Capital Structure

What finance functions add the most to firm value?

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Corporate Financing

We have been focusing on investment decision What should the firm buy?

Now we are turning to the financing decision How does the firm pay for it?

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How do Firms Pay for Stuff

Companies prefer to use the cash they generateThis account for about 70-90% of all purchases

If cash is insufficient they sell securities

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The Capital-Structure Addresses: What securities should the firm sell

This determines how the firm’s cash flows are divide

Capital Structure becomes important if the division affects the size of the cash flows

Remember: A firm is simply worth the PV of its expected future cash flows to investors

S G

B

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The Value of E and D E: The PV of cash flows to equity holders

If a company pays $1.5 mil. in dividends each year (re=8%) E =

D: The PV of the cash flows to debt holdersIf a company pays $0.75 mil. in interest each

year (rd=4%) D =

V =

Cap Structure and Value

While capital structure appears to influence firm value in the real world to understand how/why we need to start with a situation where it doesn’t

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Modigliani-Miller Proposition 1

Capital Structure DOES NOT MATTER

VL = VU

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MM1: The Simplest of Worlds

Perfect capital markets No taxes or transaction costs

No Bankruptcy Costs Everyone borrows at the same rate Investment decisions are fixed

Operating cash flow is independent of capital structure

MM Investment Intuition Set up

Suppose you have two firms that each make $50/ year

The firms are identical except that one has $50 of debt and the other has no debt

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MM Intuition Suppose Vl < Vu

Consider a 1% investment in EU

Cost = 1% EU = Payoff = 1% Earnings =

Now buy 1% of EL & 1% of DL Cost = 1% EL +1%DL=

Payoff Receive 1%*Interest=

Receive 1%*(Earnings -Int)= Total dollar payoff =

Can Vl < Vu?

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Vu Vl

V $100 $90

E $100 $40

D $0 $50

Earnings $50 $50

Int $0 $10

Cost

Payoff

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If Vl < Vu then

An investor can purchase a claim in the levered firm with the same payoff as a claim in the un-levered firm, for a lower price!

This situation is impossible in a well functioning capital market (arbitrage) Investors will buy Vl and sell it for Vu until Vl = Vu

MM Intuition the Other Way Suppose Vl > Vu

Consider a1% investment in El Cost = 1% EL = Payoff = 1%(Earnings –Int)=

Alt. buy 1% EU, & borrow1% of DL Cost= 1%Vu-1%DL=

Payoff Owe 1%*Interest= Receive 1%* Earnings = Total dollar payoff =

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Vu Vl

V $90 $100

E $90 $50

D $0 $50

Earnings $50 $50

Int $0 $10

Cost

Payoff

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If Vl > Vu then

In perfect capital markets the inequality cannot hold. Since both strategies have the same payoff, they should cost the same.

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On balance We showed how we can take positions in the

levered and un-levered company that generate the same payoff, but which only costs the same if the two firms have the same firm value

The law of one price states that investments with the same payoffs need to cost the same, therefore the two firms must be equally valuable

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MM 1 Cash Flow Proof Two firms

Earn $1,000 Unlevered

re = 10% Levered

re = 15%rd = 5%D= 5,000

Un-Levered Levered

Earn $1,000 $1,000Interest

Equity

E

D

V

Main result in this “perfect world”

The value of the firm is independent of its capital structure

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V

D/V

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Investors and Capital Structure

While leverage does not affect the risk of the overall firm, it does affect investors’ risks

Leverage increases:

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MM Proposition 2: D/E and re, βe

As leverage increases so does financial risk D/E relation with re, βe

ra = D/V * rd + E/V*re

re = ra + D/E * (ra - rd)

a = D /V * d + E/V*e

e = a + D /E * (a - d)

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βe Break-Down

e = a + D /E * (a - d)

a:

D /E * (a - d):

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MM 2: Graph

Look familiar?

3%

8%

13%

18%

23%

D/V (5%)

Re

qu

ire

d R

etu

rn

Re Rd WACC

Re

Rd

Ra

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Question 1

Shareholders demand a higher rate of return than bondholders. As debt is cheaper, we should increase the D/V ratio as it reduces ra. True or False?

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Question 2 As the firm borrows more and debt becomes riskier,

both shareholders and bondholders demand a higher rate of return. Thus by reducing the debt-equity ratio, we can reduce the cost of debt and the cost of equity. This makes everybody better off. True or False?

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Cash flows and Firm Value 1 A firm is only worth the PV of it’s cash flows

to investors Consider an un-levered firm, which has an

EBIT of $1,500. The company’s investors require a return on

12%. Assume no taxes, what is the firm worth?

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Cash flows and Firm Value 2 Consider a levered firm, which has an EBIT of

$1,500. The firm owes $1,000 in interest payments/year The company’s investors (equity and debt)

require a return on 12%. Assume no taxes, what is the firm worth?

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More Realistic World

MM showed us that in the theoretical world capital structure does not matter

But by relaxing the MM assumptions and allowing for a more realistic world, we can see how capital structure affects firm value

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Corporate Taxes

When we include taxes will the firm be more or less valuable than in a world without taxes?

Who gets paid first?

