The firms financial policy

1
The firms financial policy
2
The capital structure issue

• The capital structure issue refers to the mix of
  securities and financing sources used by firms to
  finance their investments in real assets
  
• This mix is presented by the proportions of debt
  and equity on the right-hand side of the firms
  balance sheet
  
• What should guide a firm in its decision of the
  debt-equity mix?
  
• The guiding principle should be to maximize the
  value of the firm or, equivalently, the value of
  the firms stock
  

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Which factors affect the firms choice of debt
vs. equity?

• Financial managers must choose the appropriate
  debt level that
  
• Is consistent with the firms funding needs,
  given the uncertainty of future operating
  earnings
  
• Maintains the firms access to capital markets
• Maximizes shareholder value by borrowing at the
  lowest cost of capital
  
• The choice of the firms optimal financing mix is
  usually based on a tradeoff between the benefits
  and costs of choosing debt vs. equity

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The benefits and costs of debt

• Benefits of debt
• Debt is tax deductible
• Debt imposes discipline on managers
• Costs of debt
• Higher levels of debt increase the probability of
  financial distress
  
• Debt can create conflicts between stockholders
  and bondholders
  
• Higher levels of debt lower the financial
  flexibility of the firm

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The benefits of debt

• First, firms can deduct interest payments from
  their taxes, which adds value to the firm
  
• Considering two firms, the first using only
  equity financing and the second using a mix of
  debt and equity, we see that the second firm
  
• Receives the tax savings from interest payments
• Alternatively, is faced with a lower (after-tax)
  cost of debt
  
• Firms that are faced with higher tax rates are
  more likely to have higher debt ratios, while
  firms that have benefits from other tax shields
  (depreciation) are more likely to have lower debt
  ratios

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• Second, debt imposes more discipline on the
  firms management
  
• Managers may want to allocate the firms free
  cash flows according to their preferences
  
• This may be a problem for mature firms that may
  have few profitable investment opportunities
  (push for acquisitions)
  
• A higher level of debt imposes discipline on
  managers because it limits the free cash flows
  that can be allocated at their discretion

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The costs of debt

• First, higher levels of debt increase the
  probability of financial distress in a firm
  
• Given a certain level of debt payments, firms
  with more volatile operating earnings are faced
  with a higher probability of financial distress
  
• The costs of financial distress can be very high
  for a firm and managers would prefer to avoid
  them
  
• Direct costs
• Indirect costs

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• Second, debt may create conflicts between
  stockholders and bondholders within a firm
  
• Managers, acting in the interest of stockholders
  may want to pursue investments with high risk
  
• Creditors do not want managers to pursue projects
  of high risk as this affects the firms ability
  to pay back its obligations
  
• Creditors frequently include covenants that
  restrict the use of borrowed funds by managers

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• Third, higher debt comes with the cost of lower
  financial flexibility for the firm
  
• Financial managers value financial flexibility
• They want to choose a level of debt that allows
  them to pursue the firms business strategy
  
• They also want to maintain adequate unused debt
  capacity that will cover the firms potential
  future borrowing needs
  
• They care about preserving the firms credit
  rating (investment grade)
  

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Financial leverage and the returns to stockholders

• Stockholders must consider the impact that
  financial leverage has on the returns to equity
  when they examine the tradeoff between debt and
  equity
• Higher leverage can lead to higher returns for
  stockholders, compared to a scenario of low
  leverage, when the firms earnings are good
  
• However, when earnings are low, higher leverage
  results in higher losses for stockholders
  compared to the scenario of low leverage

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Example 1 Financial leverage, EPS and ROE

• Suppose that the GL corporation has assets of 8m
  which are financed only with equity of 8m
  (400,000 shares with a current price of 20 per
  share)
• The firm is considering restructuring its capital
  structure by issuing debt of 4m and use the
  proceeds to purchase 200,000 of its shares (equal
  to 4m)
• The companys new capital structure has 50 debt,
  so the debt-equity ratio is 1
  
• What is the impact on ROE and EPS if the interest
  rate is 10?

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The variability of ROE and EPS is magnified with
financial leverage
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EBIT-EPS RelationshipAt the EBIT level of
800,000, the firm is indifferent between the two
capital structures. If EBIT is projected above
800,000, leverage is beneficial to the firm
With debt
Disadvantage to debt
EPS
No debt
2
Advantage to debt
Break-even EBIT
800,000
EBIT
- 2
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Is there an optimal capital structure?

