Capital Structure and Firm Value

Does Capital Structure affect value? Empirical patterns Empirical patterns –Across Industries –Across Firms –Across Years –Who has lower debt? High intangible assets/specialized assets High intangible assets/specialized assets High growth firms High growth firms High cash flow volatility High cash flow volatility High information asymmetry High information asymmetry Industry leaders Industry leaders Is capital structure managed? Is capital structure managed? –If so much time is spent on capital structure then there must be some value to it (or managers/investors are irrational)

Debt and Equity Only? Typically thought of and measured this way Typically thought of and measured this way Much more complex Much more complex –Investment opportunities and strategy (needs) –Financing (sources) Cash balance Cash balance Distribution: Dividend and repurchases Distribution: Dividend and repurchases Debt capacity Debt capacity Equity capacity Equity capacity Existing debt and equity Existing debt and equity –Other financial policies: Financial Hedging, Cash Flow Volatility, Forms of Compensation

How does capital structure affect value? To prove this we start in the “perfect world” To prove this we start in the “perfect world” –Based on the work of Miller and Modigliani –Shows that capital structure is irrelevant Value is derived from market imperfections Value is derived from market imperfections Example: What if a firm is considering issuing debt and retiring equal amounts of equity? Example: What if a firm is considering issuing debt and retiring equal amounts of equity?

CurrentProposed Assets8000 Debt04000 Equity Interest0.1 Share Price20 Outstanding Shares400200

CurrentRecessionExpectedExpansion Earnings ROA ROE EPS135 ProposedRecessionExpectedExpansion EBI Interest400 Earnings ROA ROE EPS048

Position #1: Buy 100 shares of the levered firm ($20*100=$2,000 Initial Investment) RecessionExpectedExpansion Earnings Position #2: Buy 200 shares of the unlevered firm and borrow $2000 (($20*200)-$2,000=$2,000 Initial investment). RecessionExpectedExpansion Earnings Interest200 Net Earnings

Capital Structure is Irrelevant Miller and Modigliani assume perfect capital markets Miller and Modigliani assume perfect capital markets Proposition #1: The market value of any firm is independent of its capital structure. Proposition #1: The market value of any firm is independent of its capital structure.

Firm Value: Perfect Capital Markets %25%50%75%100% D/E Value V(Unlevered)

Market Imperfections: Taxes Taxes Taxes –US Tax Code: Deductibility of interest leads to lower cost of debt (Rd(1-t)) –Simple specification overvalues benefit Ignores personal taxes which Ignores personal taxes which –Decreases investors debt return –Increases investors preference for equity  Capital gains: Defer and rate difference  Dividend: Some portion is deductible

Market Imperfections: Contracting Costs In imperfect markets, alternative ways to contract optimal behavior are necessary In imperfect markets, alternative ways to contract optimal behavior are necessary Costs of financial distress Costs of financial distress –Underinvestment (rejecting NPV>0 projects), direct, indirect costs, etc. Benefits of debt Benefits of debt –Monitoring function, manages free cash flow problem (Accepting NPV<0 projects), etc. Contracting costs and taxes are primary motives for static trade off theory debt Contracting costs and taxes are primary motives for static trade off theory debt

Market Imperfections: Information Costs With asymmetric information, leverage may reveal something about the existing firm With asymmetric information, leverage may reveal something about the existing firm Market timing: Managers take advantage of superior information Market timing: Managers take advantage of superior information –Issue equity when it is overvalued –Issue debt when it is undervalued Signaling: Managers use financing to signal future prospects of firms Signaling: Managers use financing to signal future prospects of firms –Issue equity to signal good growth opportunities (preserve financial flexibility) –Issue debt when expected cash flows are strong and stable Motivates Pecking Order Theory Motivates Pecking Order Theory

Can we quantify the value of market imperfections? Debt adds value to the firm due to the interest deductibility (assume taxes only) Assume the simple case:

Firm Value: Perfect Capital Markets %25%50%75%100% D/E Value V(Unlevered) V(Levered)

More Complex Tax Shields Uneven and/or limited time payments Uneven and/or limited time payments –Discount all flows back to time 0 What r do you use? What r do you use? –Certain the tax shield can be used: r D –Uncertain? Higher r

Financial Distress As leverage increases, the probability therefore PV of financial distress increases As leverage increases, the probability therefore PV of financial distress increases How do we estimate the cost of distress? How do we estimate the cost of distress? –Prob(Distress)*Cost of Distress Probability can be estimated in several ways Probability can be estimated in several ways –Logit/Probit regressions –Debt ratings

Firm Value: with Taxes and Fiancial Distress D/E V(Unlevered) V(Levered) V(Distress)

