1. Capital Structure
MBA 253

2. The Financing Decision
The firm has limited ways to raise funds:
Debt: Bank Debt, Commercial Paper and Corporate Bonds
Equity: Owners Equity, Venture Capital, Common Stock and Warrants
Hybrid Securities: Mixtures of Debt and Equity: Convertible Debt, Preferred Stock, Option Linked Bonds
What mix of debt and equity should be used? (what is the firm’s Capital Structure)

3. Debt vs. Equity Debt Equity Fixed Claim Tax Deductible
High Priority in Financial Trouble
Fixed Maturity
No Management Control
Equity
Residual Claimant
No Tax Deduction
Lowest Priority in Financial Trouble
No Maturity
Management Control

4. Debt Bank Debt Corporate Bonds
Small amounts, Intermediation for small firms, No ratings agencies - public information can be minimized
Corporate Bonds
Risk Sharing, special features
Issues to be addressed
Short or long term
Fixed or Floating Rates
Assets used as Security
Special Features

5. Special Features of Debt
Floating Rate Loans: Rate Varies with Index
Puttable Bonds: Bond holders can receive face value
Convertible / Exchangeable: Can be converted into Equity
Extendable Life of Bond can be extended by borrower
Caps and Floors: Limits rate movements of floatable bonds
Swaps: Exchange of fixed for floating and vice versa
Reverse Floating Rate Notes: Rate varies inversely with index
Swapations: Options on a swap

6. Equity Owners Equity Venture Capital Common Stock Warrants
returning earnings on the seed money to the firm
Venture Capital
capital provided in return for ownership share
Common Stock
Warrants
Holders receive the right to buy shares in the company at a fixed price
priced upon implied volatility
create no financial obligation at time of issue
Contingent value rights
Investors can sell their stock at a fixed price

7. Warrants Similar to a long term call option
Difference is that exercising a warrant affects the value of the underlying asset (it increase the number of shares outstanding)

8. Hybrid Securities Convertible Debt Preferred Stock Option Linked Bonds
Lowers the interest rate paid by the firm
bondholder given the option to convert into stock
Preferred Stock
promised payment (like bonds)
infinite life, limited voting privileges
Option Linked Bonds
Commodity linked bonds

9. Does Capital Structure Matter?
WACC = rd(1-t)wd + rpswps + rewe
Generally: Keeping the risk level the same, Debt is less expensive than Equity
However, Increasing debt, increases the risk to the shareholders, the cost of equity should increase due to the higher risk.
Which has a larger influence: the decreased cost associated with the use of debt or increase cost associated with equity?

10. Debt Benefits and Cap Structure
Debt ratios of firms with higher tax rates should be higher than those with lower tax rates
Firms that have substantial non-debt tax shield (depreciation for example)should be less likely to use debt
If tax rates increase over time so should debt ratios

11. The Costs of Debt Bankruptcy costs Agency Costs Lost Flexibility
probability of bankruptcy
Indirect and Direct Costs
Agency Costs
Creates tensions between shareholders and lenders
Lost Flexibility
Firms value the ability to take on new projects

12. Bankruptcy Probability Increases with Costs of Bankruptcy
The size of debt obligations relative to the size of operating cash flows
The variability of cash flows
Costs of Bankruptcy
Direct Costs --Legal and administrative costs
Indirect Costs -- decreased sales, availability of credit
Indirect costs are higher when firms produce
Durable products
Products dependent on quality reputation
Products requiring service and complementary products
Products requiring support services

13. Bankruptcy and Cap Structure
Firms in volatile industries should use debt less than firms in more stable industries
If debt can be structured so that cash flows on debt increase and decrease with cash flows can borrow more
If external protection from bankruptcy exists firms will borrow more
Firms with non divisible and non marketable assets are more likely to use debt
If products require long-term servicing should have lower leverage

14. Agency Costs Conflicts between Bondholders and Stockholders
Investment decisions (risk shifting)
Financing Decisions
Dividend policy
Agency costs are important when
Bondholders believe that stockholder actions will increase chance of default
Protective Covenants require monitoring costs and indirectly reduce flexibility
The firms investments are not easily monitored
projects are long term

