Lecture 5 Capital structure I Specifics of different sources of long-term financing Common stock vs preferred stock vs debt The Modigliani and Miller model The Miller model

The Long-Term Financial Deficit (1999) Uses of Cash Flow (100%) Capital spending 80% Net working capital plus other uses 20% Sources of Cash Flow (100%) Internal cash flow (retained earnings plus depreciation) 70% Long-term debt and equity 30% Internal cash flow Financial deficit External cash flow

Firms usually spend more than they generate internally Capital Structure Firms usually spend more than they generate internally The deficit is financed by new sales of debt & equity Sources of long-term financing: Internal financing Retained earnings External financing Debt Preferred stock Common stock

Elements of the Capital Structure Mix of different classes of capital: Retained earnings vs debt & equity Control rights vs cash flow rights Maturity: refinancing risk vs reinvestment risk Agency conflict Asymmetric information and signaling Important subtopics: Debt: bank credit vs bonds Payout policy: dividends vs share repurchase Costs of new issues

Common Stock Basic Shareholders’ Rights (may differ for dual classes): Control rights Residual claim on assets (after paying up liabilities) Limited liability Components of Shareholders’ Equity: Common Stock Par Value Capital Surplus (directly contributed equity in excess of the par value) Retained Earnings (accumulated over time) Treasury Stock at Cost Shares: Authorized vs Issued vs Outstanding Market vs Book vs Replacement Value MV = price of the stock times the number of shares outstanding BV = par value + capital surplus + accumulated retained earnings RV = current cost of replacing the assets of the firm At the time a firm purchases an asset, MV=BV=RV

The Right to Elect the Directors The most important control device Directors are elected each year at an annual meeting by a vote of the holders of a majority of shares who are present and entitled to vote Straight voting Shareholders have as many votes as shares and each position on the board has its own election A tendency to freeze out minority shareholders Cumulative voting Each shareholder may cast # shares multiplied by # directors to be elected; these votes can be distributed over one or more candidates The effect is to permit minority participation Proxy voting (giving voting right to someone else) Proxy fight: outsiders try to win enough proxy votes to oust the mgt Some (e.g. merger) decisions require supermajority (e.g. 75%)

Dividends Unless a dividend is declared by the board of directors, it is not a liability of the corporation A corporation cannot default on an undeclared dividend The payment of dividends by the corporation is not a business expense Therefore, they are not tax-deductible Dividends received by individual shareholders are considered ordinary income and are fully taxable Intra-corporate dividend exclusion: corporations are taxed only on the 20% of the received dividends

Corporate Long-Term Debt Bondholders have a contractual claim against the corporation, not an ownership interest Creditors have no voting power unless the debt is not paid, when they can legally claim the assets of the firm The corporation’s payment of interest on debt is considered a cost of doing business.. and is fully tax-deductible Corporations are very adept at creating hybrid securities that look like equity but are called debt Obviously, the distinction is important at tax time A corporation that succeeds is creating a debt security that is really equity obtains the tax benefits of debt while eliminating its bankruptcy costs

The Bond Indenture Amount of issue, date of issue, maturity, currency, par value Coupon payments: frequency, floating vs fixed rate Orderly repayment of debt (to avoid the balloon payment): Amortization, by regular installments through a sinking fund With serial bonds Option features: Call provision (possibility to retire the entire issue before the maturity) Convertibility into stocks Security (attachment to the property): debenture/note vs bond Protective covenants: Restrictions on further indebtedness, max dividends, min working K Seniority: subordinated debt paid after senior debt Other determinants of the market price: Default risk (credit rating), domestic / foreign / Eurobond

Dual Nature of Preferred Stock Preference over common stock in cash rights: in the payments of dividends in the assets in case of bankruptcy No voting rights, unless no dividends 6 quarters in a row Is it really debt in disguise? Fixed dividend: usually, cumulative (carried forward if not paid) Stated liquidating value Call provision: can be converted to common shares Corporations get 80% tax exemption on dividends But not on debt interest Most preferred stock in the U.S. is held by corporate investors Firms issuing the preferred stock: Utilities, with low taxable income, avoiding the risk of bankruptcy Preferred stock is like debt with long maturity, sensitive to changes in interest rates. In 80s, when interest rates were very volatile, some corporations issued floating-rate prefs.

Patterns of Financing Firms usually spend more than they generate internally The deficit is financed by new sales of debt and equity Internally generated cash flow dominates as a source of financing, typically between 70 and 90% New sales of debt prevail over new equity issues Outside the US, firms rely more on external equity Debt ratios for U.S. non-financial firms have been below 50% of total financing

Choice of the Capital Structure The value of a firm: sum of the value of the firm’s debt and the firm’s equity: V = B + S Why should the stockholders care about maximizing firm value? Since the payoff of the debtholders is fixed (in case of no default), changes in capital structure benefit the stockholders if and only if the value of the firm increases. S B Value of the Firm

Modigliani-Miller Model: Assumptions Perfect capital markets: Perfect competition Firms & investors can borrow/lend at the same rate No frictions (transaction costs / taxes / bankruptcy costs) Informational efficiency No need for signaling Managers are perfectly aligned with shareholders No agency costs Firms can be classified to homogeneous risk classes No CAPM at that time Perpetual cash flows, no growth The firm can issue risk-free debt

