© 2004 by Nelson, a division of Thomson Canada Limited Contemporary Financial Management Chapter 12: Capital Structure Concepts

© 2004 by Nelson, a division of Thomson Canada Limited 2 Introduction  This chapter examines the basic concepts related to a firm’s optimal capital structure.

© 2004 by Nelson, a division of Thomson Canada Limited 3 Capital Structure Theory  Studies the relationship between: Capital structure The mix of debt & equity securities on the right hand side of the Balance Sheet Cost of capital The return demanded by investors Impacts on the value of the firm

© 2004 by Nelson, a division of Thomson Canada Limited 4 Capital vs. Financial Structure  Capital Structure Amount of permanent short-term debt, long- term debt, preferred shares and common equity used to finance the firm.  Financial Structure Amount of current liabilities, long-term debt, preferred shares and common equity used to finance a firm.

© 2004 by Nelson, a division of Thomson Canada Limited 5 Capital Structure Terminology  Optimal capital structure Minimizes a firm’s weighted average cost of capital (WACC) Maximizes the value of the firm  Target capital structure Capital structure the firm plans to maintain  Debt capacity Amount of debt in the firm’s optimal capital structure

© 2004 by Nelson, a division of Thomson Canada Limited 6 Capital Structure Assumptions  Firm’s investment policy is held constant  Capital structure changes the distribution of the firm’s EBIT among the firm’s claimants Debt holders Preferred shareholders Common shareholders  Fixed investment policy leaves the debt capacity of the firm unchanged

© 2004 by Nelson, a division of Thomson Canada Limited 7 Factors Affecting Capital Structure  Business risk of the firm  Tax structure  Bankruptcy potential  Agency costs  Signaling effects

© 2004 by Nelson, a division of Thomson Canada Limited 8 Factors Affecting Business Risk  Variability of sales volume  Variability of selling price  Variability of input costs  Degree of market power  Extent of product diversification  Firm’s growth rate  Degree of operating leverage (DOL)  Both systematic and unsystematic risk

© 2004 by Nelson, a division of Thomson Canada Limited 9 Financial Risk  The variability of earnings per share (EPS)  Financial risk affects the probability of bankruptcy  Indicators of financial risk Debt to assets ratio Debt to equity ratio Fixed charge coverage ratio Times interest earned ratio Degree of Financial Leverage Probability distribution of profits EBIT-EPS analysis

© 2004 by Nelson, a division of Thomson Canada Limited 10 Three Capital Structure Models Capital Structure With No Taxes Optimal Capital Structure With Taxes Optimal Capital Structure With Taxes, Financial Distress Costs & Agency Costs

© 2004 by Nelson, a division of Thomson Canada Limited 11 Capital Structure is Irrelevant  Modigliani & Miller (MM) were the pioneers in developing the theory of capital structure  MM began by assuming perfect capital markets, including: No taxes No bankruptcy (B) costs No agency (A) costs  MM also recognized that debt will always cost less than equity because: Interest is tax deductible Debt securities are less risky than equity securities

© 2004 by Nelson, a division of Thomson Canada Limited 12 MM’s Two Propositions  Proposition #1: The market value of the firm is independent of capital structure. Therefore, capital structure is irrelevant.  Proposition #2: The cost of capital remains constant as capital structure changes. As the quantity of debt rises, the return demanded by the shareholder increases linearly, exactly offsetting the benefit due to the lower cost of debt.

© 2004 by Nelson, a division of Thomson Canada Limited 13 Cost of Capital (%) kdkd kaka keke Modigliani & Miller on Capital Structure If leverage increases, the cost of equity, k e, increases to exactly offset the benefits of more debt, leaving the cost of capital, k a, constant. Financial Leverage (Debt-to-equity ratio)

© 2004 by Nelson, a division of Thomson Canada Limited 14 MM Arbitrage Proof  Market value of the firm: Market value of equity + Market value of debt  Value of firm with no debt:  Value of firm with debt:

© 2004 by Nelson, a division of Thomson Canada Limited 15 Example: Value of an Unlevered Firm  A firm with no debt pays out $1 Million in dividends. If shareholders require a 20% return, what is the market value of the firm?

© 2004 by Nelson, a division of Thomson Canada Limited 16 Example: Value of a Levered Firm  The same firm now acquires debt at 10%, on which it pays interest of $250,000. Since this is world with no taxes, the firm has $750,000 which it pays in dividends. Since the firm is now more risky, shareholders require a 30% return. What is the market value of the firm?

© 2004 by Nelson, a division of Thomson Canada Limited 17 Why?  Dividends paid to shareholders of the levered firm are reduced by the amount of interest paid on the debt.  k e is higher for the levered firm because of the additional leverage-induced risk.  The values of the levered and the unlevered firm are identical due to arbitrage.  Thus MM’s Proposition #1: the value of the firm is independent of capital structure (in a world with no taxes)

© 2004 by Nelson, a division of Thomson Canada Limited 18 What Happens with Taxes ?  The firm’s operating income is now reduced by the amount of taxes paid  Since dividends to shareholders are paid out of after-tax income, the value of the unlevered firm should drop  But interest is a tax-deductible expense, creating a valuable tax-shield  The result - the value of the levered firm should be higher than the value of the unlevered firm

© 2004 by Nelson, a division of Thomson Canada Limited 19 The Tax Shield due to Interest  A tax shield is the amount of tax the firm would have paid, had it not incurred the interest expense.  The annual tax shield is equal to:  The PV of the tax shield is equal to: I = interest rate D = Face value of debt T = Tax rate