Financial Distress: Bankruptcy Costs Direct Costs Direct Costs –Legal, accounting and other professional fees –Re-organization losses –Estimated btw 4-10% of firm value (t-3) Indirect Costs Indirect Costs –Reputation costs –Market share –Operating losses –Estimated as 7.8% of firm value (t-2)

Financial Distress: Agency Costs Risk shifting and asset substitution Risk shifting and asset substitution –Shareholders invest in high risk projects and shift risk to the debt holders –Shareholders issue more debt, diminishing old debt holders protection Underinvestment Underinvestment Expropriating funds Expropriating funds Difficult to estimate Difficult to estimate

Other Advantages of Debt Agency cost of Equity (motive) Agency cost of Equity (motive) –Shirking is less likely when issuing debt –Perquisites are less likely with debt –Over-investment is less likely with debt Agency cost of Free Cash Flow (opportunity) Agency cost of Free Cash Flow (opportunity) –Retained earnings versus dividends? –Growth and investment opportunities Debt serves as a monitoring device, decreasing managerial discretion Debt serves as a monitoring device, decreasing managerial discretion Bankruptcy as a strategic move??? Bankruptcy as a strategic move???

Formal Models of Capital Structure Pecking Order Pecking Order –Firms prefer to raise capital Internally generated funds Internally generated funds Debt Debt Equity Equity –Implies capital structure is derived from Financing needs and capital availability Financing needs and capital availability Dynamic rather than static Dynamic rather than static Asymmetric information and signaling Asymmetric information and signaling Static Trade Off Static Trade Off

Static trade-off theory of debt Maximum Firm Value Debt Optimal amount of Debt Actual Firm Value

Implications of Static Trade Off Static rather than dynamic Taxes and Contracting Cost drive value Readjustment may be sticky –O–O–O–Optimal trade off between cost of issuances and benefit of capital structure Insights –L–L–L–Large, stable profit firms will have more debt –H–H–H–Higher the costs of distress lower debt –L–L–L–Lower taxes, lower debt –L–L–L–Less (more) favorable tax treatment of debt (equity), lower debt

Evidence: Taxes This method usually overestimates the tax consequence –M–M–M–Magnitude of leverage differences across countries and tax regimes is not that big –E–E–E–Equity taxes (personal taxes) are overestimated (Miller) Timing of capital gains Higher effective marginal tax rate, higher the leverage (Graham, 2001)

Evidence Contracting Costs: Consistent evidence Contracting Costs: Consistent evidence –Higher (lower) the growth opportunities, higher (lower) the potential underinvestment problem, lower (higher) the leverage –Higher growth opportunities would prefer Shorter maturity debt (or call provisions) Shorter maturity debt (or call provisions) Less restrictive covenants Less restrictive covenants More convertibility provisions More convertibility provisions More concentrated investors (private) More concentrated investors (private) Information costs Information costs –Consistent with market timing (SEO’s lead to -3% return) –Inconsistent with signaling and pecking order Taxes: Higher effective marginal tax rate, higher the leverage Taxes: Higher effective marginal tax rate, higher the leverage

MM: Proposition II How does leverage affect rE Start with the WACC Solve for rE The rate of return on the equity of a firm increases in proportion to the debt to equity ratio (D/E).

MM: Proposition II (with taxes)

Blue Inc. has no debt and is expected to generate $4 million in EBIT in perpetuity. Tc=30%. All after-tax earnings are paid as dividends.The firm is considering a restructuring, with a perpetual fixed $10 million in floating rate debt at an expected interest rate of 8%. The unlevered cost of equity is 18%. Blue Inc. has no debt and is expected to generate $4 million in EBIT in perpetuity. Tc=30%. All after-tax earnings are paid as dividends.The firm is considering a restructuring, with a perpetual fixed $10 million in floating rate debt at an expected interest rate of 8%. The unlevered cost of equity is 18%. What is the current value of Blue? What is the current value of Blue? What will the new value be after the restructuring? What will the new value be after the restructuring? What will the new required return on equity be? What will the new required return on equity be? What if we use the new WACC? What if we use the new WACC?

What About Financial Flexibility? The ability to quickly change the level and type of financing Value increasing if –G–G–G–Growth opportunities exist –C–C–C–Company is willing to exercise and extinguish future flexibility –N–N–N–New investments are unpredictable and large –P–P–P–Precautionary debt ratings cushion is valuable Value destroying if the opposite is true

How do we value financial flexibility?

What do we do? Choosing a target capital structure –M–M–M–Minimize taxes and contracting costs (while paying attention to information costs) –T–T–T–Target ratio should reflect the company’s Expected investment requirements Level and stability of cash flows Tax status Expected cost of financial distress Value of financial flexibility Dynamic management –F–F–F–Financing is typically a lumpy process –F–F–F–Find optimal point where cost of adjusting capital structure is equal to cost of deviating from target