1. Explain the pecking order hypothesis.

2. The trade-off theory states that firms trade off the tax benefits of debt financing against problems caused by potential bankruptcy. Explain the benefits of debt financing and limits of using debt.   

asapfollow directions

CapitalStructure Theory – Modigliani and Miller (MM) Approach

The Modigliani and Miller approach to capital theory, devised in the 1950s, advocates the capital

structure irrelevancy theory. This suggests that the valuation of a firm is irrelevant to the capital structure

of a company. Whether a firm is highly leveraged or has a lower debt component has no bearing on its

market value. Rather, the market value of a firm is solely dependent on the operating profits of the

company.

The capital structure of a company is the way a company finances its assets. A company can finance its

operations by either equity or different combinations of debt and equity. The capital structure of a

company can have a majority of the debt component or a majority of equity, or an even mix of both debt

and equity. Each approach has its own set of advantages and disadvantages. There are various capital

structure theories that attempt to establish a relationship between the financial leverage of a company

(the proportion of debt in the company’s capital structure) with its market value. One such approach is

the Modigliani and Miller Approach.

ASSUMPTIONS OF MODIGLIANI AND MILLER APPROACH

 There are no taxes.

 Transaction cost for buying and selling securities, as well as the bankruptcy cost, is nil.

 There is a symmetry of information. This means that an investor will have access to the same

information that a corporation would and investors will thus behave rationally.

 The cost of borrowing is the same for investors and companies.

 There is no floatation cost, such as an underwriting commission, payment to merchant bankers,

advertisement expenses, etc.

 There is no corporate dividend tax.

The Modigliani and Miller Approach indicates that the value of a leveraged firm (a firm that has a mix

of debt and equity) is the same as the value of an unleveraged firm (a firm that is wholly financed by

equity) if the operating profits and future prospects are same. That is, if an investor purchases shares of

a leveraged firm, it would cost him the same as buying the shares of an unleveraged firm.

Capital Structure and its Theories

Capital Structure and its Theories

Value of a Firm

Capital Structure and its Theories

https://efinancemanagement.com/financial-leverage

Corporation

MODIGLIANI AND MILLER APPROACH: TWO PROPOSITIONS WITHOUT TAXES

PROPOSITION 1

With the above assumptions of “no taxes”, the capital structure does not influence the valuation of a

firm. In other words, leveraging the company does not increase the market value of the company. It also

suggests that debt holders in the company and equity shareholders have the same priority, i.e., earnings

are split equally amongst them.

MODIGLIANI AND MILLER APPROACH: PROPOSITIONS WITH TAXES

M&M Theory 1’s assumption that there are no taxes is unrealistic. Taxes exist, and interest expense is

tax deductible i.e. the ultimate tax burden of a company with debt in its capital structure is lower than a

company with zero or lower debt. This brings us to M&M Theory 2 which relaxes the zero-tax

assumption.

Shareholders Vs Stakeholders

Proposition 1

In a tax environment, the value of a levered company is higher than the value of an unlevered company

by an amount equal to the product of absolute amount of debt and tax rate.

This can be expressed mathematically as follows:

VL = VUL + t × D

Where VL is the value of levered company i.e. company with some debt in its capital structure, VUL is the

value of an un-levered company i.e. with no or lower debt, t is the tax rate and D is the absolute amount

of debt.

The Trade-off theory of capital structure

The trade-off theory states that the optimal capital structure is a trade-off between interest tax shields

and cost of financial distress:

Value of firm = Value if all-equity financed + PV(tax shield) – PV(cost of financial distress)

The trade-off theory can be summarized graphically. The starting point is the value of the all-equity

financed firm illustrated by the black horizontal line in Figure 10. The present value of tax shields is then

added to form the red line. Note that PV(tax shield) initially increases as the firm borrows more, until

additional borrowing increases the probability of financial distress rapidly. In addition, the firm cannot

be sure to benefit from the full tax shield if it borrows excessively as it takes positive earnings to save

corporate taxes. Cost of financial distress is assumed to increase with the debt level.

The cost of financial distress is illustrated in the diagram as the difference between the red and blue

curve. Thus, the blue curve shows firm value as a function of the debt level. Moreover, as the graph

suggest an optimal debt policy exists which maximized firm value.

In summary, the trade-off theory states that capital structure is based on a trade-off between tax savings

and distress costs of debt. Firms with safe, tangible assets and plenty of taxable income to shield should

have high target debt ratios. The theory is capable of explaining why capital structures differ between

industries, whereas it cannot explain why profitable companies within the industry have lower debt ratios

(trade-off theory predicts the opposite as profitable firms have a larger scope for tax shields and therefore

subsequently should have higher debt levels).

