1. Capital Structure FIN 461: Financial Cases & Modeling George W. Gallinger Associate Professor of Finance W. P. Carey School of Business Arizona State University

2. W. P. Carey School of BusinessSlide 2 Management’s Objective Maximize firm's value Firm value = Market value of debt + market value of equity Firm's investments affect its value Accept value enhancing projects.

3. W. P. Carey School of BusinessSlide 3 Value Eroded; Value Created

4. W. P. Carey School of BusinessSlide 4 Long-Term Value Index

5. W. P. Carey School of BusinessSlide 5 Valuation of No-Growth Unlevered Firm

6. W. P. Carey School of BusinessSlide 6 Tax Benefit of Debt Financing

7. W. P. Carey School of BusinessSlide 7 Valuation of a No-Growth Levered Firm ×

8. W. P. Carey School of BusinessSlide 8 Competitive Environments

9. W. P. Carey School of BusinessSlide 9 PV of Growth Opportunities Can incorporate growth in the denominator of the 1 st term

10. W. P. Carey School of BusinessSlide 10 Contribution of PVGOs

11. W. P. Carey School of BusinessSlide 11 Calculating the Cost of Debt Alternatively, you could use the CAPM to estimate the cost of debt. The problem is knowing the debt beta.

12. W. P. Carey School of BusinessSlide 12 Cost of Preferred Stock

13. W. P. Carey School of BusinessSlide 13 Cost of Equity Using the Dividend Growth Model

14. W. P. Carey School of BusinessSlide 14 Cost of Equity Using the SML

15. W. P. Carey School of BusinessSlide 15 Cost of Equity from a Beta Perspective

16. W. P. Carey School of BusinessSlide 16 Beta & Leverage In a world with corporate taxes and riskless debt, it can be shown that the relationship between the beta of the unlevered firm and the beta of levered equity is:  Since must be more than 1 for a levered firm, it follows: Assumes the debt beta is 0.

17. W. P. Carey School of BusinessSlide 17 Beta & Leverage … If the beta of the debt is non-zero (i.e., risky), then:

18. W. P. Carey School of BusinessSlide 18 Beta & Leverage: No Corporate Taxes In a world without corporate taxes, and with riskless corporate debt, it can be shown that the relationship between the beta of the unlevered firm and the beta of levered equity is:  In a world without corporate taxes, and with risky corporate debt, it can be shown that the relationship between the beta of the unlevered firm and the beta of levered equity is:

19. W. P. Carey School of BusinessSlide 19 Effect of Debt on Cost of Equity

20. W. P. Carey School of BusinessSlide 20 Cost of Equity

21. W. P. Carey School of BusinessSlide 21 Calculation of Weights & WACC

22. W. P. Carey School of BusinessSlide 22 Pertinent Info About Ethridge Company

23. W. P. Carey School of BusinessSlide 23 Firm Value & WACC A B C

24. W. P. Carey School of BusinessSlide 24 Firm Value & WACC … A B C

25. W. P. Carey School of BusinessSlide 25 Agency Costs & Capital Structure A trade-off of debt and equity agency costs suggests that some appropriate mix of debt and equity financing exists for minimizing total agency costs.

26. W. P. Carey School of BusinessSlide 26 Costs of Financial Distress Direct costs of bankruptcy (out-of-pocket cash expenses) Legal, auditing and administrative costs (include court costs) Large in absolute amount, but only 1-2% of large firm value Indirect costs: Usually much more important Impaired ability to conduct business (e.g., lost sales) Managerial distraction, loss of best (most mobile) personnel Financial distress also gives managers adverse incentives Asset substitution problem: Incentive to take large risks Under-investment problem: S/Hs refuse to contribute funds Trade-off Model of Corporate Capital Structure Trade off tax benefits of debt vs costs of Financial distress:

27. W. P. Carey School of BusinessSlide 27 Agency Costs Of Outside Debt Issuing debt externally helps minimize agency costs of equity Gives rise to Agency Costs of Outside Debt Costs increase with amount of debt issued High debt loads give managers, acting for shareholders, incentives to play two perverse “games”: Expropriate bondholder wealth by paying excessive dividends Bait And Switch: Promise to use borrowed money for safe investment, then use to buy high/risk, high/return asset Bondholders understand incentives, protect themselves with positive and negative covenants in lending contracts Positive covenants mandate what borrower must do Negative covenants mandate what borrower must not do Agency costs of debt are burdensome, but so are solutions.

