Contemporary Financial Management

1. Contemporary Financial Management Chapter 12: Capital Structure Concepts

2. Introduction • This chapter examines the basic concepts related to a firm’s optimal capital structure.

3. Capital Structure Theory • Studies the relationship between: • Capital structure • The mix of debt & equity securities on the right hand side of the Balance Sheet • Cost of capital • The return demanded by investors • Impacts on the value of the firm

4. Capital vs. Financial Structure • Capital Structure • Amount of permanent short-term debt, long-term debt, preferred shares and common equity used to finance the firm. • Financial Structure • Amount of current liabilities, long-term debt, preferred shares and common equity used to finance a firm.

5. Capital Structure Terminology • Optimal capital structure • Minimizes a firm’s weighted average cost of capital (WACC) • Maximizes the value of the firm • Target capital structure • Capital structure the firm plans to maintain • Debt capacity • Amount of debt in the firm’s optimal capital structure

6. Capital Structure Assumptions • Firm’s investment policy is held constant • Capital structure changes the distribution of the firm’s EBIT among the firm’s claimants • Debt holders • Preferred shareholders • Common shareholders • Fixed investment policy leaves the debt capacity of the firm unchanged

7. Factors Affecting Capital Structure • Business risk of the firm • Tax structure • Bankruptcy potential • Agency costs • Signaling effects

8. Factors Affecting Business Risk • Variability of sales volume • Variability of selling price • Variability of input costs • Degree of market power • Extent of product diversification • Firm’s growth rate • Degree of operating leverage (DOL) • Both systematic and unsystematic risk

9. Financial Risk • The variability of earnings per share (EPS) • Financial risk affects the probability of bankruptcy • Indicators of financial risk • Debt to assets ratio • Debt to equity ratio • Fixed charge coverage ratio • Times interest earned ratio • Degree of Financial Leverage • Probability distribution of profits • EBIT-EPS analysis

10. Three Capital Structure Models Capital Structure With No Taxes Optimal Capital Structure With Taxes Optimal Capital Structure With Taxes, Financial Distress Costs & Agency Costs

11. Capital Structure is Irrelevant • Modigliani & Miller (MM) were the pioneers in developing the theory of capital structure • MM began by assuming perfect capital markets, including: • No taxes • No bankruptcy (B) costs • No agency (A) costs • MM also recognized that debt will always cost less than equity because: • Interest is tax deductible • Debt securities are less risky than equity securities

12. MM’s Two Propositions • Proposition #1: • The market value of the firm is independent of capital structure. Therefore, capital structure is irrelevant. • Proposition #2: • The cost of capital remains constant as capital structure changes. As the quantity of debt rises, the return demanded by the shareholder increases linearly, exactly offsetting the benefit due to the lower cost of debt.

13. ke ka kd Modigliani & Miller on Capital Structure If leverage increases, the cost of equity, ke, increases to exactly offset the benefits of more debt, leaving the cost of capital, ka, constant. Cost of Capital (%) Financial Leverage (Debt-to-equity ratio)

14. Market value of the firm: Market value of equity + Market value of debt Value of firm with no debt: Value of firm with debt: MM Arbitrage Proof

15. Example: Value of an Unlevered Firm • A firm with no debt pays out $1 Million in dividends. If shareholders require a 20% return, what is the market value of the firm?

16. Example: Value of a Levered Firm • The same firm now acquires debt at 10%, on which it pays interest of $250,000. Since this is world with no taxes, the firm has $750,000 which it pays in dividends. Since the firm is now more risky, shareholders require a 30% return. What is the market value of the firm?

17. Why? • Dividends paid to shareholders of the levered firm are reduced by the amount of interest paid on the debt. • ke is higher for the levered firm because of the additional leverage-induced risk. • The values of the levered and the unlevered firm are identical due to arbitrage. • Thus MM’s Proposition #1: the value of the firm is independent of capital structure (in a world with no taxes)

18. What Happens with Taxes ? • The firm’s operating income is now reduced by the amount of taxes paid • Since dividends to shareholders are paid out of after-tax income, the value of the unlevered firm should drop • But interest is a tax-deductible expense, creating a valuable tax-shield • The result - the value of the levered firm should be higher than the value of the unlevered firm

19. A tax shield is the amount of tax the firm would have paid, had it not incurred the interest expense. The annual tax shield is equal to: The PV of the tax shield is equal to: The Tax Shield due to Interest I = interest rate D = Face value of debt T = Tax rate

