27. Capital Structure Theories and WACC

• According to the pecking order theory, firms prefer internal financing because it sends the least negative signals to investors.

Static Trade-Off Theory

• It seeks to balance the costs of financial distress with the tax shield benefits from using debt.
• There is an optimal capital structure with an optimal proportion of debt that maximizes the firm's value.

Weighted Average Cost of Capital (WACC) Calculation

• A firm is planning a $25 million expansion project, financed with $10 million in debt and $15 million in equity.
• The before-tax required return on debt is 10%, and for equity, it is 15%.
• Assuming a 35% tax rate, the WACC is 11.6%.
• Weight of equity calculation: $15 million / ($10 million + $15 million) = 60%.
• Weight of debt calculation: $10 million / ($10 million + $15 million) = 40%.
• WACC formula: 0.60(KCE) + 0.40(after-tax kD).
• WACC calculation: 0.60(0.15) + 0.40(0.10)(1 – 0.35) = 0.09 + 0.026 = 0.116 or 11.6%.

Bonding Costs

• Bonding costs relate to implicit and explicit costs intended to make it less desirable for managers to leave the company.
• These costs include noncompete agreements and insurance premiums to guarantee performance.
• Bonding costs, along with monitoring costs and residual losses, are components of the net agency cost of equity.
• Net agency cost of equity relates to the net costs of minimizing the inherent conflict of interest between managers and shareholders.

Monitoring Costs

• These relate to costs incurred by shareholders to monitor and supervise management, including shareholder reporting expenses and board of directors compensation.

Pecking Order Theory

• It relates to managers' preference for selecting financing options, like internally generated financing, that would be viewed the least negatively by shareholders.

Modigliani and Miller's Proposition I

• Under certain assumptions, including the absence of taxes and bankruptcy costs, the value of a firm is unaffected by its capital structure.

Optimal Capital Structure

• The optimal capital structure of a firm occurs at a point where the value of a levered firm is at its peak.
• The optimal capital structure is also the point where the difference between the value of a levered firm and the value of an unlevered firm is at its maximum.

Modigliani and Miller's Capital Structure Model with Taxes

• The conclusion is that firms should be financed with all debt.
• There is that tax savings of debt financing are maximized at 100% debt.

Static Tradeoff Theory of Capital Structures

• The cost of equity is upward sloping because as leverage increases, the cost of equity increases.
• WACC initially decreases with additional debt financing but then rises when the increase in the expected value of financial distress outweighs the tax benefits of additional debt.

WACC calculation using the following data

• Debt outstanding, market value $10 million

• Common stock outstanding, market value $30 million

• Marginal tax rate 40%

• Cost of common equity 12%

• Cost of debt 8%

• Assuming Samson's ratios reflect the firm's target capital structure, Samson's weighted average cost of capital is 10.2%. -Debt to total capital = $10 / ($10 + $30) = 25% -Equity to total capital = $30 / ($10 + $30) = 75% -WACC = wdkd(1 - t) + wcekce -WACC = 0.25(0.08)(0.60) + 0.75(0.12) = 0.102 = 10.2%.

• An analyst should be most concerned when a firm's debt weight increased relative to target following the issuance of new debt.

MM's Assumptions are Maintained

• Removing the no tax assumption means that the value of the firm is maximized when the value of the tax shield is maximized.
• The capital structure of 100% debt.

Modigliani and Miller's Proposition II with Taxes

• The value of the firm is maximized at the point where the WACC is minimized, which is 100% debt under the MM assumptions.