Capital Structure and Firm Value

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Capital Structure and Firm Value
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Does Capital Structure affect value?

• Empirical patterns
• Across Industries
• Across Firms
• Across Years
• Who has lower debt?
• High intangible assets/specialized assets
• High growth firms
• High cash flow volatility
• High information asymmetry
• Industry leaders
• Is capital structure managed?
• If so much time is spent on capital structure
  then there must be some value to it (or
  managers/investors are irrational)

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Debt and Equity Only?

• Typically thought of and measured this way
• Much more complex
• Investment opportunities and strategy (needs)
• Financing (sources)
• Cash balance
• Distribution Dividend and repurchases
• Debt capacity
• Equity capacity
• Existing debt and equity
• Other financial policies Financial Hedging,
  Cash Flow Volatility, Forms of Compensation

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How does capital structure affect value?

• To prove this we start in the perfect world
• Based on the work of Miller and Modigliani
• Shows that capital structure is irrelevant
• Value is derived from market imperfections
• Example What if a firm is considering issuing
  debt and retiring equal amounts of equity?

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Current Proposed
Assets 8000 8000
Debt 0 4000
Equity 8000 4000
Interest 0.1 0.1
Share Price 20 20
Outstanding Shares 400 200
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Current Recession Expected Expansion
Earnings 400 1200 2000
ROA 0.05 0.15 0.25
ROE 0.05 0.15 0.25
EPS 1 3 5

Proposed Recession Expected Expansion
EBI 400 1200 2000
Interest 400 400 400
Earnings 0 800 1600
ROA 0.05 0.15 0.25
ROE 0 0.2 0.4
EPS 0 4 8
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Position 1 Buy 100 shares of the levered firm
(201002,000 Initial Investment)
Recession Expected Expansion
Earnings 0 400 800
Position 2 Buy 200 shares of the unlevered
firm and borrow 2000 ((20200)-2,0002,000
Initial investment).
Recession Expected Expansion
Earnings 200 600 1000
Interest 200 200 200
Net Earnings 0 400 800
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Capital Structure is Irrelevant

• Miller and Modigliani assume perfect capital
  markets
• Proposition 1 The market value of any firm is
  independent of its capital structure.

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Market Imperfections Taxes

• Taxes
• US Tax Code Deductibility of interest leads to
  lower cost of debt (Rd(1-t))
• Simple specification overvalues benefit
• Ignores personal taxes which
• Decreases investors debt return
• Increases investors preference for equity
• Capital gains Defer and rate difference
• Dividend Some portion is deductible

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Market Imperfections Contracting Costs

• In imperfect markets, alternative ways to
  contract optimal behavior are necessary
• Costs of financial distress
• Underinvestment (rejecting NPVgt0 projects),
  direct, indirect costs, etc.
• Benefits of debt
• Monitoring function, manages free cash flow
  problem (Accepting NPVlt0 projects), etc.
• Contracting costs and taxes are primary motives
  for static trade off theory debt

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Market Imperfections Information Costs

• With asymmetric information, leverage may reveal
  something about the existing firm
• Market timing Managers take advantage of
  superior information
• Issue equity when it is overvalued
• Issue debt when it is undervalued
• Signaling Managers use financing to signal
  future prospects of firms
• Issue equity to signal good growth opportunities
  (preserve financial flexibility)
• Issue debt when expected cash flows are strong
  and stable
• Motivates Pecking Order Theory

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Can we quantify the value of market imperfections?

