Jacoby, Stangeland and Wajeeh, The Capital Structure Questions The balance sheet of the firm(market values): We can write: V = B + S Or, draw a pie: Two questions: 1. Should the management aim at maximizing V or S? 2. What is the debt to equity ratio (B/S) that will maximize S? Assets (V) Debt (B) Equity (S) B S Chapters 15&16

Jacoby, Stangeland and Wajeeh, Is There An Optimal Capital Structure? Modigliani & Miller (MM) Proposition I (No Taxes) uFirm value is not affected by financial leverage: V L = V U MM assume (among other things): uNo risk of default uPerpetual Cash Flows uFirms and investors can borrow/lend at the same rate uNo taxes

Jacoby, Stangeland and Wajeeh, Proving MM Proposition I (No Taxes) uConsider two firms, identical in every way except that one is levered and the other is all equity (unlevered): UnleveredLevered AssetsV U = $1,000,000V L = ? EquityS U = $1,000,000S L = ? DebtB U = 0 B L = $400,000 Cost of Debtr B = 5% uRecall: Firms and investors can borrow/lend at the same rate, and there are no taxes uThe (uncertain) dollar return on the firm’s assets is given by Y

4 Consider the following two investment strategies: Strategy A Dollar Investment Dollar Return Buy 10% of S L 0.1S L = 0.1(V L - B L ) 0.1(Y - r B B L ) = 0.1(Y % 400,000) Total CF from A0.1(V L - B L ) 0.1Y - 2,000 Strategy B Dollar Investment Dollar Return 1) Buy 10% of V U 0.1V U 0.1Y 2) Borrow 10% of B L - 0.1B L - 0.1r B B L = % 0.05 % 400,000 = - 2,000 Total CF from B 0.1(V U - B L ) 0.1Y - 2,000 Since the dollar return from A and B is identical, the initial cost of both strategies must be identical, thus 0.1(V L - B L ) = 0.1(V U - B L ), and V L = V U MM Proposition I (No Taxes): Firm value is not affected by leverage (V L = V U )

Jacoby, Stangeland and Wajeeh, Debt-equity ratio (B/S) The Value of a Levered Firm Under MM Proposition I with No Corporate Taxes VUVU Value of the firm (V L ) V L = V U

Jacoby, Stangeland and Wajeeh, MM Proposition II (No Taxes) The cost of equity and financial leverage: A.Because of Prop. I, the WACC must be constant. With no taxes, WACC = r U = (S/A) % r S + (B/A) % r B, where A = S + B where r U is the constant return on the firm’s assets B.Solve for r S to get MM Prop. II (No Taxes): r S = r U + (r U - r B ) % (B/S) Cost of equity has two parts: 1.r U and “business” risk the risk inherent in the firm’s operations (beta of assets) 2.B/S and “financial” risk extra risk from using debt financing

Jacoby, Stangeland and Wajeeh, Debt-equity ratio (B/S) Cost of capital WACC = r U rBrB r S = r U + (r U – r B ) x (B/S) The Cost of Equity, the Cost of Debt, and the Weighted Average Cost of Capital: MM Proposition II with No Corporate Taxes

Jacoby, Stangeland and Wajeeh, Debt, Taxes, and Firm Value uThe interest tax shield and firm value For simplicity:(1) perpetual cash flows (2) no depreciation (3) no fixed asset or NWC spending A firm is considering going from zero debt to $400 at 10%: Firm UFirm L (unlevered)(levered) EBIT$200$200 Interest0$40 Tax (40%)$80$64 Net income$120$96 Cash flow from assets (EBIT-Taxes)$120 $136 Tax saving = $16 = 0.4 % $40 = T C % r B % B +$16

Jacoby, Stangeland and Wajeeh, Debt, Taxes, and Firm Value (concluded) uWhat’s the link between debt and firm value? Since interest creates a tax deduction, borrowing creates an interest tax shield. Its value is added to the value of the firm. uPV(perpetual tax savings)= $16/0.1= $160 = (T C % r B % B)/r B = T C B uMM Proposition I (with taxes): V L = V U + T C B

