1. 16 - 1 CHAPTER 16-7 Capital Structure Decisions: The Basics (Short version) Business vs. financial risk Capital structure theory Setting the optimal capital structure

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3. 16 - 3 Capital Structure Decisions: Extensions MM models Miller model Financial distress and agency costs Tradeoff models

4. 16 - 4 HOW DO YOU MEASURE THE VALUE OF THE FIRM? From the perspective of capital structure theory, the answer is: V = S(market value of equity-- common and preferred) + D (market value of debt. Key question: Does the ratio of Debt to equity (D/S) affect the value of the firm?

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6. 16 - 6 ISOLATION OF FINANCING DECISION When discussing optimal capital structure, to isolate this decision, we insist that any issuance of debt must be accompanied by a repurchase of stock; and any issuance of stock must be accompanied by a retirement of debt. Hence, only debt-equity ratio changes; no increase or decrease in “size” of the firm.

7. 16 - 7 Isolation of financing decision (continued) By this isolation, the financing decision is isolated from decisions relating to asset management or investment decisions of the firm

8. 16 - 8 Data of industrial debt equity ratios Insert graphs Do these represent “optimal” capital structure, or Do they simply represent stupidity on the part of financial managers?

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11. 16 - 11 DIGRESSION: TAX SHIELD Advantage of debt in a world of corporate taxes is that interest payments are a tax-deductible expense to the debt-issuing firm; however dividends are not tax- deductible. Hence, total amount of funds available to pay both debtholders and shareholders is greater if debt is employed. gman208n\txshld.xls

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14. 16 - 14 EV(tax shield benefits): Tax savings are not usually certain, as implied above, because: if taxable income is low or negative, tax benefits are reduced, or even eliminated if firm should go bankrupt and liquidate, future tax benefits stop. uncertainty that Congress may change the tax rate.

15. 16 - 15 Business Risk vs. Financial risk

16. 16 - 16 Business Risk versus Financial Risk Business risk: Uncertainty in future EBIT. Depends on business factors such as competition, operating leverage, etc. Financial risk: Additional business risk concentrated on common stockholders when financial leverage is used. Depends on the amount of debt and preferred stock financing. Concentrates business risk on stockholders.

17. 16 - 17 We will skip operating leverage to save some time.

18. 16 - 18 Financial Leverage

19. 16 - 19 Business Risk vs. Financial Risk Firm’s total risk (to its stockholders) is the sum of its business and financial risk: Total risk = Business risk + financial risk

20. 16 - 20 Total (stand alone) risk vs. market risk Risk may be measured in either a total (stand alone) risk or a market risk framework. This is similar to the discussion of total vs. market risk in portfolio theory.

21. 16 - 21 How are financial and business risk measured in a stand-alone (or total) risk framework, i.e., the stock is not held in a portfolio? Stand-aloneBusinessFinancial riskriskrisk = +. Stand-alone risk =  ROE. Business risk =  ROE(U). Financial risk =  ROE -  ROE(U).

22. 16 - 22 Now consider the fact that EBIT is not known with certainty. What is the impact of uncertainty on stockholder profitability and risk for Firm U and Firm L? Suppose, the unleveraged firm issues $10K of debt and buys back $10K of equity.

23. 16 - 23 Firm U: Unleveraged $1,800 1,200 $3,000 0 0.50 Avg. Economy $2,400$1,200NI 1,600 800Taxes (40%) $4,000$2,000EBT 0 0Interest $4,000$2,000EBIT 0.25 Prob. GoodBad A=20K, D=0,E=20K

24. 16 - 24 Firm L: Leveraged *Same as for Firm U. $1,080 720 $1,800 1,200 $3,000 0.50 Avg. Economy $1,680$ 480NI 1,120 320Taxes (40%) $2,800$ 800EBT 1,200 Interest $4,000$2,000EBIT* 0.25 Prob.* GoodBad A=20K, D=10K, E=10K, int=.12

25. 16 - 25 *ROI = (NI + Interest)/Total financing. 88 8 3.3x2.5x1.7xTIE 16.8%10.8%4.8%ROE 14.4%11.4%8.4%ROI* 15.0% Avg. 9.0% 15.0% Avg. 20.0%10.0%BEP GoodBadFirm L TIE 12.0%6.0%ROE 12.0%6.0%ROI* 20.0%10.0%BEP GoodBadFirm U

