1. Capital Structure Decisions
Chapter 15
Capital Structure Decisions

2. Topics in Chapter Overview of capital structure effects
Read the following sections/subsections: 15-1, 15-3ab, 15-4, 15-5b, 15-6, 15-9.
Overview of capital structure effects
Capital structure theory and implications for managers
Example: estimating the optimal capital structure
Managing the maturity structure of debt

3. Determinants of Intrinsic Value: The Capital Structure Choice
Net operating
profit after taxes
Required investments
in operating capital −
Free cash flow
(FCF) =
FCF1
FCF2
FCF∞
Value = ··· +
(1 + WACC)1
(1 + WACC)2
(1 + WACC)∞
Firm’s
debt/equity
mix
Weighted average
cost of capital
(WACC)
Market interest rates
Cost of debt
Cost of equity
Market risk aversion
Firm’s business risk

4. Overview: The Capital Structure Question
Capital Structure: the firm’s mixture of debt and equity.
Capital structure decision includes:
The choice of target capital structure
The average maturity of debt
The specific types of financing to use at any particular time
The goal: managers should make capital structure decisions designed to maximize firm value.

5. 15-1 An Overview of Capital Structure
Basic Definitions:
V = value of firm
FCF = free cash flow
WACC = weighted average cost of capital
rs and rd are costs of stock and debt
ws and wd are percentages of the firm that are financed with stock and debt.

6. How can capital structure affect value?= ∑ ∞
t=1
FCFt
(1 + WACC)t
WACC= wd (1-T) rd + wsrs

7. Table 15-1 Long-Term Debt-to-Equity Ratios for Business Sectors, Selected Sub-Sectors, and Selected Firms

8. The Questions:
Why do we see such variations in capital structure across companies and business sectors?
Can a company make itself more valuable through its choice of debt ratio/capital structure?

9. Capital Structure Theory Summary: (15-3 & 15-4)
MM (Modigliani & Miller) theory
Without taxes
With corporate taxes
With corporate and personal taxes (skipped)
Trade-off theory
Signaling theory
Pecking order hypothesis
Debt financing as a managerial constraint
Investment Opportunity Set and Reserve Borrowing Capacity
Market timing theory

10. 15-3 Capital Structure Theory: The Modigliani and Miller Models 15-3a MM Theory: No Taxes
Example:
Firm U
Firm L
EBIT
$3,000
Interest
1,200 NI
$1,800
CF to shareholder
CF to debtholder
$1,200
Total CF
Notice that the total CF are identical for both firms.

11. MM Without Taxes: VL = VU
MM assume: (1) There are no brokerage costs; (2) There are no taxes; (3) There are no bankruptcy costs; (4) Investors can borrow at the same rate as corporations; (5) All investors have the same information as management; (6) EBIT is not affected by the use of debt (operating decisions are fixed).
MM prove that if the total CF to investors of Firm U and Firm L are equal, then arbitrage is possible unless the total values of Firm U and Firm L are equal:
VL = VU.
Because FCF and values of firms L and U are equal, their WACCs are equal.
Therefore, capital structure is irrelevant.

12. 15-3b MM Theory with Corporate Taxes
Corporate tax laws allow interest to be deducted, which reduces taxes paid by levered firms.
Therefore, more CF goes to investors and less to taxes when leverage is used.
In other words, the debt “shields” some of the firm’s CF from taxation.

13. MM with Corporate Taxes: VL = VU + TD
MM show that the total CF to Firm L’s investors is equal to the total CF to Firm U’s investor plus an additional amount due to interest deductibility:
CFL = CFU + rdDT.
What is value of these cash flows?
Present Value of CFU = VU
MM show that the present value of rdDT = TD (assume perpetual debt)
Therefore, VL = VU + TD.
If T=40%, then every dollar of debt adds 40 cents of extra value to firm.

14. MM relationship between value and debt when corporate taxes are considered:
Value of Firm, V
Debt VL VU
Under MM with corporate taxes, the firm’s value increases continuously as more and more debt is used. TD

15. 15-4 Capital Structure Theory: Beyond the Modigliani and Miller Models 15-4a Trade-Off Theory
MM theory ignores bankruptcy (financial distress) costs, which increase as more leverage is used.
At low leverage levels, tax benefits outweigh bankruptcy costs.
At high levels, bankruptcy costs outweigh tax benefits.
An optimal capital structure exists that balances these costs and benefits.

16. Tax Shield vs. Cost of Financial Distress
Value of Firm, V
Debt VL VU
Tax Shield
Distress Costs

17. 15-4b Signaling Theory
MM assumed that investors and managers have the same information.
But, managers often have better information. Thus, they would:
Sell stock if stock is overvalued.
Sell bonds if stock is undervalued.
Investors understand this, so view new stock sales as a negative signal.
Implications for managers?

