lect 13 capital structure decisions - part i bb

8/6/2019 Lect 13 Capital Structure Decisions - Part I BB

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1 3- 104-Apr-11 Fin455 P. YOUROUGOU

Financial ManagementFIN 455 - Lecture 13

Capital Structure Decisions Part I

IFM Chapter 15

13 - 2Fin455 P. YOUROUGOU04-Apr-11

Topics Covered

Business versus financial risk

M&M Theory of Capital structure

MM theory

Zero taxes

Corporate taxes

Corporate and personal taxes

Hamadas Equation

Capital Structure and financial distress

Optimal structure


The key questions of corporate finance

Valuation: How do we distinguish betweengood investment project and bad ones?

Financing: How should we finance theinvestment projects we choose to undertake?


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Financing policy

Real investment policies imply funding needs.

But what is the best source of funds? Internal funds (i.e. cash)?

External

Debt (i.e. borrowing)?

Equity (i.e. issuing stock)?

Moreover, different kinds of Internal funds (e.g. cash reserves, cutting dividends)

Debt (e.g. bonds vs. banks)

Equity (e.g. Venture Capital vs. Initial Public Offering)


Capital structure

Capital structure represents the mix of claimsagainst the firms assets and free cash flows

Some characteristics of financial claims Payoff structure (e.g. fixed promised payment)

Priority (debt paid before equity)

Maturity

Restrictive covenants

Real investment policies imply funding needs.

Voting rights

Options (convertible securities, call provisions, etc..)

We will focus on leverage (debt vs. equity) and how

it can affect the firm value


The fundamental questions in

capital structure

Is there an optimal capital structure, i.e.,an optimal mix between debt and equity?

More generally, can you add value on the

RHS of the balance by following a goodfinancial policy, or by changing the mix ofdebt and equity?

Miller and Modigliani said NO under a setof assumptions.


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How can capital structure

affect value?

V =

t=1

FCFt(1 + WACC)t

WACC= wd (1-T) rd + wereThe impact of capital structure on value dependsupon the effect of debt on:

WACCFCF


Business Risk and Financial Risk

Business risk:

Uncertainty in future EBIT.

Depends on business factors such as competition,operating leverage, etc.

Financial risk:

Additional business risk concentrated on commonstockholders when financial leverage is used.

Depends on the amount of debt and preferredstock financing.


Capital Structure Theory with Miller

and Modigliani (1958)

Assumptions of the M&M World

1. Investment is given.

2. Perfect Capital Markets

a. No transactions costsb. No taxesc. Info. is costless to obtain, available to all.

3. Equal access

4. Homogeneous expectations

5. Riskless debt

6. Zero growth


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13 - 1 0Fin455 P. YOUROUGOU04-Apr-11

MMs Irrelevance Proposition I

Financing decisions are irrelevant for the value of thefirm

Purely financial transactions do not change the cash

flows. They are zero NPV investments, thus they neither

increase or decrease the value of the firm.

A firm cannot change the total value of its securities just

by splitting its cash flows into different streams.

Firm value is determined by real assets, not by securities it

issues.

Thus, the choice of capital structure is irrelevant as long as

investment is taken as given.


AN EVERYDAY ANALOGYIt should cost no more to assemble achicken than to buy one whole.

Pie Theory I

VL = VU


The Law of the Conservation of Value

Proposition I tells us Firm Value is determined on theleft hand side of the balance sheet by real assets-not bythe proportions of debt and equity securities issued bythe firm.

VL = VU

The law also applies to the mixof debt securities issued by the firm.The choice of long-term vs. short-term, secured vs. unsecured, seniorvs. subordinated, convertible vs. nonconvertible debt should have noeffect on firm value.

The law implies that the choice is irrelevant, assumingperfect capital markets and provided that the choicedoes not affect the firms investment, borrowing andoperating policies.


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Under MM I, Borrowing does notaffect Return on Invested Capital

ErDrrEDfirmtheofValueLDA s )(

securitiesallofuemarket val

incomeoperatingexpectedassetsonreturnExpected

Ar

ED

Er

ED

DrWAACr

LDA s

MM showed that, in perfect capital markets, the companys

borrowing decision does not affect either the firms operatingincome or the total market value of its securities. Therefore, itdoes not affect return on invested capital


How Leverage Affects Equity Return:MMs Proposition II

The cost of equity to a levered firm is equal to cost ofequity of unlevered firm in the same risk class plus arisk premium

rA = rU = rs DUUL rrE

Drrs

M&M II: If the value of the firm remains thesame, why return on equity increases linearly

with leverage (debt-equity ratio) ?


