Capital Structure and Firm Value - Assignment Example

Capital Structure and Firm Value Capital structure and firm value The firm value is defined as the sum of value of its debt and the value of its equity. The managers of the firm aim at maximisation of the firm value. They work towards achieving an optimal debt-equity ratio that maximises the firm value. The capital structure refers to the structure of long term financing of the firm. The assets financed with the money raised from the debt sources represent the firm’s leverage position. Miller & Modigliani capital structure irrelevance proposition In the year 1958 Franco Modigliani and Merton Miller highlighted that in “perfect capital markets” the capital structure does not have any influence on the value of the firm rendering it irrelevant. The perfect capital markets are not characterised by any market frictions like trading costs, taxes and the information is easily transmitted between the investors and the managers. M&M made a clear distinction between the financial risk and business risk faced by a firm. While the financial risk refers to the choice of risk distribution between the bondholders and shareholders, the business risk refers to the uncertainty of cash flows of the business. It has been pointed out by Miller and Modigliani that changes in leverage does not cast any significant influence on the cash flows generated by the business. Therefore changes in leverage cannot alter the value of the firm. According to them leverage simply defines the distribution of cash flows between the bondholders and the shareholders. MM Proposition without taxes Miller and Modigliani expressed doubts about an optimal capital base for a business. To prove their point they made the following assumptions- They assumed the capital markets to be perfect i.e. they assumed that there are no market frictions. The firms as well as individuals can borrow or lend at the risk-free interest rate. The firms employ risky equity and risk-free debt. There exist only corporate taxes i.e. absence of personal income taxes or wealth taxes. They assumed perpetuity of cash flows i.e. assuming the growth rate to be zero (Lee, et al., 2009, p.202). As per M&M model the value of levered firm (VL) is equal to the value of unlevered firm (VU). Suppose there are two companies- Company 1 and Company2. It is assumed that the two companies have identical cash flows and belong to same risk profile. The difference between the two companies is with respect to financing. M&M state that the market value of the two companies is same. Suppose the pay-off of Company 1 in good state is 160 and in bad state is 50. This company is financed only by the equity mode of financing. Similarly the payoff of Company 2 is 160 in good state and 50 in bad state. It is financed by the combination of debt and equity. Suppose the total debt of Company 2 is $60 and its market value is $50; the market value of its equity is $50. Then the value of the Company 2 is- VL = Value of its equity + Value of debt = 50+50 =100 Now if the value of Company 1 is different from Company 2 say 103. Then an arbitrage strategy can be created- An investor can sell Company 1 at 103. He can buy the equity of Company 2 at $50 and debt at $50. The net cash flow is- = 103-100 =3 This process will continue until the Value of Company 1 is equal to Company 2 (Banal-Estañol , 2010). The increase in leverage component raises the risk and return of the shareholders. This can be stated as- RE = RO + (B/S)(RO – RD) RE is the return on levered equity RO is return on unlevered equity B is the debt value S is the value of equity RD is the cost of debt The cost of capital is estimated as- Weighted average cost of capital = B/ (B+S) * RD +S/(B+S)*RE (The McGraw-Hill Companies Inc, n.d.). MM Proposition with taxes Modigliani and Miller have stated that the “value of leveraged firm” is equal to the sum of “the value of unleveraged firm plus tax advantage of debt”. Miller modified the equation obtained under MM Proposition without taxes (Lee, et al., 2009, p.208). In the year 1963 a follow-on paper was issued by MM where they relaxed corporate tax related assumptions. As per the Tax Code the corporations are permitted to treat taxes as an expense however any payment of dividend is not deductible. This is one of the reasons that the managers in the firms are encouraged to make use of debt in their capital base. This is because the interest paid on debt lower the tax outflow of the firms. If the firms have to shell out less payment to the government then it is left with more cash resources for paying to the investors. In short the interest tax deductibility shields the pre-tax profits of the firm. Source: (Brigham & Ehrhardt, 2010, p.613). From the above equation it is evident that the value of the levered firm is equal to the value of unlevered firm plus any tax advantage of debt. In the above equation Tc is the rate of corporate