copyright © 2003 McGraw Hill Ryerson Limited 15-1 prepared by: Carol Edwards BA, MBA, CFA Instructor, Finance British Columbia Institute of Technology Fundamentals of Corporate Finance Second Canadian Edition

copyright © 2003 McGraw Hill Ryerson Limited 15-2 Chapter 15 The Capital Structure Decision Chapter Outline  How Borrowing Affects Value in a Tax- Free Economy  Capital Structure and Corporate Taxes  Costs of Financial Distress  Explaining Financing Choices

copyright © 2003 McGraw Hill Ryerson Limited 15-3 Borrowing and Value How Borrowing Affects Value in a Tax- Free Economy  Your objective as a financial manager is to undertake actions which will maximize the value of your firm.  A firm’s capital structure is the mix of debt and equity its financial managers choose.  The key question this chapter will pose is: Can you change the value of your firm by changing its capital structure?

copyright © 2003 McGraw Hill Ryerson Limited 15-4 Borrowing and Value Firm Value in a Tax-Free Economy  The value of a firm is determined by discounting the stream of cash flows produced by its assets and operations.  The age, quantity, quality and the efficiency with which those assets are utilized will determine the size of those cash flows.  However, you cannot increase the size of these cash flows simply by altering the way you finance the firm’s operations.

copyright © 2003 McGraw Hill Ryerson Limited 15-5 Borrowing and Value Modigliani and Miller  This concept was first put forward in 1958 by Franco Modigliani and Merton Miller (MM).  They demonstrated that: When there are no taxes and well functioning capital markets exist, the market value of a company does not depend on its capital structure. In other words, managers cannot increase firm value by changing the mix of securities used to finance the company.

copyright © 2003 McGraw Hill Ryerson Limited 15-6 Borrowing and Value Modigliani and Miller  MM’s proposition rests on a number of critical simplifying assumptions: Capital markets have to be “well functioning”.  Investors can trade securities without restrictions.  Investors can borrow or lend on the same terms as the firm.  Capital markets are efficient, so securities are fairly priced given the information available to investors. There are no taxes or costs of financial distress.

copyright © 2003 McGraw Hill Ryerson Limited 15-7 Borrowing and Value Modigliani and Miller  If these simplifying assumptions are true, then the firm’s capital structure cannot make a difference to the value of the firm. Thus the most important decisions are about the company’s assets and capital structure decisions are unimportant.  If these simplifying assumptions are not true, then the firm’s capital structure can make a difference to the value of the firm. Capital structure decisions would become important.

copyright © 2003 McGraw Hill Ryerson Limited 15-8 Borrowing and Value Modigliani and Miller  If you look at Table 15.1 on page 447 of your text, you will see the financial data for River Cruises (RC).  RC is entirely equity financed.  It produces a level stream of earnings and dividends in perpetuity.  The value of the firm is $1 million. This value arises entirely from the expected cash flows generated by RC’s assets and operations.

copyright © 2003 McGraw Hill Ryerson Limited 15-9 Borrowing and Value Modigliani and Miller  Since the cash flows are a perpetuity, you can calculate the value of RC by discounting the cash flows at the cost of capital: State of the Economy SlumpNormalBoom Operating Income$75,000$125,000$175,000 Return on Shares (Cost of Capital)7.5%12.5%17.5% Present Value of Cash flows$1,000,000$1,000,000$1,000,000

copyright © 2003 McGraw Hill Ryerson Limited Borrowing and Value Modigliani and Miller  Notice that regardless of the state of the economy, the firm is worth $1million to its shareholders.  If there are 100,000 shares outstanding, then each share must be worth $10.

copyright © 2003 McGraw Hill Ryerson Limited Borrowing and Value Modigliani and Miller  But, what if you were to change the firm’s capital structure? Suppose you were to issue $500,000 of debt with a 10% coupon and use the funds to repurchase 50,000 shares at $10 apiece. Would this change in capital structure increase the value of the firm’s remaining shares?

copyright © 2003 McGraw Hill Ryerson Limited Borrowing and Value Modigliani and Miller  If RC were to borrow money, then part of its income would be paid out as interest.  The remaining cash flow would belong to the shareholders.  But, what would these cash flows be worth? As before, you can calculate their value by working out the present value of the firm’s equity earnings.

