IFM10 Ch15 Solutions Manual.docx

IFM10 Ch15 Solutions Manual.docx

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IFM10Ch15SolutionsManual

Chapter15

CapitalStructureDecisions:

PartI

ANSWERSTOBEGINNING-OF-CHAPTERQUESTIONS

PrefacetoAnswers:

Studentsoftenregardcapitalstructureasbeingthemostdifficulttopiccoveredinthistext.Theempiricalevidenceontheeffectsofcapitalstructurearefarfromdefinitive,andthetheoryiscontroversial.Academiciansgenerallyfocusonmarketvalues,whicharetheoreticallycorrect,whilemanyfinancialexecutivesfocusonbookvalues,whicharetheoreticallyquestionablebutinsomewayseasiertodealwith.Wewrestledwiththisissue,anddecidedtobaseourExcelmodelstrictlyonmarketvalues.Thisledustouseaniterativesolutionprocess,whichgetscomplicated.Ourbetterstudentsfollowalongandliketheapproach,becauseeverythingworksoutnicely.However,ourweakerand/orlazierstudentsdon’tconcentrateandgetlost.Wewentthroughthemodelinclass,asitexplainstheessentialcapitalstructureissuesrelativelywellandalsoillustratesthepowerofcomputermodeling.However,otherinstructorsmightprefertotakealessrigorousapproachandskiptheExcelmodel.

15-1Businessriskistheriskinherentinthefirm’soperatingincome.Itismeasuredbythestandarddeviationofexpectedfutureoperatingincome.Itisaffectedbymanyfactors,includingthefirm’sabilitytoraisepricesifcostsincrease,theextenttowhichsalescanbepredicted,andoperatingleverage,whichreflectstheuseoffixedcosts,orcoststhatdonotdeclinewithdecreasesinsales.Ifafirmusesmoreoperatingleveragethananotherwiseidenticalsecondfirm,then,otherthingsheldconstant,itsoperatingincomeandtherateofreturnonassetswillbelesspredictable,whichsuggestsgreaterbusinessrisk.Thehigherbusinessriskwouldaffectbothbondholdersandstockholders,althoughtheeffectonbondholdersismitigatedifthefirmusesrelativelylittledebt.ThefirstpartoftheBOCspreadsheetmodelillustratesthispoint.

Generally,higheroperatingleverageiscorrelatedwithhigherexpectedoperatingincomeandhigherreturnsoninvestedcapital.Generallyspeaking,sincemoreoperatingleveragemeansmorerisk,thenafirmwouldnotincreaseitsoperatingleverage（throughcapitalbudgetingdecisions）unlessthatresultedinhigherexpectedreturns.

However,theanalysiscanbemorecomplicated.Intheprecedingparagraphweimplicitlyassumedthatthefirm’ssalesareindependentofitsuseofoperatingleverage.However,thismightnotbetrue.Higherfixedcostsaregenerallyaccompaniedbylowervariablecosts,andproducerswithlowvariablecostscan,undercertainconditions,achieveamonopolypositionbydoingthefollowing:

（1）Chargeapricethatisabovetheirown（low）variablecostbutbelowthevariablecostsofotherproducers.

（2）Thehighcostproducersfindthemselvesinabind.Iftheydonotmatchthelow-costproducers’prices,theywilllosemarketshare,butiftheydomatchthisprice,theywilllosebig-timebecausetheywillnotevenbecoveringtheirvariablecosts.（3）Thus,thehigh-costproducerscanbedrivenfromthemarket,leavingthelow-costproducerinamonopolypositioninwhichitcanraiseitspriceandthenearnveryhighratesofreturn.Thissituationisillustratedinthemodel.

Ourconclusionfromallthisisthatincreasingoperatingleveragegenerallyincreasesbothbusinessrisksandexpectedreturns,butthisconditionmaynotbetrueifotherfirmswithlowvariablecostsarewillingtousepredatorypricinginordertoachieveamonopolyposition.Therefore,itisimportantthatstrategiccostandmarketconditionsbeanalyzed.Spreadsheetmodelscanhelpinthisregard.

15-2Financialleveragerelatestotheuseoffixedchargesecurities（debtandpreferredstock）.Sincethechargesassociatedwithdebtandpreferredarefixed,theydonotdeclinewhensalesandoperatingprofitsdecline.Therefore,themoredebtandpreferredthefirmuses,thegreatertheriskbornebythecommonstockholders

Ifthefirmisexposedtoagreatdealofbusinessrisk,thenitsoperatingincomeissubjecttouncertainty,anditsinvestorswillbeexposedtoquiteabitofrisk.Ifitthenpilesonalotoffinancialleverage,itsalreadyhighbusinessriskwillbeconcentratedonitsstockholders,exposingthemtoagreatdealofrisk.Bondholders’risksarealsoincreasedbybothtypesofleverage.Withmorefinancialleverage,therewillbehigherfixedchargestobepaidoutofwhateveroperatingincomethefirmhas,andthismeansalowertimesinterestearnedratio,whichisonewayofmeasuringtheriskinessofdebt.TheBOCshows,foranillustrativefirm,howtheTIEisaffectedbyfinancialleverage.