26. 16 - 26 2.5xE(TIE) 0.39 0.24CV ROE 4.24% 10.8% 11.4% 15.0% L 2.12%  ROE Risk Measures: 9.0%E(ROE) 9.0%E(ROI) 15.0%E(BEP) U Profitability Measures: 8

27. 16 - 27 Conclusions Basic earning power = BEP = EBIT/Total assets is unaffected by financial leverage. L has higher expected ROI and ROE because of tax savings. L has much wider ROE (and EPS) swings because of fixed interest charges. Its higher expected return is accompanied by higher risk. (More...)

28. 16 - 28 In a stand-alone risk sense, Firm L’s stockholders see much more risk than Firm U’s. U and L:  ROE(U) = 2.12%. U:  ROE = 2.12%. L:  ROE = 4.24%. L’s financial risk is  ROE -  ROE(U) = 4.24% - 2.12% = 2.12%. (U’s is zero.) (More...)

29. 16 - 29 For leverage to be positive (increase expected ROE), BEP must be > r d. If r d > BEP, the cost of leveraging will be higher than the inherent profitability of the assets, so the use of financial leverage will depress net income and ROE. In the example, E(BEP) = 15% while interest rate = 12%, so leveraging “works.”

30. 16 - 30 In Fact: ROE = BEP + (BEP - r d )(1-T) * (D/E)

31. 16 - 31 Market risk framework Hamada’s equation provides the relationship between business risk and financial risk: r sL = r rf + (r m - r rf )  u + (r m - r rf )  u (1-T)(D/S) = Time value premium + business risk premium + financial risk premium But also, r sL = r rf + (r m - r rf )  L Market Risk Framework

32. 16 - 32 Market risk framework (continued) Therefore, r rf + (r m - r rf )  u + (r m - r rf )  u (1-T)(D/S) = r rf + (r m - r rf )  L or  L =  u +  u (1-T)(D/S) Total risk = business risk + financial risk

33. 16 - 33 Hamada equation for beta:  L = + = + = +.  U Unlevered beta, which reflects the riskiness of the firm’s assets Business risk  U (1 - T)(D/S) Increased volatility of the returns to equity due to the use of debt Financial risk

34. 16 - 34 Consider financial risk term:  u (1-T)(D/S) The higher the D/S, the higher the financial risk The higher the T, the lower the financial risk. Why?

35. 16 - 35 Market risk framework (continued) or, another way to write total risk  L =  u [1 + (1-T)(D/S)]  u =  L / [1 + (1-T)(D/S)] or

36. 16 - 36 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.

37. 16 - 37 Here’s a valuation model which includes financial distress and agency costs. [X] represents either T c in the MM model or the more complex Miller term. Conclusion: Optimal leverage involves a tradeoff between the tax benefits of debt financing and the costs associated with financial distress and agency. V L = V U + [X]D - - PV of expected financial distress PV of agency costs

38. 16 - 38 V L = V U + [X]D - PV(fin.dist.costs) - PV(agency costs) Value of Firm ($) Debt ($) 43214321 Tax effect alone W/ taxes and bankruptcy and agency costs Net Tax effect alone Financial distress and agency costs Opt. Capital structure

39. 16 - 39 Relationship between value and leverage. Value of Firm ($) Debt ($) 43214321 Another view

40. 16 - 40 Cost of Capital (%) 14 4 Debt ($) Relationships between capital costs and leverage considering financial distress and agency costs. ksks WACC kdkd

41. 16 - 41 Define financial distress and agency costs. Financial distress: As firms use more and more debt financing, they face a higher probability of future financial distress, which brings with it lower sales, EBIT, and bankruptcy costs. Lowers value of stock and bonds. Agency costs: The costs of monitoring managers’ actions. Increases with leverage. More on agency and bankruptcy costs

42. 16 - 42 Bankruptcy Costs In a bankruptcy, bondholders are likely to hire lawyers to negotiate or sue the company. Similarly, the firm is likely to hire lawyers to protect itself. Costs are also incurred in a bankruptcy. These fees are all paid before the bondholder gets paid. Further, costs of purchasing inputs by a risky (subject to bankruptcy) firm increase.

