1. © Prentice Hall, 2004 16 Corporate Financial Management 3e Emery Finnerty Stowe Why Capital Structure Matters

2. Capital Structure Capital structure refers to how a firm is financed. In simple terms, capital structure refers to the proportion of debt financing used by the firm. Leverage ratio Is firm value dependent on its choice of capital structure? If so, how?

3. Perfect Market View of Capital Structure In perfect capital markets, capital structure does not affect firm value. Capital structure choice is a pure risk-return tradeoff. Leverage does not affect the firm’s cost of capital.

4. Perfect Market View of Capital Structure Similar to the Chapter 8 example: Medi-Forms, Inc., (MFI) is an all equity financed (i.e., unleveraged) firm. Expected annual cash flow is $300 per year, with a minimum of $100. Shareholders of MFI require a 15% rate of return. What is the total value of MFI, the value of its equity, and its WACC?

5. Perfect Market View of Capital Structure Since the expected annual cash flow to the shareholders is $300, and they require a 15% return, the value of MFI’s equity is $300/0.15 = $2,000. Since MFI has no debt outstanding, the total value of the firm (V U ) is also $2,000. With no debt financing, the WACC = shareholder’s required rate of return = 15%

6. Capital Structure Change in Perfect Markets Suppose MFI sells $1,000 of debt at 10% and pays the proceeds to its shareholders. What is the total value of the firm, the value of MFI’s equity, its shareholder’s wealth, its leverage ratio, and its WACC?

7. Total Firm Value in Perfect Markets The value of MFI’s debt is $1,000. In perfect markets, the value of the firm is independent of its capital structure. Since the unleveraged firm has a value of $2,000, MFI’s total value after the capital structure change will remain at $2,000.

8. Equity Value in Perfect Markets Total firm value = value of debt + value of equity. Value of MFI’s equity = $2,000 – $1,000 or $1,000. Prior to the capital structure change, MFI’s equity was worth $2,000. After the change, the equity is worth $1,000 but the shareholders have $1,000 in cash. Shareholder wealth remains unchanged which is why we say capital structure is irrelevant.

9. Perfect Market View of Capital Structure Unleveraged Firm Leveraged Firm V U = $2,000 V L = $2,000 $1,000 Equity $1,000 Debt $2,000 Equity

10. Shareholder’s Required Return in Perfect Markets At 10%, MFI’s annual interest expense is $100. The annual expected cash flow to its shareholders is $300 – $100 or $200. Since the equity is worth $1,000, the rate of return required by the shareholders is 20%: $1,000 = $200/0.20 With leverage, equity is riskier and the shareholder’s required rate of return increases.

11. Leverage Ratio The leverage ratio, (L) is: == $1, $2,. 000 05050%or valuefirm total debt of ueMarket val  L

12. WACC and Capital Structure in Perfect Markets The weighted average cost of capital is 15%: WACC = (1 – L)r e + L r d = (1 – 0.5)×(0.20) + 0.5×0.10 =15%

13. Required Return WACC in Perfect Markets L 0.0 1.0 r f rdrd rere WACC

14. Arbitrage Argument for Capital Structure Irrelevance If firm value varies with leverage, arbitrage profits can be made. In perfect markets, arbitrage opportunities cannot exist. The arbitrage profits are eliminated when firm value is independent of capital structure.

15. Arbitrage Argument for Capital Structure Irrelevance Consider firm U that is identical to MFI before its capital structure change. Firm L is identical to MFI after its capital structure change. However, L’s equity is valued at $1,500. MFI’s equity is valued at $1,000 after the capital structure change. Total value of Firm L is thus $2,500.

16. Arbitrage in Perfect Markets Suppose you own 10% of firm L’s equity. Your shares are worth $150. You are entitled to 10% of L’s cash flow to its shareholders [i.e., 10%×$200 = $20]. Sell your shares of firm L. Borrow another $150 at 10%. You have $300 in cash. Your personal leverage ratio is 50%, same as that of firm L.

