Capital StructureDebt versus Equity

Advantages of DebtInterest is tax deductible (lowers the effective cost of debt)Debt-holders are limited to a fixed return so stockholders do not have to share profits if the business does exceptionally wellDebt holders do not have voting rights

Disadvantages of DebtHigher debt ratios lead to greater risk and higher required interest rates (to compensate for the additional risk)

What is the optimal debt-equity ratio?Need to consider two kinds of risk:Business riskFinancial risk

Business RiskStandard measure is beta (controlling for financial risk)Factors:Demand variabilitySales price variabilityInput cost variabilityAbility to develop new productsForeign exchange exposureOperating leverage (fixed vs variable costs)

Financial RiskThe additional risk placed on the common stockholders as a result of the decision to finance with debt

Example of Business RiskSuppose 10 people decide to form a corporation to manufacture disk drives.If the firm is capitalized only with common stock and if each person buys 10% -- each investor shares equally in business risk

Example of Relationship Between Financial and Business RiskIf the same firm is now capitalized with 50% debt and 50% equity with five people investing in debt and five investing in equityThe 5 who put up the equity will have to bear all the business risk, so the common stock will be twice as risky as it would have been had the firm been all-equity (unlevered).

Business and Financial RiskFinancial leverage concentrates the firms business risk on the shareholders because debt-holders, who receive fixed interest payments, bear none of the business risk.

Financial RiskLeverage increases shareholder riskLeverage also increases the return on equity (to compensate for the higher risk)

Question?Is the increase in expected return due to financial leverage sufficient to compensate stockholders for the increase in risk?

Modigliani and MillerYESAssuming no taxes, the increase in return to shock-holders resulting from the use of leverage is exactly offset by the increase in risk hence no benefit to using financial leverage (and no cost).

Topics To Be CoveredLeverage in a Tax Free EnvironmentHow Leverage Affects ReturnsThe Traditional Position

Capital StructureWhen a firm issues debt and equity securities it splits cash flows into two streams:Safe stream to bondholdersRisky stream to stockholders

Capital StructureModigliani and Miller (1958) show that financing decisions dont matter in perfect capital marketsM&M Proposition 1:Firms cannot change the total value of their securities by splitting cash flows into two different streamsFirm value is determined by real assetsCapital structure is irrelevant

M&M (Debt Policy Doesnt Matter)Modigliani & MillerWhen there are no taxes and capital markets function well, it makes no difference whether the firm borrows or individual shareholders borrow. Therefore, the market value of a company does not depend on its capital structure.

M&M (Debt Policy Doesnt Matter)AssumptionsBy issuing 1 security rather than 2, company diminishes investor choice. This does not reduce value if: Investors do not need choice, OR There are sufficient alternative securitiesCapital structure does not affect cash flows e.g...No taxesNo bankruptcy costsNo effect on management incentives

An Example of the Effects of LeverageD and E are market values of debt and equity of Wapshot Marketing Company. Wapshot has issued 1000 shares and these are currently selling at $50 a share. Wapshot has borrowed $25,000 so Wapshots stock is levered equity.E = 1000 x $50 = $50,000D= $25,000V = E + D = $75,000

Effects of LeverageWhat happens if WPS levers up again by borrowing an additional $10,000 and at the same time paying out a special dividend of $10 per share, thereby substituting debt for equity?This should have no impact on WPS assets or total cash flows:V is unchangedD= $35,000E= $75,000 - $35,000 = $40,000Stockholders will suffer a $10,000 capital loss which is exactly offset by the $10,000 special dividend.

Effects of LeverageWhat if instead of assuming V is unchanged we allow V it rise to $80,000 as a result of the change in capital structure?Then E = $80,000 - $35,000 = $45,000Any increase or decrease in V as a result of the change in capital structure accrues to the shareholders

Effects of LeverageWhat if the new borrowing increases the risk of bankruptcy?This would suggest that the risk of the old debt is higher (and the value of the old debt is lower)If this is the case, then shareholders would gain from the increase in leverage at the expense of the original bondholders.

