1. Leverage and Capital Structure Dr. C. Bulent Aybar Professor of International Finance

2. © Dr. C. Bulent Aybar Leverage Leverage is the use of fixed-cost assets or funds to magnify the returns to owners. Leverage is closely related to the risk of being unable to meet operating and financial obligations when due. –Operating leverage refers to the sensitivity of earnings before interest and taxes to changes in sales revenue. –Financial leverage refers to the sensitivity of earnings available to common shareholders to changes in earnings before interest and taxes. –Total leverage refers to the overall sensitivity of earnings available to common shareholders to changes in sales revenue.

3. © Dr. C. Bulent Aybar Variable Definitions Q= quantity of units P= sales price per unit VC= variable costs per unit FC= fixed costs per period EBIT =Earnings Before Interest and Taxes EPS =Earnings per share

4. © Dr. C. Bulent Aybar Degree of Operating Leverage Degree of Operating Leverage measures the sensitivity of EBIT to the changes in sales volume. DOL=(% Change in EBIT)/(%Change in Sales) We can measure DOL at a base sales level of volume (Q )by measuring the impact of a change in volume (ΔQ) on the EBIT and Sales. –EBIT= (P-VC)xQ-FC  Operating Profit at a given volume Q –Change in EBIT=Δ EBIT= (P-VC)x Δ Q  –% Δ EBIT= [(P-VC)x Δ Q] / [(P-VC) x Q-FC] –Change in Sales Revenues=Δ Sales Revenues=PxΔQ –% Change in Sales= (P x ΔQ)/(P x Q) –DOL={[(P-VC)x Δ Q]/ [(P-VC) x Q-FC]}/{PxΔQ/P x Q} –DOL=[Q x (P-VC)]/[Q x (P-VC)-FC]

5. © Dr. C. Bulent Aybar Operating Breakeven Level The firm’s operating breakeven point is the level of sales at which all fixed and variable operating costs are covered; i.e., EBIT equals zero. An increase in FCs and VCs will increase the operating breakeven point and vice versa. An increase in the selling price per unit will decrease the operating breakeven point and vice versa. Q BE =FC/(P-VC) or PQ BE =FC/[1-(VC/P)]

6. © Dr. C. Bulent Aybar Financial Leverage Financial Leverage is the sensitivity of EPS to changes in EBIT. The leverage stems from fixed financial costs and DFL captures the impact of fixed financial costs on the EPS. We can define degree of financial leverage: Operationally we can calculate DFL as follows : In this equation PD/(1-T) is equal to pre-tax preferred dividends

7. © Dr. C. Bulent Aybar Total Leverage The total leverage of the firm measures the combined effect of fixed operating and financial costs. It can be summarized as the sensitivity of EPS to changes in the sales. TL= DOL x DFL=(∆EPS/EPS)/∆Sales/Sales) Increases in both types of leverage will increase total risk and vice versa. Since the impact of operating and financial leverage is multiplicative, the increases or decreases in each type of leverage is significant on the EPS.

8. © Dr. C. Bulent Aybar Example Firm R has sales of 100,000 units at P=$2/unit, VC=$1.7/unit, FC of $6,000. Interest is 10,000 per year. Firm W has sales of 100,000 units at P=$2.5/unit, VC=$1/unit, FC of $62,500. Interest is 17,500 per year. Both firms are in 40% tax bracket. Compare the relative risks of these two firms. Comment on their degree of leverage.

9. Firm-R Firm R has sales of 100,000 units at P=$2/unit, VC=$1.7/unit, FC of $6,000. Interest is 10,000 per year.

10. Firm W Firm W has sales of 100,000 units at P=$2.5/unit, VC=$1/unit, FC of $62,500. Interest is 17,500 per year.

11. © Dr. C. Bulent Aybar Risk and the Underlying Factors Firm R has less operating (business) risk but more financial risk than Firm W. Firm R has an operating breakeven point of 20,000 units (or $40,000 of sales revenues). On the other hand firm W breaks even at 62,500 units (or at $125,000 of sales revenues) While Firm R has an interest coverage ratio of 2.4, firm W has interest coverage ratio of 5. As DOL and DFL suggests, these two firms have different characteristics, yet they have same level of total leverage. In other words, for different reasons, EPS for each of these firms show sensitivity to changes in the sales levels.

12. © Dr. C. Bulent Aybar Evaluating Tampa Manufacturing Capital Structure:EPS Approach Tampa Manufacturing, an established producer of printing equipment, expects its sales to remain flat for the next 3 to 5 years because of both a weak economic outlook and an expectation of little new printing technology development over that period. On the basis of this scenario, the firm’s board has instructed its management to institute programs that will allow it to operate more efficiently, earn higher profits, and, most important, maximize share value. In this regard, the firms chief financial officer ( CFO), Jon Lawson, has been charged with evaluating the firms capital structure. Lawson believes that the current capital structure, which contains 10% debt and 90% equity, may lack adequate financial leverage. To evaluate the firms capital structure, Lawson has gathered the data. Lawson expects the firms earnings before interest and taxes ( EBIT) to remain at its current level of $ 1,200,000. The firm has a 40% tax rate.

