0. Lecture 5 Capital structure I
Specifics of different sources of long-term financing
Common stock vs preferred stock vs debt
The Modigliani and Miller model
The Miller model

1. The Long-Term Financial Deficit (1999)
Uses of Cash Flow (100%)
Capital spending 80%
Net working capital plus other uses 20%
Sources of Cash Flow (100%)
Internal cash flow (retained earnings plus depreciation) 70%
Long-term debt and equity 30%
Internal cash flow
Financial deficit
External cash flow

2. Firms usually spend more than they generate internally
Capital Structure
Firms usually spend more than they generate internally
The deficit is financed by new sales of debt & equity
Sources of long-term financing:
Internal financing
Retained earnings
External financing
Debt
Preferred stock
Common stock

3. Elements of the Capital Structure
Mix of different classes of capital:
Retained earnings vs debt & equity
Control rights vs cash flow rights
Maturity: refinancing risk vs reinvestment risk
Agency conflict
Asymmetric information and signaling
Important subtopics:
Debt: bank credit vs bonds
Payout policy: dividends vs share repurchase
Costs of new issues

4. Common Stock Basic Shareholders’ Rights (may differ for dual classes):
Control rights
Residual claim on assets (after paying up liabilities)
Limited liability
Components of Shareholders’ Equity:
Common Stock Par Value
Capital Surplus (directly contributed equity in excess of the par value)
Retained Earnings (accumulated over time)
Treasury Stock at Cost
Shares: Authorized vs Issued vs Outstanding
Market vs Book vs Replacement Value
MV = price of the stock times the number of shares outstanding
BV = par value + capital surplus + accumulated retained earnings
RV = current cost of replacing the assets of the firm
At the time a firm purchases an asset, MV=BV=RV

5. The Right to Elect the Directors
The most important control device
Directors are elected each year at an annual meeting by a vote of the holders of a majority of shares who are present and entitled to vote
Straight voting
Shareholders have as many votes as shares and each position on the board has its own election
A tendency to freeze out minority shareholders
Cumulative voting
Each shareholder may cast # shares multiplied by # directors to be elected; these votes can be distributed over one or more candidates
The effect is to permit minority participation
Proxy voting (giving voting right to someone else)
Proxy fight: outsiders try to win enough proxy votes to oust the mgt
Some (e.g. merger) decisions require supermajority (e.g. 75%)

6. Dividends
Unless a dividend is declared by the board of directors, it is not a liability of the corporation
A corporation cannot default on an undeclared dividend
The payment of dividends by the corporation is not a business expense
Therefore, they are not tax-deductible
Dividends received by individual shareholders are considered ordinary income and are fully taxable
Intra-corporate dividend exclusion: corporations are taxed only on the 20% of the received dividends

7. Corporate Long-Term Debt
Bondholders have a contractual claim against the corporation, not an ownership interest
Creditors have no voting power unless the debt is not paid,
when they can legally claim the assets of the firm
The corporation’s payment of interest on debt is considered a cost of doing business..
and is fully tax-deductible
Corporations are very adept at creating hybrid securities that look like equity but are called debt
Obviously, the distinction is important at tax time
A corporation that succeeds is creating a debt security that is really equity obtains the tax benefits of debt while eliminating its bankruptcy costs

8. The Bond Indenture
Amount of issue, date of issue, maturity, currency, par value
Coupon payments: frequency, floating vs fixed rate
Orderly repayment of debt (to avoid the balloon payment):
Amortization, by regular installments through a sinking fund
With serial bonds
Option features:
Call provision (possibility to retire the entire issue before the maturity)
Convertibility into stocks
Security (attachment to the property): debenture/note vs bond
Protective covenants:
Restrictions on further indebtedness, max dividends, min working K
Seniority: subordinated debt paid after senior debt
Other determinants of the market price:
Default risk (credit rating), domestic / foreign / Eurobond

9. Dual Nature of Preferred Stock
Preference over common stock in cash rights:
in the payments of dividends
in the assets in case of bankruptcy
No voting rights, unless no dividends 6 quarters in a row
Is it really debt in disguise?
Fixed dividend: usually, cumulative (carried forward if not paid)
Stated liquidating value
Call provision: can be converted to common shares
Corporations get 80% tax exemption on dividends
But not on debt interest
Most preferred stock in the U.S. is held by corporate investors
Firms issuing the preferred stock:
Utilities, with low taxable income, avoiding the risk of bankruptcy
Preferred stock is like debt with long maturity, sensitive to changes in interest rates.
In 80s, when interest rates were very volatile, some corporations issued floating-rate prefs.

10. Patterns of Financing
Firms usually spend more than they generate internally
The deficit is financed by new sales of debt and equity
Internally generated cash flow dominates as a source of financing, typically between 70 and 90%
New sales of debt prevail over new equity issues
Outside the US, firms rely more on external equity
Debt ratios for U.S. non-financial firms have been below 50% of total financing

11. Choice of the Capital Structure
The value of a firm: sum of the value of the firm’s debt and the firm’s equity: V = B + S
Why should the stockholders care about maximizing firm value?
Since the payoff of the debtholders is fixed (in case of no default), changes in capital structure benefit the stockholders if and only if the value of the firm increases. S B
Value of the Firm

12. Modigliani-Miller Model: Assumptions
Perfect capital markets:
Perfect competition
Firms & investors can borrow/lend at the same rate
No frictions (transaction costs / taxes / bankruptcy costs)
Informational efficiency
No need for signaling
Managers are perfectly aligned with shareholders
No agency costs
Firms can be classified to homogeneous risk classes
No CAPM at that time
Perpetual cash flows, no growth
The firm can issue risk-free debt