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Example We have two

identical firmsEBIT $1,000L: debt of

$5,000 @ 6%

Un-Levered

Levered

EBIT $1,000 $1,000Interest

EBT

Tax @ 40%

Net Income

NI + Interest

Tax Shield

Tax Shield’s Effect on Firm Value The tax shield increases firm value by the

present value of the tax reduction Tax Shield = Tax Rate * Dollar Interest PV (T.S.) = Tax Rate * Dollar Interest / rd

= Tax Rate * (Debt * rd) / rd

= Tax Rate * Debt

= 0.4 * 5,000 = $2,000

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Vl with Corporate Taxes

Vl = Vu + PV(Tax Shield)

Vl = Vu + D*Tc

As the tax shield increases company value, how should the company be financed?

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Cash flows and Firm Value 3

Consider an un-levered firm, which has an EBIT of $1,500.

The company’s investors require a return on 12%.

Taxes are 34%, what is the firm worth?

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Cash flows and Firm Value 4

Consider a levered firm, which has an EBIT of $1,500.

The firm owes $1,000 in interest The company’s investors (equity and debt) require a

return on 12%. Taxes are 34%, what is the firm worth?

Personal Taxes

Investors also pay taxes The firm is only worth the present value of the

cash investors put in their pocketThe firm wants to minimize total taxes paid

Corporate and personal

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Personal Taxes

CG $ Capital Gains

Div $ Dividends

Ti, Td Income Tax Rate (Personal)

Tcg Capital Gains Tax Rate

Te Personal Equity Tax Rate:

Te=CG/(Div+CG)*Tcg+Div/(Div+CG)*Ti

Personal Taxes and the Tax Shield

The inclusion of personal taxes generally reduces the value of the tax shield because interest is generally taxed more heavily than equity at the personal level The preferential tax treatment of capital gains on the

personal level reduces the value of the debt tax shield

PV(Tax Shield) < D*Tc

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Including Personal Taxes

Vl = Vu + D {1-[(1-Tc)(1-Te)/(1-Td)]}

This account for the investor’s preference for equity income over debt income

(1-Tc)(1-Te): Represents the after-tax return ($) from $1 in equity income

(1-Td): Represents the after-tax return ($) from $1 in debt income

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Cash flows and Firm Value 5 Consider a levered firm, which has an EBIT of

$1,500. The firm owes $1,000 in interest. The company’s investors (equity and debt) require a return on 12%.

Taxes are: Corp 34%, Income 20%, Equity 15% D = E = Vl =

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Bankruptcy Costs Direct Costs: Legal and Administrative costs

These are small Indirect Costs: Impaired ability to conduct business

These are BIGStart when a firm becomes Financially Distressed

Bankruptcy costs increase with debt, making more debt less attractiveShareholders pay these costs

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Agency Costs

In addition to bankruptcy costs, when a firm becomes financially distressed the conflict between bondholders and stockholders increasesThis can result in managers playing games

Who is the manager likely to side with?

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Asset Substitution

A firm has $6m in assets, and has $10m in debt outstanding → Financial Distress

The firm has a project requiring a $2m investment and pays $7m (PV) with a 10% probability or pays nothing with a 90%

Project NPV?

Will the firm take the project?

Potential Payoffs

If forgo the project: FV = $__Debt gets $___, Equity gets $___

Take the project and it turns out bad: FV = $__Debt gets $___, Equity gets $___

Take the project and it turns out good: FV = $_Debt gets $___, Equity gets $___

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Underinvestment

Now instead of taking –NPV projects the firm passes on +NPV projects

The same firm has a project requiring $2m investment and pays $5m (PV) with a 50% probability or pays $1m (PV) with a 50% probability

What is the NPV?

Will the firm take the project?

Potential Payoffs

If forgo the project: FV = $__Debt gets $__, Equity gets $__

Take the project and it turns out bad: FV = $__Debt gets $__, Equity gets $__

Take the project and it turns out good: FV= $_Debt gets $__, Equity gets $__

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Milk the Property (Cash out)

If the value of the firm is less than the value of the debt holders claims, then the shareholders have an incentive to sell off the assets pay themselves

Example, names changed to protect the guilty

Marriot IncOwes $1 billion and has $500 million in assets

Management creates a new firm Marriot CoEvery Inc shareholder receives shares in Co

The same shareholders own both firms

Inc sells its $500m in assets to Co for $1.00 Co has $499,999,999 in assets and no debt Inc has $1 in assets and $1b in debt

How happy are debt holders?

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Intelligent Bondholders

Bondholders know about these agency problems and act accordinglyRequiring: Higher rd, covenants

Limit possible div payments, Restrict debt issuances or sales of assets

All of this requires costly monitoring of the firmThis is another costs borne by equity holders

Trade-Off

The firm trades off the benefits and costs associated with debt to maximize firm value

If we put everything we talked about together we get:

Vl = Vu + PV (Tax shields) – PV (Bankruptcy costs) – PV (Agency costs)

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Trade-Off Graph

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Debt

Market Value of the

Firm

Unlevered Firm

PV of Tax Shield

Bankruptcy Costs

Agency Costs

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Trade-off Implications

Firms have an optimal level of debtThe amount will depend on the industry and firm

Safe, highly profitable firms with lots of tangible assets should have lots of debtUS studies finds that profitable firms have little

debt Risky, marginally profitable firms with lots of

intangible assets should have little debt