How changing capital structure

affects betas?

V

EB

V

DBBB sLDUA

V

EB

V

DBBB sLDUA

DUUsL BBE

DBB DUUsL BB

E

DBB

For a given betaof debt, equitybeta increaseswith leverage.

Market risk of a common stock of a levered firm =

business risk of its operating assets

+ financial risk of its capital structure.

E

DBBB UUsL :freeriskisdebtIf

E

DBBB UUsL :freeriskisdebtIf


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r

D

E

rD

rs

M&M Proposition II

rA

= WACC

Risk free debt Risky debt

WACC remainsconstant as leverageincreases and this isconsistent with M&MI, since the company

cost of capitalshould only dependon the risk of itsassets.


Proposition I: VL = VU.

Proposition II: rsL = rsU + (rsU - rd)(D/E).

If we assume debt is risk free: rd = rf, Bd = 0

= Risk Free Rate + Business Risk Premium + Financial Risk Premium

Take away from M&M with Zero

Taxes (1958)

E

DRRBRRBrr

FMUFMUFLs )(


Take away from M&M with Zero

Taxes (contd)

According to MM, borrowing increases expected

returns only because it increases risk.

The increase of risk exactly offsets the increase in

expected returns leaving stockholders no better or

worse off.

The firms overall market value is independent of

capital structure.


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Trip to the Real World.

Industry Debt Ratio* (%)

Electric and Gas 43.2Paper and Plastic 30.4

Food Production 22.9

Retailers 21.7

Equipment 19.1

Chemicals 17.3

Computer Software 3.5

Average over all industries 21.50%

Companies and industries vary in their capital structure


What is Missing from the Simple

M & M Story?

Taxes:

Corporate taxes

Personal taxes

Costs of Financial distress

No transaction costs for issuing debt or equity

No asymmetric information about the firmsinvestments

Capital structure does not influence managersinvestment decisions


Capital Structure and Corporate Taxes

Financial policy matters because it affects a

firms tax bill.

Different financial transactions are taxed differently.

For a corporation:

Interest payments are considered a business

expense, and are tax exemptfor the firm.

Dividends and retained earnings are taxed.


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Capital Structure & Corporate Taxes

Corporate tax deductibility of interest increases the totaldistributed income to both bondholders and

shareholders.Income

Statement of

Firm U

Income

Statement of

Firm L

Earnings before interest and taxes $1,000 $1,000

Interest paid to bondholders - 80

Pretax income 1,000 920

Tax at 35% 350 322

Net income to stockholders 650 598

Total income to both bondholders and

stockholders $0+650=$650 $80+598=$678

Interest tax shield (.35 x interest) $0 $28


Capital Structure & Corporate Taxes-- Example (contd)

Example - You own all the equity of Space Babies Diaper Co. Thecompany has no debt. The companys annual cash flow is $900,000before interest and taxes. The corporate tax rate is 35% You have theoption to exchange 1/2 of your equity position for 5% bonds w ith aface value of $2,000,000. Should you do this and why?

($ 1,000 s ) A ll Equity

EBIT 900

Interest Pmt 0

Pretax Income 900

Taxes @ 35% 315

Net Cash Flow 585

1/2 Debt

900100800280

520

Total Cash Flow

All Equity = 585

*1/2 Debt = 620

(520 + 100)Tax benefit: $620 - $585 = $35


The PV of tax shield

Example (contd):

Tax benefit = amount of Debt x Interest rate x Tax Rate

= 2,000,000 x (.05) x (.35) = $35,000

PV of $35,000 in perpetuity = 35,000 / .05 = $700,000

PV Tax Shield = $2,000,000 x .35 = $700,000

cD

cD TDR

TRDShieldTaxofPV

c

D

cD TDR

TRDShieldTaxofPV


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M&M I with corporate tax

Value of Leveraged firm = Value of All Equity Firm

+ PV Tax Shield

VL = VU + TD

Example (contd):

All Equity Value = 585 / .05 = 11,700,000

PV Tax Shield = 700,000

Firm Value with 1/2 Debt = $12,400,000


Value of Firm, V

0Debt

VL

VU

Under MM with corporate taxes, the firms value

increases continuously as more and more debt is used.

TD

MM relationship between firm value anddebt when corporate taxes are considered.

VL = VU + TD


The Cost of Equity at Different Levels of

Debt: Hamadas Equation

MM theory implies that beta changes with leverage.

