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1、Chapter 16:Financial Structure of the FirmObjectiveTo understand how a firm cancreate value through itscapital structure decisions1Copyright 2009 Pearson Education, Inc. Publishing as Prentice HallChapter 16 Contents16.1 Internal Verses External Financing16.2 Equity Financing16.3 Debt Financing16.4
2、The Irrelevance of Capital Structure in a Frictionless Environment16.5 Creating Value Through Financing Decisions16.6 Reducing Costs16.7 Dealing with Conflicts of Interest16.8 Creating New Opportunities for Stakeholders16.9 Financing Decisions in Practice16.10 How to Evaluate Levered Investments2Cop
3、yright 2009 Pearson Education, Inc. Publishing as Prentice HallIntroduction The basic unit of analysis of this chapter is The basic unit of analysis of this chapter is the firm as a wholethe firm as a whole We examine how a corporations We examine how a corporations management should make decisions
4、management should make decisions regarding the mix of debt and equityregarding the mix of debt and equity We start with Modigliani and Millers model We start with Modigliani and Millers model of a firm in a frictionless environment with of a firm in a frictionless environment with no tax and cost-fr
5、ee contract compliance, no tax and cost-free contract compliance, and later re-introduce frictionsand later re-introduce frictions3Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall16.1 Internal Verses External FinancingInternal financing sources of funds that arise from the sources
6、of funds that arise from the operation of the firm, and includes retained operation of the firm, and includes retained earnings, increases in accrued wages and earnings, increases in accrued wages and accounts payableaccounts payable External fundingExternal funding sources of funds from outside len
7、ders and sources of funds from outside lenders and investors, and includes the proceeds of bond investors, and includes the proceeds of bond and equity issuesand equity issues4Copyright 2009 Pearson Education, Inc. Publishing as Prentice HallInternal Verses External FinancingDecision Process Financi
8、ng decisions for an established firm Financing decisions for an established firm (not undertaking a major expansion) are (not undertaking a major expansion) are routine and almost automatic, and may routine and almost automatic, and may consist of a dividend policy, and maintaining consist of a divi
9、dend policy, and maintaining a banks line of credita banks line of credit Tapping outside resources is time-consuming Tapping outside resources is time-consuming for management because of the need to for management because of the need to satisfy statutory and skeptical investor satisfy statutory and
10、 skeptical investor demands, but it does expose the companys demands, but it does expose the companys plans to market disciplineplans to market discipline5Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall16.2 Equity FinancingThere are three kinds of equity claims on a company: Commo
11、n stock/sharesCommon stock/shares Corporate Stock options/WarrantsCorporate Stock options/Warrants Preferred stockPreferred stock6Copyright 2009 Pearson Education, Inc. Publishing as Prentice HallCommon stock/sharesThe residual claims to the corporations assetsMay be divided into Voting stockVoting
12、stock Non-voting stockNon-voting stock Restricted or Founders stockRestricted or Founders stock7Copyright 2009 Pearson Education, Inc. Publishing as Prentice HallCorporate Stock options/ WarrantsOptions issued by the firm Used to attract and compensate key Used to attract and compensate key employee
13、s and management in corporate employees and management in corporate startups startups Used to sweeten the bonds of risky Used to sweeten the bonds of risky venturesventures8Copyright 2009 Pearson Education, Inc. Publishing as Prentice HallPreferred stockA bond-like security that normally cannot trig
14、ger a default for non-payment of dividend Unlike bonds, it has a dividend that is not an expense for tax purposes9Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall16.3 Debt FinancingCorporate Debt is a contractual obligation of the part of the organization to make future payments in
15、 return for resources provided to it. It includes:loans and debt securities, such as bonds and mortgages promises to make future payment, such as promises to make future payment, such as accounts payable, leases and mortgagesaccounts payable, leases and mortgages10Copyright 2009 Pearson Education, I
