Capital Structure and Value

1
Capital Structure and Value

• Optimal capital structure is the mix of debt and
  equity that maximizes the value of the firm or
  minimizes the weighted average cost of capital
• Miller Modigliani
• If markets are perfect capital structure does not
  affect value
• Investors can accomplish any desired debt and
  equity mix by themselves
• Weighted average cost of capital is constant

2
Financial Leverage, EPS, and ROE

• Current Proposed
• Assets 5,000,000 5,000,000
• Debt 0 2,500,000
• Equity 5,000,000 2,500,000
• Debt/Equity ratio 0 1
• Share price 10 10
• Shares outstanding 500,000 250,000
• Interest rate n/a 10

3
Financial Leverage, EPS, and ROE

• EPS and ROE under current capital structure
• Recession Expected Expansion
• EBIT 300,000 650,000 800,000
• Interest 0 0
  0
• Net income 300,000 650,000 800,000
• EPS 0.60 1.30 1.60
• ROE 6 13 16

4
Financial Leverage, EPS, and ROE

• EPS and ROE under proposed capital structure
• Recession Expected Expansion
• EBIT 300,000 650,000 800,000
• Interest 250,000 250,000 250,000
• Net income 50,000 400,000 550,000
• EPS 0.20 1.60 2.20
• ROE 2 16 22

5
Homemade Leverage and ROE

• Firm does not adopt proposed capital
  structureInvestor put up 500 and borrows 500
  at 10 to buy 100 shares
• Investors return on her investment will be,
• Recession Expected
  Expansion
• EPS of un-levered firm 0.60
  1.30 1.60
• Earnings for 100 shares 60.00
  130.00 160.00
• less interest on 500 at 10 -50.00
  -50.00 -50.00
• Net earnings
  10.00 80.00 110.00
• ROE
  10/500 80/500 110/500
  
  2 16 22

6
Homemade Leverage and ROE

• Firm adopts proposed capital structureInvestor
  puts up 500, 250 in stock and 250 in bonds at
  10
• Investors return on her investment will be,
• 
  Recession Expected Expansion
• EPS of levered firm 0.20
  1.60 2.20
• Earnings for 25 shares 5.00
  40.00 55.00
• plus interest on 250 at 10 25.00
  25.00 25.00
• Net earnings
  30.00 65.00 80.00
• ROE
  30/500 65/500 80/500
  6
  13 16
• Note Remember we assume a world where there are
  no market imperfections such as taxes and
  transaction costs.

7
The Miller Modigliani (MM) Propositions

• Financial leverage and firm value Proposition I
• Since investors can costlessly replicate the
  financing decisions of the firm (homemade
  leverage), in the absence of taxes and other
  market imperfections, the value of the firm is
  unaffected by its capital structure.
• Implications
• There is no magic in finance - you cant get
  something for nothing.
• Capital restructurings dont create value, in and
  of themselves. (Why is the last part of the
  statement so important?)

8
The MM Propositions

• The cost of equity and financial leverage
  Proposition II
• Because of Proposition I, the WACC must be
  constant.
• With no taxes,
• WACC RA (E/V) x RE (D/V) x RD
• where RA is the return on the firms assets
• Solve for RE to get MM Proposition II
• RE RA (RA - RD) x (D/E)
• Cost of equity has two parts
• 1. RA and business risk
• 2. D/E and financial risk

9
The CAPM, the SML, and Proposition II
10
The MM Propositions
11
Introduction of Taxes

• Interest is taxed as the income of the lender,
  but equity income is taxed as corporate income
  and income of the shareholder
• By borrowing corporations create interest tax
  shield because interest expense of corporations
  reduces taxable income
• This leads to a firm that is almost entirely
  financed with debt

12
Debt, Taxes, and Firm Value

• The interest tax shield and firm value
• For simplicity (1) perpetual cash flows (2) no
  depreciation (3) no fixed asset or NWC spending
• A firm is considering going from zero debt to
  400 at 10
• Firm U Firm L (un-levered) (levered)
• EBIT 200 200
• Interest 0 40
• Tax (40) 80 64
• Net income 120 96
• Tax saving 16 0.40 x 0.10 x 400 TC x
  RD x D

13
Debt, Taxes, and Firm Value

• Whats the link between debt and firm value?
• Since interest creates a tax deduction,
  borrowing creates a tax shield. Its value is
  added to the value of the firm.
• MM Proposition I (with taxes)
• PV(tax saving) (0.40) x (10) x (400) / 0.10
  160
• (TC x RD x D)/RD TC x D
• VL VU TC x D

14
Debt, Taxes, and Firm Value
15
Debt, Taxes, and Firm Value
16
Differential Tax Rates on Debt and Equity Income

• Above conclusions assume that the tax rate on
  equity and debt income is the same
• Value of the firm with differential tax rate is
  the present value total cash flows (TCF) to
  investors
• TCF I (1 Tp) (NOI I) (1 Tc) (1 Tg)
• I interest expense
• Tp personal tax rate on interest income
• Tc corporate tax rate
• Tg personal tax rate on equity income
• TCF increases with additional debt if
• (1 Tp) gt (1 Tc) (1 Tg)

