1. Debt or equity? That is the question.
Capital Structure
TIP
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Debt or equity? That is the question.

2. Capital Restructuring
We are going to look at how changes in capital structure affect the value of the firm, all else equal
Capital restructuring involves changing the amount of leverage a firm has without changing the firm’s assets
Increase leverage by issuing debt and repurchasing outstanding shares
Decrease leverage by issuing new shares and retiring outstanding debt

3. Choosing a Capital Structure
What is the primary goal of financial managers?
Maximize stockholder wealth
We want to choose the capital structure that will maximize stockholder wealth
We can maximize stockholder wealth by maximizing firm value (or equivalently minimizing WACC).
Remind students that the WACC is the appropriate discount rate for the risk of the firm’s assets. We can find the value of the firm by discounting the firm’s expected future cash flows at the discount rate – the process is the same as finding the value of anything else. Since value and discount rate move in opposite directions, firm value will be maximized when WACC is minimized.

4. Optimal Capital Structure
Objective: Choose capital structure (the mix of debt v. common equity) at which stock price is maximized.
Trades off higher ROE and EPS against higher risk. The tax-related benefits of leverage are offset by the debt’s risk-related costs.

5. If the level of debt increases, the riskiness of the firm increases.
What effect does increasing debt have on the cost of equity for the firm?
If the level of debt increases, the riskiness of the firm increases.
The cost of debt will increase because bond rating will deteriorates with higher debt level.
Moreover, the riskiness of the firm’s equity also increases, resulting in a higher ks.

6. Capital Structure Theory Under 5 Special Cases
Case I – Assumptions
No corporate taxes
No bankruptcy costs
Case II – Assumptions
Corporate taxes
Case III – Assumptions
Bankruptcy costs
Case IV – Assumptions
Managers have private information
Case V – Assumptions
Managers tend to waste firm money and not work hard.

7. Case I: Ignoring taxes and Bankruptcy Cost
The value of the firm is NOT affected by changes in the capital structure
The cash flows of the firm do not change, therefore value doesn’t change
The WACC of the firm is NOT affected by capital structure
In this case, capital structure does not matter.
The main point with case I is that it doesn’t matter how we divide our cash flows between our stockholders and bondholders, the cash flow of the firm doesn’t change. Since the cash flows don’t change; and we haven’t changed the risk of existing cash flows, the value of the firm won’t change.

8. Figure 13.3

9. Case II consider taxes but ignore bankruptcy cost
Interest expense is tax deductible
Therefore, when a firm adds debt, it reduces taxes, all else equal
The reduction in taxes increases the firm value. Other things equal, The less tax paid to the IRS, the better off the firm.
Point out that the government effectively pays part of our interest expense for us; it is subsidizing a portion of the interest payment.

10. Case II consider taxes but ignore bankruptcy cost
The value of the firm increases by the present value of the annual interest tax shield
Value of a levered firm = value of an unlevered firm + PV of interest tax shield (VL = VU + DTC)
The WACC decreases as D/E increases because of the government subsidy on interest payments
RU is the cost of capital for an unlevered firm = RA for an unlevered firm
VU is jus the PV of the expected future cash flow from assets for an unlevered firm.

11. Figure 13.4

12. Just note the red line (WACC) in this figure

13. Case III consider both taxes and bankruptcy cost
Now we add bankruptcy costs
As the D/E ratio increases, the probability of bankruptcy increases. This increased probability will increase the expected bankruptcy costs

14. Bankruptcy Costs (financial distress cost)
Direct bankruptcy costs
Legal and administrative costs
Creditors will stop lending money to the firm.
Indirect bankruptcy costs
Larger than direct costs, but more difficult to measure and estimate
Also have lost sales, interrupted operations and loss of valuable employees

15. Capital Structure Theory
Value of Stock
Only consider taxes
Actual (consider both)
Ignore taxes and bankruptcy
D/A
D D2

17. Case III (also called Modigliani-Miller static Theory)
The graph shows MM’s tax benefit vs. bankruptcy cost theory.
With more debt, initially firm will benefit from tax reduction.
With high debt, the threat of financial distress causes the cost of debt to rise.
As financial conditions weaken, expected costs of financial distress can be large enough to outweigh the tax shield of debt financing.
Optimal debt level is some trade-off point.

18. Conclusions Case I – no taxes or bankruptcy costs
No optimal capital structure. Debt level does not matter.
Case II – corporate taxes but no bankruptcy costs
Optimal capital structure is 100% debt
More debt—more tax shield—higher firm value.
Case III – corporate taxes and bankruptcy costs
Optimal capital structure is part debt and part equity
Occurs where the marginal tax benefit from debt is just offset by the increase in bankruptcy costs

19. 3 cases

20. Case IV--Incorporating signaling effects
When managers know private information about the firm’s future than the market, there is a signaling effect.
Signaling theory suggests when firms issue new stocks, stock price will fall. (why? Next 2 slides)
firms should maintain a lower debt level so that in case the firm needs to raise money in the future, it can issue debt rather than sell new stocks.

21. What are “signaling” effects in capital structure?
Assume:
Managers have better information about a firm’s long-run value than outside investors.
Managers act in the best interests of current stockholders.
If you anticipate a big profit in the future, do you want to share it with other people ?
If you anticipate a big loss in the future, do you want to share it with other people?
But outside investors are not stupid. They view a common stock offering as a negative signal--managers think stock is overvalued.

22. Case V—High debt constrains managers’ bad behavior
Managers tend to spend a lot of cash on lavish offices, corporate jets, etc.
When would you more likely to go to a lavish restaurant? 1. After receiving a salary. 2. After receiving a lot of credit card bills.
With more debt, the need to pay interest and the threat of bankruptcy remind managers to waste less and work harder.
The fact that managers are not born to work whole heartedly for stockholders suggests using more debt.

23. Observed Capital Structure: what is the reality?
Capital structure does differ by industries. Even for firms in same industry, capital structures may vary widely.
Differences according to Cost of Capital 2000 Yearbook by Ibbotson Associates, Inc.
Lowest levels of debt
Drugs with 2.75% debt
Computers with 6.91% debt
Highest levels of debt
Steel with 55.84% debt
Department stores with 50.53% debt
You can find information about a company’s capital structure relative to its industry, sector and the S&P 500 at Yahoo Marketguide
See Table 13.5 in the book for more detail

24. Quick Quiz
Q1: What is the optimal capital structure in the 5 cases discussed in this chapter?
Q2: How would these factors affect the target capital structure?
High corporate tax rate? increase
High bankruptcy costs? decrease
Management spending lots of money on lavish perks? increase