Chapter 15

Capital Structure Decisions

Topics in Chapter

Overview and preview of capital structure effects Business versus financial risk The impact of debt on returns Capital structure theory, evidence, and implications for managers Example: Choosing the optimal structure
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Determinants of Intrinsic Value: The Capital Structure Choice

Net operating profit after taxes Required investments in operating capital =

Free cash flow (FCF)

Value =

FCF1 FCF2 FCF + + + (1 + WACC)1 (1 + WACC)2 (1 + WACC)

Weighted average cost of capital (WACC) Market interest rates Market risk aversion Cost of debt Cost of equity

Firms debt/equity mix

Firms business risk

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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 ws and wd are percentages of the firm that are financed with stock and debt.
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How can capital structure affect value?

FCFt
(1 + WACC)t

t=1

WACC= wd (1-T) rd + wsrs

5

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. Reduces the taxes paid Frees up more cash for payments to investors Reduces after-tax cost of debt
(Continued)
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Firms can deduct interest expenses.

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 highcost equity (ws) 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 in EBIT, NOPAT, and ROIC

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 relative to variable costs, 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

F
QBE Sales QBE

Sales
(More...)
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Operating Breakeven

Q is quantity sold, F is fixed cost, V is variable cost, TC is total cost, and P is price per unit. Operating breakeven = QBE QBE = F / (P V) Example: F=$200, P=$15, and V=$10: QBE = $200 / ($15 $10) = 40.
(More...)
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Business Risk versus Financial Risk

Business risk:

Uncertainty in future EBIT, NOPAT, and ROIC. Depends on business factors such as competition, operating leverage, etc. 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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Financial risk:

Consider Two Hypothetical Firms Identical Except for Debt

Capital Debt Equity Tax rate EBIT NOPAT ROIC Firm U $20,000 $0 $20,000 40% $3,000 $1,800 9% Firm L $20,000 $10,000 (12% rate) $10,000 40% $3,000 $1,800 9%
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Impact of Leverage on Returns

EBIT Interest EBT Taxes (40%) NI ROIC ROE (NI/Equity) Firm U $3,000 0 $3,000 1 ,200 $1,800 9.0% 9.0% Firm L $3,000 1,200 $1,800 720 $1,080 9.0% 10.8%
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Why does leveraging increase return?

More cash goes to investors of Firm L.

Total dollars paid to investors:

U: NI = $1,800. L: NI + Int = $1,080 + $1,200 = $2,280. U: $1,200 L: $720.

Taxes paid:

In Firm L, fewer dollars are tied up in equity.

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Impact of Leverage on Returns if EBIT Falls

Firm U Firm L EBIT $2,000 $2,000 Interest 0 1,200 EBT $2,000 $800 Taxes (40%) 800 320 NI $1,200 $480 ROIC 6.0% 6.0% ROE 6.0% 4.8% Leverage magnifies risk and return!

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Capital Structure Theory

MM theory

Zero taxes Corporate taxes Corporate and personal taxes

Trade-off theory Signaling theory Pecking order Debt financing as a managerial constraint Windows of opportunity
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MM Theory: Zero Taxes

Firm U EBIT Interest NI CF to shareholder CF to debtholder Total CF $3,000 0 $3,000 $3,000 0 $3,000 Firm L $3,000 1,200 $1,800 $1,800 $1,200 $3,000
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Notice that the total CF are identical for both firms.

MM Results: Zero Taxes

MM assume: (1) no transactions costs; (2) no restrictions or costs to short sales; and (3) individuals can borrow at the same rate as corporations. MM prove that if the total CF to investors of Firm U and Firm L are equal, then arbitrage is possible unless the total values of Firm U and Firm L are equal:

Because FCF and values of firms L and U are equal, their WACCs are equal. Therefore, capital structure is irrelevant.
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VL = VU.

MM Theory: Corporate Taxes

Corporate tax laws allow interest to be deducted, which reduces taxes paid by levered firms. Therefore, more CF goes to investors and less to taxes when leverage is used. In other words, the debt shields some of the firms CF from taxes.
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MM Result: Corporate Taxes

MM show that the total CF to Firm Ls investors is equal to the total CF to Firm Us investor plus an additional amount due to interest deductibility:

What is value of these cash flows?

CFL = CFU + rdDT.

If T=40%, then every dollar of debt adds 40 cents of extra value to firm.
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Value of CFU = VU MM show that the value of rdDT = TD Therefore, VL = VU + TD.

MM relationship between value and debt when corporate taxes are considered.
Value of Firm, V VL TD VU Debt 0
Under MM with corporate taxes, the firms value increases continuously as more and more debt is used.
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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

Tc = corporate tax rate. Td = personal tax rate on debt income. Ts = personal tax rate on stock income.

