Capital Structure

1. Capital Structure

2. MODIGLIANI AND MILLER • ANY COMBINATION OF SECURITIES IS AS GOOD AS ANY OTHER • EXAMPLE: TWO FIRMS, SAME OPERATING INCOME • DIFFER ONLY IN CAPITAL STRUCTURE • FIRM U UNLEVERED, VU = EU • FIRM L IS LEVERED, EL = VL - DL

3. MODIGLIANI AND MILLER • TWO STRATEGIES • STRATEGY 1 • BUY 1% OF FIRM U’s EQUITY • DOLLAR INVESTMENT .01 VU • DOLLAR RETURN .01 PROFITS • STRATEGY 2 • BUY 1% OF FIRM L’s EQUITY AND DEBT • DOLLAR INVESTMENT .01DL + .01EL = .01VL • DOLLAR RETURN FROM OWNING 01DL .01 INTEREST FROM OWNING .01EL .01 (PROFITS - INTEREST) TOTAL .01 PROFITS • BOTH STRATEGIES HAVE SAME PAYOFF • SAME PRICE, VU = VL

4. MODIGLIANI AND MILLER • STRATEGY 3 • BUY 1% OF FIRM L’s EQUITY • DOLLAR INVESTMENT .01 EL = .01(VL - DL) • DOLLAR RETURN .01 (PROFITS - INTEREST) • STRATEGY 4 • BUY 1% OF FIRM U’s EQUITY • BORROW ON YOUR OWN ACCOUNT .01DL • DOLLAR INVESTMENT .01(VU - DL) • DOLLAR RETURN FROM BORROWING 01DL -.01 INTEREST FROM OWNING .01EL .01 (PROFITS TOTAL .01 (PROFITS-INTEREST) • BOTH STRATEGIES AGAIN PROMISE SAME PAYOFF • MUST HAVE SAME COST .01(VL - DL) = .01(VU - DL) AND VU = VL

5. MODIGLIANI AND MILLER • DOESN’T MATTER WHAT RISK PREFERENCES ARE OF INVESTORS • ONLY CONDITION IS THAT INVESTORS CAN BORROW OR LEND FOR THEIR OWN ACCOUNT • UNDO EFFECT OF ANY CHANGES IN FIRM’S CAPITAL STRUCTURE • MM PROPOSITION 1 • VALUE OF FIRM INDEPENDENT OF ITS CAPITAL STRUCTURE • CAN ALSO BE PROVED USING CAPM (APPENDIX)

6. VALUE ADDITIVITY • WE CAN SLICE A CASH FLOW INTO AS MANY PARTS AS WE LIKE • SUM OF THE PRESENT VALUE OF THE PARTS ALWAYS EQUAL TO PRESENT VALUE OF THE ORIGINAL STREAM • LAW OF CONSERVATION OF VALUE • FIRM VALUE IS DETERMINED BY LEFT HAND SIDE OF BALANCE SHEET BY REAL ASSETS • REGARDLESS OF CLAIMS AGAINST IT • SHOULD FIRM ISSUE PREFERRED OR COMMON STOCK? • PROPOSITION 1 SAYS CHOICE IS IRRELEVANT • IF IT DOESN’T AFFECT INVESTMENT, BORROWING AND OPERATING POLICIES

7. HOW LEVERAGE AFFECTS RETURNS • EXPECTED RETURN ON THE ASSETS OF A FIRM rA = EXPECTED OPERATING INCOME MARKET VALUE OF ALL SECURITIES • SUPPOSE INVESTOR HOLDS ALL DEBT AND EQUITY OF THE COMPANY • EXPECTED RETURN ON PORTFOLIO, rA , IS WEIGHTED AVERAGE OF EXPECTED RETURNS ON INDIVIDUAL SECURITIES rA = (D/D+E)rD + (E/D+E)rE rE = rA + (D/E)(rA - rD) MM PROPOSITION 2 EXPECTED RETURN ON EQUITY = EXPECTED RETURN ON ASSETS + DEBT - EQUITY RATIO x (EXPECTED RETURN ON ASSETS -EXPECTED RETURN ON DEBT)