15. Flexibility
The ability to handle unforeseen contingencies that might arise
Provides ability to undertake new projects
Provides more breathing room
Firms with large and unpredictable demands on cash flows will require higher flexibility
As firms and industries mature the returns on projects become more stable and the desire of flexibility decreases

16. The Borrowing Trade off
Advantages
Tax Benefits
Higher tax rate higher benefit
Added Discipline
The greater the separation between management and shareholders the greater the benefit
Disadvantages
Bankruptcy Costs
Higher business risk implies
Higher cost
Agency Cost
Greater separation between stockholders and lenders results in Higher Cost
Loss of Flexibility
Greater uncertainty implies Higher costs

17. Business Risk Business Risk
The riskiness of the firm’s assets if it uses no debt
Looked at in a stand alone context
Measured by the standard deviation of the firms ROA

18. ROA vs. ROE ROA = Return to Investors/Assets
= (Net Income to Shareholders + Interest)/Assets
Without the use of debt this becomes
= (Net Income to Shareholders)/Assets
Which is ROE since Assets = equity
W/O debt business risk can be measured by the firms ROE!

19. ROE Variability in ROE is determined by: Demand Variability
Sale Price Variability
Input Cost Variability
Ability to Adjust output prices
Ability to develop new products
Fixed Costs

20. Operating Leverage The portion of the firms costs that are fixed.
Fixed costs must be paid regardless of sales – this increases risk
The Breakeven point is therefore important - it is the amount of sales needed to cover fixed cost.

21. Breakeven Point
The breakeven point occurs where the firm earns just enough to cover fixed and variable cost (EBIT = 0 and ROE = 0)
EBIT=Price(Quant)-VaribCost(Q)-FixedC)
Rearrange and solve for Q
0 = pQ-VQ-F
F = (P-V)Q
Q = F/(P-V)

22. Financial Risk
Financial Risk is the extra risk placed on shareholders when the firm decides to use debt.
Above ROE = NI/asset=NI/equity
(assets = equity when debt =0)
Now NI declines and as debt increases and equity decreases. The net effect is an increase in ROE

23. An example Stratsburg Electronics 175,000 in assets two choices
175,000 equity or 87,500 equity & 87,500 debt
Assume that the use of equity does not change the EBIT

24. Numerical Example Debt and Equity All Equity Expected EBIT 35,000
Interest (10%)
8,700
EBT
26,250
Taxes(40%)
10,500
14,000
Net Income
15,750
21,000
Expected ROE
15,750/87,500
=18%
21,000/175,000
=12%

25. The Capital Structure Question
Is there an “optimal” capital structure?
Modigilani and Miller
Capital structure is irrelevant
The decrease in cost of capital from debt is offset by the increase in the cost of equity.
Trade off Theories
The capital structure that minimizes the WACC will also produce the highest shareholder value and is the optimal capital structure.

26. Modigliani & Miller Assumptions
Firms can be classified by business risk
All investors agree about the distribution of future earnings
Perfect Capital Markets
No Bankruptcy Costs
No income taxes
All cash flows are perpetuities
EBIT is not changed by use of debt

27. M&M two propositions
Value of leveraged firm = Value of Unleveraged Firm EBIT/ WACC = EBIT / rSU
rSL = rSU + (rSU - rd) (D/S)
where:
rSL = Cost of stock leveraged firm
rSU = cost of stock unleveraged firm
rd = Constant cost of debt
D = market value of debt
S = market value of stock

28. rSL=rSU+(rSU-rd)(D/S)
M&M
EBIT/WACC = EBIT/KSU
rSL=rSU+(rSU-rd)(D/S)
Together this implies that the cost of capital doesn’t change as the amount of borrowing increases.
Assumed that EBIT doesn’t change so WACC = rSU regardless of the amount of debt used.
WACC = wd rd + wsrSL

