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Capital Structure Decisions

We have learnt so far that the value of the firm is the sum of the present value ofall the free cash flows it generate.

Free cash flows: Money left with the firm after paying everyone other than theinvestors.

Ignore preferred stock for simplicity.

1ttt )WACC1(

FCFV

WACC = wd(1-T) rd + wers

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Recall how we find free cash flows:

Sales units sold x selling price per unit - Variable Costs units sold x variable cost per unit

Gross Margin

- Fixed Operating Costs

EBIT

- Taxes

NOPAT +Depreciation

Operating Cash Flows

- Change in Net Working Capital

- Change in Net Fixed Assets

Net Free Cash Flows available to all long term investors

If you want to find the total value of the firm, you would discount these free cashflows by WACC and sum them up.

What can make these cash flows risky?


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Lets make our lives even simpler and assume that:

We either buy everything with cash or the accountspayable do not change

We either sell everything on cash basis or accountsreceivables do not change.

Our inventory and cash reserves stay at the same leveltoo.

Result: we do not have to worry about change in networking capital (because there is no change in NWC).

Also, we use only as much cash to buy new fixed assetsas the amount of depreciation we have to add back.

Result: the change in net fixed assets and add back

depreciation entries also disappear from our free cash

flow calculation.


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Here is our extremely simple world:

Sales

-variable costs

=Gross Margin

-Fixed Costs

=EBIT

-Taxes

=Free Cash flow available to all investors.

If you want to find the total value of the firm, you would discount these freecash flows by WACC and sum them up.

How do you find the value of equity?

One method you have used over and over again: Take out debt from thevalue of the firm and the remaining amount is value of equity.

There is another way: Just concentrate on cash flows to shareholders.

If you only want to know the value of equity, what are the free cash flows to

shareholders?


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If you only want to know the value of equity, how do you find the freecash flows available to shareholders only?

Sales

- Variable Costs = Gross Margin - Fixed Costs = EBIT - Interest

Taxable Income - Taxes Net Income

Since we are only looking at cash flows to shareholders, what discountrate will you use to find the total present value of all the cash flows?

Required rate of return on equity.

Why did we subtract interest here before finding taxes? Why do we take account of tax deductibility (tax shield) here but not in

the cash flows to all investors.


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What can make these cash flows risky?

What makes the cash flows risky as seen by allinvestors?

What makes the cash flows risky as seen by theshareholders only?


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That was the top part of the story. Now lets look at

the denominator:


What do we know about risk and return relationship?

Can we assume these required rates of returns tostay constant no matter how we move along the risk

spectrum?


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So risk is the likelihood of getting a return different

from what you expected. What brings about that chance?

Something unexpected. If you knew something willchange, you will adjust your expectations accordingly.So the risk stems from a shock, the unexpected.

Our major concern is that we do not want to loosemoney.

If something bad happens and we can deal with it sothat the impact is not negative, we are okay.


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Business risk: Uncertainty about future pre-tax operating income (EBIT).

Probability

EBITE(EBIT)0

? risk

? risk

Note that business risk focuses on operating

income, so it ignores financing effects.

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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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Just by looking at the cash flow calculations, we know that a lot of risk iscoming from the nature of the business. Things that determine that a

firm is safer or riskier include:

Demand Stability

Price Stability

Cost Stability

Pricing Flexibility Uncertainty about new product development

Foreign risk

Operating Leverage


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Operating Leverage

So far, I hope, you are convinced that a big part of business risk stemsfrom costs side.

Which one of the cost component is the hardest to make changes to inthe short run (the least flexible)?

Of course, the fixed costs (just as the name says).

Do you ever want to have a business with negative gross margin?

Assume we are talking about a normal business where gross margin is

positive (otherwise they will shut that business down).

What can still get you into trouble?

Fixed costs


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What is the break-even quantity for each of these businesses?

Music:

Gross Margin = SalesVariable Cost = 202 = $ 18

Fixed Costs = $3,000,000

QBE= 3,000,000/18 = 166,667 CDs

Gas Station:

Gross Margin = SalesVariable Cost = 21.50 = $ 0.50

Fixed Costs = $10,000

QBE= 10,000/0.5 = 20,000 gallons

The question you would ask yourself is, how confident you are that you will be able to sell at

least 166,667 CDs or at least 20,000 gallons of gas. Would a small change in any factor putyou below the breakeven level?


