Capital Structure

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 • 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

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= 0.40 + 0.50=$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

7. MM Intuition: Vl > Vu • 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 • Why is WACC unchanged? r rE r0 rWACC rD D/E

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 G S G S B

17. Vl with Corporate Taxes • Vl = Vu + PV(TaxShield) • Vl = Vu + D*Tc • As the tax shield increases company value how should the company be financed?

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 • 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 Value V VL 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?

23. The Effect of Financial Leverage on the Cost of Debt and Equity Capital Cost of capital: r(%) rU rB Debt-to-equityratio (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. Solvent firm Insolvent firm Debt Assets Assets Debt Equity Equity Note the negative equity Stock-Based Insolvency • The value of the firm’s assets is less than the value of the debt. Debt

29. $ Cash flow shortfall Contractual Obligations time Insolvency Cash-Based Insolvency • When the firms cash flows are insufficient to cover contractually required payments. 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 = $__ • Debt gets $___, Equity gets $___ • Take the project and it turns out good: FV = $_ • Debt gets $___, Equity gets $___

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 = $__ • Debt gets $__, Equity gets $__ • Take the project and it turns out good: FV= $_ • Debt gets $__, Equity gets $__

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 • Cohas $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 taxshield 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 ofdistress & agency costs VU = With Taxes D/E 0 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 1998-2005 • 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 • 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