1. Chapter 16
Capital Structure

2. 2. Demonstrate the benefits of borrowing.
LEARNING OBJECTIVES
1. Explain why borrowing rates are different based on ability to repay loans.
2. Demonstrate the benefits of borrowing.
3. Calculate the break-even EBIT for different capital structure.
4. Explain the appropriate borrowing strategy under the pecking order hypothesis.
5. Define optimal borrowing in a world of no taxes.
6. Explain the static theory of capital structure.

3. Chapter 16: Using other people’s money
Why do we borrow?
Consume today on future income
Households currently have almost $16 trillion in outstanding loans
Does it matter where we get our money?
What makes a good source of funds when we borrow?
Lowest cost for funds
Implicit costs can be very expensive
Is there an optimal borrowing strategy?
Reduce overall costs with a different borrowing pattern

4. 16.1 Capital Markets
In the corporate world…two major markets for borrowing
From banks and bond markets – Debt Markets
From owners – Equity Markets
Borrowers get different rates from these two markets
Debt market – different yield to maturities on bonds
Debt market – different loan rates from banks
Equity market – different return rates for stocks
Ability to pay back loan impacts the rate
Lenders (and owners) look at the future cash flow

5. 16.1 Capital Markets Different Rates for Different Borrowers
Success rate for Angel Investors – impact returns
Example 16.1 in the book Larry and Sherry
Larry is successful on four in ten investments
Sherry is successful on one in ten investments
Required Return on $1,000,000 ($100,000 for each of ten projects)
Larry gets four to payback…each must pay $250,000 so rate is ($250,000 - $100,000) / $100,000 = 150%
Sherry gets only one to payback…it must pay $1,000,000 so rate is ($1,000,000 - $100,000) / $100,000 = 900%

6. 16.2 Benefits of Borrowing Who would every pay Sherry 900% on a loan?
You have a project with a 25% chance of making $5,000,000 and a 75% chance of making $0
No banks or friends will loan you the money
Sherry offers 900% rate for the needed $100,000 investment
Do you take the loan?
Expected Payoff…
25% x $5,000,000 - $1,000,000 = $250,000
But…either you make $4,000,000 or you lose $100,000
Financial Leverage…using other people’s money

7. 16.2 Benefits of Borrowing
How do we measure financial leverage in a company?
Leverage is the amount of debt borrowed versus the amount of funds from the owners
Highly leveraged firms have high Debt to Equity ratios
Unlevered firms use only equity financing
How do we measure the benefits to a company from debt borrowing?
Earnings Per Share
Does borrowing increase or decrease the owner’s wealth?

8. 16.2 Benefits of Borrowing Page 494-497
Three companies with different Debt / Equity Ratios
Company 1 is unlevered (all equity, 400 shares)
Company 2 is 50 / 50 debt and equity (200 shares)
Company 3 is levered to the max (1 share)
High EBIT -- $2,000 Company 3 structure is best
Low EBIT -- $800 Company 1 structure is best
At $1,000 – All have the same Earnings Per Share
Capital Structure is irrelevant at $1,000

9. 16.3 Find the Break-Even EBIT
Can only find this in a pair-wise fashion (can only compare two firms at a time)
Set EPS calculation equal under the two structures
Company 1 EPS = EBIT / 400
Company 2 EPS = (EBIT - $500) / 200
Company 1 EPS = Company 2 EPS, solve for EBIT
This in a world of no taxes…
Above the Break-Even EBIT more leverage (more debt) is better for the owners.