13. Data Source of Capital Current 10% Debt Alternative A 30% Debt Alternative B 50% Debt Debt$1,000,000$3,000,000$5,000,000 Coupon rate 0.09 0.10 0.12 Common Stock100,00070,00040,000 Required Return12%13%18%

14. © Dr. C. Bulent Aybar Assignment –Use the current level of EBIT to calculate the times interest earned ratio for each capital structure. Evaluate the current and two alternative capital structures using the times interest earned and debt ratios. –Prepare a single EBIT- EPS graph showing the current and two alternative capital structures. –On the basis of the graph in part b, which capital structure will maximize Tampa’s earnings per share ( EPS) at its expected level of EBIT of $1,200,000? Why might this not be the best capital structure? –Using the zero- growth valuation model, find the market value of Tampa’s equity under each of the three capital structures at the $ 1,200,000 level of expected EBIT. –On the basis of your findings in parts c and d, which capital structure would you recommend? Why?

15. Times Interest Earned Ratio Current 10% Debt Alternative A 30% Debt Alternative B 50% Debt Debt$1,000,000$3,000,000$5,000,000 Coupon rate 0.09 0.10 0.12 Interest$ 90,000$ 300,000$ 600,000 EBIT$1,200,000 Interest$ 90,000$ 300,000$ 600,000 Times interest earned  13.3342 As the debt ratio increases from 10% to 50%, so do both financial leverage and risk. At 10% debt and $1,200,000 EBIT, the firm has over 13 times coverage of interest payments; at 30%, it still has 4 times coverage. At 50% debt, the highest financial leverage, coverage drops to 2 times, which may not provide enough cushion. Both the times interest earned and debt ratios should be compared to those of the printing equipment industry.

16. © Dr. C. Bulent Aybar Let’s consider the impact of $1,000,000; $3,000,000 and $5,000,000 debt levels on EPS under two scenarios of EBIT: $600,000 and 1,200,000

17. EPS Table If Tampa Manufacturing’s EBIT is $1,200,000, EPS is highest with the 50% debt ratio. The steeper slope of the lines representing higher debt levels demonstrates that financial leverage increases as the debt ratio increases. Although EPS is highest at 50%, the company must also take into consideration the financial risk of each alternative. The drawback to the EBIT- EPS approach is its emphasis on maximizing EPS rather than owner’s wealth. It does not take risk into account. Also, if EBIT falls below about $750,000 (intersection of 10% and 30% debt), EPS is higher with a capital structure of 10%.

18. Comparison of Capital Structures Market value: P 0  EPS  r s Current:$6.66  0.12  $55.50 Alternative A — 30%:$7.71  0.13  $59.31 Alternative B — 50%:$9.00  0.18  $50.00

19. © Dr. C. Bulent Aybar ABC Inc. ABC Inc is a manufacturing company with operating income of $1,485m. The company’s depreciation expense and annual capital expenditures are both $500m. There is no additional working capital requirement in the foreseeable future. Company’s corporate tax rate is 34%. Also assume that company has 1,000,000 outstanding shares. We will consider three alternative funding schemes for the company without altering its operating assets: –Pure equity financing –$2,500,000 debt financing –$5,000,000 debt financing In the next several slides, we will examine the implications of different capital structure schemes.

20. ABC Inc. Capital Structure Change 0% Debt/$2.5m Debt/$5mDebt/ Book Value of Debt - 2,500 5,000 Book Value of Equity 10,000 7,500 5,000 Market Value of Debt - 2,500 5,000 Market Value of Equity 8,350 6,700 Pretax Cost of Debt5.00% After-Tax Cost of Debt3.30% Market Value Weights of?? Debt0%?? Equity100%?? unlevered Beta 0.80?? Risk-Free Rate5.0% EMRP6.0% Cost of Equity??? Weighted-Average Cost of Capital??? EBIT 1,485 Taxes (@ 34%)??? EBIAT??? + Depreciation 500 - Capital exp. (500) + Change in net working capital - - - Free Cash Flow??? Value of Assets (FCF/WACC)???

21. © Dr. C. Bulent Aybar Value of Assets-Pure Equity Financing In the 100% equity case everything looks clear. Cost of equity can be calculated based on CAPM: R s =0.05 + 0.8 x 0.06 =9.8%; since there is no debt, WACC should be equal to cost of equity. Free Cash Flows are: FCF=EBIT x (1-T)+Depr-CapEx-NWCI FCF+1485 x (1-0.34)+500-500-0 =981.10 Value of Operating Assets V=FCF/WACC=980.10/0.098=10,000 EBIT $ 1,485.00 Taxes (@ 34%) $ (504.90) EBIAT $ 980.10 + Depreciation $ 500.00 -Capital exp. $ (500.00) + Change in net working capital $ - Free Cash Flow $ 980.10

22. © Dr. C. Bulent Aybar 2.5 million Debt In the case of $2.5m debt financing some changes occur. Intuition tells us that undertaking debt increases risk of equity holders; therefore they should demand higher rate of return! In other words cost of equity should increase. From our cost of capital analysis we know that firm beta increases with leverage. In other words levered beta (or equity) beta will be higher than unlevered beta. β L = β U x [1+(1-T)x(D/E)] R s =R f + {β U x [1+(1-T)x(D/E)]} x EMRP R s =R f +β U x EMRP+{ β U x [(1-T)x(D/E)] x EMRP} R s =Cost of Equity of Unlevered Firm + Financial Risk Premium