• Debt adds value to the firm due to the interest
  deductibility (assume taxes only)
• Assume the simple case

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More Complex Tax Shields

• Uneven and/or limited time payments
• Discount all flows back to time 0
• What r do you use?
• Certain the tax shield can be used rD
• Uncertain? Higher r

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Financial Distress

• As leverage increases, the probability therefore
  PV of financial distress increases

• How do we estimate the cost of distress?
• Prob(Distress)Cost of Distress
• Probability can be estimated in several ways
• Logit/Probit regressions
• Debt ratings

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Financial Distress Bankruptcy Costs

• Direct Costs
• Legal, accounting and other professional fees
• Re-organization losses
• Estimated btw 4-10 of firm value (t-3)
• Indirect Costs
• Reputation costs
• Market share
• Operating losses
• Estimated as 7.8 of firm value (t-2)

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Financial Distress Agency Costs

• Risk shifting and asset substitution
• Shareholders invest in high risk projects and
  shift risk to the debt holders
• Shareholders issue more debt, diminishing old
  debt holders protection
• Underinvestment
• Expropriating funds
• Difficult to estimate

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Other Advantages of Debt

• Agency cost of Equity (motive)
• Shirking is less likely when issuing debt
• Perquisites are less likely with debt
• Over-investment is less likely with debt
• Agency cost of Free Cash Flow (opportunity)
• Retained earnings versus dividends?
• Growth and investment opportunities
• Debt serves as a monitoring device, decreasing
  managerial discretion
• Bankruptcy as a strategic move???

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Formal Models of Capital Structure

• Pecking Order
• Firms prefer to raise capital
• Internally generated funds
• Debt
• Equity
• Implies capital structure is derived from
• Financing needs and capital availability
• Dynamic rather than static
• Asymmetric information and signaling
• Static Trade Off

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Static trade-off theory of debt
Firm Value
Maximum Firm Value
Actual Firm Value
Debt
Optimal amount of Debt
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Implications of Static Trade Off

• Static rather than dynamic
• Taxes and Contracting Cost drive value
• Readjustment may be sticky
• Optimal trade off between cost of issuances and
  benefit of capital structure
• Insights
• Large, stable profit firms will have more debt
• Higher the costs of distress lower debt
• Lower taxes, lower debt
• Less (more) favorable tax treatment of debt
  (equity), lower debt

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Evidence Taxes

• This method usually overestimates the tax
  consequence
• Magnitude of leverage differences across
  countries and tax regimes is not that big
• Equity taxes (personal taxes) are overestimated
  (Miller)
• Timing of capital gains
• Higher effective marginal tax rate, higher the
  leverage (Graham, 2001)

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Evidence

• Contracting Costs Consistent evidence
• Higher (lower) the growth opportunities, higher
  (lower) the potential underinvestment problem,
  lower (higher) the leverage
• Higher growth opportunities would prefer
• Shorter maturity debt (or call provisions)
• Less restrictive covenants
• More convertibility provisions
• More concentrated investors (private)
• Information costs
• Consistent with market timing (SEOs lead to -3
  return)
• Inconsistent with signaling and pecking order
• Taxes Higher effective marginal tax rate,
  higher the leverage

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MM Proposition II

• How does leverage affect rE
• Start with the WACC
• Solve for rE
• The rate of return on the equity of a firm
  increases in proportion to the debt to equity
  ratio (D/E).

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MM Proposition II (with taxes)
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• Blue Inc. has no debt and is expected to generate
  4 million in EBIT in perpetuity. Tc30. All
  after-tax earnings are paid as dividends.The firm
  is considering a restructuring, with a perpetual
  fixed 10 million in floating rate debt at an
  expected interest rate of 8. The unlevered cost
  of equity is 18.
• What is the current value of Blue?
• What will the new value be after the
  restructuring?
• What will the new required return on equity be?
• What if we use the new WACC?

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What About Financial Flexibility?

• The ability to quickly change the level and type
  of financing
• Value increasing if
• Growth opportunities exist
• Company is willing to exercise and extinguish
  future flexibility
• New investments are unpredictable and large
• Precautionary debt ratings cushion is valuable
• Value destroying if the opposite is true

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How do we value financial flexibility?
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What do we do?

• Choosing a target capital structure
• Minimize taxes and contracting costs (while
  paying attention to information costs)
• Target ratio should reflect the companys
• Expected investment requirements
• Level and stability of cash flows
• Tax status
• Expected cost of financial distress
• Value of financial flexibility
• Dynamic management
• Financing is typically a lumpy process
• Find optimal point where cost of adjusting
  capital structure is equal to cost of deviating
  from target