Capital Structure

Capital Structure

Capital Structure • Firm must decide how to raise long term funds • Capital structure decision • The capital structure decision is one of the most important strategic decisions faced by a firm • Can have large affect on the overall value of the firm • Direct impact on health of the firm and viability

Capital Structure • Many aspects to the decision: • How much debt and how much equity? • Equity – preferred stock or common stock? • Maturity of debt – long term versus short term? • Structure of debt – bank debt vs. bonds, secured vs. debentures, use of convertible bonds, et cetera • What currency should debt be denominated in? • If capital structure is to be changed, how to accomplish it? • Other aspects…

Here, we will concentrate on the most basic question: • Debt versus equity – how much of each? • How much should the firm borrow? • Is there an optimal capital structure? • Assumption: The goal of the financial manager is to maximize the value of the firm. • Makes capital structure decision in order to help accomplish this.

WACC vs. Firm Value • Maximizing the value of the firm is equivalent to minimizing the firm’s cost of capital. • Capital structure affects WACC, and therefore firm value Example: • Firm generates free cash flow of FCFF each year • Assume it goes on forever and, for simplicity, assume it does not grow. • The market value of the firm (market value of debt plus market value of equity) is the present value of all future cashflows • In this simple case, this is a perpetuity

WACC vs. Firm Value • Market value of the firm = V • If WACC decreases, firm value increases (and vice versa) • Therefore, choose capital structure to obtain minimum cost of capital • This makes the firm worth the maximum possible amount.

Point of Today’s Discussion: • Is there an optimal amount of debt (optimal capital structure)? • What factors affect/determine the optimal amount? • These questions first looked at formally by… Modigliani and Miller a.k.a. M & M

M & M • Before M & M (1958), there were no formal methods for evaluating capital structure • Many researchers and firms searched for how to determine the best structure • M & M did a formal, mathematical evaluation of capital structure • Their model was based on some simplifying assumptions • The two most important assumptions • No Taxes • No Costs of Bankruptcy • Under these assumptions…Capital Structure is irrelevant.

M & M • M & M said a firm’s choice of capital structure did not matter? WHY? • Consider WACC: • Debt is normally cheaper than equity • If a firm borrows more, it puts more weight on a cheaper source of financing • BUT…the firm becomes riskier • Therefore investor's required return on equity increases • The cost of equity to the firm goes up

M & M This weight goes up, decreasing WACC This cost increases, increasing WACC • M & M showed that under their assumptions, the two effects exactly offset. • WACC does not change if the capital structure changes.

M & M • Another way to think of it: • A firm cannot increase its value by its choice of financing, it is only the investments it makes that matter • Can think of the value of the firm as a pie • Part is equity • Part is debt • You cannot change the overall size of the pie by slicing it differently debt equity debt equity

M & M • Conclusions based on assumptions which are clearly unrealistic • Why important? • If there are no taxes, no bankruptcy then capital structure does not matter • Thus, factors that are important in determining capital structure in the real world must be taxes and bankruptcy • M & M then extended their model to include effect of corporate taxes • important factor…interest payments on debt are tax deductible • This gives debt an advantage over equity, and the capital structure the firm chooses does matter

M&M with Corporate Taxes • Considering taxes, there is a benefit to using more debt • This comes because of the valuable tax deduction generated Example: • Firm considers two ways to finance itself • 100% equity • Borrow some, and use some equity (amount borrowed = D) • In either case, the firm’s underlying business is the same • EBIT is the same in either case • Assume (for simplicity) no depreciation, no new investments, and no growth in cashflow in the future

M&M with Corporate Taxes • If firm is unlevered: Cashflow = FCFF = EBIT(1-T) Value of the unlevered firm = VU Where: rEU = cost of equity of unlevered firm = WACC of unlevered firm

M&M with Corporate Taxes • If firm is levered FCFF = (EBIT – rDD)(1-T) + rDD Where rD is cost of debt. Calculate present value of this to find market value of levered firm.

