J. K. Dietrich - FBE 532 – Spring 2006 Module I: Investment Banking: Capital Structure and...

J. K. Dietrich - FBE 532 – Spring 2006

Module I: Investment Banking:Capital Structure and Valuation

Week 2 – January 19, 2006

2J. K. Dietrich - FBE 532 – Spring 2006

Introduction

Cash flows to investors and their risk determine the value of claims on the firm

When a firm issues both debt and equity, it agrees to split the cash flows produced by its real assets between shareholders and bondholders. The firm’s mix of securities is known as its capital structure.

Firm value depends on capital structure in a fundamental way. This lecture reviews the theory of capital structure and its links to valuation.


Distribution of Corporate Income E

B I

T

EAC (Div + Retained Earnings)

I (Fixed Claims)

T (No Value to Investors)


Cash Flow Determination

Items From the Income Statement – Revenues (R)

– Cash Expenses (W)

– Non-Cash Expenses (Dep)

– Capital Expenditures (Capex)

– Cost of Goods Sold (CGS): » Excludes depreciation

– Interest Expense (Int)

– Taxes (T)


Cash Flow Determination

Other Items – Tax Rate ()– Repayment of Principal (P)– Changes in Net Working Capital (NWC)– Permanent Debt (D)


Definition of Earnings Components

Earnings Before Interest & Taxes [EBIT]R-(W+Dep+CGS)

Earnings Before Interest, Taxes, Depreciation (and Amortization) = EBITD(A) = EBIT+Dep+(Amort)

Amortization is associated with allocation of past financial investments over book value (e.g. good will)


Definitions of Earnings Components

Pre-Tax Income – [EBIT-Int]

Tax Bill [T]– (EBIT-Int)

Net Income – NI =Pre-Tax Income - T


Cash Flow Definitions

Levered Cash Flow [to equity] {LCF or FTE}Money that goes to stockholders account

[R-(W+Dep+CGS+Int)](1-)+Dep-Capex-P-NWC

Unlevered Cash Flow {UCF}Cash flow that would occur if there was no debt

(1-)EBIT+Dep-Capex -NWC


Value and Leverage StrategyConservative Strategy

Equity

Debt

Aggressive Strategy

Debt

Equity


Empirical Facts

Most corporations set a target debt ratio. There are many similarities in capital

structure– Across firms in the same industry– Across industries in different countries– These regularities suggest that there are some

fundamental determinants of capital structure


Summary M-M Theory & Issues M-M ISSUES STATE

OF DEBATE CAPITAL STRUCTURE IRRELEVANT

(1) TAXES (2) BANKRUPTCY (3) AGENCY (4) EQUILIBRIUM

TRADEOFFS

DIVIDENDS IRRELEVANT

(1) INFORMATION (2) TAXES (3) MILLER-SCHOLES

EVIDENCE


An Example

Consider the following data for a company reviewing its capital structure. – Number of Shares 100– Price Per Share $20– Market Value of Shares $2,000– Market Value of Debt $0– Interest Rate 10%– Tax Rate 0


Possible Outcomes:

Depending on the state of the economy, EBIT may be as predicted, below average or above average.

If EBIT is $250, as predicted, earnings per share are $250/100 = $2.50 and the return on equity is $2.50/$20 = 0.125 or 12.5 percent.


EBIT-EPS Table

Recession Predicted Boom

EBIT ($) 100 250 300

EPS ($) 1.00 2.50 3.00

Return on Equity (%) 5 12.5 15

Based on the hypothetical EBITs, we can compute the associated EPS. This gives rise to the EBIT-EPS table or chart.


EBIT-EPS Chart

0

0.5

1

1.5

2

2.5

3

3.5

0 50 100 150 200 250 300 350

EBIT

EPS


Desirability of Leverage

Suppose the company repurchases $1,000 of equity at $20 each

The purchase is financed by issuing consol bonds.

The new capital structure consists of 50 shares of stock and $1,000 of debt.


Hypothetical Outcomes:Levered Firm


EBIT ($) 100 250 300

Interest ($) 100 100 100

Equity Earnings ($) 0 150 200

EPS ($) 0 3 4

Return on Equity (%) 0 15 20


EBIT-EPS Chart

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

4.5

0 50 100 150 200 250 300 350

EBIT

EP

S

Levered Firm

Unlevered Firm


The Home-made Leverage

Consider an alternative scenario now Suppose an investor were to borrow $20

and invest $40 in two (unlevered) shares of the original all equity company.

The net cost to the investor is $20.


Home Made Leverage


Share Earnings ($) 2 5 6

Interest on $20 ($) 2 2 2

Net Earnings ($) 0 3 4

Return on $20 inv (%) 0 15 20


Home Made Leverage

The returns from this strategy are exactly the same as buying 1 share of the levered firm. Therefore a share in the levered firm must sell for $20 (= 2 x 20 - 20).

Investors on their own can accomplish what the company can do by adding debt, so leverage will not create value. This leads to the famous irrelevance proposition of Merton Miller and Franco Modigliani.


