Capital Structure

Capital Structure

What finance functions add the most to firm value?

Corporate Financing • We have been focusing on investment decision • What should the firm buy? • Now we are turning to the financing decision • How does the firm pay for it?

How do Firms Pay for Stuff • Companies prefer to use the cash they generate • This account for about 70-90% of all purchases • If cash is insufficient they sell securities

Capital-Structure • Addresses: What securities should the firm sell • This determines how the firm’s cash flows are divide • Capital Structure becomes important if the division affects the size of the cash flows • Remember: A firm is simply worth the PV of its expected future cash flows to investors S B

The Value of E and D • E: The PV of cash flows to equity holders • If a company pays $1.5 mil. in dividends each year (re=8%) E = • D: The PV of the cash flows to debt holders • If a company pays $0.75 mil. in interest each year (rd=4%) D = • V =

The Value of E and D • E: The PV of cash flows to equity holders • If a company pays $1.5 mil. in dividends each year (re=8%) E = 1.5 / 0.08 = $18.75mil • D: The PV of the cash flows to debt holders • If a company pays $0.75 mil. in interest each year (rd=4%) D = 0.75/0.04= $18.75mil • V = 18.75 + 18.75 = $37.5 mil

Cap Structure and Value While capital structure appears to influence firm value in the real world to understand how/why we need to start with a situation where it doesn’t

Modigliani-Miller Proposition 1 Capital Structure DOES NOT MATTER VL = VU

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

MM Investment 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

MM Intuition • Suppose Vl < Vu • Consider a 1% investment in EU • Cost = 1% EU = • Payoff = 1% Earnings = • Now buy 1% of EL & 1% of DL • Cost = 1% EL +1%DL= Payoff • Receive 1%*Interest= Receive 1%*(Earnings -Int)= • Total dollar payoff = • Can Vl < Vu?

MM Intuition • Suppose Vl < Vu • Consider a 1% investment in EU • Cost = 1% EU = $1.00 • Payoff = 1% Earnings = • Now buy 1% of EL & 1% of DL • Cost = 1% EL +1%DL= Payoff • Receive 1%*Interest= Receive 1%*(Earnings -Int)= • Total dollar payoff = • Can Vl < Vu?

MM Intuition • Suppose Vl < Vu • Consider a 1% investment in EU • Cost = 1% EU = $1.00 • Payoff = 1% Earnings = $0.50 • Now buy 1% of EL & 1% of DL • Cost = 1% EL +1%DL= Payoff • Receive 1%*Interest= Receive 1%*(Earnings -Int)= • Total dollar payoff = • Can Vl < Vu?

MM Intuition • Suppose Vl < Vu • Consider a 1% investment in EU • Cost = 1% EU = $1.00 • Payoff = 1% Earnings = $0.50 • Now buy 1% of EL & 1% of DL • Cost = 1% EL +1%DL= 0.40 + 0.50=$0.90 • Payoff • Receive 1%*Interest= 0.01*10=$0.10 • Receive 1%*(Earnings-Int)= 0.01*40=$0.40 • Total dollar payoff = $0.10+$0.40=$0.50 • Can Vl < Vu?

MM Intuition • Suppose Vl < Vu • Consider a 1% investment in EU • Cost = 1% EU = $1.00 • Payoff = 1% Earnings = $0.50 • Now buy 1% of EL & 1% of DL • Cost = 1% EL +1%DL= 0.40 + 0.50=$0.90 • Payoff • Receive 1%*Interest= 0.01*10=$0.10 • Receive 1%*(Earnings -Int)= 0.01*40=$0.40 • Total dollar payoff = $0.10+$0.40=$0.50 • Can Vl < Vu?

If Vl < Vu then • An investor can purchase a claim in the levered firm with the same payoff as a claim in the un-levered firm, for a lower price! • This situation is impossible in a well functioning capital market (arbitrage) • Investors will buy Vl and sell it for Vu until Vl = Vu

MM Intuition the Other Way • Suppose Vl > Vu • Consider a1% investment in El • Cost = 1% EL = • Payoff = 1%(Earnings –Int)= • Alt. buy 1% EU, & borrow1% of DL • Cost= 1%Vu-1%DL= Payoff • Owe 1%*Interest= • Receive 1%* Earnings = • Total dollar payoff =

