Week4
Capital Structure
CapitalStructure
References:
BerkandDeMarzo Ch.16
Lecture Outline
LectureOutline
C it l St t
CapitalStructureChoices
Ch i
MeasuringtheEffectsofLeverageonaBusiness
g
g
CostsofFinancialDistress
TheTradeoffTheory
A
AgencyCostsofLeverage
C t fL
AgencyBenefitsofLeverage
g y
g
InformationBenefitsofLeverage
CapitalStructureChoices
Whenraisingfundsfromoutsideinvestors,afirm
must choose what type of security to issue and
mustchoosewhattypeofsecuritytoissueand
whatcapitalstructuretohave
Capitalstructure
Capital structure
thecollectionofsecuritiesafirmissuestoraisecapital
frominvestors
Firmsconsiderwhetherthesecuritiesissued:
Willreceiveafairpriceinthemarket
Havetaxconsequences
Entailtransactionscosts
Changefutureinvestmentopportunities
Afirmsdebttovalueratioisthefractionof
p
thefirmstotalvaluethatcorrespondstodebt
D/(E+D)
Figure15.6DebttoValueRatio
[D/(E+D)]ofU.S.Firms,19752011
Source:Compustat andFederalReserve,FlowofFundsAccountsoftheUnited
States,2012.
Figure15.7DebttoValueRatio[D/(E
+D)]forSelectIndustries
Source:CapitalIQ,2012.
MeasuringtheEffectsofLeverageona
Business
LeveragedRecapitalization:
d
i li i
Achangeincapitalstructureorownership
compositioninvolvingsubstantialdebtfinancing
iti i l i
b t ti l d bt fi
i
Examples:
Issuingdebtandusingtheproceedstofinancealarge
projectoracquisition
Issuingdebtandusingtheproceedstopayadividend
I i d b
d i
h
d
di id d
toequityholders
Issuingdebtandusingtheproceedstorepurchase
Issuing debt and using the proceeds to repurchase
shares
M&M
Modigliani
and
Miller
(MM)
ProposiNon
I:
c Interest
(rd D)
= c
rd
rd
= c D
E
D
=
rE +
rD (1 c )
E + D
E + D
rwacc =
rU
D
rD c
E
+
D
This
assumes
that
capital
structure
is
staying
at
a
given
target
(Say
D/V=50%)
and
not
changing
(for
the
life
of
the
rm
or
project
Pretax WACC
Reduction Due
to Interest Tax Shield
Example
Midco Industriescurrentlyhas20million
g
p
sharesoutstandingwithamarketpriceof$15
pershareandnodebt.Midco hashad
consistently stable earnings and pays a 35%
consistentlystableearnings,andpaysa35%
taxrate.Managementplanstoborrow$100
million on a permanent basis and they will use
milliononapermanentbasisandtheywilluse
theborrowedfundstorepurchase
outstandingshares.
IfMidco borrows$100millionusing
p
permanentdebt,thepresentvalueofthe
,
p
firmsfuturetaxsavingsis
PV(interesttaxshield)=
PV(i t
tt
hi ld) cD =35%
35% $100million
$100 illi
=$35million
Thusthetotalvalueoftheleveredfirmwillbe
VL =V
VU + cD =$300million+$35million
$300 million + $35 million =$335
$335
million
Becausethevalueofthedebtis$100million,
q y
thevalueoftheequityis
E= VL D =$335million$100million=$235
million
Althoughthevalueofthesharesoutstanding
p
dropsto$235million,shareholderswillalso
receivethe$100millionthatMidco willpay
out through the share repurchase
outthroughthesharerepurchase.
Intotal,theywillreceivethefull$335million,
y
againof$35millionoverthevalueoftheir
shares without leverage
shareswithoutleverage.
It
Itwillthenhave13.33millionshares
will then have 13 33 million shares
outstanding.
20million6.67million=13.33million
Thetotalvalueofequityis$235million;
p
thereforethenewsharepriceis
$17.625/share.
