Lecture 8 Capital Structure Chapter 16, 17

1
Lecture 8 Capital Structure
(Chapter 16, 17)

• Capital Structure Theories
• - Tradeoff theory
• - Pecking order theory
• - Market timing theory
• Recapitalization Decisions

2
Capital Structure

• Percent of debt financing, also called
  (financial) leverage.

3
Financial Risk

• The extra risk that shareholders face when the
  firm uses debt.

4
Example of financial risk
Sales 1,400,000 Variable
Costs (800,000) Fixed Costs (250,000)
EBIT 350,000 Interest (125,000)
EBT 225,000 Taxes (34)
(76,500) Net Income 148,500
5
Sales 1,540,000 10 Variable
Costs (880,000) Fixed Costs (250,000)
EBIT 410,000 17.14 Interest
(125,000) EBT 285,000 Taxes (34)
(96,900) Net Income 188,100 26.67
6
Sales 1,330,000 -5 Variable
Costs (760,000) Fixed Costs (250,000) EBIT
320,000 -8.57
Interest (125,000) EBT 195,000 Taxes
(34) (66,300) Net Income
128,700 -13.33
7
Trade-off Theory

• There is an optimal capital structure, target
  capital structure, that trade off the benefits
  and the costs of debt and maximizes the firm
  value.
• Miller and Modigliani (MM)

8
MM Version One No Friction (1958)

• Changes in capital structure do not affect firm
  value when financial markets are perfect. Only
  market imperfections (taxes, etc.) allow for
  leverage to affect firm value.
• MM perfect market assumptions
• No taxes.
• No brokerage costs.
• No bankruptcy costs.
• Investors can borrow at the same rate as
  corporations.
• All investors have the same information as
  management about the firms future investment
  opportunities.
• EBIT is not affected by the use of debt.

9

• Proposition I
• levered firm value unlevered firm
  value.
• VL VU
  
  
• 
  (EBIT/WACC) EBIT/ksU
• where ksU cost of equity for an
  unlevered firm.
• ? Firm value is independent of leverage.

10

• Proof with capital structure arbitrage
• (see P. 611-612)
• For two firms with exactly the same business
  characteristics and different financial leverage
  levels, if they are differently valued, investors
  can do capital structure arbitrage by
  short-selling the stocks of the high-value firm,
  and using the proceeds to buy the stocks of the
  low-value firm, which creates profits.
• In a more realistic situation, this arbitrage
  would occur in a matter of seconds. The low-value
  firms price is pushed up and the high-value
  firms price is lowered down, eventually reaching
  an equilibrium with two firms equally valued.

11

• Proposition II
• ksL ksU Risk premium
• ksU (ksU - kd)(D/S)
• where ksU cost of equity for an
  unlevered firm, ksL cost of
  equity for a levered firm, D
  market value of firms debt, S
  market value of firms equity,
  kd cost of risk-free debt.
• ? As a firm increases its use of debt, its
  cost of equity
• also increases but its WACC remains
  constant.

12
MM Version Two with Corporate Taxes

• Because interest is a tax-deductible expense for
  corporations, a levered firm should be more
  valuable than an unlevered firm (assuming that
  this difference in capital structure is the only
  difference).
• Proposition I
• VL VU TD

where T firms tax rate, D value of debt.
13

• Proposition II
• ksL ksU (ksU - kd)(1-T)(D/S)
• where S value of equity.

14
MM Version Three with Multiple Frictions

• Taxes mentioned earlier (in MM Version Two).
• Bankruptcy cost direct costs (such as legal
  costs) and indirect costs (such as reputation
  loss and financial distress).
• Agency problems e.g. risk-shifting ? firm may
  increase risk and thereby extract value from
  existing bondholders. (Covenants could reduce the
  problems)
• Free cash flow reduction debt might reduce extra
  cash in the firms hence alleviate management
  deviations.