copyright © 2003 McGraw Hill Ryerson Limited Borrowing and Value Modigliani and Miller  You can calculate the new value of RC’s equity by discounting the cash flows at the cost of capital: State of the Economy SlumpNormalBoom Operating Income$25,000$75,000$125,000 Return on Shares (Cost of Capital)5.0%15.0%25.0% Present Value of Cash flows$500,000$500,000$500,000

copyright © 2003 McGraw Hill Ryerson Limited Borrowing and Value Modigliani and Miller  Thus, regardless of the state of the economy, the equity is now worth $500,000 to the shareholders. If there are 50,000 shares outstanding, then each share must be worth $10.  Notice RC has not changed the value of the firm’s equity by altering its capital structure.

copyright © 2003 McGraw Hill Ryerson Limited Borrowing and Value Modigliani and Miller  Furthermore, RC has not changed the total value of the firm: Before the restructuring the firm was all equity and had a total value of $1 million. After the restructuring, the firm consists of $500,000 of debt and $500,000 of equity. Thus, the firm still has a total value of $1 million!

copyright © 2003 McGraw Hill Ryerson Limited Borrowing and Value MM’s Proposition I (Debt Irrelevance Proposition)  MM proposed that: The value of a firm is unaffected by its capital structure.  This conclusion is known as MM’s Proposition I. It shows that under ideal conditions, a firm’s debt policy shouldn’t matter to its shareholders.

copyright © 2003 McGraw Hill Ryerson Limited Borrowing and Value How Borrowing Affects Risk and Return  This proposition can be shown graphically. Notice that the firm is worth $1 million regardless of the amount of equity value: Firm Value: All Equity FinancingAfter Restructuring $1 million Debt:$500 k Equity:$500 k

copyright © 2003 McGraw Hill Ryerson Limited Borrowing and Value Expected Income: All Equity Financing Equity Income $125,000 Interest: $50,000 Dividend: $75,000 How Borrowing Affects Risk and Return  The firm is worth $1 million because, regardless of its capital structure, its assets generate $125,000 per year of expected cash flow: After Restructuring Total Income

copyright © 2003 McGraw Hill Ryerson Limited Borrowing and Value Expected Income: Equity Income $125,000 Interest: $50,000 Dividend: $75,000 How Borrowing Affects Risk and Return Total Income Proof: Value of Equity Income = $125,000/0.125 = $1 million Value of Total Income = $75,000/ $50,000/0.10 = $500,000 + $500,000 = $1 million

copyright © 2003 McGraw Hill Ryerson Limited Borrowing and Value How Borrowing Affects Risk and Return  Before the restructuring, the firm is worth $1 million and is owned 100% by the shareholders. After the restructuring, the firm is still worth $1 million and is owned 50% by the shareholders and 50% by the creditors.  Notice that the two circles on the previous slide are the same size: Both represent $125,000 of expected cash flow.  However, the second circle shows that the shareholders expect to receive 60% of the income ($75,000/$125,000), even though they own only 50% of the firm.

copyright © 2003 McGraw Hill Ryerson Limited Borrowing and Value How Borrowing Affects Risk and Return  Does the fact that the shareholders will receive more than 50% of the cash flow mean they are better off?  Note that if they were better off, then their shares should increase in value. Thus the shares would be worth more than ½ the value of the firm ($500,000).

copyright © 2003 McGraw Hill Ryerson Limited Borrowing and Value How Borrowing Affects Risk and Return  MM say no – the shareholders are not better off, even though they receive more than ½ of the cash flow.  Why? The answer is that, with more debt, the shareholders bear more risk and thus demand a higher rate of return. As you can see on Slide #19, the discount rate for the equity cash flows increased from 12.5% to 15%. This increase in the discount rate exactly cancels out the increased dollar return.

copyright © 2003 McGraw Hill Ryerson Limited Borrowing and Value How Borrowing Affects Risk and Return  To recapitulate: Restructuring does not affect operating income.  The operating risk, or business risk, of the firm is unchanged. However, with more debt in the capital structure, the eps become more uncertain (in other words, more risky).  That is, debt financing increases the financial risk of the firm.

copyright © 2003 McGraw Hill Ryerson Limited Borrowing and Value How Borrowing Affects Risk and Return  If the firm is financed entirely by equity, a decline of $50,000 in operating income reduces the return on the shares by 5%. That is, if you look at Table 15.1, the return falls from 12.5% to 7.5%.  However, if the firm is financed 50% with debt, then a decline of $50,000 in operating income reduces the return on the shares by 10%. That is, if you look at Table 15.2, the return falls from 15.0% to 5.0%.