43. 16 - 43 BANKRUPTCY COSTS (cont’d) The possibility of bankruptcy has a negative effect on the value of the firm. It is not the RISK of bankruptcy, but rather it is the COSTS associated with bankruptcy that lower value. Bankruptcy eats up part of the “pie” leaving less for stockholders and bondholders.

44. 16 - 44 AGENCY COSTS Definition: A contract under which one or more people (principals) hire another person (agent) to perform some service and then delegates decision making authority to that agent.

45. 16 - 45 Types of Agency Cost relationships Stockholders vs. management Stockholders vs. bondholders: Recall Marriott example. Assets 200Debt 100Assets 100Debt 100 Eq. 100 Assets 100Equity 100

46. 16 - 46 Event Risk The risk that some deliberate action or event will convert a high-grade bond into a junk bond overnight and thus lead to a sharp decline in it value. E.g. Marriott or RJR. Effect of adding more and more debt: From the stockholder’s point of view: Heads I win {risks pay off}; Tails you (the bondholder) lose.{risks don’t pay off}

47. 16 - 47 AGENCY COSTS If a company were to sell only a small amount of debt, the debt would have: low risk a high bond rating a low interest rate However, if, after it sold the low risk debt, it issued more debt, secured by the same assets…

48. 16 - 48 This would: Raise risk faced by all bondholders Cause r d to rise Cause original bondholders to suffer capital losses

49. 16 - 49 Similarly, suppose that after issuing the new debt, the firm decides to restructure its assets: Selling of low risk assets, and Acquiring riskier assets, which have a higher expected rates of return

50. 16 - 50 If things work out, stockholders benefit; If things don’t work out, most of the loss falls on the leveraged bondholders: Stockholders are playing the game “Heads I win, tails you lose” with the bondholders.

51. 16 - 51 AGENCY COSTS There are deliberate actions which would help stockholders and harm bondholders. As we have seen, if there were no restrictions, stockholders would be tempted to: sell successive debt issues backed by the same assets sell existing assets, replacing them with high risk assets issue junk bonds and expand or go through a LBO

52. 16 - 52 Agency Costs Because of these possibilities, bond holders are protected by restrictive bond covenants. These often hamper the firm’s legitimate operations to some extent. Further the company must be monitored to insure compliance.

53. 16 - 53 Agency Costs The restrictive costs of these bond covenants and monitoring costs (I.e. lost efficiencies) are passed through to the stockholders in the form of higher debt costs. The greater the debt ratio, the greater the agency costs. As a result. this reduces the value of debt, and lowers the debt/equity ratio.

54. 16 - 54 How do financial distress and agency costs change the MM and Miller models? MM/Miller ignored these costs, hence those models overstate the value of leverage.

55. 16 - 55 An example of signaling theory Asymmetric Information:

56. 16 - 56 Asymmetric Information The asymmetric information theory of capital structure is based on two assumptions: 1. Managers have better information about their firm’s future prospects than do investors. Thus asymmetric information exists.

57. 16 - 57 Asymmetric information theory (cont’) 2. Managers act in the best interest of the current shareholders in the sense that managers act to maximize current shareholders (including themselves) wealth.

58. 16 - 58 Asymmetric information theory (cont’) Under these assumptions, if outside capital is needed, managers would issue new stock … if they believed their stock to be overvalued… But, they would issue new debt if they believed the stock to be undervalued.

59. 16 - 59 Asymmetric information theory (cont’) 1. Investors recognize this, and thus tend to view a new common stock offering as a negative signal (overvalued stock). Therefore, the price of company’s stock typically declines if it announces a new stock offering. (Doesn’t apply to IPO’s)

60. 16 - 60 Asymmetric information theory (cont’) 2. Since managers are reluctant to take actions which lower their firm’s stock price, they avoid issuing stock when they believe investors will react negatively. 3. However, since external capital still may be needed to fund especially good investment opportunities,

61. 16 - 61 Asymmetric information theory (cont’) Financial managers try to maintain a reserve borrowing capacity that they can tap it needed. Consequently a pecking order of financing exists: Earnings (and depreciation) Debt issue Stock issue

62. 16 - 62 Financial forecasting models can help show how capital structure changes are likely to affect stock prices, coverage ratios, and so on. What type of analysis should firms conduct to help find their optimal, or target, capital structure? (More...)

