1 EMBA 514 Capital Structure Theory. 2 Capital Structure Effects on Value The impact of capital structure on value depends upon the effect of debt on:

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EMBA 514Capital Structure Theory

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Capital Structure Effects on Value

The impact of capital structure on value depends upon the effect of debt on:WACCFeedback to FCF

1 )1(tt

t

WACC

FCFEV

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Cost of Equity effect

In seeking to minimize the WACC, firms trade-off the benefit of using more lower cost debt against a rising cost of equity

We need an equation for how the cost of equity might be expected to behave as debt increases

The Modigliani and Miller model provides a framework for estimating the cost of equity at different capital structures

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Modigliani and Miller Assumptions

No taxes

All debt is riskless, so the cost of debt is constant no possibility of default

Capital structure has no impact on operating cash flows

No agency costs

No information asymmetry

Perpetual cash flows

In MM Enterprise Value depends entirely on level and volatility of EBIT

Current Assets - Oper. Current Liab.

PP&E Debt Equity

EBIT = Free Cash Flow here

Capital investment generates

Net Working Capital

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Same EBIT, same risk (WACC), same Enterprise Value

1 )1(tt

t

WACC

FCFEV

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MM Proposition 1 with Zero Taxes Under the previous restrictive assumptions, we can argue

that two firms with the same EBIT and variance in EBIT (‘operating risk’) should have the same Enterprise Value (Debt + Stock)

VL = VU = EBIT capitalized at WACC (zero growth and no tax, so EBIT=NOPAT=FCFF)

WACC

EBITV

sUr

EBITV

For an unlevered company, the cost of equity (rsU) is the same as WACC, since the capital structure is 100% equity

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MM Proposition 2 with Zero Taxes The cost of equity of a levered firm (rsL) is equal to the cost

of equity of an unlevered firm plus a risk premium which depends on the degree of financial leverage.

Reductions in capital costs as a result of using more lower cost debt (rd) are exactly offset by increases in the cost of levered equity (rsL) due to added financial risk. As a result the WACC is constant at all debt levels, as is

Enterprise Value (V)

S

Drrrr dsUsUsL )( proof shown below

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Proposition 2 equation for the levered cost of Equity (see MM example in Excel)

S

DrEBITr d

sL

sUr

EBITDSV

)( DSrEBIT sU

For a zero-growth company with no taxes, Free Cash Flow to Equity = Net Income = EBIT – Interest Expense = EBIT - rdD

S

DrDSrr dsU

sL

)(

S

Drrrr dsUsUsL )(

From Proposition 1

(1)

(2)

Substitute (2) into (1)

This is the Proposition 2 equation

EBIT = Return to capital x Capital

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MM Proposition 2: No taxes

Cost of Capital (%)

Debt/Value Ratio (%)

rs

WACC

rd

rsU

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MM Proposition 1 with Taxes

The value of an unlevered firm is equal to EBIT (1-T) capitalized at the cost of equity

sUU r

TEBITV

)1(

The value of a levered firm is equal to the value of an unlevered firm of the same risk class, plus the value of the interest tax savings capitalized at the cost of debt

TDVr

TDrVV U

d

dUL

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MM Proposition 2 with Taxes

The cost of equity of a levered firm is equal to the cost of equity of an unlevered firm plus a risk premium which depends on both the degree of leverage and the corporate tax rate.

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MM Proposition 2 with Taxes

L

dsULsL S

TDrrTDVr

)1()(

L

dsL S

TDrEBITr

)1)((

L

dsL S

TDrTEBITr

)1()1(

(1) The no-tax eq (1) with taxes

TDr

TEBITV

sUL

)1(

TDrTEBITrV sUsUL )1(

From proposition 1

(2)

(3)

L

ddsUsULsL S

TDrDrTDrrVr

sUL rTDVTEBIT )()1(

Substitute (3) into (2) for EBIT(1-T)

Rearrange (1)

Rearrange

Rearrange

Rearrange

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MM Proposition 2 with Taxes

DSV LL L

ddsUsULsL S

TDrDrTDrrVr

L

ddsUsUsULsL S

TDrDrTDrDrrSr

Last equation from prior slide

LdsUsUsL S

DTrrrr )1)((

(4)

(5)

Substitute (5) into (4)

LddsUsUsUsL S

DTrrTrrrr )(

This is Proposition 2 with taxes

Factor out D/S

Value = Stock + Debt

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MM Proposition 2 with Taxes

rsL increases with leverage at a slower rate when corporate taxes are considered.

Taxes are an additional variable cost that reduce the variability in cash flow.

The government now shares in the risk of the cash flows.

The WACC continues to decline as new debt is added, and entity value continues to rise. Pile on the debt!

LdsUsUsL S

DTrrrr )1)((

Risk premium now includes (1-T)

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Cost of Capital (%)

Debt/Value Ratio (%)

MM Proposition II: With taxes

rs

WACCrd(1 - T)

rsU

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Value of Entity, V (%)

Debt

VL

VU

MM relationship between value and debt with taxes

TD VU

VL = VU + TxD

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Adjusting Beta for Capital Structure Effects In practice, the effect of capital structure on the Equity

cost of capital is recognized by adjusting Beta in the Capital Asset Pricing Model MM theory implies that beta increases with leverage

As firms borrow, they create fixed costs (interest payments) that make their cash flows to equity investors more volatile (financial risk)

This increased earnings volatility increases the equity Beta

Need equation for beta as a function of leverage Hamada’s Equation

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Hamada’s Equation)( RFMLRFsL rrBrr

