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Copyright K. Cuthbertson and D. Nitzsche 1 Lecture Capital Structure and the Modigliani-Miller Propositions 11/9/2001

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Copyright K. Cuthbertson and D. Nitzsche 2 Preliminary definitions ~Capital structure question -what is it? Capital structure question -the theories ~Traditional view ~Modigliani-Miller MM - propositions I and II (no taxes) ~Modigliani-Miller MM - propositions I and II (with taxes) Modigliani-Miller: More Realism ~Financial Distress and Bankruptcy TOPICS COVERED

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Copyright K. Cuthbertson and D. Nitzsche 3 Investments:Spot and Derivative Markets K.Cuthbertson and D.Nitzsche CHAPTER 11: excluding Section 11.4 (Dividend Policy) and Section 11.4 (Dividend Policy) and Appendices Appendices READING

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Copyright K. Cuthbertson and D. Nitzsche 4 Preliminary Definitions Capital structure question -what is it?

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Copyright K. Cuthbertson and D. Nitzsche 5 Manufacturing Sector (UK, E. Midlands, averages 1984-94) Chemicals140% Metals 90% Mech. Eng.76% Construction75% Retail Distn158% Business Services125% Figures are all ‘book value’ Leverage = Total Debt / Net Worth(‘Shareholders Funds’) Leverage varies greatly even within same sector Manufacturing (Leverage =Debt to Equity Ratio)

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Copyright K. Cuthbertson and D. Nitzsche 6 LEVERED(GEARED) = financed by debt and equity DISCOUNT RATE TO USE FOR A LEVERED FIRM Assume (debt-equity ratios will remain broadly unchanged) (‘After tax’)Weighted Average Cost of Capital WACC, WACC = (1-z) R S + z R B (1-t) z = B / V, (1-z) = S / V ~ ‘weights’ sum to 1. Preliminary Definitions

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Copyright K. Cuthbertson and D. Nitzsche 7 Using the WACC as the discount rate WACC can be used: I) if the new project gives rise cash flows that have the same degree of business risk as the existing general cash flows of the firm. That is, the project is ‘scale enhancing’ and ii) if the project does not lead to a (large) change in the firm’s debt ratio. In fact, the WACC calculation assumes that the amount of debt outstanding is rebalanced every period to maintain a constant ratio B/V ratio for the firm as a whole.

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Copyright K. Cuthbertson and D. Nitzsche 8 SO, VALUE OF THE FIRM IS:V = Y / WACC Hold the firm’s cash flows constant (and for ever) (Also, assume Y is independent of capital structure) CAPITAL STRUCTURE QUESTION Can we alter WACC (and hence V) by altering the mix of debt and equity finance ? Example.$100 total in debt and equity. Do we gain by moving from 20% debt/80% equity finance, to 70% debt-30% equity finance ? - done by issuing more $50 more in bonds and using the proceeds to buy-back $50 of outstanding shares. Capital Structure Question

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Copyright K. Cuthbertson and D. Nitzsche 9 Capital Structure: Traditional View

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Copyright K. Cuthbertson and D. Nitzsche 10 As you increase the proportion of ‘cheap’ debt (and initially the required return on equity remains constant ) then WACC will fall and hence V will rise. After a certain debt level (e.g. 70%) the equity holders will require a higher return because of increased ‘risk’. This will raise the WACC and V will begin to fall. Hence: There is a particular level for the debt-equity ratio which will maximise the value of the firm. Capital Structure: Traditional View

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Copyright K. Cuthbertson and D. Nitzsche Traditional View : Cost of Capital * Optimal( B/S)* Equity, R s WACC Debt R b Debt-Equity Ratio (B/S) Cost of Capital or V VALUE OF FIRM

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Copyright K. Cuthbertson and D. Nitzsche 12 Capital Structure: Modigliani-Miller Propositions I and II (No taxes) Propositions I and II (No taxes)

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Copyright K. Cuthbertson and D. Nitzsche 13 Modigliani-Miller Approach ASSUMPTIONS IN THE MODIGLIANI-MILLER APPROACH Borrowing and lending rates equal and the same for companies and persons. No corporate or personal taxes or transactions costs. No costs of financial distress or liquidation net cash flows Y,are independent of the debt-equity mix. Investors can arbitrage between the shares of companies (with the same business risk) where one is all-equity financed and the other is a levered firm.

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Copyright K. Cuthbertson and D. Nitzsche 14 Under certain restrictive assumptions MM show that the fall in WACC as you increase the proportion of debt finance is exactly offset by the rise in the required return on equity, R S - so the overall WACC remains constant. In this MM world there is therefore no optimal debt-equity ratio. So, MM argue that you can finance a project with NPV>0, with any arbitrary mix of debt and equity, without affecting the overall value of the firm. MM PROPOSITION I (NO TAXES)

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Copyright K. Cuthbertson and D. Nitzsche The Value of the Firm: MM Proposition-I (no taxes) Value of firm, V Debt-Equity Ratio (B/S) V V is independent of B/S

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Copyright K. Cuthbertson and D. Nitzsche 16 Why do shareholders demand a higher return on equity R s as we increase proportion of debt relative to equity finance ? R s increases because these returns are more uncertain (i.e. have a higher standard deviation) the larger is the proportion of debt finance. Why Does R s Increase With Leverage ?

