Capital Structure and Valuation 8-1

8-2 Example

8-3 Capital Structure Current Proposed

8-4 Miller and Modigliani: Proposition I Strategy A: Buy 100 shares of levered equity Strategy B: Buy 200 shares of unlevered equity using $2,000 in borrowing (Homemade Leverage) Proposition I (no taxes): Value of the unlevered firm is equal to the value of the levered firm

8-5 Miller and Modigliani: Proposition II (no taxes) Remember: r WACC = D/A × r D + E/A × r E Remember: r WACC = D/A × r D + E/A × r E MM(I) implies r WACC is independent of leverage MM(I) implies r WACC is independent of leverage Define r 0 is cost of capital for all-equity firm Define r 0 is cost of capital for all-equity firm r 0 = unlevered earnings / unlevered equity =15% r 0 = unlevered earnings / unlevered equity =15% Result: r 0 =r WACC if there are no taxes Result: r 0 =r WACC if there are no taxes Result: MM(II) (no taxes): r E = r 0 + D/E × (r 0 – r D ) Result: MM(II) (no taxes): r E = r 0 + D/E × (r 0 – r D )

8-6 Cost of Capital and MM(2) r0r0 rErE r WACC rDrD D/E Cost of Capital (%)

8-7 Taxes Present value of the tax shield Present value of the tax shield Interest = r D × D Interest = r D × D Tax reduction = T c × r D × D Tax reduction = T c × r D × D Under normal circumstances we can assume: Under normal circumstances we can assume: cash flow from tax reduction has same risk as debt cash flow from tax reduction has same risk as debt cash flows are perpetual cash flows are perpetual PV(Tax Shield) = (T c × r D × D) / r D = T c × D PV(Tax Shield) = (T c × r D × D) / r D = T c × D MM(I): V L = V U + T c × D MM(I): V L = V U + T c × D VU = (EBIT × (1 – T c )) / r 0 VU = (EBIT × (1 – T c )) / r 0

8-8 MM(2): r E = r 0 + D/E × (1-T c ) (r 0 – r D ) r0r0 rErE r WACC rDrD D/E Cost of Capital (%) A declining r WACC is a direct result from MM(I), i.e, the value of the firm rises in leverage

8-9 Example Blue Inc. has no debt and is expected to generate $4 million in EBIT in perpetuity. T c =30%. All after-tax earnings are paid as dividends.The firm is considering a restructuring, allowing $10 million in debt at an interest rate of 8%. The unlevered cost of equity, r 0, is 18%. Blue Inc. has no debt and is expected to generate $4 million in EBIT in perpetuity. T c =30%. All after-tax earnings are paid as dividends.The firm is considering a restructuring, allowing $10 million in debt at an interest rate of 8%. The unlevered cost of equity, r 0, is 18%. What is the current value of Blue? What is the current value of Blue? V U =EBIT × (1–T c ) / r 0 = ($4 million × 0.7) / 0.18 = $15.56 million V U =EBIT × (1–T c ) / r 0 = ($4 million × 0.7) / 0.18 = $15.56 million What will the new value be after the restructuring? What will the new value be after the restructuring? V L = V U + T c × D = $ × $10 = $18.56 million V L = V U + T c × D = $ × $10 = $18.56 million What will the new required return on equity be? What will the new required return on equity be? r E = (10/8.56) × 0.7 × (0.18 – 0.08) = 26.18% r E = (10/8.56) × 0.7 × (0.18 – 0.08) = 26.18% Check with: E levered = ((4 – 0.8) × 0.7) / = $8.56 million Check with: E levered = ((4 – 0.8) × 0.7) / = $8.56 million

8-10 How about using r WACC ? r WACC = (10/18.56) × 0.7 × (8.56/18.56) × = 15.08% r WACC = (10/18.56) × 0.7 × (8.56/18.56) × = 15.08% Hence, Blue has decreased its WACC from 18% to 15.08% Hence, Blue has decreased its WACC from 18% to 15.08% V L = (4 × 0.7) / = $18.56 million V L = (4 × 0.7) / = $18.56 million

8-11 Downside of Debt Financial Distress and Agency Costs Financial Distress costs decrease the size of the firm and hence decrease the distribution to shareholders and bondholders. Financial Distress costs decrease the size of the firm and hence decrease the distribution to shareholders and bondholders. Costs Costs Direct costs of financial distress Direct costs of financial distress Indirect costs of financial distress Indirect costs of financial distress Agency costs (of debt) Agency costs (of debt) Asset substitution and risk shifting Asset substitution and risk shifting Underinvestment Underinvestment Milking the company Milking the company

8-12 Static trade-off theory of debt Maximum Firm Value Debt Optimal amount of Debt Actual Firm Value

8-13 More on Agency Costs Benefits of debt Agency cost of Equity (motive) Agency cost of Equity (motive) Shirking is less likely when issuing debt Shirking is less likely when issuing debt Perquisites are less likely with debt Perquisites are less likely with debt Over-investment is less likely with debt Over-investment is less likely with debt Agency cost of Free Cash Flow (opportunity) Agency cost of Free Cash Flow (opportunity) Retained earnings versus dividends? Retained earnings versus dividends? Growth and investment opportunities Growth and investment opportunities Debt serves as a monitoring device, decreasing managerial discretion Debt serves as a monitoring device, decreasing managerial discretion

