Rest of Chapter 14

 Capital Structure  M&M (Modigliani and Miller) concepts 2

 Capital structure refers to the mix of a firm’s debt and equity financing  Financial leverage refers to using borrowed money to enhance the effectiveness of invested equity  Measured with the debt ratio (TL/TA)  More leverage means more risk (measures used debt ratio, TIE, and DFL)  Higher leverage increases the company’s beta (higher cost of equity)  More risk means a higher cost of capital (higher required rate of return on investments) 3 skim

 Equity at a point in time is fixed  Add equity over time with retained earnings  Do not have easy access to equity capital market  Capital structure is an extremely important business decision and directly affects the size of the business  Trade off of more risk as additional debt is taken versus the additional return from adding the debt 4

 Capital structure is independent (mostly) of the size of the company and its asset mix  The question is: can the use of debt increase the firm’s stock price?  An optimal capital structure maximizes stock price  The relationship between capital structure and stock price is not precise nor fully understood 5 skim

 Borrowing money (leverage) is used to increase average ROE and EPS  The use of borrowed money incurs interest, which increases DFL and decreases TIE  When the rate of return (BEP) is greater than the interest rate then financial leverage will improve a firm’s ROE and EPS  However, if BEP is lower than the interest rate then borrowing money will worsen EPS and ROE 6

 Return on Capital Employed (ROCE) ◦ Measures the profitability of operations before financing charges but after taxes on a basis comparable to ROE 7 When the ROCE exceeds the after-tax cost of debt, more leverage improves ROE and EPS When ROCE is less than the after-tax cost of debt, more leverage makes ROE and EPS worse BEP: Can compare to pre tax interest rate.

8 As the firm’s debt ratio rises, both EPS and ROE rise dramatically. While EAT falls, the number of shares outstanding falls at a faster rate as debt replaces equity.

9 ABC is now doing rather poorly—ROE and ROCE are quite low. As the firm adds leverage, EPS and ROE decrease.

 Leverage enhances returns while it adds risk, pushing stock prices in opposite directions ◦ Enhanced performance increases dividends, which increases the PV of dividends per share (driving up the stock’s price) ◦ The increased risk increases the stocks beta and this decreases the PV of dividends per share (drives down the stock’s price)  Which effect dominates is a big question?  Principle of increasing. Risk increases at an increasing rate as leverage increases. ◦ At low leverage an increase in debt increases risk a little ◦ At high leverage an increase in debt increases risk a lot 10

 When leverage is low an increase in debt has a positive effect on stock prices  At high debt levels concerns about risk dominate and adding more debt decreases the stock’s price  As leverage increase its effect goes from positive to negative, which results in an optimum capital structure 11

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 There is no way to determine the exact optimum amount of leverage for a particular company at a particular time ◦ Appropriate level tends to vary according to  Nature of a company’s business  If firm has high business risk (DOL) it should use less leverage  Economic climate  If the outlook is poor investors are likely to be more sensitive to risk  As a practical matter the optimum capital structure is a guess  The best we can usually do is compare to the industry average 13

 A firm’s target capital structure that we use in calculating the WACC is management’s estimate of the optimal capital structure ◦ An approximation or best guess as to the amount of debt that will maximize the firm’s stock price 14

 Restrictive Assumptions in the Original Model ◦ In 1958 MM published their first paper on capital structure  Included numerous restrictions such as  No income taxes  Securities trade in perfectly efficient capital markets with no transaction costs  No costs to bankruptcy  Investors and companies can borrow or lend as much as they want at the same rate 15

 The Result ◦ Under MM’s initial set of restrictions, value is independent of capital structure ◦ As cheaper debt is added the cost of equity increases because of increased risk  However the weight of the more expensive equity is decreasing while the weight of the cheaper debt is increasing, leading to a constant weighted average cost of capital  Thus the PV of the firm does not change 16

 The Assumptions and Reality ◦ Income taxes exist and favor debt ◦ The costs of bankruptcy are quite large ◦ Individuals cannot borrow at the same rate as companies and interest rates usually rise as more money is borrowed  Interpreting the Result ◦ The MM result implies that leverage affects value because of market imperfections  Such as taxes and transaction costs (including bankruptcy) 17

 Financing and the U.S. Tax System ◦ Tax system favors debt financing over equity financing  Interest expense on debt is tax deductible while dividends on stock are not  Bankruptcy costs (favor equity financing) ◦ Greater chance of incurring cost as more debt is used, thus causes value of stock to decline at some point as risk gets too high  Interest rate on debt rises as debt increases – causing stock price to decline at some point  Relaxing MM assumptions suggests that an optimal amount of debt exists for a corporation, but doesn’t really help us find it. 18

Capital Structures Around the World Capital Structure Percentages for Selected Countries Ranked by Common Equity Ratios, 1995 Source: Essentials of Managerial Finance by Besley and Brigham