16、nc. Publishing as Prentice HallWe now describe secured debtsecured debt long-term leaseslong-term leases pension liabilitiespension liabilities11Copyright 2009 Pearson Education, Inc. Publishing as Prentice HallSecured DebtAn asset pledged as security for a debt is called collateral, and the debt is
17、 said to be secured12Copyright 2009 Pearson Education, Inc. Publishing as Prentice HallSecured Debt Should a company with secured debt Should a company with secured debt become insolvent, then the secured become insolvent, then the secured bondholders are paid from the proceeds of bondholders are pa
18、id from the proceeds of the sale of the collateralthe sale of the collateral Any money remaining from the sale of the Any money remaining from the sale of the collateral is added to the pool used to pay collateral is added to the pool used to pay other creditors: IRS, employee wages, other creditors
19、: IRS, employee wages, debenture holders, trade creditors, et cetera debenture holders, trade creditors, et cetera If the proceeds are inadequate, then the If the proceeds are inadequate, then the shortfall becomes a general liability, and is shortfall becomes a general liability, and is paid after
20、payment to the IRS, and wagespaid after payment to the IRS, and wages13Copyright 2009 Pearson Education, Inc. Publishing as Prentice HallLong-Term Leases Leasing an asset for a period of time that is Leasing an asset for a period of time that is long compared to the assets useful life is long compar
21、ed to the assets useful life is similar to buying the asset, and financing the similar to buying the asset, and financing the purchase with debt secured by the leased purchase with debt secured by the leased assetsassets The main difference is in who bears the risk The main difference is in who bear
22、s the risk associated with the residual market value at associated with the residual market value at the end of the term of the leasethe end of the term of the lease A secondary difference may occur if the lessor is A secondary difference may occur if the lessor is unable to fully utilize the deprec
23、iation tax shelterunable to fully utilize the depreciation tax shelter14Copyright 2009 Pearson Education, Inc. Publishing as Prentice HallPension Liabilities Pension funds are eitherPension funds are either defined contributiondefined contribution defined benefitdefined benefit Some pension plans ar
24、e Some pension plans are fundedfunded, and some , and some are are unfundedunfunded Some jurisdictions require that pension plans Some jurisdictions require that pension plans are funded, and/or are disclosed in financial are funded, and/or are disclosed in financial statements, others do notstateme
25、nts, others do not Pension fund liability is often substantialPension fund liability is often substantial resolving precisely what a companys pension resolving precisely what a companys pension fund liabilities are is often critical when fund liabilities are is often critical when determining capita
26、l structuredetermining capital structure15Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall16.4 The Irrelevance of Capital Structure in a Frictionless EnvironmentModigliani and Miller:In an economists idealized world of frictionless markets the total market value of all securities i
27、ssued the total market value of all securities issued by a firm by a firm is governed by the earning power and risk of is governed by the earning power and risk of its underlying real assets, its underlying real assets, and is and is independentindependent of the of the mixmix of securities of secur
28、ities issued to finance the firmissued to finance the firm16Copyright 2009 Pearson Education, Inc. Publishing as Prentice HallFrictionless Environment Assumptions no income taxesno income taxes no transaction costs of issuing debt/equitiesno transaction costs of issuing debt/equities investors and m
29、anagement have same investors and management have same informationinformation stakeholders are able to resolve conflicts stakeholders are able to resolve conflicts costlesslycostlessly17Copyright 2009 Pearson Education, Inc. Publishing as Prentice HallExampleNodett Dividends = Earnings = EBIT (no ta
30、x, no Dividends = Earnings = EBIT (no tax, no interest)interest) Common StockCommon Stock Market Value = $100 millionMarket Value = $100 million dividends = $10 million/yeardividends = $10 million/year18Copyright 2009 Pearson Education, Inc. Publishing as Prentice HallExampleSomdett (otherwise ident
