Capital Structure Decisions: Part I Chapter 15 Capital Structure Decisions: Part I

Topics in Chapter Overview of capital structure effects Business versus financial risk The impact of debt on returns Capital structure theory, evidence, and implications Choosing the optimal capital structure: An example

Basic Definitions V = value of firm FCF = free cash flow WACC = weighted average cost of capital rs and rd = costs of stock and debt wce and wd = percentages of the firm that are financed with stock and debt

Capital Structure and Firm Value = ∑ ∞ t=1 FCFt (1 + WACC)t (15-1) WACC= wd (1-T) rd + wcers (15-2)

Capital Structure Effects Preview The impact of capital structure on value depends upon the effect of debt on: WACC FCF

The Effect of Debt on WACC Debt increases the cost of equity, rs Debt holders have a prior claim on cash flows relative to stockholders. Debtholders’ “fixed” claim increases risk of stockholders’ “residual” claim. Debt reduces the firm’s taxes Firm’s can deduct interest expenses. Frees up more cash for payments to investors Reduces after-tax cost of debt

The Effect of Debt on WACC Debt increases risk of bankruptcy Causes pre-tax cost of debt to increase Adding debt: Increases percent of firm financed with low-cost debt (wd) Decreases percent financed with high-cost equity (wce) Net effect on WACC = uncertain

The Effect of Debt on FCF  debt   probability of bankruptcy Direct costs: Legal fees “Fire” sales, etc. Indirect costs: Lost customers Reduction in productivity of managers and line workers, Reduction in credit (i.e., accounts payable) offered by suppliers

The Effect of Additional Debt Impact of indirect costs  Sales &  Productivity Customers choose other sources Workers worry about their jobs NOWC  Suppliers tighten credit NOPAT  FCF 

The Effect of Additional Debt on Managerial Behavior Reduces agency costs: Debt reduces free cash flow waste Increases agency costs: Underinvestment potential

Asymmetric Information and Signaling “Asymmetric Information” = insiders know more than outsiders Managers know the firm’s future prospects better than investors. Managers would not issue additional equity if they thought the current stock price was less than the true value of the stock = Investors often perceive an additional issuance of stock as a negative signal Stock price 

Business Risk vs. Financial Risk Uncertainty about future EBIT Depends on business factors such as competition, operating leverage, etc. Financial risk: Additional business risk concentrated on common stockholders when financial leverage is used

Business risk: Uncertainty about future pre-tax operating income (EBIT). Probability EBIT E(EBIT) Low risk High risk Note: Business risk focuses on operating income, ignoring financing effects.

Factors That Influence Business Risk Demand variability (uncertainty unit sales) Sales price variability Input cost variability Ability to adjust output prices for changes input costs Ability to develop new products Foreign risk exposure Degree of operating leverage (DOL)

Operating Leverage Operating leverage is the change in EBIT caused by a change in quantity sold. > Fixed costs  > Operating leverage The higher the proportion of fixed costs within a firm’s overall cost structure, the greater the operating leverage.

Figure 15.1 Illustration of Operating Leverage

Higher operating leverage leads to more business risk: small sales decline causes a larger EBIT decline. Rev. Rev. $ $ } TC EBIT TC F F QBE Sales Sales QBE

Strasburg Electronics Company

Strasburg Expected Sales

Strasburg Plan A Figure 15-1 Lower Panel

Strasburg Plan B Figure 15-1 Lower Panel

Strasburg: Plans A & B Figure 15-1 Upper Panel

Operating Breakeven: QBE QBE = F / (P – V) (15-4) QBE = Operating breakeven quantity F = Fixed cost V = Variable cost per unit P = Price per unit

Strasburg Breakeven

Strasburg: Plans A & B

Higher operating leverage leads to higher expected EBIT and higher risk. Low operating leverage Probability High operating leverage EBITL EBITH

