Capital Structure Theory Lecture 11 Chapter 15

Which one is more? How would you like your pizza to be sliced? By 4 or 8 pieces? Let’s make it 4, I cannot eat 8 pieces.

Capital Structure and the Pie The value of a firm is defined to be the sum of the value of the firm’s debt and the firm’s equity. V = B + S If the goal of the firm’s management is to make the firm as valuable as possible, then the firm should pick the debt-equity ratio that makes the pie as big as possible. S B S S B B Value of the Firm

What is pizza for us? Our assets determine the size of the pizza; The mix of securities determines how the pizza is sliced; The only way to increase the amount of pizza is to increase the value of assets (pizza), not slicing (financing) in a new combination of slices;

Value and Capital Structure Assets Liabilities and Stockholder’s Equity Value of cash flows from firm’s real assets and operations Market value of debt Market value of equity Value of Firm Value of Firm 2

Debt ratio The ratio of total liabilities to total assets; It measures the percentage of funds provided by creditors

Average Book Debt Ratios 2

Modigliani and Miller Modern capital structure theory began in 1958; Professors Franco Modigliani and Merton Miller (MM) issued an article concerning how a firm’s value is linked with its capital structure;

M&M (Debt Policy Doesn’t Matter) Modigliani & Miller When there are no taxes and capital markets function well, the market value of a company does not depend on its capital structure. In other words, financial managers cannot increase value by changing the mix securities used to finance the company. 3

M&M (Debt Policy Doesn’t Matter) Assumptions By issuing 1 security rather than 2, company diminishes investor choice. This does not reduce value if: Investors do not need choice, OR There are sufficient alternative securities Capital structure does not affect cash flows e.g... No taxes No bankruptcy costs No effect on management incentives 4

M&M (Debt Policy Doesn’t Matter) Example - River Cruises - All Equity Financed 5

What is what? To calculate Earnings per share, take Operating income number of shares outstanding ; or 75,000/100,000=0.75 p To calculate return on shares, take Operating income/ market value of shares 75,000/1,000,000=0.075=7.5%

M&M (Debt Policy Doesn’t Matter) Example cont. 50% debt 6

What is what? To calculate Earnings per share, take Operating income number of shares outstanding ; or 25,000/50,000=0.5 p To calculate return on shares, take Operating income/ market value of shares 25,000/500,000=0.075=0.05%

M&M (Debt Policy Doesn’t Matter) Example - River Cruises - All Equity Financed - Debt replicated by investors 7

M&M (Debt Policy Doesn’t Matter) Example - River Cruises – Firm debt at 50% - Investor can unwrap debt 7

MM Proposition I (No Taxes) We can create a levered or unlevered position by adjusting the trading in our own account. Capital structure is irrelevant in determining the value of the firm: VL = VU

MM Propositions I & II (With Taxes) Proposition I (with Corporate Taxes) Firm value increases with leverage VL = VU + TC D Proposition II (with Corporate Taxes) Some of the increase in equity risk and return is offset by the interest tax shield;

C.S. & Corporate Taxes Operating Risk (business risk): The riskiness inherent in the firm’s operations if it uses no debt; A firm has little business risk if the demand for its product is stable, if the prices of its inputs and products remain constant; The lower a firm’s business risk, the higher its optimal debt ratio; 10

C.S. & 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. It is the extent to which fixed-income securities (debt and preferred stock) are used in a firm’s capital structure; 10

C.S. & Corporate Taxes The dollar interest is Interest rate x Amount borrowed The reduction in corporate taxes is corporate tax rate x dollar amount of interest Interest Tax Shield- Tax savings resulting from deductibility of interest payments. The present value of the tax shield is PV of tax shield = annual tax shield/ rdebt = Tc x (rdebt x D)/rdebt = Tc D 10

Cost of Capital

M&M Proposition II The cost of equity depends on three things” The required rate of return on the firm’s assets; The firm’s cost of debt; The firm’s debt/equity ratio, D/E

MM’s Proposition II (w/fixed interest rate) rD D V

What is what? As the firm raises its debt/equity ratio, the increase in leverage raises the risk of the equity and the required return or cost of equity;

MM’s Proposition II (w/risky debt) rE rA rD Risky debt D V Risk free debt Includes Bankruptcy Risk 9

Weighted Average Cost of Capital rE WACC with no bankruptcy risk WACC rD D V

C.S. & Corporate Taxes Example - You own all the equity of Space Babies Diaper Co. The company has no debt. The company’s annual cash flow is $10,000, before interest and taxes. The corporate tax rate is 35%. You have the option to exchange part of your equity position for 6% bonds with a face value of $50,000. Should you do this and why? 11

C.S. & Corporate Taxes Example - You own all the equity of Space Babies Diaper Co. The company has no debt. The company’s annual cash flow is $10,000, before interest and taxes. The corporate tax rate is 35%. You have the option to exchange part of your equity position for 6% bonds with a face value of $50,000. Should you do this and why? 13