Homemade Leverage: An Example Recession Expected Expansion EPS of Unlevered Firm $2.50 $5.00 $7.50 Earnings for 40 shares $100 $200 $300 Less interest on $800 (8%) $64 $64 $64 Net Profits $36 $136 $236 ROE (Net Profits / $1,200) 3% 11% 20% We are buying 40 shares of a $50 stock and borrow $800. We get the same ROE as in the levered firm. Our personal debt equity ratio:

Homemade (Un)Leverage: An Example Recession Expected Expansion EPS of Levered Firm $1.50 $5.67 $9.83 Earnings for 24 shares $36 $136 $236 Plus interest on $800 (8%) $64 $64 $64 Net Profits $100 $200 $300 ROE (Net Profits / $2,000) 5% 10% 15% Buying 24 shares of an otherwise identical levered firm along with some of the firm’s debt gives us ROE of the unlevered firm. This is the fundamental insight of MM

The MM Propositions (No Taxes), 1958 Prop. I: firm's value is not affected by leverage VL = VU Prop. II: leverage increases the risk and return to stockholders rs = r0 + (B/S) (r0 - rB) rB is the interest rate (cost of debt) rs is the return on (levered) equity (cost of equity) r0 is the return on unlevered equity (cost of capital) B is the value of debt S is the value of levered equity

MM II: Cost of Equity and WACC Cost of capital: r (%) r0 rB rB Debt-to-equity Ratio

The MM Propositions (with Corporate Taxes), 1963 Prop. I: firm's value increases with leverage VL = VU + TC B Prop. II: the increase in equity risk and return is partly offset by the tax shield of debt rS = r0 + (B/S)×(1-TC)×(r0 - rB) rB is the interest rate (cost of debt) rs is the return on (levered) equity (cost of equity) r0 is the return on unlevered equity (cost of capital) B is the value of debt S is the value of levered equity TC is the corporate tax rate

Derivation of MM (with Corporate Taxes) Each period, shareholders and bondholders receive (EBIT - RBB)(1 - TC) + RBB = EBIT(1 - TC) + TCRBB PV of this stream of CFs discounted at r0 and rB is S + B ≡ VL = VU + TC B Thus, VU = S + B(1-TC). Both sides yield equal CFs: r0VU = rSS+rBB(1-TC) or r0(S+B(1-TC)) =rSS+rBB(1-TC) The cost of equity: rs = r0 + (B/S) (1-TC) (r0 - rB) WACC: rS S/(S+B) + (1 - TC) rB B/(S+B) = r0 [1 - TC B/(S+B)]

MM II: Cost of Equity and WACC Cost of capital: r (%) r0 rB Debt-to-equity ratio (B/S)

Does it matter how to cut the pizza into pieces? Summary: MM Model Does it matter how to cut the pizza into pieces? In a world of no taxes: The firm’s value is fully determined by investments Shareholders can achieve any pattern of payouts they desire with homemade leverage In a world of taxes, but no bankruptcy costs: The firm’s value increases with leverage If you count the government as the stakeholder, value of the firm stays the same! WACC differs from r0 Both models give unrealistic predictions

The Miller Model: Impact of Personal Taxes Miller (1977) shows that the value of a levered firm can be expressed in terms of an unlevered firm as: where TS = personal tax rate on equity income TB = personal tax rate on bond income TC = corporate tax rate

Derivation of the Miller Model Assume that each year the firm earns EBIT and pays interest on debt with face value F:

Derivation of the Miller Model The total CF to all stakeholders in the levered firm is: The first term is the cash flow of an unlevered firm after all taxes. Its value = VU The bond promises to pay rBF×(1-TB) after taxes and is worth B=F(1-TB). Thus, the value of the second term is: The value of the sum of these two terms must be VL

Firm Value with Corporate & Personal Taxes VL = VU+TCB when TS =TB Value of firm (V) VL < VU + TCB when TS < TB but (1-TB) > (1-TC)×(1-TS) VU VL =VU when (1-TB) = (1-TC)×(1-TS) VL < VU when (1-TB) < (1-TC)×(1-TS) Debt (B)

Interpretation of the Miller Model Personal tax rates differ: TS < TB Effective tax rate on capital gains is lower (can be deferred) 80% of dividends received by corporations are tax-exempt Many types of investment funds pay no taxes Bond market equilibrium (assuming TS = 0): The supply of funds is fixed at rS = r0/(1-TC) The demand rises from r0 sufficient for tax-exempt investors to r0/(1-TB,i) for investors in i's tax bracket In equilibrium, no tax advantage for leverage An equilibrium amount of corporate debt is determined by relative corporate & personal tax rates

DeAngelo-Masulis Model, 1980 The tax shield may be underutilized: Effects of tax shield substitutes (depreciation and investment tax credit) Higher debt increases probability of negative earnings and bankruptcy Modified bond market equilibrium: The supply of funds depends on the corporation-specific tax rate: rS = r0/(1-TC,i) The higher the level of tax shield substitutes and the cost of bankruptcy, the lower the leverage

Value of the Firm (MM-Proposition I with Taxes and Bankruptcy) MM-with corporate taxes only Value of the Firm MM-with corporate taxes and bankruptcy costs MM-no taxes Optimal debt-equity ratio Debt-Equity Ratio (B/S)