Managerscancontroltheirfinancialleverage,atleastinitially,althoughleveragewillchangeoncethefirmisupandrunningduetochangesinthemarketvalueofitsdebtandequity.Managerscanalsocontroloperatingleveragetoacertainextent,althoughinmostindustriesefficiencyrequiresatleastacertainamountofoperatingleverage.IntheBOCmodel,weassumethatthefirmcanoperatewitheitherPlanAorPlanB,althoughweeventuallyassumethatPlanAisruledout.

Regardingfinancialleverage,thefirmcanestablishatargetcapitalstructureandthenplantofinanceaccordingtothetarget.However,oncethefirmisinbusiness,withagivenamountofdebtandsomenumberofsharesoutstanding,changesinitssalesandearnings,andalsoincapitalmarketrates,canleadtodeparturesfromthetarget.Ifthingsgowell,thevalueoftheequitywillincrease,andthatwillleadtoalowermarketvaluedebtratio.Then,thefirmcouldborrow,usethefundstoretirestock,andlowerthedebtratiotothetargetlevel.However,ifconditionsdeteriorate,causingequityvaluesgodownandthedebtratiogoesup,itmaybeextremelydifficulttogetbacktothetarget.Still,inaplanningsense,firmscancontroltheircapitalstructuresandfinancialleverage.

15-3ModiglianiandMillerareNobelPrizewinningfinancialeconomistswhodidpioneeringworkoncapitalstructuretheory.Theyconcludedthat,underaspecificsetofassumptions,includingtheassumptionofnotaxes,capitalstructureisirrelevantbecauseithasnoeffectoneithertheWACCorthevalueofafirm.Whentheyaddincorporatetaxes,theirmodelleadstotheconclusionthatafirm’scostofcapitalisminimized,anditsvaluemaximized,at100%debt.

15-4IfmanagersthoughtMMwerecorrect—i.e.,thattheirassumptionsweretrue—thentheywoulduse100%debt.Sincefirmsdonotgenerallysetcapitalstructureswith100%debt,thisdemonstratesthatexecutivesseeaproblemwiththepureMMmodel.MM’sassumptionsareclearlynotcorrect,hencenooneshouldexpecttheresultsoftheirmodeltobecorrectintherealworld.Still,thebeautyofMM’sworkisthatitshowsuswhatdoescausecapitalstructuretoaffectWACCandvalue—thingsliketaxes,brokeragecosts,bankruptcy,andsoon.

15-5Thetrade-offtheorymodifiesMMandbringsintheeffectsofbankruptcy,taxes,andsoforth.WhereasMMproducepreciseresultsunderspecificassumptions,thetrade-offtheoryproducesnebulous,impreciseresults.Still,thetrade-offresultsaremoreconsistentwithrealworldobservationsthanaretheMMresults.Seethegraphonaseparatetabinthemodel（Figure2）fortherelationshipbetweencostofcapitalandcapitalstructurenderthetrade-offtheory,andFigure1towardthebottomofthe“MainModel）forvalueversuscapitalstructureunderMMandtrade-off.Wedon’tshowagraphofstockpriceversuscapitalstructure,butoneofthedatatablesinthemodelshowsthatthefirm’sstockpriceismaximizedat40%debt,wherethestock’spriceis$16.46,upfrom$15ifnodebtisused.InthecaseofanIPO,whichisthefirstsituationanalyzedinthemodel,thestockpriceissetat$15andthendifferentpercentagesofthecompanyaregiventooutsideinvestorstobringintheneededequitycapital.

MM’smodelleadstotheconclusionthatfirmsshouldfinanceentirelywithdebt,whereasthetradeoffmodelreachesthemorelogicalandempiricallycorrectconclusionthatfirmsshouldnotfinanceentirelywithdebt,andthatthereissomeoptimalcapitalstructure（whichvariesfromfirmtofirmdependingonitsoperatingconditionsanditsaccesstodebtandequitycapitalmarketsandthecostofthosefunds）.

15-6Whencompaniesfinancewithstock,theybringinnewinvestors.Ifmanagementthinksthatthingsinthefuturewillbealotbetter,theywouldnotwanttobringinnewequityinvestors,asthiswouldmeanmoresharesoutstandingandadilutionofthecurrentequity.So,ifmanagementseesgoodtimesahead,thepreferredfinancingvehicleisdebt.Therefore,ifafirmannouncesthatitplanstosellanewstockissue,investorstakethisasanegativesignal—asignalthatthingsmightnowgoverywellinthefuture.Ontheotherhand,theannouncementofalargedebtofferingistakenasapositivesignal.Consequently,whenafirmannouncesasignificantnewstockoffering,itspricetypicallydeclines,whereastheannouncementofadebtofferingislikelytoleadtoastockpriceincrease.

Knowingthis,managersarereluctanttofinancewithnewstock.Thisinfluencesdividendpolicy,causingcompaniestoretainmoreearningssoastobuildequitythatwillsupportadditionaldebtofferingsattimeswhennewcapitalisneeded.Inthefinancialjargon,astrongbalancesheet（i.e.,arelativelylowdebtratio）providesfinancialflexibility,whichmeanstheabilitytoraisecapitalasdebtiftheneedarises.

Theendresultisthatsignalingconsiderationscausecompaniestocarryalowerdebtratioduring“normal”timesthanthetrade-offtheor