Capital Structure Modigliani-Miller Finance - Pedro Barroso

Capital Structure and the Pie Market value of a firm is the sum of the value of the firm’s debt and the firm’s equity: V = D + E Goal of the firm’s management is to make the firm as valuable as possible, then the firm should pick the debt-to-equity ratio that makes the pie as big as possible S D E Value of the Firm Finance - Pedro Barroso

Stockholder Interests There are two important questions: Why should the stockholders care about maximizing firm value? Perhaps they should be interested in strategies that maximize shareholder value. What is the ratio of debt-to-equity that maximizes the shareholder’s value? As it turns out, changes in capital structure benefit the stockholders if and only if the value of the firm increases. Finance - Pedro Barroso

Variety of Capital Structures Out There AT&T Boeing Boston Edison John Deere Delta Air Lines Disney General Motors Hewlett-Packard McDonalds 3M Philip Morris Raytheon Safeway Stores Texaco Wal-Mart Company Name Debt Debt + Mkt Equity Total Book Assets EBITDA Interest 20% 15 49 40 53 9 61 13 15 6 27 9 55 27 14 29% 13 42 37 32 20 37 17 31 12 35 12 53 26 36 16.36 14.37 3.49 2.47 1.08 14.09 2.98 21.67 7.18 59.70 6.72 37.88 3.06 4.70 7.54 Finance - Pedro Barroso

Modigliani-Miller Assumptions Perfect capital markets: no transaction costs and no taxes no bankruptcy costs no agency costs no asymmetric information in capital markets no arbitrage Finance - Pedro Barroso

MM Proposition I (No Taxes) Total market value of the firm (debt + equity) is not affected by the capital structure “The size of the pie does not change no matter how you slice it” A firm’s value is determined by its real assets and growth opportunities, not by the types of securities it issues Cost of capital is independent of capital structure Finance - Pedro Barroso

MM Proposition I (No Taxes) We can create a levered or unlevered position by adjusting the trading in our own account This homemade leverage suggests that capital structure is irrelevant in determining the market value of the firm: VL = VU Finance - Pedro Barroso

Home-Made (Un)Leverage Consider twin firms with same assets that generate perpetual cash flow FCF Notice that FCF = EBIT (= 100) No taxes Zero growth: Depreciation = CAPEX, Working capital = 0 Unlevered firm U: all-equity firm with value VU = E (= 1500) VU = EBIT / rU , rU is cost of capital of unlevered firm Levered firm L: firm with debt and equity; firm value VL = D + E (= 500 + 1000 = 1500) Debt is perpetual bond with coupon of DrD (rD = 10%) Finance - Pedro Barroso

Home-Made (Un)Leverage Strategy A: investor buys 10% of levered firm (L) equity, which is 10%E Cost = 10%(VL-D) Strategy B: investor buys 10% of unlevered firm (U) with loan of 10%D at interest rate of rD plus own investment of 10%(VU – D) Cost= 10%(VU – D) Finance - Pedro Barroso

Home-Made (Un)Leverage Strategy A payoff: 10%[EBIT – DrD] 10% [100 – 500 x 10%] = 5 Strategy B payoff: 10%EBIT – 10%DrD = 10% [EBIT – DrD] 10% x 100 – 10% x 500 x 10% = 5 Finance - Pedro Barroso

Home-Made (Un)Leverage No arbitrage condition: investments with equal payoffs must have same initial investment 10% (VL-D) = 10%(VU – D) [10% x 1000 = 10% (1500 - 500)] VU = D + E VU = VL Investors can leverage (or unleverage) a firm’s capital structure to any given level through a personal loan (or deposit) Finance - Pedro Barroso

MM Proposition II (No Taxes) where: rU is cost of capital of unlevered firm (all-equity) rE is cost of equity (or required return on equity) rD is cost of debt E is market value of equity D is market value of debt WACC is weighted-average cost of capital Finance - Pedro Barroso

MM Proposition II (No Taxes) Define the weighted average cost of capital: Set rU = WACC (cost of capital is independent of capital structure) Finance - Pedro Barroso

MM Proposition II (No Taxes) Cost of capital rU rD rD Debt-to-equity ratio Finance - Pedro Barroso

Finance - Pedro Barroso MM II (No Taxes) Increasing the debt load does not affect the riskiness of the assets, but it does increase the riskiness of the equity In the same firm, rD is always less than rE, because the debt has a higher priority and thus less risk But the weighted sum (WACC) of the costs of debt and equity is always a constant Finance - Pedro Barroso

MM (With Corporate Taxes) Corporate taxes on profits introduce a new claimholder on the firm’s cash flows (government) Maximum corporate tax rate in the US is 34% and 25% in Portugal Minimizing government’s share of the pie leaves more for debt and equity holders Financing policy can be a tool to increase firm value (i.e. market value of debt plus market value of equity) Finance - Pedro Barroso

MM (With Corporate Taxes) A firm has pre-tax cash flow FCF = EBIT and interest payments D rD Firm pays corporate tax at rate t After-tax cash flow to shareholders and debtholders: FCF = EBIT (1 – t) + t D rD NI + D rD = (EBIT – D rD ) (1 – t) + D rD t D rD is tax shield from debt (interest tax shield) Levered firm value is present value of FCFs Finance - Pedro Barroso

Finance - Pedro Barroso Example Unlevered Firm Levered Firm EBIT 100 Interest expenses (rD x D) 10 = 10% x 100 Earnings before taxes 90 Taxes (t = 30%) 30 27 Net Income 70 63 FCF (NI + Interest expenses) 73 = 63 + 10 Finance - Pedro Barroso

MM Propositions I & II (With Taxes) Proposition I: Firm value increases with leverage VL = VU + tD Proposition II: Some of the increase in equity risk and return is offset by the interest tax shield Optimal capital sructure: 100% debt! Finance - Pedro Barroso

MM Proposition II (With Taxes) Expected cash flow from LHS of balance sheet can be written as: Expected cash flow to debtholders and stockholders can be written as: Thus, Finance - Pedro Barroso

Finance - Pedro Barroso WACC (With Taxes) Weighted average cost of capital (WACC) with corporate taxes: Thus, Finance - Pedro Barroso

MM Proposition II (With Taxes) Cost of capital rU rD Debt-to-equity ratio (D/E) Finance - Pedro Barroso

Total Cash Flow to Investors All-equity firm Levered firm E G E G D Levered firm pays less in taxes than does the all-equity firm Thus, the sum of the debt plus the equity of the levered firm is greater than the equity of the unlevered firm This is how cutting the pie differently can make the pie “larger” - the government takes a smaller slice of the pie! Finance - Pedro Barroso

Finance - Pedro Barroso Caveats Correct tax rate to value the interest tax shield is the expected marginal tax rate, or the expected increase in the firm’s tax liability when its taxable income increases by $1. This may not be the statutory rate! The firm may not always be taxable Earnings may not be large enough to fully utilize the shield Tax losses can be carried back 2 years or forward 20 years in the U.S.; only carry forward 4 years in Portugal Non-debt tax shields may already suffice to offset earnings Depreciation Investment tax credit Finance - Pedro Barroso