Lecture 9 – Capital Structure Decisions 1 Lecture 9 - Capital Structure Decisions 2 Basic Definitions V = value of firm FCF = free cash flow WACC = weighted average cost of capital r s and r d are costs of stock and debt w e and w d are percentages of the firm that are financed with stock and debt. 3 How Can Capital Structure Affect Value? V = t=1 FCF t (1 + WACC) t WACC= w d (1-T) r d + w e r s The impact of capital structure on value depends upon the effect of debt on: WACC FCF 4 The Effect of Additional Debt on WACC Debtholders have a prior claim on cash flows relative to stockholders. Debtholders’ “fixed” claim increases risk of stockholders’ “residual” claim. Cost of stock, r s , goes up. Firm’s can deduct interest expenses. Reduces the taxes paid Frees up more cash for payments to investors Reduces after-tax cost of debt (Continued…)
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Lecture 9 - Capital Structure Decisions V = value of firm FCF = free … · 2018-07-02 · operating income (EBIT). Stock-Sales EBIT EPS holders 22 23 Financial Leverage (DFL) Financial
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Lecture 9 – Capital Structure Decisions
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Lecture 9 - Capital Structure Decisions
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Basic Definitions
V = value of firmFCF = free cash flowWACC = weighted average cost ofcapitalrs and rd are costs of stock and debtwe and wd are percentages of the firmthat are financed with stock and debt.
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How Can Capital Structure Affect Value?
V = ��
t=1
FCFt
(1 + WACC)t
WACC= wd (1-T) rd + wers
� The impact of capital structure on value depends upon the effect of debt on:� WACC� FCF
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The Effect of Additional Debt on WACC
Debtholders have a prior claim on cashflows relative to stockholders.
Firm’s can deduct interest expenses.Reduces the taxes paidFrees up more cash for payments to investorsReduces after-tax cost of debt
(Continued…)
Lecture 9 – Capital Structure Decisions
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The Effect on WACC (Continued)
Debt increases risk of bankruptcyCauses pre-tax cost of debt, rd, to increase
Adding debt increases percent of firmfinanced with low-cost debt (wd) anddecreases percent financed with high-cost equity (we)Net effect on WACC = uncertain.
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The Effect of Additional Debt on FCF
Additional debt increases the probability ofbankruptcy.
Direct costs: Legal fees, “fire” sales, etc.Indirect costs: Lost customers, reduction inproductivity of managers and line workers,reduction in credit (i.e., accounts payable) offeredby suppliersImpact of indirect costs
NOPAT goes down due to lost customers anddrop in productivityInvestment in capital goes up due to increase innet operating working capital (accounts payablegoes down as suppliers tighten credit).
(Continued…)
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Additional debt can affect the behavior ofmanagers.
Reductions in agency costs: debt “pre-commits,” or “bonds,” free cash flow for use inmaking interest payments.Thus, managers are less likely to waste FCF onperquisites or non-value adding acquisitions.Increases in agency costs: debt can makemanagers too risk-averse, causing“underinvestment” in risky but positive NPVprojects.
The Effect of Additional Debt on FCF
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Asymmetric Information and Signaling
Managers know the firm’s future prospectsbetter than investors.Managers would not issue additional equity ifthey thought the current stock price was lessthan the true value of the stock (given theirinside information).Hence, investors often perceive an additionalissuance of stock as a negative signal, andthe stock price falls.
Lecture 9 – Capital Structure Decisions
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Business Risk versus Financial Risk
Business risk:Uncertainty in future EBIT.Depends on business factors such ascompetition, operating leverage, etc.
Financial risk:Additional business risk concentrated oncommon stockholders when financial leverage isused.Depends on the amount of debt and preferredstock financing.
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Business RiskThe variability or uncertainty of a firm’s operating income (EBIT).
Business Risk: Uncertainty about Future Pre-tax Operating Income (EBIT)
Probability
EBITE(EBIT)0
Low risk
High risk
Note that business risk focuses on operating income, so it ignores financing effects.
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Financial RiskThe variability or uncertainty of a firm’s earnings per share (EPS) and the increased probability of insolvency that arises when a firm uses financial leverage.
FIRMFIRMEBIT EPSStockStock--holdersholders
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What is Leverage?Ability to influence a system, or an environment,in a way that multiplies the outcome of one'sefforts without a corresponding increase in theconsumption of resources. In other words,leverage is an advantageous-condition of havinga relatively small amount of cost yield arelatively high level of returns. Thus, "doing a lotwith a little."
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Two Concepts that Enhance Understanding of Risk
1) Operating Leverage - affects a firm’s business risk.
2) Financial Leverage - affects a firm’s financial risk.
The use of fixed operating costs as opposed tovariable operating costs.A firm with relatively high fixed operating costswill experience more variable operating income ifsales change.
The use of fixed-cost sources of financing (debt,preferred stock) rather than variable-cost sources(common stock).