copyright © 2003 McGraw Hill Ryerson Limited Borrowing and Value How Borrowing Affects Risk and Return  This increase in earnings uncertainty (risk), is why the use of debt financing is referred to as financial leverage. Financial leverage means that debt financing amplifies the effects of changes in operating income on the returns to stockholders.  With increased uncertainty and risk, the shareholders must demand a higher rate of return.

copyright © 2003 McGraw Hill Ryerson Limited Borrowing and Value How Borrowing Affects Risk and Return  The result: Adding debt to the capital structure of the firm will increase the shareholders’ expected returns. However, it will also increase the risk of those returns. These two effects cancel each other out, leaving the shareholder value unchanged.

copyright © 2003 McGraw Hill Ryerson Limited Borrowing and Value Debt and the Cost of Equity  What is RC’s cost of capital? When it is all equity financed, the answer is easy:  Shareholders are paying $10 per share and expect eps of $1.25.  If the earnings are a perpetuity, the expected return is $1.25/$10.00 = 12.5%.  Thus r equity is 12.5%

copyright © 2003 McGraw Hill Ryerson Limited Borrowing and Value Debt and the Cost of Equity  If r equity is 12.5% and the firm has no debt, the r assets is also 12.5%.  Suppose RC now issues debt and you can afford to buy all of its securities, both debt and equity: What rate of return would you expect on this package of securities? In other words, what should you pay to own a cash flow of $125,000 per year in perpetuity?  Hint: restructuring so that RC has 50% debt will not change its cash flows.

copyright © 2003 McGraw Hill Ryerson Limited Borrowing and Value Debt and the Cost of Equity  The answer is 12.5% since, if you own all of the securities, you will effectively own all of RC’s assets and receive all of its operating income. Proof: From Chapter 11, you know that in a tax free world: r assets = (D/V x r debt ) + (E/V x r equity )  RC’s r assets = (0.50 x 10%) + (0.50 x 15%) = 12.5%

copyright © 2003 McGraw Hill Ryerson Limited Borrowing and Value Debt and the Cost of Equity  Thus, the return on the package of securities is unchanged.  What does change is the return the investors require on each of the components in the package.  Leverage increases the risk of the equity and the return that the shareholders will demand.

copyright © 2003 McGraw Hill Ryerson Limited Borrowing and Value MM’s Proposition II  To see how the expected return on equity varies with leverage, we rearrange the formula for the company cost of capital as follows: r equity = r assets + (D/E) x (r assets - r debt )  This formula is known as MM’s Proposition II.  It states that the required return on a firm’s equity increases as the firm’s debt-equity ratio increases.

copyright © 2003 McGraw Hill Ryerson Limited Borrowing and Value MM’s Proposition II  If you look at Figure 15.3 on page 454 of your text, you can see a graph of these relationships.  Notice that: The r assets is constant, no matter how much the firm borrows. The expected return on the individual securities does, however, change:  The expected return on the equity rises smoothly as the firm adds more debt.

copyright © 2003 McGraw Hill Ryerson Limited Borrowing and Value MM’s Proposition II  In Figure 15.3, notice that the interest rate on the debt is shown as constant, no matter how much the firm borrows.  This is not realistic. As companies borrow more, their debt becomes more risky as higher interest payments increase the chance of default. The consequence is that, at some point, the firm will have to pay a higher interest rate if it wishes to borrow more.

copyright © 2003 McGraw Hill Ryerson Limited Borrowing and Value MM’s Proposition II  Proposition II continues to predict that the expected return on the package of debt and equity does not change.  This is demonstrated in Figure 15.4: The r assets line is still constant. However, the r debt line now increases. Notice, though, that the r equity line tapers off as the D/E increases.  This happens because, as the firm borrows more, some of the risk is transferred from the shareholders to the bondholders.

copyright © 2003 McGraw Hill Ryerson Limited Capital Structure and Corporate Taxes Does Debt Matter?  MM’s propositions suggest that debt policy should not matter.  However, in reality, debt matters a lot, and financial managers spend a great deal of their time worrying about the optimal debt to equity ratio for their firm.  Which leads to a critical question: What is wrong with MM’s theory?

copyright © 2003 McGraw Hill Ryerson Limited Capital Structure and Corporate Taxes Does Debt Matter?  Debt financing has an important advantage. If the company pays tax, interest is a tax deductible expense.  To see the advantage conferred by debt, let’s assume that RC is in a 35% tax bracket. On the next slide, the left-hand column shows what happens if RC is entirely financed with equity. The right-hand column shows what happens if it is 50% financed with debt.

