1. Capital Structure

2. The Capital-Structure
Capital Structure deals with how the firm pays for investments
It also determines how we slice the firm’s cash flows
Capital Structure is important if how we slice the cash flows affects the size of the cash flows
Remember: A firm is simply worth the PV of its expected future cash flows to investors
V = D + E S G B

3. Modigliani-Miller Proposition 1
Capital Structure
JUST DOES NOT MATTER
VL = VU
Firm value is not affected by capital structure
This won them a Noble Prize

4. MM1: The Simplest of Worlds
Perfect capital markets
No taxes or transaction costs
No Bankruptcy Costs
Everyone borrows at the same rate
Investment decisions are fixed
Operating cash flow is independent of capital structure

5. MM Intuition Set up
Suppose you have two firms that each make $50/ year
The firms are identical except that one has $50 of debt and the other has no debt

6. MM Intuition: Vl < Vu
Consider a 1% investment in EU
Cost = 1% EU = $1.00
Payoff = 1% Profits = $0.50
Now buy 1% of EL & 1% of DL
Cost = 1% EL +1%DL=
=$0.90
Payoff
Receive 1%*interest=
0.01*10=$0.10
Receive 1%*(Profits-Interest)=
0.01*40=$0.40
Total dollar payoff =
$0.10+$0.40=$0.50
Can Vl < Vu? NO Vu Vl V
$100
$90 E
$40 D $0
$50
Int
$10
Profit
Cost $1
$0.9
Payoff
$0.50
$0.5

7. MM Intuition: Vl > Vu
$90
$100 E
$50 D $0
Int
$10
Profit
Cost
$0.4
$0.5
Payoff
Consider a1% investment in El
Cost = 1% EL = $0.50
Payoff = 1%(Profits –Int)= $0.40
Alt. buy 1% EU, & borrow1% of DL
Cost= 1%Vu-1%DL=
$0.90-$0.50=$0.40
Payoff
Owe 1%*interest=
0.01*10=$0.10
Receive 1%*Profits=
0.01*50=$0.50
Total dollar payoff =
-$0.10+$0.50=$0.40
Can Vl > Vu? NO

8. Vl = Vu If Vl cannot be worth less than Vu
And Vl cannot be worth more than Vu
Vl must be as valuable as Vu

9. MM1 and WACC
If you own the entire firm then you are only compensated for the risk of the firm’s assets
Given that the assets do not change as D/V changes the risk of the company will not change

10. D/V and Shareholders
While leverage does not affect the risk of the overall firm, it does affect the risk to the shareholders
Leverage increases:

11. MM Proposition 2: D/E and re, βe
Increasing leverage increases the financial risk of the equity investment, and equity holders need to be compensated for bearing this risk
D/E relationship with re, βe
ra = D/V * rd + E/V*re
re = ra + D/E * (ra - rd)
a = D /V * d + E/V*e
e = a + D /E * (a - d)

12. βe Break-Down
e = a + D /E * (a - d)

13. Graph of MM2 As debt increases the cost of equity and debt increases
rWACC rD rE r0
As debt increases the cost of equity and debt increases
Why is WACC unchanged?

14. Corporate Taxes
What does the inclusion of taxes mean for firm value?

15. Corporate Taxes & Debt
Because interest payments are tax deductible, they act a shield protecting some of the firm’s cash flows from the government
If less money flows to the government, what will happen to firm value?

16. Total Cash Flow to Investors
All-equity firm Levered firm S G B S G

17. Vl with Corporate Taxes
Vl = Vu + PV(Tax Shield)
Vl = Vu + D*Tc
As the tax shield increases company value how should the company be financed?
tax shield = Tax Rate * Debt
Implication: Firms should be completely debt financed to maximize value

18. Unlevered Firm Value
Consider an un-levered firm, which has an EBIT of $1,500.
The company’s investors require a return on 12%.
Taxes are 34%, what is the firm worth?