13. Homemade Leverage: An Example
Recession Expected Expansion
EPS of Unlevered Firm $2.50 $5.00 $7.50
Earnings for 40 shares $100 $200 $300
Less interest on $800 (8%) $64 $64 $64
Net Profits $36 $136 $236
ROE (Net Profits / $1,200) 3% 11% 20%
We are buying 40 shares of a $50 stock and borrow $800. We get the same ROE as in the levered firm. Our personal debt equity ratio:

14. Homemade (Un)Leverage: An Example
Recession Expected Expansion
EPS of Levered Firm $1.50 $5.67 $9.83
Earnings for 24 shares $36 $136 $236
Plus interest on $800 (8%) $64 $64 $64
Net Profits $100 $200 $300
ROE (Net Profits / $2,000) 5% 10% 15%
Buying 24 shares of an otherwise identical levered firm along with some of the firm’s debt gives us ROE of the unlevered firm.
This is the fundamental insight of MM

15. The MM Propositions (No Taxes), 1958
Prop. I: firm's value is not affected by leverage
VL = VU
Prop. II: leverage increases the risk and return to stockholders
rs = r0 + (B/S) (r0 - rB)
rB is the interest rate (cost of debt)
rs is the return on (levered) equity (cost of equity)
r0 is the return on unlevered equity (cost of capital)
B is the value of debt
S is the value of levered equity

16. MM II: Cost of Equity and WACC
Cost of capital: r (%) r0 rB rB
Debt-to-equity Ratio

17. The MM Propositions (with Corporate Taxes), 1963
Prop. I: firm's value increases with leverage
VL = VU + TC B
Prop. II: the increase in equity risk and return is partly offset by the tax shield of debt
rS = r0 + (B/S)×(1-TC)×(r0 - rB)
rB is the interest rate (cost of debt)
rs is the return on (levered) equity (cost of equity)
r0 is the return on unlevered equity (cost of capital)
B is the value of debt
S is the value of levered equity
TC is the corporate tax rate

18. Derivation of MM (with Corporate Taxes)
Each period, shareholders and bondholders receive
(EBIT - RBB)(1 - TC) + RBB = EBIT(1 - TC) + TCRBB
PV of this stream of CFs discounted at r0 and rB is
S + B ≡ VL = VU + TC B
Thus, VU = S + B(1-TC). Both sides yield equal CFs:
r0VU = rSS+rBB(1-TC) or r0(S+B(1-TC)) =rSS+rBB(1-TC)
The cost of equity:
rs = r0 + (B/S) (1-TC) (r0 - rB)
WACC:
rS S/(S+B) + (1 - TC) rB B/(S+B) = r0 [1 - TC B/(S+B)]

19. MM II: Cost of Equity and WACC
Cost of capital: r (%) r0 rB
Debt-to-equity ratio (B/S)

20. Does it matter how to cut the pizza into pieces?
Summary: MM Model
Does it matter how to cut the pizza into pieces?
In a world of no taxes:
The firm’s value is fully determined by investments
Shareholders can achieve any pattern of payouts they desire with homemade leverage
In a world of taxes, but no bankruptcy costs:
The firm’s value increases with leverage
If you count the government as the stakeholder, value of the firm stays the same!
WACC differs from r0
Both models give unrealistic predictions

21. The Miller Model: Impact of Personal Taxes
Miller (1977) shows that the value of a levered firm can be expressed in terms of an unlevered firm as:
where
TS = personal tax rate on equity income
TB = personal tax rate on bond income
TC = corporate tax rate

22. Derivation of the Miller Model
Assume that each year the firm earns EBIT and pays interest on debt with face value F:

23. Derivation of the Miller Model
The total CF to all stakeholders in the levered firm is:
The first term is the cash flow of an unlevered firm after all taxes.
Its value = VU
The bond promises to pay rBF×(1-TB) after taxes and is worth B=F(1-TB). Thus, the value of the second term is:
The value of the sum of these two terms must be VL

24. Firm Value with Corporate & Personal Taxes
VL = VU+TCB when TS =TB
Value of firm (V)
VL < VU + TCB when TS < TB
but (1-TB) > (1-TC)×(1-TS) VU
VL =VU
when (1-TB) = (1-TC)×(1-TS)
VL < VU when (1-TB) < (1-TC)×(1-TS)
Debt (B)

25. Interpretation of the Miller Model
Personal tax rates differ: TS < TB
Effective tax rate on capital gains is lower (can be deferred)
80% of dividends received by corporations are tax-exempt
Many types of investment funds pay no taxes
Bond market equilibrium (assuming TS = 0):
The supply of funds is fixed at rS = r0/(1-TC)
The demand rises from r0 sufficient for tax-exempt investors to r0/(1-TB,i) for investors in i's tax bracket
In equilibrium, no tax advantage for leverage
An equilibrium amount of corporate debt is determined by relative corporate & personal tax rates

26. DeAngelo-Masulis Model, 1980
The tax shield may be underutilized:
Effects of tax shield substitutes (depreciation and investment tax credit)
Higher debt increases probability of negative earnings and bankruptcy
Modified bond market equilibrium:
The supply of funds depends on the corporation-specific tax rate: rS = r0/(1-TC,i)
The higher the level of tax shield substitutes and the cost of bankruptcy, the lower the leverage

27. Value of the Firm (MM-Proposition I with Taxes and Bankruptcy)
MM-with corporate taxes only
Value of the Firm
MM-with corporate taxes and bankruptcy costs
MM-no taxes
Optimal debt-equity ratio
Debt-Equity Ratio (B/S)