Capital Structure PDF

Capital Structure 2. THE CAPITAL STRUCTURE DECISION A capital structure is the mix of debt and equity which MM Proposition II without Taxes: Higher Financial...

Capital Structure 2. THE CAPITAL STRUCTURE DECISION A capital structure is the mix of debt and equity which MM Proposition II without Taxes: Higher Financial 2.2 the company uses to finance its business. Leverage Raises the Cost of Equity Goal of Capital Structure Decision: Goal of capital “The cost of equity is a linear function of the structure decision is to determine that capital structure company’s debt/equity ratio”. which maximizes the value of the company and minimizes the WACC (cost of capital). Which implies as the company increases its use of debt financing, the cost of equity rises linearly but WACC  
  
    1     and cost of debt remain constant/unchanged.   where, Assumptions: rWACC represents the overall Marginal cost of capital of the company i.e. the costs of raising Additional No financial distress costs. capital. Debt-holders have prior claim to assets and income relative to equity-holders therefore, Cost of rd= before-tax Marginal cost of debt Debt < cost of Equity.* re= marginal cost of equity t = marginal tax rate * However, as debt increases, the risk to equity-holders  = market value of debt divided by value of increases which in turn increases the cost of equity.  company  Risk of equity: = market value of equity divided by value of  company It depends on two factors Total value of Company = V = D + E Business risk (risk of Business Risk determines the company’s cost of capital Modigliani and Miller (MM) Proposition I without operations) 2.1 Taxes: Capital Structure Irrelevance Financial risk Capital structure determines “The market value of a company is not affected by (degree of financial the Financial Risk the capital structure of the company” leverage) Value of a company levered (VL) = Value unlevered (V WACC without taxes is: U)   Which implies, -        WACC for a company is unaffected by its capital where, structure in the no-tax case. rWACC= weighted average cost of capital of the The value of a company is determined solely by its company cash flows, not by its capital structure. rd= before-tax Marginal cost of debt= after-tax marginal cost of debt with no tax assumption Without taxes: re= marginal cost of equity VL = VU t = marginal tax rate  = market value of debt divided by value of company      !" #$%"  VU  VL  EBIT  = market value of equity divided by value of   
 company Assumptions: Cost of equity is a linear function of the debt/equity This proposition is based on certain assumptions: ratio i.e. 1. All investors have homogeneous expectations.  ./0.1 234506  -  -  - -  2. There are no transaction costs, no taxes, no  bankruptcy costs and everyone has the same information.(Perfect capital markets) Intercept Slope coefficient 3. Investors can borrow and lend at the risk-free rate. 4. There are no agency costs. NOTE: 5. The company’s operating income is not affected by (r0- r d) is positive because cost of equity must be an the changes in the capital structure of a company. increasing function of the debt/equity ratio so that WACC remains constant when debt ratio is changed. 9:;;?@;:< B: D;E 782 AB