31、ical to Nodett) dividends = Earnings = EBIT - Debt Servicedividends = Earnings = EBIT - Debt Service Perpetual bonds Perpetual bonds market value= $40 millionmarket value= $40 million coupon 3.2 million/year (risk-free, see later)coupon 3.2 million/year (risk-free, see later) Common StockCommon Stoc
32、k Market Value = $100 - $40 = $60 millionMarket Value = $100 - $40 = $60 million dividends = $10 - $3.2 = $6.8 million/yeardividends = $10 - $3.2 = $6.8 million/year19Copyright 2009 Pearson Education, Inc. Publishing as Prentice HallExample The probabilities of EBIT (shown later) are The probabiliti
33、es of EBIT (shown later) are such that the debt is risk-free, but the stock such that the debt is risk-free, but the stock has riskhas risk The contingent claims chapter showed that The contingent claims chapter showed that we could evaluate common stock by we could evaluate common stock by subtract
34、ing the (risk-free) bond value from subtracting the (risk-free) bond value from the value of the company as a wholethe value of the company as a whole M&M follows from contingent claims theory, M&M follows from contingent claims theory, which follows from the Law of One Pricewhich follows from the L
35、aw of One Price20Copyright 2009 Pearson Education, Inc. Publishing as Prentice HallExample Let us see what happens if EBIT is volatile, Let us see what happens if EBIT is volatile, with discrete values of $5, $10, and $15 with discrete values of $5, $10, and $15 million (each with probability = 33.3
36、3%)million (each with probability = 33.33%) The total dividends of Nodett will be $5, $10, The total dividends of Nodett will be $5, $10, and $15 millionand $15 million The total dividends of Somdett will be $1.8, The total dividends of Somdett will be $1.8, $6.8, and $11.8 million $6.8, and $11.8 m
37、illion (note that, given the facts, the interest will (note that, given the facts, the interest will always be paid: the bondholders are riskless)always be paid: the bondholders are riskless)21Copyright 2009 Pearson Education, Inc. Publishing as Prentice HallExample The expected dividends areThe exp
38、ected dividends are Nodett $10 millionNodett $10 million Somdett $6.8 million Somdett $6.8 million (the same values as in the case of no volatility, (the same values as in the case of no volatility, results from the distribution)results from the distribution) The standard deviation of The standard d
39、eviation of NodettsNodetts dividends dividends is (-5)2 +02+52)/3)0.5 = $4.082 is (-5)2 +02+52)/3)0.5 = $4.082 millionmillion The standard deviation of The standard deviation of SomdettsSomdetts dividends = $4.082 dividends = $4.082 22Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hal
40、lExample If we now assume that 1,000,000 shares of If we now assume that 1,000,000 shares of Nodett, and 600,000 shares of Somdett were Nodett, and 600,000 shares of Somdett were issued, (market value is then $100 each), issued, (market value is then $100 each), each shares return has the statistics
41、:each shares return has the statistics:23Copyright 2009 Pearson Education, Inc. Publishing as Prentice HallExampleNote that the two values fall on the line m = rf + = rf + s (firms return-bonds return)(firms return-bonds return)We would expect this CML-like behaviorAdditionally, if the un-leveraged
42、stock has a beta = b, then the beta of the leveraged stock is b/0.624Copyright 2009 Pearson Education, Inc. Publishing as Prentice HallExample ConclusionIf Nodett were to issue $40 million of debt, and repurchase 400,000 shares at $100 each, the value of the outstanding shares would remain unchanged
43、 at $(100,000,000 - 40,000,000)/(1,000,000 - 400,000) = $100 eachIf the debt was not, in fact, risk-free, then the analysis will become a little more complex, but the essential conclusions are unchanged25Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall16.5 Creating Value Through Fi
44、nancing DecisionsWe now take a step in the direction of greater realism We reintroduce taxWe reintroduce tax Bankruptcy costsBankruptcy costs Costly stakeholder conflictsCostly stakeholder conflicts Financial intermediary benefitsFinancial intermediary benefits26Copyright 2009 Pearson Education, Inc
45、. Publishing as Prentice Hall16.6 Reducing CostsBy its choice of capital structure, a firm can reduce its costs. Examples are taxes. Subsidies, and the cost of financial distress27Copyright 2009 Pearson Education, Inc. Publishing as Prentice HallTaxesIn addition to shareholders and creditors, the go
46、vernment tax authority is a claimant to the EBIT of a firmSome of the taxes are paid at the corporate level, and some at the level of the individual shareholders realized capital gainsrealized capital gains personal taxes on cash dividendspersonal taxes on cash dividends28Copyright 2009 Pearson Educ
