Capital+Structure

Lecture 8 Capital Structure (Chapter 16, 17)

Capital Structure Theories - Tradeoff theory - Pecking order theory - Market timing theory Recapitalization Decisions

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Capital Structure

Percent of debt financing, also called (financial) leverage.

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The extra risk that shareholders face when the firm uses debt.

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Financial Risk

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Sales 1,400,000 Variable Costs (800,000) Fixed Costs (250,000) EBIT 350,000 Interest (125,000) EBT 225,000 Taxes (34%) (76,500) Net Income 148,500

Example of financial risk

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Sales 1,540,000 +10% Variable Costs (880,000) Fixed Costs (250,000) EBIT 410,000 +17.14% Interest (125,000) EBT 285,000 Taxes (34%) (96,900) Net Income 188,100 +26.67%

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Sales 1,330,000 -5% Variable Costs (760,000) Fixed Costs (250,000) EBIT 320,000 -8.57% Interest (125,000) EBT 195,000 Taxes (34%) (66,300) Net Income 128,700 -13.33%

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Trade-off Theory

There is an optimal capital structure, target capital structure, that trade off the benefits and the costs of debt and maximizes the firm value.

Miller and Modigliani (MM)

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MM Version One: No Friction (1958)

Changes in capital structure do not affect firm value when financial markets are perfect. Only market imperfections (taxes, etc.) allow for leverage to affect firm value.

MM perfect market assumptions: No taxes. No brokerage costs. No bankruptcy costs. Investors can borrow at the same rate as corporations. All investors have the same information as management about the firm’s

future investment opportunities. EBIT is not affected by the use of debt.

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Proposition I:

levered firm value = unlevered firm value. VL = VU

= (EBIT/WACC) = EBIT/ksU

where: ksU = cost of equity for an unlevered firm.

Firm value is independent of leverage.

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Proof with capital structure arbitrage (see P. 611-612):

For two firms with exactly the same business characteristics and different financial leverage levels, if they are differently valued, investors can do capital structure arbitrage by short-selling the stocks of the high-value firm, and using the proceeds to buy the stocks of the low-value firm, which creates profits.

In a more realistic situation, this arbitrage would occur in a matter of seconds. The low-value firm’s price is pushed up and the high-value firm’s price is lowered down, eventually reaching an equilibrium with two firms equally valued.

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Proposition II:

ksL = ksU + Risk premium

= ksU +(ksU - kd)(D/S)

where: ksU = cost of equity for an unlevered firm, ksL= cost of equity for a levered firm, D = market value of firm’s debt, S = market value of firm’s equity, kd = cost of risk-free debt.

As a firm increases its use of debt, its cost of equity also increases; but its WACC remains constant.

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MM Version Two: with Corporate Taxes

Because interest is a tax-deductible expense for corporations, a levered firm should be more valuable than an unlevered firm (assuming that this difference in capital structure is the only difference).

Proposition I: VL = VU + TD

where: T = firm’s tax rate, D = value of debt.

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Proposition II:

ksL = ksU + (ksU - kd)(1-T)(D/S) where: S = value of equity.

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MM Version Three: with Multiple Frictions

Taxes: mentioned earlier (in MM Version Two).

Bankruptcy cost: direct costs (such as legal costs) and indirect costs (such as reputation loss and financial distress).

Agency problems: [e.g.] risk-shifting firm may increase risk and thereby extract value from existing bondholders. (Covenants could reduce the problems)

Free cash flow reduction: debt might reduce extra cash in the firms hence alleviate management deviations.

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Proposition I:

VL = VU

+ TD - (PV of bankruptcy costs) - (PV of agency costs) +(PV of free cash flow reduction)

The optimal capital structure is determined by a trade off between benefits and costs of debt.

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[Example] Suppose Titan Photo has no growth, and its expected EBIT is $100,000, corporate tax rate is 30%. It uses $500,000 of 12% debt financing, and the cost of equity to an unlevered firm in the same business risk level is 16%.

1) What is the value of the firm according to MM with tax? S = (EBIT – kd D)(1-T)/ksL

VU = SU =EBIT (1-T) / ksU = 100000 * (1-30%) /0.16 = 437500 VL = VU+ TD = 437500 + 0.3 * 500000 = 587500 SL = VL– D = 587500 – 500000 = 87500

2) What is this firm’s cost of equity? ksL = ksU + (ksU -kL) (1-T) (D/S) = 16% + (16%-12%) (1-30%) (500000/87500) = 32%

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Pecking Order Theory

Stewart Myers (1984)

Managers are better informed than investors. Investors might see an external equity issuance a bad news about the company, assuming that managers want outside shareholders to share the loss, thus investors will react to this issuance negatively, increasing the issuance cost of external equity.

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Firms therefore prioritize their sources of financing according to the law of least effort, or of least resistance: internal funds are used first, and when that is depleted, debt is issued, and when it is not sensible to issue any more debt, equity is issued.

This theory maintains that businesses adhere to a hierarchy of financing sources and prefer internal financing when available, and debt is preferred over equity if external financing is required.

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Market Timing Theory

A firm will issue a type of external capitals when the associated capital market is good. For instance, it will issue stocks when the stock market is hot.

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Other Issues Need to be Considered in Practice

Business Risk: firms with low BR may use more debt.

Assets: firms with marketable fixed assets may use more debt.

Growth: rapid growth often requires external financing, and will typically use more debt.

Debt Ratings: Some firms want to use more debt than their lenders may be willing to provide. Banks and rating agencies (S&P) use the financial ratios (TIE and other debt ratios) for their decisions.

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Recapitalization

Ways to recapitalize (that is, to change the existing capital structure, equity structure, or debt structure):

- Raising new equity: such as raising VC, IPO, SEO; - Raising new debt/bond; - Stock repurchase; - Leveraged buyout, etc.

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Recapitalization

[Example] PPC has total mkt value = $100M, with 1M shares at $50 per share, and $50M of 10% perpetual bonds selling at par. EBIT = $13.24, and Tc = 15%.

PPC can change its capital structure by increasing debt to $70M or decreasing it to $30M. If it increases leverage, it will call its old

bonds and issue new ones with a 12% coupon. If it decreases leverage, it will call the old bonds and issue new ones with a 8% coupon. PPC will sell or repurchase stock at the new equilibrium price to complete the CS change. It pays all earnings as dividends and is thus a 0% growth stock. If it increases leverage ks will be 16%, if it decreases leverage ks will be 13%.

Should the firm change its capital structure?

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Solution: base situation (D = $50M)

.million $100 = $50 + $50 =

V = Firm Value = D + E = Value of Debt + Value of Equity.

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Solution: Two scenarios

.million $100.88 = $70.88 + $30 =

0.13

)$2.4)(0.85 - ($13.24 + $30 = V

.million $95.71 = $25.71 + $70 = 0.16

(0.85)$8.4 - $13.24 + $70 = V

Decrease leverage (to D = $30M).

Increase leverage (to D = $70M).

k

T) - (1])k(D - [EBIT + D = V

s

d

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Managing Capital Structure

Firms may set target (desired) capital structures by: setting up financial statement forecasts several years into

the future, explicitly including the AFN lines in the forecasts, and varying the proportions of new debt and equity used to

finance future growth, and varying the dividend payout (additional cash back to

shareholders means that more funds will be needed in the future), repurchase of equity and type of debt (some debt has higher interest costs).

With such forecasts, managers are able to understand how different scenarios affect firm value.