capital structure lesson7

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    1

    Background

    Two major decisions that concern managers includedetermining:

    Which projects create the most value

    Which mix of sources of capital is best for nancing the rmsinvestments

    Too much debt is damaging because the rm will have diculty

    in servicing its debtToo little debt is scally inecient because of the taxdeductibility of interest expenses

    How should a rm choose its debte!uity ratio"

    This part examines how managers should combine debtand e!uity nancing to achieve an optimal or targetcapital structure that maximi#es the value of the rmsassets

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    2

    Background

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    The Pie

    The value of a rm is dened to be the sumof the value of the rms debt and therms e!uity$

    V %D+ E If the goal of the firmsmanagement is to

    maximize the value of the

    firm, then the firm should

    pick the debt-equity ratio

    that makes the pie as big

    as possible.alue of the !irm

    D E

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    The usual case

    &n general' changes in capital structurebenet the stoc(holders if and only ifthevalue of the rm increases$

    Thus' we will be focusing on how todetermine the optimal capital structure thatmaximi#es rm value$

    )ets illustrate the e*ect of capital structure

    on returns to shareholders

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    Financial leverage and frm value

    Trans +m ,orp$ currently has no debt in itscapital structure$ The rm is consideringissuing debt$

    Hp: no corporate taxes and no nancial

    distress costs CURRENT FUTURE

    Assets 8,000$ 8,000$

    Debt 0$ 4,000$

    Equity 8,000$ 4,000$

    Interest rate 10% 10%

    Market a!ue "er s#are 0$ 0$

    N s#ares utstan&in' 400 00

    We consider the e*ect of a change in the capital

    structure on the rms -./ and 01- for three possiblescenarios: recession' expected performance' boom$

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    Financial leverage and frm value

    &f scenarios 2expected and boom3 are moreli(ely' leverage is advantageous$ &f 2recession3is more li(ely' it is not good to raise debt$

    CURRENT FUTURE

    Re(essin E)"e(te& *+ Re(essin E)"e(te& *+

    Earnin's 400$ 1,00$ ,000$

    Earnin's bere interest 400$ 1,00$ ,000$

    R-A .% 1.% .% .% 1.% .%

    interest 0 0 0 /400$ /400$ /400$

    Earnin's ater interest 400$ 1,00$ ,000$ 0$ 800$ 1,00$

    R-E .% 1.% .% 0% 0% 40%

    E2 1$ 3$ .$ 0$ 4$ 8$

    4556'555%76554'555%958

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    Financial leverage and frm value

    The e*ect of nancial leverage depends on the companysearnings before interest$The levered rm has fewer shares of stoc( outstanding$Hence' any increase in -& leads to a greater increase in -./$

    ;%5

    ;

    -./ +dvantageto debt

    ;isadvantage to debt

    rea(?evenpoint

    + ris(?adverse investormight prefer the all?e!uity rm$ + ris(?neutralinvestor might preferleverage$

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    Which capital structure is better?

    &magine that shareholders issue debt along twostrategies:

    +> uy @55 shares of the levered e!uity=cost%9'555A>

    > uy 955 shares of the unlevered e!uity at 95Aper share using borrowed money =9'555A>Bowninvestment =9'555A>$

    Total cost of shares%955 x 95A%4'555A

    /trategy +:

    -./Crecession%5A -arningsCrec%-./x@55 shares%5A

    -./Cexpected%4A -arningsCexp%-./x@55 shares%455A

    -./Cboom%6A -arningsCboom%-./x@55shares%655A

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    Which capital structure is better?/trategy :

    -./Crecession%@A -arningsCrec%-./x955 shares%955A

    -./Cexpected%DA -arningsCexp%-./x955 shares%E55A

    -./Cboom%7A -arningsCboom%-./x955shares%@555A

    &f you pay interest =@58> on debt:

    &nterest expense%5$@5x9'555%955A for all the three states

    -arningsCrec%955?955%5A

    -arningsCexp%E55?955%455A-arningsCboom%@555?955%655A

    The payo* of the two strategies are the same and do not

    a*ect shareholders welfareF =as far as the shareholder can

    use borrowed money at the same interest rate applied onthe

    rms debt$>

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    Modigliani and Miller (19!"

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    Modigliani and Miller (19!"

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    Modigliani and Miller #

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    Modigliani and Miller #

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    Modigliani and Miller #

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    Modigliani and Miller #

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    Modigliani and Miller ##

    55E

    Drrrr

    E

    Dr

    E

    EDr duudue +=

    +=

    GG .roposition &&: The expected return on e!uity is positivelyrelated to leverage because the ris( to e!uity holders increases

    with leverage$

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    $ome algebra

    deWACC rED

    DrED

    Er +++=

    uWACC rr =

    E

    ED +bysi&esbt#+u!ti"!y

    E

    ED

    ED

    Dr

    E

    ED

    ED

    Err

    E

    EDdeu

    +

    ++

    +

    +=

    +

    )evered rm

    nleveredrm

    deu rED

    DrED

    Er +++=

    E

    Drrr

    E

    EDdeu +=

    +

    5duue

    rrE

    Drr +=

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    Modigliani and Miller ##

