CHAPTER 16-7 Capital Structure Decisions: The Basics (Short version)

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CHAPTER 16-7 Capital Structure Decisions
The Basics (Short version)

• Business vs. financial risk
• Capital structure theory
• Setting the optimal capital structure

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Capital Structure Decisions Extensions

• MM models
• Miller model
• Financial distress and agency costs
• Tradeoff models

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HOW DO YOU MEASURE THE VALUE OF THE FIRM?

• From the perspective of capital structure theory,
  the answer is
• V S(market value of equity--common and
  preferred) D (market value of debt.
• Key question Does the ratio of Debt to equity
  (D/S) affect the value of the firm?
  

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ISOLATION OF FINANCING DECISION

• When discussing optimal capital structure, to
  isolate this decision, we insist that any
  issuance of debt must be accompanied by a
  repurchase of stock and any issuance of stock
  must be accompanied by a retirement of debt.
• Hence, only debt-equity ratio changes no
  increase or decrease in size of the firm.

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Isolation of financing decision (continued)

• By this isolation, the financing decision is
  isolated from decisions relating to asset
  management or investment decisions of the firm

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Data of industrial debt equity ratios Insert
graphs

• Do these represent optimal capital structure,
  or
• Do they simply represent stupidity on the part of
  financial managers?

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DIGRESSION TAX SHIELD

• Advantage of debt in a world of corporate taxes
  is that interest payments are a tax-deductible
  expense to the debt-issuing firm however
  dividends are not tax-deductible.
• Hence, total amount of funds available to pay
  both debtholders and shareholders is greater if
  debt is employed.
  gman208n\txshld.xls

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EV(tax shield benefits)

• Tax savings are not usually certain, as implied
  above, because
• if taxable income is low or negative, tax
  benefits are reduced, or even eliminated
• if firm should go bankrupt and liquidate, future
  tax benefits stop.
• uncertainty that Congress may change the tax rate.

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Business Risk vs. Financial risk
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Business Risk versus Financial Risk

• Business risk
• Uncertainty in future EBIT.
• Depends on business factors such as competition,
  operating leverage, etc.
• Financial risk
• Additional business risk concentrated on common
  stockholders when financial leverage is used.
• Depends on the amount of debt and preferred stock
  financing.
• Concentrates business risk on stockholders.

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We will skip operating leverage to save some time.
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Financial Leverage
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Business Risk vs. Financial Risk

• Firms total risk (to its stockholders) is the
  sum of its business and financial risk
• Total risk Business risk financial risk

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Total (stand alone) risk vs. market risk

• Risk may be measured in either a total (stand
  alone) risk or a market risk framework. This is
  similar to the discussion of total vs. market
  risk in portfolio theory.

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How are financial and business risk measured in a
stand-alone (or total) risk framework, i.e., the
stock is not held in a portfolio?
Stand-alone Business Financial risk risk risk
.
Stand-alone risk sROE. Business risk
sROE(U). Financial risk sROE - sROE(U).
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Now consider the fact that EBIT is not known with
certainty. What is the impact of uncertainty on
stockholder profitability and risk for Firm U and
Firm L?

• Suppose, the unleveraged firm issues 10K of debt
  and buys back 10K of equity.

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Firm U Unleveraged
A20K, D0,E20K
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Firm L Leveraged
Same as for Firm U.
A20K, D10K, E10K, int.12
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8
8
8
ROI (NI Interest)/Total financing.
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8
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Conclusions

• Basic earning power BEP EBIT/Total assets is
  unaffected by financial leverage.
• L has higher expected ROI and ROE because of tax
  savings.
• L has much wider ROE (and EPS) swings because of
  fixed interest charges. Its higher expected
  return is accompanied by higher risk.

(More...)
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• In a stand-alone risk sense, Firm Ls
  stockholders see much more risk than Firm Us.
• U and L ?ROE(U) 2.12.
• U ?ROE 2.12.
• L ?ROE 4.24.
• Ls financial risk is ?ROE - ?ROE(U) 4.24 -
  2.12 2.12. (Us is zero.)

