1. EMBA 514 Capital Structure Theory

2. Capital Structure Effects on Value
The impact of capital structure on value depends upon the effect of debt on:
WACC
Feedback to FCF

3. Cost of Equity effect
In seeking to minimize the WACC, firms trade-off the benefit of using more lower cost debt against a rising cost of equity
We need an equation for how the cost of equity might be expected to behave as debt increases
The Modigliani and Miller model provides a framework for estimating the cost of equity at different capital structures

4. Modigliani and Miller Assumptions
No taxes
All debt is riskless, so the cost of debt is constant
no possibility of default
Capital structure has no impact on operating cash flows
No agency costs
No information asymmetry
Perpetual cash flows

5. Same EBIT, same risk (WACC), same Enterprise Value
In MM Enterprise Value depends entirely on level and volatility of EBIT
Current Assets Oper. Current Liab.
PP&E Debt Equity
Net Working Capital
Capital investment generates
EBIT = Free Cash Flow here
Same EBIT, same risk (WACC), same Enterprise Value

6. MM Proposition 1 with Zero Taxes
Under the previous restrictive assumptions, we can argue that two firms with the same EBIT and variance in EBIT (‘operating risk’) should have the same Enterprise Value (Debt + Stock)
VL = VU = EBIT capitalized at WACC (zero growth and no tax, so EBIT=NOPAT=FCFF)
For an unlevered company, the cost of equity (rsU) is the same as WACC, since the capital structure is 100% equity

7. MM Proposition 2 with Zero Taxes
The cost of equity of a levered firm (rsL) is equal to the cost of equity of an unlevered firm plus a risk premium which depends on the degree of financial leverage.
Reductions in capital costs as a result of using more lower cost debt (rd) are exactly offset by increases in the cost of levered equity (rsL) due to added financial risk.
As a result the WACC is constant at all debt levels, as is Enterprise Value (V)
proof shown below

8. Proposition 2 equation for the levered cost of Equity (see MM example in Excel)
For a zero-growth company with no taxes, Free Cash Flow to Equity = Net Income = EBIT – Interest Expense = EBIT - rdD
(1)
From Proposition 1
(2)
EBIT = Return to capital x Capital
Substitute (2) into (1)
This is the Proposition 2 equation

9. MM Proposition 2: No taxes
Cost of Capital (%) rs
WACC
rsU rd
Debt/Value Ratio (%)

10. MM Proposition 1 with Taxes
The value of an unlevered firm is equal to EBIT (1-T) capitalized at the cost of equity
The value of a levered firm is equal to the value of an unlevered firm of the same risk class, plus the value of the interest tax savings capitalized at the cost of debt

11. MM Proposition 2 with Taxes
The cost of equity of a levered firm is equal to the cost of equity of an unlevered firm plus a risk premium which depends on both the degree of leverage and the corporate tax rate.

12. MM Proposition 2 with Taxes
(1)
The no-tax eq (1) with taxes
Rearrange (1)
(2)
From proposition 1
Rearrange
(3)
Rearrange
Substitute (3) into (2) for EBIT(1-T)
Rearrange

13. MM Proposition 2 with Taxes
(4)
Last equation from prior slide
(5)
Value = Stock + Debt
Substitute (5) into (4)
Factor out D/S
This is Proposition 2 with taxes

14. MM Proposition 2 with Taxes
Risk premium now includes (1-T)
rsL increases with leverage at a slower rate when corporate taxes are considered.
Taxes are an additional variable cost that reduce the variability in cash flow.
The government now shares in the risk of the cash flows.
The WACC continues to decline as new debt is added, and entity value continues to rise. Pile on the debt!

15. MM Proposition II: With taxes
Cost of Capital (%) rs
rsU
WACC
rd(1 - T)
Debt/Value Ratio (%)

16. MM relationship between value and debt with taxes
Value of Entity, V (%) VL TD VU VU
Debt
VL = VU + TxD

17. Adjusting Beta for Capital Structure Effects
In practice, the effect of capital structure on the Equity cost of capital is recognized by adjusting Beta in the Capital Asset Pricing Model
MM theory implies that beta increases with leverage
As firms borrow, they create fixed costs (interest payments) that make their cash flows to equity investors more volatile (financial risk)
This increased earnings volatility increases the equity Beta
Need equation for beta as a function of leverage
Hamada’s Equation

18. Hamada’s Equation CAPM equation for a levered firm
CAPM equation for an unlevered firm
Riskless debt assumption
Proposition 2
Substitute levered CAPM in left side of Proposition 2 and unlevered CAPM in right side:
Cancel the rRF and divide by (rM-rRF)
Hamada’s Equation

19. Trade-off Theory
MM theory assumes away financial distress costs, which increase as more leverage is used:
Higher debt costs, including negotiation and monitoring by creditors (MM assume constant cost of debt)
Feedback to Free Cash Flow
Rejection of +NPV investments (under-investment)
Growth prospects suffer as business reduces R&D and Marketing expenditures
Loan covenants, which constrain growth
Fire sales of assets to raise cash
Lost customers, suppliers, and employees
Investment in Capital increases as lose trade credit
Contradicts assumption of MM that capital structure doesn’t effect operating cash flows
Growth

20. Trade-off Theory (cont.)
Trade-off theory suggests optimal capital structure is reached at point where marginal distress costs exceed the marginal tax benefit from adding debt in the MM model.
At this same point the WACC is minimized and entity value is maximized.