19. Levered Firm Value The firm owes $1,000 in interest
Consider an levered firm, which has an EBIT of $1,500.
The firm owes $1,000 in interest
The company’s investors require a return on 12%.
Taxes are 34%, what is the firm worth?
The cash flow to investors are:
Debt:
Equity:
VL =

20. Levered Firm Value ALT
Consider an levered firm, with an EBIT of $1,500.
The firm owes $1,000 in interest
The company’s investors require a return on 12%.
Taxes are 34%, what is the firm worth?
VL = VU + D*T

21. Leverage and Firm ValueVL VU
D/E

22. MM 2 With Corporate Taxes
Earlier I showed you how re changes with debt, when we ignore taxes
re = ra + D/E * (ra - rd)
What happens if we include corporate taxes?
re = ra + D/E * (ra - rd) (1-T)

23. The Effect of Financial Leverage on the Cost of Debt and Equity Capital
Cost of capital: r (%) rU rB
Debt-to-equity ratio (D/E)
S/h risk and return increase with leverage

24. With only Corporate Taxes
Firm value increases with leverage
This suggests that firms should be 100% debt finance which we don’t see in the real world
Why not?

25. Bankruptcy Costs
One reason we don’t see firms with 100% debt financing
The possibility that a firm goes bankrupt reduces firm value
A firm does not need to declare bankruptcy to experience bankruptcy costs
VL = VU + PV(tax shield) – PV(distress costs)

26. Bankruptcy Costs
Direct Bankruptcy Costs: Legal and administrative costs associated with bankruptcy
Relatively small
Indirect Costs: Impaired ability to conduct business
This is where the Big Costs are
Lost sales, Higher rates, Warranties loss value
A firm can start to experience these indirect costs when it becomes financially distressed

27. What is Financial Distress?
Firm’s operating cash flows, are not sufficient to satisfy current obligations
This can lead to:
Default
Financial Penalties
Financial Restructuring
Bankruptcy

28. Stock-Based Insolvency
The value of the firm’s assets is less than the value of the debt.
Assets
Debt
Equity
Solvent firm
Debt
Assets
Equity
Insolvent firm
Debt
Note the negative equity

29. Cash-Based Insolvency
When the firms cash flows are insufficient to cover contractually required payments.
Contractual Obligations
Insolvency $
Cash flow shortfall
time
Firm cash flow

30. Stock v Cash Insolvency
Which is worse Stock or Cash Insolvency?

31. What Happens in Financial Distress?
Financial distress does not usually result in the firm’s death
Who hasn’t flow on a bankrupt airline?
However, a firm in financial distress may find it hard to operate
How willing are people to accept warranties?
How willing are people to extend credit?

32. Agency Costs
In addition to bankruptcy costs, when a firm becomes financially distressed, it creates incentive for the equity holders, who control the firm, to try an take from the debt holders
Asset Substitution
Incentive to underinvestment
Milk the property

33. Asset Substitution
A firm has $6m in assets, and has $10m in debt outstanding → Financial Distress
The firm has a project requiring a $2m investment and pays $7m (PV) with a 10% probability or pays nothing with a 90%
Project NPV?
Will the firm take the project?

34. Potential Payoffs If forgo the project: FV = $__
Debt gets $___, Equity gets $___
Take the project and it turns out bad: FV = $__
Take the project and it turns out good: FV = $_

35. Potential Payoffs If forgo the project: FV = $6
Debt gets $6, Equity gets $0
Take the project and it turns out bad: FV = $4
Debt gets $4, Equity gets $0
Take the project and it turns out good: FV=$11
Debt gets $10, Equity gets $1
Equity holders want to take this project
A chance at something is better than nothing

36. Underinvestment
Now instead of taking –NPV projects the firm passes on +NPV projects
The same firm has a project requiring $2m investment and pays $5m (PV) with a 50% probability or pays $1m (PV) with a 50% probability
What is the NPV?
-2 + [(0.5*5) + (0.5*1)] = $1
Will the firm take the project?
Probably not

37. Potential Payoffs If forgo the project: FV = $__
Debt gets $__, Equity gets $__
Take the project and it turns out bad: FV = $__
Take the project and it turns out good: FV= $_

38. Milk the Property (Cash out)
If the value of the firm is less than the value of the debt holders claims, then the shareholders have an incentive to sell off the assets and issue a cash dividends to themselves.

