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Chapter 17 -- Capital Structure and Value. Overview: Perfect markets and capital structure irrelevance Influence on capital structure Information problems and capital structure Other considerations Empirical evidence on capital structure and value. Perfect markets -- Modigliani and Miller.
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Chapter 17 -- Capital Structure and Value • Overview: • Perfect markets and capital structure irrelevance • Influence on capital structure • Information problems and capital structure • Other considerations • Empirical evidence on capital structure and value
Perfect markets -- Modigliani and Miller • No taxes, no bankruptcy, same information sets, no transaction cost • Capital structure does not matter • Shareholders will adjust the company’s structure to whatever they want
Taxes and Capital Structure • Differential tax rates • Personal ordinary income rate • What shareholders pay if they receive a dividend • Corporate ordinary income rate • What the corporation shares with the government • Personal capital gains rate • What you pay on the gain if you sell your stock
Taxes and Capital Structure • Differential tax rates within the corporation • May have other tax shields such as depreciation • May not have the income to pay taxes
Bankruptcy or Liquidation cost and Capital Structure • Legal cost • Disruption cost • Expected bankruptcy cost and capital structure
Information Problems: Agency Cost • Agency cost of debt • Cost borne by your debt-holders to monitor your actions or prospective actions • very low when debt is low but goes up as debt in increased
Information Problems: Agency Costs • Agency cost of equity • Cost borne by shareholders to monitor your actions • High with no debt but decreases as debt increases • These cost decrease because • others (debt-holders) are monitoring, often with better information (monthly statements) • Cost of a loss is less with others participating
Information Problems: Agency Costs • Look for the mixture of debt and equity that minimizes total agency costs
Information Problems: Signaling • Management may have a better information set than the shareholders • Actions speak louder than words • The assumption of debt signals management’s confidence in future cash flows • Issuing debt to buy back equity is a very positive signal
Other Considerations and Capital Structure Choice • Unequal cost of corporate borrowing and personal borrowing • This favors corporate borrowing over personal borrowing
Other Considerations and Capital Structure Choice • Additional liability of homemade leverage • Favors corporate over personal borrowing • You can only lose the value of your stock investment • With homemade leverage you can lose your personal assets • Restrictions on homemade leverage
Empirical Evidence on Capital Structure and Value • As theories predict, taxes, bankruptcy costs, and agency costs all have roles in determining capital structure • Science is not so complete that we can predict or prescribe the exact optimal capital structure