Modigliani and MillerAny combination of securities is as good as any other.Example:Two Firms with the same operating income who differ only in capital structure

Firm U is unlevered: VU=EU

Firm L is levered: EL= VL-DL

Modigliani and MillerFour StrategiesStrategy 1Buy 1% of Firm Us EquityDollar investment = .01VUDollar Return=.01 ProfitsStrategy 2Buy 1% of Firm Ls Equity and DebtDollar investment=.01DL + .01EL = .01VLDollar Return=From owning .01 DL.01 interestFrom owning .01 EL.01 (Profits interest)Total.01 ProfitsBoth Strategies give the same payoff

Modigliani and MillerStrategy 3Buy 1% of Firm Ls EquityDollar investment = .01EL= .01(VL-DL)Dollar Return=.01 (Profits interest)Strategy 4Buy 1% of Firm Us Equity and borrow on your own account .01DL (home-made leverage)Dollar investment=.01(Vu DL)Dollar Return=From borrowing .01DL-.01 interestFrom owning .01 EU .01 (Profits)Total.01 (Profits interest)Both Strategies give the same payoff

Modigliani and MillerIt does not matter what risk preferences are for investors.Just need that investors have the ability to borrow and lend for their own account (and at the same rate as firms) so that they can undo any changes in firms capital structureM&M Proposition 1: the value of a firm is independent of its capital structure.

Leverage and Returns

M&M Proposition IIrDErDrErARisk free debtRisky debt

M&M Proposition 2Bonds are almost risk-free at low debt levelsrD is independent of leveragerE increases linearly with debt-equity ratios and the increase in expected return reflects increased riskAs firms borrow more, the risk of default risesrD starts to increaserE increases more slowly (because the holders of risky debt bear some of the firms business risk)

The Return on EquityThe increase in expected equity return reflects increased riskThe increase in leverage increases the amplitude of variation in cash flows available to share-holders (the same change in operating income is now distributed among fewer shares)We can understand the increase in risk in terms of Betas

Leverage and Returns

The Traditional PositionWhat did financial experts think before M&M?They used the concept of WACC (weighted average cost of capital)WACC is the expected return on the portfolio of all the companys securities

WACC WACC is the traditional view of capital structure, risk and return.

WACC.10=rD.20=rE.15=rABEBABDRiskExpected ReturnEquityAll assetsDebt

WACCExample - A firm has $2 mil of debt and 100,000 of outstanding shares at $30 each. If they can borrow at 8% and the stockholders require 15% return what is the firms WACC?D = $2 millionE = 100,000 shares X $30 per share = $3 millionV = D + E = 2 + 3 = $5 million

WACCExample - A firm has $2 mil of debt and 100,000 of outstanding shares at $30 each. If they can borrow at 8% and the stockholders require 15% return what is the firms WACC?D = $2 millionE = 100,000 shares X $30 per share = $3 millionV = D + E = 2 + 3 = $5 million

The Traditional PositionThe return on equity (rE) is constantWACC declines with increasing leverage because rD

WACC(if rE does not change with increases in leverage )rDVrDrErA =WACC

An intermediate positionA moderate degree of financial leverage may increase the return on equity (but less than predicted by M&M proposition 2)A high degree of financial leverage increases the return on equity (but by more than predicted by M&M proposition 2)WACC then declines at first, then rises with increasing leverage (U-shape)Its minimum point is the point of optimal capital structure.

WACC (intermediate view)rDErDrEWACC

The intermediate positionInvestors dont notice risk of moderate borrowingThey wake up with debt is excessiveThe problem with this view is that it confuses default risk with financial risk.Default risk may not be serious for moderate amounts of leverageFinancial risk (in terms of increased volatility of return and higher beta) will increase with leverage even with no risk of default

Modigliani and Miller RevisitedM&M proposition 1: A firms total value is independent of its capital structureAssumptions needed for Prop 1 to hold:Capital markets are perfect and completeBefore-tax operating profits are not affected by capital structureCorporate and personal taxes are not affected by capital structureThe firms choice of capital structure does not convey important information to the market

Modigliani and Miller RevisitedM&M Proposition 2: The return on equity will rise as the debt-equity ratio rises in order to compensate equity holders for the additional (financial) risk.Note: Proposition 2 does not rely on default risk rE rises because of the rise in financial risk

WACC (M&M view)rDErDrEWACC

Capital Structure and Corporate TaxesFinancial Risk - Risk to shareholders resulting from the use of debt.Financial Leverage - Increase in the variability of shareholder returns that comes from the use of debt.Interest Tax Shield- Tax savings resulting from deductibility of interest payments.