© 2004 by Nelson, a division of Thomson Canada Limited 20 Example: The Impact of Tax Firm UFirm L EBIT$1,000 Less Interest0 100 Income before Tax1, Less 40% Income (for Dividends) Interest + Dividends Return on debt-5% Market value of debt-2,000 Return on equity10%11.25% Market value of equity$6,000$4,800 Market value of firm$6,000$6,800

© 2004 by Nelson, a division of Thomson Canada Limited 21 Market Value of the Unlevered Firm  Market value of the firm: Market value of equity + Market value of debt

© 2004 by Nelson, a division of Thomson Canada Limited 22 Market Value of the Levered Firm  Market value of the firm: Market value of equity + Market value of debt

© 2004 by Nelson, a division of Thomson Canada Limited 23 Why the Difference?  The difference in value between the levered and the unlevered firm in a world including taxes is due to the value of the tax shield  Therefore: Market value (MV) of levered firm = MV of unlevered firm + PV of the tax shield

© 2004 by Nelson, a division of Thomson Canada Limited 24 V L = V U + Present Value of Tax Shield Mkt Value of Firm Debt $ VUVU VLVL PV of Tax Shield

© 2004 by Nelson, a division of Thomson Canada Limited 25 Capital Structure k i = k d (1 – T) kaka keke Cost of Capital (%) The cost of capital decreases with the amount of debt. The firm maximizes its value by choosing a capital structure that is all debt. Financial Leverage (Debt-to-equity)

© 2004 by Nelson, a division of Thomson Canada Limited 26 The Problem?  If the value of the firm increases linearly with debt, the logical conclusion would be that all firms should be financed with 100% debt!  This conclusion defies logic and is counter to customary practice  What are we missing?

© 2004 by Nelson, a division of Thomson Canada Limited 27 Financial Distress (Bankruptcy) Costs  Financial distress costs include: Costs incurred to avoid bankruptcy Pay higher interest rates due to greater risk Direct & indirect costs incurred if the firm files for bankruptcy Direct costs – costs paid by debtors in the bankruptcy & restructuring process Indirect costs – costs due to loss of customers, suppliers, employees plus the cost of management’s time

© 2004 by Nelson, a division of Thomson Canada Limited 28 Bankruptcy Costs  Lenders may demand higher interest rates  Lenders may decline to lend at all  Customers may shift their business to other firms  Distress incurs extra accounting and legal costs  If forced to liquidate, assets may have to be sold for less than market value

© 2004 by Nelson, a division of Thomson Canada Limited 29 Agency Costs  The firm’s debt & equity holders (the principals) are usually not the firm’s managers  The principals employ agents (firm management) to manage the firm on their behalf  Conflicts often develop between the interests of the principals and the interests of the agents

© 2004 by Nelson, a division of Thomson Canada Limited 30 Agency Costs & Shareholders  Shareholders have an incentive to undertake risky projects financed with debt If the project succeeds, the shareholders win If the project fails, the bondholders suffer the loss  Therefore, bondholders will Charge higher interest rates, or Implement protective covenants to protect themselves

© 2004 by Nelson, a division of Thomson Canada Limited 31 Agency Costs & Shareholders  Investing in high risk/high return projects can shift wealth from bondholders to shareholders  Shareholders may forgo some profitable investments in debt is required  Shareholders may issue high quantities of new debt, diminishing the protection afforded to earlier bondholders  Bondholders will shift monitoring and bonding costs back to the shareholders by charging higher interest rates & imposing covenants

© 2004 by Nelson, a division of Thomson Canada Limited 32 Taxes, Bankruptcy and Agency Costs  Bankrupcty and agency costs increase with the amount of leverage  At some point, these offset the positive benefits from the value of the tax shield Market value of unlevered firm + PV of tax shield – PV of bankruptcy costs – PV of agency costs Market value of leverage firm

© 2004 by Nelson, a division of Thomson Canada Limited 33 Optimal Debt Ratio Debt Ratio VUVU PV of Tax Shield Mkt value of leveraged firm PV B&A Costs VLVL Optimal Debt Ratio Market Value of the Firm

© 2004 by Nelson, a division of Thomson Canada Limited 34 Least Cost Capital Structure Cost of Capital D D + E kiki keke kaka Optimal Capital Structure

© 2004 by Nelson, a division of Thomson Canada Limited 35 Other Considerations  Personal tax costs (interest is fully taxable) Could offset some corporate tax advantages No optimal capital structure when both corporate & personal taxes are considered  Industry effects Firms with stable cash flows tend to have higher debt ratios More profitable firms tend to have lower debt ratios Market appears to reward firms with capital structures appropriate to their industry

© 2004 by Nelson, a division of Thomson Canada Limited 36 Other Considerations  Signaling effects (Asymmetric Information) Firm management have access to confidential information Management decisions may be a signal to the market  Managerial preferences (Pecking order theory) Firms prefer internal to external financing New issues incur flotation costs External financing incurs more monitoring by the market

© 2004 by Nelson, a division of Thomson Canada Limited 37 Pecking Order Theory  Firms have a definite preference in the order in which they finance new projects Internal Equity Debt External Equity Most Preferred Least Preferred

© 2004 by Nelson, a division of Thomson Canada Limited 38 Major Points  Choosing an appropriate capital structure is an important management decision  In a world with no taxes, the value of the unlevered firm equals the value of the levered firm  In a world with taxes, interest creates a valuable tax shield.  The value of the levered firm equals the value of the unlevered plus the PV of the tax shield

© 2004 by Nelson, a division of Thomson Canada Limited 39 Major Points  Financial distress & agency costs increase as debt rises, eventually offsetting the marginal value of the interest tax shield  Optimal capital structures appear to be influenced by Variability of cash flows Nature of the industry