18. 15-4c Reserve Borrowing Capacity
Because issuing stock (SEO) sends a negative signal and tends to depress the stock price even if the company’s true prospects are bright, a company should try to maintain a reserve borrowing capacity so that debt can be used if an especially good investment opportunity comes along.
The implication of signaling theory: firms should, in normal times, use more equity and less debt than is suggested by the tax benefit–bankruptcy cost trade-off model.

19. 15-4d The Pecking Order Hypothesis
Firms use internally generated funds first, because there are no flotation costs or negative signals.
If more funds are needed, firms then issue debt because it has lower flotation costs than equity and not negative signals.
If more funds are needed, firms then issue equity.

20. The use of financial leverage:
15-4e Debt Financing and Agency Costs: Using Debt to Constrain Managers
One agency problem is that managers can use corporate funds for non-value maximizing purposes.
The use of financial leverage:
Bonds “free cash flow.”
Forces discipline on managers to avoid perks and non-value adding acquisitions.
(More...)

21. But too much debt may overly constrain managers, causing another type of agency problem:
A second agency problem is the potential for “underinvestment” with too much debt:
Debt increases risk of financial distress.
Therefore, managers may avoid risky projects even if they have positive NPVs.

22. 15-4f Investment Opportunity Set and Reserve Borrowing Capacity
Firms with many investment opportunities should maintain reserve borrowing capacity by using low levels of debt, especially if they have problems with asymmetric information (which would cause equity issues to be costly).
Firms with few profitable investment opportunities should use high levels of debt and thus have substantial interest payments (and pay less taxes), which impose managerial constraints through debt.

23. 15-4g Market Timing Theory
Managers try to “time the market” when issuing securities.
They issue equity when the market is “high” and after big stock price run ups.
They issue debt when the stock market is “low” and when interest rates are “low.”
The maturity of the issued debt also reflects an attempt to time interest rates.

24. 15-5b Implications for Managers
Take advantage of tax benefits by issuing debt, especially if the firm has:
High tax rate
Stable sales
Low operating leverage (less business risk)

25. Implications for Managers (Continued)
Avoid financial distress costs by maintaining excess borrowing capacity, especially if the firm has:
Volatile sales
High operating leverage
Many potential investment opportunities
Special purpose assets (instead of general purpose assets that make good collateral)

26. Implications for Managers (Continued)
If managers have asymmetric information regarding firm’s future prospects, then avoid issuing equity if actual prospects are better than the market perceives.
Managers should consider conditions in the stock and bond markets.
Always consider the impact of capital structure choices on lenders’ and rating agencies’ attitudes.

27. 15-6 Estimating the Optimal Capital Structure 15-6a Strasburg’s Current Value and Capital Structure
Given information:
tax rate: T=40%; current leverage ratio: wd = 20%; cost of debt: rd = 8%; stock beta: bL=0.2 = 1.25;
rRF = 6.3%; RPM = 6%.
Strasburg’s current cost of equity and WACC:
Cost of equity using CAPM:
rs = rRF +b*(RPM)= 6.3% (6%)
= 13.8%
The weighted average cost of capital:
WACC = wdrd(1-T) +wsrs
= 20%*8%*(1-0.4) + 80%*13.8%
=12%

28. Strasburg’s Current Value of Operations
Given information: Expected FCF = $30 million; Firm expects zero growth: g = 0. (The FCF stream is a perpetuity.)
Vop = FCF / WACC
= $30 / 0.12
= $250 million

29. 15-6b Estimating the WACC for Different Levels of Debt Investment bankers provided estimates of rd for different capital structures: wd 0%
10%
20%
30%
40%
50%
60% rd
7.7%
7.8%
8.0%
8.5%
9.9%
12.0%
16.0%
current
When financial leverage increases (use more debt), the default risk increases, so the required rate of return on debt (bond yield) increases to compensate for the increased risk (risk-return tradeoff relationship).
If company recapitalizes, it will use proceeds from debt issuance to repurchase stock or use proceeds from stock issuance to retire debt.

30. The Cost of Equity at Different Levels of Debt: The Hamada Equation
MM theory implies that beta changes with leverage: financial leverage increases the (systematic) risk of equity, so beta (measure of systematic risk) of the equity increases.
bU is the beta of a firm when it has no debt (the unlevered beta).
Then bL = bU * [1 + (1 - T)(wd/ws)]
or bU = bL / [1 + (1 - T)(wd/ws)]

31. The Cost of Equity for wd = 0 (all equity/unlevered firm)
Use the Hamada equation to find unlevered beta:
bU = bL=0.2 / [1 + (1 - T)(wd/ws)]
= 1.25 / [1 + (1-0.4) (20% / 80%) ]
= 1.087
Use CAPM to find the cost of equity
rU= rRF + bU (RPM)
= 6.3% *(6%) = 12.82%

32. The WACC for wd = 0% WACC = wd (1-T) rd + ws rs
Next, the cost of equity and WACC under the capital structure of Wd = 10%:

33. The Cost of Equity for wd = 10%:
Use the Hamada equation to find equity beta when wd = 10%:
bL=0.1 = bU * [1 + (1 - T)(wd/ws)]
= * [1 + (1-0.4) (10% / 90%) ]
= 1.16
Use CAPM to find the cost of equity when wd = 10%:
rs= rRF + bL=0.1 (RPM)
= 6.3% *(6%) = 13.26%

34. The WACC When wd = 10%:
WACC = wd (1-T) rd + ws rs
WACC = 10%*0.6*7.8% + 90%*(13.26%)
WACC = 12.40%
Repeat this for all capital structures under consideration.