U is the beta of a firm when it has no debt (theunlevered beta)

sL = U [1 + (1 - T)(D/E)]

= Risk Free Rate + Business Risk Premium + Financial Risk

Premium

E

DTRRBRRBrr

FMUFMUFLs )1()(


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Notes About the New Propositions

When corporate taxes are added,

VL VU. VL increases as debt is added to thecapital structure, and the greater the debt

usage, the higher the value of the firm.

rsL increases with leverage at a slower rate

when corporate taxes are considered.


Personal Taxes

Investors return from debt and equity aretaxed differently

Classical Tax Systems

Interest and dividends are taxed as ordinaryincome.

Capital gains are taxed at a lower rate.

Capital gains can be deferred (contrary todividends and interest)

Corporations have a 70% dividend exclusion


Capital structure and personal &

corp. taxes -- Example

Interest Equity Income

Income before tax $1 $1

Less corporate tax at Tc =.35 0 0.35Income after corporate tax 1 0.65

Personal tax at TpB = .35 and Tpe = .105 0.35 0.068

Income after all taxes $0.675 $0.582

Advant age to deb t= $ .083

Capital structure determines whether operatingincome is paid out as interest or equity income.


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Corporate and Personal TaxesMillers Model

TC = corporate tax rate.

TPB = personal tax rate on debt income.

TPE = personal tax rate on stock income.

D

TTTVV

PB

PECUL ]

1)1)(1(1[


Millers Model with Corporate

and Personal Taxes Example

DV

DV

DVV

U

U

UL

25.0

)75.01(

]30.01

)12.01)(40.01(1[

Tc = 40%, TPB = 30%, and TPE = 12%.

Value rises with debt; each $1 increase in debt raisesLs value by $0.25.


Tax shield of debt matters,

potentially quite a bit

Pie theory gets you to ask the right question: How does afinancing choice affect the IRS bite of the corporate pie?

Pie Theory II


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Is debt policy still irrelevant withCorporate and Personal Taxes?

Two special cases:

ifTPB = TPE, then the relative advantagedepends only on the corporate tax rate.

If(1-TpB) = (1-TpE)(1-Tc) then debt policy isirrelevant.


Conclusions with Personal Taxes

Use of debt financing remainsadvantageous, but benefits are less thanunder only corporate taxes.

Implications: Is leverage good? Since taxes favor debt for most firms, should all

firms be 100% debt financed?

Note: However, Miller argued that in equilibrium,the tax rates of marginal investors would adjustuntil there was no advantage to debt.

What is missing?


Cost of Financial Distress

Costs arising from bankruptcy or distorted businessdecisions before bankruptcy.

Financial distress without bankruptcy: Financial distressoccurs when promises to creditors are broken or

honored with difficulty. Financial distress includesfailure to pay interest or principal or both. Financialdistress can sometimes lead to bankruptcy.

Evidence of bankruptcy costs: Eastern Airlines: $114 millions in professional fees Enron: $306 millions in consultants fees

The mere threat of bankruptcy can be very costly Loss of suppliers Loss of valuable employees and inability to attract new

employees


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Debt policy matters if debt is risky and

may cause Financial Distress

Pie Theory III


Capital structure and costly

financial distress

Market Value = Value if all Equity Financed

+ PV Tax Shield

- PV Costs of Financial Distress

VL = VU + TD PV (Cost of Financial Distress)


Tradeoff between the tax benefits and the costs of distress

determines an optimal capital structure

Debt

MarketValueofTheFirm

Value ofunlevered

firm

PV of interesttax shields

Costs offinancial distress

Value of levered firm

Optimal amountof debt

Maximum value of firm


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Static-tradeoff Theory of Capital

Structure

There is a tradeoff between the tax benefits and the

costs of financial distress. This tradeoff determines the optimal capital structure.

At moderate debt levels, the increase in risk issmall, so tax advantages dominate.

At some point, the probability of financial distressincreases rapidly with additional borrowing.

Also, if the firm cant be sure of utilizing the taxshield further, the tax advantage disappears.

This is known as the static-tradeoff theory of capitalstructure.


Beyond M&M,

Theories of Capital Structure

The static-tradeoff theory:

taxes, costs of distress

Pecking order approach.

Asymmetric information: convey private information,

reduce adverse selection costs.

Agency Costs:

conflicts of interest between stakeholders.

Corporate control contests:

leverage influences the ability of firms to avoid hostile

takeovers.

lect 13 capital structure decisions - part i bb

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