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Breakeven Analysis
Illustrates the effects of operating leverage.Useful for forecasting the profitability of afirm, division or product line.
Useful for analyzing the impact of changes infixed costs, variable costs, and sales price.
With Operating Leverage a firm increases itsfixed operating costs and reduces (oreliminates) its variable costs?
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Higher Operating Leverage Leads to More Business Risk: Small Sales
Decline Causes a Larger EBIT Decline
(More...)
Sales
$ Rev.TC
F
QBE
EBIT}$
Rev.
TC
F
QBESales
This assumes that VC will fall as a result higher FC
Lecture 9 – Capital Structure Decisions
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Operating Breakeven
Q is quantity sold, F is total fixed cost, V is variable cost per unit (economists call this AVC), TC is total cost, and P is price per unit.Profit= TR – TC = PQ – VQ - FAt breakeven Profit = 0, thus PQ – VQ – F = 0Operating breakeven = Q = QBE
� More EBIT goes to investors in Firm L.� Total dollars paid to investors:
� U: NI = $1,800. {$3000(1-T)} = $3000(.6)� L: NI + Int = (3000 – 1200)(0.6) + 1200
=$1,080 + $1,200 = $2,280.� Taxes paid:
� U: $1,200; L: $720.
Leveraging Increases Returns
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On the next slides we consider the fact that EBIT is notknown with certainty. What is the impact of uncertainty onstockholder profitability and risk for Firm U and Firm L?
Firm L: Leveraged
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Lecture 9 – Capital Structure Decisions
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Basic earning power (EBIT/TA) and ROIC (NOPAT/Capital =EBIT(1-T)/TA) are unaffected by financial leverage.L has higher expected ROE: tax savings and smaller equity base.L has much wider ROE swings because of fixed interest charges.Higher expected return is accompanied by higher risk.
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ConclusionsIn a stand-alone risk sense, Firm L’s stockholders see much more risk than Firm U’s.
U and L: �ROIC = 2.12%.U: �ROE = 2.12%. L: �ROE = 4.24%.
L’s financial risk is �ROE - �ROIC = 4.24% - 2.12% = 2.12%. (U’s is zero.) For leverage to be positive (increase expected ROE), BEP must be > rd.If rd > BEP, the cost of leveraging will be higher than the inherent profitability of the assets, so the use of financial leverage will depress net income and ROE.In the example, E(BEP) = 15% while interest rate = 12%, so leveraging “works.”
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Capital Structure Theory
Modigliani and Miller (MM) theoryZero taxesCorporate taxesCorporate and personal taxes
Trade-off theorySignaling theoryPecking orderDebt financing as a managerial constraintWindows of opportunity
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Who are Modigliani and Miller (MM)?
They published theoretical papers that changed the way people thought about financial leverage.They won Nobel prizes in economics because of their work.MM’s papers were published in 1958 and 1963. Miller had a separate paper in 1977. The papers differed in their assumptions about taxes.
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MM Theory: Zero Taxes
MM prove, under a very restrictive set of assumptions, that a firm’s value is unaffected by its financing mix:
VL = VU.
Therefore, capital structure is irrelevant.Any increase in ROE resulting from financial leverage is exactly offset by the increase in risk (i.e., rs), so WACC is constant.
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MM Theory: Corporate Taxes
Corporate tax laws favor debt financing over equity financing.With corporate taxes, the benefits of financial leverage exceed the risks: More EBIT goes to investors and less to taxes when leverage is used.MM show that: VL = VU + Total Debt (TD).If T=40%, then every dollar of debt adds 40 cents of extra value to firm.
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Value of Firm, V
0Debt
VL
VU
Under MM with corporate taxes, the firm’s value increases continuously as more and more debt is used.
TD
MM Relationship Between Value and Debt When Corporate Taxes are Considered.
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Cost of Capital (%)
0 20 40 60 80 100Debt/Value Ratio (%)
rs
WACCrd(1 - T)
MM Relationship Between Value and Debt When Corporate Taxes are Considered.
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Miller’s Theory: Corporate and Personal Taxes
Personal taxes lessen the advantage of corporate debt:
Corporate taxes favor debt financing since corporations can deduct interest expenses.Personal taxes favor equity financing, since no gain is reported until stock is sold, and long-term gains are taxed at a lower rate.
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VL = VU + [1 - ]D.
Tc = corporate tax rate.Td = personal tax rate on debt income.Ts = personal tax rate on stock income.
(1 - Tc)(1 - Ts)(1 - Td)
Miller’s Model with Corporate and Personal Taxes
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VL = VU + [1 - ]D
= VU + (1 - 0.75)D
= VU + 0.25D.
Value rises with debt; each $1 increase in debt raises L’s value by $0.25.
(1 - 0.40)(1 - 0.12)(1 - 0.30)
Tc = 40%, Td = 30%, and Ts = 12%.