• According to the tradeoff theory of capital
  structure, the firm examines the benefits and
  costs of debt when selecting its financing mix
  
• As a starting point in this analysis, we can
  consider the two propositions by Modigliani and
  Miller (MM) who proved that
  
• The firms choice of capital structure has no
  impact on firm value
  
• The firms choice of capital structure does not
  affect its cost or availability of capital

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MM Proposition IThe pie model

• Assume a world where there are
• No taxes
• No transaction costs
• No possibility of default
• MM Proposition I
• The value of the firm is independent of the
  firms capital structure

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The firms assets and operations and, thus, cash
flows are the same regardless of how they are
financed
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MM Proposition II Financial leverage and the
cost of equity

• MM Proposition II
• The firms cost of equity increases as the firms
  financial leverage increases
  
• Implication The firms cost of capital is
  constant regardless of the debt ratio
  
• Any attempt by the firm to substitute cheap
  debt for expensive equity fails to reduce the
  firms overall cost of capital because it makes
  the remaining equity more expensive

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• This means that the rate of return on equity
  increases enough to offset the higher risk that
  stockholders face from the firms increased
  leverage
• To see this, recall that
• WACC (D/V)rD (E/V)rE
• Denote WACC by rA (the required return on the
  firms assets) and rewrite
  
• rE rA (rA rD)(D/E)

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The firms cost of capital is unaffected by the
firms capital structureAs D/E increases, the
cost of debt is constant and cost of equity
increases linearly initially. But, as the cost of
debt increases with default risk, the cost of
equity increases at a slower rate so that cost of
capital is constant
Cost of equity
Cost of equity increases at a slower rate as fi
nancial leverage increases
Cost of financing
Cost of capital
Cost of debt
Cost of debt increases as default risk increases
Risk-free debt
Risky debt
Debt-equity ratio
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MM Propositions with taxes

• MM Proposition I and corporate taxes
• We know that borrowing through debt implies that
  the firm receives the benefit from the interest
  tax shield
  
• Consider a firm that has raised financing through
  debt equal to the amount D and that this debt is
  fixed and perpetual (meaning it will be rolled
  over indefinitely)
• This implies that the interest expense (D ? rD)
  and the interest tax shield (D ? rD ? t) are a
  perpetuity

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• The value of the interest tax shield for the firm
  is equal to the PV of this perpetuity or
  
• PV of interest tax shield (D ? rD ? t)/rD t ?
  D
  
• Thus, if the value of the unlevered firm (with no
  debt) is equal to VU, then the value of the
  levered firm is
  
• VL VU (t ? D)

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Value of the levered firm is always higher than
that of unlevered firmIllogical conclusion
Firms capital structure should be 100 debt
VL
Value of the firm
t ? D
VU
Total debt
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• Some problems with the above conclusion are
• Firms will not always have income to shield
• Firms also shield income in other ways (e.g.,
  depreciation, write-offs for RD)
  
• The marginal tax rate may not always be the same
• The risk of the tax shield is not the same as the
  risk of interest payments
  

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• MM Proposition II and corporate taxes
• Assuming corporate taxes exist, the result of MM
  proposition II is written as follows
  
• rE rU (rU rD)(D/E)(1 t),
• (rU cost of capital for unlevered firm)
• Note that from the WACC equation, the firms cost
  of capital decreases with higher leverage,
  implying that in a world with taxes, debt matters
  for the firms cost of capital

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Tradeoff theory and optimal capital structure for
the firm

• According to the tradeoff theory of capital
  structure, the firm considers in its decision of
  the level of debt
  
• The benefit form the interest tax shield
• The costs from the higher probability of
  bankruptcy
  
• The firm should borrow up to the point where
• Marginal benefit of the tax shield Marginal
  cost of
  
• financial distress

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With corporate taxes and costs of financial
distress, the firms value is maximized at the
optimal level of debt, D
VL
Value of the firm
PV of tax shield
Financial distress costs
Max firm value
VU
D
Debt ratio
Optimal debt
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The Pecking Order Theory

• According to this theory of the firms capital
  structure, there exists asymmetric information
  between the firms managers and outside
  investors
• Managers know more about the true value of the
  firms existing assets or new investment
  opportunities
  
• Assume also that managers act in the interests of
  shareholders, meaning they attempt to maximize
  shareholder value and refuse, in general, to
  issue undervalued shares

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• If a firm issues new shares, two scenarios can
  explain this decision
  
• The firm has good growth opportunities, which
  would be something good for outside investors who
  buy the new shares
  
• The firms managers are trying to take advantage
  of their belief that the firms existing assets
  are currently overvalued, which would be bad news
  for investors
• Given the problem of asymmetric information,
  outside investors are only willing to buy new
  shares if these are offered at a markdown
  

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• Thus, firms with undervalued assets and future
  growth opportunities will refuse to issue shares,
  even if it means passing by a positive NPV
  project, because this would imply a drop in the
  shareholder value
• This implies that if a firm has multiple choices
  of financing sources, it would prefer other
  sources as opposed to equity
  
• For example, given the fact that debt has fixed
  cash flows and priority over equity, debt
  financing will not affect the firms share price
  that much

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• All this leads to a pecking order of firm
  financing
  
• Internal financing (retained earnings) is
  preferred over external financing
  
• If the firm needs external financing, then it
  will prefer debt over equity
  
• If debt capacity is reached, then firms issue
  equity
  
• Implication start with debt, then use hybrid
  securities, then equity

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Implications of the pecking order theory for firm
financing

• The pecking order theory explains why most of the
  external financing of firms comes from debt as we
  observe in the data
  
