70391 - Finance Leverage and Capital Structure The structure of a firm’s sources of long-term financing 70391 – Finance – Fall 2016 Tepper School of Business Carnegie Mellon University c 2016 Chris Telmer. Some content from slides by Bryan Routledge. Used with permission. 11.21.2016 12:37
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70391 - Finance
Leverage and Capital StructureThe structure of a firm’s sources of long-term financing
:: Private firm: founders and others contribute money
:: Publicly-traded firm: shareholders contribute money in theinitial public offering (IPO). Subsequently, more funds can beraised in a seasoned equity offering.
:: Retained earnings: shareholders money gets “plowed back in.”
:: Debt financing
:: Bank loans
:: Corporate bonds
Capital Structure 2
Capital Structure
Cash
AR, Inventory
Property, Plant & Equipment
(PPE)
Long-Term Cash
AP
Long-Term AP
Debt
Equity
=
Capital Structure 3
Capital Structure
Future Free Cash Flow (FCF)
Profitability and Efficiency
Profit margins Operating efficiency Capital (asset) efficiency ROIC
Growth Opportunities New customers New products R&D, innovation
The risk in the business cash flows is affected by operatingleverage, but not by financial leverage.
Capital Structure 9
Operating AND Financial Leverage
Enter financial leverage
:: It affects the equity cost of capital (recall above example:leverage increases risk for shareholder)
:: Can also affect the debt cost of capital, if debt is big enoughto make financial distress an important possibility
Capital Structure 10
Effect of Corporate Financial Leverage
:: Recall:I Leverage increases riskI Risk is proportional to betaI So leverage must affect beta ....
:: Recall: “value weighted averages”
I Portfolio returns:rp = γ1r1 +
(1− γ1
)r2
I Portfolio expected returns:µp = γ1µ1 +
(1− γ1
)µ2
I Portfolio betas:βp = γ1β1 +
(1− γ1
)β2
Capital Structure 11
Effect of Corporate Financial Leverage
:: Recall:I Leverage increases riskI Risk is proportional to betaI So leverage must affect beta ....
:: Recall: “value weighted averages”
I Portfolio returns:rp = γ1r1 +
(1− γ1
)r2
I Portfolio expected returns:µp = γ1µ1 +
(1− γ1
)µ2
I Portfolio betas:βp = γ1β1 +
(1− γ1
)β2
Capital Structure 11
Operating + Financial Leverage
Cash
AR, Inventory
Property, Plant & Equipment
(PPE)
AP
Debt
Equity
=
Capital Structure 12
From Equity Beta to Business Asset BetaWe can estimate βE using stock return data and then solve for the beta that applies to the business assets.
:: If debt is riskless:
βBA = βEE
BA
:: If debt is risky (i.e., default is possible)
βBA = βDD
BA+ βE
E
BA
Capital Structure 13
Warning! “Unlevered Beta”NOT what we have above. What you’ll find on the internet. Related to WACC. Assumes debt and tax shield betas are zero.Discussed further below.
Cash
AR, Inventory
Property, Plant & Equipment
(PPE)
AP
Debt
Equity
=
PV(tax benefits)
V = Vu + τD = D + E
=⇒ βuVu
V+ βtax
τD
V=
D
VβD +
E
VβE
=⇒ βu =E
V − τDβE =
1
1 + (1− τ)D/EβE
Capital Structure 14
Example: AEO
Capital Structure 15
Example: GPS
Capital Structure 16
Industry DataNote: second column is net debt: Dnet = D − cash. So EV = BA = Dnet + E , and βBA = βE E/EV = βE (1 − Dnet/EV ), so
you can compute the 4th column given the 2nd and 1st . Source: COMPUSTAT averages, 1980-2012, via Bryan Routledge.
Capital Structure 17
Summary: Operating + Financial Leverage
Capital Structure 18
Summary: Operating + Financial Leverage
Future Free Cash Flow (FCF)
Profitability and Efficiency
Profit margins Operating efficiency Capital (asset) efficiency ROIC
Growth Opportunities New customers New products R&D, innovation
Efficient Markets Market forces will tend to drive market value toward intrinsic value
Risk
Cost of Capital (%)
Investors required rate-of-return
Intrinsic Value of Operations (Discounted FCF)
Market Value of the Firm
Total Debt
Market Value of Equity
Share Price
Number of Shares
Non-Operating Assets (Cash)
Discounted by
Capital Markets Capital Structure (firm’s choice
of debt and equity)
Capital Structure 19
The Irrelevance of Capital Structure(The Miller-Modigliani Theorems)
Capital Structure 20
Capital Structure
:: Corporation Finance
:: Capital Budgeting
:: Decisions about the operations of the company
:: Use financial markets to select projects
:: Capital Structure
:: How should a project be funded?
