Capital Structure

The Capital-Structure Capital Structure deals with how the firm pays for investments It also determines how we slice the firm’s cash flows Capital Structure is important if how we slice the cash flows affects the size of the cash flows Remember: A firm is simply worth the PV of its expected future cash flows to investors V = D + E S G B

Modigliani-Miller Proposition 1 Capital Structure JUST DOES NOT MATTER VL = VU Firm value is not affected by capital structure This won them a Noble Prize

MM1: The Simplest of Worlds Perfect capital markets No taxes or transaction costs No Bankruptcy Costs Everyone borrows at the same rate Investment decisions are fixed Operating cash flow is independent of capital structure

MM Intuition Set up Suppose you have two firms that each make $50/ year The firms are identical except that one has $50 of debt and the other has no debt

MM Intuition: Vl < Vu Consider a 1% investment in EU Cost = 1% EU = $1.00 Payoff = 1% Profits = $0.50 Now buy 1% of EL & 1% of DL Cost = 1% EL +1%DL= 0.40 + 0.50=$0.90 Payoff Receive 1%*interest= 0.01*10=$0.10 Receive 1%*(Profits-Interest)= 0.01*40=$0.40 Total dollar payoff = $0.10+$0.40=$0.50 Can Vl < Vu? NO Vu Vl V $100 $90 E $40 D $0 $50 Int $10 Profit Cost $1 $0.9 Payoff $0.50 $0.5

MM Intuition: Vl > Vu $90 $100 E $50 D $0 Int $10 Profit Cost $0.4 $0.5 Payoff Consider a1% investment in El Cost = 1% EL = $0.50 Payoff = 1%(Profits –Int)= $0.40 Alt. buy 1% EU, & borrow1% of DL Cost= 1%Vu-1%DL= $0.90-$0.50=$0.40 Payoff Owe 1%*interest= 0.01*10=$0.10 Receive 1%*Profits= 0.01*50=$0.50 Total dollar payoff = -$0.10+$0.50=$0.40 Can Vl > Vu? NO

Vl = Vu If Vl cannot be worth less than Vu And Vl cannot be worth more than Vu Vl must be as valuable as Vu

MM1 and WACC If you own the entire firm then you are only compensated for the risk of the firm’s assets Given that the assets do not change as D/V changes the risk of the company will not change

D/V and Shareholders While leverage does not affect the risk of the overall firm, it does affect the risk to the shareholders Leverage increases:

MM Proposition 2: D/E and re, βe Increasing leverage increases the financial risk of the equity investment, and equity holders need to be compensated for bearing this risk D/E relationship with re, βe ra = D/V * rd + E/V*re re = ra + D/E * (ra - rd) a = D /V * d + E/V*e e = a + D /E * (a - d)

βe Break-Down e = a + D /E * (a - d)

Graph of MM2 As debt increases the cost of equity and debt increases rWACC rD rE r0 As debt increases the cost of equity and debt increases Why is WACC unchanged?

Corporate Taxes What does the inclusion of taxes mean for firm value?

Corporate Taxes & Debt Because interest payments are tax deductible, they act a shield protecting some of the firm’s cash flows from the government If less money flows to the government, what will happen to firm value?

Total Cash Flow to Investors All-equity firm Levered firm S G B S G

Vl with Corporate Taxes Vl = Vu + PV(Tax Shield) Vl = Vu + D*Tc As the tax shield increases company value how should the company be financed? tax shield = Tax Rate * Debt Implication: Firms should be completely debt financed to maximize value

Unlevered Firm Value Consider an un-levered firm, which has an EBIT of $1,500. The company’s investors require a return on 12%. Taxes are 34%, what is the firm worth?

Levered Firm Value The firm owes $1,000 in interest Consider an levered firm, which has an EBIT of $1,500. The firm owes $1,000 in interest The company’s investors require a return on 12%. Taxes are 34%, what is the firm worth? The cash flow to investors are: Debt: Equity: VL =

Levered Firm Value ALT Consider an levered firm, with an EBIT of $1,500. The firm owes $1,000 in interest The company’s investors require a return on 12%. Taxes are 34%, what is the firm worth? VL = VU + D*T

Leverage and Firm Value VL VU D/E

MM 2 With Corporate Taxes Earlier I showed you how re changes with debt, when we ignore taxes re = ra + D/E * (ra - rd) What happens if we include corporate taxes? re = ra + D/E * (ra - rd) (1-T)

The Effect of Financial Leverage on the Cost of Debt and Equity Capital Cost of capital: r (%) rU rB Debt-to-equity ratio (D/E) S/h risk and return increase with leverage

With only Corporate Taxes Firm value increases with leverage This suggests that firms should be 100% debt finance which we don’t see in the real world Why not?

Bankruptcy Costs One reason we don’t see firms with 100% debt financing The possibility that a firm goes bankrupt reduces firm value A firm does not need to declare bankruptcy to experience bankruptcy costs VL = VU + PV(tax shield) – PV(distress costs)

Bankruptcy Costs Direct Bankruptcy Costs: Legal and administrative costs associated with bankruptcy Relatively small Indirect Costs: Impaired ability to conduct business This is where the Big Costs are Lost sales, Higher rates, Warranties loss value A firm can start to experience these indirect costs when it becomes financially distressed

What is Financial Distress? Firm’s operating cash flows, are not sufficient to satisfy current obligations This can lead to: Default Financial Penalties Financial Restructuring Bankruptcy

Stock-Based Insolvency The value of the firm’s assets is less than the value of the debt. Assets Debt Equity Solvent firm Debt Assets Equity Insolvent firm Debt Note the negative equity

Cash-Based Insolvency When the firms cash flows are insufficient to cover contractually required payments. Contractual Obligations Insolvency $ Cash flow shortfall time Firm cash flow

Stock v Cash Insolvency Which is worse Stock or Cash Insolvency?

