J. K. Dietrich - FBE 532 – Spring 2006 Module I: Investment Banking: Capital Structure and Valuation Week 2 – January 19, 2006

J. K. Dietrich - FBE 532 – Spring Introduction u Cash flows to investors and their risk determine the value of claims on the firm u When a firm issues both debt and equity, it agrees to split the cash flows produced by its real assets between shareholders and bondholders. The firm’s mix of securities is known as its capital structure. u Firm value depends on capital structure in a fundamental way. This lecture reviews the theory of capital structure and its links to valuation.

J. K. Dietrich - FBE 532 – Spring 2006 Distribution of Corporate Income E B I T EAC (Div + Retained Earnings) I (Fixed Claims) T (No Value to Investors)

J. K. Dietrich - FBE 532 – Spring 2006 Cash Flow Determination u Items From the Income Statement –Revenues (R) –Cash Expenses (W) –Non-Cash Expenses (Dep) –Capital Expenditures (Capex) –Cost of Goods Sold (CGS): »Excludes depreciation –Interest Expense (Int) –Taxes (T)

J. K. Dietrich - FBE 532 – Spring 2006 Cash Flow Determination u Other Items –Tax Rate (  ) –Repayment of Principal (P) –Changes in Net Working Capital (  NWC) –Permanent Debt (D)

J. K. Dietrich - FBE 532 – Spring 2006 Definition of Earnings Components u Earnings Before Interest & Taxes [EBIT] R-(W+Dep+CGS) u Earnings Before Interest, Taxes, Depreciation (and Amortization) = EBITD(A) = EBIT+Dep+(Amort) u Amortization is associated with allocation of past financial investments over book value (e.g. good will)

J. K. Dietrich - FBE 532 – Spring 2006 Definitions of Earnings Components u Pre-Tax Income –[EBIT-Int] u Tax Bill [T] –  (EBIT-Int) u Net Income –NI =Pre-Tax Income - T

J. K. Dietrich - FBE 532 – Spring 2006 Cash Flow Definitions u Levered Cash Flow [to equity] {LCF or FTE} Money that goes to stockholders account [R-(W+Dep+CGS+Int)](1-  )+Dep-Capex-P-  NWC u Unlevered Cash Flow {UCF} Cash flow that would occur if there was no debt (1-  )EBIT+Dep-Capex -  NWC

J. K. Dietrich - FBE 532 – Spring 2006 Value and Leverage Strategy Conservative Strategy Equity Debt Aggressive Strategy Debt Equity

J. K. Dietrich - FBE 532 – Spring Empirical Facts u Most corporations set a target debt ratio. u There are many similarities in capital structure –Across firms in the same industry –Across industries in different countries –These regularities suggest that there are some fundamental determinants of capital structure

J. K. Dietrich - FBE 532 – Spring 2006 Summary M-M Theory & Issues

J. K. Dietrich - FBE 532 – Spring An Example u Consider the following data for a company reviewing its capital structure. –Number of Shares100 –Price Per Share$20 –Market Value of Shares$2,000 –Market Value of Debt$0 –Interest Rate10% –Tax Rate0

J. K. Dietrich - FBE 532 – Spring 2006 Possible Outcomes: u Depending on the state of the economy, EBIT may be as predicted, below average or above average. u If EBIT is $250, as predicted, earnings per share are $250/100 = $2.50 and the return on equity is $2.50/$20 = or 12.5 percent.

J. K. Dietrich - FBE 532 – Spring EBIT-EPS Table Based on the hypothetical EBITs, we can compute the associated EPS. This gives rise to the EBIT-EPS table or chart.

J. K. Dietrich - FBE 532 – Spring 2006 EBIT-EPS Chart

J. K. Dietrich - FBE 532 – Spring 2006 Desirability of Leverage u Suppose the company repurchases $1,000 of equity at $20 each u The purchase is financed by issuing consol bonds. u The new capital structure consists of 50 shares of stock and $1,000 of debt.

J. K. Dietrich - FBE 532 – Spring Hypothetical Outcomes: Levered Firm

J. K. Dietrich - FBE 532 – Spring 2006 EBIT-EPS Chart

J. K. Dietrich - FBE 532 – Spring 2006 The Home-made Leverage u Consider an alternative scenario now u Suppose an investor were to borrow $20 and invest $40 in two (unlevered) shares of the original all equity company. u The net cost to the investor is $20.

J. K. Dietrich - FBE 532 – Spring Home Made Leverage

J. K. Dietrich - FBE 532 – Spring Home Made Leverage u The returns from this strategy are exactly the same as buying 1 share of the levered firm. Therefore a share in the levered firm must sell for $20 (= 2 x ). u Investors on their own can accomplish what the company can do by adding debt, so leverage will not create value. This leads to the famous irrelevance proposition of Merton Miller and Franco Modigliani.

J. K. Dietrich - FBE 532 – Spring Miller-Modigliani Theory u The Miller-Modigliani Proposition I: With no taxes and perfect financial markets, the value of any firm is independent of its capital structure.

