Capital Structure

1. Capital Structure TIP If you do not understand something, ask me! Debt or equity? That is the question.

2. Capital Restructuring • We are going to look at how changes in capital structure affect the value of the firm, all else equal • Capital restructuring involves changing the amount of leverage a firm has without changing the firm’s assets • Increase leverage by issuing debt and repurchasing outstanding shares • Decrease leverage by issuing new shares and retiring outstanding debt

3. Choosing a Capital Structure • What is the primary goal of financial managers? • Maximize stockholder wealth • We want to choose the capital structure that will maximize stockholder wealth • We can maximize stockholder wealth by maximizing firm value (or equivalently minimizing WACC).

4. Optimal Capital Structure • Objective: Choose capital structure (the mix of debt v. common equity) at which stock price is maximized. • Trades off higher ROE and EPS against higher risk. The tax-related benefits of leverage are offset by the debt’s risk-related costs.

5. What effect does increasing debt have on the cost of equity for the firm? • If the level of debt increases, the riskiness of the firm increases. • The cost of debt will increase because bond rating will deteriorates with higher debt level. • Moreover, the riskiness of the firm’s equity also increases, resulting in a higher ks.

6. Capital Structure Theory Under 5 Special Cases • Case I – Assumptions • No corporate taxes • No bankruptcy costs • Case II – Assumptions • Corporate taxes • No bankruptcy costs • Case III – Assumptions • Bankruptcy costs • Corporate taxes • Case IV – Assumptions • Managers have private information • Case V – Assumptions • Managers tend to waste firm money and not work hard.

7. Case I: Ignoring taxes and Bankruptcy Cost • The value of the firm is NOT affected by changes in the capital structure • The cash flows of the firm do not change, therefore value doesn’t change • The WACC of the firm is NOT affected by capital structure • In this case, capital structure does not matter.

8. Figure 13.3

9. Case II consider taxes but ignore bankruptcy cost • Interest expense is tax deductible • Therefore, when a firm adds debt, it reduces taxes, all else equal • The reduction in taxes increases the firm value. Other things equal, The less tax paid to the IRS, the better off the firm.

10. Case II consider taxes but ignore bankruptcy cost • The value of the firm increases by the present value of the annual interest tax shield • Value of a levered firm = value of an unlevered firm + PV of interest tax shield (VL = VU + DTC) • The WACC decreases as D/E increases because of the government subsidy on interest payments

11. Figure 13.4

12. Just note the red line (WACC) in this figure

13. Case III consider both taxes and bankruptcy cost • Now we add bankruptcy costs • As the D/E ratio increases, the probability of bankruptcy increases. This increased probability will increase the expected bankruptcy costs

14. Bankruptcy Costs (financial distress cost) • Direct bankruptcy costs • Legal and administrative costs • Creditors will stop lending money to the firm. • Indirect bankruptcy costs • Larger than direct costs, but more difficult to measure and estimate • Also have lost sales, interrupted operations and loss of valuable employees

15. Capital Structure Theory Value of Stock Only consider taxes Actual (consider both) Ignore taxes and bankruptcy D/A 0 D1 D2

17. Case III (also called Modigliani-Miller static Theory) • The graph shows MM’s tax benefit vs. bankruptcy cost theory. • With more debt, initially firm will benefit from tax reduction. • With high debt, the threat of financial distress causes the cost of debt to rise. • As financial conditions weaken, expected costs of financial distress can be large enough to outweigh the tax shield of debt financing. • Optimal debt level is some trade-off point.

18. Conclusions • Case I – no taxes or bankruptcy costs • No optimal capital structure. Debt level does not matter. • Case II – corporate taxes but no bankruptcy costs • Optimal capital structure is 100% debt • More debt—more tax shield—higher firm value. • Case III – corporate taxes and bankruptcy costs • Optimal capital structure is part debt and part equity • Occurs where the marginal tax benefit from debt is just offset by the increase in bankruptcy costs

19. 3 cases

20. Case IV--Incorporating signaling effects • When managers know private information about the firm’s future than the market, there is a signaling effect. • Signaling theory suggests when firms issue new stocks, stock price will fall. (why? Next 2 slides) • firms should maintain a lower debt level so that in case the firm needs to raise money in the future, it can issue debt rather than sell new stocks.

21. What are “signaling” effects in capital structure? • Assume: • Managers have better information about a firm’s long-run value than outside investors. • Managers act in the best interests of current stockholders. If you anticipate a big profit in the future, do you want to share it with other people ? If you anticipate a big loss in the future, do you want to share it with other people? • But outside investors are not stupid. They view a common stock offering as a negative signal--managers think stock is overvalued.

22. Case V—High debt constrains managers’ bad behavior • Managers tend to spend a lot of cash on lavish offices, corporate jets, etc. • When would you more likely to go to a lavish restaurant? 1. After receiving a salary. 2. After receiving a lot of credit card bills. • With more debt, the need to pay interest and the threat of bankruptcy remind managers to waste less and work harder. • The fact that managers are not born to work whole heartedly for stockholders suggests using more debt.

23. Observed Capital Structure: what is the reality? • Capital structure does differ by industries. Even for firms in same industry, capital structures may vary widely. • Differences according to Cost of Capital 2000 Yearbook by Ibbotson Associates, Inc. • Lowest levels of debt • Drugs with 2.75% debt • Computers with 6.91% debt • Highest levels of debt • Steel with 55.84% debt • Department stores with 50.53% debt • You can find information about a company’s capital structure relative to its industry, sector and the S&P 500 at Yahoo Marketguide

24. Quick Quiz Q1: What is the optimal capital structure in the 5 cases discussed in this chapter? Q2: How would these factors affect the target capital structure? • High corporate tax rate?increase • High bankruptcy costs?decrease • Management spending lots of money on lavish perks?increase