Chapter 16: Capital Structure Decisions: The Basics

Overview and preview of capital structure effects Business versus financial risk The impact of debt on returns Capital structure theory Example: Choosing the optimal structure Setting the capital structure in practice

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Basic Definitions
V = value of firm FCF = free cash flow WACC = weighted average cost of capital rs and rd are costs of stock and debt we and wd are percentages of the firm that are financed with stock and debt.

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How can capital structure affect value?

V =
t=1

FCFt
(1 + WACC)t

WACC= wd (1-T) rd + wers

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A Preview of Capital Structure Effects

The impact of capital structure on value depends upon the effect of debt on:
WACC FCF

(Continued)
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The Effect of Additional Debt on WACC

Debtholders have a prior claim on cash flows relative to stockholders.
Debtholders fixed claim increases risk of stockholders residual claim. Cost of stock, rs, goes up.

Firms can deduct interest expenses.

Reduces the taxes paid Frees up more cash for payments to investors Reduces after-tax cost of debt
(Continued)
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The Effect on WACC (Continued)

Debt increases risk of bankruptcy
Causes pre-tax cost of debt, rd, to increase

Adding debt increase percent of firm financed with low-cost debt (wd) and decreases percent financed with high-cost equity (we) Net effect on WACC = uncertain.
(Continued)
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The Effect of Additional Debt on FCF

Additional debt increases the probability of bankruptcy.
Direct costs: Legal fees, fire sales, etc. Indirect costs: Lost customers, reduction in productivity of managers and line workers, reduction in credit (i.e., accounts payable) offered by suppliers

(Continued)
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Impact of indirect costs

NOPAT goes down due to lost customers and drop in productivity Investment in capital goes up due to increase in net operating working capital (accounts payable goes down as suppliers tighten credit).

(Continued)
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 Additional debt can affect the behavior of managers.

Reductions in agency costs: debt pre-commits, or bonds, free cash flow for use in making interest payments. Thus, managers are less likely to waste FCF on perquisites or non-value adding acquisitions. Increases in agency costs: debt can make managers too risk-averse, causing underinvestment in risky but positive NPV projects.

(Continued)
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Asymmetric Information and Signaling

Managers know the firms future prospects better than investors. Managers would not issue additional equity if they thought the current stock price was less than the true value of the stock (given their inside information). Hence, investors often perceive an additional issuance of stock as a negative signal, and the stock price falls.
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Business risk: Uncertainty about future pre-tax operating income (EBIT).

Probability

Low risk High risk

0 E(EBIT)

EBIT

Note that business risk focuses on operating income, so it ignores financing effects. Cal State East Bay

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Factors That Influence Business Risk

Uncertainty about demand (unit sales). Uncertainty about output prices. Uncertainty about input costs. Product and other types of liability. Degree of operating leverage (DOL).

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What is operating leverage, and how does it affect a firms business risk?
Operating leverage is the change in EBIT caused by a change in quantity sold. The higher the proportion of fixed costs within a firms overall cost structure, the greater the operating leverage.

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Higher operating leverage leads to more business risk: small sales decline causes a larger EBIT decline.

Rev. $ TC

Rev.

EBIT } TC
F QBE

F
QBE Sales

Sales
(More...)

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Higher operating leverage leads to higher expected EBIT and higher risk.

Probability

Low operating leverage High operating leverage

EBITL
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EBITH

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Business Risk versus Financial Risk

Business risk:
Uncertainty in future EBIT. Depends on business factors such as competition, operating leverage, etc.

Financial risk:
Additional business risk concentrated on common stockholders when financial leverage is used. Depends on the amount of debt and preferred stock financing.