29. Value of firm = EBIT/ KSU
An Example: EBIT/WACC = EBIT/KSU KSL=KSU+(KSU-Kd)(D/S) Assume that KSU = 10% Kd = 6%
10% Debt
KSL=KSU+(KSU-Kd)(D/S)
KSL= ( )(1/9)
KSL=
WACC = wd Kd + ws KSL
WACC = .10(.06)+.9(.10444)
WACC = .10
Value of firm = EBIT/.10
No Debt
Value of firm = EBIT/ KSU
Value of firm = EBIT/.10

30. Including Taxes
What if the interest payments on debt are tax deductible? Then WACC will decrease at the percentage of debt increases.
This implies that the value of the firm will increase as the amount of debt increases. In fact the optimal capital structure would be 100% debt.
Miller also showed that if personal income taxes are included that one possible scenario is still capital structure irrelevance. (see book for details)

31. If Debt Doesn’t Matter
The cost of capital is unaffected by changes in the proportions of debt and equity
The value of the firm is unaffected by leverage
The investment decision can be made independently of the financing decision.

32. Tradeoff Theory
Initially adding debt causes the WACC to decline. The tax benefit of debt causes the WACC to decrease for now bankruptcy costs are low.
As the firm uses more debt bankruptcy costs start to increase. The decrease in the WACC is less for every unit of debt added.
As the amount of debt increase, so do bankruptcy costs Eventually the indirect and direct costs to the firm outweigh the tax benefits and the WACC increases.
This implies that a minimum WACC exists, at this point the value of the firm (EBIT/WACC) will be maximized.

33. Trade Off Theory If this is the case – the use of debt matters,
The point were the WACC will be minimized will maximize the value of the firm

34. Empirical Evidence The Debt Ratio is:
Negatively correlated with the volatility in annual operating earnings as predicted by bankruptcy costs
Positively related to the level of non-debt tax shields opposite of what was predicted
Negatively related to advertising and R&D expenses, as predicted by tradeoff theory
Positively related to the marginal tax rate as predicted by the tradeoff theory
Negatively related to the need for decision making flexibility as predicted by tradeoff theory
Negatively related to variability in operating cash flows as predicted by tradeoff theory

35. Information Asymmetry
Managers prefer retained earnings to external financing since external financing depends upon the market pricing the security
If management believes that the market is overvaluing its securities it is more willing to issue new equity, even if projects don’t exist
If management believes that the market is underpricing its securities it is less willing to issue new equity even if good projects exist.

36. Signaling
Therefore issuing securities signals the market that firms believe their security is overvalued and it is interpreted as a negative signal. (The market believes the firm has negative information not publicly available)
The signal is more negative if there is a greater possibility of asymmetry (stocks for example).

37. Capital Structure Decisions
Rank Source Principles Cited
1 Retained Earnings None
2 Straight Debt Max Security Prices
3 Convertible Debt Cash Flow and
Survivability
4 External Common Avoiding Dilution of Equity
5 Straight Pref Stock Comparability
6 Convertible Pref None

38. Other Things to Consider
Some final considerations in the capital structure decision
1) Long Run Viability
2) Managerial Conservatism
3) Lender and Rating Agency Attitudes
4) Financial Flexibility
5) Control
6) Asset Structure
7) Growth Rate
8) Profitability

39. Cap Structure: Models and Applications
Cost of Capital Approach
Analysis based on the cost to the firm of financing new projects (the WACC calculated earlier)
Adjusted Present Value
Valuing the firm by starting without leverage then adjusting its value as more debt is added
Comparative Analysis
Comparing the debt ratio and other financial information to industry averages

40. The Cost of Capital Approach
Basic Idea:
Attempt to maximize firm value by finding the level of debt that produces its minimum WACC.
Procedure:
Calculate the cost of debt, cost of equity and the WACC at various levels of debt to identify its minimum WACC.

41. WACC = rdwd(1-t) + rpswps + rewe
The weighted average cost of capital is defined as the weighted average of the cost of the different components of financing
WACC = rdwd(1-t) + rpswps + rewe
where:
rd = before tax cost of debt wd = % of financing from debt
rps = cost of preferred stock wps = % of financing from Pref stock
rd = cost of debt equity wd = weight of financing from equity
t = firms marginal tax rate

42. WACC and Firm Value
The value of the firm is the present value of its future cash flows (FCFF) discounted at the WACC (the hurdle rate)
Value of the firm = S [FCFF/(1+WACC)t]
Notice as the WACC decreases the value of the firm will increase, if the WACC increases the value of the firm will decrease.

