Capital Structure Theory Perfect and Imperfect Capital Markets

Outline of the Topics 1 Capital Structure Choices 2 Capital Structure in Perfect Capital Markets 3 Debt and Taxes 4 The Costs of Bankruptcy and Financial Distress 5 Optimal Capital Structure: The Tradeoff Theory 6 Additional Consequences of Leverage: Agency Costs and Information 7 Capital Structure: Putting It All Together 2

Learning Objectives Examine how capital structures vary across industries and companies Understand why investment decisions, rather than financing decisions, fundamentally determine the value and cost of capital of a firm Describe how leverage increases the risk of the firm’s equity Demonstrate how debt can affect firm value through taxes and bankruptcy costs 3

Learning Objectives (cont’d) Show how the optimal mix of debt and equity trades off the costs (including financial distress costs) and benefits (including the tax advantage) of debt Analyze how debt can alter the incentives of managers to choose different projects and can be used as a signal to investors Weigh the many costs and benefits to debt that a manager must balance when deciding how to finance the firm’s investments

Capital Structure Choices The collection of securities a firm issues to raise capital from investors Firms consider whether the securities issued: Will receive a fair price in the market Have tax consequences Entail transactions costs Change future investment opportunities 5

Capital Structure Choices A firm’s debt-to-value ratio is the fraction of the firm’s total value that corresponds to debt D / (E+D) Capital structure choices often vary across industries and within industry 6

Figure 1 Debt-to-Value Ratio [D/(E + D)] for Select Industries

Figure 2 Capital Structures of Intel and ARM Holdings 8

2. Capital Structure in Perfect Capital Markets A perfect capital market is a market in which: Securities are fairly priced No tax consequences or transactions costs Investment cash flows are independent of financing choices 9

2. Capital Structure in Perfect Capital Markets Application: Financing a coffee shop that costs $24,000 to open Expected cash flow is $34,500 at the end of one year (details in Table 16.1) Given the risk, coffee shop should earn 15% NPV of the project is -$24,000+$34,500/1.15 = $6,000 Finance with equity costing $30,000 Use some debt 10

2. Capital Structure in Perfect Capital Markets Choices: Finance with equity costing $30,000 Use some debt (say, $15,000) Leverage increases the cost of equity 11

2. Capital Structure in Perfect Capital Markets Modigliani and Miller (MM) with perfect capital markets In an unlevered firm, cash flows to equity equal the free cash flows from the firm’s assets In a levered firm, the same cash flows are divided between debt and equity holders The total to all investors equals the free cash flows generated by the firm’s assets 12

Figure 3 Unlevered Versus Levered Cash Flows with Perfect Capital Markets 13

2. Capital Structure in Perfect Capital Markets MM Proposition I: In a perfect capital market, the total value of a firm is equal to the market value of the free cash flows generated by its assets and is not affected by its choice of capital structure VL= E + D =VU (Eq. 1) 14

Table 1 Returns to Equity in Different Scenarios with and Without Leverage 15

Figure 4 Unlevered Versus Levered Returns with Perfect Capital Market 16

Example 1- The Risk and Return of Levered Equity Problem: Suppose you borrow only $6,000 when financing your coffee shop. According to Modigliani and Miller, what should the value of the equity be? What is the expected return? Solution: The value of the firm’s total cash flows does not change: it is still $30,000. Thus, if you borrow $6000, your firm’s equity will be worth $24,000. To determine its expected return, we will compute the cash flows to equity under the two scenarios . The cash flows to equity are the cash flows of the firm net of the cash flows to debt (repayment of principal plus interest). 17

Example 1- The Risk and Return of Levered Equity Solution: The firm will owe debt holders $6,000  1.05 = $6,300 in one year Thus, the expected payoff to equity holders is $34,500 – $6,300 = $28,200, for a return of $28,200 / $24,000 – 1 = 17.5% 18

Example 1- The Risk and Return of Levered Equity Evaluate: While the total value of the firm is unchanged, the firm’s equity in this case is more risky than it would be without debt, but less risky than if the firm borrowed $15,000 To illustrate, note that if demand is weak, the equity holders will receive $27,000 – $6,300 = $20,700, for a return of $20,700/$24,000 – 1 = – 13.75% 19

Example 1- The Risk and Return of Levered Equity Solution (cont’d): Compare this return to – 10% without leverage and – 25% if the firm borrowed $15,000. As a result, the expected return of the levered equity is higher in this case than for unlevered equity (17.5% versus 15%), but not as high as in the previous example (17.5% versus 25% with more leverage) 20