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• For leverage to be positive (increase expected
  ROE), BEP must be gt rd.
• If rd gt BEP, the cost of leveraging will be
  higher than the inherent profitability of the
  assets, so the use of financial leverage will
  depress net income and ROE.
• In the example, E(BEP) 15 while interest rate
  12, so leveraging works.

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In Fact

• ROE BEP (BEP - rd)(1-T) (D/E)

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Market risk framework
Market Risk Framework

• Hamadas equation provides the relationship
  between business risk and financial risk
• rsL rrf (rm - rrf)bu (rm - rrf)
  bu(1-T)(D/S)

Time value premium
business risk premium

financial risk premium

But also, rsL rrf (rm - rrf) bL
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Market risk framework (continued)

• Therefore,
• rrf (rm - rrf) bu (rm - rrf) bu(1-T)(D/S)
  

rrf (rm - rrf) bL
or bL bu bu(1-T)(D/S)
business risk
Total risk

financial risk

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Hamada equation for beta bL

.
bU Unlevered beta, which reflects the riskiness
of the firms assets Business risk
b U(1 - T)(D/S) Increased volatility of the
returns to equity due to the use of
debt Financial risk
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Consider financial risk term
bu(1-T)(D/S)
The higher the D/S, the higher the financial risk
The higher the T, the lower the financial risk.
Why?
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Market risk framework (continued)

• or , another way to write total risk

bL bu 1 (1-T)(D/S)
or
bu bL / 1 (1-T)(D/S)
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Trade-off Theory

• MM theory ignores bankruptcy (financial distress)
  costs, which increase as more leverage is used.
• At low leverage levels, tax benefits outweigh
  bankruptcy costs.
• At high levels, bankruptcy costs outweigh tax
  benefits.
• An optimal capital structure exists that balances
  these costs and benefits.

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Heres a valuation model which includes financial
distress and agency costs.
PV of expected financial distress
PV of agency costs
VL VU XD -
-

• X represents either Tc in the MM model or the
  more complex Miller term.
• Conclusion Optimal leverage involves a tradeoff
  between the tax benefits of debt financing and
  the costs associated with financial distress and
  agency.

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VL VU XD - PV(fin.dist.costs) - PV(agency
costs)
Tax effect alone
Value of Firm ()
Net Tax effect alone
4 3 2 1
Financial distress and agency costs
W/ taxes and bankruptcy and agency costs
Debt ()
Opt. Capital structure
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Relationship between value and leverage.
Value of Firm ()
4 3 2 1
Debt ()
Another view
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Relationships between capital costs and leverage
considering financial distress and agency costs.
Cost of Capital ()
ks
14 4
WACC
kd
Debt ()
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Define financial distress and agency costs.

• Financial distress As firms use more and more
  debt financing, they face a higher probability of
  future financial distress, which brings with it
  lower sales, EBIT, and bankruptcy costs. Lowers
  value of stock and bonds.
• Agency costs The costs of monitoring managers
  actions. Increases with leverage.

More on agency and bankruptcy costs
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Bankruptcy Costs

• In a bankruptcy, bondholders are likely to hire
  lawyers to negotiate or sue the company.
  Similarly, the firm is likely to hire lawyers to
  protect itself. Costs are also incurred in a
  bankruptcy. These fees are all paid before the
  bondholder gets paid.
• Further, costs of purchasing inputs by a risky
  (subject to bankruptcy) firm increase.

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BANKRUPTCY COSTS (contd)

• The possibility of bankruptcy has a negative
  effect on the value of the firm.
• It is not the RISK of bankruptcy, but rather it
  is the COSTS associated with bankruptcy that
  lower value.
• Bankruptcy eats up part of the pie leaving less
  for stockholders and bondholders.

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AGENCY COSTS

• Definition A contract under which one or more
  people (principals) hire another person (agent)
  to perform some service and then delegates
  decision making authority to that agent.

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Types of Agency Cost relationships

• Stockholders vs. management
• Stockholders vs. bondholders Recall Marriott
  example.

