1. Session 9 Topics to be covered: –Debt Policy –Capital Structure –Modigliani-Miller Propositions

2. Debt Policy A firm’s basic resource is the stream of cash flows produced by its assets. When a firm is financed entirely by common stock, all of those cash flows belong to the stockholders. When it issues both debt and equity securities, it undertakes to split up the cash flows into two streams. –A relatively safe stream of cash flows goes to debtholders. –A relatively risky stream of cash flows goes to stockholders

3. Exercise Company1998 Debt Ratio (LTD/LTD+E) Eli Lilly72% Colgate Palmolive52% Waste Management33% PepsiCo39%

4. Capital Structure A firm’s mix of different securities is known as its capital structure. A firm can issue many different types of distinct securities to attempt to maximize its overall value. Are these efforts worthwhile? To analyze this question, we will proceed in four steps: –Assume no taxes or transactions costs –Consider corporate taxes –Consider investor taxes –Consider bankruptcy and other transactions costs

5. Modigliani and Miller Modigliani-Miller Proposition I: Assuming perfect capital markets (no taxes or transaction costs), the market value of any firm is independent of its capital structure. –The value of an asset is preserved regardless of the nature of the claims against it. –We have assumed that companies and individuals can borrow and lend at the same risk-free rate (or at least on the same terms). We have also ignored taxes, transaction costs, etc.

6. How Leverage Affects Returns Recall that we computed the expected return on a portfolio consisting of all the firm’s securities (ignoring taxes): Also, we can write the ß of a firm’s assets as follows: MM Proposition I means that –market value of assets –risk of assets (ß A ) –expected return to assets (E(r A )) are all unaffected by the capital structure.

7. Example Assume that there are no taxes or transaction costs. Company ABC is 100% common stock. –ß e = 1.0 –E(r e ) =.10 The company decides to repurchase half of the common stock and substitute and equal value of risk- free debt, E(r d ) =.05. How do the ß and expected returns of the various parts of the capital structure change?

8. Taxes and Transaction Costs How much should a firm borrow? When markets are perfect and competitive, a firm’s borrowing policy does not matter. In reality, markets are not perfect and competitive. Some major sources of market imperfections are: –taxes –costs of financial distress (bankruptcy, reputation) –potential conflicts of interest –interaction of investment and financing decisions.

9. Corporate Taxes When we ignore taxes, we ignore some important differences between debt and equity. –Interest on debt is deductible by the issuer, but dividends are not. Firm value is maximized when we minimize the total payments we make to “outsiders,” including the IRS. As we increase debt, we reduce corporate taxes paid. Corporate taxes alone create a strong incentive for firms to borrow.

10. Personal Taxes Investor taxes vary for debt and equity. –Individuals (investors) pay taxes on interest as ordinary income. –Dividends are also taxed at ordinary tax rates. –Under many tax regimes, taxes on capital gains are taxed at a lower rate. –There are additional benefits, lowering effective capital gains tax rates (timing, deferral). A corporate objective could be to minimize the present value of all taxes paid on corporate income.

11. Personal Taxes Although corporate taxes favor debt, personal taxes favor equity. –Personal taxes help explain why we don’t see 100% debt firms. Investors have many different tax rates. –Firms don’t often know these rates. Therefore, it is difficult for an individual firm to base its capital structure decision on the tax rates of its investors.

12. Bankruptcy Costs Bankruptcy costs are an important factor for capital structure decisions. As the amount of debt in a firm’s capital structure increases, so does the probability it will default. The expected costs of financial distress can be huge. Costs include –Lawyer and banker fees. –Managers time and effort. –Disruption of supplies and customer research. –Delay of research or capital improvement projects. These costs can be difficult to estimate.

13. Bankruptcy Costs Investors know that levered firms may fall into financial distress, and they demand to be compensated through higher returns. Eventually, the expected costs of bankruptcy offset the tax benefits of debt. There is such a thing as too much debt.

14. Optimal Capital Structure: Trade-Off Theory Based on corporate taxes, debt is preferable to equity. Personal taxes help explain why we see some equity in the economy, but do not explain the capital structure of any particular firm. Bankruptcy costs become large at high debt levels, so there is such a thing as too much debt. The optimal capital structure is that which maximizes value available to debt and equity by minimizing value going to the IRS and bankruptcy costs.

15. Example You are CFO of New Industries, Inc. New Industries needs to raise capital, and has 3 choices. (Table summarizes old+new capital) PlanDebt E(r d ) EquityE(r e ) All Equity 600.072 2400.130 Debt/Equity 800.075 2250.135 All Debt 1000.080 2000.150

16. Example Given a corporate tax rate of 36%, which capital structure should you choose? Compute total value of assets (debt+equity): Assets (1) = 60+240 = $300 Assets (2) = 80+225 = 305 Assets (3) = 100+200 = 300 Plan 2 (debt and equity) maximizes firm value.

17. Example Compute the WACC Plan 2 also minimizes the WACC.

18. Example You should choose the second plan (debt+equity), because this plan maximizes firm value and minimizes the WACC. –The first plan does not take optimal advantage of the interest tax shield –The third plan has so much debt that the probability of bankruptcy appears nontrivial.