Financial Structure

1
Financial Structure

• Debt, Equity, or Something in Between?
• (Readings chapter 15)

2
Some Financial Facts

• Firms prefer to finance with
• Retained Earnings
• Debt
• Hybrid Securities (Convertible Bonds)
• Equity
• This is known as Pecking Order of financial
  sources

3
More Financial Facts

• Capital Structures (Debt-Equity Mix) vary
  considerably across industries.
• High growth companies (pharmaceuticals, software)
  have little debt, or use convertible bonds
• Cash Cows have considerable debt
• Highly profitable companies in each industry
  could easily borrow much more than they do (e.g.
  Microsoft, Amgen, Intel,)

4
Financial Facts continued

• Small Firms prefer short-term debt and debt
  hybrids
• Increases in leverage are viewed positively by
  investors (and vice versa)
• Corporate Bonds are complex contracts. They
  typically contain covenants that restrict issue
  of more debt and sometimes other restrictions

5
Overview Does Debt Matter?

• This chapter proceeds as follows
• We will see that in a simple world, the
  debt-equity decision does not matter
  (Modigliani-Miller Theorem)
• But we know from reality that it does!
• So it must be factors outside the simplistic
  model that drive corporate financing decisions.

6
The Modigliani-Miller Theorem

• The value of a firm is independent of how it is
  financed if
• The firms total after-tax cash flows are
  independent of how it is financed
• There are no transaction costs
• Note that this ignores tax differences,
  bankruptcy costs, agency problems, and the like

7
Proof by Example

• Elco Corp. has 1,000 shares outstanding at 100 a
  share. It also has 1-year zero-coupon debt
  outstanding with a market value of 10,000
• Elco is considering to increase its leverage
• For this purpose, it plans to issue 50,000 of
  debt in order to repurchase 500 shares at 100 a
  piece.

8
An Elco shareholder is not affected by this
change

• Let X denote the random cash flow of Elco. Prior
  to the change, an investor owning 100 shares
  would receive
• After the change, the investor would receive (he
  now owns 20 of the company)

9
An Elco shareholder is not affected by this
change (ctd.)

• Suppose he sells 50 of his shares and uses the
  proceeds to buy 5,000 of the firms bonds. His
  payoff will be
• Which is exactly as before.
• This example can be extended to include potential
  bankruptcies

10
Intuition

• Financial Policy cannot create value because
  shareholders can lever or unlever equally well
  themselves
• To create value, managers have to do things that
  investors cannot do themselves, i.e. increase
  cash flows
• The most important way debt creates value is due
  to the tax benefits of debt

11
Debt and Taxes The two Certainties of Corporate
Life

• Modigliani-Miller ignores the impact of corporate
  taxes
• Interest payments are tax deductible at the
  corporate level
• If the company faces a tax rate of tC, then every
  dollar of interest payments only cost 1-tC
• These tax savings are called the debt tax
  shield

12
WACC with Taxes

• In chapter 12, we discussed the weighted average
  cost of capital in the absence of taxes
• Now, we should include the debt tax savings
• Typically, WACC refers to the 2nd case

13
1980s Leveraged Buy-Outs

• In the 1980s, many takeovers created value by
  issuing more debt to save on taxes
• In theory, the firm should issue infinite debt to
  eliminate all tax liabilities
• In reality, the firm can only issue a limited
  amount of debt (debt capacity)
• Also, we only save on taxes if the company is
  profitable

14
1980s Leveraged Buy-Outs

• So what companies really benefit from the debt
  tax shield?
• Companies that are highly profitable
• Companies that do not need to retain earnings for
  future growth
• Companies that have many assets that are suitable
  as collateral

15
1980s Leveraged Buy-OutsExample RJR Nabisco

• A prime example is RJR Nabisco (RJR tobacco,
  Nabisco food)
• In 1987, RJR Nabisco earned 2,304m before
  interest and taxes.
• It paid 735m in taxes and 488m in interest (tax
  rate tC40.5)
• What if the company chose to distribute 5b in
  9.4 bonds to shareholders? These bonds require
  470m interest

16
1980s Leveraged Buy-OutsExample RJR Nabisco
CF increases by 2.64-1.88 0.76 a share
17
RJR Nabisco

• We will revisit that company soon and see how the
  calculation above tempted Kohlberg, Kravis,
  Roberts (KKR) to buy the company and create value
  by issuing an enormous amount of debt.
• Many companies nowadays have near-optimal capital
  structures
• Exception Some companies like Microsoft, Intel,
  Amgen, could easily have much more debt than they
  do