Capital Structure and Corporate TaxesExample - You own all the equity in a company. The company has no debt. The companys annual cash flow is $1,000, before interest and taxes. The corporate tax rate is 40%. You have the option to exchange 1/2 of your equity position for 10% bonds with a face value of $1,000.

Should you do this and why?

Capital Structure and Corporate Taxes All Equity1/2 DebtEBIT1,0001,000Interest Pmt 0 100 Pretax Income1,000 900Taxes @ 40% 400 360Net Cash Flow$600$540Total Cash Flow All Equity = 600

*1/2 Debt = 640 (540 + 100)

Capital StructurePV of Tax Shield = (assume perpetuity) D x rD x Tc rD= D x TcExample:Tax benefit = 1000 x (.10) x (.40) = $40 PV of 40 perpetuity = 40 / .10 = $400

PV Tax Shield = D x Tc = 1000 x .4 = $400

Capital StructureFirm Value = Value of All Equity Firm + PV Tax ShieldExampleAll Equity Value = 600 / .10 = 6,000 PV Tax Shield = 400

Firm Value with 1/2 Debt = $6,400

U.S. Tax CodeAllows corporations to deduct interest payments on debt as an expenseDividend payments to stockholders are not deductibleDifferential treatment results in a net benefit to financial leverage (debt)

U.S. Tax CodePersonal taxes bias the other way (toward equity)Income from bonds generally comes as interest and is taxed at the personal income tax rateIncome from equity comes partly from dividends and partly from capital gainsCapital gains are often taxed at a lower rate and the tax is deferred until the stock is sold and the gain realized.If the owner of the stock dies no capital gain tax is paidOn balance, common stock returns are taxed at lower rates than debt returns

U.S. Tax RatesTop bracket (over $250,000 for a married couple)Personal rates: 35%Capital gains: 18% (holding period of 18mos)If stock is held for less than 1 year capital gain is taxed at the personal rateIf stock is held for over 1 year but less than 18mos the capital gains tax is between 18-35%

Capital Structure and Financial DistressCosts of Financial Distress - Costs arising from bankruptcy or distorted business decisions before bankruptcy.

Market Value =Value if all Equity Financed + PV Tax Shield - PV Costs of Financial Distress

Weighted Average Cost of Capital without taxes (traditional view)rDErDrEIncludes Bankruptcy RiskWACC

Financial DistressDebt/Total AssetsMarket Value of The FirmValue ofunleveredfirmPV of interesttax shieldsCosts offinancial distressValue of levered firmOptimal amount of debtMaximum value of firm

M&M with taxes and bankruptcyWACC now is more hump-shaped (similar to the traditional view though for different reasons).The minimum WACC occurs where the stock price is maximized.Thus, the same capital structure that maximizes stock price also minimizes the WACC.

Financial ChoicesTrade-off Theory - Theory that capital structure is based on a trade-off between tax savings and distress costs of debt.

Pecking Order Theory - Theory stating that firms prefer to issue debt rather than equity if internal finance is insufficient.

Pecking Order Theory The announcement of a stock issue drives down the stock price because investors believe managers are more likely to issue when shares are overpriced.

Therefore firms prefer internal finance since funds can be raised without sending adverse signals.

If external finance is required, firms issue debt first and equity as a last resort.

The most profitable firms borrow less not because they have lower target debt ratios but because they don't need external finance.

Pecking Order TheorySome Implications:Internal equity may be better than external equity.Financial slack is valuable.If external capital is required, debt is better. (There is less room for difference in opinions about what debt is worth).

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