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Music Business

$-

$1,000,000

$2,000,000

$3,000,000

$4,000,000

$5,000,000

$6,000,000

$7,000,000

- 100,000 200,000 300,000 400,000

Units sold

Revenueandcost

Sales Total Cos ts Fixed Costs

Gas Station

$-

$100,000

$200,000

$300,000

$400,000

$500,000

$600,000

$700,000

- 100,000 200,000 300,000 400,000

Units Sold

Revenuesandcost

Sales Total Costs Fixed Costs

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15

Consider Two HypotheticalFirms

Firm U Firm L

No debt $10,000 of 12% debt

$20,000 in assets $20,000 in assets

40% tax rate 40% tax rate

Both firms have same operating leverage,business risk, and EBIT of $3,000. They differonly with respect to use of debt.

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16

Impact of Leverage onReturns

Firm U Firm L

EBIT $3,000 $3,000

Interest 0 1,200EBT $3,000 $1,800

Taxes (40%) 1 ,200 720

NI (Net Income) $1,800 $1,080

ROEROE = Return on Equity

= Net Income/ Total Equity

9.0% 10.8%

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17

Impact of Leverage onReturns

Firm U Firm L

EBIT $3,000 $3,000

Interest 0 1,200EBT $3,000 $1,800

Taxes (40%) 1 ,200 720

NI (Net Income) $1,800 $1,080

ROEROE = Return on Equity

= Net Income/ Total Equity

9.0% 10.8%

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18

Why does leveraging increasereturn?

More EBIT goes to investors in Firm L.

Total dollars paid to investors:

U: NI = $1,800.

L: NI + Int = $1,080 + $1,200 = $2,280.

Taxes paid:

U: $1,200; L: $720.

Equity $ proportionally lower than NI.

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19

Continued

Now consider the fact that EBIT is notknown with certainty. What is the impactof uncertainty on stockholder profitability

and risk for Firm U and Firm L?

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20

Firm U: Unleveraged

Economy

Bad Avg. Good

Prob. 0.25 0.50 0.25

EBIT $2,000 $3,000 $4,000Interest 0 0 0

EBT $2,000 $3,000 $4,000

Taxes(40%) 800 1,200 1,600NI $1,200 $1,800 $2,400

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21

Firm U: Unleveraged

Economy

Bad Avg. Good

Prob. 0.25 0.50 0.25

EBIT $2,000 $3,000 $4,000Interest 0 0 0

EBT $2,000 $3,000 $4,000

Taxes(40%) 800 1,200 1,600NI $1,200 $1,800 $2,400

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22

Firm L: Leveraged

Economy

Bad Avg. Good

Prob.* 0.25 0.50 0.25

EBIT $2,000 $3,000 $4,000Interest 1,200 1,200 1,200

EBT $ 800 $1,800 $2,800

Taxes(40%) 320 720 1,120NI $ 480 $1,080 $1,680

*same as for Firm U

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23

Firm L: Leveraged

Economy

Bad Avg. Good

Prob.* 0.25 0.50 0.25

EBIT $2,000 $3,000 $4,000Interest 1,200 1,200 1,200

EBT $ 800 $1,800 $2,800

Taxes(40%) 320 720 1,120NI $ 480 $1,080 $1,680

*same as for Firm U

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24

Firm U Bad Avg. Good

BEP 10.0% 15.0% 20.0%

ROIC 6.0% 9.0% 12.0%ROE 6.0% 9.0% 12.0%

TIE n.a. n.a. n.a.

Firm L Bad Avg. GoodBEP 10.0% 15.0% 20.0%

ROIC 6.0% 9.0% 12.0$

ROE 4.8% 10.8% 16.8%

TIE

BEP = Basic EarningPower = EBIT/ TotalAssets

1.7x

ROIC = Return onInvested Capital =

NOPAT/ Total Assets

2.5x

ROE = NetIncome/Total Equity

3.3x

TIE = Times InterestEarned =

EBIT/Interest

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25

Firm U Bad Avg. Good

BEP 10.0% 15.0% 20.0%

ROIC 6.0% 9.0% 12.0%ROE 6.0% 9.0% 12.0%

TIE n.a. n.a. n.a.