$235million
$235 million 13.33millionshares=$17.625
13 33 million shares = $17 625
Shareholders
Shareholdersthatkeeptheirsharesearna
that keep their shares earn a
capitalgainof$2.625pershare.
$17.625
$
$
$15=$2.625
$
Thetotalgaintoshareholdersis$35million.
$2.625/share
$2.625/share 13.33millionshares
13.33millionshares=$35million
$35million
Ifthesharesareworth$17.625/shareafter
therepurchase,whywouldshareholders
tender their shares to Midco at$15/share?
tendertheirsharestoMidco
at $15/share?
No Arbitrage Pricing
NoArbitragePricing
Ifinvestorscouldbuysharesfor$15immediately
y
$
y
beforetherepurchase,andtheycouldsellthese
sharesimmediatelyafterwardatahigherprice,
y
g
p ,
thiswouldrepresentanarbitrageopportunity.
Realistically, the value of the Midcoss equitywill
equity will
Realistically,thevalueoftheMidco
riseimmediatelyfrom$300millionto$335
millionaftertherepurchaseannouncement.
p
With20millionsharesoutstanding,theshare
price will rise to $16.75 per share.
pricewillriseto$16.75pershare.
$335million 20millionshares=$16.75pershare
Witharepurchasepriceof$16.75,the
shareholderswhotendertheirsharesandthe
shareholders who hold their shares both gain
shareholderswhoholdtheirsharesbothgain
$1.75pershareasaresultofthetransaction.
$16.75$15=$1.75
$16 75 $15 $1 75
Thebenefitoftheinteresttaxshieldgoestoall
20 million of the original shares outstanding for a
20millionoftheoriginalsharesoutstandingfora
totalbenefitof$35million.
$1.75/share 20millionshares=$35million
Whensecuritiesarefairlypriced,theoriginal
shareholdersofafirmcapturethefullbenefitof
f f
p
f
f f
theinteresttaxshieldfromanincreasein
leverage.
RelaxingMoreAssumptions:Costsof
FinancialDistress
Ifincreasingdebtincreasesthevalueofthe
y
firm,whynotshiftto100%debt?
Withmoredebt,thereisagreaterchancethat
the firm will default on its debt obligations
thefirmwilldefaultonitsdebtobligations.
Afirmthathastroublemeetingitsdebt
obligationsisinfinancialdistress.
TheCostsofBankruptcy
andFinancialDistress
With
Withperfectcapitalmarkets,theriskof
f t
it l
k t th i k f
bankruptcyisnotadisadvantageofdebt:
Bankruptcyshiftstheownershipofthefirmfrom
equityholderstodebtholderswithoutchanging
th t t l l
thetotalvalueavailabletoallinvestors.
il bl t ll i
t
Bankruptcy
Bankruptcyisrarelysimpleand
is rarely simple and
straightforward.
Itisoftenalongandcomplicatedprocessthat
It is often a long and complicated process that
imposesbothdirectandindirectcostsonthefirm
anditsinvestors.
Chapter 7 Liquidation
Chapter7Liquidation
Atrusteeisappointedtooverseethe
q
g
liquidationofthefirmsassetsthroughan
auction.
Theproceedsfromtheliquidationareusedto
p y
paythefirmscreditors,andthefirmceasesto
exist
Chapter 11 Reorganization
Chapter11Reorganization
Ch
Chapter11isthemorecommonformof
t 11 i th
f
f
bankruptcyforlargecorporations.
WithChapter11,allpendingcollection
attemptsareautomaticallysuspended,and
thefirmsexistingmanagementisgiventhe
opportunitytoproposeareorganizationplan.
Whiledevelopingtheplan,management
continuestooperatethebusiness.
Thereorganizationplanspecifiesthe
treatmentofeachcreditorofthefirm.
C
Creditorsmayreceivecashpaymentsand/ornew
dit
i
h
t
d/
debtorequitysecuritiesofthefirm.