15

• Proposition I
• VL VU
• TD
• - (PV of bankruptcy costs)
• - (PV of agency costs)
• (PV of free cash flow
  reduction)
• ? The optimal capital structure is
  determined by a
• trade off between benefits and costs of
  debt.

16
Example Suppose Titan Photo has no growth, and
its expected EBIT is 100,000, corporate tax
rate is 30. It uses 500,000 of 12 debt
financing, and the cost of equity to an
unlevered firm in the same business risk level is
16. 1) What is the value of the firm
according to MM with tax? S
(EBIT kd D)(1-T)/ksL VU SU
EBIT (1-T) / ksU 100000
(1-30) /0.16 437500 VL VU TD
437500 0.3 500000 587500
SL VL D 587500 500000 87500 2) What
is this firms cost of equity? ksL
ksU (ksU -kL) (1-T) (D/S)
16 (16-12) (1-30) (500000/87500)
32
17
Pecking Order Theory

• Stewart Myers (1984)
• Managers are better informed than investors.
  Investors might see an external equity issuance a
  bad news about the company, assuming that
  managers want outside shareholders to share the
  loss, thus investors will react to this issuance
  negatively, increasing the issuance cost of
  external equity.

18

• Firms therefore prioritize their sources of
  financing according to the law of least effort,
  or of least resistance internal funds are used
  first, and when that is depleted, debt is issued,
  and when it is not sensible to issue any more
  debt, equity is issued.
• This theory maintains that businesses adhere to a
  hierarchy of financing sources and prefer
  internal financing when available, and debt is
  preferred over equity if external financing is
  required.

19
Market Timing Theory

• A firm will issue a type of external capitals
  when the associated capital market is good. For
  instance, it will issue stocks when the stock
  market is hot.

20
Other Issues Need to be Considered in Practice

• Business Risk firms with low BR may use more
  debt.
• Assets firms with marketable fixed assets may
  use more debt.
• Growth rapid growth often requires external
  financing, and will typically use more debt.
• Debt Ratings Some firms want to use more debt
  than their lenders may be willing to provide.
  Banks and rating agencies (SP) use the financial
  ratios (TIE and other debt ratios) for their
  decisions.

21
Recapitalization
Ways to recapitalize (that is, to change the
existing capital structure, equity structure, or
debt structure) - Raising new equity such as
raising VC, IPO, SEO - Raising new debt/bond
- Stock repurchase - Leveraged buyout, etc.
22
Recapitalization

• Example
• PPC has total mkt value 100M, with 1M
  shares at 50 per
• share, and 50M of 10 perpetual bonds
  selling at par.
• EBIT 13.24, and Tc 15.
• PPC can change its capital structure by
  increasing debt to 70M
• or decreasing it to 30M. If it increases
  leverage, it will call its old bonds and issue
  new ones with a 12 coupon. If it decreases
  leverage, it will call the old bonds and issue
  new ones with a 8 coupon. PPC will sell or
  repurchase stock at the new equilibrium price to
  complete the CS change. It pays all earnings as
  dividends and is thus a 0 growth stock. If it
  increases leverage ks will be 16, if it
  decreases leverage ks will be 13.
• Should the firm change its capital structure?

23
Solution base situation (D 50M)
V Firm Value D E Value of Debt
Value of Equity.
24
Solution Two scenarios
Decrease leverage (to D 30M).
Increase leverage (to D 70M).
25
Managing Capital Structure

• Firms may set target (desired) capital structures
  by
• setting up financial statement forecasts several
  years into the future,
• explicitly including the AFN lines in the
  forecasts, and
• varying the proportions of new debt and equity
  used to finance future growth, and
• varying the dividend payout (additional cash back
  to shareholders means that more funds will be
  needed in the future), repurchase of equity and
  type of debt (some debt has higher interest
  costs).
• With such forecasts, managers are able to
  understand how different scenarios affect firm
  value.