43. WACC and Firm Value
According to the present value formula as the discount rate decreases the PV of a future sum (or series of cash flows) will increase.
If the tradeoff theory is correct there is a minimum WACC
Does this imply that the Firm Value will be maximized at the point where the WACC is minimized?

44. WACC and Firm Value
If the cash flows to the firm do not depend on the financing mix, the value of the firm is maximized when the WACC is minimized
The Debt Equity ratio might cause a change in the FCFF, if this is the case the minimum WACC will not necessarily maximize firm value

45. Estimating the Cost of Capital*
You need to estimate the WACC for different levels of debt.
Develop an estimate for the cost of equity and various debt levels
Develop an estimate for the cost of debt at various debt levels
Combine 1 and 2 to find the WACC for various levels of debt.

46. Estimating the Cost of Equity
Step 1 Estimate the equity beta (run regression or use analysts estimate)
Step 2 Estimate the unlevered beta (Beta if the firm had no debt)
bu = bcurrent/[1+(1-t)D/E]
Step 3 Reestimate the levered beta for different levels of debt
bLevered = bu[1+(1-t)D/E]
Step 4 Use CAPM to estimate the costs of equity from the levered betas
re= rRF+ bLevered[E(rm)-rRF)

47. Disney’s Optimal Capital Structure
Step 1 Estimate Beta

48. Disney’s Cost of Equity
Step 2: Estimate the Unlevered beta:
u =current/[1+(1-t)D/E]
Disney’s D/E Ratio =
Long Term Debt = Billion
Market Capitalization =65.74 Billion
D/E = 12.67/65.74 = .19%
Assuming a 36% tax rate
u= current/[1+(1-t)D/E] =
1.094[1+(1-.36)(.19)] = 0.975

49. Disney Cost of Equity Step 3
Reestimate the levered beta at different levels of debt
Lev= u[1+(1-t)D/E]
Spreadsheet Does This step automatically

50. Disney’s Cost of Equity
Step 4 Estimate cost of equity using Levered in the CAPM
let rRF = 5%
rM- rRF = .0482%
Re=rRF+b(rM-rRF)
Spreadsheet does this automatically

51. Estimate the Cost of Debt
Step 1 Compute the market value of the firm MV of firm = MV of Debt + MV of Equity
Step 2 Compute $ value of debt at various debt ratios $Value of Debt = D/(D+E)(MV of firm)
Step 3 Compute the amount paid in interest at each debt ratio = (Interest rate)($value of Debt)
Step 4 Estimate the Interest Coverage Ratio = EBIT/Interest Expense
Step 5 Use the Interest coverage ratio to determine bond ratings and interest rate spreads
Step 6 Use Spreads to find before tax cost of debt

52. A Viscous Circle
You need the interest rate to calculate the interest payments. Then use the interest payment to determine the interest coverage and rating to find the interest rate.
Use iterative procedure to find consistent rates, Assume AAA use rate then estimate rate, if they are not the same repeat the process...

53. Estimating Cost of Debt Step 1
Step 1 Compute the market value of the firm MV of firm = MV of Debt + MV of Equity
Use this as the current amount of financing undertaken by the firm (we want to find the $ value of debt at various debt ratios)

54. Cost of Debt Step 2
Step 2 Compute $ value of debt at various debt ratios
$Value of Debt = (Debt/(D+E))(MV of firm)
The Spreadsheet will do this automatically for you for each level of debt!

55. Cost of Debt Step 3 Step 3 Compute the amount paid in interest at each
debt ratio = (Interest Rate)($value of Debt)
The problem is that you have to assume an interest rate then continue with Steps 4 and 5 to see if your assumption was correct. Your assumption of the rate is based upon the likely rating for the firm.
Starting with the increase from 0% to 10% debt assume that the firm is ranked AAA. Then look at the table relating bond ratings to rates to estimate the rate.