What Happens in Financial Distress? Financial distress does not usually result in the firm’s death Who hasn’t flow on a bankrupt airline? However, a firm in financial distress may find it hard to operate How willing are people to accept warranties? How willing are people to extend credit?

Agency Costs In addition to bankruptcy costs, when a firm becomes financially distressed, it creates incentive for the equity holders, who control the firm, to try an take from the debt holders Asset Substitution Incentive to underinvestment Milk the property

Asset Substitution A firm has $6m in assets, and has $10m in debt outstanding → Financial Distress The firm has a project requiring a $2m investment and pays $7m (PV) with a 10% probability or pays nothing with a 90% Project NPV? Will the firm take the project?

Potential Payoffs If forgo the project: FV = $__ Debt gets $___, Equity gets $___ Take the project and it turns out bad: FV = $__ Take the project and it turns out good: FV = $_

Potential Payoffs If forgo the project: FV = $6 Debt gets $6, Equity gets $0 Take the project and it turns out bad: FV = $4 Debt gets $4, Equity gets $0 Take the project and it turns out good: FV=$11 Debt gets $10, Equity gets $1 Equity holders want to take this project A chance at something is better than nothing

Underinvestment Now instead of taking –NPV projects the firm passes on +NPV projects The same firm has a project requiring $2m investment and pays $5m (PV) with a 50% probability or pays $1m (PV) with a 50% probability What is the NPV? -2 + [(0.5*5) + (0.5*1)] = $1 Will the firm take the project? Probably not

Potential Payoffs If forgo the project: FV = $__ Debt gets $__, Equity gets $__ Take the project and it turns out bad: FV = $__ Take the project and it turns out good: FV= $_

Milk the Property (Cash out) If the value of the firm is less than the value of the debt holders claims, then the shareholders have an incentive to sell off the assets and issue a cash dividends to themselves.

Example, names changed to protect the guilty Marriot Inc Owes $1 billion and has $500 million in assets Management creates a new firm Marriot Co Every Inc shareholder receives shares in Co The same shareholders own both firms Inc sells its $500m in assets to Co for $1.00 Co has $499,999,999 in assets and no debt Inc has $1 in assets and $1b in debt How happy are debt holders?

Intelligent Bondholders Bondholders know about these agency problems and act accordingly Requiring: Higher rd, covenants Limit possible div payments, Restrict debt issuances or sales of assets All of this requires costly monitoring of the firm This is another costs borne by equity holders

Trade-Off The firm trades off the benefits and costs associated with debt to maximize firm value If we put everything we talked about together we get: Vl = Vu + PV (Tax shields) – PV (Bankruptcy costs) – PV (Agency costs)

Trade-off Implications Firms have an optimal level of debt The amount will depend on the industry and firm Safe, highly profitable firms with lots of tangible assets should have lots of debt US studies finds that profitable firms have little debt Risky, marginally profitable firms with lots of intangible assets should have little debt

Tax Effects, Financial Distress and Agency costs Value of firm (V) Present value of tax shield on debt -Vu NoTax -Vu Tax -Vl Tax -Vl Bank -Tax Shield -Bank Cost Vu simple world VL = With Taxes VL = Taxes, Distress and Agency Cost Present value of distress & agency costs VU = With Taxes D/E B* Optimal amount of debt

Agency Costs Part Deux Because managers run the firm, but don’t own the firm they can potentially run the firm for their personal benefit instead of shareholders This reduces firm value But in order for management to act badly, they need both:

Motive and Opportunity Motives Who doesn’t want their own jet, little empire, more money, better car Recent research finds that when a firm goes private it reduces its fleet of corporate jets by 40% Opportunity Free cash flow: Money that is not needed to cover the firms current operations

Free Cash Flow Hypothesis If shareholders limit the amount of free cash they reduce the amount of money that managers can waste This lowers the agency costs This is accomplished with either increased dividends or increased debt Which is a more efficient? Why?

TTU: Jonathan “Jody” Nelson TTU accounting grad who became CFO at Patterson-UTI Energy Embezzled over $77 mill between 1998-2005 Basically wrote checks to himself

Real World Facts Capital structures differ across industries. In general US firms appear to be underleveraged Changes leverage does affect firm value Stock price increases with increases in leverage and vice-versa; consistent with M&M with taxes. Another interpretation is that firms signal good news when they lever up.

Factors in D/E Ratio Taxes Types of Assets If corporate tax rates tax shield is more valuable Types of Assets Tangible assets are easier to sell and make better collateral, reducing the cost of debt Uncertainty of Operating Income The more uncertain a firm’s cash flows are the more likely it will enter financial distress

Summary and Conclusions In a perfect world Capital structure does not affect firm value In a world with taxes Tax shields enhance value But there’s a limit Bankruptcy costs

Summary and Conclusion On the one hand Debt may constrain managers and reduce agency costs On the other Adds additional agency costs Shareholders vs bondholders? Managers vs bondholders?

Quick Quiz How does financial leverage affect firm value without taxes? With taxes? What is homemade leverage? What are the direct and indirect costs of bankruptcy? Define 3 agency conflicts in financially distressed firms?

Why do we care? This is big real world finance This is where people make real money It is encompasses most of the finance that we have done so far If you get this then you have a pretty good understand of finance