Strasburg & Financial Risk Strasburg going with Plan B Riskier Higher expected EBIT and ROIC Financial risk: Additional business risk concentrated on common stockholders when financial leverage is used

Strasburg - Extended To date – no debt Two financing choices: Remain at 0 debt Move to $100,000 debt and $100,000 book equity

Table 15.1 Strasburg Electronics – Effects of Financial Leverage

Strasburg with No Debt Table 15-1 Section I ROE = Net Income/Book Equity Expected ROE = ROE under each demand X Probability

Strasburg with 50% Debt Table 15-1 Section II

Strasburg w/ Zero Debt Strasburg w/ 50% Debt Higher ROE Higher Risk

Leveraging Increases ROE More EBIT goes to investors: Total dollars paid to investors: I: NI = $24,000 II: NI + Int = $18,000 + $10,000 = $28,000 Taxes paid: I: $16,000; II: $12,000 Equity $ proportionally lower than NI

Strasburg’s Financial Risk In a stand-alone sense, stockholders see much more risk with debt. I: σROE = 14.8% II: σROE = 29.6% Strasburg’s financial risk = σROE - σROIC = 29.6% - 14.8% = 14.8%

Capital Structure Theory Modigliani & Miller theory Zero taxes (MM 1958) Corporate taxes (MM 1963) Corporate and personal taxes (Miller 1977) Trade-off theory Signaling theory Pecking order Debt financing as a managerial constraint Windows of opportunity

MM Results: Zero Taxes If two portfolios (firms) produce the same cash flows, then the two portfolios must have the same value. A firm’s value is unaffected by its capital structure

MM (1958) Assumptions No brokerage costs No taxes No bankruptcy costs Investors can borrow and lend at the same rate as corporations All investors have the same information EBIT is not affected by the use of debt

MM Theory: Zero Taxes Firm U Firm L EBIT $3,000 Interest 1,200 NI 1,200 NI $1,800 CF to shareholder CF to debt holder $1,200 Total CF Notice that the total CF are identical.

MM Results: Zero Taxes MM prove: If total CF to investors of Firm U and Firm L are equal, then the total values of Firm U and Firm L must be equal: VL = VU Because FCF and values of firms L and U are equal, their WACCs are equal Therefore, capital structure is irrelevant

MM (1963): Corporate Taxes Relaxed assumption of no corporate taxes Interest may be deducted, reducing taxes paid by levered firms More CF goes to investors, less to taxes when leverage is used Debt “shields” some of the firm’s CF from taxes

MM Result: Corporate Taxes MM show that the value of a levered firm = value of an identical unlevered form + any “side effects.” VL = VU + TD (15-7) If T=40%, then every dollar of debt adds 40 cents of extra value to firm

MM relationship between value and debt when corporate taxes are considered. Value of Firm, V Debt VL VU Under MM with corporate taxes, the firm’s value increases continuously as more and more debt is used. TD

MM relationship between capital costs and leverage when corporate taxes are considered Cost of Capital (%) rs WACC rd(1 - T) Debt/Value Ratio (%) 0 20 40 60 80 100

Miller (1977): Corporate and Personal Taxes Personal taxes lessen the advantage of corporate debt: Corporate taxes favor debt financing Interest expenses deductible Personal taxes favor equity financing No gain is reported until stock is sold Long-term gains taxed at a lower rate

Miller’s Model with Corporate and Personal Taxes VL = VU + 1− D (15-8) Tc = corporate tax rate. Td = personal tax rate on debt income. Ts = personal tax rate on stock income. (1 - Tc)(1 - Ts) (1 - Td)

Tc = 40%, Td = 30%, and Ts = 12% VL = VU + 1− D (1 - 0.40)(1 - 0.12) Value rises with debt; each $1 increase in debt raises Levered firm’s value by $0.25. (1 - 0.40)(1 - 0.12) (1 - 0.30)

Trade-off Theory MM theory assume no cost to bankruptcy The probability of bankruptcy increases as more leverage is used At low leverage, tax benefits outweigh bankruptcy costs. At high levels, bankruptcy costs outweigh tax benefits. An optimal capital structure exists (theoretically) that balances costs and benefits.