2- Capital Structure in Perfect Capital Markets Homemade leverage Investors use leverage in their own portfolios to adjust firm’s leverage A perfect substitute for firm leverage in perfect capital markets 21

2- Capital Structure in Perfect Capital Markets Leverage and the Cost of Capital Weighted average cost of capital (pretax) (Eq.2) 22

2- Capital Structure in Perfect Capital Markets MM Proposition II: The cost of capital of levered equity: The Cost of Levered Equity Cost of levered equity equals the cost of unlevered equity plus a premium proportional to the debt-equity ratio (Eq.3) 23

Figure 5- WACC and Leverage with Perfect Capital Markets 24

Figure 5- WACC and Leverage with Perfect Capital Markets (cont’d) 25

Example 2- Computing the Equity Cost of Capital Problem: Suppose you borrow only $6,000 when financing your coffee shop. According to MM Proposition II, what will your firm’s equity cost of capital be? Solution: Because your firm’s assets have a market value of $30,000, by MM Proposition I the equity will have a market value of $24,000 = $30,000 – $6,000. We can use Eq. 16.3 to compute the cost of equity. We know the unlevered cost of equity is ru = 15%. We also know that rD is 5%. The cost of equity is: This result matches the expected return calculated in Example .1 where we also assumed debt of $6,000. The equity cost of capital should be the expected return of the equity holders. 26

3- Debt and Taxes Market imperfections can create a role for the capital structure Corporate taxes: Corporations can deduct interest expenses Reduces taxes paid Increases amount available to pay investors Increases value of the corporation 27

3- Debt and Taxes Consider the impact of interest expenses on taxes paid by Safeway, Inc. In 2012, Safeway had earnings before interest and taxes of $1.13 billion Interest expenses of $300 million Corporate tax rate is 35% Compare Safeway’s actual net income with what it would have been without debt 28

Safeway’s Income with and without Leverage, 2012 ($ millions) Total amount available to all investors is: 29

Interest Tax Shield = Corporate Tax Rate  Interest Payments 3- Debt and Taxes Interest Tax Shield The gain to investors from the tax deductibility of interest payments Interest Tax Shield = Corporate Tax Rate  Interest Payments (Eq. 4) 30

Example 3- Computing the Interest Tax Shield Problem: Shown below is the income statement for E.C. Builders (ECB). Given its marginal corporate tax rate of 35%, what is the amount of the interest tax shield for ECB in years 2010 through 2013? ECB Income Statement ($million) 2010 2011 2012 2013 Total Sales 3369 3706 4077 4432 Cost of Sales -2359 -2584 -2867 -3116 Selling, general, and administrative expense -226 -248 -276 -299 Depreciation -22 -25 -27 -29 Operating income 762 849 907 988 Other income 7 8 10 12 EBIT 769 857 917 1000 Interest expense -50 -80 -100 Income before tax 719 777 817 900 Taxes (35%) -252 -272 -286 -315 Net Income 467 505 531 585 31

Example 3- Computing the Interest Tax Shield Problem (cont’d): ECB Income Statement ($million) 2010 2011 2012 2013 Total Sales 3369 3706 4077 4432 Cost of Sales -2359 -2584 -2867 -3116 Selling, general, and administrative expense -226 -248 -276 -299 Depreciation -22 -25 -27 -29 Operating income 762 849 907 988 Other income 7 8 10 12 EBIT 769 857 917 1000 Interest expense -50 -80 -100 Income before tax 719 777 817 900 Taxes (35%) -252 -272 -286 -315 Net Income 467 505 531 585 32

Example 3- Computing the Interest Tax Shield Solution: From Eq. 4, the interest tax shield is the tax rate of 35% multiplied by the interest payments in each year Interest Tax Shield = Corporate Tax Rate  Interest Payments ($ million) 2010 2011 2012 2013 Interest expense 50 80 100 Interest tax shield (35% X interest expense) 17.5 28 35 By using debt, ECB is able to reduce its taxable income and therefore decrease its total tax payments by $115.5 million over the four-year period. Thus the total amount of cash flows available to all investors (debt holders and equity holders) is $115.5 million higher over the four-year period. 33

3- Debt and Taxes When a firm uses debt, the interest tax shield provides a corporate tax benefit each year To determine the benefit, compute the present value of the stream of future interest tax shields 34

Figure 6- The Cash Flows of the Unlevered and Levered Firm 35

3- Debt and Taxes By increasing the cash flows paid to debt holders through interest payments, a firm reduces the amount paid in taxes The increase in total cash flows paid to investors is the interest tax shield 36