Firm L Bad Avg. GoodBEP 10.0% 15.0% 20.0%

ROIC 6.0% 9.0% 12.0$

ROE 4.8% 10.8% 16.8%

TIE

BEP = Basic EarningPower = EBIT/ TotalAssets

1.7x

ROIC = Return onInvested Capital =

NOPAT/ Total Assets

2.5x

ROE = NetIncome/Total Equity

3.3x

TIE = Times InterestEarned =

EBIT/Interest

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26

Profitability Measures:

U LE(BEP) 15.0% 15.0%

E(ROIC) 9.0% 9.0%

E(ROE) 9.0% 10.8%

Risk Measures:

ROIC 2.12% 2.12%

ROE

E() = Expected Value

2.12% 4.24%

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27

Profitability Measures:

U LE(BEP) 15.0% 15.0%

E(ROIC) 9.0% 9.0%

E(ROE) 9.0% 10.8%

Risk Measures:

ROIC 2.12% 2.12%

ROE

E() = Expected Value

2.12% 4.24%

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28

Conclusions

Basic earning power (EBIT/TA) and ROIC(NOPAT/Capital = EBIT(1-T)/TA) are unaffectedby financial leverage.

L has higher expected ROE: tax savings andsmaller equity base.

L has much wider ROE swings because of fixedinterest charges. Higher expected return isaccompanied by higher risk.

(More...)

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29

In a stand-alone risk sense, Firm Lsstockholders see much more risk thanFirm Us.

U and L: ROIC= 2.12%. U: ROE= 2.12%.

L: ROE= 4.24%.

Ls financial risk is ROE- ROIC= 4.24% -2.12% = 2.12%. (Us is zero.)

(More...)

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30

For leverage to be positive (increase expectedROE), BEP must be > rd.

If rd> BEP, the cost of leveraging will be higher

than the inherent profitability of the assets, sothe use of financial leverage will depress netincome and ROE.

In the example, E(BEP) = 15% while interestrate = 12%, so leveraging works.

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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.

Business Risk versus Financial Risk

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Effects of Additional Debt on WACC

+From investors point of view, debt is less risk compared to equity. So the required rateof return on debt is lower. Therefore, adding debt replaces an expensive source (equity) witha cheaper source of capital.

+Debt is tax deductible so after tax cost of debt is even lower. Therefore, adding debtshould lower WACC.

-Debt payments are fixed and legally binding. If the firm does not earn enough EBIT, theshareholders have to foot the debt bill. So adding more debt makes the firm riskier (addsfinancial risk). Therefore, the shareholders require a higher rate of return when the firm addsmore debt to its capital structure. WACC should go up.

-Failure to pay debt can result in bankruptcy. Bankruptcy involves loss of firms value tonon-stakeholders like lawyers and accountants. Both shareholders and debt-holders stand toloose in this scenario. So additional debt makes the firm riskier for both bond and stockholders, increasing their required rates of returns. WACC would go up.

What is the net effect of debt on the WACC?


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Indirect Effects of Additional Debt on WACC

+Debt reduces agency costs. High debt implies high fixed recurring payments that forces themanagers not to waste firms resources.

-For the same reason, additional debt might make the managers toorisk averse and they might loose profitable but risky projects.

-If people perceive the firm close to bankruptcy, they will stop buyingfrom the firm (fear of no customer service for the firms products infuture).

-With high level of outstanding debt, the suppliers might tighten theircredit terms. More money would get stuck in net working capital.


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Indirect Effects of Additional Debt onWACC

+Issuing debt can be perceived to be a positive signal for theshareholders.

Asymmetric Information: One party knows more about the trade (dealing) than the

counterparty. Who knows more about the prospects of the firm, the

management or the investors? When would managers like to issue new shares? When the

stock is over-valued or undervalued? For this reason, the issue of new stock is taken to be a negative

signal. What is the net effect of issuing new debt on the WACC?


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Capital Structure Theory

Miller Modigliani (MM) theories

MM1: Zero taxes

MM2: Corporate taxes Miller: Corporate and personal taxes

Trade-off theory

Signaling theory

Debt financing as a managerialconstraint

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MM 1958

Assumptions:

No transactions (brokerage) costs No taxes

Same borrowing and lending rate for all.

Same level of information with all participants.

Debt does not affect EBIT.

Then

VL= VU.

Capital structure is irrelevant.

What about the point that required rate of return on equity increases with

increased leveraged? Does it not apply here?

The increase in WACC due to increase in REis exactly offset by thedecrease produced by shifting to the cheaper source (debt).