If firm is levered (continued) FCFF = (EBIT – rDD)(1-T) + rDD = EBIT(1-T) – rDD + rDDT + rDD = EBIT(1-T) + rDDT Take present value of each piece separately at appropriate discount rates to get value of levered firm (VL):

M&M with Corporate Taxes • The value of the firm increases with the use of debt TD = the present value of the interest tax shield • Implication: the more debt the firm uses, the more valuable it is • A little more realistic than original M&M model • Implies that optimal capital structure is 100% debt for all firms • Obviously, that is not what happens in the real world. • There must be other factors at work that offset, to a certain extent, the tax benefits if debt

Factors Affecting Capital Structure • A number of factors affect what the optimal capital structure is for a firm • These are things that should be considered in making the capital structure decision • Some factors are more important for certain types of firms and less important for others • Unfortunately, not all the factors are quantifiable

Factors Affecting Choice of Capital Structure • Taxes • Bankruptcy Costs • Industry Averages • Control of Firm • Risk Structure of Firm • Signaling • Need for Financial Slack • Agency Problems • Between shareholders and bondholders • Between shareholders and management

Factors Affecting Choice of Capital Structure • Given that the factors listed are taken into consideration, is there an optimal capital structure? A structure that is best for the firm? YES (Probably, the optimal is a range, rather than a single point.) • Can we calculate what the optimal capital structure is? NO

Factors Affecting Choice of Capital Structure • The tax effect of debt is quantifiable • Unfortunately, many of the other factors are not • In some cases there are quantitative methods to help analyze the situation, but no methods to calculate the exact affect of the factors on the optimal capital structure • The capital structure decision is one that must be made qualitatively in the end (again, there are quantitative methods that can help) • The list of factors is a list of things which should be considered by the manager and taken into account • Let’s look at each factor in turn…

Taxes • Effect as previously discussed • More debt means more interest tax shield = higher firm value • Other considerations: • Firm’s tax rate • The higher the tax rate, the more valuable the interest tax shield • Is the firm profitable? Does it have loss carry-forwards? • Does the firm have lots of non-debt tax shields? • Example: Capital Cost Allowance • The firm may not need the interest tax deduction

Bankruptcy Costs • Increased debt means a higher probability of going bankrupt • Even if the firm does not go bankrupt, having a high probability of doing so can affect business • There are some very important costs to being financially distressed • The costs of financial distress mitigate the tax benefits of debt • Two types of costs of financial distress • Direct Costs of Bankruptcy • Indirect Costs

Bankruptcy Costs • Direct Costs of Bankruptcy • Actually going bankrupt can be costly • Legal fees, administrative fees, cost of liquidating assets etc. • Direct costs of bankruptcy estimated around 5% of value of assets for a sample of US railroads (Warner (1977)) • Capital structure decision based on expected bankruptcy costs • (probability of bankruptcy) (cost of bankruptcy) • This increases as more is borrowed, offsets tax benefits of debt

Bankruptcy Costs Direct Costs of Bankruptcy (continued) • Firms with lower expected direct costs of bankruptcy should carry a higher debt load • Firms with mostly tangibleassets should carry more debt than firms with mostly intangible assets • Tangible assets better as collateral and easier for creditors to sell to recoup money • Therefore creditors will lend at better rates

Bankruptcy Costs Direct Costs of Bankruptcy (continued) • Firms with asset which have many uses (high fungibility or high plasticity) should carry more debt • Highly specialized assets are hard to finance with debt • In bankruptcy, they are hard to sell so creditors will charge higher rates • Firms with specialized assets will generally carry less debt

Bankruptcy Costs Indirect Costs of Financial Distress • Indirect costs are costs borne by firm because of the possibility of bankruptcy • Essentially, if people believe that a firm may go bankrupt both customers and suppliers may stop doing business with that firm • Financial distress results in loss of business • If a firm has high indirect costs of financial distress, it should use less debt.

Bankruptcy Costs Indirect Costs of Financial Distress (continued) • Firms will tend to have higher indirect costs of financial distress if: • They sell a durable good that requires future servicing, parts, or for which a warranty is important • They take payment in advance for services rendered in the future. • They finance a lot of day to day operations with trade credit • They sell a good/service for which quality is important , but the quality is difficult for customer to gauge. • The product produced depends on complementary products produced by other suppliers. A firm in any of these situations should generally use less debt.

Industry Averages • Many firms will look at what other firms in the industry are doing with capital structure in order to gauge what they should do • This is a risk averse strategy. • Do what everyone else is doing. • If you a wrong you do not look too bad because everyone else is wrong too • But, will never get an advantage over competition. • If you assume that other firms, on average, use an optimal capital structure, this approach may be the best. • If you deviate a lot from what others are doing, may have to consider what rating agencies, analysts and banks will say

Control of Firm • The more important control of firm is to the current owners, the less likely they are to issue new equity (i.e will tend to use more debt). • Aside: The earliest instance when entrepreneurs face the prospect of giving up some control of the firm is usually when they go looking for venture capital. What form do venture capital investments usually take?