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Copyright K. Cuthbertson and D. Nitzsche 17 Earnings Y can be either £0.5m, £2m or £4m (with equal probability). This is ‘business risk’. What is the range of outcomes for shareholder’s returns R s in a) the all (100%) equity financed firm b) the levered firm with 50% debt and 50% equity The range is much greater in (b) since the interest income on the debt is paid first. Why Does R s Increase With Leverage ?

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Copyright K. Cuthbertson and D. Nitzsche 18 Leverage and Equity Returns Earnings Y i Equity Return, R S 70% 40% 30% 20% 10% Y i changes from 1m to 4m, R S for the all equity firm moves from 10% to 40% (A to B) But for the 50% levered firm the equity return changes much more, from 10% to 70% (A’ to C). Hence ‘debt finance’ introduces additional ‘leverage risk’. 1 0.5 4 100% Equity (0% Debt) 50% Equity (50% Debt) C B A A’ 2

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Copyright K. Cuthbertson and D. Nitzsche 19 Capital raised=$10m =S + B = shares + debt (bonds) Cost of Debt =10% 1. Poor 2. Average3. Good Earnings before interest Y 1 = $0.5 Y 2 = $2Y 3 = $4.0 (equal probability=1/3) Note (below): Expected return is calculated ER = 1/3 R 1 + 1/3 R 2 +1/3 R 3 Standard Deviation is: ‘Sum from k=1 to 3 of [ 1/3( R k - ER) 2 ] Leverage and Equity Returns

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Copyright K. Cuthbertson and D. Nitzsche 20 1. Poor2. Average 3. Good Earnings before interest, Y i Y 1 = $0.5Y 2 = $2 Y 3 = $4.0. 100% Equity (0% Leverage) ( S = $10m equity) Debt interest rB 0 00 Earnings/Dividends$0.5 $2 $4 Return on shares, R i = Div/ S0.5/10 = 5%2/10 = 20%4/10 = 40% Expected Return (standard deviation)= 21.7% (14.3) Note (not crucial here!): R = Total Earnings / Total value shares = Div / S = Earnings per share / Share price = EPS / P S where P S = S / N Leverage and Equity Returns

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Copyright K. Cuthbertson and D. Nitzsche 21 1. Poor 2. Average 3. Good Earnings before interestY 1 = $0.5 Y 2 = $2 Y 3 = $4.0..20% Levered (z = B/V = 2/10) (B= $2m debt, S= $8m equity) Debt interest rB $0.2$0.2$0.2 Earnings $0.3$1.8$3.8 R i = Div/ S 0.3/8 = 3.75% 1.8/8 = 22.5% 3.8/8 = 47.5% Expected Return (standard deviation)= 24.6 (17.9) Leverage and Equity Returns

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Copyright K. Cuthbertson and D. Nitzsche 22 TRADITIONAL VIEW There is a debt-equity mix which minimises the WACC and hence maximises the firm’s market value. MM : ‘PROPOSITION I ’: NO TAXES The WACC and the value of the firm V are both independent of the debt-equity mix (used in financing the firm’s activities) SUMMARY SO FAR !

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Copyright K. Cuthbertson and D. Nitzsche 23 MM ‘PROPOSITION II: NO TAXES Since the WACC (R w ) is independent of debt-equity ratio, this implies cost of equity capital R s rises with the debt-equity ratio B/S Note: Re-arrange WACC formula, it can be shown that: R S = R w + [R w -R b ] B/S R w is constant (MM-1) and R w - R b >0 then R s will rise as B/S increases. The intuition for this was given above as the ‘increase in leverage risk’

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Copyright K. Cuthbertson and D. Nitzsche 24 CONSEQUENCES OF MM(2) R s (or R w or R b ) Debt-Equity Ratio (B/S) RbRb RwRw R S = Cost of equity Rs = R w + [R w -R b ] B/S Cost of equity rises with rising Debt-Equity Ratio

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Copyright K. Cuthbertson and D. Nitzsche 25 MM I AND II WITH CORPORATE TAXES ( ‘MM-I goes crazy’ )

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Copyright K. Cuthbertson and D. Nitzsche 26 MM I AND II ‘WITH TAXES’ MM PROPOSITION I (With Corporate Taxes): For two firms with the same business risk, then the optimal debt ratio that maximises the value of the firm involves 100% leverage (i.e. all debt financed) ! MM Proposition II (with corporate taxes) There is (still) a positive relationship between the required return on equity in a levered firm and the debt-equity ratio B L /S L.

