Capital Structure Debt versus Equity

Advantages of Debt Interest is tax deductible (lowers the effective cost of debt) Debt-holders are limited to a fixed return – so stockholders do not have to share profits if the business does exceptionally well Debt holders do not have voting rights

Disadvantages of Debt Higher debt ratios lead to greater risk and higher required interest rates (to compensate for the additional risk)

What is the optimal debt-equity ratio? Need to consider two kinds of risk: Business risk Financial risk

Business Risk Standard measure is beta (controlling for financial risk) Factors: Demand variability Sales price variability Input cost variability Ability to develop new products Foreign exchange exposure Operating leverage (fixed vs variable costs)

Financial Risk The additional risk placed on the common stockholders as a result of the decision to finance with debt

Example of Business Risk Suppose 10 people decide to form a corporation to manufacture disk drives. If the firm is capitalized only with common stock – and if each person buys 10% -- each investor shares equally in business risk

Example of Relationship Between Financial and Business Risk If the same firm is now capitalized with 50% debt and 50% equity – with five people investing in debt and five investing in equity The 5 who put up the equity will have to bear all the business risk, so the common stock will be twice as risky as it would have been had the firm been all-equity (unlevered).

Business and Financial Risk Financial leverage concentrates the firm’s business risk on the shareholders because debt-holders, who receive fixed interest payments, bear none of the business risk.

Financial Risk Leverage increases shareholder risk Leverage also increases the return on equity (to compensate for the higher risk)

Question? Is the increase in expected return due to financial leverage sufficient to compensate stockholders for the increase in risk?

Modigliani and Miller YES Assuming no taxes, the increase in return to shock-holders resulting from the use of leverage is exactly offset by the increase in risk – hence no benefit to using financial leverage (and no cost).

Capital Structure When a firm issues debt and equity securities it splits cash flows into two streams: Safe stream to bondholders Risky stream to stockholders

Capital Structure Modigliani and Miller (1958) show that financing decisions don’t matter in perfect capital markets M&M Proposition 1: Firms cannot change the total value of their securities by splitting cash flows into two different streams Firm value is determined by real assets Capital structure is irrelevant

Modigliani and Miller Any combination of securities is as good as any other. Example: Two Firms with the same operating income who differ only in capital structure Firm U is unlevered: VU=EU Firm L is levered: EL= VL-DL

Modigliani and Miller It does not matter what risk preferences are for investors. Just need that investors have the ability to borrow and lend for their own account (and at the same rate as firms) so that they can “undo” any changes in firm’s capital structure M&M Proposition 1: the value of a firm is independent of its capital structure.

The Traditional Position What did financial experts think before M&M? They used the concept of WACC (weighted average cost of capital) WACC is the expected return on the portfolio of all the company’s securities

WACC WACC is the traditional view of capital structure, risk and return.

WACC Example - A firm has $2 mil of debt and 100,000 of outstanding shares at $30 each. If they can borrow at 8% and the stockholders require 15% return what is the firm’s WACC? D = $2 million E = 100,000 shares X $30 per share = $3 million V = D + E = 2 + 3 = $5 million

The Traditional Position The return on equity (rE) is constant WACC declines with increasing leverage because rD<rE Given the two assumptions above, a firm will minimize the cost of capital by issuing almost 100% debt This can’t be correct!

An intermediate position A moderate degree of financial leverage may increase the return on equity (but less than predicted by M&M proposition 2) A high degree of financial leverage increases the return on equity (but by more than predicted by M&M proposition 2) WACC then declines at first, then rises with increasing leverage (U-shape) Its minimum point is the point of “optimal capital structure”.

WACC (intermediate view) rE WACC rD D E 8

Modigliani and Miller Revisited M&M proposition 1: A firm’s total value is independent of its capital structure Assumptions needed for Prop 1 to hold: Capital markets are perfect and complete Before-tax operating profits are not affected by capital structure Corporate and personal taxes are not affected by capital structure The firm’s choice of capital structure does not convey important information to the market

Modigliani and Miller Revisited M&M Proposition 2: The return on equity will rise as the debt-equity ratio rises in order to compensate equity holders for the additional (financial) risk. Note: Proposition 2 does not rely on default risk – rE rises because of the rise in financial risk

WACC (M&M view) r rE WACC rD D E 9

Capital Structure and Corporate Taxes Financial Risk - Risk to shareholders resulting from the use of debt. Financial Leverage - Increase in the variability of shareholder returns that comes from the use of debt. Interest Tax Shield- Tax savings resulting from deductibility of interest payments.

Capital Structure and Corporate Taxes Example - You own all the equity in a company. The company has no debt. The company’s annual cash flow is $1,000, before interest and taxes. The corporate tax rate is 40%. You have the option to exchange 1/2 of your equity position for 10% bonds with a face value of $1,000. Should you do this and why?

Capital Structure and Corporate Taxes All Equity 1/2 Debt EBIT 1,000 1,000 Interest Pmt 0 100 Pretax Income 1,000 900 Taxes @ 40% 400 360 Net Cash Flow $600 $540 Total Cash Flow All Equity = 600 *1/2 Debt = 640 (540 + 100)

U.S. Tax Code Allows corporations to deduct interest payments on debt as an expense Dividend payments to stockholders are not deductible Differential treatment results in a net benefit to financial leverage (debt)