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MM 1963

Assumptions:

Same as before except this time there are taxes. Last time, the increase in WACC due to increase in REwas offset by the

decrease coming from higher weight on cheaper RD.

If the same story holds and on top of that you add a tax benefit, whatwould happen to WACC with increased leverage?

WACC should get smaller with increased leverage.

How much extra advantage is the leveraged firm getting?

Equal to the tax benefit over the life of the debt, or

Tax Rate * Debt.

Then

VL= V

U+ Tax Rate*Debt

Capital structure is not irrelevant.

There is an optimal capital structure and that is ?

100% Debt

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Value of Firm, V

0Debt

VL

VU

MM relationship between value and debtwhen corporate taxes are considered.

Under MM with corporate taxes, the firms valueincreases continuously as more and more debt is used.

TD

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Cost ofCapital (%)

0 20 40 60 80 100Debt/ValueRatio (%)

MM relationship between capital costs

and leverage when corporate taxes areconsidered.

rs

WACC

rd(1 - T)

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Miller 1977 Debt gives the firm a tax benefit but equity also gives a tax benefit. To whom?

To the investors!

Interest payments are not taxed at corporate level but are taxed fully (say, atabout 35%) when the lender receives interest income.

Equity income is taxed at corporate rate. It goes to the shareholders in twoforms: Dividend Income and, Capital Gains

Capital Gains tax has historically been very low.

Even Dividend income is now taxed at a much lower rate (about 15%).

Due to this, an equity investor is willing to accept a rate or return lower thanwhat is dictated by risk alone.

So, the firm that has high equity versus debt also has some advantage (it canget away with paying something less to its investors than the what the risklevel requires).

The net advantage for the leveraged firm is then: Then

VL= VU+ [1 - ]D Will the leveraged firm always have higher value than the unlevered one?

What is the optimal capital structure?

(1 - Tc)(1 - Ts)(1 - Td)

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Tc= 40%, Td= 30%, and Ts= 12%.

VL= VU+ [1 - ]D= VU+ (1 - 0.75)D

=VU+ 0.25D.

Value rises with debt; each $1 increase indebt raises Ls value by $0.25.

(1 - 0.40)(1 - 0.12)(1 - 0.30)

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Trade-off Theory

MM theory ignores bankruptcy (financialdistress) costs, which increase as moreleverage is used.

At low leverage levels, tax benefits outweighbankruptcy costs.

At high levels, bankruptcy costs outweigh taxbenefits.

An optimal capital structure exists that balancesthese costs and benefits.

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Signaling Theory

MM assumed that investors and managers have thesame 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 asa negative signal.

Implications for managers?

Reserve Borrowing Capacity Pecking order

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Choosing the Optimal Capital Structure:Example

Currently is all-equity financed.

Expected EBIT = $500,000.

Firm expects zero growth.

100,000 shares outstanding; rs= 12%;

P0= $25; T = 40%; b = 1.0; rRF= 6%;

RPM= 6%.

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Estimates of Cost of Debt

Percent financedwith debt, wd rd

0% N/A

20% 8.0%

30% 8.5%

40% 10.0%

50% 12.0%If company recapitalizes, debt would be issued to repurchasestock.How about Cost of Equity? How will it change with a change inleverage?

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Hamadas Equation

We know so far that:

When leverage increases, equitys cash flow becomeriskier.

As a result, the cost of equity goes up.

But by how much?

Hamadas equation tries to answer this question.

To use this, you have to be a believer in CAPM.

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

bL= bU[1 + (1 - T)(D/S)]

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Hamadas Equation What if you do not know the unlevered beta?

That is your firm is moving from one level of debt to another, not frombeing totally unlevered to levered.

So your previous beta was for the previous level of debt and you wantto find a new one for the new capital structure. How would you do that?

Use the same Hamada equation to first unlever your beta. If,

bL= bU[1 + (1 - T)(D/S)] Then, using old D/S

bU= bL/[1 + (1 - T)(Dold/Sold)]

Once you have the unlevered beta, you can use new D/S to find thenew beta.

bL= bU[1 + (1 - T)(Dnew/Snew)]

Use your levered beta in CAPM equation to find the cost of equity.

Use that cost of equity in CAPM to find the WACC.

Th C t f E it f 20%

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The Cost of Equity for wd= 20% Use Hamadas 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)

= 6% + 1.15 (6%) = 12.9%

You can find the cost of equity for a wholehost of different capital structures.