10. 16.4 Pecking Order Hypothesis
Borrow from the cheapest source first
Once the source is “exhausted” move to the second cheapest source
Continue to additional sources as needed for funding once each level is “exhausted”
This borrowing hypothesis is based on asymmetric information
One set of agents (company managers and owners) know more about the future cash flow prospects of the company than the lending agents
Firms Prefer Internal Financing First
Firms Choose to Issue the cheapest security first
Firms Use Equity as a Last Resort

11. 16.4 Pecking Order Hypothesis
Example 16.3 Rogen vs. Rudd Corporations
Facts: Outsiders think that the stock could go as high as $50 or as low as $35 but it now is fairly valued at $42
Rogen CEO knows the company has a major break-through and stock will climb to $50
However the information is proprietary
Rudd CEO knows they have a new product too but, will not cause a rise in stock prices
Competitors will be able to quickly imitate new product

12. 16.4 Pecking Order Hypothesis
How do you finance the needed $50 million?
Rogen CEO cannot tell public about product and will not sell equity below the new $50 value once the product is released (transfer of wealth from original owners to new owners) as the new owners will only pay $42 a share without the inside information
Rogen CEO thus chooses to use debt to avoid wealth transfer
Rudd CEO knows stock is worth $42 but if he chooses to sell equity the market will pay only $35. New owners believe that Rudd would only sell equity if it is overpriced, thus the $35 is the correct price
Rudd CEO thus chooses to use debt to avoid wealth transfer
16.4 Pecking Order Hypothesis

13. 16.4 Pecking Order Hypothesis
Conclusion
Profitable companies will borrow less and signal more debt capacity
Less profitable companies need more outside funding and will first seek debt (avoiding wealth transfer)
As a last resort, companies will sell equity
While this Hypothesis has some support, we see many companies use debt when they have internal funding…

14. 16.5 Modigliani and Miller on Optimal Capital Structure
Start with the simplest world…no taxes and no bankruptcy (firms never default)
M&M Proposition 1 – Capital Structure is irrelevant
Value of an all equity firm (VE) is equal to the value of a leveraged firm (VL)
Think of two pies of equal size, the value (volume) of the pie does not change when we cut it into smaller pieces
M&M Proposition 2 – A firm’s value is based on
The required rate of return
The cost of Debt
The firm’s debt-to-equity ratio

15. 16.5 Modigliani and Miller on Optimal Capital Structure
The math…
WACC = (E/V) x Re + (D/V) x Rd x (1 - Tc )
The required return on the assets, Ra, is equal to WACC
Ra = (E/V) x Re + (D/V) x Rd
In a world of no taxes, the required return on assets is the weighted average of equity and debt
Re = Ra + (Ra –Rd) x (D/E)
The visual…page 504 Figure 16.3

16. 16.5 Modigliani and Miller on Optimal Capital Structure
But the world has taxes…so what happens when we add taxes
M&M Proposition 1 – with taxes
All debt financing is preferred
Adding debt reduces the government’s claim to the pie
M&M Proposition 2 – with taxes
As the firm adds debt the WACC falls
There is a tax shield with debt
The bigger the debt the greater the tax shield
Visual is Pie Charts on page 505

17. 16.5 Modigliani and Miller on Optimal Capital Structure
 What is the tax shield?
The government allows the deduction of interest expense from taxable income (pays part of the interest for the company)
The owners of the company claim this tax shield
VL = VE + (D x TC)
Thus the owner’s value increases as a company adds more debt financing
See Figure 16.5 on page 507
Optimal Capital Structure is now all debt

18. 16.5 The Static Theory of Capital Structure
We now relax the last parameter…bankruptcy
When a firm borrows “too much” and cash flow is insufficient to cover interest payments
The company goes into bankruptcy
Technically the debt holders get the company
Bankruptcy costs
Direct costs are relatively small
Indirect costs can be large…takes the managers away from the required tasks and puts the company in financial distress
The greater the debt, the greater the chance of financial distress

19. 16.5 The Static Theory of Capital Structure
As a firm starts to add debt…the tax shield provides wealth to the owners of the company (again cutting into the government’s share) and the WACC is falling across this range
At some point the costs of financial distress begin to enter as more debt is added
Eventually the additional $1 benefit of the tax shield is exactly offset by the additional cost of financial distress
At that point WACC is lowest and we have the optimal debt/equity ratio for the firm.
See Figure 16.6 on page 510