21. Trade-off tax shield against distress costsVL
VL = VU + TD
Distress costs
Max VL
VL = VU + TD – distress VU
VL = Total value with debt
VU = Total value with no debt
T = Tax rate
D = Debt
Debt
Optimal
Debt Level

22. Trade-off theory suggests these types of firms will use more debt (least impacted by financial distress)
Low growth opportunities (predictable funds needs and less risk of jeopardizing growth investments)
High and stable free cash flow
Large size (safety and lower growth)
Marketable collateral (less service or R&D intensive)
Product not subject to ongoing maintenance/warranties, observable quality
Profitable enough to benefit from tax shelter

23. Debt can reduce Equity Agency Costs
Equity agency problem is that managers might:
use corporate funds for non-value maximizing purposes (e.g. perks, acquisitions, value-destroying growth)
or seek low risk due to undiversified interest in firm
Problem is most significant in large firms with diffuse stockholders where management ownership is low

24. Debt can reduce Equity Agency Costs (cont.)
The use of financial leverage:
Bonds free cash flow for firms generating more cash than required to fund +NPV opportunities, reducing perk consumption and value-destroying growth.
Increases free cash flow by forcing efficiencies: failure risk gets managers’ attention

25. Signaling Theory
MM assumed that investors and managers have the same information.
Where significant information asymmetries exist, stockholders assume:
Stock issues may indicate lower expected FCF, unwilling to commit to increased debt service
Company issues new stock when it is overvalued
Bonds are issued when stock is undervalued
Leverage-decreasing events signal overvalued stock, and vice versa, supported by empirical data

26. Signaling theory results in Pecking Order Hypothesis
Firms will choose the following sequence of funding sources to maintain financial flexibility and avoid negative signals
Retained earnings
Excess cash
Debt issuance
Stock issuance
Maintenance of borrowing capacity is most important for high-growth firms, where value depends on the ability to fund growth investments
Maintain borrowing capacity

27. Evidence on Signaling Theory
Profitable firms use less debt (surprise) because they can build more equity internally
Contradicts Trade-off theory which suggests they should have high debt due to low default risk and need for tax shelters
Suggests capital structure decision is a residual that depends on cash flow, and the investment and distribution decisions
Mature firms issue stock very infrequently

28. Steps in the distribution decision
How many + NPV investments?
Reinvestment:
Capex +
Working Capital
How much will you borrow?
How much cash on
Balance Sheet?
CF to Debt:
Principal +
Interest
NOPAT
Free
Cash
Flow
Cash held on
Balance Sheet
Cash flow
available
to stockholders
Cash paid out
Repurchases
Dividends
Which type of distribution?
Suggest stock repurchases are a residual from the FCF forecast

29. Evidence on Signaling Theory (cont.)
When setting capital structure targets, survey evidence indicates managers consider, in rank order:
Financial Flexibility
Long-term survival
Maintenance of predictable funds sources
Maximization of stock price
Suggests concerns over feedback to operating performance

30. Summing the theories This leaves us with:
VL = VU + tax benefit – financial distress
+ equity agency + signaling
Capital structure decision requires judgment!

31. Practical approach to quantifying capital structure choice
Use Hamada’s equation to estimate changes in cost of Equity
Use credit ratios to estimate changes in cost of debt
Find weights where WACC is minimized
Compare result to peers and use judgment to incorporate the other factors:
1) financial distress; 2) agency; 3) signaling
See Excel example

32. Additional considerations in setting the target capital structure
Effect on sustainable growth: willingness to increase debt allows for higher growth rate today
Sustainable g = ROE x (1 – Dividend Payout Ratio) ROE = ROIC + [ROIC - rd(1-t)] x D/E
Example of target D/E given target growth: Dividend payout = 40%; Target growth = 15%; ROIC = 12%; rd(1-t) = 5.5%
Required ROE = g ÷ (1-DPR) = .15 ÷ (1-.40) = 25% Required D/E = (25% - 12%) ÷ (12% - 5.5%) = 2.0
See Excel example

33. Additional considerations in setting the target capital structure (cont.)
Lender and rating agency attitudes (impact on credit ratings)
Debt ratios of other firms in the industry
Risk aversion of managers
Intersection with distribution policy

34. Additional considerations in
setting the target capital structure (cont.)
Use debt to retain control and avoid takeover
Realize value of tax shield to boost stock price
Concentrate ownership in friendly hands
Signal operating improvements that will lead to increased profit and stock price
Signal strategy to disgorge excess FCF