Module I: Investment Banking: Capital Structure and Valuation

1
Module I Investment BankingCapital Structure
and Valuation

• Week 3 September 11, 2002

2
Introduction

• 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 firms 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.

3
Value and Leverage Strategy
Conservative Strategy
Aggressive Strategy
Debt
Debt
Equity
Equity
4
Distribution of Corporate Income
EAC (Div Retained Earnings)

• E B I T

I (Fixed Claims)
T (No Value to Investors)
5
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

6
Capital Structure Theory
7
Summary M-M Debate Issues
8
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

9
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.

10
EBIT-EPS Table
Based on the hypothetical EBITs, we can compute
the associated EPS. This gives rise to the
EBIT-EPS table or chart.
11
EBIT-EPS Chart
12
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.

13
Hypothetical Outcomes Levered Firm
14
EBIT-EPS Chart
15
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.

16
Home Made Leverage
17
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.

18
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.

19
Miller-Modigliani Theory Firm Value
Firm Value
Leverage has no effect on firm value when there
are no taxes and markets are perfect
All Equity Firm Value
Leverage Ratio
20
Miller-Modigliani Theory WACC
21
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.

22
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.

23
Levered and Unlevered Firms
24
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.

25
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.

26
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.

27
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?

28
Miller-Modigliani Theory with Corporate Taxes
Firm Value
Value of a Levered Firm
Present value of the tax shield
All Equity Firm Value
Leverage Ratio
29
MM With Taxes WACC
With taxes, the weighted average cost of capital
declines with higher leverage
Cost of Equity

WACC
Cost of Debt
Leverage Ratio
30
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.

31
MM with Taxes and COFD
Optimal Leverage Zone Balances Tax Advantages of
Debt Against the Costs of Financial Distress
Firm Value
All Equity Firm Value
Leverage Ratio
32
MM with Taxes and COFD WACC
The weighted average cost of capital declines
with higher leverage and then rises
Cost of Equity

WACC
Cost of Debt
Leverage Ratio
33
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

34
Valuation and LeverageSome Common Mistakes
35
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.

36
Cost of Capital for All Equity Firm?

• 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

37
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

38
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

39
Next Week September 16 18

• Review background readings on valuation
  implications of mergers and acquisitions
• Read and discuss The Hostile Bid for Red October
  case with your group next week
• Allocate tasks associated with group write-up and
  do necessary work
• Hand in case write-up at the beginning of class
  on September 23, 2002 and keep copies for class
  discussion