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Cost of Equity vs. Leverage

wd D/S bL rs

0% 0.00 1.000 12.00%

20% 0.25 1.150 12.90%30% 0.43 1.257 13.54%

40% 0.67 1.400 14.40%

50% 1.00 1.600 15.60%

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WACC vs. Leverage

wd rd rs WACC

0% 0.0% 12.00% 12.00%

20% 8.0% 12.90% 11.28%30% 8.5% 13.54% 11.01%

40% 10.0% 14.40% 11.04%

50% 12.0% 15.60% 11.40%

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The WACC for wd= 20%


WACC = 0.2 (10.4) (8%) + 0.8 (12.9%)

WACC = 11.28%

Repeat this for all capital structures under

consideration and find the optimal capital

structure.

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WACC vs. Leverage

wd rd rs WACC

0% 0.0% 12.00% 12.00%

20% 8.0% 12.90% 11.28%30% 8.5% 13.54% 11.01%

40% 10.0% 14.40% 11.04%

50% 12.0% 15.60% 11.40%

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Corporate Value for wd= 20%

V = FCF / (WACC-g)

g=0, so investment in capital is zero; so FCF = NOPAT

= EBIT (1-T). NOPAT = ($500,000)(1-0.40) = $300,000.

V = $300,000 / 0.1128 = $2,659,574.

Find the value of the firm for all the capital structures in

the previous slide.

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Corporate Value vs. Leverage

wd WACC Corp. Value

0% 12.00% $2,500,000

20% 11.28% $2,659,57430% 11.01% $2,724,796

40% 11.04% $2,717,391

50% 11.40% $2,631,579

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Debt and Equity for wd= 20%

The dollar value of debt is:

D = wdV = 0.2 ($2,659,574) = $531,915.

S = VD

S = $2,659,574 - $531,915 = $2,127,659.

Debt and Stock Value vs

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Debt and Stock Value vs.Leverage

wd Debt, D Stock Value, S

0% $0 $2,500,000

20% $531,915 $2,127,66030% $817,439 $1,907,357

40% $1,086,957 $1,630,435

50% $1,315,789 $1,315,789

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Wealth of Shareholders

Value of the equity declines as more debtis issued, because debt is used torepurchase stock.

But total wealth of shareholders is value ofstock after the recap plus the cashreceived in repurchase, and this total goes

up (It is equal to Corporate Value onearlier slide).

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Stock Price for wd= 20%

The firm issues debt, which changes its

WACC, which changes value.

The firm then uses debt proceeds torepurchase stock.

Stock price changes after debt is issued, but

does not change during actual repurchase

(or arbitrage is possible).

(More)

Stock Price for wd = 20%

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Stock Price for wd 20%

(Continued)

The stock price after debt is issued

but before stock is repurchased

reflects shareholder wealth: S, value of stock

Cash paid in repurchase.

(More)

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Stock Price for wd= 20%

D0and n0are debt and outstanding

shares before recap.

D - D0is equal to cash that will be used torepurchase stock.

S + (D - D0) is wealth of shareholders

after the debt is issued but immediately

before the repurchase.

Stock Price for wd = 20%

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Stock Price for wd 20%

(Continued)

P = S + (DD0)

n0

P = $2,127,660 + ($531,915 0)

100,000

P = $26.596 per share.

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Number of Shares Repurchased

# Repurchased = (D - D0) / P

# Rep. = ($531,915 0) / $26.596

= 20,000. # Remaining = n = S / P

n = $2,127,660 / $26.596

= 80,000.

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Price per Share vs. Leverage

# shares # shares

wd P Repurch. Remaining

0% $25.00 0 100,00020% $26.60 20,000 80,000

30% $27.25 30,000 70,000

40% $27.17 40,000 60,000

50% $26.32 50,000 50,000

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Optimal Capital Structure

wd= 30% gives:

Highest corporate value

Lowest WACC Highest stock price per share

But wd= 40% is close. Optimal range

is pretty flat.

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Debt ratios of other firms in the

industry.

Pro forma coverage ratios at differentcapital structures under different

economic scenarios. Lender and rating agency attitudes

(impact on bond ratings).

What other factors would managers

consider when setting the targetcapital structure?

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Reserve borrowing capacity.

Effects on control.

Type of assets: Are they tangible, andhence suitable as collateral?

Tax rates.

Documents

CHAP 15