63. 16 - 63 Forecasting models can generate results under various scenarios, but the financial manager must specify appropriate input values, interpret the output, and eventually decide on a target capital structure. In the end, capital structure decision will be based on a combination of analysis and judgment.

64. 16 - 64 IMPLICATIONS OF CAPITAL STRUCTURE THEORY Unfortunately, capital structure theory cannot be used to set a precise optimal structure. However, theory does provide the following insights:

65. 16 - 65 1. Other things held constant, firms with high tax rates should use ?

66. 16 - 66 1. Other things held constant, firms with high tax rates should use more leverage than firms with low rates, because the value of the debt financing is its tax deductibility, and this value increases with the tax rate.

67. 16 - 67 2. Firms with more inherent business risk should use: ?

68. 16 - 68 2. Firms with more inherent business risk should use less leverage than low risk firms, because riskier firms have higher probabilities of facing financing financial distress.

69. 16 - 69 3. Firms with high potential distress costs, such as firms whose value is derived from intangible factors such as “growth opportunities” rather than from tangible assets which can be readily sold, should use: ?

70. 16 - 70 3. Firms with high potential distress costs, such as firms whose value is derived from intangible factors such as “growth opportunities” rather than from tangible assets which can be readily sold, should use less leverage than firms with low potential distress costs.

71. 16 - 71 4. Firms characterized by a high degree of information asymmetry, such as those with highly confidential research and development programs, should maintain a larger reserve borrowing capacity, and hence use: ?

72. 16 - 72 4. Firms characterized by a high degree of information asymmetry, such as those with highly confidential research and development programs, should maintain a larger reserve borrowing capacity, and hence use less leverage, than firms with a low degree of asymmetry.

73. 16 - 73 Debt ratios of other firms in the industry. Pro forma coverage ratios at different capital structures under different economic scenarios. Lender/rating agency attitudes (impact on bond ratings). What other factors would managers consider when setting the target capital structure?

74. 16 - 74 Reserve borrowing capacity. Effects on control. Type of assets--good collateral? Tax rates.

75. 16 - 75 The End

76. 16 - 76 INITIAL ASSUMPTIONS: All cash flows are perpetuities All earnings are paid out as dividends [i.e. retention rate (b)] = 0 No growth No taxes (to be relaxed later)

77. 16 - 77 Cost of Capital (%) D/S Traditional View ksks WACC kdkd (D/S)*

78. 16 - 78 (Tax term omitted by assumption) WACC = w s k s + w d k d where w s + w d = 1. or WACC = (S/V) k s + (D/V) k d It seems reasonable that, as debt increases, an increasing weight on the lower k d will cause a falling WACC, (for a while).

79. 16 - 79 Cost of Capital (%) 14 4 D/S Alternative View ksks WACC kdkd (D/S)* Example showing a constant WACC: M&M wks (Omitted)

80. 16 - 80 WACC = w s k s + w d k d or, moving to the right, as D WACC = (S/V) k s + (D/V) k d An increase in the supposedly “cheaper” debt funds could be offset by the increase in the required rate of return on equity, k e.

81. 16 - 81 i.e., it is possible that k s rises just enough to offset the increasing weight on k d and decreasing weight on k s, leaving the WACC constant. As the firm increases its use of financial leverage, it becomes increasingly risky, and investors penalize the stock by raising the required equity return in keeping with the debt/equity ratio But how likely is this possibility? M&M show that, under their assumptions, it will, not just may occur.

82. 16 - 82 Who are Modigliani and Miller (MM)? They published theoretical papers that changed the way people thought about financial leverage. They won Nobel prizes in economics because of this work. MM’s papers were published in 1958 and 1963. Miller had a separate paper in 1977.

83. 16 - 83 M & M worksheets

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85. 16 - 85.12.1429.15.16 % D/S 0.75 kdkd keke kaka

86. 16 - 86 Initial Situation Initial Balance Sheet: L’s Stock 400 NW 400 Note: 1% of L’s total stock is held Initial Income Statement: Income 64 Net 64

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88. 16 - 88 Final Situation Final Balance Sheet: Cash 33.33 Borrowing 300 U’s stock 666.67 NW 400 Final Income Statement: Income 64 Borr.Costs 36 Net 64 Nb: 1% of U’s Stock and Debt = 1% of U’s debt is held.

