Capital Structure ( the heart and soul of a firm)

1. Capital Structure(the heart and soul of a firm)

2. Capital Structure Capital Structure Decision: • Firm’s mix of debt and equity • How a firm gets its money can be assessed by analyzing its effect on • Firm earnings • Firm value Note: #1 is somewhat more practical and intuitive, but #2 is better.

3. Capital Structure (cont.) IDEA: How firm does long term financing affect shareholder wealth Recall: Objective: Maximize shareholder wealth Generally:  Max Shareholder Wealth Max Value of Firm

4. Capital Structure (cont.) Let: V = Market Value of Firm V = Value of All Assets = Value of All Liabilities or V = Sum of Value of All Claims on Firm

5. Capital Structure (cont.) Let: B = Market Value of Debt E = Market Value of Equity Then Ignore all else! V = B + E By definition!

6.  wiCosti All sources i of financing Cost of Capital WACC = RA = Weighted-Average Cost of Capital (LT financing) WACC = wi: Weight of Source i Costi: Cost of Source i We consider only 2 sources: Debt & Equity

7. Cost of Capital (cont.) With Debt & Equity: Where V = B + E RD = cost of Debt RE = cost of Equity TC = corporate tax rate

8. Cost of Debt-Bond Pricing Let P = price of bond F = face value (i.e. $1000) c = coupon rate N = number of years to maturity y = discount rate Then P = PV of Interest Payment + PV of Principal

9. Cost of Debt-Bond Pricing (cont.) • y is “Yield to Maturity” (YTM). • It is discount rate that equates market price of bond with PV of payments from bond. • YTM = cost of debt • It is dynamic (always changing as P changes).

10. y = 10% Note: y is dynamic and not equal to book cost of 7%. Cost of Debt-Bond Pricing (cont.) Example: • Market price of a 2-year bond with coupon rate 7% is $947.94, the face price is $1000. y = ? P = $947.94 , cF = 0.07 × 1000 = $70

11. Cost of Debt-Bond Pricing (cont.) Example: • Debt / equity = 0.50, ERM = 0.12, RD = 0.07, TC = 0.30, RF = 0.05, E = 1.1, Find WACC?

12. Need B/V, E/V, and RE B/E = 0.33 B/V = B/(B + E) = (B/E) + 1 E/V = 1 – B/V = 0.67 RE = RF + E MP = 0.127 WACC = 10.1% Cost of Debt-Bond Pricing (cont.) • Example (cont.):

13. Capital Structure - Theory • Perfect Market • M&M Prop. I • M&M Prop. II • M&M with taxes (Prop.I & Prop. II)

14. Perfect Market • No transaction costs (frictionless markets) • No taxes • Perfectly competitive markets (no monopolistic behavior) • Information is free and available to all • All can borrow or lend at same risk-free rate • No financial distress costs (no bankruptcy costs)

15. M&M • M&M (1958) • Seminal landmark paper on firm capital structure • Derived two propositions assuming a world of perfect markets

16. M&M Prop. I • In a world of perfect markets, a firm’s capital structure does not affect firm value!

17. M&M Prop. I (cont.) Note: • Like a perpetuity, EBIT goes to bond & stock holders, and EBIT simply discount at average rate. • Value and WACC do not depend on how firm financed!

18. M&M Prop. I (cont.) Note: • Debt is assumed to be a perpetuity that pays interest each year forever. Let r = risk-free rate D = face value of debt B = market value of debt RD = return to bondholders Then B = rD / RD

19. M&M Prop. I (cont.) • Used often in text • Interest rD is constant, but RD and B are constantly changing even though RD × B does not change!

20. B RE = RA + (RA– RD) E M & M Prop. II Says: • Equity holders require a premium over what everyone is paid if the firm has debt. • The premium DOES depend upon the firm’s financing mix. • Form of Prop. II is like CAPM (Recall this was 1958, CAPM came in 1964!)