17. Arbitrage in Perfect Markets Buy $300 of firm U’s stock. Since U’s equity is worth $2,000, you own 15% of U’s equity. You are entitled to 15% of U’s cash flow to its shareholders. You get 15%×$300 = $45 from firm U.

18. Arbitrage in Perfect Markets After paying $15 of interest, your annual cash flow increases from $20 to $30 without any additional investment on your part. This arbitrage opportunity cannot exist in perfect markets. It will be eliminated when the total value of firm L equals the total value of firm U. Value of L’s equity must be $1,000.

19. Capital Market Imperfections: Corporate Income Taxes Interest payments made by a corporation are tax deductible, while dividend payments are not. This tax asymmetry makes debt financing cheaper than equity financing. The corporate tax view of capital structure implies that firm value is maximized when the firm is all-debt financed.

20. Capital Structure with Corporate Income Taxes Consider Medi-Forms again, before its leverage change. Assume that MFI’s corporate income tax rate is 40%. Compute the value of the equity and the total firm value.

21. Capital Structure with Corporate Income Taxes The after-corporate income tax cash flow to MFI’s shareholders is $300(1 - 0.40) or $180. Since MFI’s shareholders require a 15% rate of return from this unleveraged firm’s equity, the value of the equity is $180/0.15 or $1,200. Since MFI has no debt outstanding, this is also the total value of the firm.

22. Capital Structure with Corporate Income Taxes Now suppose MFI sells $1,000 of new debt at 10%, and pays the proceeds to the shareholders. What is the total value of the firm, the value of MFI’s equity, its shareholder’s wealth, its leverage ratio, and its WACC?

23. Capital Structure with Corporate Income Taxes Annual interest expense = $100. After-corporate-tax cash flow to MFI’s shareholders is ($300 – $100)×(1 – 0.40) = $120. Since the shareholders require a 20% return, the value of the equity is $120/0.20 = $600.

24. Capital Structure with Corporate Income Taxes The wealth of the shareholders increases from $1,200 before the leverage change to ($600 in stock + $1,000 in cash) or $1,600 after. The total value of the firm increases to $1,600: Value of debt ($1,000) + Value of Equity($600) All of the increase in firm value accrues to MFI’s shareholders.

25. Capital Structure with Corporate Taxes $400 Taxes $600 Equity Unlevered Firm Leveraged Firm V U = $1,200 V L = $1,600 $1,200 Equity $800 Taxes $1,000 Debt

26. Gain from Leverage The gain from leverage comes from the savings in corporate income taxes. As an unleveraged firm, MFI pays $300×(0.40) = $120 per year in taxes. As a leveraged firm, MFI pays ($300 – $100)×(0.40) = $80 in taxes.

27. Gain from Leverage The value of the leveraged firm can also be computed as: V L = V U + TD = $1,200 +.40×$1,000 = $1,600

28. Leverage Ratio The leverage ratio, L is: L = == market valueof debt total firm value $1,,.. 000 600 06256250%or

29. WACC with Corporate Taxes The weighted average cost of capital is: WACC = (1 – L)r e + L(1 – T) r d = (1 – 0.625)×(0.20) + 0.625(1 – 0.40)×0.10 =11.25%

30. WACC with Corporate Taxes Required Return L 0.0 1.0 (1 - T)r f (1 - T)r d rere WACC

31. Alternative Valuation of the Leveraged Firm The value of the leveraged firm can also be computed in terms of: the “basic” after-tax cash flow of the firm, and WACC adjusted for leverage and corporate income taxes.

32. WACC with Corporate Taxes A value for WACC can be found by setting the two equations above equal to each other and solving for WACC. The result is: For MFI:

33. Firm Value with Corporate Taxes

34. Personal Income Taxes Interest and dividend income received by investors in the firm is taxed immediately upon receipt. Capital gains are taxed only when the shares are sold. Capital gains taxes can be postponed by not selling the shares. Capital losses can be deducted immediately by realizing the gain. Tax timing option is valuable.

