MBA 643 Managerial Finance Lecture 12: Corporate Capital Structure Policy

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MBA 643Managerial FinanceLecture 12 Corporate
Capital Structure Policy

• Spring 2006
• Jim Hsieh

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Overview

• A firm consists of assets, which produce a stream
  of cash flows. The capital structure decision
  determines how those assets will be paid for, and
  how the cash flows will be allocated among
  different claims (debt or equity).
• An important question (revisit) Can a firm
  increase the value of its assets by issuing a
  particular set of securities?

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The Modigliani/Miller Theorem (1958)

• Proposition I If
• There are no taxes
• There are no contracting costs
• The firms investment policy is fixed
• Then
• The value of the firm is independent of its
  financing policy.
• A Quick Lesson on Logic
• If A then B implies If (not B) then (not
  A)

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Restatement of Proposition I

• If the choice of capital structure affects
  current firm value, then it does so by
• Changing tax liabilities
• Changing contracting costs
• Changing investment incentives

E
D
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Example 1.A

• The Nantucket Nugget is unlevered and is valued
  at 640,000. Nantucket is currently deciding
  whether including debt in their capital structure
  would increase their value. Under consideration
  is issuing 300,000 in new debt with an 8
  interest rate. Nantucket would repurchase
  300,000 of stock with the proceeds of the debt
  issue. There are currently 32,000 shares
  outstanding and their effective tax rate is zero.
  What is the change in value? How many shares of
  stock will be repurchased?
• Old CS V 640,000 E
• New CS D 300,000 and E 640,000-300,000
  340,000
• Price 640,000/32,000 20
• Shares repurchased 300,000/20 15,000 (shares)

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MM Proposition II (no taxes)

• MM(I) implies rA is independent of leverage.
• Remember rWACC rA D/A rD E/A rE
• gt rE rA (D/E)(rA rD)
• MM (II) rE increases with leverage.

r ()
rE
rA
rD
D/E
riskless debt
risky debt
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MM II (no taxes)

• The expected return on equity (rE) increases
  linearly with the D/E ratio as long as debt is
  risk-free. But if leverage increases the risk of
  the debt, debtholders demand a higher return on
  debt. This causes the rate of increase in rE to
  slow down.
• Example 1.B The Nantucket Nugget currently has
  rE 12. After Nantucket repurchases the stock,
  what will the firms overall cost of capital (rA)
  be?
• According to MM I, rA rE 12
• After the repurchase, what will be cost of equity
  be?
• rE rA(D/E)(rA rD) 0.12300,000/340,000(0.1
  2-0.08) 15.53

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Relaxing the MM Assumptions

• If debt policy were completely irrelevant, debt
  ratios would look random. But, they dont. Debt
  ratios tend to cluster within industries,
  suggesting that firm characteristics are
  important.

Median Industry Debt Ratios, 1993 Median Industry Debt Ratios, 1993
Apparel 0.059
Chemicals 0.097
Oil and Gas Extraction 0.195
Restaurants 0.248
Communications 0.438
Air Transportation 0.566
Hotels and Lodging 0.602
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What Can Explain Firms Financing Choices?

• We know that if capital structure matters, it
  matters because at least one of the MM
  assumptions are violated.
• Taxes (Corporate and individual)
• Costs of financial distress (Bankruptcy costs)
• Agency costs
• We discuss the first two assumptions in this
  lecture.

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Corporate Taxes (MM, 1963)

• Interest payments to bondholders are deductible
  for tax purposes while dividend payments to
  equityholders are not.

D
E
TC
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How Much a Firm Can Save By Using Debt?

• If the firm uses debt
• Interest payment rDD
• Interest payment can be deducted before tax is
  calculated.
• So, tax reduction from interest payment TCrDD
• If we assume the companys debt is permanent,
  then
• PV(tax shield) TCrDD/rD TCD
• MM I with corporate taxes
• VL VU TCD
• Value of a levered firm Value if all-equity
  financed PV of tax shield
• MM II with corporate taxes
• rE rA D/E(1-TC)(rA rD)

Tax Shield
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Example 2

• Blue Inc. has no debt and is expected to generate
  4 million in EBIT in perpetuity. TC30. All
  after-tax earnings are paid as dividends. The
  firm is considering a restructuring, allowing 10
  million in debt with an interest rate of 8. The
  unlevered rE18.
• What is the current value of Blue?
• VUEBIT(1-TC)/rA(40.7)/0.18 15.56 million
• What will the new value be after the
  restructuring?
• VLVUTCxD 15.56 0.310 18.56 million
• New CS D10 million, E8.56 million
• What will the new required return on equity be?
• rE rA D/E(1-TC)(rA rD)
  0.18(10/8.56)(0.7)(0.18-0.08) 26.18

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Personal Taxes

• Unfortunately, the above MM I implies that 100
  debt financing is optimal. In reality, we dont
  observe firms with debt ratios equal to 100.
• There are two costs associated with debt
• Personal taxes
• Bankruptcy costs
• When corporations pay interest on debt, they
  reduce their own taxes, but increase the taxes of
  individuals (debtholders). Thus, while there is
  a corporate tax advantage to debt, there is a tax
  disadvantage to the debtholders.

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Personal Taxes

• Ultimately, the corporations must bear all of the
  taxes associated with its activities either
  directly or indirectly through higher required
  rates of return on debt.
• Under corporate and personal taxes, we have the
  new valuation model (Miller, 1977)
• TB personal tax rate on ordinary income such as
  interest
• TS personal tax rate on equity distributions
  such as dividend
• If (1-TB)(1-TC)(1-TS), then debt policy is
  irrelevant again.
• If TBTS, then we go back to the world without
  personal taxes.

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Bankruptcy Costs

• If the costs of financial distress are positive,
  then this implies that 100 debt financing is NOT
  optimal.
• New Valuation Model VL VU TCD - BC
• Bankruptcy is a legal mechanism that allows firms
  to renegotiate the terms of their debt contracts.
• Direct bankruptcy costs costs of using this
  legal framework.
• Indirect bankruptcy costs loss in value realized
  when customers nd suppliers abandon a bankrupt
  firm.

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More on Bankruptcy

• Default
• When the firm is in violation of debt covenants
  or any other contract provisions.
• Bankruptcy
• The legal proceedings under which court
  protection allows the firm to liquidate (Chapter
  7) or reorganize (Chapter 11).
• Liquidation (Chapter 7)
• The death of the firm. Its assets are sold and
  the proceeds distributed to claimholders.
• Only 10 of all bankruptcies end in Chapter 7.
• Reorganization (Chapter 11)
• 90 are reorganizations which are debtor friendly.

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Put Everything Together-- The Trade-off Theory
Firm Value
Optimal Capital Structure
VU PV(tax shield)
BC
VL VU PV(tax shield) - BC
PV(tax shield)
Value if all equity financed (VU)
Debt Ratio
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An Alternative Explanation on CS-- The Pecking
Order Theory

• Information asymmetry between financial managers
  and outside investors
• Equity issuances send a signal to the market that
  managers feel its a window of opportunity to
  issue more equities.
• Over-valuation argument
• Rules of the Pecking Order
• Internal financing Use project-generated CFs
• External financing Issue the Safest Securities
  first.
• Debt financing
• Equity financing (last resort)