Miller-Modigliani Theory

The Miller-Modigliani Proposition I:

With no taxes and perfect financial markets, the value of any firm is independent of its capital structure.


Miller-Modigliani Theory: Value of the Firm

Leverage Ratio

Firm Value

All Equity Firm Value

Leverage has no effect on firm value when there are no taxes and markets are perfect


Miller-Modigliani Theory: WACC

Leverage Ratio

%

WACC

With no taxes and perfect markets, the weighted average cost of capital is constant

Cost of Debt

Cost of Equity


Implications

The Miller-Modigliani theorem is a starting point to examining capital structure effects in the real world.

If capital structure matters, it is because one of the MM assumptions is violated.

The first assumption to relax is the assumption that there are no corporate taxes.


Miller-Modigliani Theory and Taxes

As a simple example, consider two firms, U and L.

Firm U has no debt and firm L has issued consol bonds worth $200 at the current interest rate of 10 percent; otherwise the firms are the same.


Levered and Unlevered Firms

Firm U Firm L

Operating Income ($) 100 100

- Interest to Bondholders ($) 0 -20

= Pretax Income ($) 100 80

- Tax at 34% ($) -34 -27.2

= Net Income to Stockholders ($) 66 52.8

Value of Equity ($) 660 528

Value of Debt ($) 0 200

Value of the Firm (Debt + Equity)($)

660 728


Implications

This simple example shows that interest tax deductibility increases the value of the firm that is levered.

The tax bill of L is $6.80 less than that of U In effect, the government is paying 34

percent of the interest expense of L. This perpetual reduction in taxes is worth $6.80/0.10 = $68.


Value of the Interest Tax Shield

The present value of the tax shield accounts for the difference in firm value.

If tC is the corporate tax rate and rD the debt rate, then interest payments = rD.D and the tax shield is tC.rD.D. – How do we value the tax shields with risk?

The most common approach is that the risk of the tax shields is the same as the interest payments generating them.


A Convenient Formula

For perpetual debt, we have:

PV tax shield = (tC.rD.D)/rD = tC.D

which is independent of rD. The MM Theorem with corporate taxes

implies: VL = VU + tCD.– The PV of tax shields is lowered if the firm

does not borrow permanently or if it may not be able to use the tax shields in the future.


A Paradox

The Miller-Modigliani theorem implies capital structure is irrelevant if there are no taxes and capital markets are perfect. – Relaxing the assumption of no corporate taxes

leads to the result that the company should take on as much debt as it can.

– But an all debt company is owned by its creditors. What stops a company from being entirely debt financed?


Miller-Modigliani Theory with Corporate Taxes

Leverage Ratio

Firm Value


Value of a Levered Firm

Present value of the tax shield


MM With Taxes: WACC

Leverage Ratio

%

WACC

With taxes, the weighted average cost of capital declines with higher leverage

Cost of Debt

Cost of Equity


A Reconciliation

What offsets the tax advantages of debt financing? – Bankruptcy costs

» But empirical evidence seems to suggest these direct costs are quite small

– Costs of financial distress» These costs may be sufficiently large as debt

increases that there it offsets the tax shield.


MM with Taxes and COFD

Leverage Ratio

Firm Value


Optimal Leverage Zone Balances Tax Advantages of Debt Against the Costs of Financial Distress


MM with Taxes and COFD: WACC

Leverage Ratio

%

WACC

The weighted average cost of capital declines with higher leverage and then rises

Cost of Debt

Cost of Equity


Real-World Capital Structure

Some stylized facts fit well with the theory– Firms with high taxes rely more on debt– Firms with a high percentage of intangible

assets rely on equity– Firms with uncertain operating income avoid

debt


Cost of Capital for All Equity Firm?

Many - including some executives - believe it is zero because – there is no direct cost to internal funds or from

equity capital issued some time ago– no obligation to pay a dividend.

This reasoning is wrong.


It is the opportunity cost of the equity that matters.

The cost of capital is simply the rate that investors use discount the cash flows from the firm. Investors will price the stock to offer this expected return. If CAPM holds we have :

Cost of Capital for All Equity Firm?


Cost of Capital for All-Debt Financed Projects

Many firms issue either debt or equity to finance purchases of new assets and projects. What is the cost of capital for a project financed 100% with debt?

It is not the after-tax debt rate. Why?– You cannot 100% debt-finance all projects– Debt capacity comes from existing assets - not

all the tax shield is attributable to the project


Review

The capital structure decision is a crucial one for the firm and is fundamentally linked to questions of valuation

Firms trade-off the tax benefits of debt financing against the costs of financial distress

Finding the right capital structure is difficult in practice


Next Week – January 26 Review background readings on valuation

implications of mergers and acquisitions Read, analyze and prepare individual write-

up for Continental Carriers Inc. case Form group and sign-up members and

schedule meetings needed for group do necessary work and write-up for next case

Hand in case write-ups (group and individual) at the beginning of classes

J. K. Dietrich - FBE 532 – Spring 2006 Module I: Investment Banking: Capital Structure and...

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