CAPITAL STRUCTURE: PART IExhibit IExhibit IIExhibit IIIReturnDebt / EquityExhibit IVValueExhibit VReturnCORPORATE FINANCE:AN INTRODUCTORY COURSEDISCUSSION NOTESMODULE #141CAPITAL STRUCTURE: PART II. An Initial Perspective:As a business student, one of the features that I liked about finance was the specificationof an unambiguous objective function for managerial decisions -- The goal of financialdecision-making is to take actions that maximize the wealth of shareholders. Nothingwishy-washy here! The criterion for making the capital structure decision continues in this framework ofwealth maximization. How do we design the capital structure, or the right-hand side of afirm’s balance sheet, to maximize shareholder wealth? This discussion begins our journeyto answer this question.The firm's menu of different financing choices is bewildering, even to finance professionalsand professors. Therefore, we will keep this discussion relatively simple. We willcategorize the firm's choice of capital structure as the choice between generic debt andequity. In the notation used by many texts, we will use B to represent bonds (debt) and Sto represent stock (equity). However, many texts and applications use D and E torepresent these securities. In lecture I will use both notations to help you becomecomfortable with either presentation.II. The Capital Structure Decision in Perfect Capital Markets (PCM):As in other areas of economics, financial economics begins most investigations of a topicby assuming the most simple of all environments, environments "pure" of contaminating"real world" factors. In this context, we will begin by assuming Perfect Capital Markets(PCM) to address the question of how the choice of capital structures affects shareholderwealth.2 Once we have answered the question in this environment, we will begin relaxingour PCM assumptions, one-by-one, to see how the "real world" existence of marketimperfections influences our capital structure choice. We will conclude that if it were not for market imperfections, shareholders would betotally indifferent to the managers' decisions about capital structure, i.e., one capital1 This lecture module is designed to complement Chapter 14 in B&D.2 As a review, under PCM the following conditions are assumed: 1) Information is free and available to everyone on an equal basis. 2) No distorting taxes exist. 3) Flotation and transactions costs are non-existent. 4) No contracting costs or agency costs exist; therefore, managers make decision to maximize shareholder wealth and they do not attempt to exploit bondholders. 5) All investors and firms are price-takers, i.e., they do not exert enough power in the markets to influence the market price of securities. 6) Individuals and firms all have equal access to the financial markets and on the same terms, e.g., interest rates.1structure would be just as good as another. To put it a slightly different way, no capitalstructure would increase shareholder wealth relative to another capital structure.Why do we begin with the unrealistic world of PCM? As we will discover, marketimperfections are so complicated that if we threw them all into a capital structure model atonce we would become hopelessly confused. Accordingly, we relax the assumptions andadd imperfections one at a time to get "cleaner" picture of what imperfections might"cause" capital structure to matter (i.e., impact shareholder wealth) in what way.While we will relax most of our assumptions about PCM, we will not relax two additionalassumptions :- The firm will make all real investment decisions using the NPV Rule, i.e., takeall projects that have positive NPV's, and- The firm will hold its dividend policy constant, i.e., do not change the dividendpolicy of the firm as a function of the capital structure decision.At this point in the course, you should be comfortable with the fact that managers canincrease shareholder wealth by taking positive NPV projects. While the evidence is muchless compelling, we will later learn that it is possible that managers may be able toinfluence shareholder wealth by their choice of dividend policies. Accordingly, toseparately examine the influence of capital structure on shareholder wealth, we will holdthese other two decisions constant.In our simplified model of capital structure, the value of the unlevered (all equity financed)firm, Vu, is simply the market value of the firm's equity, orVU = S, whereS is the aggregate value of the equity, or the price per share of common stock times thenumber of shares of common stock outstanding. Correspondingly, the value of the leveredfirm, VL is the market value of the firm’s debt plus the market value of its equity, orVL = B + S, whereB is the aggregate value of the debt, or the price of each bond times the number of bondsoutstanding; and S is defined as above.3Again, our goal as financial managers is to maximize shareholder wealth. While we willnot mathematically prove that maximizing shareholder wealth is equivalent to maximizingfirm value, this conclusion holds under the assumptions we maintain.Maximizing firm value also will maximize shareholder wealth.4 3 Perhaps it goes without saying, but without debt a firm is "unlevered." With debt, a firm has “leverage,” is “levered” or, more specifically, has “financial leverage.”4 This conclusions holds under the conditions that default on the firm's debt is not likely. Most textbooks illustrate this condition. For instance, see Ross, Westerfield, Jaffee, Corporate Finance, Irwin McGraw-Hill, 2001, 6th Ed., Section 15.2.2Under these conditions, the financial manager strives to choose the capital structure thatmaximizes firm value. Since all firms must have some equity, i.e., some residual owners must exist5, the realquestion is whether by adding debt we can design a capital structure so that VL > VU, orthe value of the firm if it were levered is greater than the firm’s value is when it isunlevered.Also if we can get this inequality to hold, what is the optimal amount of debt to add, i.e.,the amount of debt that will maximize VL?Modigliani and Miller:Without doubt, the most famous names in corporate finance are Franco Modigliani(MIT) and Merton Miller (University of Chicago). These financial