21. EBIT– rDEBIT– RDB RE = = EE ButEBIT = RAV = RA(B + E) (by Prop. I) RA(B + E) – RDB So RE = E B B = RA + RA – RD E E B = RA + (RA – RD) E M & M Prop. II (cont.) Proof:

22. Prop. I WACC M & M Traditional B E Graphic View of M & M Prop. I & II

23. RE Prop. II B M & M Slope = RA– RD E Traditional RA Graphic View of M & M Prop. I & II

24. Together To E1 To E2 V = E1 + B1 V = E2 + B2 Graphic View of M & M Prop. I & II B2 > B1

25. M & M Prop. II (cont.) Example Firm: WACC = 10%, B = 4000, RD = 5%, EBIT = 1000 Find:V, E, RE?

26. B E B E NOTE: = 0.40 = 0.60 V V WACC = 0.4  0.05 + 0.6  0.1333 = 0.10 Good Check! M & M Prop. II (cont.) Example (cont.) V = EBIT /RD = 1000 / 0.10 = 10000 V = E + B E = V – B E = 6000 RE = RA + (RA– RD) = 0.1333

27. M & M with Corporate Taxes • Relax only one of the perfect market assumptions. • Consider a firm with no debt (i.e. all equity or unlevered) with a value of Vu. • Suppose firm changes capital structure by issuing debt and retiring some equity but nothing else — firm will realize gain since interest payments on debt are tax-deductible, so tax liability will decline!

28. M & M with Corporate Taxes(cont.) • For perpetual debt: Yearly Tax Savings (Tax Shield) = Interest × TC = r ×D × TC = RD ×B × TC • Tax shield will be realized each year forever. Since it goes to bondholders, it should be discounted at RD, thus PV of tax shield = (RD ×B × TC)/ RD = B × TC

29. M & M with Corporate Taxes(cont.) • Value of firm with debt VL (i.e. “levered firm”) will be : VL = Vu + B × TC • Value increases by PV of tax shield. • Tax advantage of debt increases as TC increases. • In M&M world (TC = 0), VL = Vu

30. M & M with Corporate Taxes(cont.) VL Slope = TC PV of tax shield M&M value VU B

31. M & M with Corporate Taxes(cont.) Example: • If TC = 0.40, for $1 of debt, value of firm will increase $0.40. • Firm with B/E = 0.50, if the firm had no debt, value would be $25 million, tax rate is 50%. Find value of the firm, value of its debt, value of its equity.

32. M & M with Corporate Taxes(cont.) Example (cont.): VU = 25, B/E = 0.50, TC = 0.50 VL = VU + B × TC = 25 + 0.5B  B + E = 25 + 0.5B but B = 0.5E  E = 20 Thus B = 10, VL = 30 NOTE: Conclusion: —M&M with taxes, V does depend on B/E!

33. VL , RA are not constant. • RU = WACC for all equity firm (i.e. cost of equity). M & M with Corporate Taxes(cont.) • New Prop. I:

34. M & M with Corporate Taxes(cont.) Example: • Firm with EBIT = 2,000; Debt = 5,000; TC = 40%. If firm was all equity, its WACC would be 15%. Find V & E.  VL = VU + BTC BTC = 0.4 × 5,000 = 2,000 VU = EBIT (1- TC)/RU = 8,000  VL = 8,000 + 2,000 = 10,000 E = VL – B = 5,000 Note: Origin all equity: 8,000  5,000 paid off & 5,000 left Increase 2,000 – PV of tax shield!

35. M & M with Corporate Taxes(cont.) New Prop. II: RE = RA + [RA – RD(1 – TC)] × B/E RE = RU + [RU – RD(1 – TC)] × B/E where, RA = WACC for levered firm RU = WACC for all equity firm Note: If RA = RU, TC = 0 both versions are the same.

