Slide 1Overview Of Capital Structure Theory & PracticeCapital Structure Patterns Observed WorldwideMarket Value Debt Ratios, Selected U.S. Corporations, July 2002Leverage Ratios For G-7 And Selected Developing Countries, 1980-91CS Patterns Observed Worldwide (Continued)Market-Value Leverage Ratios (Total Debt-to-Total Capital) For US Corporations, 1929-1993Capital Structure Patterns Observed Worldwide (Continued)Theoretical Models Of Capital StructureThe M&M Capital Structure ModelM&M’s Proposition I: Capital Structure IrrelevanceTable C: Income Statements For Unleverco & Leverco With Corporate Income TaxesDel HawleyFIN 634Del HawleyFIN 634Fall 2003Fall 2003Capital Structure: Theory And TaxesCapital Structure: Theory And TaxesChapter 12Chapter 12Overview Of Capital Structure Theory & PracticeOverview Of Capital Structure Theory & Practice•The capital structure question: can the mix of debt and equity a firm issues affect its total market valuation?–Has been a key issue in finance theory & practice since 1958•Capital Structure patterns observed worldwide–Similarities & differences between US, other OECD countries•The Agency Cost/Tax Trade-Off Theory of capital structure–Not perfect, but works better than principal competitors–Time won’t allow examination of other two theories•The Modigliani-Miller capital structure irrelevance propositions–Perfect capital markets assumption underlying Proposition I–Proposition II’s implications for corporate financial policy•The impact of income taxes on the irrelevance propositions–Corporate income tax: 100% debt is optimal–Irrelevance perhaps rescued by personal taxesCapital Structure Patterns Observed WorldwideCapital Structure Patterns Observed Worldwide•Capital structures have strong industry patterns, and these are the same around the world. –High debt-to-equity industries: utilities, transport cos, and mature, capital-intensive manufacturing firms –Low D/E industries: service firms, mining companies, most rapidly growing or technology-based manufacturing firms –Implies an industry's optimal asset mix influences CSs chosen by firms in that industry anywhereMarket Value Debt Ratios, Selected U.S. Corporations, July 2002Market Value Debt Ratios, Selected U.S. Corporations, July 20021.190.550.69Georgia Pacific1.620.360.54American Electric Power1.920.250.27Walt Disney10.130.070.12Procter & Gamble3.650.240.27Boeing4.120.830.84General Motors0.820.750.77Delta Air Lines3.720.030.04ExxonMobil4.0300Intel5.5400Microsoft Market to book ratioL-T debt to total capitalDebt to total assetsCompanyLeverage Ratios For G-7 And Selected Developing Countries, 1980-91Leverage Ratios For G-7 And Selected Developing Countries, 1980-91 Country Total debt to total asset (Book value %) L-T debt to total assets (Book value %) L-T debt to total capital (Market value %) United States 58% 37% 28% Japan 69 53 29 Germany 73 38 23 France 71 48 41 Italy 70 47 46 United Kingdom 54 28 35 Canada 56 39 35 India 67 34 35 South Korea 73 49 64 Turkey 59 24 11 Source: Rajan and Zingales, “What do We Know About Capital Structure: Some Evidence fromInternational Data,” Journal of Finance 50 (1995).CS Patterns Observed Worldwide (Continued)CS Patterns Observed Worldwide (Continued)•Leverage ratios are inversely related to the perceived costs of financial distress. –Both across industries & across countries, the more costly is financial distress, the less debt will be used. –Companies rich in collateralizeable assets have higher leverage than firms rich in growth options. •Within industries, leverage is inversely related to profitability –In all industries, the most profitable companies typically borrow the least, suggesting that CS at least partly residual•Corporate & personal taxes influence capital structures, but they neither cause nor prevent corporate leverage. –US corps used as much debt before 1913 as after–Increased corporate tax rates yield increased debt usage –Decreases in the personal tax rates on equity income yield decreased corporate debt usage.Market-Value Leverage Ratios (Total Debt-to-Total Capital) For US Corporations, 1929-1993Market-Value Leverage Ratios (Total Debt-to-Total Capital) For US Corporations, 1929-199305101520253035404550%19901980197019601940 19501930Capital Structure Patterns Observed Worldwide (Continued)Capital Structure Patterns Observed Worldwide (Continued)•Existing S/Hs consider leverage-increasing events "good news" and leverage-decreasing events "bad news" –Stock prices rise when leverage-increasing events announced, but fall for leverage-decreasing events. •Corporations that are forced away from a preferred capital structure tend to return to that structure over time –Has occurred frequently, particularly for US firms that have taken on large amounts of new debt to finance takeovers. –More generally, corporations like to operate within target leverage zones, and will issue new equity when debt ratios get too high and will issue debt if they fall too low.Theoretical Models Of Capital StructureTheoretical Models Of Capital Structure•First important theoretical model in corporate finance was Modigliani & Miller’s (M&M) capital structure model in 1958–In frictionless capital markets, with no taxes or transactions costs, CS is irrelevant--doesn’t affect valuation•Today’s best theoretical explanation for observed CS patterns is the Agency Cost/Tax Shield Trade-Off Model–Assumes that observed CSs result from firms trading off the tax benefits of debt usage against the increasingly severe agency costs as debt ratios approach critical levels•The Pecking Order Theory based on two key assumptions–(1) managers are better informed about the investment opportunities faced by their firms than are outsiders; (2) managers act in the best interests of existing shareholders.•Signaling Model of CS also assumes asymmetric information–but managers use debt as a costly signal to differentiate their firms from weaker competitorsThe M&M Capital Structure ModelThe M&M Capital Structure Model•Assumptions of the M&M Capital Structure Model–All physical assets are owned by corporations;–Frictionless Capital markets: no corporate or personal income taxes, securities are traded costlessly, no bankruptcy costs;–Corporations can issue only risky equity and risk-free debt;–Both individuals and corporations can borrow or lend at the