28. W. P. Carey School of BusinessSlide 28 Game #1: The Asset Substitution Problem When a firm falls into financial distress, management has incentive to substitute assets Assume Firm Substitute has debt with a face value of $12,000,000 million outstanding, matures 1 month $10,000,000 of cash on hand Firm still controls investment policy until default actually occurs If firm defaults, bondholders take over all remaining assets (including cash on hand) Substitute’s managers offered two projects, both requiring $10,000,000 cash investment & both paying off in 30 days: Safe promises a certain $10,200,000 payoff (2% monthly return) Lottery offers a 25% chance of $13,000,000 payoff, and a 75% chance of $7,500,000: expected value = $8,875,000.

29. W. P. Carey School of BusinessSlide 29 Game #1: Asset Substitution Problem … Safe has positive NPV and is preferred by bondholders But stockholders and managers rationally choose Lottery If gamble is successful Payoff = $13,000,000 million Pay maturing debt, keep remaining $1,000,000 If gamble unsuccessful Stockholders are no worse off Bondholders will take firm’s remaining assets in 30 days Game is important because shareholders (through managers) have incentive to gamble with bondholders’ money Would not accept Lottery if all-equity financed firm Would not accept Lottery if company was a partnership Limited liability means bondholders have no recourse to shareholders.

30. W. P. Carey School of BusinessSlide 30 Game # 2: The Under- Investment Problem Shareholders refuse to contribute funds for positive NPV projects Occurs if shareholders must contribute cash, but all project’s benefits accrue to bondholders. Assume firm has $10,000,000 cash on hand and a bond worth $12,000,000 million maturing in 30 days Firm is offered chance to purchase a competitor at a discount price of $11,000,000  offer open only 30 days Merger would maximize firm value, and bondholders would accept Shareholders control firm’s investment policy until default occurs Firm’s managers, acting for the shareholders, would reject merger Even though value-maximizing, shareholders have to contribute additional $1,000,000 cash  yet firm will still default in 30 days If firm all-equity financed, shareholders would invest additional cash.

31. W. P. Carey School of BusinessSlide 31 Theoretical Optimal Capital Structure Optimal capital structure Point where the value of the firm is maximized WACC is minimized Management trades off benefits realized from the interest tax shield against financial distress and agency costs.

32. W. P. Carey School of BusinessSlide 32 Maximize Value of the Firm

33. W. P. Carey School of BusinessSlide 33

34. W. P. Carey School of BusinessSlide 34 Coverage Ratios

35. W. P. Carey School of BusinessSlide 35 Median Value by Rating Category

36. W. P. Carey School of BusinessSlide 36 Industry Debt-to-Asset Ratios

37. W. P. Carey School of BusinessSlide 37 Market Value Debt Ratios, July 2002 1.190.550.69Georgia Pacific 1.620.360.54AEP 1.920.250.27Walt Disney 10.130.070.12Procter & Gamble 3.650.240.27Boeing 4.120.830.84General Motors 0.820.750.77Delta Air Lines 3.720.030.04ExxonMobil 4.0300Intel 5.5400Microsoft Market to book ratio L-T debt to total capital Debt to total assets Company

38. W. P. Carey School of BusinessSlide 38 Financial Relationships Earnings before interest and taxes represent the operating income (before taxes) generated by the firm's assets Interest expense is the (accounting) cost of debt financing If you define ROA as net income/assets, you are mixing the earning power of the assets with a financing cost.

39. W. P. Carey School of BusinessSlide 39 Trading on the Equity

40. W. P. Carey School of BusinessSlide 40 EBIT-Profitability Analysis When EBIT is below the level of $80, the firm will be more profitable if management finances with an all-equity capital structure Above the indifference point, a combination of debt and equity financing improves profitability.

41. W. P. Carey School of BusinessSlide 41 EBIT Indifference Levels for Different Capital Structures

42. W. P. Carey School of BusinessSlide 42 Indifference Levels …

43. W. P. Carey School of BusinessSlide 43 Choice Among Different Capital Structures The capital structure choice is to use no debt if EBIT is below $90, use $300 of debt and $700 of equity financing if EBIT is in the range between $90 to $104, and use $600 of debt and $400 of equity financing if EBIT is above $104.

44. W. P. Carey School of BusinessSlide 44 Calculating Financial Leverage

45. W. P. Carey School of BusinessSlide 45 Breakeven Sales Level

46. W. P. Carey School of BusinessSlide 46 Managing Total Risk

47. W. P. Carey School of BusinessSlide 47 The End