The pecking order theory of capital structure

The pecking order theory has emerged as alternative theory to the trade-off theory. Rather than

introducing corporate taxes and financial distress into the MM framework, the key assumption of the

pecking order theory is asymmetric information. Asymmetric information captures that managers know

more than investors and their actions therefore provides a signal to investors about the prospects of the

firm.

The intuition behind the pecking order theory is derived from considering the following string of

arguments:

 If the firm announces a stock issue it will drive down the stock price because investors believe

managers are more likely to issue when shares are overpriced.

 Therefore firms prefer to issue debt as this will allow the firm to raise funds without sending adverse

signals to the stock market. Moreover, even debt issues might create information problems if the

probability of default is significant, since a pessimistic manager will issue debt just before bad news

get out.

This leads to the following pecking order in the financing decision:

1. Internal cash flow

2. Issue debt

3. Issue equity

The pecking order theory states that internal financing is preferred over external financing, and if external

finance is required, firms should issue debt first and equity as a last resort. Moreover, the pecking order

seems to explain why profitable firms have low debt ratios: This happens not because they have low

target debt ratios, but because they do not need to obtain external financing. Thus, unlike the trade-off

theory the pecking order theory is capable of explaining differences in capital structures within

industries.

Capital Structure Policy

Chapter 13

Learning Objectives

Understand the difference between business risk and financial risk.

Use the technique of break-even analysis.

Understand capital structure theories.

Business Risk
Business Risk is the variation in the firm’s expected earnings attributable to the industry in which the firm operates.
Determinants of business risk:
The stability of the domestic economy
The exposure to, and stability of, foreign economies
Sensitivity to the business cycle
Competitive pressures in the firm’s industry

Operating Risk
Operating risk is the variation in the firm’s operating earnings that results from firm’s cost structure (mix of fixed and variable operating costs).
Earnings of firms with higher proportion of fixed operating costs are more vulnerable to change in revenues.

5
Operating Leverage
Operating leverage is the change in EBIT caused by a change in quantity sold.
The higher the proportion of fixed costs relative to variable costs, the greater the operating leverage.

6
Higher operating leverage leads to more business risk: small sales decline causes a larger EBIT decline.

Sales
$
Rev.
TC
F

QBE

EBIT

}
$
Rev.
TC
F
QBE
Sales

7
Operating Breakeven
Q is quantity sold, F is total fixed cost, V is variable cost per unit, TC is total cost, and P is price per unit.
Operating breakeven = QBE
Let EBIT=PQ-VQ-F= 0
QBE = F / (P – V)
Example: F=$200, P=$15, and V=$10:
QBE = $200 / ($15 – $10) = 40.

Financial Risk
Financial Risk is the variation in earnings as a result of firm’s financing mix or proportion of financing that requires a fixed return.
Additional business risk concentrated on common stockholders when financial leverage is used.

Capital Structure Theory
MM theory
Zero taxes
Corporate taxes
Corporate and personal taxes
Trade-off theory
Signaling theory
Pecking order
Debt financing as a managerial constraint

Modigliani-Miller (MM) Theory: Zero Taxes
Firm U Firm L
EBIT $3,000 $3,000
Interest 0 1,200
NI $3,000 $1,800

CF to shareholder $3,000 $1,800
CF to debtholder 0 $1,200
Total CF $3,000 $3,000
Notice that the total CF are identical for both firms.

MM Results: Zero Taxes
MM assume: (1) no transactions costs; (2) no restrictions or costs to short sales; and (3) individuals can borrow at the same rate as corporations.
MM prove that if the total CF to investors of Firm U and Firm L are equal, then arbitrage is possible unless the total values of Firm U and Firm L are equal:
VL = VU.
Because FCF and values of firms L and U are equal, their WACCs are equal.
Therefore, capital structure is irrelevant.

12
MM Theory: Corporate Taxes
Corporate tax laws allow interest to be deducted, which reduces taxes paid by levered firms.
Therefore, more CF goes to investors and less to taxes when leverage is used.
In other words, the debt “shields” some of the firm’s CF from taxes.

13
MM Result: Corporate Taxes
MM show that the total value to Firm L’s investors (VL )is equal to the total value to Firm U’s investor (VU )plus an additional amount due to interest deductibility (t*D).

Tax shield of debt= t*D, t=corporate tax rate, D=total debt

VL = VU + t*D

14
Value of Firm, V
0
Debt
VL
VU
Under MM with corporate taxes, the firm’s value increases continuously as more and more debt is used.
TD

MM relationship between value and debt when corporate taxes are considered.