Th
Thevalueofthecashandsecuritiesistypicallyless
l
f th
h d
iti i t i ll l
thantheamounteachcreditorisowed,butmorethan
thecreditorswouldreceiveifthefirmwereshutdown
immediatelyandliquidated.
Thecreditorsmustvotetoaccepttheplan,andit
p
p ,
mustbeapprovedbythebankruptcycourt.
If
Ifanacceptableplanisnotputforth,thecourt
an acceptable plan is not put forth the court
mayultimatelyforceaChapter7liquidation
Thedirectcostsofbankruptcyreducethe
valueoftheassetsthatthefirmsinvestors
willultimatelyreceive.
Theaveragedirectcostsofbankruptcyare
h
di
fb k
approximately3%to4%oftheprebankruptcy
marketvalueoftotalassets.
k
l
f
l
Giventhedirectcostsofbankruptcy,firms
y
g
p y y
mayavoidfilingforbankruptcybyfirst
negotiatingdirectlywithcreditors.
Workout
Amethodforavoidingbankruptcyinwhichafirm
infinancialdistressnegotiatesdirectlywithits
creditorstoreorganize
Thedirectcostsofbankruptcyshouldnotsubstantially
exceedthecostofaworkout.
PrepackagedBankruptcy(Prepack)
Amethodforavoidingmanyofthelegalandother
A method for avoiding many of the legal and other
directcostsofbankruptcyinwhichafirmfirst
develops a reorganization plan with the
developsareorganizationplanwiththe
agreementofitsmaincreditorsandthenfiles
Chapter 11 to implement the plan
Chapter11toimplementtheplan
Withaprepackagedbankruptcy,thefirmemergesfrom
bankruptcy quickly and with minimal direct costs
bankruptcyquicklyandwithminimaldirectcosts.
Th
Theindirectcostsoffinancialdistressmay
i di t
t f fi
i l di t
besubstantial.
It
Itisestimatedthatthepotentiallossduetofinancial
is estimated that the potential loss due to financial
distressis10%to20%offirmvalue
When
Whenestimatingindirectcosts,twoimportantpoints
estimating indirect costs two important points
mustbeconsidered.
Losses
Lossestototalfirmvalue(andnotsolelylossestoequity
to total firm value (and not solely losses to equity
holdersordebtholders,ortransfersbetweenthem)must
beidentified.
Theincrementallossesthatareassociatedwithfinancial
distress,aboveandbeyondanylossesthatwouldoccur
,
duetothefirmseconomicdistress,mustbeidentified.
Example:Moon Industries
Considerthefollowingoutcomesbothforthe
C
id th f ll i
t
b th f th
followingscenarioswithandwithoutleveragefor
Moon Industriesnewventure:
MoonIndustries
new venture:
ValueofDebtandEquitywithandwithoutLevearge
($million)
With t L
WithoutLeverage
With L
WithLeverage
Success Failure Success Failure
Debtvalue
$150
$90
Equityvalue
$250
$90
$100
$0
Totaltoallinvestors
$250
$90
$250
$90
Assume:
Moonsnewventureisequallylikelytosucceedorto
fail.
Theriskfreerateis4%.
Theventurehasabetaof0andthecostofcapitalis
equaltotheriskfreerate.
q
.5($250) .5($90)
Equity (unlevered) V
$163.46 million
1 04
1.04
U
.5($100)
5($100) .5($0)
5($0)
Equity (Levered) V
$48.08 million
1.04
L
.5($150) .5($90)
Debt
$115.38 million
1 04
1.04
VL =$48.08+$115.38
$48.08 + $115.38 =$163.46
$163.46
AsstatedbyMMPropositionI,thetotalvalueofthe
fi i
firmisunaffectedbyleverage.
ff t d b l
assumenowthatthecostsoffinancialdistressare
$15million:
ValueofDebtandEquitywithandwithoutLevearge
($ million)
($million)
WithoutLeverage
WithLeverage
Success Failure Success Failure
Debtvalue
$150
$75
Equityvalue
$250
$90
$100
$0
Total to all investors
Totaltoallinvestors
$250
$90
$250
$75
ComputethevalueofMoon
Compute
the value of Moonsssecuritiesatthe
securities at the
beginningoftheyearwithandwithoutleverage
giventhatfinancialdistressiscostly.
