7 Things We Understand About Finance

1. 7 Things We Understand About Finance 5: Capital Structure

2. FIN 4250, Dr. Tufte 2 Having It Both Ways The point of the Modigliani-Miller theorem is that capital structure doesn�t matter except when it does It�s easy to interpret that as a cop-out, but we shouldn�t.

3. FIN 4250, Dr. Tufte 3 Borderlines In Our Thinking Conservation of value: Doesn�t bother us at all when we are talking about quarters and dollars Does bother us when we think about whether we want to be paid with a check or cash Somewhere in there is a threshold which divides our financial world: on one side things work one way, and on the other they work another way.

4. FIN 4250, Dr. Tufte 4 Modigliani-Miller Helps Us Tell Where the Borderline Is It gives conditions for determining where that borderline is It makes us a bit uncomfortable because it says that far more capital structure decisions that don�t matter than people are comfortable with.

5. FIN 4250, Dr. Tufte 5 What Are the Modigliani-Miller Assumptions? Assumptions No taxes No issuance costs No costs to bankruptcy No agency costs Not surprisingly, they find that capital structure doesn�t matter They�ve excluded all the interesting stuff

6. FIN 4250, Dr. Tufte 6 Modigliani-Miller With Taxes and Interest Write-Offs Allowing for taxes � with a write-off of interest - makes the optimal capital structure 100% debt This can�t be right, because we don�t see many projects run this way. On the other hand, it is consistent with the move towards increased leverage over the last century

7. FIN 4250, Dr. Tufte 7 (Modigliani)-Miller with Realistic Taxes On All Parties Capital structure won�t matter if: All tax rates are zero Tax rates on debt and equity are the same Taxes on personal income (which is the relevant rate for debt) are substantially higher than on corporations � making up for the double taxation of equity This isn�t too far off the facts

8. FIN 4250, Dr. Tufte 8 How Is Modigliani-Miller Helpful? It�s really saying that the cost of capital doesn�t change when you change your capital structure How is this possible? As you shift more towards an asset with a low rate, you increase the costs associated with that method as well It also means that the project decision can be made on the merits of the project, not on how it is financed

9. FIN 4250, Dr. Tufte 9 Capital Structure Might Matter, Depending On the Pros and Cons of Debt 2 Pros Taxes Discipline 3 Cons Bankruptcy Agency Flexibility

10. FIN 4250, Dr. Tufte 10 Advantages of Debt Tax benefit Because it requires a consistent cash flow, it disciplines managers

11. FIN 4250, Dr. Tufte 11 Disadvantages of Debt Increased risk of loss of control (through bankruptcy) Increased potential for conflict between equity holders and debt holders Loss of flexibility for future financing

12. FIN 4250, Dr. Tufte 12 Two Views On Debt There is no optimal level of debt Strict Modigliani-Miller result Debt is preferable up to some threshold level The avenues along which Modigliani-Miller doesn�t hold in practice lead to some upper limit on debt that is not 100%

13. FIN 4250, Dr. Tufte 13 Tax Benefits of Debt Most countries have this Some try to correct for it Carrot: the U.K. - tax credit on dividends Stick: Germany - tax penalty on retained earnings

14. FIN 4250, Dr. Tufte 14 Tax Savings from Interest Payments All firms increase their value by issuing debt, since there is a positive present value associated with not paying taxes on interest you will pay in the future This gain is the tax rate expected on future earnings times the face value of debt at issue Note that this tax rate is not marginal, since it covers all the debt not just changes in debt Note that this says nothing about costs of debt

15. FIN 4250, Dr. Tufte 15 Costs of Debt Effective interest rates on debt are lower kD = r(1-t) Note that we use the marginal tax rate since we are talking about new debt Note that this is only a benefit if your actually making earnings that can be taxed.

16. FIN 4250, Dr. Tufte 16 Predictions About the Relationship of Taxes and Debt Firms that face higher tax rates should have more leverage We see this with REITs, which don�t pay corporate taxes, and are less leveraged than similar firms Firms that can shield themselves in other ways � say through depreciation � should have less debt Changes in tax rates should be correlated with changes in leverage ratios Countries with higher taxes should have more leveraged firms

17. FIN 4250, Dr. Tufte 17 How Does Debt Discipline a Firm? Free cash flows � those over which managers have some discretion � invite management inefficiency For practical purposes, there has to be some limit to how much you need to discipline your managers � so this isn�t an argument for infinite leverage

18. FIN 4250, Dr. Tufte 18 What Can We Infer From This? Managers with a preference for equity financing probably don�t want investors watching them too closely Countries in which shareholders have more power should also be ones in which leverage is higher Takeover targets are less leveraged than other firms Operating efficiency is higher in leveraged firms

19. FIN 4250, Dr. Tufte 19 When Is Bankruptcy More Likely? Operating cash flows are small relative to debt obligations Operating cash flows are relatively volatile

20. FIN 4250, Dr. Tufte 20 What Are the Direct Costs of Bankruptcy? Not very high 1% of assets held 5 years prior to bankruptcy 5% of assets at the time of bankruptcy This reflects slow dissolution of assets prior to filing Costs are higher if the firm is holding assets that are less liquid