tax, Ts is the rate of personal tax on the income earned from stocks and Td is rate of tax on income derived from debt. The argument put forward by Miller is that the rate of tax on stock and debt balance in a way that the term in bracket becomes zero such that Vu = VL. However some observers view that there exist tax advantages of debt (Brigham & Ehrhardt, 2010, p.613). As per Miller and Modigliani Proposition I with taxes there is a rise in the value of the firm due to the incorporation of debt in the capital structure. VL = Vu + Present value of tax benefit of debt = Vu + tcB The return required by the shareholders moves up however this rise is less as compared to earlier situation. RE = RO + (B/S)(RO – RD)(1-tc) RE is the return on levered equity RO is the return on unlevered equity B is the value of debt S is the value of equity tc is the rate of corporate taxes. (Rau, n.d.). Here also there is a similar relationship whereby the cost of equity increases with the rise in leverage. However there is a difference in the WACC estimation. In the MM Proposition with taxes they have identified the effect of taxes i.e. the impact of gearing by substituting equity with debt results in a fall in the weighted average cost of capital (WACC). Practical relevance of MM proposition The practical credibility and relevance of the propositions of MM cannot be based on the absence of demand for debt or other specialised instruments. The support for the proposition must be based on supply side. This proposition holds good when the associated cost with “slicing of pizza” is relatively small as compared to the firm’s market value. If the cost of supply is small then the clientele willing to spend extra for borrowing from a corporation are not required to do so, as the manufacturing cost of equity and debt securities is only a small portion of the market value of securities. The debt supply expands until the added value reaches zero. From the point of view of law, public policy and regulation the debt irrelevance proposition of MM is the ultimate end result. It these results can be obtained n practice then the diverse demand of the investors for specialised securities can be met at trivial costs. All the business firms will enjoy equal capital accessibility and the cost of acquiring capital will remain independent of financing but will only be a factor of business risk. Thereby, there will be a direct flow of capital to the most optimal use (Myers, 2000). Propositions on dividend policy As per the Miler and Modigliani the dividends paid out by the firm are irrelevant and the investors remain indifferent to dividend declaration. The assumptions underlying the dividend irrelevance proposition are simple to interpret. The firms that declare high dividends provide limited appreciation in price however they provide similar return to the investors based on the risk profile and the anticipated cash flows. Therefore it implies that in the absence of taxes or of capital gains and dividends are taxed using the same rate, the investors would remain indifferent as to whether they receive their returns price appreciation or dividend. Assuming that there is neither a tax advantage nor disadvantage with dividends the followings assumptions have been outlined- No transaction costs are involved in the conversion of appreciation in prices into cash by liquidating the stock. If this is not true then the investors preferring urgent cash would prefer dividends. The firms declaring high rates of dividends can issue shares in the absence of any transaction costs or floatation costs to finance new projects. There is an implied that the shares are fairly prices by the market participants. The investment related decisions of the business are not affected by the dividend decisions and the operating cash flows of the firm remain the same irrespective of the dividend policy by it. The managers of the business entities that pay limited dividends do not misuse the cash for their own personal interests or the cash flows are not wasted on bad projects. Based on the abovementioned assumptions neither the shareholders receiving dividends nor the firms declaring them are adversely impacted by high or low dividend declarations of the firms (Leonard N. Stern School of Business, n.d.). Implications of MM dividend irrelevance proposition If the dividends are assumed to be irrelevant then the firms spend considerable amount of resources on an issues that is of little significance to the shareholders. This gives rise to a number of propositions. One is that there is no change in the value of equity with any changes in the dividend policy. It does not signify that the share price will not be affected but large dividends would amount to low stock prices and higher number of outstanding stock. Besides in the long run there are no co-relations between the stock returns and its dividend policy. It is of little importance to the investor whether