36. M & M with Corporate Taxes(cont.) Example: WACC = 0.11, RD = 0.11, TC = 0.35, • If B/E = 2.5, find RE & RU? RE = RA + [RA – RD(1 – TC)] × B/E = 0.2062 Also, RE = RU + [RU – RD(1 – TC)] × B/E  RU = 0.1466 • If B/E = 1.5, find RE? RE = RU + [RU – RD(1 – TC)] × B/E = 0.1823 Note: We cannot use RA form, since we do not know RA.

37. L =U × [1 + (1 – TC) × B/E] Where L = equity beta for firm with B/E U = equity beta for all equity firm Note: In M&M world TC = 0, L = U× [1+B/E] Beta will change! Equity Beta & Capital Structure • About 1980, Hamada (University of Chicago) showed

38. Equity Beta & Capital Structure (cont.) Example: XYZ has B/E = 0.5, E = 0.90, E(RM) = 0.19, RF = 0.09, TC = 0.40, RD = 0.10. It is considering changing to B/E = 0.75. • WACC? • WACC, if B/E = 0.75?

39. B/E 1 = (a) B/V = B/E + 1 3 RE = 0.09 × 0.9 × (0.19 – 0.09) = 0.18 E B × RD (1 – TC) + × RE RA = V V = 0.14 ( with B/E = 0.50) Equity Beta & Capital Structure (cont.) Example (cont.):

40. Equity Beta & Capital Structure (cont.) Example (cont.): (b) Want RA @ B/E = 0.75 B/V = 0.429, E/V = 0.571. Want RE? Need  ? L =U × [1 + (1 – TC) × B/E] when B/E = 0.5, 0.90 = U × [1 + 0.6 × 0.5]  U = 0.692 when B/E = 0.75, L =U × [1 + (1 – TC) × B/E] = 1.0034  RE = 0.19, RA = 0.134 RA falls!

41. V VU B Suggests: Optimal capital structure is all debt. Capital Structure (cont.) • Recall: M&M with taxes

42. Capital Structure (cont.) • But we find firms spanning the full debt/equity spectrum from no debt to high B/E ratios. • Something left out, consider: • Bankruptcy costs • Information/agency costs

43. Bankruptcy Costs • Two types: • Direct costs — those directly associated with bankruptcy, both legal and administrative. • Indirect costs — costs associated with a firm experiencing financial distress (creditors, bankers, customers, employers, etc.) • Bankruptcy costs = direct costs + indirect costs • V = VU + PV of tax shield – PV of bankruptcy costs

44. PV of bankruptcy cost V PV of tax shield VU B M & M with Taxes and Bankruptcy Costs

45. M & M with Taxes and Bankruptcy Costs • Note: • PV of tax shield , as B  • But, PV of bankruptcy costs , as B  • Idea: • At high debt levels, PV of bankruptcy dominate over PV of tax shield.

46. Agency Costs • Evident that bankruptcy costs are not significant enough. • Agency costs address information assumption. • Agency costs: Costs due to people taking “extra” precautions to protect themselves due to lack of information. • Examples: • Costs associated with use of debt restrictive covenants, resolving bondholder/shareholder conflicts, higher yields, more bond features. • Costs associated with problems, bad publicity (e.g. product defects, layoffs, mismanagements, etc.)

47. Agency Costs (cont.) • May be hundreds of agency costs. • Difficult to identify and estimate, but exist V = VU + BTC – PVBC– PV of agency costs • PVBC + PVAC eventually dominate over PV of tax shield. • PV of agency costs , as B  generally.

48. PVBC + PVAC V PV of tax shield VU B Agency Costs (cont.)

49. Corporate Finance Practices • Firms prefer internal to external financing. • Firms prefer debt financing to equity financing • Firms tend to “ time ” equity offerings. • Firms with valuable intangible assets or growth opportunities tend to borrow less than firms with mostly tangible assets. • Firms appear to have target B/E ratios and slowly move toward them. • Taxes appear to have little affect on capital structure decision (e.g. 1980 TC , but B/E ).