Risk Structure of Firm • Firm’s with very volatile or very cyclical earnings (or revenues) should use less debt. • If earnings are volatile, the probability of bankruptcy is greater (increases expected bankruptcy costs). • Could measure this with asset (unlevered) beta • Example: Utilities tend to have stable revenues. Utilities typically use high levels of debt

Risk Structure of Firm • The cost structure of the firm can also affect its level of risk. • In particular, firms with high operating leverage will tend to have more volatile earnings • High operating leverage occurs when fixed are high relative to variable costs Example: two firms (A and B) in same business. Volatility in their revenues is the same. Each uses different production technology. • Firm A: fixed costs = $500, variable costs = 50% of revenue • Firm B: fixed costs = $300, variable costs = 70% of revenue • A has greater operating leverage.

Risk Structure of Firm • Firm with higher operating (Firm A) leverage has more variability in EBIT • Firms with higher operating leverage should use less debt. • Note: there may be strategic trade-off between production technology chosen and financing chosen. • If utilize high fixed costs – use less debt • If decide to use more variable costs – can use more debt.

Signaling • A firm’s choice of financing can send a signal to the financial markets. • Empirically – when firms issue equity, share price drops (on average) • Market sees firm selling stock • Market believes that managers of firm have inside knowledge • “If managers are selling shares, it must be because the share price is too high.”

Signaling • Empirically – when firms increase debt, share price increases (on average) • Market sees firm increasing debt • Market believes that managers of firm have inside knowledge • “Managers would only increase debt if they knew the firm could handle the increased interest payments therefore the future must be good for the firm.”

Need for Financial Slack Asymmetric Information: managers may know more about the true value of the firm than shareholders do • Underinvestment: With asymmetric information, managers may pass up NPV > 0 projects if they cannot be financed with internal funds. (covered previously in course) • If stock (perhaps temporarily) undervalued, firm may decide not to issue new shares to finance a NPV>0 project • The fact that managers may pass up some good projects depresses current share price.

Need for Financial Slack • Financial slack = internal funds (or unused debt capacity) which the firm can use to invest in good projects when they come along. • Having financial slack is valuable • The greater the potential for NPV > 0 projects coming along, the more important is financial slack • E.g. more important in rapidly expanding industries than in mature industries

Need for Financial Slack • If the firm has financial slack, then the firm does not have to pass up good investments • Market knows that a firm with slack will take all good projects, and therefore the share price is higher. • Underinvestment can occur when firm has to issue new equity, but a similar story holds for issuing new debt too (firm may pay higher interest rate than the manager knows they really deserve to) • However, much lesser effect than for issuing new equity • Debt has less asymmetric information than equity • Leads to pecking order of financing choices for firms: • Firms use internal funds to finance projects first (or pre-arranged debt, such as line of credit). • If no internal funds, then they use new debt. • If cannot get debt, use equity.

Agency Problems • Agency problem: an agent is supposed to act on behalf of someone else. If the agent shirks their responsibilities, there is an agency problem. • Essentially, there are certain conflicts in a firm between different parties. One party may not act in the best interests of the other party. • Two types of conflicts in particular: • Conflicts between shareholders and lenders. • Conflicts between shareholders and managers.

Agency Problems Conflicts between shareholders and lenders • Underinvestment • Default Option • Covered previously in course • Because of these possibilities, lenders will charge higher rates • Limits the amount of debt a firm will take on

Agency Problems Conflict between shareholders and managers • Separation of ownership and control in a corporation • If managers have corporate cash at their disposal, they may use it for their own benefit rather than for the benefit of the shareholders as they are supposed to do. • That is, they may just waste money if they have too much around. • Debt in the capital structure forces managers to pay out excess cash.

Agency Problems • Managers must be more careful in running company well, because of the discipline imposed by debt. • If they do not run firm well, bankruptcy is possible • In terms of motivating managers: “Debt is a sword, equity a pillow”

Note: • Too much cash on hand = managers may waste it. • Not enough cash on hand = no financial slack • There is a balancing act and the correct amount of cash to have on hand depends on the characteristics of the firm and the industry.

Conclusion • Many factors to consider in determining optimal capital structure • Tax effect is quantifiable, many others are not. • Firm must weigh different factors against each other and attempt to come to a (hopefully) optimal decision.

Capital Structure