8. LEVERAGE AND THE EXPECTED RETURN ON EQUITY AS LEVERAGE INCREASES, VA AND rA ARE UNCHANGED BUT THE EXPECTED RETURN ON EQUITY INCREASES FOR RISKY DEBT, rD INCREASES AS LEVERAGE INCREASES Expected return rE rA rD Debt-equity ratio (D/E)

9. rE • INCREASE IN EXPECTED EQUITY RETURN REFLECTS INCREASED RISK • INCREASE IN LEVERAGE INCREASES AMPLITUDE OF VARIATIONS IN CASH FLOWS AVAILABLE TO SHAREHOLDERS • SAME CHANGE IN OPERATING INCOME NOW DISTRIBUTED AMONG FEWER SHARES • WE CAN UNDERSTAND THE INCREASED RISK IN TERMS OF s WE KNOW THAT A= (D/D + E)D + (E/D + E)E E = A + (D/E)(A - D )

10. INTEREST TAX SHIELD • DISCOUNT INTEREST TAX SHIELD AT EXPECTED RATE OF RETURN DEMANDED BY INVESTORS HOLDING THE FIRM’S DEBT • PV (TAX SHIELD) = 28/.08 = $350 • MORE GENERALLY, PV (TAX SHIELD) = TAX RATE x INTEREST PAYMENT / DISCOUNT RATE = TC (rDD) /rD = TCD • VALUE OF FIRM INCREASES BY PV(TAX SHIELD)

11. INTEREST TAX SHIELD • WHY DID WE SEEM TO DISCOUNT TAX SHIELD BY PRE-TAX INTEREST RATE OF 8%? • PERSONAL TAXES REDUCE THE VALUE OF THE TAX-SHIELD TO THE INVESTOR • BUT THE APPROPRIATE AFTER-TAX DISCOUNT RATE IS ALSO LOWER PV (TAX SHIELD = TC (rDD)(1-TP) / rD(1-TP) = TCD WHICH WAS OUR ORIGINAL FORMULA

12. MM PROPOSITION 1 WITH TAXES • VALUE OF FIRM = VALUE IF ALL-EQUITY-FINANCED + PV(TAX SHIELD) • SPECIAL CASE OF PERMANENT DEBT VALUE OF FIRM = VALUE IF ALL-EQUITY-FINANCED +TCD

13. COSTS OF FINANCIAL DISTRESS • FIRM HAS DIFFICULTY MEETING ITS FINANCIAL OBLIGATIONS • OR CANNOT MEET ITS OBLIGATIONS • SOMETIMES LEADS TO BANKRUPTCY • INVESTORS MAY BE CONCERNED THAT LEVERED FIRM MAY FALL INTO FINANCIAL DISTRESS VALUE OF FIRM = VALUE IF ALL EQUITY-FINANCED + PV(TAX SHIELD) - PV(COSTS OF FINANCIAL DISTRESS) • COSTS OF FINANCIAL DISTRESS DEPEND ON: • PROBABILITY OF DISTRESS • MAGNITUDE OF COSTS ENCOUNTERED IF DISTRESS OCCURS

14. COSTS OF FINANCIAL DISTRESS REDUCETHE OPTIMAL DEBT RATIO Firm Value PV Tax Shield PV Costs Of Distress Value of levered firm Value If All Equity Financed Optimum Debt Ratio

15. OPTIMAL CAPITAL STRUCTURE • PV OF TAX SHIELD GRADUALLY INCREASES AS FIRM BORROWS MORE • AT MODERATE DEBT LEVELS PV(FINANCIAL DISTRESS) SMALL • TAX ADVANTAGES DOMINATE • WITH MORE DEBT, PROBABILITY OF FINANCIAL DISTRESS INCREASES • ALSO TAX ADVANTAGE OF DEBT STARTS TO DECLINE AS FIRM CAN NO LONGER BE SURE OF PROFITING FROM THE TAX SHIELD IN ALL STATES OF THE WORLD

16. COSTS OF FINANCIAL DISTRESS • BANKRUPTCY COSTS • CORPORATE BANKRUPTCY OCCURS WHEN STOCKHOLDERS EXERCISE THEIR RIGHT TO DEFAULT • VALUABLE RIGHT • WHEN A FIRM GETS INTO TROUBLE, STOCKHOLDERS CAN WALK AWAY • FORMER CREDITORS BECOME THE NEW STOCKHOLDERS