23. © Dr. C. Bulent Aybar Note that the financial risk premium will depend on D/E ratio calculated at the market values. Debt issuance will increase the D/E ratio. In this particular case D/E ratio increases to 29.94% and the cost of equity goes up from 9.8% to 10.74%. Levered Beta=Unlevered Beta x [1+(1-T)x(D/E)] β L =0.8 x [1+(1-0.34)x(0.2994)]=0.9581 R s =0.05 + (0.9581 x 0.06) =0.107485 At this cost of equity and pre-tax cost of debt of 5% Weighted Average Cost of Capital is: –WACC=(0.2304)x(0.033)+(0.7696)x(0.107485) =0.0903226 Free cash flows to the firm should not change! 2.5 million Debt

24. © Dr. C. Bulent Aybar D/E Convergence Note that actual Debt/Equity ratio has to be calculated iteratively. For instance when I start with the assumption of D/E=0.25, I get the cost of equity of 10.59% which then leads to MVE of 8,474.3 (897.6/0.1059). At this MVE, D/E ratio is 2,500/8474.3=29.50%. This is inconsistent with the initial assumption of 25%. If we start with the assumption of D/E=27%, we get expost D/E of 29.68%; still not consistent with initial assumption of 27%. Finally in the third iteration, D/E assumption of 29.93% produces an ex- post D/E of 29.94% which is consistent with the initial estimate. Therefore, the correct D/E ratio is 29.94, and equity beta as well as risk premium was calculated based on this D/E ratio in the previous slide. Next slide shows the excel sheet that I used for convergence.

25. D/E Convergence Trial-1Trial-2Trial-3Trial-1Trial-2 Debt$2,5002500 5000 MRP0.06 Risk Free Rate0.05 Unlevered Beta0.80 Tax0.34 D/E (Ex-ante)0.250.270.29930.650.75 Levered (Equity) Beta0.930.940.961.141.19 Cost of Equity (No Leverage)0.098 Cost of Equity (with Leverage)10.59%10.66%10.75%11.86%12.16% Firm Value (No Leverage)10001.02 Cash Flow to Equity897.6 815.1 Market value of Equity8474.38423.98351.26873.1456701.291 Market value of Debt2500 5000 Firm Value (with Leverage)10974.3210923.9310851.1811873.1411701.29 D/E (Ex-Post)0.29500.29680.29940.7274690.746125

26. © Dr. C. Bulent Aybar Firm Value Increases The free cash flows to the firm is the unchanged since there is no change in operating assets of the firm. However, the value of operating assets at the new WACC turns out to be 980.10/0.90326=$10,851.11 This suggest that the firm value has increased by $851,110 Note that interest tax shield have been accounted for in the discount factor, but not in the cash flows to the firm. We do this not to double count the impact of interest tax shield. EBIT $ 1,485.00 Taxes (@ 34%) $ (504.90) EBIAT $ 980.10 + Depreciation $ 500.00 -Capital exp. $ (500.00) + Change in net working capital $ - Free Cash Flow $ 980.10

27. © Dr. C. Bulent Aybar Recap: Introduction of debt and firm value Introduction of some debt to firm’s capital structure reduced the WACC from 9.8% to 9.03%. Since firm’s operating assets and their cash generating capacity did not change, capital providers to firm still received $980.10 free cash flow. Consequently, the firm value has increased from 10,000 to $10,851 Since firm’s equity investors now face higher risk and their share from operating cash flows are effectively reduced, the value of equity in the firm should decline.

28. © Dr. C. Bulent Aybar Value of Equity Cash flows to shareholders can be calculated as follows: Given the residual cash flow of 897.60 and the cost of equity of 10.75%, the value of equity is 897.60/0.107485 =8,350.93 Cash Flow to Shareholders: EBIT $ 1,485.00 Interest 125.00 Pretax Profit 1,360.00 Taxes (@ 34%) (462.40) Net Income 897.60 + Depreciation 500.00 - Capital exp. (500.00) + Change in net working capital - Debt Amortiz. - Residual Cash Flow 897.60

29. © Dr. C. Bulent Aybar Value of Debt At the 5% cost of debt, $2,500 of debt will require $125 interest payments. Assuming that this level of debt is carried to perpetuity, the value of debt can be captured as V D =125/0.05 =2,500 Note that we made an implicit assumption here and assumed that investors in company’s debt require 5% return.