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Copyright K. Cuthbertson and D. Nitzsche 27 MM Proposition I (with corporate taxes) Taxes are paid after deduction of (debt) interest payments. As you increase the proportion of ‘cheap’ debt finance: R s increases (because of increased ‘risk’) but this does not completely offset the lower after tax cost of the debt finance (1-t) R b. Hence: WACC falls continuously and value of a firm (with taxable profits) reaches a maximum value, at 100% debt finance.

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Copyright K. Cuthbertson and D. Nitzsche 28 Modigliani-Miller: More Realism Financial Distress and Bankruptcy

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Copyright K. Cuthbertson and D. Nitzsche 29 MM (with taxes) + Costs Of Financial Distress Costs of distress - ‘legal fees’ and the loss in a ‘fire sale’ - difficult relationship with customers and suppliers - most efficient workers leave - Football teams, Polly Peck, Rover, M&S, Media and internet co.

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Copyright K. Cuthbertson and D. Nitzsche 30 As the B/S increases then probability of ‘distress’ will increase then R b and R s will increase as will WACC, so V falls. Then there is a ‘theoretical’ optimal debt-equity ratio in this ‘new’ MM world - but it requires measuring some very intangible costs ! MM (with taxes) + Costs Of Financial Distress

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Copyright K. Cuthbertson and D. Nitzsche Figure 11.5 : Value of the Firm (MM-Proposition I with Taxes and Bankruptcy). Debt-Equity Ratio (B/S) MM-no taxes MM-with corporate taxes only MM-with corporate taxes and bankruptcy costs Optimal debt-equity ratio Value of the Firm

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Copyright K. Cuthbertson and D. Nitzsche 32 More Realism ?: Definitions Agency costs costs of ensuring that managers (the agents) act in the best interests of the shareholders (i.e. the owners or principals). Debt agreements (e.g. for bonds, bank loans) usually contain restrictive covenants(e.g. preclude the managers from investing in high risk ventures) Bondholders suffer from information asymmetry.

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Copyright K. Cuthbertson and D. Nitzsche 33 More Realism ?: Issues Ignored In MM Model COSTLY MONITORING implies debt-holders may require higher R b as leverage increases. This increases the WACC and lowers V.

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Copyright K. Cuthbertson and D. Nitzsche 34 Issues Ignored in MM Model Perceived probability and costs of distress depends on; the greater the variability in earnings, the higher the risk of liquidation or ‘distress’ costs of distress will be lower the greater the liquidity and marketability of the firm’s assets the probability and costs of distress are lower, the higher the proportion of variable to fixed costs (e.g. can you quickly reduce staffing costs)

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Copyright K. Cuthbertson and D. Nitzsche 35 Shareholders may persuade managers of ‘near bankrupt’ firm to undertake highly risky projects. - ‘go-for-broke’ strategy - this worries bondholders advertising firm (with few tangible assets as security) versus leisure firm(with hotels to sell off, to repay bondholders). The latter has a higher ‘debt capacity’ than the former. Managers keep debt levels low to get the benefit of an ‘option to expand’ into profitable projects. Issues Ignored in MM Model

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Copyright K. Cuthbertson and D. Nitzsche 36 Debt levels might influence future cash flows is if they affect managerial incentives. Firms with high leverage, have to meet high interest payments every year. This may provide incentives for managers to increase productivity, cut costs and concentrate on their ‘core competencies’. Also, highly leveraged firms may not be able to ‘empire build’ since there are little or no ‘free cashflows’. Hence, high leverage might increase profits by discouraging ‘empire building’. Issues Ignored in MM Model

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Copyright K. Cuthbertson and D. Nitzsche 37 ‘External’ Factors Influence Debt Levels The pecking order ‘model’ assumes managers I) use internal funds (retained profits) first, then ii) debt (loan and bond) markets and finally ii) equity markets. High growth firms invest more than retained earnings and will therefore take up debt and then equity. Slow growing firms with ‘normal’ profits will not have any debt since there will be enough internal funds for all desirable projects

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Copyright K. Cuthbertson and D. Nitzsche 38 ‘External’ Factors Influence Debt Levels FI and venture capitalists might ‘force’ a particular (non-optimal) capital structure on firms. (i.e. correspondent banking relationships and venture capitalists on the board - with their preferred debt-equity mix) When in financial distress, ‘restructuring is often decided by a diverse group of creditors (usually a consortium of banks ) - e.g. Eurotunnel in 1990s and British Telecom in 2000

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Copyright K. Cuthbertson and D. Nitzsche 39 No easy practical solutions to the capital structure question once we take into account the complexities of the real world. Many influences on the perceived optimal debt-equity mix -the cost of financial distress/monitoring -agency and incentive problems - MBO’s and LBO’s (an unsatisfied ‘clientele’ for this type of debt) - debt restructuring ( forced on companies by creditors) Debt Levels In Practice: Nothing Fits Well !

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Copyright K. Cuthbertson and D. Nitzsche 40 END OF SLIDES.

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Chapter 12: Leverage and Capital Structure

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