35. Personal Income Taxes The capital gains timing option lowers the effective tax rate on shareholder income. The differential between tax rates on personal income from debt and equity cancels out the effect of corporate tax asymmetry. The personal tax view is that capital structure is again irrelevant.

36. Capital Structure and Personal Income Taxes Consider MFI again. Assume it is an unlevered firm. The annual cash flows are $300 per year, the corporate income tax rate is 40%, and shareholders pay 10% ( = T e ) income taxes on their equity income. Compute the value of MFI’s equity and its total firm value.

37. Unleveraged Firm Value with Corporate and Personal Taxes The after-corporate-tax cash flow to the shareholders of MFI is: $300(1 – 0.40) = $180 per year. The shareholders pay taxes on this income at 10%. Their after-personal-tax cash flow is: $180(1 – 0.10) = $162 per year. Since they require a 15% return, the value of MFI’s equity (and the total firm value) is: $162/0.15 = $1,080.

38. Capital Structure and Personal Income Taxes Now suppose MFI issues $540 of debt (L = 50%). Debtholders require a 10% rate of return after personal taxes. Debtholders face an income tax rate of 46% ( =  d ). The debt proceeds are paid to the shareholders. Compute the value of MFI’s equity, the total firm value, and shareholder’s wealth after the capital structure change.

39. Interest on New Debt Since the debtholders want a 10% return after personal taxes, they require after-tax interest income of $54 on $540 of debt: $540×(10%) = $54. On a before-tax basis, they require $100: $54 / (1 – 0.46) = $100

40. Cash Flows to Shareholders The after-corporate-tax cash flow to MFI’s shareholders is: ($300 – $100)×(1 – 0.40) = $120 Since shareholders pay income taxes on this at 10%, their after-personal-tax cash flow is: $120 (1 – 0.10) = $108

41. Equity Value and Shareholder Wealth Since they require a 20% rate of return (at L = 50%), the value of MFI’s equity is: $108 / 0.20 = $540 The shareholders have stock worth $540 and $540 in cash (proceeds from the debt issue). Their wealth is therefore unchanged. The total value of the firm is also $1,080.

42. Capital Structure with Corporate and Personal Taxes With corporate and personal taxes, the firm value and shareholder wealth is independent of the firm’s capital structure. The personal tax asymmetry cancels the effect of the corporate tax asymmetry. This occurs only for a particular set of tax rates.

43. Tax Rates for Capital Structure Irrelevance The difference in personal tax rates on debt and equity income will exactly cancel the corporate tax asymmetry when: For MFI:

44. Capital Structure with Corporate Taxes $540 Debt $540 Equity Unlevered Firm Leveraged Firm V U = $1,080 V L = $1,080 $1,080 Equity $800 Corp. Taxes $120 Personal Taxes $460.00 Debt Personal Taxes Equity Personal $400.00 Corporate Taxes Taxes $60

45. Agency Costs Capital market imperfections resulting from agency cost considerations create a complex environment in which capital structure affects firm value.

46. Agency Costs of Debt Examples of conflicts between debtholders and equityholders: Asset substitution Claim dilution Underinvestment problem Asset uniqueness

47. Agency Costs of Debt As leverage increases, the potential for these conflicts increases. The costs of resolving these conflicts increases. However, increased leverage also helps to reduce the firm’s agency costs: Monitoring costs via “free” audits when new debt is issued. Sinking fund provisions. Secured debt. Free cash flow

48. Bankruptcy Costs Financial distress and bankruptcy offset the other benefits from leverage created by corporate tax reduction and agency cost reduction. At the optimal capital structure, the marginal expected costs of financial distress and bankruptcy equal the marginal benefits of leverage. Firm value is at a maximum.

49. Direct Costs of Bankruptcy Notification costs, court costs, legal fees. Paid only if bankruptcy occurs. Generally small when compared to the indirect costs.