17
Tax Clientele Effect

• Tax rates of investors vary causing preference
  toward debt or equity
• If all companies have the same tax rate but
  investors experience different tax rates,
  companies as a group would maximize value by
  issuing enough debt to accommodate those investor
  for whom
• (1 Tp) gt (1 Tc) (1 Tg) holds
• Differential Tax Rates Among Corporations
• High tax rate of a corporation increases benefits
  of debt financing

18
Bankruptcy Costs

• As the D/E ratio increases, the probability of
  bankruptcy increases likelihood of operating
  income shortage to cover interest expense on the
  debt
• This increased probability will increase the
  expected bankruptcy costs
• At some point, the additional value of the
  interest tax shield will be offset by the
  expected bankruptcy cost
• At this point, the value of the firm will start
  to decrease and the WACC will start to increase
  as more debt is added

19
Bankruptcy Costs

• Bankruptcy Costs
• Direct costs legal and administrative fees
• Legal costs
• Indirect costs
• Lost sales of products requiring future service
• Loss of best employees
• Low employee morale
• Inability of credit purchases
• Higher financing costs and restrictions
• As the amount of debt increases, the probability
  of bankruptcy and therefore expected costs of
  bankruptcy increases, reducing firm value

20
Debt, Taxes, Bankruptcy, and Firm Value
21
Debt, Taxes, Bankruptcy, and Firm Value
22

Agency Costs

• Agency costs of debt
• Managers can increase shareholders wealth at the
  expense of creditors by taking risky projects
• If level of debt is low, risks are also low.
  High debt level requires monitoring by creditors,
  increasing agency costs even further
• Agency costs of equity
• Managers self fulfilling prophecies,
  conservatism or over-optimism in investment
  decisions
• Higher debt level prevents managers from value
  reducing activities

23
Information Signaling

• Managers convey their private information to the
  investors by changing capital structure
• High debt levels reflect managers information on
  improved future prospects of the company
• Firms with bad news cannot replicate because they
  wont have resources to support high debt level

24
Additional Considerations

• Unequal costs of borrowing
• Higher risk of personal borrowing
• Institutional restrictions on leverage

25
Capital Structure with Informed Investors

• Study the market response to determine optimal
  capital structure
• Study the relationship between different capital
  structures and the weighted average cost of
  capital
• Information from market participants
• Investment bankers
• Bond ratings and wacc
• Security analysts
• Disequilibrium

26
Capital Structure with Uninformed Investors

• If investors are not well-informed, managers
  should consider future profitability, earnings
  variability and bankruptcy risk
• Pro forma analysis of alternative capital
  structures
• Risk analysis
• Ratio measures
• Break-even point is the sales level below which
  the company has a loss
• Crossover point is the sales or EBIT level at
  which the company would earn the same EPS with
  two different capital structures
• Debt capacity analysis

27
Empirical Evidence

• Bankruptcy costs are important in determining
  optimal capital structure
• The more the physical assets the more the debt
  level in capital structure
• Announcement of equity issues cause negative
  abnormal returns
• Announcement of debt for equity exchange
  increases stock value
• Announcement of equity for debt exchange
  decreases stock value
• Abnormal price drops following leverage
  decreasing capital structure exchanges are
  positively related to unexpected earnings
  decreases
• Stock repurchases via tender offers result in
  sharp price increases
• If a firm becomes a takeover target, it increases
  debt level
• Harris and Raviv (1991), The Theory of Capital
  Structure, JOF.

28
Modigliani and Miller Summary

• I. The No-Tax Case
• A. Proposition I The value of the firm levered
  equals the value of the firm un-levered VL VU
• B. Implications of Proposition I
• 1. A firms capital structure is irrelevant.
• 2. A firms WACC is the same no matter what mix
  of debt and equity is used.
• C. Proposition II The cost of equity, RE, is
• RE RA (RA - RD) D/E
• where RA is the WACC, RD is the cost of debt, and
  D/E is the debt/equity ratio.
• D. Implications of Proposition II
• 1. The cost of equity rises as the firm increases
  its use of debt financing.
• 2. Equity risk depends on the risk of firm
  operations (business risk) and the degree of
  financial leverage (financial risk).

29
Modigliani and Miller Summary

• II. The Tax Case
• A. Proposition I with Taxes The value of the
  firm levered equals the value of the firm
  un-levered plus the present value of the interest
  tax shield
• VL VU Tc D
• where Tc is the corporate tax rate and D is the
  amount of debt.
• B. Implications of Proposition I with taxes
• 1. Debt financing is highly advantageous, and,
  in the extreme, a firms optimal capital
  structure is 100 percent debt.
• 2. A firms WACC decreases as the firm relies
  more heavily on debt.