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J. K. Dietrich - FBE 432 – Fall 2002
Module I: Investment Banking:Capital Structure and Valuation
Week 3 – September 11, 2002
2J. K. Dietrich - FBE 432 – Fall 2002
Introduction
When a firm issues both debt and equity, it agrees to split the cash flows produced by its real assets between shareholders and bondholders. The firm’s mix of securities is known as its capital structure.
Firm value depends on capital structure in a fundamental way. This lecture reviews the theory of capital structure and its links to valuation.
J. K. Dietrich - FBE 432 – Fall 2002
Value and Leverage StrategyConservative Strategy
Equity
Debt
Aggressive Strategy
Debt
Equity
J. K. Dietrich - FBE 432 – Fall 2002
Distribution of Corporate Income E
B I
T
EAC (Div + Retained Earnings)
I (Fixed Claims)
T (No Value to Investors)
5J. K. Dietrich - FBE 432 – Fall 2002
Empirical Facts
Most corporations set a target debt ratio. There are many similarities in capital
structure– Across firms in the same industry– Across industries in different countries– These regularities suggest that there are some
fundamental determinants of capital structure
J. K. Dietrich - FBE 432 – Fall 2002
Summary M-M Debate Issues M-M ISSUES STATE
OF DEBATE CAPITAL STRUCTURE IRRELEVANT
(1) TAXES (2) BANKRUPTCY (3) AGENCY (4) EQUILIBRIUM
TRADEOFFS
DIVIDENDS IRRELEVANT
(1) INFORMATION (2) TAXES (3) MILLER-SCHOLES
EVIDENCE
8J. K. Dietrich - FBE 432 – Fall 2002
An Example
Consider the following data for a company reviewing its capital structure. – Number of Shares 100– Price Per Share $20– Market Value of Shares $2,000– Market Value of Debt $0– Interest Rate 10%– Tax Rate 0
J. K. Dietrich - FBE 432 – Fall 2002
Possible Outcomes:
Depending on the state of the economy, EBIT may be as predicted, below average or above average.
If EBIT is $250, as predicted, earnings per share are $250/100 = $2.50 and the return on equity is $2.50/$20 = 0.125 or 12.5 percent.
10J. K. Dietrich - FBE 432 – Fall 2002
EBIT-EPS Table
Recession Predicted Boom
EBIT ($) 100 250 300
EPS ($) 1.00 2.50 3.00
Return on Equity (%) 5 12.5 15
Based on the hypothetical EBITs, we can compute the associated EPS. This gives rise to the EBIT-EPS table or chart.
J. K. Dietrich - FBE 432 – Fall 2002
EBIT-EPS Chart
0
0.5
1
1.5
2
2.5
3
3.5
0 50 100 150 200 250 300 350
EBIT
EPS
J. K. Dietrich - FBE 432 – Fall 2002
Desirability of Leverage
Suppose the company repurchases $1,000 of equity at $20 each
The purchase is financed by issuing consol bonds.
The new capital structure consists of 50 shares of stock and $1,000 of debt.
13J. K. Dietrich - FBE 432 – Fall 2002
Hypothetical Outcomes: Levered Firm
Recession Predicted Boom
EBIT ($) 100 250 300
Interest ($) 100 100 100
Equity Earnings ($) 0 150 200
EPS ($) 0 3 4
Return on Equity (%) 0 15 20
J. K. Dietrich - FBE 432 – Fall 2002
EBIT-EPS Chart
0.0
0.5
1.0
1.5
2.0
2.5
3.0
3.5
4.0
4.5
0 50 100 150 200 250 300 350
EBIT
EP
S
Levered Firm
Unlevered Firm
J. K. Dietrich - FBE 432 – Fall 2002
The Home-made Leverage
Consider an alternative scenario now Suppose an investor were to borrow $20
and invest $40 in two (unlevered) shares of the original all equity company.
The net cost to the investor is $20.
16J. K. Dietrich - FBE 432 – Fall 2002
Home Made Leverage
Recession Predicted Boom
Share Earnings ($) 2 5 6
Interest on $20 ($) 2 2 2
Net Earnings ($) 0 3 4
Return on $20 inv (%) 0 15 20
17J. K. Dietrich - FBE 432 – Fall 2002
Home Made Leverage
The returns from this strategy are exactly the same as buying 1 share of the levered firm. Therefore a share in the levered firm must sell for $20 (= 2 x 20 - 20).
Investors on their own can accomplish what the company can do by adding debt, so leverage will not create value. This leads to the famous irrelevance proposition of Merton Miller and Franco Modigliani.
18J. K. Dietrich - FBE 432 – Fall 2002
Miller-Modigliani Theory
The Miller-Modigliani Proposition I:
With no taxes and perfect financial markets, the value of any firm is independent of its capital structure.
J. K. Dietrich - FBE 432 – Fall 2002
Miller-Modigliani Theory: Firm Value
Leverage Ratio
Firm Value
All Equity Firm Value
Leverage has no effect on firm value when there are no taxes and markets are perfect
J. K. Dietrich - FBE 432 – Fall 2002
Miller-Modigliani Theory: WACC
Leverage Ratio
%
WACC
With no taxes and perfect markets, the weighted average cost of capital is constant
Cost of Debt
Cost of Equity
21J. K. Dietrich - FBE 432 – Fall 2002
Implications
The Miller-Modigliani theorem is a starting point to examining capital structure effects in the real world.