20. Example: The Impact of Tax

21. Market Value of the Unlevered Firm • Market value of the firm: Market value of equity + Market value of debt

22. Market Value of the Levered Firm • Market value of the firm: Market value of equity + Market value of debt

23. Why the Difference? • The difference in value between the levered and the unlevered firm in a world including taxes is due to the value of the tax shield • Therefore: • Market value (MV) of levered firm = MV of unlevered firm + PV of the tax shield

24. VL = VU + Present Value of Tax Shield VL MktValue of Firm PV of Tax Shield VU Debt $

25. ke ka ki = kd (1 – T) Capital Structure The cost of capital decreases with the amount of debt. The firm maximizes its value by choosing a capital structure that is all debt. Cost of Capital (%) Financial Leverage (Debt-to-equity)

26. The Problem? • If the value of the firm increases linearly with debt, the logical conclusion would be that all firms should be financed with 100% debt! • This conclusion defies logic and is counter to customary practice • What are we missing?

27. Financial Distress (Bankruptcy) Costs • Financial distress costs include: • Costs incurred to avoid bankruptcy • Pay higher interest rates due to greater risk • Direct & indirect costs incurred if the firm files for bankruptcy • Direct costs – costs paid by debtors in the bankruptcy & restructuring process • Indirect costs – costs due to loss of customers, suppliers, employees plus the cost of management’s time

28. Bankruptcy Costs • Lenders may demand higher interest rates • Lenders may decline to lend at all • Customers may shift their business to other firms • Distress incurs extra accounting and legal costs • If forced to liquidate, assets may have to be sold for less than market value

29. Agency Costs • The firm’s debt & equity holders (the principals) are usually not the firm’s managers • The principals employ agents (firm management) to manage the firm on their behalf • Conflicts often develop between the interests of the principals and the interests of the agents

30. Agency Costs & Shareholders • Shareholders have an incentive to undertake risky projects financed with debt • If the project succeeds, the shareholders win • If the project fails, the bondholders suffer the loss • Therefore, bondholders will • Charge higher interest rates, or • Implement protective covenants to protect themselves

31. Agency Costs & Shareholders • Investing in high risk/high return projects can shift wealth from bondholders to shareholders • Shareholders may forgo some profitable investments in debt is required • Shareholders may issue high quantities of new debt, diminishing the protection afforded to earlier bondholders • Bondholders will shift monitoring and bonding costs back to the shareholders by charging higher interest rates & imposing covenants

32. Taxes, Bankruptcy and Agency Costs • Bankrupcty and agency costs increase with the amount of leverage • At some point, these offset the positive benefits from the value of the tax shield • Market value of unlevered firm • + PV of tax shield • – PV of bankruptcy costs • – PV of agency costs • Market value of leverage firm

33. PV B&A Costs PV of Tax Shield Mkt value of leveraged firm VL VU Optimal Debt Ratio Market Value of the Firm Debt Ratio Optimal Debt Ratio

34. D Optimal Capital Structure D + E Least Cost Capital Structure Cost of Capital ke ka ki

35. Other Considerations • Personal tax costs (interest is fully taxable) • Could offset some corporate tax advantages • No optimal capital structure when both corporate & personal taxes are considered • Industry effects • Firms with stable cash flows tend to have higher debt ratios • More profitable firms tend to have lower debt ratios • Market appears to reward firms with capital structures appropriate to their industry

36. Other Considerations • Signaling effects (Asymmetric Information) • Firm management have access to confidential information • Management decisions may be a signal to the market • Managerial preferences (Pecking order theory) • Firms prefer internal to external financing • New issues incur flotation costs • External financing incurs more monitoring by the market

37. Pecking Order Theory • Firms have a definite preference in the order in which they finance new projects Least Preferred Most Preferred External Equity Debt Internal Equity

38. Major Points • Choosing an appropriate capital structure is an important management decision • In a world with no taxes, the value of the unlevered firm equals the value of the levered firm • In a world with taxes, interest creates a valuable tax shield. • The value of the levered firm equals the value of the unlevered plus the PV of the tax shield

39. Major Points • Financial distress & agency costs increase as debt rises, eventually offsetting the marginal value of the interest tax shield • Optimal capital structures appear to be influenced by • Variability of cash flows • Nature of the industry