Lecture No. 36 Review of Capital Structure Management Financial Management Lecture No. 36 Review of Capital Structure Management

Pure Miller Modigliani (MM) Theory Miller Modigliani (MM) Theory – Case of Ideal World & Efficient Markets Capital Structure, DEBT, & Corporate Financing have NO AFFECT on Capital Budgeting, MARKET VALUE OF FIRM (V), NPV, & Investment Decisions Remember that in Efficient Markets, the Fair Value of a Firm (calculated using NPV) is approximately equal to the Market Value. The Firm’s Value is determined by the Future Cash Flows generated by the Firm (or Real Assets) and NOT by the way the cash flows are split or divided amongst the Debt and Equity Holders. Market Value of Firm = V = EBIT / WACC . As Debt Increases, Risk Increases so rD and rE and WACC should increase. BUT Debt is cheaper than equity (recall Risk Theory) so as Debt Increases, WACC should decrease ! Net Effect is No Change in WACC and No Change in Value ! Major Assumptions: No Taxes, No Bankruptcy Costs, Equal Information, Efficient Markets

Pure MM Theory - Ideal Markets WACC Graph Financial Risk. Higher Required Return on Equity. Higher rE Cost of Capital (%) rE = Cost of Equity =WACC+D/E (WACC-rD) WACC = rDxD + rExE rE rD = Cost of Debt rD Debt / Equity = A Measure of Leverage = D/E = xD / ( 1- xD ) 100% Equity Firm

Tradeoff Theory Graph – Linked to Traditionalist Theory of Leverage & Optimal Capital Structure Slightly Leveraged Firm: Interest Tax Shield Benefit. Total Return to Investors Rises so Stock Value Rises. Total Return = Net Income (paid to Shareholders) + Interest (paid to Debt Holders) Excessively Leveraged Firm: Threat of Bankruptcy has Real Costs. Less Investor Confidence and Lower Share Price. Value of Firm OR Price of Stock Firm Remains 100% Equity (Un-Levered) Financial Leverage = Debt / Assets = D/(D+E) OPTIMAL Capital Structure - MAXIMUM VALUE & MINIMUM WACC

Traditionalist Theory - Real Markets WACC Graph Bankruptcy Risk & Costs. Higher Required Return on Equity. Steeper Rise. Cost of Capital (%) rE,L = Cost of Equity = WACCU + xD(WACCU -rD) (1-TC) WACCL = rD(1-Tc)xD + rExE rE rD = Cost of Debt rD Interest Tax Shield Advantage Debt / Equity = A Measure of Leverage = D/E = xD / ( 1- xD ) 100% Equity Firm Optimal Capital Structure = Minimum WACC and Maximum Value Note: xD = D / (D+E)

Capital Structure – 2 Approaches for Estimating Numerical WACC & Value NI Approach (or EBIT Approach) Starting Point is EBIT (which is given) EBIT  NI (=EBIT–Interest–Tax)  EL (=NI/rE assuming no change in rE levered or un-levered !)  VL (=EL+D where D is given)  WACCL (=rD,L(1-Tc)xD + rExE ). Note WACCU = rE Tax Shield Approach (or NOI Approach) Starting Point is Market Value of Un-levered Firm Vu which is given VL (= VU + TC D. Assumes that VL will keep increasing with D ! TcD = Tax Shield Advantage from Debt)  EL (=VL – D)  rE,L (= NI /E)  WACCL (= rD,L(1-Tc)xD + rE,LxE . Note WACCL =WACCU (1-Tc) xD

MM Model Formulas Pure MM (Without Taxes) MM With Taxes Vu = VL = EBIT / WACC = EBIT / rE WACC constant. VL constant or unaffected by Debt rE,L = rE,U + Risk Premium = rE,U + (rE,U - rRF) (D/E) MM Proposition II MM With Taxes VL = Vu + (Tc D) . VL Rises as WACC falls. Inverse Vu = EBIT (1-Tc) / rE,U rE,L = rE,U + (rE,U - rRF) (1-Tc) (D/E)

Traditionalist Model Formulas FIRM’S VALUE = EBIT / COST OF CAPITAL MORE LEVERAGE (OR DEBT) MEANS MORE RISK WHICH MEANS HIGHER COST OF CAPITAL AND THEREFORE LOWER VALUE Traditionalist View is based on Practical Reality. Leverage provides Interest Tax Savings (or Shield) but also Increases Financial Risk. Excessive Leverage leads to Bankruptcy Risk. Increase in Risk will Change Value of Firm and WACC. Traditionalists Formulas for Equity: E = NI / rE,L Note: NI = EBIT - Interest - Tax = EBT - Tax NI = (EBIT - xD rD ) (1 - Tc). rE,L=WACCu+ xD (WACCu - rD) (1-Tc). Traditionalists Formula for WACC: WACCL = xD rD (1 - Tc) + xE rE . (1-Tc) is the Tax Discount Factor. Note: V = D + E xD = D /V = D / (D+E) xD + xE = 1 V = Market Value of Firm D = Market Value of Debt E = Market Value of Equity xD = Fraction of Debt = A Measure of Leverage