If capital structure matters, it is because one of the MM assumptions is violated.
The first assumption to relax is the assumption that there are no corporate taxes.
22J. K. Dietrich - FBE 432 – Fall 2002
Miller-Modigliani Theory and Taxes
As a simple example, consider two firms, U and L.
Firm U has no debt and firm L has issued consol bonds worth $200 at the current interest rate of 10 percent; otherwise the firms are the same.
23J. K. Dietrich - FBE 432 – Fall 2002
Levered and Unlevered Firms
Firm U Firm L
Operating Income ($) 100 100
- Interest to Bondholders ($) 0 -20
= Pretax Income ($) 100 80
- Tax at 34% ($) -34 -27.2
= Net Income to Stockholders ($) 66 52.8
Value of Equity ($) 660 528
Value of Debt ($) 0 200
Value of the Firm (Debt + Equity)($)
660 728
J. K. Dietrich - FBE 432 – Fall 2002
Implications
This simple example shows that interest tax deductibility increases the value of the firm that is levered.
The tax bill of L is $6.80 less than that of U In effect, the government is paying 34
percent of the interest expense of L. This perpetual reduction in taxes is worth $6.80/0.10 = $68.
25J. K. Dietrich - FBE 432 – Fall 2002
Value of the Interest Tax Shield
The present value of the tax shield accounts for the difference in firm value.
If tC is the corporate tax rate and rD the debt rate, then interest payments = rD.D and the tax shield is tC.rD.D. – How do we value the tax shields with risk?
The most common approach is that the risk of the tax shields is the same as the interest payments generating them.
26J. K. Dietrich - FBE 432 – Fall 2002
A Convenient Formula
For perpetual debt, we have:
PV tax shield = (tC.rD.D)/rD = tC.D
which is independent of rD. The MM Theorem with corporate taxes
implies: VL = VU + tCD.– The PV of tax shields is lowered if the firm
does not borrow permanently or if it may not be able to use the tax shields in the future.
J. K. Dietrich - FBE 432 – Fall 2002
A Paradox
The Miller-Modigliani theorem implies capital structure is irrelevant if there are no taxes and capital markets are perfect. – Relaxing the assumption of no corporate taxes
leads to the result that the company should take on as much debt as it can.
– But an all debt company is owned by its creditors. What stops a company from being entirely debt financed?
J. K. Dietrich - FBE 432 – Fall 2002
Miller-Modigliani Theory with Corporate Taxes
Leverage Ratio
Firm Value
All Equity Firm Value
Value of a Levered Firm
Present value of the tax shield
J. K. Dietrich - FBE 432 – Fall 2002
MM With Taxes: WACC
Leverage Ratio
%
WACC
With taxes, the weighted average cost of capital declines with higher leverage
Cost of Debt
Cost of Equity
30J. K. Dietrich - FBE 432 – Fall 2002
A Reconciliation
What offsets the tax advantages of debt financing? – Bankruptcy costs
» But empirical evidence seems to suggest these direct costs are quite small
– Costs of financial distress» These costs may be sufficiently large as debt
increases that there it offsets the tax shield.
J. K. Dietrich - FBE 432 – Fall 2002
MM with Taxes and COFD
Leverage Ratio
Firm Value
All Equity Firm Value
Optimal Leverage Zone Balances Tax Advantages of Debt Against the Costs of Financial Distress
J. K. Dietrich - FBE 432 – Fall 2002
MM with Taxes and COFD: WACC
Leverage Ratio
%
WACC
The weighted average cost of capital declines with higher leverage and then rises
Cost of Debt
Cost of Equity
J. K. Dietrich - FBE 432 – Fall 2002
Real-World Capital Structure
Some stylized facts fit well with the theory– Firms with high taxes rely more on debt– Firms with a high percentage of intangible
assets rely on equity– Firms with uncertain operating income avoid
debt
J. K. Dietrich - FBE 432 – Fall 2002
Cost of Capital for All Equity Firm?
Many - including some executives - believe it is zero because – there is no direct cost to internal funds or from
equity capital issued some time ago– no obligation to pay a dividend.
This reasoning is wrong.
J. K. Dietrich - FBE 432 – Fall 2002
It is the opportunity cost of the equity that matters.
The cost of capital is simply the rate that investors use discount the cash flows from the firm. Investors will price the stock to offer this expected return. If CAPM holds we have :
Cost of Capital for All Equity Firm?
J. K. Dietrich - FBE 432 – Fall 2002
Cost of Capital for All-Debt Financed Projects
Many firms issue either debt or equity to finance purchases of new assets and projects. What is the cost of capital for a project financed 100% with debt?
It is not the after-tax debt rate. Why?– You cannot 100% debt-finance all projects– Debt capacity comes from existing assets - not
all the tax shield is attributable to the project
38J. K. Dietrich - FBE 432 – Fall 2002
Review
The capital structure decision is a crucial one for the firm and is fundamentally linked to questions of valuation
Firms trade-off the tax benefits of debt financing against the costs of financial distress
Finding the right capital structure is difficult in practice
J. K. Dietrich - FBE 432 – Fall 2002
Next Week – September 16 & 18 Review background readings on valuation
implications of mergers and acquisitions Read and discuss The Hostile Bid for Red
October case with your group next week Allocate tasks associated with group write-
up and do necessary work Hand in case write-up at the beginning of
class on September 23, 2002 and keep copies for class discussion