Jacoby, Stangeland and Wajeeh, Total Debt (B) VUVU The Value of a Levered Firm Under MM Proposition I with Corporate Taxes VUVU Value of the firm (V L ) Present value of tax shield on debt V L = V U + T C B

Jacoby, Stangeland and Wajeeh, Debt, Taxes, and the WACC uTaxes and firm value: an example u EBIT = $100 u T C = 30% u r U = 12.5% Q.Suppose debt goes from $0 to $100 at 10%, what happens to equity value, S? V U = EBIT(1 - T C ) / r U = V L = S L = V L - B = $

12 Debt, Taxes, and the WACC (concluded) uWACC and the cost of equity (MM Proposition II with taxes) With taxes: Recall:WACC = (S/A) % r S + (B/A) % r B % (1-T C ) uMM Proposition II (with taxes): r S = r U + (r U - r B ) % (B/S) % (1 - T C ) uIn the above example: r s = WACC = uThe WACC decreases as more debt financing is used => since WACC is a discount rate for future cash flows, the optimal capital structure is all debt!

Jacoby, Stangeland and Wajeeh, Taxes, the WACC, and Proposition II Debt-Equity Ratio (B/S) Cost of capital rUrU r B (1 – T C ) rSrS WACC rUrU

Jacoby, Stangeland and Wajeeh, Financial Distress uMM with taxes V L = V U + T C B debt provides tax benefits to the firm => the firm should borrow an infinite amount uIn reality u the firm has to pay interest and principal to bondholders regardless of profitability u if the firm defaults on a payment to its bondholders, it will enter a phase of financial distress (e.g. Eaton’s), or u ultimately, if financial distress persists, the firm will declare bankruptcy u there are costs involved in both financial distress and bankruptcy

Jacoby, Stangeland and Wajeeh, Costs of Financial Distress uDirect Costs u Legal and administrative costs (e.g. lawyers, accounting, expert witnesses) uIndirect Costs u Impaired ability to conduct business (e.g. lost sales) u Agency costs - In financial distress, stockholders may engage in u Selfish strategy 1: Incentive to take large risks u Selfish strategy 2: Incentive toward underinvestment u Selfish Strategy 3: Milking the property (liquidating dividend, or Increase perks to owners/management )

Jacoby, Stangeland and Wajeeh, Selfish Strategy 3: Milking the Property uLiquidating dividends u Such tactics are often illegal uIncrease perks to owners/management

17 The Firm Value, Tax-Shield of Debt, and Financial Distress Costs uThe Value of a levered firm: V L = V U + T C B - PV[expected costs of financial distress] uFor firms with a low financial leverage, the probability of default is close to zero, and PV[expected costs of financial distress] { 0 a $1 increase in debt, will increase tax benefits (and the firm value) at a constant rate of T C uFor highly levered firms, the probability of default is positive, and PV[expected costs of financial distress] > 0 a $1 increase in debt, will u increase tax benefits at a constant rate of T C u increase costs of financial distress at increasing rates Conclusion - increase debt as long as tax benefits exceed the PV of the costs of financial distress (up to the optimal level of debt: B*)

Jacoby, Stangeland and Wajeeh, The Optimal Capital Structure and the Value of the Firm Value of the firm (V L ) Total Debt (B) B * Optimal Level of Debt Present value of tax shield on debt Financial distress costs Actual firm value V U = Value of firm with no debt V L = V U + T C B Maximum firm value V L * VUVU

Jacoby, Stangeland and Wajeeh, The Optimal Capital Structure and the Cost of Capital Cost of capital (%) Debt/equity ratio (B/S) rUrU WACC r B (1 – T C ) rSrS rUrU WACC* Minimum cost of capital WACC = (S/V) % r S + (B/V) % r B % (1-T C ) +Premium for Costs of Financial Distress (B/S) * Optimal Leverage Ratio