.5($250) .5($90)
Equity (unlevered) V
$163.46 million
1 04
1.04
U
.5($100) .5($0)
Equity (Levered) V
$48.08
$48 08 million
1.04
L
.5($150)
5($150) .5($75)
5($75)
Debt
$108.17 million
1.04
VL =$48.08+$108.17=$156.25
VL V
VU inthepresenceoffinancialdistresscosts.
in the presence of financial distress costs
Thedierence,($163.46$156.25=$7.21),isthe
presentvalueofthe$15millioninfinancialdistress
costs:
.5($0) .5($15)
PV(Financial Distress Costs)
$7
$7.21
21 million
1.04
Ifthedebtholdersinitiallypaylessforthe
f h d b h ld i i i ll
l
f h
debt,thereislessmoneyavailableforthe
fi t
firmtopaydividends,repurchaseshares,
di id d
h
h
andmakeinvestments.
Thisdifferencecomesoutoftheequity
holderspockets.
Whensecuritiesarefairlypriced,theoriginal
shareholdersofafirmpaythepresentvalueof
thecostsassociatedwithbankruptcyand
financialdistress
OptimalCapitalStructure:
TheTradeoffTheory
The firm picks its capital structure by trading off the
benefits of the tax shield from debt against the costs of
fi
financial
i l distress
di
and
d agency costs.
The total value off a levered ffirm equals
q
the value off the
firm without leverage plus the present value of the tax
savings from debt, less the present value of financial
distress costs.
Theprobabilityoffinancialdistressincreaseswiththe
amountofafirmsliabilities(relativetoitsassets).
(
)
Theprobabilityoffinancialdistressincreaseswiththe
volatilityofafirmscashflowsandassetvalues.
2. Themagnitudeofthecostsafterafirmisindistress.
Financialdistresscostswillvarybyindustry.
Technology
Technologyfirmswilllikelyincurhighfinancialdistresscostsdue
firms will likely incur high financial distress costs due
tothepotentialforlossofcustomersandkeypersonnel,aswell
asalackoftangibleassetsthatcanbeeasilyliquidated.
Realestatefirmsarelikelytohavelowcostsoffinancialdistress
y
sincethemajorityoftheirassetscanbesoldrelativelyeasily.
3.Theappropriatediscountrateforthedistress
costs.
Dependsonthefirmsmarketrisk
Notethatbecausedistresscostsarehighwhenthefirm
doespoorly,thebetaofdistresscostshastheoppositesign
tothatofthefirm.
Thehigherthefirm
The
higher the firmssbeta,themorenegativethebetaofits
beta, the more negative the beta of its
distresscostswillbe
Thepresentvalueofdistresscostswillbehigherfor
highbetafirms.
Optimal Leverage
OptimalLeverage
Forlowlevelsofdebt,theriskofdefault
l l l fd b h i k fd f l
remainslowandthemaineffectofan
increaseinleverageisanincreaseinthe
interesttaxshield.
Asthelevelofdebtincreases,theprobability
of default increases
ofdefaultincreases.
Asthelevelofdebtincreases,thecostsof
financialdistressincrease,reducingthevalue
oftheleveredfirm.
Th
Thetradeofftheorystatesthatfirmsshouldincreasetheir
t d ff th
t t th t fi
h ld i
th i
leverageuntilitreachesthelevelforwhichthefirmvalueis
maximized.
Atthispoint,thetaxsavingsthatresultfromincreasingleverage
areperfectlyoffsetbytheincreasedprobabilityofincurringthe
costs of financial distress
costsoffinancialdistress.