30. Leverage and Firm Value 0% Debt/25% Debt/50% Debt/ 100% Equity75% Equity50% Equity Book Value of Debt $ - $ 2,500.00 $ 5,000.00 Book Value of Equity $ 10,000.00 $ 7,500.00 $ 5,000.00 Market Value of Debt $ - $ 2,500.00 $ 5,000.00 Market Value of Equity $ 10,000.00 $ 8,350.00 $ 6,700.00 Pretax Cost of Debt5.00% After-Tax Cost of Debt3.30% Market Value Weights of Debt0.00%23.04%42.74% Equity100.00%76.96%57.26% Unlevered Beta 0.80 Levered Beta 0.80 0.9580838 1.1940299 Risk-Free Rate5.00% Market Premium6.00% Cost of Equity9.80000%10.74850%12.16418% Weighted-Average Cost of Capital9.80000%9.03226%8.37607% EBIT $ 1,485.00 Taxes (@ 34%) $ (504.90) EBIAT $ 980.10 + Depreciation $ 500.00 -Capital exp. $ (500.00) + Change in net working capital $ - Free Cash Flow $ 980.10 Value of Assets (FCF/WACC) $ 10,001.02 $ 10,851.11 $ 11,701.19

31. Levering up and reallocation of value 0% Debt/25% Debt/50% Debt/ 100% Equity75% Equity50% Equity Cash Flow to Creditors: (interest) $ - $ 125.00 $ 250.00 Pretax Cost of Debt5.00% Value of Debt: $ - $ 2,500.00 $ 5,000.00 (Int/K d ) Cash Flow to Shareholders: EBIT $ 1,485.00 Interest - 125.00 250.00 Pretax Profit 1,485.00 1,360.00 1,235.00 Taxes (@ 34%) (504.90) (462.40) (419.90) Net Income 980.10 897.60 815.10 + Depreciation 500.00 - Capital exp. (500.00) + Change in net working capital - - - - Debt Amortiz. - - - Residual Cash Flow 980.10 897.60 815.10 Cost of Equity9.800000%10.748503%12.164179% Value of Equity (RCF/K e ) $ 10,001.02 $ 8,350.93 $ 6,700.82 Value of Equity plus Value of Debt $ 10,001.02 $ 10,850.93 $ 11,700.82

32. © Dr. C. Bulent Aybar The impact of Leverage on Share Price What remains to be seen however, is whether shareholders are better or worse off with more leverage. Ordinarily, total value will be a good proxy for what is happening to the price per share, but in the case of a re-levering firm, that may not be true. Implicitly we assumed that our firm repurchased stock on the open market (as you noticed EBIT did not change, so management was clearly not investing the proceeds from the loans in cash-generating assets). We held EBIT constant so that we could see clearly the effect of financial changes without getting them mixed up in the effects of investments. The point is that, as the firm borrows and repurchases shares, the total value of equity may decline, but the price per share may rise.

33. © Dr. C. Bulent Aybar Substitution of Debt for Equity  What happens to Share Price? Let’s we assume that initial debt issue of $2.5m is used to repurchase shares. To avoid potential lawsuits, ABC Inc. should first announce its recapitalization plans. Then investors would reassess their views concerning the firm's profitability and risk, and estimate a new value for the equity. No current shareholder would be willing to sell at a price below the expected post-capitalization price, so the market price would quickly adjust to a new equilibrium that reflects the recapitalization, even though it has not yet taken place. Finally, ABC Inc. would issue the debt and use the proceeds to repurchase stock at the new equilibrium price. The firm would end up with more debt but fewer common shares.

34. After the Recapitalization Announcement and before the share repurchase Market Value of Debt Cash from Debt Issue Market Value of Operating Assets Market Value of Equity Market Value of Operating Assets=FCF/WACC Market Value of Operating Assets=MVE+MVD-Cash Market Value of Operating Assets =MVE=10,850,930 Share Price=MVE/(# of Outstanding Shares) =10,850,930=$10.851 EV=980,100/0.903=10,850,930 EV=MVE=10,850,903 Share Price=10,850,930/1,000 Share Price=$10.851 1,000,000 shares outstanding

35. After the share repurchase Market Value of Debt Market Value of Operating Assets Market Value of Equity Market Value of Operating Assets=FCF/WACC Market Value of Operating Assets=MVE+MVD 10,850,930 = 8,350,930+2,500,000 Share Price=MVE/(# of Outstanding Shares) EV=980.1/0.903=10,850 EV=MVE=10,850 Share Price=10,850/1,100 Share Price=10.85 Share Repurchase: 2,500,000/10.85=230,217 Outstanding Shares after Repurchase=1,000,000- 230,414=769,585 769,782 shares outstanding

36. Implications DebtD/ECost of EquityRes. CFMVEShareholder Wealth -0.00%9.80% 980.10 10,001 2,50029.94%10.75% 897.60 8,351 10,851 5,00074.63%12.16% 815.10 6,701 11,701

37. © Dr. C. Bulent Aybar Summary of Observations In the presence of tax, share price goes up to reflect the present value of tax savings that goes to shareholders. As the leverage increases, increasing financial distress costs starts to offset the present value of tax savings and share price starts to decline. Following the share repurchase, total value of equity declines and firm’s D/E ratio increases. WACC continues to decline until the point tax savings and financial distress costs offset each other. After the threshold firm value starts to decline.