3- Debt and Taxes Value of the Interest Tax Shield 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 CFASSETS = CFDEBT +CFSTOCKHOLDERS CF = Levered CF + I where I =Rd .D CF = (EBIT - Rd .D)(1- TC)+ I= EBIT(1 - TC) + TC.Rd.D MM Proposition I with taxes: 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: VL = VU + PV(Interest Tax Shield) or VL = VU + Tc. D (Eq. 5) 37

Example 4- Valuing the Interest Tax Shield Problem: Suppose ECB from borrows $2 billion by issuing 10-year bonds. ECB’s cost of debt is 6%, so it will need to pay $120 million in interest each year for the next 10 years, and then repay the principal of $2 billion in year 10. ECB’s marginal tax rate will remain 35% throughout this period. By how much does the interest tax shield increase the value of ECB? In this case, the interest tax shield lasts for 10 years, so we can value it as a 10-year annuity. Because the tax savings are as risky as the debt that creates them, we can discount them at ECB’s cost of debt: 6%. The interest tax shield each year is 35%  $120 million = $42 million. Valued as a 10-year annuity with a discount rate of 0.06, we have: Because only interest is tax deductible, the final repayment of principal in year 10 is not deductible, so it does not contribute to the tax shield. 38

Example 4 Valuing the Interest Tax Shield Evaluate: We know that in perfect capital markets, financing transactions have an NPV of zero—the interest and principal repayment have exactly a present value of the amount of the bonds: $2 billion. However, the interest tax deductibility makes this a positive-NPV transaction for the firm. Because the government effectively subsidizes the payment of interest, issuing these bonds has an NPV of $309 million. 39

3- Debt and Taxes Interest Tax Shield with Permanent Debt The level of future interest payments varies due to: changes in the amount of debt outstanding, changes in the interest rate on that debt, changes in the firm’s marginal tax rate, and the risk that the firm may default and fail to make an interest payment 40

3- Debt and Taxes Interest Tax Shield with Permanent Debt As we know, the market value of debt must equal the present value of its future interest payments: Market value of Debt = D = PV(Future Interest Payments) (Eq. 6) 41

3- Debt and Taxes Interest Tax Shield with Permanent Debt If the firm’s marginal tax rate (TC) is constant, we have the following general formula: Value of the Interest Tax Shield of Permanent Debt PV(Interest Tax Shield)=PV(TC X Future Interest Payments) =TC X PV(Future Interest Payments) =TC X D (Eq..7) 42

3- Debt and Taxes Weighted Average Cost of Capital with Taxes Another way to incorporate the benefit of the firm’s future interest tax shield WACC = RA = (E/V)RE + (D/V)(1-T)RD Eq..8 43

3- Debt and Taxes The reduction in the WACC increases with the amount of debt financing   The higher the firm’s leverage, the more the firm exploits the tax advantage of debt, and the lower its WACC 44

Figure 7- The WACC with and without Corporate Taxes 45

3- Debt and Taxes The Bottom Line We can include the interest tax shield when assessing firm value by either: Discounting free cash flow using the pretax WACC and adding the PV of future interest tax shields, or Discounting free cash flow using the WACC (with taxes) 46

4- The Costs of Bankruptcy and Financial Distress If increasing debt increases the value of the firm, why not shift to 100% debt? With more debt, there is a greater chance that the firm will default on its debt obligations A firm that has trouble meeting its debt obligations is in financial distress 47

4- The Costs of Bankruptcy and Financial Distress Direct Costs of Bankruptcy Each country has a bankruptcy code designed to provide an orderly process for settling a firm’s debts However, the process is still complex, time-consuming, and costly Outside professionals are generally hired The creditors may also incur costs during the process. They often wait several years to receive payment 48

4- The Costs of Bankruptcy and Financial Distress Direct Costs of Bankruptcy Average direct costs are 3% to 4% of the pre-bankruptcy market value of total assets Likely to be higher for firms with more complicated business operations and for firms with larger numbers of creditors 49

16.4 The Costs of Bankruptcy and Financial Distress Indirect Costs of Financial Distress Difficult to measure accurately, and often much larger than the direct costs of bankruptcy Often occur because the firm may renege on both implicit and explicit commitments and contracts Estimated potential loss of 10% to 20% of value Many 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 50

4- The Costs of Bankruptcy and Financial Distress Examples: Loss of 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 51