21. FIN 4250, Dr. Tufte 21 What Are the Indirect Costs of Bankruptcy? Declining revenue associated with bankruptcy fears on the part of customers At this time (1/30/06) GM has already lost 80% of its peak market capitalization Stricter terms on payables

22. FIN 4250, Dr. Tufte 22 What Features Are Likely to Lead to Higher Indirect Costs? Sellers of products with: Long lives Lots of replacement parts Lots of service Sellers of products whose quality can�t be determined in advance Firms producing products with lots of complements

23. FIN 4250, Dr. Tufte 23 What Sort of Firms Will Use More Debt Because of the Nature of Bankruptcy Costs? Stable cash flows Debt payments that can be linked to cash flows Implicit or explicit government backup Firms whose assets are easily divisible and marketable Brand names are likely to be associated with lower debt

24. FIN 4250, Dr. Tufte 24 What Is the Agency Problem with Borrowing? Equity holders: Control decision making Prefer riskier projects (since equity is like a call option) Debt holders Can end up assuming more risk than they want to Owning a bond is like selling the company a put (option) in exchange for a risk-free note

25. FIN 4250, Dr. Tufte 25 Three Aspects of the Agency Problem Project choice Project finance Cash disbursement

26. FIN 4250, Dr. Tufte 26 The Agency Problem for Project Choice Managers devise projects and calculate hurdle rates Bondholders lend money based on hurdle rates and perceived risk of projects Once money is lent, equity holders have an incentive to find even riskier projects This transfer wealth from bondholders to equityholder Perversely, equityholders may even be interested in projects with negative NPV because they are high risk, and on net are winners for equityholders

27. FIN 4250, Dr. Tufte 27 How Do Bondholders Protect Themselves? With debt covenants that restrict the decision-making freedom of managers and equityholders

28. FIN 4250, Dr. Tufte 28 The Agency Problem for Project Finance Equityholders have the authority to give issuers of new debt priority (in bankruptcy) over existing debt This transfers some of the wealth of old debtholders to equityholders

29. FIN 4250, Dr. Tufte 29 How Do Bondholders Protect Themselves from Being �Disprioritized�? Write a put clause into the bond contract This allows the bonds to be sold back to the firm - at the holders discretion and at face value

30. FIN 4250, Dr. Tufte 30 The Agency Problem with Cash In the absence of viable projects, equityholders usually want to either: Pay out cash as dividends, or Use it to repurchase stock Debtholders prefer that cash be retained to ensure that they get paid There is evidence that bond prices go down after dividend announcements

31. FIN 4250, Dr. Tufte 31 How Do Debtholders Protect Themselves Against Poor Use of Cash? Covenants that restrict dividend rates Hybrid securities like convertible bonds

32. FIN 4250, Dr. Tufte 32 Implications of the Agency Cost Problem(s) Bond prices will be higher due to expectations of abuse Direct costs of monitoring covenants will push bond prices higher Indirect costs of foregone opportunities that covenants restrict

33. FIN 4250, Dr. Tufte 33 Loss of Flexibility How do we value this? Flexibility is more valuable when: You have more potential projects You have better potential projects Your projects will yield more volatile cash flows This is consistent with why Microsoft or Intel uses little (long-term) debt but holds much cash

34. FIN 4250, Dr. Tufte 34 How Do Firms Choose a Capital Structure? Base it on where you are in your growth cycle Look at comparable firms Use some hierarchy to help make your choices

35. FIN 4250, Dr. Tufte 35 What Are the Most Important Factors for Managers In Assuming Debt? Survey evidence (on a 1-5 scale) 5: flexibility, long-term survivability 4: predictable, maximize value, maintain independence, maintain rating 2: maintain comparability with other firms in the industry

36. FIN 4250, Dr. Tufte 36 Does Financing Mix Change Across the Firm�s Life Cycle? On net, the costs of debt appear to decline as the business grows to maturity (and into decline) Increasing factors: Tax benefits Added discipline Declining factors Bankruptcy costs Agency costs Need for flexibility

37. FIN 4250, Dr. Tufte 37 Does Financing Mix Depend On Your Industry? There is strong empirical evidence to support this This doesn�t mean this is evidence of a management strategy Each firm may be drawn to a similar capital structure by the costs and benefits of debt

38. FIN 4250, Dr. Tufte 38 Is There a Financing Hierarchy? Yes, and it appears to be related to flexibility and control In order, managers prefer to finance with Retained earnings Straight debt Convertible debt Common stock Preferred stock Convertible preferred stock

39. FIN 4250, Dr. Tufte 39 How Is Information Asymmetry Related to the Financing Hierarchy? If managers believe the stock is underpriced they may reject good projects rather than raise external funding, and vice versa This suggests that retained earnings are preferred because they allow projects to be judged on their merits rather than on the image their financing will project

40. FIN 4250, Dr. Tufte 40 What Is the Significance of the Financing Hierarchy? The street seems to use this ranking as an indicator of financial strength If you are issuing convertible preferred, it is a sign of weakness Issuing securities at all is a sign of weakness If you prefer retained earnings, and you have to issue securities, it is a sign you aren�t doing well enough to support the projects coming your way