50. Indirect Costs of Bankruptcy Management time devoted to dealing with distress and the bankruptcy process. Lost tax credits. Lost sales and goodwill. These are more significant in their magnitude, and are also more difficult to measure.

51. Expected Costs of Bankruptcy The expected costs of bankruptcy depend on: The degree of specialization of a firm’s assets. Type of assets: tangible versus intangible. As leverage increases, the expected bankruptcy costs increase. This increase offsets other benefits of leverage: Personal and corporate taxes. Agency costs.

52. Pecking Order (Financing Transaction Costs) The firm incurs transaction costs when external financing is obtained. There are both direct and indirect costs. In the pecking order view, the firm should use the method of financing with the least amount of transaction costs first. Financing methods with higher transaction costs are used next.

53. Transaction Cost Perspective on Capital Structure Retained earnings (internal equity) have the least cost. Next is newly issued debt. Debt-Equity combinations are third in the pecking order. Convertible debt New external equity comes last in the pecking order.

54. Signaling and Capital Structure Decisions A firm’s decision about a project’s financing reveals its choice of capital structure for the project. It also conveys information about the project.

55. Signaling and Capital Structure Decisions If a project has a large positive NPV, financing it internally will allow the current owners of the firm to get all of the benefits. If a project has a small (or zero) NPV, the current owners would be indifferent to allowing outside investors to share in the gains. Thus, how a project is financed (internal versus external funds) conveys information about the project’s value.

56. Signaling and Capital Structure Decisions Alternatively, if the firm is currently overvalued, existing owners may want to seek outside partners so as to share the decline in value. If the firm is currently undervalued, the firm might use debt financing to keep the gains to themselves. Thus, new equity issues signal overvaluation, while new debt issues signal undervaluation.

57. Financial Leverage Clienteles Investors will take into account their own tax situations in deciding which firm to invest in. The clientele effect refers to the investor’s choice of a particular security or a firm with a particular capital structure. Market segmentation

58. Financial Leverage Clienteles Investors in high tax brackets may find debt securities less attractive. Debt income is taxed at a higher rate than equity income. They prefer equity income. Investors in low tax brackets may prefer corporate leverage to personal leverage because of the higher corporate tax rate.

59. Financial Leverage Clienteles When a firm selects its capital structure, it attracts investors with a certain personal-tax driven incentive for investment. High leverage firms will attract investors in lower tax brackets and vice versa. If the demand for each type of leverage is satisfied, there is no gain from changing the current capital structure. Capital structure is irrelevant.

60. Capital Market Imperfections View of Capital Structure Debt is generally valuable. At low levels of leverage, the expected costs of financial distress are low. value-enhancing aspects of leverage resulting from taxes and net agency costs exceed the expected costs of financial distress. As leverage increases, these costs increase and at some level will exceed the benefits of leverage.

61. Capital Market Imperfections View of Capital Structure Let V L = Total firm value, V T = Net tax benefit from additional leverage V A = Total agency costs from additional leverage, and V B = Expected costs of financial distress and bankruptcy. L* = optimal capital structure (optimal leverage)

62. Capital Market Imperfections View of Capital Structure VTVT L Hypothetical optimal L = L * VLVL VAVA Total agency costs considerations Total expected financial distress and bankruptcy costs VBVB Value Value of unlevered firm plus next tax benefits

63. Cost of Capital and Market Imperfections Required Return 1.0 L Hypothetical optimal L = L * Hypothetical minimum WACC (1 – T)r f (1 – T)r d WACC rere r

64. Capital Market Imperfections View of Capital Structure Let T * denote the net-benefit-to-leverage factor.

65. Capital Structure with Market Imperfections Financing IrrelevantLeveraged Perfect Market ViewCapital Markets Imperfections View Equity All-Equity Taxes Asymmetric information Transactions Equity Taxes Debt Transactions Asymmetric information $2,000===Pie$2,000=Pie$2,000