38. Value of Equity and Debt 0% Debt/25% Debt/50% Debt/ 100% Equity75% Equity50% Equity Cash flow to creditors: Interest - 125 250 Pretax cost of debt5.0% Value of debt: (Int/K d ) Cash flow to shareholders: EBIT 1,485 Interest - 125 250 Pretax profit Taxes (@ 34%) Net income + Depreciation 500 - Capital exp. (500) + Change in net working capital - - - - Debt amortization - - - Residual cash flow Cost of equity Value of equity (RCF/K e ) Value of equity plus value of debt

39. © Dr. C. Bulent Aybar Leverage, Shareholder and Creditor Value Note that in the preceding example, there is no new investment made in the operating assets. In other words, the debt was not used for investment in operating assets. This implies that debt raised was used to repurchase shares. In the example we also divided the value of all the assets between two classes of investors: creditors and shareholders. As the table clearly shows, with increasing leverage shareholders’ claim decline, but the total firm value increases. How is this possible?

40. © Dr. C. Bulent Aybar Where the Value is Coming From? Let's divide the free cash flows of the firm into pure business flows and cash flows resulting from financing effects. A widely known axiom in finance is that you should discount cash flows at a rate consistent with the risk of those cash flows. –Pure business flows should be discounted at the unlevered cost of equity (i.e., the cost of capital for the unlevered firm). –Financing flows should be discounted at the rate of return required by the providers of debt.

41. Pure Business Cash Flows (Unlevered Firm Value) 0% Debt/25% Debt/50% Debt/ 100% Equity75% Equity50% Equity Pure Business Cash Flows: EBIT $ 1,485.00 Taxes (@ 34%) $ 504.90 EBIAT $ 980.10 +Depreciation $ 500.00 -Capital Exp. $ (500.00) +Change in net working capital $ - Free Cash Flow $ 980.10 Unlevered Beta 0.80 Risk-Free Rate5.00% Market Premium6.00% Unlevered WACC9.80% Value of Pure Business Flows: $10,001.02 As the table indicates, with no change in EBIT, value of operating assets remain constant at $10,001.02.

42. Value of Financing Effect Value of Pure Business Cash Flows: $10,001.02 ( FCF/Unlevered WACC) Financing Cash Flows Interest $ - $ 125.00 $ 250.00 Tax Reduction (Interest x Tax Rate) $ - $ 42.50 $ 85.00 Pretax Cost of Debt5.00% Value of Financing Effect: $ - $ 850.00 $ 1,700.00 Total Value (Sum of Values of $10,001.02 $10,851.02 $11,701.02 Since interest payments are tax deductable, leverage creates a tax shield and taxes paid by the firm declines. Present value of the interest tax shield represent the value of financing effect. Assuming that the debt level will be maintained perpetually, Value of Financing Effect=Interest x Tax Rate /Cost of debt.

43. Total Firm Value 0% Debt/25% Debt/50% Debt/ 100% Equity75% Equity50% Equity Pure Business Cash Flows: EBIT $ 1,485.00 Taxes (@ 34%) $ 504.90 EBIAT $ 980.10 +Depreciation $ 500.00 -Capital Exp. $ (500.00) +Change in net working capital $ - Free Cash Flow $ 980.10 Unlevered Beta 0.80 Risk-Free Rate5.00% Market Premium6.00% Unlevered WACC9.80% Value of Pure Business Flows: $10,001.02 (FCF/Unlevered WACC) Financing Cash Flows Interest $ - $ 125.00 $ 250.00 Tax Reduction $ - $ 42.50 $ 85.00 Pretax Cost of Debt5.00% Value of Financing Effect: $ - $ 850.00 $ 1,700.00 Total Value (Sum of Values of $10,001.02 $10,851.02 $11,701.02

44. © Dr. C. Bulent Aybar Modigliani-Miller Proposition-I with Taxes Cash flows of the levered firm are equal to the sum of the cash flows from the unlevered firm plus the interest tax shield. By the Valuation Principle the same must be true for the present values of these cash flows. The total value of the levered firm exceeds the value of the firm without leverage due to the present value of the tax savings from debt: V L = V U + PV(Interest Tax Shield)

45. © Dr. C. Bulent Aybar MM Proposition II: Cost of Levered Equity MM Proposition II: The Cost of Capital of Levered Equity Note: This may can be derived by solving the equation that gives the expected return of the firm's assets: r u = cost of unlevered equity or expected return on operating assets r E = cost of equity or expected return on levered equity

46. © Dr. C. Bulent Aybar Optimal Capital Structure: The Tradeoff Theory Tradeoff Theory: the total value of a levered firm equals the value of the firm without leverage plus the present value of the tax savings from debt, less the present value of financial distress costs:

47. © Dr. C. Bulent Aybar Optimal Leverage with Taxes and Financial Distress Costs

48. © Dr. C. Bulent Aybar The Costs of Bankruptcy and Financial Distress Direct Costs of Bankruptcy –The average direct costs of bankruptcy are approximately 3% to 4% of the pre-bankruptcy market value of total assets. The costs are likely to be higher for firms with more complicated business operations and for firms with larger numbers of creditors. Indirect Costs of Financial Distress –Indirect bankruptcy costs often occur because the firm may renege on both implicit and explicit commitments and contracts when in financial distress. –Estimated potential loss due to financial distress of 10% to 20% of firm value. –Many of these indirect costs may be incurred even if the firm is not yet in financial distress, but simply faces a significant possibility that it may occur in the future.

