RCMA 3: T3.4-RISK AND RETURN

TAXES AND CAPITAL STRUCTURE

Capital Structure

Capital structure refers to the way a corporation finances its assets through a combination of equity (ownership) and debt (borrowings).

The mix of debt, preferred stock, and common equity that is used to finance the firm’s assets. A company's capital structure is commonly described as the proportion of different sources of funding contributed by investors, summing up to 100%. The ideal capital structure represents a blend of debt, preferred stock, and common equity that enhances the inherent value of the company's stock. As we'll explore further, the capital structure that optimizes intrinsic value simultaneously minimizes the Weighted Average Cost of Capital (WACC).

Components of Capital Structure:

1. Equity Capital:

Represents ownership in the company.
Includes common stock and preferred stock.
Equity holders have voting rights and are entitled to dividends.

2. Debt Capital:

Involves borrowing funds which need to be repaid over time.
Debt can be short-term (like loans) or long-term (such as bonds).
Debt holders are entitled to interest payments and repayment of principal.

Factors Influencing Capital Structure:

1. Business Risk:

The nature of the industry and the stability of cash flows affect the optimal mix of debt and equity.
Higher business risk may lead to a lower proportion of debt in the capital structure
2. Financial Flexibility:
Companies may prefer flexibility in capital structure to adapt to changing economic conditions or investment opportunities.
3. Cost of Capital:
Balancing the costs of debt (interest payments) and equity (dividend payments, stock issuance costs) to minimize the overall cost of capital.
4. Tax Considerations:
Interest on debt is tax-deductible, making debt financing more attractive for companies in higher tax brackets.
5. Market Conditions:
Availability of credit, interest rates, and investor sentiment influence the feasibility and cost of debt financing.

Theories of Capital Structure:

1. Trade-off Theory:

Suggests that firms balance the tax advantages of debt with the costs of financial distress and agency costs associated with higher leverage.
Firms choose a capital structure that maximizes their value by balancing tax shields and bankruptcy costs.
2. Pecking Order Theory:
Companies prefer internal financing (retained earnings) first, then debt, and finally equity, due to information asymmetry.
External financing (debt and equity) is seen as a last resort, indicating that companies prefer to avoid issuing new securities if possible.

Implications of Capital Structure Decisions:

1. Financial Risk:

Higher leverage increases financial risk due to fixed interest payments, which may lead to financial distress if not managed properly.

2. Cost of Capital:

A firm's capital structure affects its weighted average cost of capital (WACC), which influences investment decisions and firm valuation.

3. Ownership Structure:

Capital structure decisions can influence ownership and control within the firm, particularly in the case of equity financing.

4. Market Perception:

Investors and creditors assess a company's capital structure to evaluate its risk profile and financial health.

5. Flexibility for Growth:

A well-balanced capital structure provides the flexibility needed for future growth initiatives and investment opportunities.

Understanding and managing capital structure is crucial for companies to optimize their financing decisions and maximize shareholder value while balancing risk.

MEASURING THE CAPITAL STRUCTURE

To begin, we must answer this question: How should the capital structure be measured? Should we work with book values as provided by accountants and shown on the balance sheet; with the market values of the debt, preferred stock, and common equity; or with some other set of numbers? To see what’s involved, consider the Table below which compares the book and market values for Caterpillar (CAT) from a recent financial statement.

In this instance, as is commonly observed, the market value of the debt closely aligned with its book value. Therefore, for simplicity's sake, we present the same amount of debt in both the book and market value columns.
However, during the analysis period, the market price of the common stock was $91.22 per share, significantly higher than its book value of $22.61 per share. With 584.3 million shares outstanding, the market value of the equity totaled $53.3 billion, calculated as $91.22 multiplied by 584,300,000 shares, compared to a book value of $13.1 billion.
From the perspective of capital structure, there's no differentiation between common equity obtained through stock issuance or retained earnings. Both components are contributed by shareholders, either through purchasing newly issued shares or allowing the company to retain earnings instead of distributing them as dividends.
Although Caterpillar doesn't utilize preferred stock, if it did, the market value of preferred stock would be determined similarly to how we calculated the market value of its common equity.
While financial theorists generally advocate for using market values over book values, many financial analysts and bond rating agencies rely heavily on book values in their reporting. Additionally, stock prices are highly volatile, leading to fluctuating weights in calculating the Weighted Average Cost of Capital (WACC). For these reasons, some analysts argue in favor of using book values.
Ideally, a firm would identify its optimal capital structure based on market values, maintain that structure through capital raising, and use the optimal percentages to calculate WACC. However, due to market volatility and the impossibility of precisely identifying the optimal structure, most firms focus on a target range for debt ratio rather than a single figure.
Typically, a firm's CFO evaluates the capital structures of benchmarked firms and conducts a similar analysis to the one discussed in this chapter.
Assuming Caterpillar's management determines that the optimal capital structure comprises 50% debt with a target debt range of 45% to 55%, and with average interest rates of 5% for both short-term and long-term debt, an equity cost of 11%, and a corporate tax rate of approximately 30%, the following calculations illustrate the impact of capital structure choice on WACC estimates:

The greater the difference between the stock’s book value and market value, the greater the difference between the alternative WACCs.