C.S. & Corporate Taxes Example - You own all the equity of Space Babies Diaper Co. The company has no debt. The company’s annual cash flow is $10,000, before interest and taxes. The corporate tax rate is 35%. You have the option to exchange part of your equity position for 6% bonds with a face value of $50,000. Should you do this and why? Total Cash Flow All Equity = 6,500 *1/2 Debt = 7,550 (4,550 + 3,000) 14

Capital Structure D x rD x Tc rD PV of Tax Shield = = D x Tc Example: (assume perpetuity) = D x Tc Example: Tax benefit = 10,000 x (.06) x (.35) = $210 PV of 210 perpetuity = 210 / .06 = $3,500 PV Tax Shield = D x Tc = 10,000 x .35 = $3,500 18

Total Cash Flow to Investors All-equity firm Levered firm S G S G B The levered firm pays less in taxes than does the all-equity firm. Thus, the sum of the debt plus the equity of the levered firm is greater than the equity of the unlevered firm. This is how cutting the pie differently can make the pie “larger.” -the government takes a smaller slice of the pie!

The levered firm pays less in taxes than does the all-equity firm. Thus, the sum of the debt plus the equity of the levered firm is greater than the equity of the unlevered firm. This is how cutting the pie differently can make the pie “larger.” -the government takes a smaller slice of the pie!

Financial Distress Costs of Financial Distress - Costs arising from bankruptcy or distorted business decisions before bankruptcy. Market Value = Value if all Equity Financed + PV Tax Shield - PV Costs of Financial Distress 24

Financial Distress Market Value of The Firm Debt Maximum value of firm Costs of financial distress Market Value of The Firm PV of interest tax shields Value of levered firm Value of unlevered firm Optimal amount of debt Debt 25

Risk and Cost of Debt As debt increases, the probability of financial distress, or even bankruptcy, goes up; With higher bankruptcy risk, debtholders will insist on a higher promised return; This increases the pre-tax cost of debt, rd;

Optimal Capital Structure Managers should choose the capital structure that maximizes shareholders’ wealth; This can be done by through a trial capital structure; It is based on the market values of the debt and equity, and then estimate the wealth of the shareholders under this capital structure; This approach is repeated until an optimal capital structure is found;

Five steps for the analysis of each capital structure Estimate the interest rate the firm will pay; Estimate the cost of equity; Estimate the weighted average cost of capital; Estimate the free cash flows and their present value (the value of the firm); Deduct the value of the debt to find the shareholders wealth which you want to maximize;

Financial Choices Trade-off Theory - Theory that capital structure is based on a trade-off between tax savings and distress costs of debt. Pecking Order Theory - Theory stating that firms prefer to issue debt rather than equity if internal finance is insufficient. 26

Financial Slack Financial slack - ready access to cash from the sale of assets or debt financing; It provides flexibility and is valuable to the financial manager.  Excessive financial slack encourages excessive expenditure, limited dividends, and low NPV investments.

Financial Slack Use of debt and the accompanying interest and principal payments require use of cash to service debt, thus reducing excessive cash.  The optimal level of financial slack is just enough cash to satisfy liquidity needs and to finance all positive NPV investments.

Summary: No Taxes In a world of no taxes, the value of the firm is unaffected by capital structure. This is M&M Proposition I: VL = VU Proposition I holds because shareholders can achieve any pattern of payouts they desire with homemade leverage. In a world of no taxes, M&M Proposition II states that leverage increases the risk and return to stockholders.

Summary: Taxes In a world of taxes, but no bankruptcy costs, the value of the firm increases with leverage. This is M&M Proposition I: VL = VU + TC B Proposition I holds because shareholders can achieve any pattern of payouts they desire with homemade leverage. In a world of taxes, M&M Proposition II states that leverage increases the risk and return to stockholders.

Let’s try… Thompson & Thomson is an all equity firm that has 500,000 shares of stock outstanding. The company is in the process of borrowing $8 million at 9% interest to repurchase 200,000 shares of the outstanding stock. What is the value of this firm if you ignore taxes?

Calculations Price per share = $8m 200k = $40; [(500,000  200,000)  $40] + $8m = 500,000  $40 = $20m; Value of the firm is $20m

Another one Your firm has a $250,000 bond issue outstanding. These bonds have a 7% coupon, pay interest semiannually, and have a current market price equal to 103% of face value. What is the amount of the annual interest tax shield given a tax rate of 35%?

Solution Annual interest tax shield = = $250,000  .07  .35 = $6,125

The last one Juanita’s Steak House has $12,000 of debt outstanding that is selling at par and has a coupon rate of 8%. The tax rate is 34%. What is the present value of the tax shield?

See how it is simple Present value of the tax shield = =0.34  $12,000 = $4,080

Thank you