Figure 15.2 Effect of Leverage on Value

Signaling Theory MM assumed that investors and managers have the same information. Managers often have better information and would: Sell stock if stock is overvalued Sell bonds if stock is undervalued Investors understand this, so view new stock sales as a negative signal.

Pecking Order Theory Firms use internally generated funds first (1): No flotation costs No negative signals If more funds are needed, firms then issue debt (2) Lower flotation costs than equity If more funds are still needed, firms then issue equity (3)

Pecking Order Theory INTERNAL EXTERNAL DEBT 2 EQUITY 1 3

Debt Financing & Agency Costs Agency problem #1: Managers use corporate funds for non-value maximizing purposes Financial leverage: Bonds commit “free cash flow” Forces discipline on managers to avoid perks and non-value adding acquisitions. LBO = ultimate use of debt controlling management actions

Debt Financing & Agency Costs Agency problem #2: “Underinvestment” Debt increases risk of financial distress Managers may avoid risky projects even if they have positive NPVs

Investment Opportunity Set and Reserve Borrowing Capacity Firms should normally use more equity, less debt than optimal “Reserve borrowing power” Especially important if: Many investment opportunities Asymmetric information issues cause equity issues to be costly

Windows of Opportunity Managers try to “time the market” when issuing securities. Issue When And Equity Market is “high” Stocks have “run up” Debt Market is “low” Interest rates low S/T Debt Term structure is upward sloping L/T Debt Term structure is flat

Empirical Evidence Tax benefits are important Bankruptcies are costly $1 debt adds  $0.10 to value Supports Miller model with personal taxes Bankruptcies are costly Costs can =10% to 20% of firm value Firms don’t make quick corrections when Δstock price  Δdebt ratios Doesn’t support trade-off model

Empirical Evidence After stock price , debt ratio , but firms tend to issue equity not debt Inconsistent with trade-off model Inconsistent with pecking order Consistent with windows of opportunity Firms tend to maintain excess borrowing capacity Firms with growth options Firms with asymmetric information problems

Implications for Managers Take advantage of tax benefits by issuing debt, especially if the firm has: High tax rate Stable sales Less operating leverage

Implications for Managers Avoid financial distress costs by maintaining excess borrowing capacity, especially if the firm has: Volatile sales High operating leverage Many potential investment opportunities Special purpose assets (instead of general purpose assets that make good collateral)

Implications for Managers If manager has asymmetric information regarding firm’s future prospects, then: Avoid issuing equity if actual prospects are better than the market perceives Consider impact of capital structure choices on lenders’ and rating agencies’ attitudes

The Optimal Capital Structure Maximizes shareholder wealth Maximizes firm value Maximizes stock price Minimizes WACC Does NOT maximize EPS

Estimating the Optimal Capital Structure: 5 Steps Estimate the interest rate the firm will pay (cost of debt) Estimate the cost of equity Estimate the WACC Estimate the free cash flows and their present value (value of the firm) Deduct the value of debt to find Shareholder Wealth  Maximize

Choosing the Optimal Capital Structure: Strasburg Example Currently all-equity financed Expected EBIT = $40,000 10,000 shares outstanding rs = 12% P0 = $25 T = 40% b = 1.0 rRF = 6% RPM = 6%

Step 1: Estimates of Cost of Debt TABLE 15.2

The Cost of Equity at Different Levels of Debt: Hamada’s Equation MM theory  beta changes with leverage bU = the beta of a firm with NO debt Unlevered beta b = bU [1 + (1 - T)(D/S)] D = Market value of firm’s debt S = Market value of firm’s equity T = Firm’s corporate tax rate