• It also explains why profitable firms borrow less
  (also observed in the data) not because their
  target debt ratio is low, but because they have
  higher retained earnings
• Also, according to the pecking order theory, firm
  dividends are sticky, meaning that firms do not
  like to cut dividends to finance their
  investments rather firms prefer to maintain a
  buffer stock/financial slack to finance
  investments when earnings are low

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The Free Cash Flow Theory

• The assumption that managers always act in the
  best interest of shareholders has weak support
  from practical experience and evidence
  
• If this assumption does not hold, then there may
  be a dark side to having a lot of free cash flows
  (retained earnings)
  
• Managers may use those cash flows to expand their
  perks or attempt to build an empire through
  acquisitions, all at the expense of shareholder
  value

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• This scenario is more commonly found in mature
  firms whose operating cash flows significantly
  exceed their profitable investment opportunities
  
• Under the above scenario, agency costs (the costs
  that shareholders will incur to ensure that
  managers act in their best interests) can be
  mitigated through higher levels of debt
• Thus, a higher level of debt, despite its impact
  on the probability of financial distress, is
  beneficial to shareholders because it disciplines
  managers (by limiting the behaviors described
  above) by reducing the amount of free cash flows
  at their discretion

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Practical issues in the design of corporate
financial policy

• The design of corporate financial (or capital
  structure) policy must be viewed from three
  perspectives
  
• The perspective of the firms marginal investor
• The perspective of the firms competitive
  position in its industry
  
• The internal perspective

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Capital structure from the investors perspective

• From the perspective of the firms stockholders,
  the choice of the firms capital structure must
  
• Maximize shareholder wealth
• Maximize the value of the firm
• Minimize the firms cost of capital
• Failure to achieve these goals may lead to a
  reaction from the markets, which could
  potentially include a takeover
  
• Financial managers must examine alternative
  capital structures and evaluate their impact on
  firm value
  

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• The evaluation of alternative capital structure
  must take into consideration
  
• The firms cost of debt
• The firms cost of equity
• The debt/equity mix and its impact on the WACC
• A comparison of the firms P/E ratio,
  market-to-book ratio, and EBIT multiples to those
  of comparable firms
  
• The firms bond rating
• The firms current ownership structure and the
  potential actions of large shareholders
  
• Bottom line Financial managers must think like
  investors

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Capital structure from the firms competitive
perspective

• From a competitive perspective, the firms choice
  of capital structure must be compared to those of
  the firms competitors to identify any potential
  advantages or disadvantages
• Given that any firms capital structure will most
  likely differ from those of its competitors, the
  goal is to examine and understand those
  differences
• What is the competitors historical pattern of
  capital structure?
  
• Why has there been a recent change in the capital
  structure of one or more of the competitor
  firms?
  

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Capital structure viewed from the internal
perspective

• From the internal perspective, the choice of
  capital structure must be consistent with the
  firms future goals and expectations
  
• The idea is that the firm should not run out of
  cash if it has plans for future growth given the
  firms dividend policy
  
• Using forecasts of cash flows, financial
  statements and sources-and-uses-of-funds
  statements help the financial manager decide on
  what is the best capital structure given the
  alternative scenarios

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• The financial manager would like to
  estimate/consider
  
• The unused debt capacity associated with the
  firms current rating and debt level
  
• The cost of capital associated with each credit
  rating and whether the firms chosen debt-equity
  mix achieves the lowest cost of capital
  
• The maturity structure of the firms securities
  in order to avoid maturity mismatches and the
  risk from changing interest rates
  
• The impact of the firms capital structure on the
  control of managers

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A useful tool The FRICT framework

• A useful tool in the capital structure analysis
  is to evaluate the capital structure decision by
  using the FRICT framework
  
• FRICT stands for
• Financial flexibility
• Risk
• Income
• Control
• Timing

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• Financial flexibility does the capital structure
  maintain the firms financial flexibility? We can
  look at bond ratings, coverage ratios,
  capitalization ratios
• Risk what are the business risks faced by the
  firm? What is the variability of the firms EBIT
  and how does it affect shareholders? A useful
  tool is the EBIT-EPS analysis
• Income how does the chosen capital structure
  affect value creation? Examine projected EPS,
  ROE, cost of capital, and estimate firms value
  through DCF analysis

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• Control how does the firms capital structure
  affect the control of the firm? How are the
  firms stockholders and bondholders affected in
  that respect?
• Timing is this the best time to change the
  firms capital structure? What are the conditions
  in capital markets? We can examine the yield
  curve (term structure of interest rates), trends
  in interest rates and P/E multiples

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Survey of 392 CFO(Source Graham and Harvey)

• Do you have optimal/target debt-equity ratio?
• Very strict / somewhat tight target 44
• Flexible target 37
• No target 19
• What factors affect amount of debt for your
  firm?
  
• Financial flexibility (fund for future
  projects) 59
  
• Credit rating 57
• Earnings volatility 48
• Tax advantage of interest deductibility 45
• Costs of bankruptcy / financial distress 21
• Have debt to make unattractive takeover
  target 5
  
• Tax cost faced by investors when they receive
  interest 5
  
• To ensure that upper management works hard 2