49. © Dr. C. Bulent Aybar The Costs of Bankruptcy and Financial Distress –Loss of customers: Because bankruptcy may enable firms to walk away from future commitments to their customers, customers may be unwilling to purchase products whose value depends on future support or service from the firm. –Loss of suppliers: Suppliers may be unwilling to provide a firm with inventory if they fear they will not be paid –Cost to employees: One important cost that often receives a great deal of press coverage is the cost of financial distress to employees. Most firms offer their employees explicit long- term employment contracts, or an implicit promise regarding job security. During bankruptcy these contracts and commitments are often ignored and significant numbers of employees can be laid off –Fire Sales of Assets: Companies in distress may be forced to sell assets quickly to raise cash, possibly accepting a lower price than the assets are actually worth to the firm.

50. © Dr. C. Bulent Aybar The probability of financial distress –This probability increases with the amount of a firm’s liabilities (relative to its assets). –It increases with the volatility of a firm’s cash flows and asset values. Firms with steady cash flows, such as utility companies, are able to use high levels of debt and still have a very low probability of default. Firms whose value and cash flows are volatile (like semiconductor firms) must have lower levels of debt to avoid a risk of default.

51. © Dr. C. Bulent Aybar Cost of Financial Distress The magnitude of the direct and indirect costs related to financial distress that the firm will incur. –These will depend on the relative importance of the sources of these costs and is likely to vary by industry. –For example, technology firms are likely to incur high costs associated with financial distress, due to the potential for loss of customers and key personnel, as well as a lack of tangible assets that can be easily liquidated. –In contrast, real estate firms are likely to have low costs of financial distress, as much of their value derives from tangible assets (land and buildings) that can be sold if necessary.

52. © Dr. C. Bulent Aybar The Tradeoff Theory Resolves Two Issues: The presence of financial distress costs can explain why firms choose debt levels that are too low to fully exploit the interest tax shield. Differences in the magnitude of financial distress costs and the volatility of cash flows can explain the differences in the use of leverage across industries.

53. Debt Ratios for Selected US Industries Source: Compustat North America

54. © Dr. C. Bulent Aybar Are there factors other than “tax shield” that encourage use of debt? Debt is a device that helps reduce the agency costs arising from the separation of ownership from control Debt is a device that allows current owners to retain control Debt is a device that helps resolve the problem of information asymmetry between managers and outside investors

55. © Dr. C. Bulent Aybar Factors other than financial distress costs that may discourage borrowing Excessive debt may prevent firms from taking full advantage of the interest tax shield Excessive debt may create costly conflicts of interest between shareholders and debt holders Excessive debt may constrain the firm's ability to pay stable dividends Excessive debt may reduce the firm's financial flexibility Excessive debt affect firm’s credit rating

56. © Dr. C. Bulent Aybar Leverage and Principle Agent Conflict Agency costs are the costs that arise when there are conflicts of interest between stakeholders. Managerial Entrenchment: managers often own shares of the firm, but in most large corporations they own only a very small fraction of the outstanding shares. This separation of ownership and control creates the possibility of management entrenchment; with little threat of being fired and replaced, managers are free to run the firm in their own best interests. They may make decisions that: –benefit themselves at investors’ expense, –reduce their effort, –spend excessively on perks such as corporate jets, –or undertake wasteful projects that increase the size of the firm (and their paychecks) at the expense of shareholder value, often called “empire building.”

57. © Dr. C. Bulent Aybar Debt may reduce Agency Costs-So debt may be good for Shareholders If these decisions have negative NPV for the firm, they are a form of agency cost. Debt can help provide incentives for managers to run the firm efficiently and effectively. The two main ways are: –By borrowing rather than raising funds by issuing shares, ownership of the firm may remain more concentrated, improving monitoring of management. –Forcing the firm to pay out cash to meet interest and principal payments, debt reduces the funds available at management’s discretion. For managers to engage in wasteful investment, they must have the cash to invest. Only when cash is tight, managers are more likely to be motivated to run the firm efficiently.

58. © Dr. C. Bulent Aybar Agency Cost of Debt: Equity-Debt Holder Conflicts When there is leverage, a conflict of interest exists if investment decisions have different consequences for the value of equity and the value of debt. Such a conflict is most likely to occur when the risk of financial distress is high. In some circumstances, managers may take actions that benefit shareholders but harm the firm’s creditors and lower the total value of the firm. This means that when firms are highly levered up, they face very high cost of debt, enough to compensate the creditor’s agency costs.

59. © Dr. C. Bulent Aybar Debt as a Solution to Overinvestment Problem if too much debt can lead to underinvestment (and more demanding stakeholders), too little can lead to overinvestment. As it was argued by Michael Jensen, large, mature public companies generate substantial “free cash flow”—that is, operating cash flow that cannot be reinvested profitably within the firm. The natural inclination of corporate managers is to use excess cash to sustain growth at the expense of profitability, either by overinvesting in their core businesses or, diversifying through acquisition into unfamiliar ones. Substituting debt for equity (for example, in the form of leveraged stock repurchases) may provide an effective solution to overinvestment—one in which contractually obligated payments of interest and principal perform the role of dividend payments in squeezing out excess capital.