Assets 200 Debt 100 Assets 100 Debt 100 Eq.
100 Assets 100 Equity 100
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Event Risk

• The risk that some deliberate action or event
  will convert a high-grade bond into a junk bond
  overnight and thus lead to a sharp decline in it
  value. E.g. Marriott or RJR. Effect of adding
  more and more debt From the stockholders point
  of view Heads I win risks pay off Tails you
  (the bondholder) lose.risks dont pay off

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AGENCY COSTS

• If a company were to sell only a small amount of
  debt, the debt would have
• low risk
• a high bond rating
• a low interest rate
• However, if, after it sold the low risk debt, it
  issued more debt, secured by the same assets

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• This would
• Raise risk faced by all bondholders
• Cause rd to rise
• Cause original bondholders to suffer capital
  losses

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• Similarly, suppose that after issuing the new
  debt, the firm decides to restructure its assets
• Selling of low risk assets, and
• Acquiring riskier assets, which have a higher
  expected rates of return

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• If things work out, stockholders benefit
• If things dont work out, most of the loss falls
  on the leveraged bondholders
• Stockholders are playing the game Heads I win,
  tails you lose with the bondholders.

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AGENCY COSTS

• There are deliberate actions which would help
  stockholders and harm bondholders.
• As we have seen, if there were no restrictions,
  stockholders would be tempted to
• sell successive debt issues backed by the same
  assets
• sell existing assets, replacing them with high
  risk assets
• issue junk bonds and expand or go through a LBO

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Agency Costs

• Because of these possibilities, bond holders are
  protected by restrictive bond covenants. These
  often hamper the firms legitimate operations to
  some extent.
• Further the company must be monitored to insure
  compliance.

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Agency Costs

• The restrictive costs of these bond covenants and
  monitoring costs (I.e. lost efficiencies) are
  passed through to the stockholders in the form of
  higher debt costs.
• The greater the debt ratio, the greater the
  agency costs.
• As a result. this reduces the value of debt, and
  lowers the debt/equity ratio.

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How do financial distress and agency costs change
the MM and Miller models?

• MM/Miller ignored these costs, hence those models
  overstate the value of leverage.

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An example of signaling theory
Asymmetric Information
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Asymmetric Information

• The asymmetric information theory of capital
  structure is based on two assumptions
• 1. Managers have better information about their
  firms future prospects than do investors. Thus
  asymmetric information exists.

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Asymmetric information theory (cont)

• 2. Managers act in the best interest of the
  current shareholders in the sense that managers
  act to maximize current shareholders (including
  themselves) wealth.

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Asymmetric information theory (cont)

• Under these assumptions, if outside capital is
  needed, managers would issue new stock if they
  believed their stock to be overvalued
• But, they would issue new debt if they believed
  the stock to be undervalued.

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Asymmetric information theory (cont)

• 1. Investors recognize this, and thus tend to
  view a new common stock offering as a negative
  signal (overvalued stock). Therefore, the price
  of companys stock typically declines if it
  announces a new stock offering.
• (Doesnt apply to IPOs)

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Asymmetric information theory (cont)

• 2. Since managers are reluctant to take actions
  which lower their firms stock price, they avoid
  issuing stock when they believe investors will
  react negatively.
• 3. However, since external capital still may be
  needed to fund especially good investment
  opportunities,

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Asymmetric information theory (cont)

• Financial managers try to maintain a reserve
  borrowing capacity that they can tap it needed.
• Consequently a pecking order of financing exists
• Earnings (and depreciation)
• Debt issue
• Stock issue

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What type of analysis should firms conduct to
help find their optimal, or target, capital
structure?

• Financial forecasting models can help show how
  capital structure changes are likely to affect
  stock prices, coverage ratios, and so on.

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• Forecasting models can generate results under
  various scenarios, but the financial manager must
  specify appropriate input values, interpret the
  output, and eventually decide on a target capital
  structure.
• In the end, capital structure decision will be
  based on a combination of analysis and judgment.