    &n our previousexample:

    %1.%1.000,8

    000,8%10

    000,8

    06 =+=WACCrUNLEVERED

    %1.%$0000,8000,4%10

    000,8000,46 =+=WACCrLEVERED

    WACCu rr === %1.000,8

    00,1

    &ndependently of the capitalstructure rW+,, is always the sameF

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    Modigliani and Miller ##

    4455EDrrrr

    EDr

    EEDr duudue +=

    +=

    The cost of e!uity rises with leverage

    because the ris( to e!uity rises withleverage$

    ruIrd

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    %n interpretation o& MM

    GG indicate that managers cannot change the valueof a rm by repac(aging the rms securities

    The si#e of the pie does not change' no matter howstoc(holders and bondholders divide it

    + rms capital structure is irrelevant

    GG argue that the rms overall cost of capitalcannot be reduced as debt is substituted for e!uity'even if debt is cheaper than e!uity$

    +s the rm adds debt' the remaining e!uity becomesmore ris(y and the cost of e!uity capital rises as aresult$

    Hence' the increase in the cost of e!uity capital o*setsthe higher proportion of the rm nanced by low?costdebt

    oth the value of the rm and the rms overall cost of

    capital are invariant to leverage

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    'orporate taes

    &n the presence of corporate taxes' rm value ispositively related to its debt

    &n most countries interest =but not dividend>payments are tax deductible$

    !an I7 n &ebt !an II7 &ebt

    E*IT 1,000,000 1,000,000

    Interest e)"ense 0 400,000

    Earnin's bere ta)es 1,000,000 00,000

    Ta)es 53.% 3.0,000 10,000

    Tta! Earnin's .0,000 30,000

    Tta! (as# !9 t bt# st(k#!&ers an& bn!&ers .0,000 :0,000

    rd%@58

    ;ebt%4'555'555A

    ;ebt?interest tax shield =;&T/>%Tc J rd;

    &t is the amount of money saved because interest expenses are tax deductible

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    MM# and corporate taes

    u

    CU

    rTEBITV 15 =

    +ssumption: the ,K expressed by ;&T/ has the same ris( as the intereston debt

    DTrDrT

    C

    d

    dC=

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    MM## and corporate taes

    GG && with corporate tax: 5515

    E

    DrrTrr ducue +=

    ruIrd

    There is an incentive to issue debt because it allows to minimi#ethe cost of capital for the rmF

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    MM and corporate taes

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    Personal taes

    )ets introduce personal taxes$ We assume allearnings are paid out as dividends$ ;ividends andinterests are taxed at the same rate D58$

    ;ebt increases the value of the rmF

    !an I7 n &ebt !an II7 &ebt

    Dii&en&s .0,000 30,000

    ersna! ta)es n &ii&en&s 530% 51.,000 511:,000

    Dii&en&s ater "ersna! ta)es 4..,000 :3,000

    Interest e)"ense 0 400,000

    ersna! ta)es n interest 530% 0 510,000

    Interest e)"ense ater "ersna! ta)es 0 80,000

    Tta! (as# !9 t bt# st(k#!&ers an& bn!&ers 4..,000 ..3,000

    .lan &%corporate tax B personal tax on div%D75'555B@L7'555%747'555A

    .lan &&%corporate tax B personal tax on div Bpersonal tax oninterest%9@5'555B@@M'555B@95'555%44M'555A

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    Personal taes

    Higher tax rate on interest than on dividends$.ersonal tax rate on dividends is @58$ .ersonaltax rate on interest is 758$

    ;ebt does not increase the value of the rmF

    !an I7 n &ebt !an II7 &ebt

    Dii&en&s .0,000 30,000

    ersna! ta)es n &ii&en&s 510% 5.,000 53,000

    Dii&en&s ater "ersna! ta)es .8.,000 3.1,000

    Interest e)"ense 0 400,000

    ersna! ta)es n interest 5.0% 0 500,000

    Interest e)"ense ater "ersna! ta)es 0 00,000

    Tta! (as# !9 t bt# st(k#!&ers an& bn!&ers .8.,000 ..1,000

    .lan &%corporate tax B personal tax on div%D75'555BE7'555%4@7'555A

    .lan &&%corporate tax B personal tax on div Bpersonal tax oninterest%9@5'555BDL'555B955'555%44L'555A

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    Miller 199)* the e+ects o& personaltaes

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    Miller 199)* derivation

    DrT dpd15

    15155 pecd TTDrEBIT

    The value of the levered rm N) is the present value of its

    expected after tax earnings which is partitioned into twoparts:

    Othe shareholders

    Othe debt holders$

    The yearly cash Pows to shareholders after corporate andpersonal taxation are given by:

    The yearly cash Pows to bondholders are given by:

    Thus the total cash Pow of all investors is:

    DrTTTDrEBIT dpdpecd 41541451455 +

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    Miller 199)* derivation

    DrTTTDrEBITdpdpecd

    1515155 +

    +

    15

    15151151515

    pd

    pec

    dpdpecT

    TTDrTTTEBIT

    DrT dpd15

    can be rewritten as:

    The rst term is the cash Pow from an unlevered rm after alltaxes and is e!ual to Nu$ +n individual buying a bond for ;

    receives after all taxes:

    Thus' the value of the second term must be:

    Therefore' the value of the levered rm must be:

    +=

    15

    15151

    pd

    pec

    UL

    T

    TTDVV

    15

    1515

    1pd

    pec

    T

    TT

    D

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    Miller 199)* the model

    +=

    15

    15151

    pd

    pec

    ULT

    TTDVV

    pdpe TT = DTVV cUL +=

    The value of a levered rm is:

    &f we set the formulareduces toWhen pdpe TT < 151515 pecpd TTT >

    DTVV cUL +' the increase in the .N of K;, given from an additional A of debt is e!ualto the increase in the .N =;&T/>

    eyond point ;J nancial distress costs increase faster than the tax shield' implying a reduction in rm value$

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    $tatic,trade o+ model

    rW+,, falls initially because of the tax advantage to debt$ eyondthe optimal level of debt it rises because of nancial distress costs

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    Firm proftabilit- and debt level

    Kirms with low anticipated prots =less valuable> will ta(eon a low level of debt

    Gore valuable rms will ta(e on more debt in order tofurther reduce taxes from their greater earnings$

    ;ebt signalling theory:

    When rms expect their earnings to rise' they raise debt

    This is interpreted as a signal of rm valuestoc( pricesrise

    Ganagers have incentives to fool the public:

    &f a rm has already an optimal level of debt' but managers

    decide to raise debt to increase the stoc( price&nvestors could thin( that the rm is more valuable thanwhat it really is and stoc( prices go up$

    However' at some point the mar(et will (now that the rmis not valuable and stoc( prices will fall at lower levels thanbefore the debt issuance$

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    #n&ormation structures

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    Principal,agent games and agenc-cost

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    Moral .a/ard

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    'ostl- control mechanisms

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    %genc- cost o& debt

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    $ources o& debt,shareholders con0ict

    /hareholders are tempted to pursue selsh strategies when thereis a probability of ban(ruptacy:

    &ncentives to ta(e large ris(s

    &ncentives towards underinvestment

    Gil(ing the property

    &ncentive to ta(e large ris(s-x$ + levered rm is considering two mutually?exclusive projects=low?ris( and high?ris(>$ There are two e!ually li(ely states of theeconomy =recession' boom>$ &f recession hits' the rm will comenear to ban(ruptacy with the low?ris( project and in ban(ruptacywith the other$ ondholders are promised to be paid @55A'

    shareholders are residual claimants$

    &f the low?ris( project is ta(en:

    rb ;a!ue ir+ 7 2t(k < *n&s

    Re(essin 0=. 100$ 0$ 100$

    *+ 0=. 00$ 100$ 100$

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    $ources o& debt,shareholders con0ict

    -xpected value of the rm%5$7J@55AB5$7J955A%@75A-xpected value of the stoc(%5$7J5AB5$7J@55A%75A

    &f the high?ris( project is ta(en:

    rb ;a!ue ir+ 7 2t(k < *n&s

    Re(essin 0=. .0$ 0$ .0$

    *+ 0=. 40$ 140$ 100$

    -xpected value of the rm%5$7J75AB5$7J945A%@47A

    -xpected value of the stoc(%5$7J5AB5$7J@45A%M5AThe high?ris( project increases rm value in boom and decreases it in recession

    The stoc(holders will receive anything in recession in both cases' so they have anincentive to choose the high?ris( projectF

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    $ources o& debt,shareholders con0ict&ncentive towards underinvestment

    -x$ + rm has a high probability to go in ban(ruptacy with a recession because its ,Kswill be only 9'455A and it has to service debt for 4'555A$ &t has the possibility to investin a new project' by raising new e!uity and avoiding ban(ruptacy in recession$ Theproject costs @'555A and brings @'M55A in both states but its cost is entirelycontributed by stoc(holders

    N "r>e(t ?es "r>e(t

    *+ Re(essin *+ Re(essin

    CFs .,000 $ ,400$ ,:00$ 4,100$

    *n!&er (!ai+ 4,000 $ ,400$ 4,0000$ 4,000$

    2t(k#!&er (!ai+ 1,000 $ 0 $ ,:00$ 100$

    The all?e!uity rm always ta(es projects with positive Q.N'but the unlevered rm might deviate from this policy$

    Gil(ing the property

    &t means paying extra?dividends in time of nancial distress' leavingless in the rm to bondholders$

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    Bondholders de&ence againststockholders

    Qegative covenants%limit actions that the company has to

    ta(e

    .ositive covenants%specify an action that a company agrees

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    %genc- costs o& eternal euit-

    Ganagers have the tendency to waste corporateresources and this tendency is bigger if the rm cangenerate cash Pows

    Kree cash Pow hp%debt reduces free?cash Pow and soboostes rm value

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    Pecking order model

    ,ompared to previous theories:it does not imply a target amount ofleverage$ 1nly when debt capacity isexhausted' the rm can turn to e!uity

    .rotable rms generate cash internally