:: How should the cash flows be allocated?
Capital Structure 21
Capital Structure Decisions - Modern FinanceFranco Modigliani and Merton Miller, “The Cost of Capital, Corporation Finance and the Theory of Investment,” AmericanEconomic Review, 48, June 1958, 261-297
Capital Structure 22
Debt Policy: No Frictions (no tax)
:: Two companies (A and B) have identical assets. Eachcompany produces cash flows (earnings or EBIT) equivalentto one ounce of gold for ONE year.
A: Debt = $0
B: Debt = $950 principal + $50 interest = $1000
:: Tax Rate is zero (τ = 0)
Capital Structure 23
MM: Frictionless, Certainty
Capital Structure 24
MM: Frictionless, Uncertainty
Capital Structure 25
Effect of Capital Structure: No Frictions
:: In frictionless capital markets capital structure does notchange the value of the firm
:: Dividing up the cash-flow differently can’t change itsmagnitude nor its present value
:: Capital structure does affect the value of the components(equity, debt)
:: And the risk of the components
Capital Structure 26
Effect of Capital Structure: No Frictions
No effect of firm value, big effect on risk and return
:: Does change the distribution of risk and expected returnbetween debt and equity holders
:: Does not make the firm riskier
:: Does make the equity riskier
:: Can make the debt risky (or riskier)
Capital Structure 30
Capital Structure and Taxes(The present value of “tax shields”)
Capital Structure 31
Debt Policy – In Practice
:: In practice companies spend a lot of effort choosing anoptimal capital structure
:: Capital structure changes do affect value
Capital Structure 32
Debt Policy – In Practice[John R. Graham, Campbell R. Harvey, The theory and practice of corporate finance: evidence from the field, Journal of FinancialEconomics, Volume 60, Issues 2-3, May 2001, Pages 187-243 http://bit.ly/21Dj7K]
Capital Structure 33
Debt Policy - Frictions (taxes!)
:: Two companies (A and B) have identical assets (hold capitalbudgeting decision fixed.) Each company produces cash flows(EBIT) equivalent to one ounce of gold per year (inperpetuity).
A: has debt of zero (100% equity financing)
B: as perpetual debt of D with an interest rate of r%
:: Tax rate is not zero (τ = 35%)
Capital Structure 34
Perpetual Debt: Fact or Fiction?Source: U.K. to Repay First World War Bonds, Wall Street Journal, October 31, 2014. The bond is perpetual. The U.K.
government makes interest payments, but doesn’t have to pay the principal. But they were exercising some sort of prepaymentoption and paying the debt off since, in October 2014, interest rates were low relative to the rates on the bonds (exactlyanalogous to a homeowner pre-paying their mortgage when rates fall). Note for history buffs ... these bonds include debt incurredduring the Crimean War and the collapse of the South Sea Company! The latter got bundled in, along with a bunch of WWIdebt, during a 1927 “restructuring.”
More Recent ExampleSource: Financial Times, LEX Column, April 1, 2016
Capital Structure 36
MM: Taxes
Capital Structure 37
MM: Taxes
Capital Structure 38
MM: Taxes
Capital Structure 39
Debt policy - Taxes and “Tax Shields”
V = VU + Value of Interest Deductibility
V ≈ VU + τ D
V = Value of the debt and equity (“the firm”)
VU = Value of the firm if it had no leverage
τ = Marginal tax rate
D = Amount of debt
Note: value of “interest deductibility” often called value of “taxshields.”
Capital Structure 40
Summary
:: Having debt creates value
:: Reduces your tax bill
:: So “PV the FCF” understates a levered firm’s value.
:: NOPAT is “too low” since it ignores interest expense
:: What to do? Either
:1: Adjust the cash flows (“Adjusted Present Value” (APV))
:2: Adjust the discount rate (“Weighted Average Cost of Capital”(WACC))
Capital Structure 41
Application: Levered Re-Cap
Capital Structure 42
A Levered Re-Cap – Using MM and Tax Shields
Company X currently has $910 million debt (market value). Thereare 100 million shares outstanding at $81.90 each (market value).The CFO wants to issue $2,000 million in new debt and issue adividend with the proceeds. The tax rate is 30%.
Capital Structure 43
Levered Re-Cap
Capital Structure 44
Levered Re-Cap – Yeah ... Buts. . .