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Consider Two Hypothetical Firms

Firm U No debt $20,000 in assets 40% tax rate $20,000 equity Firm L $10,000 of 12% debt $20,000 in assets 40% tax rate $10,000 equity

Both firms have same operating leverage, business risk, and EBIT of $3,000. They differ only with respect to use of debt.
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Impact of Leverage on Returns

EBIT Interest EBT Taxes (40%) NI ROE
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Firm U $3,000 0 $3,000 1 ,200 $1,800 9.0%

Firm L $3,000 1,200 $1,800 720 $1,080 10.8%

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Why does leveraging increase return?

More of the EBIT goes to investors in Firm L.
Total dollars paid to investors:
U: NI = $1,800. L: NI + Int = $1,080 + $1,200 = $2,280.

Taxes paid:
U: $1,200; L: $720.

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Uncertainty
Now consider the fact that EBIT is not known with certainty. What is the impact of uncertainty on stockholder profitability and risk for Firm U and Firm L?

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Firm U: Unleveraged
Bad 0.25 $2,000 0 $2,000 800 $1,200 Economy Avg. 0.50 $3,000 0 $3,000 1,200 $1,800 Good 0.25 $4,000 0 $4,000 1,600 $2,400
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Prob. EBIT Interest EBT Taxes(40%) NI

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Firm L: Leveraged
Bad 0.25 $2,000 1,200 $ 800 320 $ 480 Economy Avg. 0.50 $3,000 1,200 $1,800 720 $1,080 Good 0.25 $4,000 1,200 $2,800 1,120 $1,680
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Prob.* EBIT Interest EBT Taxes(40%) NI

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Unlevered vs. Levered

Firm U
BEP ROIC ROE

Bad
10.0% 6.0% 6.0%

Avg.
15.0% 9.0% 9.0%

Good
20.0% 12.0% 12.0%

Firm L
BEP ROIC ROE
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Bad
10.0% 6.0% 4.8%

Avg.
15.0% 9.0% 10.8%

Good
20.0% 12.0% 16.8%
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Profitabilty Ratios
BEP (Basic earning power)=EBIT / Total assets ROIC (Return on invested capital) = NOPAT / Total Assets = EBIT (1-T) / Total assets ROE (Return on equity) = Net income / Equity
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Conclusions
Basic profitability ratios, earning power and ROIC are unaffected by financial leverage. L has much wider ROE swings because of fixed interest charges. Higher expected return is accompanied by higher risk.

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Risk and return

Profitability Measures: E(BEP) E(ROIC) E(ROE) Risk Measures: ROIC ROE
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U 15.0% 9.0% 9.0%

L 15.0% 9.0% 10.8%

2.12% 2.12%

2.12% 4.24%
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 In a stand-alone risk sense, Firm Ls stockholders see much more risk than Firm Us.
U and L: ROIC = 2.12%. U: ROE = 2.12%. L: ROE = 4.24%.

Ls financial risk is ROE - ROIC = 4.24% 2.12% = 2.12%. (Us is zero.)

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Capital Structure Theory

MM theory
Zero taxes Corporate taxes Corporate and personal taxes

Trade-off theory Signaling theory Debt financing as a managerial constraint

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MM Theory: Zero Taxes

MM prove, under a very restrictive set of assumptions, that a firms value is unaffected by its financing mix:
VL = VU. WACC=ws*rs + wd*rd As wd increases, ws decreases and rs increases. Net effect on WACC is zero.

Therefore, capital structure is irrelevant.

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MM Theory: Zero Taxes

MM prove, under a very restrictive set of assumptions, that a firms value is unaffected by its financing mix:
VL = VU. WACC=ws*rs + wd*rd As wd increases, ws decreases and rs increases. Net effect on WACC is zero.

Therefore, capital structure is irrelevant.

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MM Theory: Zero Taxes

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MM Theory: Corporate Taxes

Corporate tax laws favor debt financing over equity financing.
WACC=ws*rs + wd*rd*(1-T)

With corporate taxes, the benefits of financial leverage exceed the risks: More EBIT goes to investors and less to taxes when leverage is used. MM show that: VL = VU + TD. If T=40%, then every dollar of debt adds 40 cents of extra value to firm.
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MM relationship between value and debt when corporate taxes are considered.
Value of Firm, V V L TD V U Debt

Under MM with corporate taxes, the firms value increases continuously as more and more debt is used.
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MM relationship between capital costs and leverage when corporate taxes are considered.