60. © Dr. C. Bulent Aybar Underinvestment Problem Although the direct expenses associated with the bankruptcy process appear small in relation to market values, the indirect costs can be substantial. For many companies, the most important indirect cost is the loss in value that results from cutbacks in promising investment when the firm gets into financial trouble. When a company files for bankruptcy, the bankruptcy judge effectively assumes control of corporate investment policy—and it’s not hard to imagine circumstances in which judges fail to maximize value. But even in conditions less extreme than bankruptcy, highly leveraged companies are more likely than their low-debt counterparts to pass up valuable investment opportunities, especially when faced with the prospect of default. In such cases, corporate managers are likely not only to postpone major capital projects, but to make cutbacks in R&D, maintenance, advertising, travel, or training that end up reducing future profits.

61. © Dr. C. Bulent Aybar Optimal Leverage with Taxes, Financial Distress, and Agency Costs

62. © Dr. C. Bulent Aybar Asymmetric Information Due to asymmetric information, managers’ information about the firm and its future cash flows is likely to be superior to that of outside investors. This asymmetric information may motivate managers to alter a firm’s capital structure. Leverage as a Credible Signal: Managers use leverage as a way to convince investors that they do have information that the firm will grow, even if they cannot provide verifiable details about the sources of growth. The use of leverage as a way to signal good information to investors is known as the signaling theory of debt. Market Timing: selling new shares when they believe the stock is overvalued, and relying on debt and retained earnings (and possibly repurchasing shares) if they believe the stock is undervalued.

63. © Dr. C. Bulent Aybar (How do CFOs Make Capital Structure Decisions, JACF, Graham & Campbell,2002) 45% of CFOs indicate that tax shield is an important reason why they take more on debt in their capital structure. The 52.3% of CFOs are motivated to raise debt capital to take advantage of foreign tax treatments. 21% of the CFOs indicate that potential cost of financial distress affect their debt decisions, and 60% of the CFOs consider financial flexibility and credit rating concerns as very important factors in their debt decisions. 48% of the CFOs consider earnings volatility in their debt decisions. Most CFOs did not think that Debt had a disciplining effect on the management.

64. Capital Structure Theories and Practice

65. © Dr. C. Bulent Aybar Pecking Order Theory The “pecking-order” theory, suggests that actual corporate leverage ratios typically do not reflect capital structure targets, but rather the widely observed corporate practice of financing new investments with internal funds when possible and issuing debt rather than equity if external funds are required. In the Pecking Order model, an equity offering is typically regarded as a very expensive last resort.

66. © Dr. C. Bulent Aybar Pecking Order Theory and Information Costs The theory is based on the premise that managers avoid issuing securities, particularly equity, when the company is undervalued. Investors thus rationally interpret most management decisions to raise equity as a sign that the firm is overvalued—at least based on management’s view of the future—and the stock price falls. For those companies that are in fact overvalued when the new equity issue is announced, the drop in price (provided it is not too large) is more of a correction in value than a real economic cost to shareholders. But for those companies that are fairly valued (or even undervalued) at the time of the announcement, the negative market reaction and resulting undervaluation will cause the existing shareholders to experience a dilution of value (as distinguished from the dilution of earnings per share).

67. © Dr. C. Bulent Aybar Information Costs In other words, issuing equity is likely to create a cost that is referred as “information costs.” Such negative market reactions and the associated information costs are likely to be largest when the “information gap” between management and investors is greatest—that is, in circumstances when investors have the greatest uncertainty about either the firm’s prospects and what management intends to do with the capital.

68. © Dr. C. Bulent Aybar Is Pecking Order Theory Consistent with Practice According to Duke survey 46.8% of CFOs indicated that insufficient internal funds was a fairly important influence on the decision to issue debt. 30% of the CFOs indicated that they issued equity because they did not have sufficient internal funds, 15% said they issued equity after they exhausted their ability to issue debt. On the other hand two-thirds of the CFOs indicated that they were reluctant to issue equity when they thought that their stock was undervalued. Over 50% of CFOs suggested that they would issue Convertible debt when they thought equity was undervalued!

69. © Dr. C. Bulent Aybar Market Timing It is argued that managers take advantage of the market circumstances to raise funds. They issue equity when their equity is overvalued, and issue debt, when they think cost of debt is low. Although surveyed CFOs did not explicitly indicate that they attempt to time the market, their responses to indirect questions suggested that they time the markets. This is more so for large companies with sophisticated treasuries.

70. Factors Affecting Common Stock Issues Primary Factors: EPS Dilution, Signaling, Market Timing, Target Capital Structure

71. Motivation to Issue Convertibles Many companies choose to issue convertible debt, which has become especially popular among growth firms. Over half the CFOs (50.7%) cited equity undervaluation as a major reason to use convertibles.

72. Do Companies Have Optimal or Target Capital Ratios When CFOs were asked whether their companies have an optimal or “target” debt-equity ratio, only 19% of the firms said they did not have a target debt ratio or target range. Another 37% said they had “flexible” targets, and 44% had “strict” or “somewhat strict” targets or ranges. Larger companies (55%) were considerably more likely than small firms (36%) to have at least somewhat strict target debt ratios. Moreover, such targets were more common among investment grade (64%) than speculative companies (41%), and among regulated (67%) than unregulated firms (43%).