copyright © 2003 McGraw Hill Ryerson Limited Does Debt Matter? Capital Structure and Corporate Taxes Zero Debt50% Debt Operating Income$125,000$125,000 Less: Interest (10%) 0 50,000 Before-Tax Income125,000 75,000 Less: Tax (35%) 43,750 26,250 After-Tax Income81,25048,750 Combined Payments to Security Holders (Interest + After-Tax Income)81,250$98,750 ++

copyright © 2003 McGraw Hill Ryerson Limited Capital Structure and Corporate Taxes Does Debt Matter?  Notice on the previous slide that after- tax income available to just the shareholders falls from $81,250 to $48,750 if the firm borrows.  But, the combined cash flow available to all the security holders rises from $81,250 to $98,750. What explains this?

copyright © 2003 McGraw Hill Ryerson Limited Capital Structure and Corporate Taxes Debt and Taxes  The combined income to the debt and equityholders is higher by $17,500 when RC is levered. This occurs because interest payments are tax deductible. Therefore every $1 of interest RC pays reduces its taxes by $0.35: Tax Savings= tax rate x interest payments = 0.35 x $50,000 = $17,500 per year

copyright © 2003 McGraw Hill Ryerson Limited Capital Structure and Corporate Taxes Debt and Taxes  When it has no debt, the value of RC to the shareholders is simply the PV of the $81,250 after-tax income in perpetuity. If the firm is all equity financed, we know its required return on equity is 12.5%: Value of RC With no Debt= $81,250 / = $650,000* Without taxes RC was worth $1 million. With taxes, 35% of the firm’s value is lost to the government.

copyright © 2003 McGraw Hill Ryerson Limited Capital Structure and Corporate Taxes Debt and Taxes  But, if RC issues $500,000 of debt, the value of all of the firm’s securities must increase by the value of the tax shield.  This means, in a world with taxes, the value of a firm increases with debt: Value of RC with Debt = Value of RC Without Debt + Tax Shield = $650,000 + $175,000 = $825,000

copyright © 2003 McGraw Hill Ryerson Limited Capital Structure and Corporate Taxes Debt and Taxes  To generalize: Annual Tax Shield= Corporate Tax Rate x Interest = Tc Tc x (r debt x Amount of Debt) = Tc Tc x (r debt x D) PV of Tax Shield= Annual Tax Shield / r debt = [Tc [Tc x (r debt x D)] / r debt = Tc Tc x D If the tax shield is perpetual, we can use the perpetuity formula to calculate the value of the tax shield:

copyright © 2003 McGraw Hill Ryerson Limited Capital Structure and Corporate Taxes MM’s Modified Proposition I  In a no tax world, MM’s Proposition I states that the value of the firm is unaffected by capital structure.  MM’s modified Proposition I recognizes the impact of taxes on firm value: Value of Levered Firm = Value of All-Equity Financed Firm + PV of Tax Shield Value of Levered Firm = Value of All-Equity Financed Firm + TcDTcD In the special case of permanent debt:

copyright © 2003 McGraw Hill Ryerson Limited Capital Structure and Corporate Taxes WACC and Debt Policy  To summarize for RC if it issues $500,000 of debt: Value of the firm = $825,000 Value of the Debt = $500,000  Value of the Equity = $325,000  MM’s Proposition II with corporate taxes tells us RC’s cost of equity should be: r equity = r assets + (D/E) x (1 - T c ) x (r assets - r debt ) = 12.5% + (500/325) x (1-0.35) x (12.5%-10%) = 15%

copyright © 2003 McGraw Hill Ryerson Limited Capital Structure and Corporate Taxes WACC and Debt Policy  We now have all the information we need to calculate RC’s WACC if it issues debt in a world with taxes: r assets = [D/V x (1-T c )r debt ] + (E/V x r equity ) = [500/825 x ( ) x 10%] + (325/825 x 15%) = 9.85% Thus, adding debt in a world with taxes reduces RC’s WACC from 12.5% to 9.85%.

copyright © 2003 McGraw Hill Ryerson Limited Capital Structure and Corporate Taxes WACC and Debt Policy  If you look at Figure 15.3 on page 459 of your text, you can see that as RC borrows more, its expected return on equity increases. But the rise is less rapid than it would be in a tax free world.  In addition, the cost of debt has fallen from 10% to 6.85%.  The result: The WACC declines as RC’s debt-equity ratio increases.