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IMPLICATIONS OF CAPITAL STRUCTURE THEORY

• Unfortunately, capital structure theory cannot be
  used to set a precise optimal structure.
  However, theory does provide the following
  insights

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• 1. Other things held constant, firms with high
  tax rates should use

?
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• 1. Other things held constant, firms with high
  tax rates should use more leverage than firms
  with low rates, because the value of the debt
  financing is its tax deductibility, and this
  value increases with the tax rate.

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• 2. Firms with more inherent business risk should
  use

?
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• 2. Firms with more inherent business risk should
  use less leverage than low risk firms, because
  riskier firms have higher probabilities of facing
  financing financial distress.

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• 3. Firms with high potential distress costs, such
  as firms whose value is derived from intangible
  factors such as growth opportunities rather
  than from tangible assets which can be readily
  sold, should use
• ?

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• 3. Firms with high potential distress costs, such
  as firms whose value is derived from intangible
  factors such as growth opportunities rather
  than from tangible assets which can be readily
  sold, should use less leverage than firms with
  low potential distress costs.

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• 4. Firms characterized by a high degree of
  information asymmetry, such as those with highly
  confidential research and development programs,
  should maintain a larger reserve borrowing
  capacity, and hence use
• ?
  
  

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• 4. Firms characterized by a high degree of
  information asymmetry, such as those with highly
  confidential research and development programs,
  should maintain a larger reserve borrowing
  capacity, and hence use less leverage, than firms
  with a low degree of asymmetry.

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What other factors would managers consider when
setting the target capital structure?

• Debt ratios of other firms in the industry.
• Pro forma coverage ratios at different capital
  structures under different economic scenarios.
• Lender/rating agency attitudes (impact on bond
  ratings).

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• Reserve borrowing capacity.
• Effects on control.
• Type of assets--good collateral?
• Tax rates.

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The End
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INITIAL ASSUMPTIONS

• All cash flows are perpetuities
• All earnings are paid out as dividends i.e.
  retention rate (b) 0
• No growth
• No taxes (to be relaxed later)

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Traditional View
Cost of Capital ()
ks

WACC
kd
D/S
(D/S)
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(Tax term omitted by assumption)

• WACC wsks wdkd
• where ws wd 1.
• or
• WACC (S/V) ks (D/V) kd
• It seems reasonable that, as debt increases, an
  increasing weight on the lower kd will cause a
  falling WACC, (for a while).

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Alternative View
Cost of Capital ()
ks
14 4
WACC
kd
D/S
(D/S)
Example showing a constant WACC MM wks (Omitted)
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• WACC wsks wdkd
• or, moving to the right, as D
• WACC (S/V) ks (D/V) kd
• An increase in the supposedly cheaper debt
  funds could be offset by the increase in the
  required rate of return on equity, ke.

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• i.e., it is possible that ks rises just enough to
  offset the increasing weight on kd and decreasing
  weight on ks, leaving the WACC constant.
• As the firm increases its use of financial
  leverage, it becomes increasingly risky, and
  investors penalize the stock by raising the
  required equity return in keeping with the
  debt/equity ratio
• But how likely is this possibility?
• MM show that, under their assumptions, it will,
  not just may occur.

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Who are Modigliani and Miller (MM)?

• They published theoretical papers that changed
  the way people thought about financial leverage.
• They won Nobel prizes in economics because of
  this work.
• MMs papers were published in 1958 and 1963.
  Miller had a separate paper in 1977.

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M M worksheets
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ke
.16
.15
.1429
ka
.12
kd
D/S
0
.75
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Initial Situation

• Initial Balance Sheet
• Ls Stock 400
• NW 400
• Note 1 of Ls total stock is held

• Initial Income Statement
• Income 64
• Net 64

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Final Situation

• Final Income Statement
• Income 64
• Borr.Costs 36
• Net 64

• Final Balance Sheet
• Cash 33.33
• Borrowing 300
• Us stock 666.67
• NW 400

Nb 1 of Us Stock and Debt 1 of Us debt is
held.
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• In this process, price of Us stock will rise, so
  NW will increase.
• Us price will rise and Ls price will fall until
  value of firms are equal I.e. kas are equal.
  ARBITRAGE HAS CAUSED LEVERAGE TO HAVE NO EFFECT
  ON WACC.