47、ation, Inc. Publishing as Prentice HallExampleReconsider Nodett and Somdett, this time in a world where there is a 34% tax on earnings after interest, and no personal income taxes29Copyright 2009 Pearson Education, Inc. Publishing as Prentice HallClaimant Classes30Copyright 2009 Pearson Education, I
48、nc. Publishing as Prentice HallLeverage (Gearing) Equations31Copyright 2009 Pearson Education, Inc. Publishing as Prentice HallMaximization of Somdetts Cash FlowThe cash flows above are the combined flows to the shareholders & stockholders The greater the annual interest payment, the The greater the
49、 annual interest payment, the greater the combined cash flow, and the greater the combined cash flow, and the greater the value of the firm as a wholegreater the value of the firm as a wholeThe Market Value of Somdett = Market Value of Nodett + PV Interest Tax Shield32Copyright 2009 Pearson Educatio
50、n, Inc. Publishing as Prentice HallMaximization of Somdetts Cash FlowEarlier, we showed that the $40 million debt issue at 8% was risk-free, given the distribution of earningsThe market values of claims is then given in the next table:33Copyright 2009 Pearson Education, Inc. Publishing as Prentice H
51、allMarket Values of Claims34Copyright 2009 Pearson Education, Inc. Publishing as Prentice HallValue of Tax Shield The value of the tax shield is the loss of The value of the tax shield is the loss of value to the government of issuing bonds, value to the government of issuing bonds, $(34.0-20.4) mil
52、lion = $13.6 million = value $(34.0-20.4) million = $13.6 million = value of bonds * interestof bonds * interest Recall from before, we converted Nodett into Recall from before, we converted Nodett into an image of Somdett by purchasing shares an image of Somdett by purchasing shares and issuing $40
53、 million of bondsand issuing $40 million of bonds35Copyright 2009 Pearson Education, Inc. Publishing as Prentice HallValue of Tax Shield Directly after the announcement, the share Directly after the announcement, the share price will rise from $66 to $(66+13.6) = price will rise from $66 to $(66+13.
54、6) = $79.6 each$79.6 each The company would repurchase $40 million / The company would repurchase $40 million / $79.6 = 502,513 shares, leaving 497,487 $79.6 = 502,513 shares, leaving 497,487 outstandingoutstanding Sellers will be subject to an additional capital Sellers will be subject to an additi
55、onal capital gain of $13.6/share, and holders to an gain of $13.6/share, and holders to an unrealized capital gain of the same amountunrealized capital gain of the same amount36Copyright 2009 Pearson Education, Inc. Publishing as Prentice HallSub-chapter S CorporationsA small business may set up as
56、a sub-chapter S corporation and be taxed as a partnership In this case, the earnings are passed In this case, the earnings are passed through to shareholders without corporate through to shareholders without corporate taxes, so there is not a leverage advantagetaxes, so there is not a leverage advan
57、tage The Modigliani and Miller symmetry is not The Modigliani and Miller symmetry is not shattered by introducing taxes in this caseshattered by introducing taxes in this case37Copyright 2009 Pearson Education, Inc. Publishing as Prentice HallSubsidiesSome governments offer incentives to businesses
58、to re-locate to achieve a social goal The government may guarantee a bond The government may guarantee a bond issue, resulting in lower debt serviceissue, resulting in lower debt service The value of the debt guarantee is a capital The value of the debt guarantee is a capital gain to the shareholder
59、s, offset by the lower gain to the shareholders, offset by the lower value of the interest tax shield, and the value of the interest tax shield, and the additional costs of relocating the facilityadditional costs of relocating the facility38Copyright 2009 Pearson Education, Inc. Publishing as Prenti
60、ce HallReducing Costs: SubsidiesSome governments offer incentives to businesses to re-locate to achieve a social goal The government may offer investment tax The government may offer investment tax credits, and/or immediate depreciation of credits, and/or immediate depreciation of new capital invest
61、ments, and/or tax holidaysnew capital investments, and/or tax holidays These are essentially payments to the These are essentially payments to the shareholders, that are partly offset by other shareholders, that are partly offset by other losseslosses39Copyright 2009 Pearson Education, Inc. Publishi