)( RFMURFsU rrBrr

RFd rr

S

DTrrrBrrrBrrrBr RFRFMURFRFMURFRFMLRF )1]()([)()(

S

DTBBB UUL )1(

S

DTBB UL )1(1

CAPM equation for a levered firm

CAPM equation for an unlevered firm

Riskless debt assumption

S

DTrrrr dsUsUsL )1)((

Substitute levered CAPM in left side of Proposition 2 and unlevered CAPM in right side:

Proposition 2

Cancel the rRF and divide by (rM-rRF)

Hamada’s Equation

sLr sUr sUrRFd rr

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Trade-off Theory MM theory assumes away financial distress costs, which

increase as more leverage is used: Higher debt costs, including negotiation and monitoring

by creditors (MM assume constant cost of debt) Feedback to Free Cash Flow

Rejection of +NPV investments (under-investment) Growth prospects suffer as business reduces R&D and

Marketing expenditures Loan covenants, which constrain growth Fire sales of assets to raise cash Lost customers, suppliers, and employees Investment in Capital increases as lose trade credit

Contradicts assumption of MM that capital structure doesn’t effect operating cash flows

Growth

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Trade-off Theory (cont.)

Trade-off theory suggests optimal capital structure is reached at point where marginal distress costs exceed the marginal tax benefit from adding debt in the MM model.

At this same point the WACC is minimized and entity value is maximized.

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Trade-off tax shield against distress costs

VL = VU + TD – distress

VL = VU + TD

OptimalDebt Level

VU

Max VL

VL

Debt

VL = Total value with debtVU = Total value with no debt T = Tax rate D = Debt

Distress costs

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Trade-off theory suggests these types of firms will use more debt (least impacted by financial distress)

Low growth opportunities (predictable funds needs and less risk of jeopardizing growth investments)

High and stable free cash flow Large size (safety and lower growth) Marketable collateral (less service or R&D intensive) Product not subject to ongoing maintenance/warranties,

observable quality Profitable enough to benefit from tax shelter

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Debt can reduce Equity Agency Costs Equity agency problem is that managers

might:use corporate funds for non-value maximizing

purposes (e.g. perks, acquisitions, value-destroying growth)

or seek low risk due to undiversified interest in firm

Problem is most significant in large firms with diffuse stockholders where management ownership is low

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Debt can reduce Equity Agency Costs (cont.) The use of financial leverage:

Bonds free cash flow for firms generating more cash than required to fund +NPV opportunities, reducing perk consumption and value-destroying growth.

Increases free cash flow by forcing efficiencies: failure risk gets managers’ attention

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Signaling Theory MM assumed that investors and managers have the

same information. Where significant information asymmetries exist,

stockholders assume: Stock issues may indicate lower expected FCF,

unwilling to commit to increased debt service Company issues new stock when it is overvalued Bonds are issued when stock is undervalued

Leverage-decreasing events signal overvalued stock, and vice versa, supported by empirical data

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Signaling theory results in Pecking Order Hypothesis Firms will choose the following sequence of funding

sources to maintain financial flexibility and avoid negative signals

Retained earnings Excess cash Debt issuance Stock issuance Maintenance of borrowing capacity is most important for

high-growth firms, where value depends on the ability to fund growth investments

Maintain borrowing capacity

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Evidence on Signaling Theory

Profitable firms use less debt (surprise) because they can build more equity internally Contradicts Trade-off theory which suggests they

should have high debt due to low default risk and need for tax shelters

Suggests capital structure decision is a residual that depends on cash flow, and the investment and distribution decisions

Mature firms issue stock very infrequently

Steps in the distribution decision

NOPATCF to Debt:Principal +

InterestFreeCashFlow

How much will you borrow?Reinvestment:Capex +

Working Capital

How many + NPV investments?

Cash flowavailable

to stockholders

Cash held onBalance Sheet

Cash paid out

How much cash on

Balance Sheet?

Repurchases DividendsWhich type of distribution?

Suggest stock repurchases are a residual from the FCF forecast

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Evidence on Signaling Theory (cont.)

When setting capital structure targets, survey evidence indicates managers consider, in rank order:

1. Financial Flexibility2. Long-term survival3. Maintenance of predictable funds sources4. Maximization of stock price

Suggests concerns over feedback to operating performance

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Summing the theories

This leaves us with:

VL = VU + tax benefit – financial distress

+ equity agency + signaling

Capital structure decision requires judgment!

Practical approach to quantifying capital structure choice Use Hamada’s equation to estimate changes in

cost of Equity Use credit ratios to estimate changes in cost of

debt Find weights where WACC is minimized Compare result to peers and use judgment to

incorporate the other factors:

1) financial distress; 2) agency; 3) signaling

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See Excel example

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Effect on sustainable growth: willingness to increase debt allows for higher growth rate today

Sustainable g = ROE x (1 – Dividend Payout Ratio)ROE = ROIC + [ROIC - rd(1-t)] x D/E

Example of target D/E given target growth:Dividend payout = 40%; Target growth = 15%;ROIC = 12%; rd(1-t) = 5.5%

Required ROE = g ÷ (1-DPR) = .15 ÷ (1-.40) = 25%Required D/E = (25% - 12%) ÷ (12% - 5.5%) = 2.0

See Excel example

Additional considerations in setting the target capital structure

Additional considerations in setting the target capital structure (cont.)

Lender and rating agency attitudes(impact on credit ratings)

Debt ratios of other firms in the industry

Risk aversion of managers

Intersection with distribution policy

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Use debt to retain control and avoid takeover Realize value of tax shield to boost stock price

Concentrate ownership in friendly hands

Signal operating improvements that will lead to increased profit and stock price

Signal strategy to disgorge excess FCF

Additional considerations in setting the target capital structure (cont.)