Traditionalist Theory - Effect of Capital Structure on Firm Value & Share Price As 100% Equity Firm Takes On More and More Debt (or Leverage): Cost of Capital decreases (cost of debt is cheaper than equity), reaches a minimum point, and then rises (excessive debt increases financial risk). Total Market Value of Firm ( V = D + E = Market Value of Debt + Market Value of Equity) first rises (because of Interest Tax Shield savings), then reaches a maximum point (optimal capital structure), and finally falls (because of excessive fall in Net Income and Equity value because of interest payments). Share Price (Po= Total Value / Original Number of Shares OR Equity value / Number of Shares Outstanding) first rises, then reaches maximum (same point as maximum Value), and finally falls. Follows same shape as Total Market Value of Firm. Share Price is a measure of Firm Value.

Traditionalist Theory - Effect of Capital Structure on Earnings and Risk As 100% Equity Firm Replaces More and More Equity with Debt (or Leverage): Mean (or Expected) EBIT assumed to be unchanged although excessive debt can cause it to rise because of higher operational costs because of financial distress Mean EBT will fall because interest payments rise Mean Net Income (or Earnings) generally falls continuously because interest payments rise faster than any interest tax savings. Mean Earnings Per Share (EPS = Net Income / Number of Shares outstanding) generally first rises if number of shares falls if Equity is Replaced with Debt, then reaches maximum (different capital structure mix from that which maximizes Value & Share Price) , and finally falls (because interest payments grow faster). Similar shape to Share Price Curve but reaches Maximum at a different Debt Ratio and Capital Structure. For Optimizing Capital Structure, we should focus on Share Price and not EPS. Earnings Risk (Variation or Standard Deviation) Increases because of Leveraging or Magnifying effect of Debt. Debt increases Financial Distress and Risk of Bankruptcy. And if Firm is financially unhealthy ie. EBIT / Total Assets < Cost of Debt then small fall in EBIT can lead to large fall in ROE.

Weaknesses of Capital Structure Mathematical Models Forecasting Errors Changes in Cost of Debt and Equity (or Capitalization Rates) are unpredictable when Debt Ratio is changing Changes in EBIT are also difficult to correlate to changes in Debt or Capital Structure Share Price and EPS calculation is very Sensitive to minor errors in above. Focus on Corporate Finance is on Market Value (of Equity, Debt, Stocks) BUT Market Value may not be so important for Proprietorships and Private Ltd Companies where only a few shareholders to whom the market value assessed by investors in the market is irrelevant. Fundamentally, Stock Prices should be fundamentally driven by Operating Decisions and Focus on Improving Earnings and Cash Flows – and NOT by manipulating Capital Structure. Capital Structure and Corporate Financing can be used to fine tune the value.

Practical Capital Structure Management Financial Stability and Conservatism vs Real-time Capital Structure Optimization ! Aim for Target Capital Structure Long Run Viability vs Short-term Stock Price Maximization Financial Ratio Targets Coverage Ratio ie. TIE (Times Interest Earned) = EBIT / Interest. Higher (over 2.0) is better. Long Term Debt / Total Capitalization Ratio - about 30% FCC (Fixed Charge Coverage) = (EBIT - Lease Rental) / ( Interest + Lease Rental + Adjusted Sinking Fund Payment). Takes into account Fixed Financial Charges other than Interest Maintain Reserve Borrowing Capacity (recall Signaling Theory) in case attractive Positive NPV projects are found & also to give the right Signal to Market

Practical Capital Structure Management Management Control use Debt to avoid giving away voting rights and control BUT Creditors can take control if firm becomes insolvent or defaults Corporate Raiders can take over a firm with large assets if debt is too low - using LBO (Leveraged Buy Out). They convince shareholders to give them control in exchange for higher share prices and EPS as a result of future leveraging. Firms with (1) solid assets that can be mortgaged as security against a loan and (2) stable sales and Operating Leverage can generally use debt more safely. Retained Earnings: profitable firms have sizeable Cash and Retained Earnings. These are ideal sources of capital because No transaction costs. High Tax Bracket Firms: such firms have greater advantage in using debt because of large Interest Tax Shield Savings.