4- The Costs of Bankruptcy and Financial Distress Examples: Cost to employees: Most firms offer their employees explicit long- term employment contracts During bankruptcy these contracts and commitments are often ignored and employees can be laid off Fire Sales of Assets: Companies in distress may be forced to sell assets quickly 52

5- Optimal Capital Structure: The Tradeoff Theory 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: (Eq. 16.10) 53

5- Optimal Capital Structure: The Tradeoff Theory Key qualitative factors determine the present value of financial distress costs: The probability of financial distress Depends on the likelihood that a firm will default 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 54

5- Optimal Capital Structure: The Tradeoff Theory Key qualitative factors determine the present value of financial distress costs: The magnitude of the direct and indirect costs related to financial distress that the firm will incur Depend on the relative importance of the sources of these costs and likely to vary by industry 55

5- Optimal Capital Structure: The Tradeoff Theory As debt increases, tax benefits of debt increase until interest expense exceeds EBIT Probability of default, and hence present value of financial distress costs, also increases The optimal level of debt, D*, occurs when these the value of the levered firm is maximized D* will be lower for firms with higher costs of financial distress 56

Figure 8- Optimal Leverage with Taxes and Financial Distress Costs 57

5- Optimal Capital Structure: The Tradeoff Theory The Tradeoff Theory helps to resolve two important facts about leverage: 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 58

6- Additional Consequences of Leverage: Agency Costs and Information costs that arise when there are conflicts of interest between stakeholders Separation of ownership and control: Managers may make decisions that: Benefit themselves at investors’ expense Reduce their effort Spend excessively on perks Engage in “empire building” 59

6- Additional Consequences of Leverage: Agency Costs and Information If these decisions have negative NPV for the firm, they are a form of agency cost Debt provides incentives for managers to run the firm efficiently: Ownership may remain more concentrated, improving monitoring of management Since interest and principle payments are required, debt reduces the funds available at management’s discretion to use wastefully 60

6- Additional Consequences of Leverage: Agency Costs and Information Equity-Debt Holder Conflicts A conflict of interest exists if investment decisions have different consequences for the value of equity and the value of debt most likely to occur when the risk of financial distress is high managers may take actions that benefit shareholders but harm creditors and lower the total value of the firm 61

6- Additional Consequences of Leverage: Agency Costs and Information Agency costs for a company in distress that will likely default: Excessive risk-taking A risky project could save the firm even if the expected outcome is so poor that it would normally be rejected Under-investment problem Shareholders could decline new projects. Management could distribute as much as possible to the shareholders before the bondholders take over 62

Figure 9- Optimal Leverage with Taxes, Financial Distress, and Agency Costs 63

Optimal Leverage with Taxes, Financial Distress, and Agency Costs

Optimal Leverage with Taxes, Financial Distress, and Agency Costs

Putting All Together

Conclusions Case I – no taxes or bankruptcy costs No optimal capital structure Case II – corporate taxes but no bankruptcy costs Optimal capital structure is almost 100% debt Each additional dollar of debt increases the cash flow of the firm Case III – corporate taxes and bankruptcy costs Optimal capital structure is part debt and part equity Occurs where the benefit from an additional dollar of debt is just offset by the increase in expected bankruptcy costs 16-67

6- Additional Consequences of Leverage: Agency Costs and Information As debt increases, firm value increases Interest tax shield (TCD) Improvements in managerial incentives. If leverage is too high, firm value is reduced by present value of financial distress costs agency costs The optimal level of debt, D*, balances these benefits and costs of leverage 68

6- Additional Consequences of Leverage: Agency Costs and Information Asymmetric information Managers’ information about the firm and its future cash flows is likely to be superior to that of outside investors This may motivate managers to alter a firm’s capital structure 69

6- Additional Consequences of Leverage: Agency Costs and Information Leverage as a Credible Signal Managers use leverage to convince investors that the firm will grow, even if they cannot provide verifiable details The use of leverage as a way to signal good information is known as the signaling theory of debt 70

6- Additional Consequences of Leverage: Agency Costs and Information Market Timing Managers sell new shares when they believe the stock is overvalued, and rely on debt and retained earnings if they believe the stock is undervalued 71

6- Additional Consequences of Leverage: Agency Costs and Information Adverse Selection and the Pecking Order Hypothesis Suppose managers issue equity when it is overpriced Knowing this, investors will discount the price they are willing to pay for the stock Managers do not want to sell equity at a discount so they may seek other forms of financing 72

6- Additional Consequences of Leverage: Agency Costs and Information The pecking order hypothesis states: Managers have a preference to fund investment using retained earnings, followed by debt, and will only choose to issue equity as a last resort 73