56. Bond Ratings and Interest Coverage Ratios
Rating Int Cov Rating Int Cov
AAA >12.5 B
AA B
A B
A CCC
A CC
BBB C
BB D <0.5

57. Bond Spreads Summer 2012

58. Cost of Debt Step 3 For Example: Assuming a 2% Treasury Rate
A rating of AAA implies a 2.35% interest rate for the firm (0.35% spread over the long term rate)
Given the interest rate you can calculate the interest expense = (Interest Rate)($ Value of Debt) =(0.0235)($ Value of Debt)
Use your answer to calculate the interest coverage ratio in step 4

59. Disney’s Cost of Debt Steps 4 & 5
Step 4 Estimate the Interest Coverage Ratio = EBIT/Interest Expense
Compare your answer to the interest coverage ratio that corresponds to the rating that you assumed.
If the interest coverage ratio is in the range for the rating you assumed stop, if it is not change your assumption to the rating implied by the new coverage ratio and go back to step 3.
Repeat until the answer is consistent

60. Cost of Capital
Using the cost of equity and cost of debt at various debt levels you can find the WACC of each level of debt.
Remember, the debt level determine the weights of each type of financing (the capital structure).

61. Optimal Debt Ratio

62. Minimum WACC
The minimum WACC occurs at approximately 25% debt. This is the “Optimal” amount of debt for the firm
The value of the firm could then be found assuming that the future FCFF can be estimated.

63. FCFF A Disney Example
FCFF = EBIT(1-t) + Depreciation - Capital Spending
Disney’s 2005 financial statements show that
EBIT = Billion
Depreciation = Billion
Capital Spending = Billion
Assuming a tax rate of 36%
FCFF = 5.301(1-.36) – =

64. Firm Value and WACC
In General the value of the firm is the present value of its discounted cash flows:
If the cash flows are constant over time similar to a perpetuity this reduces to

65. Constant growth in FCFF
This is the same formula as for valuing stocks with constant growth in dividends (now the cash flows being discounted are FCFF instead of Dividends.
Let g be the constant rate of growth in FCFF then the value of the firm is given by:

66. Annual Savings
Disney is currently operating at a debt level of 16%. But its optimal debt level is 30%
The annual financing cost at the current debt ratio is 78.41(.09242) = Billion
At a debt level of 25% (WACC = )
The annual financing costs would be equal to (.08985) = Billion
This implies an annual savings of
7.2466B = $ Million
IF the firm moves to its optimal capital structure

67. Rearrange to find the growth rate
Implied Growth Rate
Rearrange to find the growth rate

68. Implied Growth Rate
Use the current MV of the firm from before as the PV PV=78.41 B, FCFF = Billion, WACC = %
78.41  .
08985 
2.9086  
.05087
2.9086 
78.41

69. Assuming that the annual savings also grows at the implied growth rate of 7.36%, the PV of the annual savings will represent an increase in the value of the firm since it reduces its yearly interest expense.

70. Share Price
The value of the firm increased by Billion, this can be transformed to a per share value by dividing by the number of shares outstanding.
The resulting number should represent an increase in the share price of the firm. It would be the increase in the PV of the future cash flows to the firm.
Given 2.1 Billion Shares issued:
5.431/2.113 = $2.57
The share price should increase by $2.57 or 2.57/31.45 = 8.1%

71. Final Thoughts
The model assumes that the relationship between bond ratings and risk premiums is the same over time
The model assumes that all debt will be refinanced at the new level of interest rates
Is this the optimal capital ratio if the bonds are ranked below investment grade?