Cost of Capital (%)

rs

0
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20

40

60

80

WACC rd(1 - T) Debt/Value 100 Ratio (%)

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Millers Theory: Corporate and Personal Taxes

Personal taxes lessen the advantage of corporate debt:
Corporate taxes favor debt financing since corporations can deduct interest expenses. Personal taxes favor equity financing, since no gain is reported until stock is sold, and long-term gains are taxed at a lower rate.

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Millers Model with Corporate and Personal Taxes

(1 - Tc)(1 - Ts) VL = VU + 1 (1 - Td)

]D.
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Tc = corporate tax rate. Td = personal tax rate on debt income. T = personal tax rate on stock income. s Cal State East Bay

Tc = 40%, Td = 30%, and Ts = 12%.

(1 - 0.40)(1 -.12) (1 - 0.30) VL= VU + 1 -

]D

= VU + (1 - 0.75)D
= VU + 0.25D

Value rises with debt; each $1 increase in debt raises Ls value by $0.25.
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Conclusions with Personal Taxes

Use of debt financing remains advantageous, but benefits are less than under only corporate taxes. Firms should still use 100% debt.

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Trade-off Theory
MM theory ignores bankruptcy (financial distress) costs, which increase as more leverage is used. At low leverage levels, tax benefits outweigh bankruptcy costs. At high levels, bankruptcy costs outweigh tax benefits. An optimal capital structure exists that balances these costs and benefits.

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Signaling Theory
MM assumed that investors and managers have the same information. But, managers often have better information. Thus, they would:
Sell stock if stock is overvalued. Sell bonds if stock is undervalued.

Investors understand this, so view new stock sales as a negative signal. Implications for managers?

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Debt Financing and Agency Costs

One agency problem is that managers can use corporate funds for non-value maximizing purposes. The use of financial leverage:
Bonds free cash flow. Forces discipline on managers to avoid perks and non-value adding acquisitions.
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Agency costs
A second agency problem is the potential for underinvestment.
Debt increases risk of financial distress. Therefore, managers may avoid risky projects even if they have positive NPVs.

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Choosing the Optimal Capital Structure: Example

Currently is all-equity financed. Expected EBIT = $500,000. Firm expects zero growth. 100,000 shares outstanding; rs = 12%; P0 = $25; T = 40%; b = 1.0; rRF = 6%; RPM = 6%.

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Estimates of Cost of Debt

% financed with debt, wd rd

0%
20%

8.0%

30%
40%

8.5%
10.0%

50% 12.0% If company recapitalizes, debt would be issued to repurchase stock.

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The Cost of Equity at Different Levels of Debt: Hamadas Equation

MM theory implies that beta changes with leverage. bU is the beta of a firm when it has no debt (the unlevered beta) bL = bU [1 + (1 - T)(D/S)]

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The Cost of Equity for wd = 20%

Use Hamadas equation to find beta: bL= bU [1 + (1 - T)(D/S)] = 1.0 [1 + (1-0.4) (20% / 80%) ] = 1.15 Use CAPM to find the cost of equity: rs= rRF + bL (RPM) = 6% + 1.15 (6%) = 12.9%
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Cost of Equity vs. Leverage

wd 0% 20% 30% D/S 0.00 0.25 0.43 bL 1.000 1.150 1.257 rs 12.00% 12.90% 13.54%

40% 50%
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0.67 1.00

1.400 1.600

14.40% 15.60%
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The WACC for wd = 20%

WACC = wd (1-T) rd + we rs WACC = 0.2 (1 0.4) (8%) + 0.8 (12.9%) WACC = 11.28% Repeat this for all capital structures under consideration.