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• NOTE RATIO OF DEBT/NW IS THE SAME FOR THIS
  INDIVIDUAL (300/400) AS FOR THE FIRM L
  (3000/4000). INDIVIDUAL HAS SUBSTITUTED PERSONAL
  LEVERAGE FOR THE LEVERAGE OF THE FIRM.
• Roll your own leverage

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MM Conclusion

• Individual started with 1 of L
• I.e. 1 of Ls EBIT 100
• and 1 of Ls Debt - 36
• 64
• Ended with
• 1 of Us Stock
• 1 of Us EBIT 100
• and 300 of personal debt
• Interest Cost -36
• 64

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MM Conclusion

• And had 33.33 in Cash which can be invested
• if at 12 4
• So pure arbitrage made this individual better
  off.
• Arbitrage opportunity will continue to exist
  until the WACC, ka, are equal, and therefore the
  values of the two firms are equal.

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MM CONCLUSION

• When arbitrage is possible, the Debt/Equity ratio
  has no effect on the value of the firm.

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ke
.16
.15
New WACC
.1429
ka
.12
kd
D/S
0
.75
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MM

• The important element in this process is the
  presence of rational investors in the market who
  are willing to substitute personal or homemade
  or roll your own leverage to substitute for
  corporate leverage

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MM (Continued)

• On the basis of this arbitrage process, MM
  conclude that a firm cannot change its total
  value or its WACC by using financial leverage.
• BUT, when we add other elements(e.g. TAXES) the
  conclusion does not hold

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Without corporate taxes, the MM propositions
are Proposition I VL VU. Propostion II ksL
ksU (ksU - kd)(D/S).
or ROE BEP (BEP - kd)(D/S)
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Graph the relationships between capital costs and
leverage as measured by D/V.
Without taxes
Cost of Capital ()
26 20 14 8
ks
WACC
kd
Debt/Value Ratio ()
0 20 40 60 80 100
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• While kd remains constant, ks increases with
  leverage. The increase in ks is exactly
  sufficient to keep WACC constant.
• The more debt the firm adds to its capital
  structure, the riskier the equity becomes and
  thus the higher its cost.

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Graph of Value vs. Debt, without Taxes
Value of Firm, V ()
4 3 2 1
VL
VU
Firm value (3.6 Million)
0 0.5 1.0 1.5 2.0 2.5
Debt (Millions of )
With zero taxes, MM argue that value is
unaffected by leverage.
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With corporate taxes (assume a 40 corporate tax
rate).
With corporate taxes added, the MM propositions
are Proposition I VL VU TD. Proposition
II ksL ksU (KsU - kd)(1 - T)(D/S).
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END!
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Consider a simple example of leverage. Ignore
taxes for simplicity. Current Situation

• Assets
• Assets 100

• Liabs. And Equity
• Equity 100

ROA BEPROE10/100 10
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Now consider expansion Suppose BEP remains at
10. A. NO LEVERAGE

• Assets
• Assets 150

• Liabs. And Equity
• Equity 150

Net Income 15
ROA BEPROE150/150 10
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Now consider expansion Suppose BEP remains at
10. B. WITH LEVERAGE

• Assets
• Assets 150

• Liabs. And Equity
• Debt 50
• Equity 100

EBIT 15
BEP 10, but not equal to ROE
Net Income ?
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Now consider expansion Suppose BEP remains at
10. B. WITH LEVERAGE

• Net Income 15 - kd Debt

Kd Net ROE .05 15-.055012.5 12.5/100
12.5, .10 15 - .105010 10/100
10 .15 15-.15507.5 15/1007.5
Positive effect of leverage
Negative effect of leverage
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In Fact

• ROE BEP (BEP - kd) (D/E)
• For example, for kd 5
• ROE .10 (.10 - 05)(1/2) 12.5