:: Why bother paying a dividend? Just hold on to the cash!
:: But equity is more risky for shareholders!
:: Increased interest expense is a bad thing: earnings will belower
Capital Structure 45
Finance-1 in the News
Capital Structure 46
Weighted Average Cost of Capital(The WACC)
Capital Structure 47
Debt policy - Taxes, “Tax Shields” and the WACCBare bones: more coming in further finance classes
WACC: Weighted Average Cost of Capital
:: NOPAT (part of FCF) ignores interest expense
:: So expected taxes in FCF is too large
:: As a fix, the WACC lowers the discount rate to offset
Capital Structure 48
WACC
WACC ≡ rf (1− τ)D
V+ re
E
V
:: rf = debt cost of capital (assumed riskless)
:: re = equity cost of capital (expected return)
:: τ = (marginal) corporate tax rate
:: rf (1− τ) = after tax cost of debt
:: V = D + E
Capital Structure 49
Modigliani-Miller WACC FormulaRelating the definition of the WACC to the cost-of-capital for the (unlevered) business assets, r .
Simplest set of assumptions: (i) c = constant, perpetual stream ofafter tax expected FCF, unlevered firm (ii) D= principal onperpetual risk-free debt (iii) riskless interest rate = rf , (iv)opportunity cost of capital = r .
Tax shields:
Net Income =(EBIT − rf D
)(1− τ
)= EBIT
(1− τ
)− rf D︸ ︷︷ ︸
Net Income, No Deduction
+ rf τ D︸ ︷︷ ︸Tax Shield
Present value, perpetual stream of tax shields:
PV (Tax Shields) =rf τ D
rf
= τ D
Capital Structure 50
Modigliani-Miller WACC FormulaRelating the definition of the WACC to the cost-of-capital for the (unlevered) business assets, r .
Simplest set of assumptions: (i) c = constant, perpetual stream ofafter tax expected FCF, unlevered firm (ii) D= principal onperpetual risk-free debt (iii) riskless interest rate = rf , (iv)opportunity cost of capital = r .
Tax shields:
Net Income =(EBIT − rf D
)(1− τ
)= EBIT
(1− τ
)− rf D︸ ︷︷ ︸
Net Income, No Deduction
+ rf τ D︸ ︷︷ ︸Tax Shield
Present value, perpetual stream of tax shields:
PV (Tax Shields) =rf τ D
rf
= τ D
Capital Structure 50
Modigliani-Miller WACC FormulaRelating the definition of the WACC to the cost-of-capital for the (unlevered) business assets, r .
Simplest set of assumptions: (i) c = constant, perpetual stream ofafter tax expected FCF, unlevered firm (ii) D= principal onperpetual risk-free debt (iii) riskless interest rate = rf , (iv)opportunity cost of capital = r .
Tax shields:
Net Income =(EBIT − rf D
)(1− τ
)= EBIT
(1− τ
)− rf D︸ ︷︷ ︸
Net Income, No Deduction
+ rf τ D︸ ︷︷ ︸Tax Shield
Present value, perpetual stream of tax shields:
PV (Tax Shields) =rf τ D
rf
= τ D
Capital Structure 50
Modigliani-Miller WACC Formula
Firm Value = Value(Unlevered Firm) + Value(Tax Shields)
Firm Value:
V =c
r+ τ D
Define L = D/V :
V =c
r+ τ L V
=c
r
( 1
1− τL
)=
c
r(1− τ DV )
Weighted-Average Cost of Capital:
WACC = r(1− τ D
V)
Capital Structure 51
Modigliani-Miller WACC Formula
Firm Value = Value(Unlevered Firm) + Value(Tax Shields)
Firm Value:
V =c
r+ τ D
Define L = D/V :
V =c
r+ τ L V
=c
r
( 1
1− τL
)=
c
r(1− τ DV )
Weighted-Average Cost of Capital:
WACC = r(1− τ D
V)
Capital Structure 51
Modigliani-Miller WACC Formula
Firm Value = Value(Unlevered Firm) + Value(Tax Shields)
Firm Value:
V =c
r+ τ D
Define L = D/V :
V =c
r+ τ L V
=c
r
( 1
1− τL
)
=c
r(1− τ DV )
Weighted-Average Cost of Capital:
WACC = r(1− τ D
V)
Capital Structure 51
Modigliani-Miller WACC Formula
Firm Value = Value(Unlevered Firm) + Value(Tax Shields)
Firm Value:
V =c
r+ τ D
Define L = D/V :
V =c
r+ τ L V
=c
r
( 1
1− τL
)=
c
r(1− τ DV )
Weighted-Average Cost of Capital:
WACC = r(1− τ D
V)
Capital Structure 51
Modigliani-Miller WACC Formula
Firm Value = Value(Unlevered Firm) + Value(Tax Shields)
Firm Value:
V =c
r+ τ D
Define L = D/V :
V =c
r+ τ L V
=c
r
( 1
1− τL
)=
c
r(1− τ DV )
Weighted-Average Cost of Capital:
WACC = r(1− τ D
V)
Capital Structure 51
What the Hell is This Thing?
