Chapter 12 Capital Structure

1. Chapter 12Capital Structure • Quick Review of Capital Markets • Benefits of Borrowing • Pecking Order Hypothesis • Modigliani and Miller Optimal Capital Structure Theory

2. Quick review of Capital Markets • Capital Markets • Borrow from more than one year • Various types of markets • Bond • Equity • Investors return is borrower’s cost • Not all borrowers get the same rate • Function of risk to investor • See Example 12.1, Lucky Larry at 11.11% and Sometimes Lucky Sherry at 42.86%

3. Benefits of Borrowing • Using other people’s money • Financial leverage • Cost of debt is less than the anticipated return of the investment • Financial leverage benefit measured via EPS • Owners of the firm can be better off with debt financing • Example 12.2 – Jordan Enterprises • Adding debt improves EPS if earnings exceed $960,000 • Adding debt hurts EPS if earnings less than $960,000 • Jordan Enterprises will add debt if it believes earnings will be greater than $960,000

4. Pecking Order Hypothesis (POH) • Preferred borrowing pattern • Borrow from cheapest source first • Asymmetric information • Firms know more than lenders • Information is costly to obtain • Information may be proprietary • Borrowing pattern from POH • Internal first • Avoid swings in dividend payments • External financing – cheapest first (debt) and equity as last resort

5. Pecking Order Hypothesis (POH) • Example 12.3 – Abbot and Costello borrowing choices • Outsiders believe managers only issue equity when stock over priced • Outsiders therefore lower price they will pay for equity • Managers thus choose to issue debt if possible • More profitable companies • Borrow less from external sources • Therefore have lower debt-equity ratios

6. Modigliani and Miller Optimal Capital Structure Theory • Starts with a world of no taxes • Two Propositions • Proposition I – It is irrelevant what borrowing pattern a firm chooses…the value of the firm remains the same • Proposition II – cost of equity is a function of three things • Require return on assets • Cost of debt • Debt-Equity ratio • In world of no taxes, WACC is constant and the firm is insensitive to the funding choice

7. Modigliani and Miller Optimal Capital Structure Theory • Modified to a world of corporate taxes • Proposition I – all debt financing is optimal • Proposition II – the WACC of the firm falls as more debt is added • What is happening in this world? • Government is losing out to equity holders • Tax shield due to interest payments reduces government’s direct share of profits and captured by equity holders • VL = VE + D x TC

8. Modigliani and Miller Optimal Capital Structure Theory • One more modification – World of corporate taxes and bankruptcy • Bankruptcy is costly • When debt payments cannot be made equity holders lose company to debt holders • Must avoid bankruptcy • Optimal debt-equity ratio arises • At point where marginal benefits of debt financing equal marginal costs of bankruptcy • At this point WACC is lowest and value of firm highest

9. Problems • Problem 3 – Benefits of Borrowing • Problem 7 – Pecking Order Hypothesis • Problem 9 – Finding WACC • Problem 11 – M&M in World of No Taxes