Capital structure (Chapter 15)

Capital Structure Overview of capital structure effects Business risk and financial risk Impact of debt on returns Optimal capital structure Capital structure theory Capital structure in practice

Capital Structure Mixture of debt and equity Actual capital structure varies over time but most firms try to keep their financing mix close to a target capital structure

Capital Structure Assume no non-operating assets WACC = wd (1-T) rd + we rs Assume no non-operating assets

Capital Structure Effects of additional debt on WACC: Increase pre-tax cost of debt (rd) Decrease after-tax cost of debt [(1-T)rd] Increase cost of equity (re) Increase wd and decrease we

Capital Structure Effects of additional debt on FCF: Increase risk of bankruptcy Direct costs: Legal fees Indirect costs: Lost sales & customers Lower productivity of managers and workers Lower credit offered by suppliers Lower NOPAT

Capital Structure Effects of additional debt on managers’ behavior Agency cost? Debt lowers agency cost Debt increases agency cost Underinvestment problem

Business Risk Uncertainty about future EBIT: Probability E(EBIT) EBIT Low risk High risk E(EBIT) EBIT

Business Risk Factors affecting business risk: Uncertainty about demand (unit sales) Uncertainty about output prices Uncertainty about input costs Degree of operating leverage (DOL)

Total revenue – Total variable costs – Total fixed costs = EBIT Operating Breakeven PQ-VQ-F = EBIT QBE = F ÷ (P – V) Example: F=$200 P=$15 V=$10 QBE = ? Total revenue – Total variable costs – Total fixed costs = EBIT

} Operating Breakeven } $ QBE Sales TC = Total cost Revenue EBIT EBIT F QBE EBIT } } EBIT TC = Total cost

Business Risk Probability Low operating leverage High operating leverage EBITL EBITH Higher operating leverage leads to higher expected EBIT, but also increases business risk

Business Risk vs. Financial Risk Uncertainty in future EBIT Depends on business factors & the use of operating leverage Financial risk: Uncertainty in future EPS Depends on the amount of debt and preferred stock financing

Unleveraged Firm vs. Leveraged Firm

Unleveraged Firm vs. Leveraged Firm

Unleveraged Firm vs. Leveraged Firm

Unleveraged Firm vs. Leveraged Firm

Unleveraged Firm vs. Leveraged Firm

Unleveraged Firm vs. Leveraged Firm

Conclusions BEP and ROIC are unaffected by financial leverage Firm L has higher expected ROE due to tax savings and smaller equity base But Firm L has higher ROE because of fixed interest charges Firm L’s higher expected return is accompanied by higher risk

Conclusions Firm L’s stockholders has more risk than Firm U’s stockholders although, U and L: ROIC = 2.12% but, U: ROE = 2.12% whereas, L: ROE = 4.24% Firm L’s financial risk is ROE - ROIC = 4.24% - 2.12% = 2.12%. (whereas Firm U’s financial risk is zero since it did not use debt financing)

Optimal Capital Structure

Optimal Capital Structure

Optimal Capital Structure

Optimal Capital Structure

Optimal Capital Structure

Optimal Capital Structure

Optimal Capital Structure

Optimal Capital Structure

Optimal Capital Structure

Optimal Capital Structure

Optimal Capital Structure

Optimal Capital Structure

Optimal Capital Structure

Optimal Capital Structure

Optimal Capital Structure

Optimal Capital Structure

Optimal Capital Structure

Optimal Capital Structure

Optimal Capital Structure

Optimal Capital Structure

Capital Structure Theory Capital structure choices affect a firm’s ROE and its risk. Capital structures vary across industries (and among firms within a given industry). What factors explain the differences? Academics & practitioners have developed several theories to explain capital structure.

Capital Structure Theory Modigliani & Miller (MM) theory Zero taxes (MM: 1958) Corporate taxes (MM: 1963) Corporate & personal taxes (M: 1977) Trade-off theory Signaling theory Agency theory

MM Theory: Zero Taxes (MM: 1958) Assume no corporate & personal taxes: As financial leverage increases, more weight is given to debt but it makes equity riskier thereby increasing cost of equity (rs) Any increase in ROE (from the use of debt) is exactly offset by an increase in risk (rs), so WACC is constant. VL = VU Firm value is unaffected by its financing mix. Capital structure is irrelevant.