affirm pays dividends or not as an investor can replicate the cash flows arising under different dividend policy scenarios. For instance if affirm declares large amount of dividends then the investor preferring to invest the extra cash received in the form of dividend can re-invest this income by purchasing more shares of the company. On the other hand if a firm retains huge portion of its earnings into the business then the market price of the company’s shares will be stimulated by its strong cash position. Then the investor can simply sell-off some portion of his investment in the company. These arguments are in line with the dividend irrelevance proposition of Miller and Modigliani. But there are instances when the investors are affected by the dividend policy decisions of the company. The tax consequences are taken into account for the decisions relating to dividend payments. The steps taken by the company to minimise the tax bill varies as per the shareholders’ base and the prevailing tax rules. Though tax has an important impact on the dividend policy yet there are companies that declare dividends even in the presence of tax laws. The dividend irrelevance theory ignores the transaction costs that are incurred in the buying or selling of shares. In the case of companies following a dividend policy that suits the investors they do not have to incur transaction costs for replicating a different dividend policy. Moreover dividends send a signal to the market. A dividend cut is not taken favourable by the shareholders. The return of money in the form of dividend payments reassures the investors. Therefore the dividend irrelevance theory may not be correct in entirety it indicates that in reality the dividend policy decisions can be ignored at the time of fundamental valuation (Pietersz, 2011). Part 2- Limitations of the net present value method of investment evaluation The Net Present Value (NPV) method of investment evaluation is the most common and popular method of investment appraisal. Under this method the present value of the estimated cash inflows of the project are adjusted with the cost associated with the project to find out the net value derived from the investment. The present value of the anticipated cash flows is obtained by discounting the cash flows with an appropriate discounting rate. Although there is a preference for this method among the project managers because it can be adjusted according to some specific case like comparison of project of varying sizes and life spans, but there are cases where the NPV criteria is complex to be implemented. A major limitation is that the NPV methods assesses projects on take or leave basis i.e. it takes into account only the available information ignoring the several opportunities that may arise in the due course of the project and as more project related information becomes available. The net present value of a project is estimated from the anticipated stream of cash flows of a project and discounted using the cost of capital depending on the risk of the project. The estimated cash flows and the associated cost of capital depends on the information that is available at the time of calculation of NPV. The information includes factors like product marketability, selling price, obsolescence risk, the technological expertise required in product manufacturing and regulatory, tax & economic environments. A project which can be easily and cost-effectively adjusted to any significant factor changes will have more positive impact on the firm value that what is indicated by NPV (Hawawini & Viallet, 2010, p.208). The cash flows used in NPV estimation are difficult to forecast with certainty. Also in reality it is difficult to correctly assess the discount rate as the project risks may not be implicitly clear. Real Options and capital budgeting The NPV method of investment appraisal ignores the actions that can be initiated by the managers to enhance an investment’s value once it has been selected. There are situations when the managers can respond to environmental changes in a way that it can alter the value of the investment it is said that the project has an inbuilt real option. A real option refers to the right without an obligation to take an action in the future that can change the value of the investment. By way of a simple example it can be shown where the NPV method may be erroneous. Suppose the project manager of a company bids for the extraction rights of oil from a site for the next one year. It is assumed that the costs of extraction is $65 each barrel. The prices of oil do not remain fixed and fluctuate with time. The expected price of oil cannot be forecasted with certainty therefore it is assumed that prices of oil do not follow any trend rather it is assumed to follow a ‘random walk’. This means that the oil prices do not have any connection with the past movement in prices and do not have a tendency to reach the mean