9. Utilizing the 50% midpoint target debt ratio, the estimated WACC for an average-risk project for CAT would be 7.25%, approximately 7.3%.

If the actual debt ratio deviates significantly from the target range, the firm may raise capital through debt issuance if below the range, or through equity if above. Additionally, the target range is likely to adjust over time in response to changing conditions.

CAPITAL STRUCTURE CHANGES OVER TIME

Firms' capital structures naturally undergo changes over time, driven by two main factors:

1. Intentional Actions: Companies may actively adjust their capital structures if they are not currently aligned with their target goals. This adjustment often involves raising new capital in a manner that brings the actual structure closer to the desired target.

2. Market Forces: External factors, such as significant profits or losses, can result in notable shifts in a firm's balance sheet and stock price. While the book value of debt may remain constant, fluctuations in interest rates or changes in the firm's risk profile can impact the market value of debt. These market dynamics can lead to substantial changes in the measured capital structure.

Despite these changes, most firms typically have a specific target range for their capital structure. If the current debt ratio exceeds the target, a company may opt to issue additional stock and use the proceeds to pay down debt. Conversely, if a rise in stock price lowers the debt ratio below the target, the company may issue bonds to buy back its own shares. Additionally, firms can gradually move closer to their target over time through annual financing activities to support their capital investment plans.

IMPACT OF INCOME TAXES ON CAPITAL STRUCTURE AND CAPITAL DECISIONS

a. Taxation plays a crucial role as it can encompass a substantial portion, ranging from 25% to 50%, of overall costs.

b. Corporate capital gains are subject to taxation at standard rates, while individual capital gains currently face a tax rate of 16% or less.

c. The dividends-received deduction exempts a significant portion, ranging from 70% to 100%, of dividends received by a company from its investments in another company's stock from taxation. This deduction serves to mitigate or eliminate double taxation and promotes investment in other companies. However, conflicting preferences may arise between corporate and individual owners, as individuals may favor capital gains, whereas corporate owners typically prefer dividends.

d. Interest payments on debt are tax-deductible for the borrowing company, unlike dividends, which are not deductible. Consequently, a company seeking capital may opt to issue bonds rather than stocks to benefit from the tax-deductible interest. This preference leans towards debt issuance for the issuer, as interest deductions reduce tax liabilities. Conversely, investors may lean towards stocks due to their more favorable tax treatment, as returns on stocks are only partially taxable or taxed at lower rates. Additionally, corporations may hesitate to issue common stock to avoid dilution of control, while investors may prefer stocks due to their tax advantages.

e. Multinational corporations often generate income from various countries, each with its tax laws. Therefore, any capital decision involving multiple countries necessitates consideration of the tax regulations of each nation in which the corporation operates.

Sample problems

Question 1:

Which of the following statements best describes the concept of capital structure?

A) The amount of cash a company holds in its reserves

B) The mix of debt and equity used by a company to finance its operations

C) The total number of shares outstanding in a company

D) The ratio of short-term liabilities to long-term liabilities in a company

E) The market value of a company's assets

Question 2:

What is the primary purpose of leveraging in a firm's capital structure?

A) To reduce the risk of financial distress

B) To increase the firm's cost of equity

C) To minimize the firm's weighted average cost of capital (WACC)

D) To maintain a stable debt-to-equity ratio

E) To maximize shareholder dividends

Question 3:

According to the Modigliani-Miller (M&M) propositions, which statement is true?

A) A firm's value is positively correlated with its debt-to-equity ratio

B) A firm's value is dependent on its capital structure

C) A firm's cost of equity is inversely related to its level of leverage

D) A firm's capital structure has no impact on its value under certain conditions

E) A firm's cost of debt is lower when it has higher levels of leverage

Question 4:

What effect does issuing debt typically have on a firm's weighted average cost of capital (WACC)?

A) Decreases WACC

B) Increases WACC

C) Has no effect on WACC

D) Decreases cost of equity but increases cost of debt

E) Increases cost of equity but decreases cost of debt

Question 5:

Which factor does NOT typically influence a firm's capital structure decisions?

