16 - 1

CHAPTER 16-7Capital Structure Decisions:

The Basics (Short version)

Business vs. financial riskCapital structure theorySetting the optimal capital structure

16 - 2

13 - 1

Graph of Value vs. Debt/Equity Ratio

Value of Firm, V (%)$

3

2

1

0 .25 .5 .75 .99Debt/Equity Ratio

VU

Firm value

16 - 3

Capital Structure Decisions: Extensions

MM models Miller modelFinancial distress and agency

costsTradeoff models

16 - 4HOW 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?

16 - 5

13 - 1

Graph of Value vs. Debt/Equity Ratio

Value of Firm, V (%)

$

3

2

1

0 .25 .5 .75 .99Debt/Equity Ratio

VU

Firm value

16 - 6

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.

16 - 7Isolation of financing decision

(continued)

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

16 - 8Data 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?

16 - 9Proportion of Capital from debt and Equity, Selected Industries, 1991

Textile Mill products

Accident and Health Insurance

Air Transportation

Grocery Stores

Cigarettes

Eating places

Computer and Office Equipment

Grain mill products

Chemicals and allied products

Aircraft manufacturing

Beverages

Petroleum Refining

Catalog and mail-order houses

Agricultural products; crops

Hazardous waste management

Computer storage devices

Apparel and Accessory Stores

Iron and Steel Foundaries

Malt Beverages

Electronic Computeres

0 0.2 0.4 0.6 0.8 1 1.2

Percentage of Capital

Debt Equity

16 - 10

Proportion of capital from Debt and Equity, Malt beverage Industry, 1991

0 0.2 0.4 0.6 0.8 1 1.2

Pavichevich Brewing

Anheuser Busch

Coors

Bass

Genessee

Proportion of Capital

DebtEquity

16 - 11

DIGRESSION: TAX SHIELDAdvantage 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

16 - 12INTEREST TAX SHIELDSuppose some stockholders of U agree to exchange $5k of stock for $5K

debt. How does this affect the value of the firm?Data:

Company U Company Lks 0.16Debt (@12%) -$ 5,000$ ======================================================================================================================================================================================Net Operating Income EBIT 2,000$ 2,000$ EBITInterest on debt - 600$ I or kd*D(income to debtholders)

___________ __________Income before taxes 2,000$ 1,400$ (EBIT - I)

Taxes (@40%) t(EBIT) 800$ 560$ t*(EBIT - I)____________ __________

Income available to common shareholders (1-t)(EBIT) 1,200$ 840$ (EBIT - I)(1-t)

Total income available to(debt + equity) security holders (1-t)(EBIT) 1,200$ 1,440$ (EBIT - I)(1-t)+ I

DIFFERENCE 240$ (EBIT - I)(1-t) + I - (EBIT(1-t))

= -I(1-t)+ I = I*t

= kd*D*t

16 - 13

INCOME AVAILABLE INCREASES BY $240; WHO LOSES?

Value of firm = Value of + Value of

unlevered firm Tax Shield

$1200/.16 + $240/.12

$7,500 + $2,000 = $9,500

16 - 14

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.

16 - 15

Business Risk vs. Financial risk

16 - 16

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.

16 - 17

We will skip operating leverage to save some time.

16 - 18

Financial Leverage

16 - 19

Business Risk vs. Financial Risk

Firm’s total risk (to its stockholders) is the sum of its business and financial risk:

Total risk = Business risk + financial risk

16 - 20

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.

16 - 21

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 Financialrisk risk risk= + .

Stand-alone risk = ROE.

Business risk = ROE(U).

Financial risk = ROE - ROE(U).

16 - 22

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.

16 - 23

Firm U: Unleveraged

$1,800

1,200

$3,000

0

$3,000

0.50

Avg.

Economy

$2,400$1,200NI

1,600 800Taxes (40%)

$4,000$2,000EBT

0 0Interest

$4,000$2,000EBIT

0.250.25Prob.

GoodBad

A=20K, D=0,E=20K

16 - 24

Firm L: Leveraged

*Same as for Firm U.$1,080

720

$1,800

1,200

$3,000

0.50 Avg.

Economy

$1,680$ 480NI

1,120 320Taxes (40%)

$2,800$ 800EBT

1,200 1,200Interest

$4,000$2,000EBIT*

0.250.25Prob.* GoodBad

A=20K, D=10K, E=10K, int=.12

16 - 25

*ROI = (NI + Interest)/Total financing.

8 8 8

3.3x2.5x1.7xTIE

16.8%10.8%4.8%ROE

14.4%11.4%8.4%ROI*

15.0%

Avg.

9.0%

9.0%

15.0%

Avg.

20.0%10.0%BEP

GoodBadFirm L

TIE

12.0%6.0%ROE

12.0%6.0%ROI*

20.0%10.0%BEP

GoodBadFirm U

16 - 26

2.5xE(TIE)

0.39 0.24CVROE

4.24%

10.8%

11.4%

15.0%

L

2.12%ROE

Risk Measures:

9.0%E(ROE)

9.0%E(ROI)

15.0%E(BEP)

U

Profitability Measures:

8

16 - 27

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...)