72. Adjusted Present Value
Start with the PV of the firm assuming that there is no debt
As debt is added adjust the present value to account for the positive and negative effects of adding debt.
Assuming that the largest benefit of borrowing is the tax saving and the largest source of costs are bankruptcy costs:
Value of Value of PV of PV of
Levered = Unlevered + Tax Benefits - Bankruptcy
Firm Firm of debt Costs

73. Value of Unlevered Firm
Assumes that the firm has no debt. this requires an estimate of the unlevered cost of equity.
The unlevered cost of equity is found by using the unlevered beta in the CAPM
The value of the unlevered firm is then:

74. Tax Benefit
The expected tax benefit from borrowing is based upon the level of debt in the firm.
Each years tax savings equal the tax rate multiplied by the amount of debt multiplied by the cost of debt
The benefit should be discounted at the cost of debt
PV of tax benefit = (Tax rate)(Cost of Debt)(Debt) Cost of Debt = (Tax Rate)(Debt)
Note: The cost of debt changes as the level of debt changes

75. Expected Bankruptcy Costs
The expected bankruptcy costs depends upon the probability of default
The probability of default will increase as the firm increases its use of debt.
The expected bankruptcy cost is the probability of default multiplied by the PV of the bankruptcy costs if the firm defaults.
PV of Expected Probability PV of
Bankruptcy = of x Bankruptcy
Costs Bankruptcy Costs

76. Optimal Debt Ratio
To find the optimal debt ratio the adjusted value of the firm needs to be calculated at various levels of debt
The level of debt that maximizes the adjusted value of the levered firm is the one that is the optimal level of debt.

77. Adjusted Present Value

78. Comparative Analysis
Compare debt ratio to similar firms, Easiest approach is to compare to the industry average.
The most important thing is to then investigate why the firm might have a higher or lower debt ratio than the average.

79. The Financing Details
If the firm is not at its optimal level of debt it must decide if it wants to move toward its optimal level. Outside pressure often plays a key role in making this decision.
If it decides to move toward its optimal level it has two choices.
Gradual Change --Change only new projects or also adjust existing ones?
Quick Change

80. Immediate or Gradual
The decision of an unlevered firm to change its debt ratio is based upon
Degree of Confidence in the Optimal Estimate
Comparability of Peer Groups
Likelihood of a takeover
Need for flexibility (financing slack)

81. ?? Speed of Change ??
Assume that a firm which currently has more debt than identified as its optimal level has substantial indirect bankruptcy costs. Is the speed that it attempts to return to its optimal level affected by its bankruptcy costs?

82. Increasing Leverage Quickly
Borrowing money and buying back stock
Debt for Equity Swap
Using the proceeds from the sales of assets to buyback stock

83. Why Increase Leverage Quickly?
Often to avoid a hostile takeover bid. Firms with large cash balances are prime targets for takeover. Some recent examples of increased leverage to fight a takeover are
CBS Inc. in Bought back 21% of Stock
Goodyear Tire 1986 Sold three units and bought back 20 Million shares
Phillips Petrol Doubled debt to buy back shares

84. Decreasing Leverage Quickly
Creates a problem since the it signals that the firm is desperate to decrease its debt level (It might not survive if it doesn’t decrease its debt level)
Most often this happens in one of two ways
Renegotiating debt agreements. Convincing lenders to take an equity stake in the firm
Selling assets and using proceeds to retire some debt
Which assets should the firm sell? Worst performing, Best performing or most liquid?

85. Increasing Leverage Gradually
The ability to increase the the firms leverage gradually allows the firm to look for quality projects. Some possible ways of increasing the portion of debt include:
Increasing the Dividend Payout Ratio
Repurchasing stock each year
Increasing Capital expenditures

86. Decreasing Leverage Gradually
Firms can finance new projects with retained earnings, lowering the amount of debt used by the firm. Lowering (or suspending) dividend is another approach (although not one favored by shareholders) to decreasing the debt level.

87. Details of New Finance
The firm needs to specify the details that outline either its new equity (common stock, warrants or contingency rights) or debt (maturity, fixed or floating, conversion options....)
Will discuss a series of steps that will help in the decision making process

88. Details Examine the Cash Flow Characteristics
Want to match Cash Flows and Liabilities (duration, fixed or floating rates, inflation, currency risk...)
Examine the tax implications
Consider the response of Rating Agencies
Examine the effects of Asymmetric Information
Consider any Agency Costs
A Sensitivity Analysis