Optimal Capital Structure Analysis: Market Influences and Empirical Evidence

1. Chapter 17 -- Capital Structure and Value • Overview: • Perfect markets and capital structure irrelevance • Influence on capital structure • Information problems and capital structure • Other considerations • Empirical evidence on capital structure and value

2. Perfect markets -- Modigliani and Miller • No taxes, no bankruptcy, same information sets, no transaction cost • Capital structure does not matter • Shareholders will adjust the company’s structure to whatever they want

3. Taxes and Capital Structure • Differential tax rates • Personal ordinary income rate • What shareholders pay if they receive a dividend • Corporate ordinary income rate • What the corporation shares with the government • Personal capital gains rate • What you pay on the gain if you sell your stock

4. Taxes and Capital Structure • Differential tax rates within the corporation • May have other tax shields such as depreciation • May not have the income to pay taxes

5. Bankruptcy or Liquidation cost and Capital Structure • Legal cost • Disruption cost • Expected bankruptcy cost and capital structure

6. Information Problems: Agency Cost • Agency cost of debt • Cost borne by your debt-holders to monitor your actions or prospective actions • very low when debt is low but goes up as debt in increased

7. Information Problems: Agency Costs • Agency cost of equity • Cost borne by shareholders to monitor your actions • High with no debt but decreases as debt increases • These cost decrease because • others (debt-holders) are monitoring, often with better information (monthly statements) • Cost of a loss is less with others participating

8. Information Problems: Agency Costs • Look for the mixture of debt and equity that minimizes total agency costs

9. Information Problems: Signaling • Management may have a better information set than the shareholders • Actions speak louder than words • The assumption of debt signals management’s confidence in future cash flows • Issuing debt to buy back equity is a very positive signal

10. Other Considerations and Capital Structure Choice • Unequal cost of corporate borrowing and personal borrowing • This favors corporate borrowing over personal borrowing

11. Other Considerations and Capital Structure Choice • Additional liability of homemade leverage • Favors corporate over personal borrowing • You can only lose the value of your stock investment • With homemade leverage you can lose your personal assets • Restrictions on homemade leverage

12. Empirical Evidence on Capital Structure and Value • As theories predict, taxes, bankruptcy costs, and agency costs all have roles in determining capital structure • Science is not so complete that we can predict or prescribe the exact optimal capital structure