $3,000 Taxes (Tc = 35% $350 $700 $1,050 Total Cash Flow to S/H $650 $1,300 $1,950 LeveredRecession Expected Expansion EBIT $1,000 $2,000 $3,000 Interest ($800 @ 8% ) 640 640 640 EBT $360 $1,360 $2,360 Taxes (Tc = 35%) $126 $476 $826 Total Cash Flow $234+640 $468+$640 $1,534+$640 (to both S/H & B/H): $874 $1,524 $2,174 EBIT(1-Tc)+TCrBB $650+$224 $1,300+$224 $1,950+$224 $874 $1,524 $2,174 Chapter 14, 15 and 16 – MBA504

  31. Total Cash Flow to Investors Under Each Capital Structure with Corp. Taxes All-equity firm Levered firm S G S G B The sum of the debt plus the equity of the levered firm is greater than the equity of the unlevered firm. This is how cutting the pie differently can make the pie larger: the government takes a smaller slice of the pie! Chapter 14, 15 and 16 – MBA504

  32. Limits to the Use of Debt (chapter 16) • Financial Distress Costs • Agency costs -- excessive leverage is costly to shareholders. Chapter 14, 15 and 16 – MBA504

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