V =∞∑
t=1
E (FCFt)
(1 + r)t+∞∑
t=1
E (tst)
(1 + rts)t
=∞∑
t=1
E (FCFt)
(1 + rWACC )t
Capital Structure 52
What the Hell is This Thing?
V =∞∑
t=1
E (FCFt)
(1 + r)t+∞∑
t=1
E (tst)
(1 + rts)t=∞∑
t=1
E (FCFt)
(1 + rWACC )t
Capital Structure 52
Unlevered Beta ReduxAssume that the debt beta and the tax-shield beta are zero.
Capital Structure 53
Using It
Capital Structure 54
Bankruptcy and Tradeoff Theory(When debt becomes risky .... optimal capital structure)
Capital Structure 55
A Levered Re-Cap – OK then. . .
:: Why stop at $2,000 million in debt?
Capital Structure 56
Bankruptcy
Important to distinguish between:
:: Bankruptcy
:: Liquidity (can’t pay rD)
:: Insolvency (D > PV (FCF ))
:: A division of the cash flows
:: Business failure (FCF < 0)
Capital Structure 57
Bankruptcy
Bankruptcy is typically not the main problem
Bankruptcy is a division of the cash flows
Capital Structure 58
Bankruptcy
Bankruptcy is typically not the main problem
Bankruptcy is a division of the cash flows
Capital Structure 58
Bankruptcy Costs
Nevertheless .... dividing-up results in “deadweight costs.”
:: Direct costs
:: Legal fees:: Opportunity cost of management time
:: Indirect Costs
:: Lost business:: Production inefficiencies:: Employees quitting:: Inefficient liquidation (“firesale”)
Deadweight bankruptcy costs are costs that a non-levered firmwould not face if in the same business situation
Capital Structure 59
Bankruptcy Costs
Nevertheless .... dividing-up results in “deadweight costs.”
:: Direct costs
:: Legal fees:: Opportunity cost of management time
:: Indirect Costs
:: Lost business:: Production inefficiencies:: Employees quitting:: Inefficient liquidation (“firesale”)
Deadweight bankruptcy costs are costs that a non-levered firmwould not face if in the same business situation
Capital Structure 59
How Big?
:: Bankruptcy Cost
= Value of assets before bankruptcy (but including anyeconomic distress) minus value after bankruptcy resolved
Capital Structure 60
Bankruptcy Costs - LBOs/MBOs of the 1980s[Gregor Andrade and Steven N. Kaplan, How Costly is Financial (Not Economic) Distress? Evidence from HighlyLeveragedTransactions that Became Distressed, Journal of Finance, 53: 5 (October 1998)]
Capital Structure 61
Bankruptcy and Tax Shields – The Tradeoff
:: Cash flows (EBIT) equivalent to one ounce of gold nextyear
:: Debt of D with an interest rate of y% (owe (1 + y)D atyear-end)
:: Tax Rate is τ = 35%
:: “Bankruptcy costs” are $b (e.g., legal fees)
:: Choose D
Capital Structure 62
Trade-Off Theory of Capital Structure
VL = VU
+Value of tax savings of interest
−Value of bankruptcy costs
Capital Structure 63
Defaultable Debt(“Junk Bonds”)
Capital Structure 64
They Might Not Pay!Price=$100, par=$100, coup=0.15, prob(up)=0.9,recovery=$70. Returns = 15%, -30%, E(r) = 10.5%.
What do bondholders get if “default” occurs? What is their:
:: Promised return? (i.e., maximum return)
:: Realized return?
:: Expected return?
Capital Structure 65
Exercise
Same as above, but the bond does not “sell at par:”
:: Price =$95
I Answer: realized returns are 0.2105263 and −0.2631579 and expected return is0.1631579
Capital Structure 66
Exercise
Same as above, but the bond does not “sell at par:”
:: Price =$95
I Answer: realized returns are 0.2105263 and −0.2631579 and expected return is0.1631579