39. Example, names changed to protect the guilty
Marriot Inc
Owes $1 billion and has $500 million in assets
Management creates a new firm Marriot Co
Every Inc shareholder receives shares in Co
The same shareholders own both firms
Inc sells its $500m in assets to Co for $1.00
Co has $499,999,999 in assets and no debt
Inc has $1 in assets and $1b in debt
How happy are debt holders?

40. Intelligent Bondholders
Bondholders know about these agency problems and act accordingly
Requiring: Higher rd, covenants
Limit possible div payments, Restrict debt issuances or sales of assets
All of this requires costly monitoring of the firm
This is another costs borne by equity holders

41. Trade-Off
The firm trades off the benefits and costs associated with debt to maximize firm value
If we put everything we talked about together we get:
Vl = Vu + PV (Tax shields) – PV (Bankruptcy costs) – PV (Agency costs)

42. Trade-off Implications
Firms have an optimal level of debt
The amount will depend on the industry and firm
Safe, highly profitable firms with lots of tangible assets should have lots of debt
US studies finds that profitable firms have little debt
Risky, marginally profitable firms with lots of intangible assets should have little debt

43. Tax Effects, Financial Distress and Agency costs
Value of firm (V)
Present value of tax shield on debt
-Vu NoTax
-Vu Tax
-Vl Tax
-Vl Bank
-Tax Shield
-Bank Cost
Vu simple world
VL = With Taxes
VL = Taxes, Distress and Agency Cost
Present value of distress & agency costs
VU = With Taxes
D/E B*
Optimal amount of debt

44. Agency Costs Part Deux
Because managers run the firm, but don’t own the firm they can potentially run the firm for their personal benefit instead of shareholders
This reduces firm value
But in order for management to act badly, they need both:

45. Motive and Opportunity
Motives
Who doesn’t want their own jet, little empire, more money, better car
Recent research finds that when a firm goes private it reduces its fleet of corporate jets by 40%
Opportunity
Free cash flow: Money that is not needed to cover the firms current operations

46. Free Cash Flow Hypothesis
If shareholders limit the amount of free cash they reduce the amount of money that managers can waste
This lowers the agency costs
This is accomplished with either increased dividends or increased debt
Which is a more efficient? Why?

47. TTU: Jonathan “Jody” Nelson
TTU accounting grad who became CFO at Patterson-UTI Energy
Embezzled over $77 mill between
Basically wrote checks to himself

48. Real World Facts Capital structures differ across industries.
In general US firms appear to be underleveraged
Changes leverage does affect firm value
Stock price increases with increases in leverage and vice-versa;
consistent with M&M with taxes.
Another interpretation is that firms signal good news when they lever up.

49. Factors in D/E Ratio Taxes Types of Assets
If corporate tax rates tax shield is more valuable
Types of Assets
Tangible assets are easier to sell and make better collateral, reducing the cost of debt
Uncertainty of Operating Income
The more uncertain a firm’s cash flows are the more likely it will enter financial distress

50. Summary and Conclusions
In a perfect world
Capital structure does not affect firm value
In a world with taxes
Tax shields enhance value
But there’s a limit
Bankruptcy costs

51. Summary and Conclusion
On the one hand
Debt may constrain managers and reduce agency costs
On the other
Adds additional agency costs
Shareholders vs bondholders?
Managers vs bondholders?

52. Quick Quiz
How does financial leverage affect firm value without taxes? With taxes?
What is homemade leverage?
What are the direct and indirect costs of bankruptcy?
Define 3 agency conflicts in financially distressed firms?

53. Why do we care? This is big real world finance
This is where people make real money
It is encompasses most of the finance that we have done so far
If you get this then you have a pretty good understand of finance