copyright © 2003 McGraw Hill Ryerson Limited Capital Structure and Corporate Taxes Does Debt Matter?  If borrowing provides a debt shield, then we discover that the optimal debt policy is for all firms to borrow to the extreme. This minimizes the WACC and thus maximizes the value of the firm.  In reality, financial managers do not believe that if they borrow to the hilt this will maximize the value of the their firm. So, now what is wrong with MM’s theory?

copyright © 2003 McGraw Hill Ryerson Limited Costs of Financial Distress Other Factors to Consider  Clearly, there are factors other than taxes which a financial manager must consider when determining how much their firm should borrow.  Costs of Distress arise from bankruptcy or distorted business decisions before bankruptcy occurs.  These distress costs reduce the value of the firm.  And, as the firm adds debt to its capital structure, these costs start to increase significantly.

copyright © 2003 McGraw Hill Ryerson Limited Costs of Financial Distress Other Factors to Consider  As debt increases, the costs of distress offset the benefits the firm receives from the interest tax shield.  The result: Value of All-Equity Firm + PV of the Tax Shield – PV of the Costs of Financial Distress = Value of the Levered Firm

copyright © 2003 McGraw Hill Ryerson Limited Costs of Financial Distress Other Factors to Consider  This formula is known as the Trade-Off Theory.  The Trade-Off Theory says that financial managers choose the level of debt which will balance the firm’s interest tax shields against its costs of financial distress.  Look at Figure 15.7 on page 460 to see how the Trade-Off Theory works.

copyright © 2003 McGraw Hill Ryerson Limited Costs of Financial Distress The Trade-Off Theory  In Figure 15.7, you can see that, at first, adding debt to the firm’s capital structure increases the value of the firm. This reflects the benefits the firm receives from the interest tax shields.  But, at some point, as the firm borrows more, the costs of distress become more important.  They offset the benefits of the tax shield and the value of the firm starts to decline.

copyright © 2003 McGraw Hill Ryerson Limited Explaining Financing Choices A Competing Theory  The Trade-Off Theory states that the firm’s choice of its debt-equity ratio is a trade-off between its interest tax shields and the costs of financial distress.  The Trade-Off Theory can explain much of how firms in various industries behave when they take-on debt.  However, there are things this theory cannot explain.

copyright © 2003 McGraw Hill Ryerson Limited Explaining Financing Choices A Competing Theory  The Pecking Order Theory states that firms prefer to issue debt rather than equity if internal finance is insufficient.  They do this, because, as we saw in the previous chapter, investors believe that a share issue is an indicator the management believes the firm’s shares are overvalued.  A share issue is thus interpreted by the markets as a bad omen.  Debt is less likely to be interpreted this way.

copyright © 2003 McGraw Hill Ryerson Limited Explaining Financing Choices A Competing Theory  As we saw in Chapter 13, Canadian corporations do rely on internal funds to finance the majority of their new investment.  In addition, most external financing comes from debt.  Thus, aggregate financing patterns are consistent with the Pecking Order theory. But, the theory works best for mature firms. As with the Trade-Off Theory, there are things it cannot explain.

copyright © 2003 McGraw Hill Ryerson Limited Summary of Chapter 15  The goal of the financial manager is to maximize the value of the firm.  The key question is: Can a financial manager increase the value of the firm by changing the firm’s debt-equity ratio?  MM’s Proposition I states that the value of a firm arises from the cash flows produced by its assets. You cannot change these cash flows by changing the way the assets are financed. All you can change is how those cash flows are distributed to investors.

copyright © 2003 McGraw Hill Ryerson Limited Summary of Chapter 15  If you cannot change the size of the cash flows by changing the financing of the firm, then its debt-equity structure is irrelevant.  MM’s Proposition I holds only in well-functioning capital markets in which there are no taxes and no costs of financial distress.  With the existence of taxes, the firm’s interest payments become tax deductible, creating a tax shield which increases the value of the firm.  Under these circumstances, managers should borrow as much as possible, because it maximizes the value of the firm.

copyright © 2003 McGraw Hill Ryerson Limited Summary of Chapter 15  But, as you add debt to the firm’s capital structure, the costs of financial distress increase, offsetting the value of the tax shields.  The Trade-Off Theory states that there is an optimal capital structure for a firm. It occurs when the value of the tax shields balances the costs of distress.  A competing theory, the Pecking Order Theory, says that firms prefer internal financing.  However, if internal funds are insufficient, the firm will prefer debt financing to issuing equity.