Miller’s Theory: Corporate and Personal Taxes
Personal taxes lessen the advantage of corporate debt:
Corporate taxes favor debt financing since corporations can deduct interest expenses.
Personal taxes favor equity financing, since no gain is reported until stock is sold, and long-term gains are taxed at a lower rate.

16
Trade-off Theory
Capital structure is based on a trade-off between the tax advantage of debt and the costs of financial distress.
MM theory ignores bankruptcy (financial distress) costs, which increase as more leverage is used.
At low leverage levels, tax benefits outweigh bankruptcy costs.
At high levels, bankruptcy costs outweigh tax benefits.
An optimal capital structure exists that balances these costs and benefits.

17
Costs of Financial Distress
What is financial distress?
Bankruptcy
Ch 7: Liquidation
Ch 11: Reorganization
Cost of Financial Distress
Direct Costs
Legal and administrative costs
Indirect Costs
Impaired ability to conduct business
Agency Costs

17

18
Tax Shield vs. Cost of Financial Distress
Value of Firm, V
0
Debt
V = Actual value of firm
VU =Value of firm with no debt
Tax Shield=t*D

Distress Costs
VL=Value of firm with corporate
taxes and debt
VL = VU + t*D

19
Signaling Theory
MM assumed that investors and managers have the same information.
But, managers often have better information. Thus, they would:
Sell stock if stock is overvalued.
Sell bonds if stock is undervalued.
Investors understand this, so view new stock sales as a negative signal.

Pecking Order Theory
Theory stating that firms prefer to issue debt rather than equity if internal finance is insufficient
Internal equity is first choice, external equity is last
Based on asymmetric information
Rules
Use internal financing
Issue the safest security first (debt before external equity)

20

21
Pecking Order Theory
Consider the following story:
The announcement of a stock issue drives down the stock price because investors believe managers are more likely to issue when shares are overpriced.
Therefore firms prefer internal finance since funds can be raised without sending adverse signals.
If external finance is required, firms issue debt first and equity as a last resort.
The most profitable firms borrow less not because they have lower target debt ratios but because they don’t need external finance.

21

Pecking Order Theory
Implications
Internal equity is “better” than external equity
Debt is preferred to external equity
Financial slack is valuable
No target debt/equity ratio

22

Debt Financing and Agency Costs
One agency problem is that managers can use corporate funds for non-value maximizing purposes.
The use of financial leverage:
Bonds “free cash flow.”
Forces discipline on managers to avoid perks and non-value adding acquisitions.
A second agency problem is the potential for “underinvestment”.
Debt increases risk of financial distress.
Therefore, managers may avoid risky projects even if they have positive NPVs.

Working Capital Management

Chapter 15

Working Capital Terminology

Working capital: current assets.

Net working capital:

current assets – current liabilities.

Net operating working capital:

current assets – (current liabilities – notes payable).

Working capital management:

controlling cash, inventories, and A/R, plus short-term liability management.

2

Working Capital Financing Policies
Aggressive: Use short-term financing to finance permanent assets.
Moderate: Match the maturity of the assets with the maturity of the financing.
Maturity Matching, or “Self-Liquidating”, approach
Conservative: Use permanent capital for permanent assets and temporary assets.

3

Cash Conversion Cycle
The cash conversion cycle focuses on the length of time between when a company makes payments to its creditors and when a company receives payments from its customers.

4

Cash Conversion Cycle

15-5

5

Cash Budget
Forecasts cash inflows, outflows, and ending cash balances.
Used to plan loans needed or funds available to invest.
Can be daily, weekly, or monthly, forecasts.
Monthly for annual planning and daily for actual cash management.

6

Cash and Marketable Securities
Currency
Demand Deposit
Marketable Securities

Inventories
Supplies
Raw materials
Work in process
Finished goods

Accounts Receivable: Credit Policy
Credit Period: How long to pay? Shorter period reduces days sales outstanding (DSO) and average A/R, but it may discourage sales.
Cash Discounts: Lowers price. Attracts new customers and reduces DSO.
Credit Standards: Restrictive standards tend to reduce sales, but reduce bad debt expense. Fewer bad debts reduce DSO.
Collection Policy: How tough? Restrictive policy will reduce DSO but may damage customer relationships.

9

Accounts Payable: Trade Credit
Trade credit is credit furnished by a firm’s suppliers.
Trade credit is often the largest source of short-term credit, especially for small firms.
Spontaneous, easy to get, but cost can be high.

10

period
deferral
Payables

period
collection
Average

period
conversion
Inventory

CCC
–
+
=