A) Current interest rates

B) Corporate tax rates

C) Market volatility

D) CEO's personal investment preferences

E) Industry regulations

Problem 1:

ABC Company has a total market value of $100 million, with $60 million in equity and $40 million in debt. The cost of equity is 12%, and the cost of debt is 6%. Calculate the weighted average cost of capital (WACC) for ABC Company.

Problem 2:

XYZ Corporation is considering issuing $10 million in new debt to finance an expansion project. Currently, XYZ's capital structure consists of 60% equity and 40% debt. If the cost of equity is 15% and the cost of debt is 8%, calculate the new weighted average cost of capital (WACC) for XYZ after issuing the additional debt.

Problem 3:

LMN Inc. has a target capital structure of 40% debt and 60% equity. The company's before-tax cost of debt is 7%, and its cost of equity is 14%. Calculate the weighted average cost of capital (WACC) for LMN Inc. if the corporate tax rate is 30%.

Problem 4:

DEF Corporation has a total market value of $80 million, with $50 million in equity and $30 million in debt. The company's cost of equity is 10%, and its cost of debt is 5%. If DEF's corporate tax rate is 25%, calculate the weighted average cost of capital (WACC) for DEF.

Problem 5:

GHI Enterprises has a current capital structure consisting of 50% debt and 50% equity. The cost of debt is 6%, and the cost of equity is 12%. The company is considering a new project that requires $5 million in funding. If GHI maintains its target capital structure, calculate the maximum cost of equity the company can afford for the new project to keep the weighted average cost of capital (WACC) at 8%.

Answers Key:

MCQ:

B) The mix of debt and equity used by a company to finance its operations
C) To minimize the firm's weighted average cost of capital (WACC)
D) A firm's capital structure has no impact on its value under certain conditions
A) Decreases WACC
D) CEO's personal investment preferences

PROBLEMS:

Problem 1:

ABC Company’s WACC can be calculated using the formula:

Where:

E = Market value of equity = $60 million

D = Market value of debt = $40 million

V = Total market value of the firm = $100 million

re= Cost of equity = 12%

rd= Cost of debt = 6%

T = Corporate tax rate = 0 (as there is no tax mentioned)

Substituting the values:

So, ABC Company's WACC is 9.6%.

Problem 2:

First, let's calculate the new proportion of debt after issuing the additional $10 million debt:

New Debt = $40 million (current debt) + $10 million (additional debt) = $50 million

New Equity = $60 million (total market value) - $50 million (new debt) = $10 million

Now, we can calculate the new WACC using the same formula as Problem 1

Substituting the values:

So, XYZ Corporation's new WACC after issuing the additional debt is 5%.

Problem 3:

First, let's calculate the market value of equity and debt based on LMN Inc.'s target capital structure:

Market Value of Equity (E) = Total Market Value × Proportion of Equity

=V×60%

Market Value of Debt (D) = Total Market Value × Proportion of Debt

=V×40%

Next, let's determine the total market value of the firm (V). Since the target capital structure is given, we can assume any value for the total market value and solve accordingly.

Let's assume the total market value (V) is $100 million.

E = 100 \text{ million} \times 60\% = $60 \text{ million}

D = 100 \text{ million} \times 40\% = $40 \text{ million}

Now, we can calculate the WACC using the formula:

Where:

E = $60 million

D = $40 million

V = $100 millio

𝑟𝑒= 14%

𝑟𝑑= 7%

T = 30%

Substituting the values:

So, the weighted average cost of capital (WACC) for LMN Inc. is 10.36%.

Problem 4:

DEF Corporation's WACC can be calculated using the formula from Problem 1

Where:

E = Market value of equity = $50 million

D = Market value of debt = $30 million

V = Total market value of the firm = $80 million

re= Cost of equity = 10%

rd= Cost of debt = 5%

T = Corporate tax rate = 25%

Substituting the values:

So, DEF Corporation's WACC is 7.66%.

Problem 5:

We know that:

And since GHI Enterprises maintains its target capital structure,

𝐸/𝑉 and 𝐷/𝑉 will remain constant. Therefore, we can use the following equation:

(the initial cost of equity) when WACC is given as 8%.

Let's solve for

𝑟𝑒0:

So, the maximum cost of equity the company can afford for the new project to keep the WACC at 8% is 10.96%.

Sources:

Brigham,E.F., & Houston, J.F. (2019). Chapter 14: Capital Structure and Leverage.

Fundamentals of Financial Management (15th Edition, pp. 476-478). Florida: Cengage.

ISBN: 978-1-337-39525-0

Tuovila, A. (2024, February 25). Capital Structure Definition, Types, Importance, and Examples. Investopedia. https://www.investopedia.com/terms/c/capitalstructure.asp