62、ng as Prentice HallReducing Costs: Financial DistressLets look at a firm where there is a probability of financial distress Financial distress: the imminent danger of Financial distress: the imminent danger of defaulting on debtdefaulting on debt40Copyright 2009 Pearson Education, Inc. Publishing as
63、 Prentice Hall41Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall16.7 Dealing with Conflicts of Interest: Free Cash FlowHaving debt outstanding reduces the free cash flow and this makes managers more accountable to the market The need for new financing occurs more The need for new f
64、inancing occurs more frequently, making managers less likely to frequently, making managers less likely to invest in projects that increase their power, invest in projects that increase their power, prestige or perksprestige or perks42Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hal
65、lIncreasing Risks Management (acting in the interests of Management (acting in the interests of shareholders) may increase total risk at the shareholders) may increase total risk at the expense of total value of the firmexpense of total value of the firm Badpenny currently has bonds and stock outsta
66、nding, Badpenny currently has bonds and stock outstanding, each with a market value of $50 million, and has each with a market value of $50 million, and has assets invested in short-term T-billsassets invested in short-term T-bills Management enters into a project with Capone Management enters into
67、a project with Capone Enterprises in which an unfair coin (with a probability Enterprises in which an unfair coin (with a probability 60% heads) is tossed in the air60% heads) is tossed in the air If a tail shows, Capone Industries will double If a tail shows, Capone Industries will double Badpennys
68、 investment in T-bills, otherwise, Capone Badpennys investment in T-bills, otherwise, Capone takes all Badpennys T-billstakes all Badpennys T-bills43Copyright 2009 Pearson Education, Inc. Publishing as Prentice HallBadpenny (Continued) If Badpenny is unlucky, its bonds and stock If Badpenny is unluc
69、ky, its bonds and stock will be worth nothingwill be worth nothing If Badpenny is lucky, its bonds retain the If Badpenny is lucky, its bonds retain the original value, but the stock price will tripleoriginal value, but the stock price will triple The expected wealth of Badpennys bond holders is The
70、 expected wealth of Badpennys bond holders is $(1-0.60)*50 million = $20 million$(1-0.60)*50 million = $20 million The expected wealth of the stockholders is $(1-The expected wealth of the stockholders is $(1-0.60)*(200-50) million = $60 million0.60)*(200-50) million = $60 million New expected value
71、 of the firm = $80 millionNew expected value of the firm = $80 million44Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall16.8 Creating New Opportunities for StakeholdersCapital structure decisions may create value by creating opportunities that may not otherwise be available, or ava
72、ilable only at a higher priceExample: Pension promises45Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall16.9 Financial Decisions in PracticeThe selection of financing method is company specific as it will depend upon the economic environment in which the firm finds itself What fina
73、ncing method is most appropriate What financing method is most appropriate for the following five companies?for the following five companies?46Copyright 2009 Pearson Education, Inc. Publishing as Prentice HallOrre Oil Company Needs Needs $10 million now to test drill in New Guinea$10 million now to
74、test drill in New Guinea $10 million more to develop if test is $10 million more to develop if test is successfulsuccessful Currently Currently Earnings $2/share, & Stock is $10/share Earnings $2/share, & Stock is $10/share (Industry: Stock 10 to 12 times earnings)(Industry: Stock 10 to 12 times ear
75、nings) Debt ratio 25% (Industry is 40%)Debt ratio 25% (Industry is 40%) Total assets $105 millionTotal assets $105 million47Copyright 2009 Pearson Education, Inc. Publishing as Prentice HallGormeh Foods, Inc.Currently Assets $15 million, 5 equal shareholdersAssets $15 million, 5 equal shareholders P
76、rofitable, rapid growth causing $ strainProfitable, rapid growth causing $ strain Need $2 million for new equipmentNeed $2 million for new equipment Real estate heavily mortgagedReal estate heavily mortgaged Inventory secures bank loanInventory secures bank loan Accounts receivables are factoredAcco