MM Intuition the Other Way • Suppose Vl > Vu • Consider a1% investment in El • Cost = 1% EL = $0.50 • Payoff = 1%(Earnings –Int)= • Alt. buy 1% EU, & borrow1% of DL • Cost= 1%Vu-1%DL= Payoff • Owe 1%*Interest= • Receive 1%* Earnings = • Total dollar payoff =

MM Intuition the Other Way • Suppose Vl > Vu • Consider a1% investment in El • Cost = 1% EL = $0.50 • Payoff = 1%(Earnings –Int)= $0.40 • Alt. buy 1% EU, & borrow1% of DL • Cost= 1%Vu-1%DL= Payoff • Owe 1%*Interest= • Receive 1%* Earnings = • Total dollar payoff =

MM Intuition the Other Way • Suppose Vl > Vu • Consider a1% investment in El • Cost = 1% EL = $0.50 • Payoff = 1%(Earnings –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%* Earnings = 0.01*50=$0.50 • Total dollar payoff = -$0.10+$0.50=$0.40

If Vl > Vu then • In perfect capital markets the inequality cannot hold. Since both strategies have the same payoff, they should cost the same.

On balance • The intuition shows how we can take positions in the levered and un-levered company that generate the same payoff, but which only costs the same if the two firms have the same firm value • The law of one price states that investments with the same payoffs need to cost the same, therefore the two firms must be equally valuable • Arbitrage

MM 1 Cash Flow Proof • Two firms • Earn $1,000 • Unlevered • re = 10% • Levered • re = 15% • rd = 5% • D= 5,000

V D/V Main result in this “perfect world” The value of the firm is independent of its capital structure

Investors and Capital Structure • While leverage does not affect the risk of the overall firm, it does affect investors’ risks • Leverage increases: Financial/Default Risk

MM Proposition 2: D/E and re,βe • As leverage increases so does financial risk • D/E relation 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)

βe Break-Down e= a + D/E * (a - d) • a: Captures the Business Risk of the firm • D/E * (a - d): Captures the Financial Risk of the firm

Re Ra Rd MM 2: Graph • Look familiar?

Question 1 • Shareholders demand a higher rate of return than bondholders. As debt is cheaper, we should increase the D/V ratio as it reduces ra. True or False? • False. As D/E increases, re & rd also increase (financial risk) → So ra will not change

Question 2 • As the firm borrows more and debt becomes riskier, both shareholders and bondholders demand a higher rate of return. Thus by reducing the debt-equity ratio, we can reduce the cost of debt and the cost of equity. This makes everybody better off. True or False? • False. rd & re will fall, but a larger proportion of the firm is financed by relatively expensive equity. So the overall effect is to leave ra unchanged.

Cash flows and Firm Value 1 A firm is only worth the PV of it’s cash flows to investors • Consider an un-levered firm, which has an EBIT of $1,500. • The company’s investors require a return on 12%. • Assume no taxes, what is the firm worth? • Vu = E • Vu = 1,500 / 0.12 = $12,500

Cash flows and Firm Value 2 • Consider a levered firm, which has an EBIT of $1,500. • The firm owes $1,000 in interest payments/year • The company’s investors (equity and debt) require a return on 12%. • Assume no taxes, what is the firm worth? • VL = D + E • D= 1,000/0.12 = $8,333.33 • E= 500/0.12 = $4,166.67 • VL =$12,500

Lets get Real • MM showed us that in the theoretical world capital structure does not matter • But by relaxing the MM assumptions and allowing for a more realistic world, we can see how capital structure affects firm value

Corporate Taxes • When we include taxes will the firm be more or less valuable than in a world without taxes? • LESS Valuable • As some of the money generated by the company is now needed to pay taxes less flows to the investor, reducing firm value

Who gets paid first? • Debt • Interest payments reduce our taxable income → reducing our taxes • Less money to Uncle Sam mean more for investors • Firm value will increase as debt increases

Example • We have two identical firms • EBIT $1,000 • L: debt of $5,000 @ 6%

Example • We have two identical firms • EBIT $1,000 • L: debt of $5,000 @ 6% • The tax shield increases the cash available for investors

Tax Shield’s Effect on Firm Value • The tax shield increases firm value by the present value of the tax reduction • Tax Shield = Tax Rate * Dollar Interest • PV (T.S.) = Tax Rate * Dollar Interest / rd = Tax Rate * (Debt * rd) / rd = Tax Rate * Debt = 0.4 * 5,000 = $2,000

Capital Structure