Step 2: The Cost of Equity for wd = 50% Use Hamada’s equation to find beta: b = bU [1 + (1 - T)(D/S)] = 1.0 [1 + (1-0.4) (50% / 50%) ] = 1.60 Use CAPM to find the cost of equity: rs= rRF + bL (RPM) = 6% + 1.60 (6%) = 15.6%

TABLE 15.3 Strasburg’s optimal Capital Structure

Step 3: Strasburg’s WACC & Optimal Capital Structure Note: The Capital Structure that MAXIMIZES firm value is the one that MINIMIZES WACC

Notes to Table 15-3

Figure 15.3 Strasburg’s Required Rate of Return on Equity

Figure 15-4: Effects of Capital Structure on Cost of Capital

Step 4: Corporate Value for wd = 0% Vop = FCF(1+g) / (WACC-g) g=0, so investment in capital is zero FCF = NOPAT = EBIT (1-T) NOPAT = ($40,000)(1-0.40) = $24,000 Vop = $24,000 / 0.12 = $200,000

Step 4: Strasburg’s Firm Value Note: The Capital Structure that MAXIMIZES firm value is the one that MINIMIZES WACC

Implications for Strasburg Firm should recapitalize (“recap”) Issue debt Use funds to repurchase equity Optimal debt = 40% WACC = 10.80% Maximizes Firm Value

Anatomy of Strasburg’s Recap: Before Issuing Debt

Issue Debt (wd = 40%), But Before Repurchase WACC decreases to 10.80% Vop increases to $222,222 Short-term funds = $88,889 Temporary until it uses these funds to repurchase stock Debt is now $88,889

Anatomy of a Recap: After Debt, but Before Repurchase Vop  $222,222 Debt = $88,889 S/T funds = $88,889 Stock Price  $22.22 Shareholder wealth  $222.222

The Repurchase: No Effect on Stock Price Announcement of intended repurchase might send a signal that affects stock price The repurchase itself has no impact on stock price. If investors think the repurchase would:  stock price, they would purchase stock the day before, which would drive up its price.  stock price, they would all sell short the stock the day before, which would drive down the stock price.

Remaining Number of Shares After Repurchase D0 = original amount of debt D = amount after issuing new debt If all new debt is used to repurchase shares, then total dollars used equals: (D – D0) = ($88,889 - $0) = $88,889 n0 = number of shares before repurchase, n = number after repurchase. n = n0 – (D – D0)/P = 10,000 - $88,889/$22.22 n = 10,000 – 4,000 = 6,000

Anatomy of Strasburg’s Recap: After Repurchase

Strasburg after Recapitalization Key Points Short Term investments used to repurchase stock Stock price is unchanged Value of stock falls to $133,333 Firm no longer owns the short-term investments Wealth of shareholders remains at $222,222

Shortcuts The corporate valuation approach will always give the correct answer There are some shortcuts for finding S, P, and n Shortcuts on next slides

Calculating S, the Value of Equity after the Recap S = (1 – wd) Vop (15-13) At wd = 40%: SPrior = S + (D – D0) (15-14) S = (1 – 0.40) $222,222 S = $133,333 SPrior = $133,333 + (88,889 – 0) SPrior = $222,222

Calculating P, the Stock Price after the Recap P = [S + (D – D0)]/n0 (15-15) P = $133,333 + ($88,889 – 0) 10,000 P = $22.22 per share

Number of Shares after a Repurchase, n # Repurchased = (D - D0) / P n = n0 - (D - D0) / P # Rep. = ($88,889 – 0) / $22.22 # Rep. = 4,000 n = 10,000 – 4,000 n = 6,000

TABLE 15.5 Strasburg’s Stock Price & EPS

Analyzing the Recap Table 15-5

FIGURE 15.5 Effects of Capital Structure on Firm Value, Price and EPS

Effects of Capital Structure on Price and EPS

Optimal Capital Structure wd = 40% gives: Highest corporate value Lowest WACC Highest stock price per share Does NOT maximize EPS