MM Theory: Corporate Taxes (MM: 1963) MM (1963) relax the assumption of no corporate taxes. Corporate tax laws favor debt financing over equity financing: Interest payments are tax deductible expenses whereas dividend payments are non-tax deductible expenses. Interest payments reduce tax paid by firm and if firm pays less tax to government, then more cash flow is available for its investors.

MM Theory: Corporate Taxes (MM: 1963) MM show that: VL = VU + PV of tax shield VL = VU + TD T = Corporate tax rate D = Amount of debt Ex: If T = 40%, then VL = VU + 0.4D Firm value rises with debt; each $1 increase in debt raises firm L’s value by $0.4

MM Theory: Corporate Taxes (MM: 1963)

Miller’s Theory (1977): Corporate and Personal Taxes Miller (1977) consider the effects of personal income taxes. Income from bonds is generally interest. Income from stocks are dividends & capital gain. Capital gain tax is deferred until the stock is sold and the gain is realized. On average, return on stocks are taxed at lower effectively rates than return on bonds. Corporate taxes favor debt financing. Personal taxes favor equity financing -- more favorable tax treatment of income from stocks lowers required rate of return on stock. Use of debt financing remains advantageous, but benefits are less than under only corporate taxes.

Trade-off Theory MM theory ignores bankruptcy costs (financial distress) that increase as more debt is used. At low debt levels, tax benefits outweigh bankruptcy costs. At high levels, bankruptcy costs outweigh tax benefits. An optimal capital structure exists that balances these benefits & costs. Firm trades off between tax benefit & bankruptcy cost of using debt.

Trade-off Theory

Signaling Theory MM assume investors & managers have the same information about firm’s prospects – symmetric information. Managers often have better information than outside investors – asymmetric information. Consider the following two situations.

Signaling Theory Firm P (Positive prospect) Firm N (Negative prospect) Firm P just discovers new drug and wants to keep the new product as secret as long as possible to delay competitors’ entry into the market. Firm P must build new plants to make new drug. So, firm P must raise new capital. Firm P tries to avoid issuing new stocks (but rather issuing debt) to avoid sharing the benefits of new drug development with new stockholders. Firm N (Negative prospect) Firm N’s managers have information that their sales orders drop sharply since its competitor has installed new technology that has improved its products’ quality. So, firm N must upgrade its own production to maintain its market share and must raise new capital. Firm N would want to issue stock which would mean bringing in new shareholders to share any losses if occur.

Signaling Theory Thus, By issuing stocks: Firm sends signal about its negative prospect. Also, manager tries to sell stock when it is overvalued. By issuing debts: Firm sends signal about its positive prospect. Also, manager tries to sell bonds if stock is undervalued.

Signaling Theory Since managers know firm’s future prospects better than investors. Managers would not issue additional stock if they thought the current stock price was less than the true value of the stock (given their inside information). Investors understand this situation. Thus, investors often perceive an additional issuance of stock as a negative signal, and the stock price falls i.e. the price of its stock usually declines when firm announces a new stock issuance (even if the firm’s prospects are good).

Signaling Theory Implications for managers? Firm should maintain a reserve borrowing capacity that can be used in the event that some especially good investment opportunity comes along. In other words, firm uses less debt than is suggested by trade-off theory.

Debt Financing & Agency Costs Agency problems may arise if managers & shareholders have different goals. Managers can use FCF for non-value maximizing purposes: Perquisites – nicer offices, corporate jets & cars etc. Non-value maximizing projects The use of debt financing: Forces discipline on managers to avoid perquisites & non-value adding projects -- debt financing commits managers to service it.

Debt Financing & Agency Costs Underinvestment problem: Debt increases risk of financial distress. The more debt the firm has, the greater the likelihood of financial distress, and therefore the greater the likelihood that managers will forgo risky projects even if they have positive NPVs.

Capital Structure in Practice Factors affecting capital structure decision: Sales stability Asset structure Operating leverage Growth rate Profitability Taxes Management attitudes Reserve borrowing capacity