17. COSTS OF DISTRESS VARY WITH TYPE OF ASSET • YOUR COMPANY OWNS HOTEL • OCCUPANCY FALLS • FIRM GOES BANKRUPT • MORTGAGE HOLDER SELLS TO NEW OWNER • LOW BANKRUPTCY COSTS • LEGAL AND COURT FEES • HOTEL BUSINESS UNAFFECTED BY BANKRUPTCY

18. COSTS OF DISTRESS VARY WITH TYPE OF ASSET • YOUR COMPANY OWNS ELECTRONICS COMPANY • STOCKHOLDERS MAY BE UNWILLING TO PROVIDE MORE CAPITAL IN FINANCIAL DISTRESS • MORE SERIOUS THAN FOR HOTEL • IF COMPANY GOES BANKRUPT • CREDITOR WOULD HAVE DIFFICULTY SELLING OFF ASSETS • MANY ASSETS INTANGIBLE • ALSO DIFFICULT IN CARRYING ON AS GOING CONCERN • ODDS OF DEFECTIONS BY KEY EMPLOYEES • ASSURANCES TO CUSTOMERS THAT FIRM WILL BE AROUND TO SERVICE ITS PRODUCTS

19. COSTS OF DISTRESS VARY WITH TYPE OF ASSET • SOME ASSETS, LIKE COMMERCIAL REAL ESTATE, CAN GO THROUGH BANKRUPTCY LARGELY UNSCATHED • BUT COMPANIES WITH INTANGIBLE ASSETS THAT ARE INTEGRAL PART OF FIRM AS GOING CONCERN SUFFER MAJOR LOSS IN BANKRUPTCY • REASON DEBT-EQUITY RATIOS LOW IN PHARMACEUTICAL INDUSTRY • NEEDS CONTINUED R&D • DEBT-EQUITY RATIOS ALSO LOW IN MANY SERVICE INDUSTRIES • INTANGIBLE INVESTMENTS IN HUMAN CAPITAL

20. PECKING ORDER OF FINANCING CHOICES • MANAGERS KNOW MORE ABOUT THEIR FIRM THAN OUTSIDERS • PROSPECTS, RISKS • ASYMMETRIC INFORMATION • MANAGERS KNOW MORE THAN INVESTORS • DIVIDEND SIGNALING • INVESTORS INTERPRET INCREASE IN DIVIDEND AS SIGN OF MANAGEMENT CONFIDENCE • ASYMMETRIC INFORMATION AFFECTS CHOICE BETWEEN • INTERNAL VS EXTERNAL FINANCING • ISSUING DEBT VS EQUITY

21. PECKING ORDER • LEADS TO FOLLOWING PECKING ORDER • INVESTMENTS FIRST FINANCED WITH • INTERNAL FUNDS • NEW DEBT • NEW EQUITY

22. Financial Choices Trade-off Theory - Theory that capital structure is based on a trade-off between tax savings and distress costs of debt. Pecking Order Theory - Theory stating that firms prefer to issue debt rather than equity if internal finance is insufficient.

23. Trade Off Theory & Prices 1. Stock-for-debt Stock price exchange offers falls Debt-for-stock Stock price exchange offers rises 2. Issuing common stock drives down stock prices; repurchase increases stock prices. 3. Issuing straight debt has a small negative impact.

24. Issues and Stock Prices • Why do security issues affect stock price? The demand for a firm’s securities ought to be flat. • Any firm is a drop in the bucket. • Plenty of close substitutes. • Large debt issues don’t significantly depress the stock price.

25. Pecking Order Theory Consider the following story: The announcement of a stock issue drives down the stock price because investors believe managers are more likely to issue when shares are overpriced. Therefore firms prefer internal finance since funds can be raised without sending adverse signals. If external finance is required, firms issue debt first and equity as a last resort. The most profitable firms borrow less not because they have lower target debt ratios but because they don't need external finance.

26. Pecking Order Theory Some Implications: • Internal equity may be better than external equity. • Financial slack is valuable. • If external capital is required, debt is better. (There is less room for difference in opinions about what debt is worth).