8-14 The Pecking-Order Theory Internal Financing Internal Financing External Financing External Financing Debt Financing Debt Financing Equity Financing (last resort) Equity Financing (last resort) Asymmetric information and Signaling Asymmetric information and Signaling Dynamic decision, rather than static Dynamic decision, rather than static

8-15 Valuation Weighted Average Cost of Capital Weighted Average Cost of Capital All Cash Flows discounted by discount rate that takes into account leverage All Cash Flows discounted by discount rate that takes into account leverage Adjusted Present Value Adjusted Present Value Separate cash flows from project and cash flows from financing Separate cash flows from project and cash flows from financing Flow-to-Equity Approach Flow-to-Equity Approach Cash flows to equity holders discounted by the cost of equity Cash flows to equity holders discounted by the cost of equity

8-16 Example You are considering a project with the following characteristics: You are considering a project with the following characteristics: Perpetual cash inflows starting in year 1 of $25,000 per year Perpetual cash inflows starting in year 1 of $25,000 per year Yearly operating expenses of 12% of revenues Yearly operating expenses of 12% of revenues Initial investment outlay of $125,000 Initial investment outlay of $125,000 T c =34% and r 0 =14%, r D =8% T c =34% and r 0 =14%, r D =8%  Calculate the NPV for an all-equity firm  Calculate the NPV for a firm with a target capital structure of 65% debt and 35% equity Use WACC method Use WACC method Use APV method Use APV method Use FTE method Use FTE method

8-17 Answers  Unlevered firm valuation Cash Inflows$25,000 Operating Expenses$ 3,000 Operating Income$22,000 Tax$ 7,480 Unlevered Cash Flow (UCF)$14,520 NPV = –$125,000 + ($14,520 / 0.14) = –$21,286 To the shareholders

8-18 Answer  WACC r WACC = (D/V) × (1–T c ) × r D + (E/V) × r E r WACC = (0.65) × (1– 0.34) × (0.35) × r E r E = r 0 + (D/E) × (1 – T c ) × (r 0 – r D ) r E = (65/35) × (1 – 0.34) × (0.06) = = 21.35% r WACC = (0.65) × (1– 0.34) × (0.35) × = % NPV = –$125,000 + ($14,520 / ) = $8,138

8-19 Answer  APV APV = NPV + NPVF NPVF = T c × D APV = –$21,286 + (0.34 × 0.65 × (APV + $125,000)) × APV = $6,339 APV = $8,138 Verify the target capital structure: Firm borrows 0.65 × ($125,000 + $8,138) Firm borrows 0.65 × $133,137 = $86, Firm uses $125,000 – $86, = $38, in equity NPV of Financing Side Effects

8-20 V L = V U + T c × D V L = 125,000 – 21, × 0.65 × V L V L = 133,138  D = 0.65 × 133,138 Answer  FTE method Cash Inflows$25,000 Operating Expenses$ 3,000 Operating Income$22,000 Interest (8% of $86,539.52)$ 6,923 Income after interest$15,077 Tax$ 5,126 Levered Cash Flow (LCF)$ 9,951 From before, r E = 21.35% and PV = $9,951 / = $46,609 NPV = – $38,460 + $46,598 = $8,138 To the shareholders

8-21 Evaluation Valuation for all-equity firm is easy Valuation for all-equity firm is easy Valuation for levered firm is complex Valuation for levered firm is complex tax shields tax shields bankruptcy, agency, and other costs bankruptcy, agency, and other costs WACC, APV, and FTE method WACC, APV, and FTE method constant risk over life of project (constant r 0 ) constant risk over life of project (constant r 0 ) constant debt/value ratio over life of project (constant r E and r WACC ) constant debt/value ratio over life of project (constant r E and r WACC ) FTE and WACC work well under this scenario FTE and WACC work well under this scenario if debt/value ratio is changing use APV (based on the level of debt) if debt/value ratio is changing use APV (based on the level of debt) APV works well for LBO’s and cases with interest subsidies and flotation costs (see example in Appendix 17A). APV works well for LBO’s and cases with interest subsidies and flotation costs (see example in Appendix 17A).

8-22 Beta revisited Remember the following: Remember the following:  Levered Equity =  L =  Unlevered Assets × (1 + (D/E))  Levered Equity =  L =  Unlevered Assets × (1 + (D/E)) Assumes  Debt = 0 and no corporate taxes Assumes  Debt = 0 and no corporate taxes With corporate taxes (assume  Debt = 0): With corporate taxes (assume  Debt = 0):  L =  U × [1 + (1–T c ) × (D/E)]  L =  U × [1 + (1–T c ) × (D/E)]  Unlevered Firm <  Levered Equity  Unlevered Firm <  Levered Equity Remember: R E > R 0 > R D

8-23 What if Beta of debt  0?  L =  U + [(1–T c ) × (  U –  D ) × (D/E)]  L =  U + [(1–T c ) × (  U –  D ) × (D/E)] L = levered equity U = unlevered equity (100% equity firm) D = debt E = equity