J. K. Dietrich - FBE 532 – Spring 2006 Miller-Modigliani Theory: Value of the Firm Leverage Ratio Firm Value All Equity Firm Value Leverage has no effect on firm value when there are no taxes and markets are perfect

J. K. Dietrich - FBE 532 – Spring 2006 Miller-Modigliani Theory: WACC Leverage Ratio % WACC With no taxes and perfect markets, the weighted average cost of capital is constant Cost of Debt Cost of Equity

J. K. Dietrich - FBE 532 – Spring Implications u The Miller-Modigliani theorem is a starting point to examining capital structure effects in the real world. u If capital structure matters, it is because one of the MM assumptions is violated. u The first assumption to relax is the assumption that there are no corporate taxes.

J. K. Dietrich - FBE 532 – Spring Miller-Modigliani Theory and Taxes u As a simple example, consider two firms, U and L. u Firm U has no debt and firm L has issued consol bonds worth $200 at the current interest rate of 10 percent; otherwise the firms are the same.

J. K. Dietrich - FBE 532 – Spring Levered and Unlevered Firms

J. K. Dietrich - FBE 532 – Spring 2006 Implications u This simple example shows that interest tax deductibility increases the value of the firm that is levered. u The tax bill of L is $6.80 less than that of U u In effect, the government is paying 34 percent of the interest expense of L. This perpetual reduction in taxes is worth $6.80/0.10 = $68.

J. K. Dietrich - FBE 532 – Spring Value of the Interest Tax Shield u The present value of the tax shield accounts for the difference in firm value. u If t C is the corporate tax rate and r D the debt rate, then interest payments = r D.D and the tax shield is t C.r D.D. –How do we value the tax shields with risk? The most common approach is that the risk of the tax shields is the same as the interest payments generating them.

J. K. Dietrich - FBE 532 – Spring A Convenient Formula u For perpetual debt, we have: PV tax shield = (t C.r D.D)/r D = t C.D which is independent of r D. u The MM Theorem with corporate taxes implies: V L = V U + t C D. –The PV of tax shields is lowered if the firm does not borrow permanently or if it may not be able to use the tax shields in the future.

J. K. Dietrich - FBE 532 – Spring 2006 A Paradox u The Miller-Modigliani theorem implies capital structure is irrelevant if there are no taxes and capital markets are perfect. –Relaxing the assumption of no corporate taxes leads to the result that the company should take on as much debt as it can. –But an all debt company is owned by its creditors. What stops a company from being entirely debt financed?

J. K. Dietrich - FBE 532 – Spring 2006 Miller-Modigliani Theory with Corporate Taxes Leverage Ratio Firm Value All Equity Firm Value Value of a Levered Firm Present value of the tax shield

J. K. Dietrich - FBE 532 – Spring 2006 MM With Taxes: WACC Leverage Ratio % WACC With taxes, the weighted average cost of capital declines with higher leverage Cost of Debt Cost of Equity

J. K. Dietrich - FBE 532 – Spring A Reconciliation u What offsets the tax advantages of debt financing? –Bankruptcy costs »But empirical evidence seems to suggest these direct costs are quite small –Costs of financial distress »These costs may be sufficiently large as debt increases that there it offsets the tax shield.

J. K. Dietrich - FBE 532 – Spring 2006 MM with Taxes and COFD Leverage Ratio Firm Value All Equity Firm Value Optimal Leverage Zone Balances Tax Advantages of Debt Against the Costs of Financial Distress

J. K. Dietrich - FBE 532 – Spring 2006 MM with Taxes and COFD: WACC Leverage Ratio % WACC The weighted average cost of capital declines with higher leverage and then rises Cost of Debt Cost of Equity

J. K. Dietrich - FBE 532 – Spring 2006 Real-World Capital Structure u Some stylized facts fit well with the theory –Firms with high taxes rely more on debt –Firms with a high percentage of intangible assets rely on equity –Firms with uncertain operating income avoid debt

J. K. Dietrich - FBE 532 – Spring 2006 Cost of Capital for All Equity Firm? u Many - including some executives - believe it is zero because –there is no direct cost to internal funds or from equity capital issued some time ago –no obligation to pay a dividend. u This reasoning is wrong.

J. K. Dietrich - FBE 532 – Spring 2006 u It is the opportunity cost of the equity that matters. u The cost of capital is simply the rate that investors use discount the cash flows from the firm. Investors will price the stock to offer this expected return. If CAPM holds we have : Cost of Capital for All Equity Firm?

J. K. Dietrich - FBE 532 – Spring 2006 Cost of Capital for All-Debt Financed Projects u Many firms issue either debt or equity to finance purchases of new assets and projects. What is the cost of capital for a project financed 100% with debt? u It is not the after-tax debt rate. Why? –You cannot 100% debt-finance all projects –Debt capacity comes from existing assets - not all the tax shield is attributable to the project

J. K. Dietrich - FBE 532 – Spring Review u The capital structure decision is a crucial one for the firm and is fundamentally linked to questions of valuation u Firms trade-off the tax benefits of debt financing against the costs of financial distress u Finding the right capital structure is difficult in practice

J. K. Dietrich - FBE 532 – Spring 2006 Next Week – January 26 u Review background readings on valuation implications of mergers and acquisitions u Read, analyze and prepare individual write- up for Continental Carriers Inc. case u Form group and sign-up members and schedule meetings needed for group do necessary work and write-up for next case u Hand in case write-ups (group and individual) at the beginning of classes