77、unts receivables are factored48Copyright 2009 Pearson Education, Inc. Publishing as Prentice HallBombay Textile Company Sub-Continent based cloth manufacturerSub-Continent based cloth manufacturer 50% production goes to small clothing manufacturers in 50% production goes to small clothing manufactur
78、ers in SingaporeSingapore P&E financed in part by government loan, no other long-P&E financed in part by government loan, no other long-term debtterm debt Pays cash for inputs, and offers 60 day credit to Singapore Pays cash for inputs, and offers 60 day credit to Singapore customerscustomers Growth
79、 in exports (now 5 million) have led to a need for Growth in exports (now 5 million) have led to a need for $500,000 new financing$500,000 new financing49Copyright 2009 Pearson Education, Inc. Publishing as Prentice HallHoleys Burger Queen Holeys savings are $50,000, and he wishes Holeys savings are
80、 $50,000, and he wishes to purchase a Burger Queen franchiseto purchase a Burger Queen franchise Burger Queen requires minimum of Burger Queen requires minimum of $100,000 equity capital, and will then $100,000 equity capital, and will then provide debt financing of the remainderprovide debt financi
81、ng of the remainder An existing Burger Queen is on the market An existing Burger Queen is on the market for $250,000for $250,00050Copyright 2009 Pearson Education, Inc. Publishing as Prentice HallLee Productions Small movie production company with 10 Small movie production company with 10 ownersowne
82、rs One recent “unexpected” successOne recent “unexpected” success Want to double the number of films being Want to double the number of films being producedproduced Recently incorporated, and wants to raise Recently incorporated, and wants to raise $10 million from outside investors$10 million from
83、outside investors51Copyright 2009 Pearson Education, Inc. Publishing as Prentice HallFive Financing MethodsLoans from friends or relativesLeasing ArrangementsCommon stockDebt with warrantsFactoring receivables 52Copyright 2009 Pearson Education, Inc. Publishing as Prentice HallAlso Consider: Joint v
84、enturesJoint ventures Limited partnerships for individual projectsLimited partnerships for individual projects Government programs for farmers, small Government programs for farmers, small businesses, exporters, et c.businesses, exporters, et c. Franchising as an alternative method of Franchising as
85、 an alternative method of profitable expansionprofitable expansion Offer incentives for early payment of a/r and Offer incentives for early payment of a/r and negotiate with suppliers for special a/p termsnegotiate with suppliers for special a/p terms “Creative financing” with old owner financing “C
86、reative financing” with old owner financing new ownernew owner53Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall16.10 How to Evaluate Levered InvestmentsAdjusted Present Value (APV)Flows to Equity (FTE)Weighted Average Cost of Capital54Copyright 2009 Pearson Education, Inc. Publish
87、ing as Prentice HallAdjusted Present Value (APV)Add to the projects unleveraged NPV the value that is created through debt financing55Copyright 2009 Pearson Education, Inc. Publishing as Prentice HallFlows to Equity (FTE)Calculate the incremental expected after-tax cash flows to the firms shareholde
88、rs and then compute the NPV using the cost of the equity capital56Copyright 2009 Pearson Education, Inc. Publishing as Prentice HallWeighted Average Cost of CapitalThe cost of capital depends upon its use not its source A firms cost of equity is the A firms cost of equity is the expected rate of ret
89、urn investors require on expected rate of return investors require on an investment in a firms common stockan investment in a firms common stock A firms weighted average cost of capital A firms weighted average cost of capital (WACC) is the (WACC) is the discount rate used in computing a firms value
90、 discount rate used in computing a firms value from its future cash flowsfrom its future cash flows57Copyright 2009 Pearson Education, Inc. Publishing as Prentice HallThe Firms Weighted-Average Cost of Capital As a practical matter, determining the cost of As a practical matter, determining the cost
91、 of capital of a company with transaction costs capital of a company with transaction costs is quite difficult, and involves optimizing the is quite difficult, and involves optimizing the timing of new debt and equity issuestiming of new debt and equity issues Assuming a M&M economy, the following Assuming a M&M economy, the following equations apply:equations apply:58Copyright 2009 Pearson Education, Inc. Publishing as Prentice HallM&M Equations59Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall
