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Chapter 15

Capital Structure

Decisions

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Capital Structure Decisions

A preview of capital structure issues

Business versus financial risk

The impact of debt on returns

Capital structure theory

Example: Choosing the optimal structure

Setting the capital structure in practice

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Basic Definitions

V = value of firm

FCF = free cash flow

WACC = weighted average cost of

capital

rs and rd are costs of stock and debt

We and wd are percentages of the

firm that are financed with stock and

debt.

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How can capital structure affect value?

1t

tt

)WACC1(

FCFV

(Continued…)

WACC = wd (1-T) rd + we rs

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A Preview of Capital Structure Effects

The impact of capital structure on

value depends upon the effect of

debt on:

WACC

FCF

(Continued…)

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The Effect of Additional Debt on WACC

Debtholders have a prior claim on

cash flows relative to stockholders.

Debtholders’ “fixed” claim increases

risk of stockholders’ “residual” claim.

Cost of stock, rs, goes up

(Debt increases the cost of stock).

(Continued…)

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The Effect of Additional Debt on WACC

Firm’s can deduct interest expenses.

Debt reduces the taxes paid

Frees up more cash for payments to

investors

Reduces after-tax cost of debt

(Continued…)

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The Effect on WACC (Continued)

Debt increases risk of bankruptcy

Causes pre-tax cost of debt, rd, to increase.

Adding debt increase percent of firm

financed with low-cost debt (wd) and

decreases percent financed with high-

cost equity (we)

Net effect on WACC = uncertain. (Continued…)

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The Effect of Additional Debt on FCF

Additional debt increases the

probability of bankruptcy.

Direct costs: Legal fees, “fire” sales, etc.

Indirect costs: Lost customers,

reduction in productivity of managers

and line workers, reduction in credit (i.e.,

accounts payable) offered by suppliers

(Continued…)

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Impact of indirect costs

NOPAT goes down due to lost

customers and drop in productivity

Investment in capital goes up due to

increase in net operating working

capital (accounts payable goes up as

suppliers tighten credit).

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Business Risk and Financial Risk

Business risk is the risk a firm’s common

stockholders would face if the firm had no

debt.

It is the risk inherent in the firm’s

operations, which arises from uncertainty

about future operating profits and capital

requirements.

It is the uncertainty in projections of future

EBIT, NOPAT, and ROIC.

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Factors That Influence Business Risk

Uncertainty about demand (unit sales).

Uncertainty about output prices.

Uncertainty about input costs.

Product and other types of liability.

Degree of operating leverage (DOL).

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Business Risk and Financial Risk

Financial risk is the additional risk placed

on common stockholders as a result of

the decision to finance with debt.

If a firm debt financial leverage), then the

business risk is concentrated on the

common stockholders.

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Business Risk versus Financial Risk :

A conclusion

Business risk:

Uncertainty in future EBIT , NOPAT, and ROIC.

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

Financial risk:

Additional business risk concentrated on common stockholders when financial leverage is used.

Depends on the amount of debt and preferred stock financing.

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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

Consider Two Hypothetical Firms

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

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Impact of Leverage on Returns

EBIT $3,000 $3,000

Interest 0 1,200

EBT $3,000 $1,800

Taxes (40%) 1 ,200 720

NI $1,800 $1,080

ROE 9.0% 10.8%

Firm U Firm L

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Why does leveraging increase return?

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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The Trade-off Between

Profitability And Risk

If a company decides to use debt, it

will be faced with a trade-off between

the following:

Debt can be issued to increase

expected EPS, but then the firm’s

shareholders will have to take

more risk.

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The Trade-off Between

Profitability And Risk

Stay all-equity financed, but then the

firm shareholders will end up with

lower expected EPS

To find out what to do, we need to

determine how debt financing affects

the firm’s value, not just EPS

The pizza theory of capital structure

provides the answer.

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Capital Structure

Theory

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Capital Structure Theory

MM theory

Zero taxes

Corporate taxes

Corporate and personal taxes

Trade-off theory

Signaling theory

Pecking order theory

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Who are Modigliani and Miller (MM)?

They published theoretical papers that changed the way people thought about financial leverage.

They won Nobel prizes in economics because of their work.

MM’s papers were published in 1958 and 1963. Miller had a separate paper in 1977. The papers differed in their assumptions about taxes.

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What assumptions underlie the MM

and Miller models?

Firms can be grouped into homogeneous classes based on business risk.

Investors have identical expectations about firms’ future earnings.

There are no transactions costs. (More...)

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All debt is riskless, and both individuals and corporations can borrow unlimited amounts of money at the risk-free rate.

All cash flows are perpetuities. This implies perpetual debt is issued, firms have zero growth, and expected EBIT is constant over time.

(More...)

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MM’s first paper (1958) assumed zero taxes. Later papers added taxes.

No agency or financial distress costs.

These assumptions were necessary for MM to prove their propositions on the basis of investor arbitrage.

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MM Theory: Zero Taxes

MM prove, under a very restrictive set of

assumptions, that a firm’s value is

unaffected by its financing mix:

VL = VU.

Therefore, capital structure is irrelevant.

Any increase in ROE resulting from financial

leverage is exactly offset by the increase in

risk (i.e., rs), so WACC is constant.

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MM Theory: Corporate Taxes

Corporate tax laws favor debt financing over equity financing.

With corporate taxes, the benefits of financial leverage exceed the risks: More EBIT goes to investors and less to taxes when leverage is used.

MM show that: VL = VU + TD.

If T=40%, then every dollar of debt adds 40 cents of extra value to firm.

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Value of Firm, V

0 Debt

VL

VU

MM relationship between value and debt when corporate taxes are considered.

Under MM with corporate taxes, the firm’s value increases continuously as more and more debt is used.

TD

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Cost of Capital (%)

0 20 40 60 80 100 Debt/Value Ratio (%)

MM relationship between capital costs

and leverage when corporate taxes are

considered.

rs

WACC

rd(1 - T)

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Miller’s Theory: Corporate and Personal Taxes

Personal taxes lessen the advantage of corporate debt:

Corporate taxes favor debt financing since corporations can deduct interest expenses.

Personal taxes favor equity financing, since no gain is reported until stock is sold, and long-term gains are taxed at a lower rate.

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Miller’s Model with Corporate and Personal Taxes

VL = VU + [1 - ]D.

Tc = corporate tax rate.

Td = personal tax rate on debt income.

Ts = personal tax rate on stock income.

(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 in

debt raises L’s value by $0.25.

(1 - 0.40)(1 - 0.12)

(1 - 0.30)

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Conclusions with Personal Taxes

Use of debt financing remains advantageous, but benefits are less than under only corporate taxes.

Firms should still use 100% debt.

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

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Trade-off Theory

MM theory ignores bankruptcy (financial distress) costs, which increase as more leverage is used.

At low leverage levels, tax benefits outweigh bankruptcy costs.

At high levels, bankruptcy costs outweigh tax benefits.

An optimal capital structure exists that balances these costs and benefits.

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Signaling Theory

MM assumed that investors and managers have the same 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 as a negative signal.

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Pecking Order Theory

Firms use internally generated funds first, because there are no flotation costs or negative signals.

If more funds are needed, firms then issue debt because it has lower flotation costs than equity and not negative signals.

If more funds are needed, firms then issue equity.

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Choosing the Optimal

Capital Structure:

Example

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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 financed with debt, wd rd

0% -

20% 8.0%

30% 8.5%

40% 10.0%

50% 12.0% If company recapitalizes, debt would be issued to repurchase stock.

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The Cost of Equity at Different Levels of Debt: Hamada’s Equation

MM theory implies that beta changes

with leverage.

bU is the beta of a firm when it has no

debt (the unlevered beta)

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

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The Cost of Equity for wd = 20%

Use Hamada’s 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%

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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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The WACC for wd = 20%

WACC = wd (1-T) rd + we rs

WACC = 0.2 (1 – 0.4) (8%) + 0.8 (12.9%)

WACC = 11.28%

Repeat this for all capital structures

under consideration.

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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.

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Corporate Value vs. Leverage

wd WACC Corp. Value

0% 12.00% $2,500,000

20% 11.28% $2,659,574

30% 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 = wd V = 0.2 ($2,659,574) = $531,915.

S = V – D

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

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Optimal Capital Structure

wd = 30% gives:

Highest corporate value

Lowest WACC

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 different capital structures under different economic scenarios.

Lender and rating agency attitudes (impact on bond ratings).

What other factors would managers consider when setting the target

capital structure?

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Reserve borrowing capacity.

Effects on control.

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

Tax rates.