89. 16 - 89 In this process, price of U’s stock will rise, so NW will increase. U’s price will rise and L’s price will fall until value of firms are equal; I.e. k a ’s are equal. ARBITRAGE HAS CAUSED LEVERAGE TO HAVE NO EFFECT ON WACC.

90. 16 - 90 NOTE: RATIO OF DEBT/NW IS THE SAME FOR THIS INDIVIDUAL (300/400) AS FOR THE FIRM L (3000/4000). INDIVIDUAL HAS SUBSTITUTED PERSONAL LEVERAGE FOR THE LEVERAGE OF THE FIRM. “Roll your own leverage”

91. 16 - 91 M&M Conclusion Individual started with 1% of L: I.e. 1% of L’s EBIT100 and 1% of L’s Debt- 36 $64 Ended with: 1% of U’s Stock 1% of U’s EBIT100 and $300 of personal debt Interest Cost -36 $64

92. 16 - 92 M&M Conclusion And had $33.33 in Cash which can be invested: if at 12%$4 So pure arbitrage made this individual better off. Arbitrage opportunity will continue to exist until the WACC, ka, are equal, and therefore the values of the two firms are equal.

93. 16 - 93 M&M CONCLUSION When arbitrage is possible, the Debt/Equity ratio has no effect on the value of the firm.

94. 16 - 94.12.1429.15.16 % D/S 0.75 kdkd keke kaka New WACC

95. 16 - 95 M&M The important element in this process is the presence of rational investors in the market who are willing to substitute personal or “homemade” or “roll your own” leverage to substitute for corporate leverage

96. 16 - 96 M&M (Continued) On the basis of this arbitrage process, M&M conclude that a firm cannot change its total value or its WACC by using financial leverage. BUT, when we add other elements(e.g. TAXES) the conclusion does not hold

97. 16 - 97 Without corporate taxes, the MM propositions are: Proposition I: V L = V U. Propostion II: k sL = k sU + (k sU - k d )(D/S). or ROE = BEP + (BEP - kd)(D/S)

98. 16 - 98 Graph the relationships between capital costs and leverage as measured by D/V. Without taxes Cost of Capital (%) 26 20 14 8 020406080100 Debt/Value Ratio (%) ksks WACC kdkd

99. 16 - 99 While k d remains constant, k s increases with leverage. The increase in k s is exactly sufficient to keep WACC constant. The more debt the firm adds to its capital structure, the riskier the equity becomes and thus the higher its cost.

100. 16 - 100 Graph of Value vs. Debt, without Taxes Value of Firm, V (%) 43214321 00.51.01.52.02.5 Debt (Millions of $) VLVL VUVU Firm value ($3.6 Million) With zero taxes, MM argue that value is unaffected by leverage.

101. 16 - 101 With corporate taxes (assume a 40% corporate tax rate). With corporate taxes added, the MM propositions are: Proposition I: V L = V U + TD. Proposition II: k sL = k sU + (K sU - k d )(1 - T)(D/S).

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103. 16 - 103 Consider a simple example of leverage. Ignore taxes for simplicity. Current Situation: Assets Assets 100 Liabs. And Equity Equity 100 ROA = BEP=ROE=10/100 = 10%

104. 16 - 104 Now consider expansion: Suppose BEP remains at 10%. A. NO LEVERAGE Assets Assets 150 Liabs. And Equity Equity 150 ROA = BEP=ROE=150/150 = 10% Net Income = 15

105. 16 - 105 Now consider expansion: Suppose BEP remains at 10%. B. WITH LEVERAGE Assets Assets 150 Liabs. And Equity Debt 50 Equity 100 BEP= 10%, but not equal to ROE EBIT = 15 Net Income = ?

106. 16 - 106 Now consider expansion: Suppose BEP remains at 10%. B. WITH LEVERAGE Net Income = 15 - k d * Debt K d NetROE.0515-.05*50=12.512.5/100 = 12.5%,.1015 -.10*50=1010/100= 10%.1515-.15*50=7.515/100=7.5% Negative effect of leverage Positive effect of leverage

107. 16 - 107 In Fact: ROE = BEP + (BEP - k d ) * (D/E) For example, for k d = 5%: ROE =.10 + (.10 - 05)(1/2) = 12.5%