16 - 28

In a stand-alone risk sense, Firm L’s stockholders see much more risk than Firm U’s.

U and L: ROE(U) = 2.12%.

U: ROE = 2.12%.

L: ROE = 4.24%.

L’s financial risk is ROE - ROE(U) = 4.24% - 2.12% = 2.12%. (U’s is zero.)

(More...)

16 - 29

For leverage to be positive (increase expected ROE), BEP must be > rd.

If rd > 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.”

16 - 30

In Fact:

ROE = BEP + (BEP - rd)(1-T) * (D/E)

16 - 31

Market risk framework

Hamada’s equation provides the relationship between business risk and financial risk:

rsL= rrf + (rm - rrf)u + (rm - rrf) u(1-T)(D/S)

= Timevaluepremium

+ businessrisk premium

+ financialriskpremium

But also, rsL= rrf + (rm - rrf) L

Market Risk Framework

16 - 32

Market risk framework (continued)

Therefore, rrf + (rm - rrf) u + (rm - rrf) u(1-T)(D/S) =

rrf + (rm - rrf) L

or L = u + u(1-T)(D/S)

Total risk

= business risk

+ financial risk

16 - 33Hamada equation for beta:

L = +

= +

= + .

U

Unlevered beta, which reflects the riskiness of the firm’s

assets

Business risk

U(1 - T)(D/S)

Increased volatility of the returnsto equity

due to the use of debt

Financialrisk

16 - 34

Consider financial risk term:

u(1-T)(D/S)

The higher the D/S, the higher the financial risk

The higher the T, the lower the financial risk. Why?

16 - 35

Market risk framework (continued)

or , another way to write total risk

L = u [1 + (1-T)(D/S)]

u = L / [1 + (1-T)(D/S)]

or

16 - 36

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.

16 - 37

Here’s a valuation model which includes financial distress and agency costs.

[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.

VL = VU + [X]D - - PV of expected

financial distressPV of

agency costs

16 - 38

VL = VU + [X]D - PV(fin.dist.costs) - PV(agency costs)

Value of Firm ($)

Debt ($)

4

3

2

1

Tax effect alone

W/ taxes and bankruptcy and agency costs

Net Tax effect alone

Financial distress and agency costs

Opt. Capital structure

16 - 39

Relationship between value and leverage.

Value of Firm ($)

Debt ($)

4

3

2

1

Another view

16 - 40

Cost of Capital (%)

14

4

Debt ($)

Relationships between capital costs and leverage considering financial

distress and agency costs.

ks

WACC

kd

16 - 41

Define financial distress andagency 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

16 - 42

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.

16 - 43

BANKRUPTCY COSTS (cont’d)

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.

16 - 44

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.

16 - 45

Types of Agency Cost relationships

Stockholders vs. managementStockholders vs. bondholders:

Recall Marriott example.

Assets 200 Debt 100 Assets 100 Debt 100

Eq. 100

Assets 100 Equity 100

16 - 46

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 stockholder’s point of view: Heads I win {risks pay off}; Tails you (the bondholder) lose.{risks don’t pay off}

16 - 47

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…

16 - 48

This would:Raise risk faced by all

bondholdersCause rd to rise

Cause original bondholders to suffer capital losses

16 - 49

Similarly, suppose that after issuing the new debt, the firm decides to restructure its assets:Selling of low risk assets, andAcquiring riskier assets, which

have a higher expected rates of return

16 - 50

If things work out, stockholders benefit;

If things don’t 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.

16 - 51AGENCY 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 assetssell existing assets, replacing them with

high risk assetsissue junk bonds and expand or go through

a LBO

16 - 52

Agency Costs

Because of these possibilities, bond holders are protected by restrictive bond covenants. These often hamper the firm’s legitimate operations to some extent.

Further the company must be monitored to insure compliance.

16 - 53

Agency CostsThe 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.

16 - 54

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.

16 - 55

An example of signaling theory

Asymmetric Information:

16 - 56

Asymmetric Information

The asymmetric information theory of capital structure is based on two assumptions:1. Managers have better

information about their firm’s future prospects than do investors. Thus asymmetric information exists.

16 - 57

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.

16 - 58

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.

16 - 59

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 company’s stock typically declines if it announces a new stock offering.

(Doesn’t apply to IPO’s)

16 - 60

Asymmetric information theory (cont’)

2. Since managers are reluctant to take actions which lower their firm’s 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,

16 - 61

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 issueStock issue

16 - 62

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

What type of analysis should firms conduct to help find their optimal, or

target, capital structure?

(More...)

16 - 63

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.

16 - 64IMPLICATIONS OF CAPITAL

STRUCTURE THEORY

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

16 - 65

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

?

16 - 66

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.

16 - 67

2. Firms with more inherent business risk should use:

?

16 - 68

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.

16 - 69

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:

?

16 - 70

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.

16 - 71

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:

?

16 - 72

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.

16 - 73

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).

What other factors would managers consider when setting the target capital

structure?

16 - 74

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

16 - 75

The End

16 - 76

INITIAL ASSUMPTIONS:

All cash flows are perpetuitiesAll earnings are paid out as

dividends [i.e. retention rate (b)] = 0No growthNo taxes (to be relaxed later)

16 - 77

Cost of Capital (%)

D/S

Traditional View

ks

WACC

kd

(D/S)*

16 - 78

(Tax term omitted by assumption)

WACC = wsks + wdkd

where ws + wd = 1.

orWACC = (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).

16 - 79

Cost of Capital (%)

14

4

D/S

Alternative View

ks

WACC

kd

(D/S)*Example showing a constant WACC: M&M wks (Omitted)

16 - 80

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.

16 - 81 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? M&M show that, under their assumptions,

it will, not just may occur.

16 - 82

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.

MM’s papers were published in 1958 and 1963. Miller had a separate paper in 1977.

16 - 83

M & M worksheets

16 - 84Begin with two firms (U and L), identical except for Financial structure:

Company U Company L

EBIT $10,000 $10,000Interest Rate 12%Debt - $30,000Int. on Debt - 3,600EACS (EBIT – kd*D) $10,000 $ 6,400Ke 15% 16%Market Value of S

i.e. EACS/ Ke $66,667 $40,000Market Value of D $0 $30,000V = S + D $66,667 $70,000Ka = WACC i.e. (D/V)*kd + (S/V)*ks 15.00% 14.29%Debt/Equity (D/S) 0.00% 75.00%

16 - 85

.12

.1429

.15

.16

%

D/S0 .75

kd

ke

ka

16 - 86

Initial Situation

Initial Balance Sheet:

L’s Stock 400 NW 400

Note: 1% of L’s total stock is held

Initial Income Statement:

Income 64 Net 64

16 - 871. Sell 1% of L’s Stock

L’s Stock 400L’s Stock -400Cash +400NW 400

2. Borrow 300 at going interest rate(i.e. borrow an amt. = 1% of L’s debt)

Cash 400New Cash 300 Total Cash 700Borrowing 300NW 400

3. Buy 1% of U’s Stock

Cash 700Borrowing 3001% of U’s stock 666.67Cash (666.67)NW 400

16 - 88

Final Situation

Final Balance Sheet:

Cash 33.33 Borrowing 300 U’s stock 666.67 NW 400

Final Income Statement:

Income 64 Borr.Costs

36 Net 64

Nb: 1% of U’s Stock and Debt = 1% of U’s debt is held.

16 - 89

In this process, price of U’s stock will rise, so NW will increase.

U’s price will rise and L’s price will fall until value of firms are equal; I.e. ka’s are equal. ARBITRAGE HAS CAUSED LEVERAGE TO HAVE NO EFFECT ON WACC.

16 - 90

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”

16 - 91M&M Conclusion

Individual started with 1% of L:I.e. 1% of L’s EBIT 100and 1% of L’s Debt - 36

• $64

Ended with:1% of U’s Stock

• 1% of U’s EBIT 100

and $300 of personal debt• Interest Cost -36

• $64

16 - 92

M&M ConclusionAnd 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.

16 - 93

M&M CONCLUSION

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

16 - 94

.12

.1429

.15

.16

%

D/S0 .75

kd

ke

ka

New WACC

16 - 95

M&M

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

16 - 96

M&M (Continued)

On the basis of this arbitrage process, M&M 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

16 - 97

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)

16 - 98

Graph the relationships between capital costs and leverage as

measured by D/V.

Without taxesCost of Capital (%)

26

20

14

8

0 20 40 60 80 100Debt/Value Ratio (%)

ks

WACCkd

16 - 99

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.

16 - 100Graph of Value vs. Debt, without

TaxesValue of Firm, V (%)

4

3

2

10 0.5 1.0 1.5 2.0 2.5

Debt (Millions of $)

VLVU

Firm value ($3.6 Million)

With zero taxes, MM argue that value is unaffected by leverage.

16 - 101

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).

16 - 102

16 - 103Consider a simple example of leverage. Ignore taxes for simplicity.

Current Situation:

Assets Assets 100

Liabs. And EquityEquity 100

ROA = BEP=ROE=10/100 = 10%

16 - 104Now consider expansion:Suppose BEP remains at 10%.

A. NO LEVERAGE

Assets Assets 150

Liabs. And EquityEquity 150

ROA = BEP=ROE=150/150 = 10%

Net Income = 15

16 - 105Now consider expansion:Suppose BEP remains at 10%.

B. WITH LEVERAGE

Assets Assets 150

Liabs. And EquityDebt 50Equity 100

BEP= 10%, but not equal to ROE

EBIT = 15

Net Income = ?

16 - 106Now consider expansion:Suppose BEP remains at 10%.

B. WITH LEVERAGE

Net Income = 15 - kd * DebtKd Net ROE

.05 15-.05*50=12.5 12.5/100 = 12.5%,

.10 15 - .10*50=10 10/100= 10%

.15 15-.15*50=7.5 15/100=7.5%

Negative effect of leverage

Positive effect of leverage

16 - 107

In Fact:

ROE = BEP + (BEP - kd) * (D/E)

For example, for kd = 5%:

ROE = .10 + (.10 - 05)(1/2) = 12.5%