value with the passage of time. In such a case the best estimate of the price of oil in the future is today’s price. An analysis using NPV technique would discard the project. If the best possible forecast of oil price in the future is $60 each barrel then there will be no profits based on the extraction cost of $65 each. The anticipated NPV of the project is negative irrespective of the oil that can be extracted in the future. However a real option approach of investment appraisal yields a different result. If the company owns the rights to oil extraction there is no obligation to do this if the oil price is very low. A reason can be given that the oil will be pumped only when the market price of oil is sufficient to recoup the extraction costs. Though predicting when the oil price will be high to yield profits is difficult but based on historical fluctuations in prices it may be possible that at least on some occasions the price will be more than the extraction costs thereby yielding profits. Based on this it can be said that the extraction rights are definitely of more value than zero. Therefore the NPV method is a static approach of investment appraisal. NPV often overstates or understates the true value of a project. In the case of the oil extraction example buying the rights to extraction creates a real option i.e. the oil may be pumped or may not be pumped in the future whereas the NPV underestimates the value of the investment (Graham, et al., 2009, p.338). Challenges associated with real options in capital budgeting- One challenge associated with real option valuation in capital budgeting is with respect to the parameters in the Black Scholes model of option valuation. The value of the option is sensitive to volatility estimation. The volatility is often assumed to be 50% for simplicity however the determination of the volatility of expected future cash flows is not that simple. The volatility of the estimated cash flows of the investment impacts two main elements: there is a positive relationship between volatility and option value i.e. higher the volatility higher is the option value; whereas the volatility has a negative relationship with the static NPV i.e. higher the volatility higher is the cost of capital thereby lowering the static NPV. Again there may be several options in an investment with an interaction of some embedded options. For instance, a firm investing in research and development over a span of years, for a new product development has minimum two options: an option to abandon project in the development phase and the option to defer the same. The valuation problems arising in the multiple options cannot be carried out by simple addition of separate option values. This is because the value of one option may be impacted by the value of other options. Incorporating the value of all options that may arise for multiple interacting options falls beyond the reach of Black Scholes model as it requires the use of various numerical methods (Peterson & Fabozzi, 2002, p.156). Reference Banal-Estañol , A. (2010). Chapter 1: The Modigliani-Miller Propositions, Taxes and Bankruptcy Costs. Available at: http://www.staff.city.ac.uk/~sa874/Corporate%20Finance%20Pompeu/chapter%201.pdf [Accessed on April 16, 2010]. Brigham, F.E. Ehrhardt, C.M. (2010). Financial Management: Theory and Practice. Cengage Learning. Graham, J. Smart, B.S. Megginson, L.W. (2009). Corporate Finance: Linking Theory to What Companies Do. Cengage Learning. Hawawini, G. Viallet, C. (2010). Finance for Executives: Managing for Value Creation. Cengage Learning. Lee, C.A. Lee, C.J. Lee, F.C. (2009). Financial analysis, planning & forecasting: theory and application. World Scientific. Myers, C.S. (2000). Capital Structure: Some Legal and Policy Issues. OECD. Available at: http://www.oecd.org/dataoecd/21/29/1857283.pdf [Accessed on April 16, 2010]. Leonard N. Stern School of Business. (No Date). When Are Dividends Irrelevant? (The Miller Modigliani Proposition). Available at: http://pages.stern.nyu.edu/~adamodar/New_Home_Page/invfables/dividirrelevance.htm [Accessed on April 16, 2010]. Peterson, P.P. Fabozzi, J.F. (2002). Capital budgeting: theory and practice. John Wiley and Sons. Pietersz, G. (2011). Dividend irrelevance. Available at: http://moneyterms.co.uk/dividend_irrelevance/ [Accessed on April 16, 2010]. Rau, R. (No Date). Capital Structure With Taxes: The Modigliani-Miller Propositions. Available at: http://www.krannert.purdue.edu/faculty/Rau/mgmt611G/ftp/CapitalStructure/MMTaxes.pdf [Accessed on April 16, 2010]. The McGraw-Hill Companies Inc. (No Date). Capital Structure Basic Concepts. Available at: http://www.google.co.in/url?sa=t&source=web&cd=5&ved=0CC4QFjAE&url=http%3A%2F%2Fwww.wku.edu%2F~indudeep.chhachhi%2F519files%2F519ch15.ppt&rct=j&q=MM%20propositions%20without%20tax%20%281958&ei=TGypTea_LYHTrQfoq4GoCA&usg=AFQjCNErFTaSZcnGBHWwUPuxhRW2cPPUag&cad=rja [Accessed on April 16, 2010]. Read More