35. Beta, rs, and WACC wd 0%
10%
20%
30%
40%
50%
60% rd
7.7%
7.8%
8.0%
8.5%
9.9%
12.0%
16.0% ws
100%
90%
80%
70% b
1.087
1.16
1.25
1.37
1.52
1.74
2.07 rs
12.82%
13.26%
13.80%
14.50%
15.43%
16.73%
18.69%
WACC
12.40%
12.00%
11.68%
11.63%
11.97%
13.24%
The WACC is minimized when wd = 40%. This is the optimal capital structure.

36. 15-6c Estimating the Firm’s Value (for Different Levels of Debt)
Corporate Value for wd = 0%:
Vop = FCF / WACC
= $30 /
= $ million
Debt = wd Vop
= 0%*(234.01) = 0
Equity = ws Vop
= 100%*(234.01) = $ million

37. Corporate Value for wd = 10%
Vop = FCF / WACCL=0.1
= $30 /
= $ million
Debt = wd Vop
= 10%*(241.94) = $24.19 million
Equity = ws Vop
= 90%*(241.94) = $ million
Repeat this for all capital structures under consideration.

38. Value of operations is maximized at wd = 40%.
Value of Operations, Debt, and Equity (Some numbers are slightly different from the previous calculations due to rounding errors.) wd 0%
10%
20%
30%
40%
50%
60% rd
7.7%
7.8%
8.0%
8.5%
9.9%
12.0%
16.0% ws
100%
90%
80%
70% b
1.09
1.16
1.25
1.37
1.52
1.74
2.07 rs
12.82%
13.26%
13.80%
14.50%
15.43%
16.73%
18.69%
WACC
12.40%
12.00%
11.68%
11.63%
11.97%
13.24%
Vop
$233.98
$241.96
$250.00
$256.87
$257.86
$250.68
$226.65 D
$0.00
$24.20
$50.00
$77.06
$103.14
$125.34
$135.99 S
$217.76
$200.00
$179.81
$154.72
$90.66
Value of operations is maximized at wd = 40%.

39. The Optimal Capital Structure
wd = 40% gives:
Highest corporate value
Lowest WACC
Highest stock price per share
But wd = 30% is close. So optimal range is pretty flat.

40. Figure 15-7: Effects of Capital Structure on the Cost of Capital

41. Figure 15-8: Effects of Capital Structure on the Value of Operations (Millions of Dollars)

42. 15-9 Managing the Maturity Structure of Debt 15-9a Maturity Matching
The safest all-round financing strategy is to match debt maturities with asset maturities.
Maturity matching often dominates the debt maturity decision.

43. 15-9b Effects of Interest Rate Levels and Forecasts
If long-term interest rates are high by historical standards and are expected to fall, managers will be reluctant to issue long-term debt.
One solution is to use a call provision.
Floating-rate debt could be used.
Another alternative would be to finance with short-term debt; but the risk is that interest rates may move even higher.

44. 15-9c Information Asymmetries
A company with better prospects than expected by the market can issue short-term debt, then refinance at a lower rate when the debt comes due and the firm’s excellent prospects have been realized.
A company with poorer prospects than expected by the market would prefer to lock in a better interest rate than its true situation warrants, so it would want to issue long-term debt.

45. 15-9d Amount of Financing Required
Due to flotation costs, smaller issues would most likely be done with a term loan or a privately placed bond issue; larger issues would most likely use a public offering of long-term bonds.

46. 15-9e Availability of Collateral
Generally secured debt is less costly than unsecured debt. Thus, firms with large amounts of marketable fixed assets are likely to use a relatively large amount of long-term debt, especially mortgage bonds.
Additionally, each year’s financing decision would be influenced by the amount of qualified assets available as security for new bonds.

47. 15-9f Evidence on Debt Maturity in Practice
In general, many public companies today (mature and new) have high levels of informational asymmetry because they compete in complex product environments, including information technology, bio-technology, and pharmaceuticals.
Theory suggests that such firms should raise capital from debt rather than equity and should raise short-term debt rather than long-term debt, and this is what the evidence shows.

48. Homework Questions on P646: 15-1c, 15-5, 15-6, 15-8;
Problems on P649: