Do firms care about capital structure?

1. Do firms care about capital structure? • “Capital Structure is a … part of a much larger, value creating equation. At Sears, as in most companies, creating shareholder value is the main governing objective….There is considerable effort aimed at achieving the lowest long-term cost of capital by managing the capital structure…. That leads to a discussion in which we determine our…target capital structure…. I can tell you we have dug seriously into the capital structure question.” - Alice Peterson, Vice-President and Treasurer of Sears (1998) F305 - Capital Structure & Cost of Capital

2. Capital Structure • Think of the capital structure of the firm as an analysis of the right side of the balance sheet • The balance sheet is based on book value; capital structure on market • How does the firm finance its activities? Through the use of debt or equity? • Just as an investor views a rate of return, the firm must view its cost of capital. Expectations must be in synch. How does this effect the capital structure? F305 - Capital Structure & Cost of Capital

3. Uses of the Cost of Capital • Capital budgeting decisions • Projects • Divisions • Risk /return trade-off • Valuation of the firm • Up to now, this has always been a given in our problems! F305 - Capital Structure & Cost of Capital

4. How does capital structure affect firm value? • The value of any company is the sum of the firm’s future operating or free cash flows discounted at the firm’s cost of capital (discount rate). • Does capital structure impact operating cash flow? • Interest expense is not part of operating cash flow • Dividends or distributions to shareholders are not part of operating cash flow • Operating cash flow is based on investments in operations. • Investment and financing decisions are separate corporate decisions, but both impact value. • Does capital structure impact the firm’s cost of capital? • The cost of capital is the return investors require on their investment in the company. • Do investors require a greater return from more levered companies? F305 - Capital Structure & Cost of Capital

5. Assumptions in a Perfect Market • The following analysis assumes no market imperfections. This means • No Taxes • No Default Risk • No Agency Problems • Once we understand the perfect market, we will relax each of these assumptions and determine how things change F305 - Capital Structure & Cost of Capital

6. How Does Capital Structure Effect Firm Value in a World with No Taxes? • Let’s consider to companies, one with leverage and one without, and the choices available to the potential shareholder • COMPANY A • Has no debt • Has a market value of $8.0M • Has 400,000 shares of stock outstanding at $20 share • COMPANY B • Is identical to company A, but it has issued $4.0M in debt to buy back 200,000 shares of stock at $20/ share • Has a market value of $8.0M ($4.0M in debt/$4.0M in equity) • Now has 200,000 shares outstanding at $20 per share • Which of these companies is more attractive to a potential shareholder? F305 - Capital Structure & Cost of Capital

7. Potential Results for Companies A & B F305 - Capital Structure & Cost of Capital

8. Potential Results for Companies A & B F305 - Capital Structure & Cost of Capital

9. Does the Shareholder prefer the results of A or B? F305 - Capital Structure & Cost of Capital

10. Does the Shareholder prefer the results of A or B? • The presence of debt effects both the Shareholder’s ROE and EPS • If the shareholder can duplicate the results for both capital structures using an investment strategy, then the firm is not creating an advantage for the shareholder by changing its capital structure. • Consider the following 2 strategies: • Strategy A • Expend $2,000 to buy 100 shares of the levered firm at $20/Share • Strategy B • Expend $2,000 to but 100 shares of the Un-Levered firm at $20/share and borrow $2,000 using the proceeds to buy another 100 shares F305 - Capital Structure & Cost of Capital

11. Results of “Homemade Leverage” F305 - Capital Structure & Cost of Capital

12. How Does Capital Structure Effect Cost of Capital • The cost of capital is the weighted average of the cost of equity and the cost of debt (or any other securities). where E is the market value of equity, D is the market value of debt, and V is total market value. • We sometimes use the book value of debt as a proxy for the market value of debt when the market value of debt is unknown. F305 - Capital Structure & Cost of Capital

13. Capital Structure and Cost of Capital • So, does capital structure affect value, i.e. does it alter a firm’s weighted average cost of capital? • France Modigliani and Merton Miller won the Nobel prize for their answer to this question. They have two basic propositions re: capital structure in a world with no taxes: 1. The value of the levered firm is the same as the value of the un-levered firm. So: VU = VL 2. The expected return on equity is positively related to leverage, so the return to shareholders must increase as leverage, and consequently risk, also increase. F305 - Capital Structure & Cost of Capital

14. Capital Structure and Cost of Capital • Keeping Value Constant • If the cost of equity is greater than the cost of debt and you add more debt, shouldn’t the weighted average cost of capital decrease? • No, because the cost of equity increases with more debt in the capital structure. This is because the increased debt also increases the risk, and hence the return, to shareholders • So that the WACC is left unaffected. F305 - Capital Structure & Cost of Capital

15. Measuring Risk • According to the CAPM, the cost of equity Re depends on the firms systematic risk as measured by Be. We can measure the effect of debt on both Re and Be F305 - Capital Structure & Cost of Capital

16. Types of Risk • If you think of Re as being representative of a risk adjusted rate, then there are two elements of risk related to Re • The business risk of the firm's equity which comes from the nature of the firm's operating activities, Ra • The financial risk of the firm's equity comes from the financial policy or capital structure of the firm, (Ra - Rd) (D/E) F305 - Capital Structure & Cost of Capital

17. Changing leverage ratios without taxes • Assume that a firm has a debt to equity ratio of .4, an equity beta of 1.1, and a cost of equity 12.8% and a cost of debt of 10% • If the firm increases repurchases of stock and finances the repurchase with debt so its debt to equity ratio moves from .4 to .6, • What is the firm’s new beta? • What is the firm’s new cost of equity? • What does this mean to the WACC? • What is the change return required because of the firm’s business risk? • What is the change return required because of the firm’s financial risk? F305 - Capital Structure & Cost of Capital

18. Market Imperfections • So, in a perfect world, capital structure influences the firms financial risk and, thus, the cost of equity but not the firm’s cost of capital (WACC). • But what if the world is not perfect…. • Taxes • Interest on debt is tax deductible for Corporations. • Shareholders and Bondholders have different tax rates. • Default Risk • Debt increases the probability of Bankruptcy. • Agency Problems • Debt may alter shareholder incentives. • Debt may alter managers incentives. F305 - Capital Structure & Cost of Capital

19. Corporate Taxes • Assume I am holding $10 for you. If I put $5 in my left pocket and $5 in my right, do you care? No, (unless I have a hole in my pocket!). • Let’s pretend now that my right pocket is a magic pocket and will turn 1 dollar into 1 dollar and 25 cents. • Now, if I am holding your $10. Do you care if I hold it in my right or left pocket? • Debt is like the right pocket and the “magic” taxes. • Interest is tax deductible. Dividends are not. So, a firm can keep money from the government by having more debt rather than equity. • So, debt accomplishes 2 things • It provides an Interest deduction which reduces taxes • It creates the potential for bankruptcy F305 - Capital Structure & Cost of Capital

20. Corporate Taxes • MM recognize the impact of corporate taxes and show that: • where R(U) is the cost of capital for the un-levered firm, which is equivalent to the cost of equity for the un-levered firm since it has no debt. • This implies that firms should have 100% debt to maximize the value of the tax shield. However, other costs and benefits of debt must be considered. F305 - Capital Structure & Cost of Capital

21. Corporate Taxes • The WACC equation with corporate taxes only accounts for one benefit and none of the costs of debt. We often use this equation in our analysis. • It is important to recognize that there are other costs and benefits to debt and a firm will obviously not have 100% debt. F305 - Capital Structure & Cost of Capital

22. Corporate Taxes • Corporate Taxes reduce the financial risk of the firm. • We can also restate the relationship between beta and leverage incorporating debt. F305 - Capital Structure & Cost of Capital

23. Changing the Capital Structure • Using the WACC incorporating taxes to value the firm requires that the firm does not change its leverage ratio. If the firm’s leverage changes, then the WACC will change. • You must UNLEVER and RELEVER F305 - Capital Structure & Cost of Capital

24. Changing leverage ratios with taxes • Assume in a world with no taxes, that a firm has a debt to equity ratio of .5, an equity beta of 1.4, and a cost of equity 15.2% and a cost of debt of 10%. • If the firm increases repurchases stock and finances the repurchase with debt and its debt to equity ratio from .5 to .7, • What is the equity of the firm’s new beta? • What is the firm’s new cost of equity? • What is the change return required because of the firm’s business risk? • What is the change return required because of the firm’s financial risk? F305 - Capital Structure & Cost of Capital

25. Changing leverage ratios with taxes • Now, in addition, assume that a firm has a corporate tax rate of 30% • What happens to the firm’s WACC? • What happens to the firm’s cost of equity? • What happens to the beta of that equity? • What happens to the cash flows, and hence the valuation of the levered firm? • Assume EBIT = 1,000 • Levered firm has $1,000 in debt at an 8% interest rate in perpetuity • Levered firm has a tax rate of 30% F305 - Capital Structure & Cost of Capital

26. Accounting for Leverage in Valuation • To examine the costs and other benefits of debt and how they influence value, we must break up the value of the firm into the value of the firm if it had no debt and the value due to debt. • Note this is NOT the value of debt but the value due to having debt. F305 - Capital Structure & Cost of Capital

27. Accounting for Leverage in Valuation • Value of the levered firm = Value of the un-levered firm + Value of Debt • You can either: • Value the levered firm at the WACC, or • Value the firm as if it is un-levered at the un-levered cost of capital and add any benefits or subtract any costs of having debt. F305 - Capital Structure & Cost of Capital

28. Cost of Capital for the Levered Firm • To value the firm as a whole (A+B) • As in the cases of Smucker’s and Barnes & Noble, you would discount the FCF and terminal value at the firm’s weighted average cost of capital (WACC). • WACC is the Cost of Capital for the levered firm (A+B) E=market value of equity D=Market value of debt V=E+D F305 - Capital Structure & Cost of Capital

29. But, to Value the firm in parts (Value of A + Value of B) • Value of the un-levered firm = FCF and Terminal Value discounted at the COC for the un-levered firm r(U). • Value added by debt ? (this is not the same as the value of debt) • Must consider all of the costs and benefits of debt to derive the firm’s Optimal Capital Structure. • Corporate Taxes • Bankruptcy Costs • Agency Problems F305 - Capital Structure & Cost of Capital

30. Corporate Taxes • What is the value of debt considering only the impact of corporate taxes? • Present Value of the Interest Tax Shield • Tax Shield = Interest Paid * corporate tax rate = (Debt * rD) * tc • PV(Tax Shield) = (Debt * rD) * tc rD • The Tax Shield is a perpetuity just like the firm’s cash flows are a perpetuity. (Going Concern Assumption of Accounting) • Value added by Debt = PV(Tax Shield) = Debt * tc • If Debt=1,000 and the tax rate is 30%, the value added by debt is 300. F305 - Capital Structure & Cost of Capital

31. Default Risk • Let’s think back to the money in my right and left pocket. • Assume that there is a hole in the top of my right pocket. • If you put a little money in it – no problem • If you put too much money in the right pocket, then some will get lost • Debt is like the right pocket and the potential for bankruptcy is the hole in the pocket. • Too much debt and you will lose some of your money. F305 - Capital Structure & Cost of Capital

32. Default Risk • Debt increases the probability of Financial Distress, or Bankruptcy. • Financial distress short of bankruptcy has costs • Management time in dealing with debtholders • Time spent managing working capital • Bankruptcy has costs. • Direct Costs: Legal and Administrative • Only 1% of market value 7 years prior [Warner (1977)]. • Indirect Bankruptcy: Costs due to disruption of normal activities (ex. Business lost due to pending bankruptcy). • Approximately 12% of market value 3 years prior [Altman (1984)]. F305 - Capital Structure & Cost of Capital

33. Default Risk • Bankruptcy impacts value by the present value of the expected bankruptcy costs (estimated costs * probability of bankruptcy). • Value added by Debt = Debt * tc – PV(E[Bankruptcy Costs]) • If PV(bankruptcy cost) are $500 and the probability of bankruptcy is 5%, then the value added = 350 - (.05 * 500)=325 F305 - Capital Structure & Cost of Capital

34. Agency Problems between Shareholders and Debtholders • Shareholders incentives: • Shareholders of a levered firm may take on more risk because they have less to lose. • By doing this, they increase the value of the equity and reduce the value of debt. • Assume a firm has two choices of equal probability cashflow and the firm will distribute all cashflow (so expected CF = Value). F305 - Capital Structure & Cost of Capital

35. Agency Problems between Shareholders and Managers • Managers may waste excess cash flow (i.e. free cash flow after dividend and debt payments). • The more you have the more you spend. • Managers may invest in – NPV projects (pet projects) or consume perquisites. • Debt acts as a monitor. The more debt the less excess cash to waste. • Make use of protective covenants to protect the debtholder • Value added by Debt = Debt * tc – PV(Bankruptcy Costs) – Value loss due to excess risk taking + improved monitoring due to debt • It is more difficult to calculate these costs. F305 - Capital Structure & Cost of Capital

36. Why do debt ratios differ? • Corporate Tax shield • Same for all firms with effective tax rate • Differ if more non-debt tax shields • Bankruptcy Costs • Increase with probability of bankuptcy (risk and volatility) • Increase with cost of bankruptcy (intangibles) • Agency Problems between debtholders and shareholders • Increase with growth opportunities • Agency Problems between managers and shareholders • Increase with excess cash flow F305 - Capital Structure & Cost of Capital

37. Understanding Firms Debt Ratios • Why doesn’t Microsoft have any debt? • Benefit of tax shield out weighed by costs of debt • High growth / intangibles so greater agency problems between debtholders and equityholders. • Higher bankruptcy costs? • Probability low but cost may be high if firm is unique • Agency problems between shareholders and managers may not be an issue because of high insider ownership. • Other firms with higher than average debt to assets ratios (1997) • Benefit of tax shield > costs of debt • Dole Foods – 0.31 • General Motors – 0.41 • Sears – 0.54 F305 - Capital Structure & Cost of Capital

38. Review • To value the unlevered firm by discounting FCF and terminal value at unlevered firm’s cost of capital plus the value added by debt we need 3 things: • We know how to value debt. • We know how to calculate FCF and terminal value • How do you calculate the unlevered cost of capital? F305 - Capital Structure & Cost of Capital

39. Cost of Capital for the Unlevered Firm • If there is a tax advantage to debt, you must unlever the firms cost of equity. • If you consider personal taxes, you multiply the unlevered COC by (1- te). However, you must also do the same for the cash flow you are discounting, so they cancel each other out. • Without taxes, WACC = R(U), the return on the unlevered firm. F305 - Capital Structure & Cost of Capital

40. Valuing the levered firm • Two ways to value the levered firm. • Value unlevered firm by discounting FCF and terminal value at unlevered firm’s cost of capital plus the value added by debt (considering all costs and benefits). • Value whole firm by discounting FCF and terminal value at the levered firm’s cost of capital. • Need the levered firm’s weighted average cost of capital. • How do you incorporate other costs and benefits of debt into WACC? • Bankruptcy costs and the agency cost of debt will influence the firm’s cost of debt. • The monitoring benefit of debt will influence the cost of equity. F305 - Capital Structure & Cost of Capital

41. Optimal Capital Structure • A firm wants to choose a capital structure that maximizes firm value or minimizes the cost of capital. • This targeted debt/equity mix will be: • Greater due to corporate taxes • Affected by personal taxes (possible lower) • Lower due to bankruptcy costs. • Lower due to the risk shifting that occurs due to the agency problems between shareholders and debtholders • Greater due to debt monitoring, reduction in agency problems between managers and shareholders. F305 - Capital Structure & Cost of Capital

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