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WACC vs. Leverage

wd 0% 20% 30% 40% 50%
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rd 0.0% 8.0% 8.5% 10.0% 12.0%

rs 12.00% 12.90% 13.54% 14.40% 15.60%

WACC 12.00% 11.28% 11.01% 11.04% 11.40%

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Corporate Value for wd = 20%

V = FCF(1+g) / (WACC-g) g=0, so investment in capital is zero; so FCF = NOPAT = EBIT (1-T). NOPAT = ($500,000)(1-0.40) = $300,000. V = $300,000 / 0.1128 = $2,659,574.

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Corporate Value vs. Leverage

wd 0% 20% 30% 40% WACC 12.00% 11.28% 11.01% 11.04% Corp. Value $2,500,000 $2,659,574 $2,724,796 $2,717,391

50%
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11.40%

$2,631,579
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Debt and Equity for wd = 20%

The dollar value of debt is: D = wd V = 0.2 ($2,659,574) = $531,915. S =VD S = $2,659,574 - $531,915 = $2,127,659.

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Debt and Stock Value vs. Leverage

wd Debt, D Stock Value, S

0%
20% 30% 40% 50%

$0
$531,915 $817,439 $1,086,957 $1,315,789

$2,500,000
$2,127,660 $1,907,357 $1,630,435 $1,315,789

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Wealth of Shareholders
Value of the equity declines as more debt is issued, because debt is used to repurchase stock. But total wealth of shareholders is value of stock after the recap plus the cash received in repurchase, and this total goes up (It is equal to Corporate Value on earlier slide).
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Stock Price for wd = 20%

The firm issues debt, which changes its WACC, which changes value. The firm then uses debt proceeds to repurchase stock. Stock price changes after debt is issued, but does not change during actual repurchase (or arbitrage is possible).
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Stock Price for wd = 20% (Continued)

The stock price after debt is issued but before stock is repurchased reflects shareholder wealth:
S, value of stock Cash paid in repurchase.

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Stock Price for wd = 20%

(Continued) P = S + (D D0) n0 P = $2,127,660 + ($531,915 0) 100,000 P = $26.596 per share.
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Number of Shares Repurchased

# Repurchased = (D - D0) / P # Rep. = ($531,915 0) / $26.596 = 20,000. # Remaining = n = S / P n = $2,127,660 / $26.596 = 80,000.

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Price per Share vs. Leverage

# shares wd P Repurch. # shares Remaining

0%
20%

$25.00
$26.60

0
20,000

100,000
80,000

30%
40% 50%
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$27.25
$27.17 $26.32

30,000
40,000 50,000

70,000
60,000 50,000
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Optimal Capital Structure

wd = 30% gives:
Highest corporate value Lowest WACC Highest stock price per share

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Empirical Evidence
Tax benefits are important $1 debt adds about $0.10 to value.
Supports Miller model with personal taxes.

Bankruptcies are costly costs can be up to 10% to 20% of firm value. Firms dont make quick corrections when stock price changes cause their debt ratios to change doesnt support trade-off model.
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Empirical Evidence
(Continued)
After big stock price run ups, debt ratio falls, but firms tend to issue equity instead of debt.
Inconsistent with trade-off model. Inconsistent with pecking order. Consistent with windows of opportunity.

Many firms, especially those with growth options and asymmetric information problems, tend to maintain excess borrowing capacity.
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Implications for Managers

Take advantage of tax benefits by issuing debt, especially if the firm has:
High tax rate Stable sales Less operating leverage

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Implications for Managers

(Continued)
Avoid financial distress costs by maintaining excess borrowing capacity, especially if the firm has:
Volatile sales High operating leverage Many potential investment opportunities Special purpose assets (instead of general purpose assets that make good collateral)

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Implications for Managers

(Continued)
If manager has asymmetric information regarding firms future prospects, then avoid issuing equity if actual prospects are better than the market perceives. Always consider the impact of capital structure choices on lenders and rating agencies attitudes

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