Capital Structure

1. Capital Structure

2. What finance functions add the most to firm value?

3. Corporate Financing • We have been focusing on investment decision • What should the firm buy? • Now we are turning to the financing decision • How does the firm pay for it?

4. How do Firms Pay for Stuff • Companies prefer to use the cash they generate • This account for about 70-90% of all purchases • If cash is insufficient they sell securities

5. The Capital-Structure • Addresses: What securities should the firm sell • This determines how the firm’s cash flows are divide • Capital Structure becomes important if the division affects the size of the cash flows • Remember: A firm is simply worth the PV of its expected future cash flows to investors G S B

6. The Value of E and D • E: The PV of cash flows to equity holders • If a company pays $1.5 mil. in dividends each year (re=8%) E = • D: The PV of the cash flows to debt holders • If a company pays $0.75 mil. in interest each year (rd=4%) D = • V =

7. Cap Structure and Value While capital structure appears to influence firm value in the real world to understand how/why we need to start with a situation where it doesn’t

8. Modigliani-Miller Proposition 1 Capital Structure DOES NOT MATTER VL = VU

9. 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

10. MM Investment 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

11. MM Intuition • Suppose Vl < Vu • Consider a 1% investment in EU • Cost = 1% EU = • Payoff = 1% Earnings = • Now buy 1% of EL & 1% of DL • Cost = 1% EL +1%DL= Payoff • Receive 1%*Interest= Receive 1%*(Earnings -Int)= • Total dollar payoff = • Can Vl < Vu?

12. If Vl < Vu then • An investor can purchase a claim in the levered firm with the same payoff as a claim in the un-levered firm, for a lower price! • This situation is impossible in a well functioning capital market (arbitrage) • Investors will buy Vl and sell it for Vu until Vl = Vu

13. MM Intuition the Other Way • Suppose Vl > Vu • Consider a1% investment in El • Cost = 1% EL = • Payoff = 1%(Earnings –Int)= • Alt. buy 1% EU, & borrow1% of DL • Cost= 1%Vu-1%DL= Payoff • Owe 1%*Interest= • Receive 1%* Earnings = • Total dollar payoff =

14. If Vl > Vu then • In perfect capital markets the inequality cannot hold. Since both strategies have the same payoff, they should cost the same.

15. On balance • We showed how we can take positions in the levered and un-levered company that generate the same payoff, but which only costs the same if the two firms have the same firm value • The law of one price states that investments with the same payoffs need to cost the same, therefore the two firms must be equally valuable

16. MM 1 Cash Flow Proof • Two firms • Earn $1,000 • Unlevered • re = 10% • Levered • re = 15% • rd = 5% • D= 5,000

17. V D/V Main result in this “perfect world” The value of the firm is independent of its capital structure

18. Investors and Capital Structure • While leverage does not affect the risk of the overall firm, it does affect investors’ risks • Leverage increases:

19. MM Proposition 2: D/E and re,βe • As leverage increases so does financial risk • D/E relation 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)

20. βe Break-Down e= a + D/E * (a - d) • a: • D/E * (a - d):

21. Re Ra Rd MM 2: Graph • Look familiar?

22. Question 1 • Shareholders demand a higher rate of return than bondholders. As debt is cheaper, we should increase the D/V ratio as it reduces ra. True or False?

23. Question 2 • As the firm borrows more and debt becomes riskier, both shareholders and bondholders demand a higher rate of return. Thus by reducing the debt-equity ratio, we can reduce the cost of debt and the cost of equity. This makes everybody better off. True or False?

24. Cash flows and Firm Value 1 • A firm is only worth the PV of it’s cash flows to investors • Consider an un-levered firm, which has an EBIT of $1,500. • The company’s investors require a return on 12%. • Assume no taxes, what is the firm worth?

25. Cash flows and Firm Value 2 • Consider a levered firm, which has an EBIT of $1,500. • The firm owes $1,000 in interest payments/year • The company’s investors (equity and debt) require a return on 12%. • Assume no taxes, what is the firm worth?

26. More Realistic World • MM showed us that in the theoretical world capital structure does not matter • But by relaxing the MM assumptions and allowing for a more realistic world, we can see how capital structure affects firm value

27. Corporate Taxes • When we include taxes will the firm be more or less valuable than in a world without taxes?

28. Who gets paid first?

29. Example • We have two identical firms • EBIT $1,000 • L: debt of $5,000 @ 6%

30. Tax Shield’s Effect on Firm Value • The tax shield increases firm value by the present value of the tax reduction • Tax Shield = Tax Rate * Dollar Interest • PV (T.S.) = Tax Rate * Dollar Interest / rd = Tax Rate * (Debt * rd) / rd = Tax Rate * Debt = 0.4 * 5,000 = $2,000

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

32. Cash flows and Firm Value 3 • 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?

33. Cash flows and Firm Value 4 • Consider a levered firm, which has an EBIT of $1,500. • The firm owes $1,000 in interest • The company’s investors (equity and debt) require a return on 12%. • Taxes are 34%, what is the firm worth?

34. Personal Taxes • Investors also pay taxes • The firm is only worth the present value of the cash investors put in their pocket • The firm wants to minimize total taxes paid • Corporate and personal

35. Personal Taxes

36. Personal Taxes and the Tax Shield • The inclusion of personal taxes generally reduces the value of the tax shield because interest is generally taxed more heavily than equity at the personal level • The preferential tax treatment of capital gains on the personal level reduces the value of the debt tax shield • PV(Tax Shield) < D*Tc

37. Including Personal Taxes Vl = Vu + D {1-[(1-Tc)(1-Te)/(1-Td)]} • This account for the investor’s preference for equity income over debt income • (1-Tc)(1-Te): Represents the after-tax return ($) from $1 in equity income • (1-Td): Represents the after-tax return ($) from $1 in debt income

38. Cash flows and Firm Value 5 • Consider a levered firm, which has an EBIT of $1,500. The firm owes $1,000 in interest. The company’s investors (equity and debt) require a return on 12%. • Taxes are: Corp 34%, Income 20%, Equity 15% • D = • E = • Vl =

39. Bankruptcy Costs • Direct Costs: Legal and Administrative costs • These are small • Indirect Costs: Impaired ability to conduct business • These are BIG • Start when a firm becomes Financially Distressed • Bankruptcy costs increase with debt, making more debt less attractive • Shareholders pay these costs

40. Agency Costs • In addition to bankruptcy costs, when a firm becomes financially distressed the conflict between bondholders and stockholders increases • This can result in managers playing games • Who is the manager likely to side with?

41. 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?

42. 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 $___

43. 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? • Will the firm take the project?

44. 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 $__

45. 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 pay themselves

46. 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?

47. 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

48. 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)

49. Trade-Off Graph Market Value of the Firm Bankruptcy Costs Agency Costs PV of Tax Shield Unlevered Firm Debt

50. 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