73. Recapitalization Example: Blazer Plc.

74. © Dr. C. Bulent Aybar Example: Recapitalization and Firm Value Beazer Plc., a British construction company, and Morgan Stanley (an investment banking firm), commenced a hostile tender offer to purchase all the outstanding stock of Koppers Company, Inc., a producer of construction materials, chemicals, and building products. Originally the raiders offered $45 per share; subsequently the offer was raised to $56, and then finally $61 per share. The Koppers board generally asserted that the offers were inadequate and its management was reviewing the possibility of a major recapitalization. Kopper’s pre recapitalization balance sheet is in the next slide.

75. Book Value of the Firm (in 000) Pre- Recapitalization Book Value Balance Sheets Net working capital $ 212,453 Fixed assets 601,446 Total assets 813,899 Long-term debt 172,409 Deferred taxes, etc. 195,616 Preferred stock 15,000 Common equity 430,874 Total capital $ 813,899

76. Market Value of the Firm (in 000) Market-Value Balance Sheets Net working capital $ 212,453 Fixed assets 1,618,081 PV debt tax shield 58,619 Total assets 1,889,153 Long term debt 172,409 Deferred taxes, etc. - Preferred stock 15,000 Common equity 1,701,744 Total capital $ 1,889,153 Number of shares 28,128 Price per share $ 60.50 Value to Public Shareholders Cash received $ - Value of shares $ 1,701,744 Total $ 1,701,744 Total per share $ 60.50

77. © Dr. C. Bulent Aybar Market Value of Assets and Market Value of Capital Note that long term debt of 172,409 creates a tax shield of 172,409x 0.34=$58,619. Accordingly, the market value of the firm assets is given as: Market value of firm’s capital is given as follows: Market-Value of Assets (000) Net working capital $ 212,453 Fixed assets 1,618,081 PV debt tax shield 58,619 Total assets 1,889,153 Market Value of Debt & Equity (000) Long term debt 172,409 Preferred stock 15,000 Common equity 1,701,744 Total capital $ 1,889,153

78. © Dr. C. Bulent Aybar Recapitalization Plan Now, let’s assume that company can borrow a maximum of $1,738,095,000 at a pre-tax of 10.5% and that the aggregate amount of debt will remain constant in perpetuity. Thus, Koppers will take on additional debt of $1,565,686,000 (i.e., $1,738,095,000 - $172,409,000). Also assume that the proceeds of the loan would be paid as an extraordinary dividend to shareholders. Let see the post recapitalization picture of the company:

79. Balance Sheet-Book Values BeforeAfter RecapitalizationChangesRecapitalization Book Value Balance Sheets Net working capital $ 212,453 Fixed assets 601,446 Total assets 813,899 Long-term debt 172,409 1,565,686 1,738,095 Deferred taxes, etc. 195,616 Preferred stock 15,000 Common equity 430,874 (1,565,686) (1,134,812) Total capital $ 813,899

80. Market Value Balance Sheet Market-Value Balance Sheets Pre-RecapPost-Recap Net working capital $ 212,453 Fixed assets 1,618,081 PV debt tax shield (equals.34 times debt balance) 58,619 532,333 590,952 Total assets $ 1,889,153 $ 2,421,486 Long term debt 172,409 1,565,686 1,738,095 Deferred taxes, etc.00 Preferred stock 15,000 Common equity 1,701,744 (1,033,353) $ 668,391 Total capital $ 1,889,153 $ 2,421,486 Number of shares 28,128 Price per share $ 60.50 $ 23.76 While book value perspective looks depressing, when we look at market values, the picture is slightly different:

81. © Dr. C. Bulent Aybar Recapitalization Increased the Shareholder Wealth The recapitalization clearly reduced the value of equity. Total equity in the firm declined from $1,701,744 to $668,391. On a per share basis, share price declined from $60.50 to $23.76. However, remember that the cash generated from debt issue was used to pay extraordinary dividends to shareholders. The value to the public shareholders then is: The bottom line is that while levering the firm did reduce the value of equity, it increased the shareholder value. On a per capita basis the increase came from interest tax shield: –($1,565,686 x 0.34)/28,128=$18.93 which explains the increase in per share value captured by equity holders –60.50 + 18.93 =79.43 Value to Public Shareholders Pre-RecapPos-Recap Cash received0 $ 1,565,686 Value of shares $ 1,701,744 $ 668,391 Total 1,701,744 2,234,077 Total per share $ 60.50 $ 79.43

82. © Dr. C. Bulent Aybar What if the company repurchased shares If the company decided for a share repurchase rather than paying a special dividend, shares would be repurchased at post recapitalization share price of $79.43 per share. 1,565,686,000/79.43 = 19,711,519 shares would be repurchased. Outstanding shares would decline to 28,128,000-19,711,519 =8,416,480 Per share price would remain at: 668,391,000/8,416,480 ~79.43 (there is a small discrepancy because of rounding)