Thetradeofftheorycanhelpexplain
Whyfirmschoosedebtlevelsthataretoolowtofullyexploit
y
y p
theinteresttaxshield(duetothepresenceoffinancialdistress
costs)
Differences
Differencesintheuseofleverageacrossindustries(dueto
in the use of leverage across industries (due to
differencesinthemagnitudeoffinancialdistresscostsandthe
volatilityofcashflows)
OptimalLeveragewithTaxesand
FinancialDistressCosts
ExploitingDebtHolders:
TheAgencyCostsofLeverage
AgencyCosts
C
Coststhatarisewhenthereareconflictsofinterest
betweenthefirmsstakeholders
Management
Managementwillgenerallymakedecisions
will generally make decisions
thatincreasethevalueofthefirmsequity.
H
However,whenafirmhasleverage,managers
h
fi h l
maymakedecisionsthatbenefitshareholdersbut
harm the firmsscreditorsandlowerthetotal
harmthefirm
creditors and lower the total
valueofthefirm.
ConsiderBaxter,Inc.,whichisfacing
financial distress
financialdistress.
Baxterhasaloanof$1milliondueattheendoftheyear.
Withoutachangeinitsstrategy,themarketvalueofits
assetswillbeonly$900,000atthattime,andBaxterwill
default on its debt
defaultonitsdebt.
Anewstrategyrequiresnoupfrontinvestment,butithasonly
a50%chanceofsuccess.
Ifthenewstrategysucceeds,itwillincreasethevalueof
thefirmsassetto$1.3million.
Ifthenewstrategyfails,thevalueofthefirmsassetswill
fallto$300,000
The
Theexpectedvalueofthefirmsassetsunderthe
expected value of the firms assets under the
newstrategyis$800,000,adeclineof$100,000
fromtheoldstrategy.
gy
50% $1.3million+50% $300,000=$800,000
IfBaxterdoesnothing,itwillultimatelydefault
and equity holders will get nothing with certainty
andequityholderswillgetnothingwithcertainty.
EquityholdershavenothingtoloseifBaxtertriesthe
riskystrategy.
y
gy
Ifthestrategysucceeds,equityholderswill
receive $300,000 after paying off the debt.
receive$300,000afterpayingoffthedebt.
Givena50%chanceofsuccess,theequityholders
expectedpayoffis$150,000.
EEquityholdersgainfromthisstrategy,even
it h ld
i f
thi t t
thoughithasanegativeexpectedpayoff,
while debt holders lose
whiledebtholderslose.
Iftheprojectsucceeds,debtholdersarefully
repaidandreceive$1million.
d d
$
ll
Iftheprojectfails,debtholdersreceiveonly
p j
,
y
$300,000.
Thedebtholdersexpectedpayoffis$650,000,alossof
$250,000comparedtotheoldstrategy.
50% $1million+50% $300,000=$650,000
ExcessiveRiskTakingandOver
investment
Th
Thedebtholders$250,000losscorrespondsto
d bt h ld $250 000 l
d t
the$100,000expecteddeclineinfirmvaluedue
to the risky strategy and the equity holderss
totheriskystrategyandtheequityholder
$150,000gain.
EEquityholdersgainallofthepotentialbenefits,
it h ld
i ll f th
t ti l b
fit
butdebtholdersfaceallofthepotentialcosts.
Overall this is negative NPV for the firm but for
OverallthisisnegativeNPVforthefirm,butfor
equityitispositiveNPV
Effectively
Effectively,theequityholdersaregamblingwith
the equity holders are gambling with
thedebtholdersmoney.
OverinvestmentProblem
Whenafirmfacesfinancialdistress,shareholders
When a firm faces financial distress shareholders
cangainattheexpenseofdebtholdersbytaking
a negative NPV project if it is sufficiently risky
anegativeNPVproject,ifitissufficientlyrisky.
Anticipatingthisbadbehavior,securityholders
willpaylessforthefirminitially.
OutcomesforBaxtersDebtandEquitywithand
withouttheNewProject($thousands)
Ifequityholderscontribute$100,000tofundtheproject,they
g
getbackonly$50,000.
y
Theother$100,000fromtheprojectgoestothedebtholders,
whose payoff increases from $900 000 to $1 million
whosepayoffincreasesfrom$900,000to$1million.
Thedebtholdersreceivemostofthebenefit,thusthisproject
is a negative NPV investment opportunity for equity holders
isanegativeNPVinvestmentopportunityforequityholders,
eventhoughitoffersapositiveNPVforthefirm
UnderinvestmentProblem
Asituationinwhichequityholderschoosenotto
A situation in which equity holders choose not to
investinapositiveNPVprojectbecausethefirmis
in financial distress and the value of undertaking
infinancialdistressandthevalueofundertaking
theinvestmentopportunitywillaccrueto
bondholders rather than themselves
bondholdersratherthanthemselves.
Alsocalledadebtoverhangproblem(cashing
outisanexample)
NPV D D
>
I
E E
Mayhelptoreduceagencycosts
y p
g y
Mayhindermanagementflexibilityandprevent
investment in positive NPV opportunities and can
investmentinpositiveNPVopportunitiesandcan
havecostsoftheirown.
Creditorswillcloselymonitorafirms
managers,providingmoremonitoring
Reducewastefulinvestmentbyreducingfree
cashflow
Empirebuilding(managerswanttorunlargefirms
more than small firms)
morethansmallfirms)
Managersmaybeoverconfident
Petprojects,donations,etc
P t
j t d
ti
t
Wh
Whencashistight,managerswillbemotivatedto
h i ti ht
ill b
ti t d t
runthefirmasefficientlyaspossible.
Commitsthefirmtomakingfutureinterestpaymentsthus
f
f
reducescashforbadinvestments
Reduces
Reducesmanagerialentrenchmentasmanagersaremore
managerial entrenchment as managers are more
likelytobefiredwhenafirmfacesfinancialdistress.
Managers
Managersmoreconcernedabouttheirperformanceand
more concerned about their performance and
lesslikelytoengageinwastefulinvestment.
Firmbecomeafiercercompetitorandactsmore
aggressivelyinprotectingitsmarketsbecauseitcannot
riskthepossibilityofbankruptcy.
IssuingEquityandAdverseSelection
I i E it
d Ad
S l ti
AdverseSelection
Th
Theideathatwhenthebuyersandsellershave
id th t h th b
d ll h
differentinformation,theaveragequalityofassetsin
themarketwilldifferfromtheaveragequalityoverall
LemonsPrinciple
When
Whenasellerhasprivateinformationaboutthevalue
a seller has private information about the value
ofagood,buyerswilldiscountthepricetheyare
willingtopayduetoadverseselection
Eg UsedCars
d
Ifsellerknowsthecarisgood,theywillkeepit.If
itadud,theywillsellit
Buyersknowthisandonlywillpaypriceofbadcar
Equityasalemon:
Managerswhoknowtheirprospectsaregoodwill
Managers who know their prospects are good will
notissueequity(andsharethesegains)
Willfundinternallyorissuedebt
Will fund internally or issue debt
PeckingOrderHypothesis
AgencyCosts
andtheTradeoffTheory
Thevalueoftheleveredfirmcannowbe
showntobe:
V
VL =V
VU +PV(InterestTaxShield)+PV
PV (I
T Shi ld) PV
(FinancialDistressCosts)+PV(AgencyCostsof
Debt)+PV(AgencyBenefitsofDebt)+PV
(Information Benefits of Leverage)
(InformationBenefitsofLeverage)
LowGrowth,MatureFirms
Mature,lowgrowthfirmswithstablecashflowsand
tangibleassetsoftencarryahighdebtload.
Thesefirmstendtohavehighfreecashflowswithfew
goodinvestmentopportunities.
Homework
Chapter15:Problems8,10,16
Chapter16:Problems1,6,8,12,13,20,21,
Chapter 16 : Problems 1, 6, 8, 12, 13, 20, 21,
24,26,28,33
ReadChapter12
R d Ch
12