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Conclusions with Personal Taxes
Use of debt financing remains advantageous, but benefits are less than under only corporate taxes.
Firms should still use 100% debt.
Note: However, Miller argued that in equilibrium, the tax rates of marginal investors would adjust until there was no advantage to debt.
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Trade-off Theory
MM theory ignores bankruptcy (financial distress) costs, which increase as more leverage is used.At low leverage levels, tax benefits outweigh bankruptcy costs.At high levels, bankruptcy costs outweigh tax benefits.An optimal capital structure exists that balances these costs and benefits.
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Signaling Theory
MM assumed that investors and managers have the same information.But, managers often have better information. Thus, they would:
Sell stock if stock is overvalued.Sell bonds if stock is undervalued.
Investors understand this, so view new stock sales as a negative signal.Implications for managers?
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Pecking Order Theory
Firms use internally generated funds first, because there are no flotation costs or negative signals.If more funds are needed, firms then issue debt because it has lower flotation costs than equity and not negative signals.If more funds are needed, firms then issue equity.
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Debt Financing and Agency Costs
One agency problem is that managers can use corporate funds for non-value maximizing purposes.The use of financial leverage:
Bonds “free cash flow.”Forces discipline on managers to avoid perks and non-value adding acquisitions. A second agency problem is the potential for “underinvestment”.
Debt increases risk of financial distress.Therefore, managers may avoid risky projects even if they have positive NPVs.
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Investment Opportunity Set and Reserve Borrowing Capacity
Firms with many investment opportunities should maintain reserve borrowing capacity, especially if they have problems with asymmetric information (which would cause equity issues to be costly).
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Windows of Opportunity
Managers try to “time the market” when issuing securities.They issue equity when the market is “high” and after big stock price run ups.They issue debt when the stock market is “low” and when interest rates are “low.”The issue short-term debt when the term structure is upward sloping and long-term debt when it is relatively flat.
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Empirical Evidence
Tax benefits are important– $1 debt adds about $0.10 to value.Supports Miller model with personal taxes.
Bankruptcies are costly– costs can be up to 10% to 20% of firm value.Firms don’t make quick corrections when stock price changes cause their debt ratios to change– doesn’t support trade-off model.After big stock price run ups, debt ratio falls, but firms tend to issue equity instead of debt.
Inconsistent with trade-off model.Inconsistent with pecking order.Consistent with windows of opportunity.
Many firms, especially those with growth options and asymmetric information problems, tend to maintain excess borrowing capacity.
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Implications for ManagersTake advantage of tax benefits by issuing debt, especially if the firm has:
High tax rateStable sales
Less operating leverageAvoid financial distress costs by maintaining excess borrowing capacity, especially if the firm has:
Volatile salesHigh operating leverageMany potential investment opportunitiesSpecial purpose assets (instead of general purpose assets that make good collateral)
If manager has asymmetric information regarding firm’s future prospects, then avoid issuing equity if actual prospects are better than the market perceives.Always consider the impact of capital structure choices on lenders’ and rating agencies’ attitudes
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1. Estimating the Cost of Debt
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2. Estimating the Cost of Equity at Different Levels of Debt: Hamada’s Equation
MM theory implies that beta changes with leverage.
bU is the beta of a firm when it has no debt (the unlevered beta)
bL = bU [1 + (1 - T)(D/S)]
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The Cost of Equity for wd = 20%(assuming tax rate of 40%)
Use Hamada’s equation to find beta:bL= bU [1 + (1 - T)(D/S)]
= 1.0 [1 + (1-0.4) (20% / 80%) ]= 1.15
Use CAPM to find the cost of equity:rs= rRF + bL (RPM)
Repeat this for all capital structures under consideration.
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4. Estimating Corporate Value
g=0, so investment in capital is zero; soFCF = NOPAT = EBIT (1-T).From earlier EV of EBIT = $40,000NOPAT = ($40,000)(1-0.40) = $24,000.V = $24,000/ 0.12 = $200,000
This assumes zero debt.
V = FCF
(WACC)
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5. Estimating Shareholder Wealth and Stock Price
Value of the equity declines as moredebt is issued, because debt is used torepurchase stock.
But total wealth of shareholders is valueof stock after the recapitalization plusthe cash received in repurchase, andthis total goes up (It is equal toCorporate Value on earlier slide).
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Stock Price for wd = 40%
The firm issues debt, which changes its WACC, which changes value.The firm then uses debt proceeds to repurchase stock.Stock price changes after debt is issued, but does not change during actual repurchase (or arbitrage is possible).The stock price after debt is issued but before stock is repurchased reflects shareholder wealth:
S, value of stockCash paid in repurchase.
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Stock Price for wd = 40% (Continued)
D0 and n0 are debt and outstanding shares before recapitalization.D - D0 is equal to cash that will be used to repurchase stock.S + (D - D0) is wealth of shareholders’ after the debt is issued but immediately before the repurchase.