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

(1 - 0.40)(1 - 0.12) VL = VU + 1 (1 - 0.30) = 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. Note: However, Miller argued that in equilibrium, the tax rates of marginal investors would adjust until there was no advantage to 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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Tax Shield vs. Cost of Financial Distress

Value of Firm, V VL
Tax Shield

VU
0 Debt

Distress Costs
33

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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Pecking Order Theory

Firms use internally generated funds first, because there are no flotation costs or negative signals. If more funds are needed, firms then issue debt because it has lower flotation costs than equity and not negative signals. If more funds are needed, firms then issue equity. 35

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.
(More...)
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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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Investment Opportunity Set and Reserve Borrowing Capacity

Firms with many investment opportunities should maintain reserve borrowing capacity, especially if they have problems with asymmetric information (which would cause equity issues to be costly).

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Windows of Opportunity

Managers try to time the market when issuing securities. They issue equity when the market is high and after big stock price run ups. They issue debt when the stock market is low and when interest rates are low. The issue short-term debt when the term structure is upward sloping and long-term debt when it is relatively flat.
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Empirical Evidence

Tax benefits are important $1 debt adds about $0.10 to value. 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. 41

Implications for Managers

Take advantage of tax benefits by issuing debt, especially if the firm has:

High tax rate Stable sales Low 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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Choosing the Optimal Capital Structure: Example

b = 1.0; rRF = 6%; RPM = 6%. Cost of equity using CAPM:

rs = rRF +b (RPM)= 6% + 1(6%) = 12% WACC = rs = 12%.

Currently has no debt: wd = 0%.

Tax rate is T = 40%.

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Current Value of Operations

Expected FCF = $30 million. Firm expects zero growth: g = 0. Vop = [FCF(1+g)]/(WACC g) Vop = [$30(1+0)]/(0.12 0) Vop = $250 million.

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Other Data for Valuation Analysis

Company has no ST investments. Company has no preferred stock. 100,000 shares outstanding

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Current Valuation Analysis

Vop + ST Inv. VTotal Debt S n P $250 0 $250 0 $250 10 $25.00
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Investment bankers provided estimates of rd for different capital structures.

wd
rd

0%
0.0%

20%
8.0%

30%
8.5%

40%
10.0%

50%
12.0%

If company recapitalizes, it will use proceeds from debt issuance to repurchase stock.

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

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

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The Cost of Equity for wd = 20%

Use Hamadas equation to find beta: b = bU [1 + (1 - T)(wd/ws)] = 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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The WACC for wd = 20%

WACC = wd (1-T) rd + wce 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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Beta, rs, and WACC

wd
rd ws b rs WACC

0%
0.0% 100% 1.000 12.00% 12.00%

20%
8.0% 80% 1.150 12.90% 11.28%

30%
8.5% 70% 1.257 13.54% 11.01%

40%
10.0% 60% 1.400 14.40% 11.04%

50%
12.0% 50% 1.600 15.60% 11.40%

The WACC is minimized for wd = 30%. This is the optimal capital structure.
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Corporate Value for wd = 20%

Vop = [FCF(1+g)]/(WACC g) Vop = [$30(1+0)]/(0.1128 0) Vop = $265.96 million. Debt = DNew = wd Vop Debt = 0.20(265.96) = $53.19 million. Equity = S = ws Vop

Equity = 0.80(265.96) = $212.77 million.

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Value of Operations, Debt, and Equity

wd
rd ws b rs WACC Vop D S

0%
0.0% 100% 1.000 12.00% 12.00% $250.00 $0.00 $250.00

20%
8.0% 80% 1.150 12.90% 11.28% $53.19 $212.77

30%
8.5% 70% 1.257 13.54% 11.01% $81.74 $190.74

40%
10.0% 60% 1.400 14.40% 11.04% $271.74 $108.70 $163.04

50%
12.0% 50% 1.600 15.60% 11.40% $263.16 $131.58 $131.58

$265.96 $272.48

Value of operations is maximized at wd = 30%.

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Anatomy of a Recap: Before Issuing Debt

Before Debt Vop $250

+ ST Inv.
VTotal Debt S

0
$250 0 $250 10 $25.00 $250

n
P Total shareholder wealth: S + Cash

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Issue Debt (wd = 20%), But Before Repurchase

WACC decreases to 11.28%. Vop increases to $265.9574. Firm temporarily has short-term investments of $53.1915 (until it uses these funds to repurchase stock). Debt is now $53.1915.

57

Anatomy of a Recap: After Debt, but Before Repurchase

Before Debt Vop + ST Inv. VTotal Debt S $250 0 $250 0 $250

After Debt, Before Rep.

$265.96 53.19 $319.15 53.19 $265.96

n
P Total shareholder

10
$25.00

10
$26.60

wealth: S + Cash

$250

$265.96

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After Issuing Debt, Before Repurchasing Stock

Stock price increases from $25.00 to $26.60. Wealth of shareholders (due to ownership of equity) increases from $250 million to $265.96 million.

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The Repurchase: No Effect on Stock Price

The announcement of an intended repurchase might send a signal that affects stock price, and the previous change in capital structure affects stock price, but the repurchase itself has no impact on stock price.

If investors thought that the repurchase would increase the stock price, they would all purchase stock the day before, which would drive up its price. If investors thought that the repurchase would decrease the stock price, they would all sell short the stock the day before, which would drive down the stock price.

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Remaining Number of Shares After Repurchase

DOld is amount of debt the firm initially has, DNew is amount after issuing new debt. If all new debt is used to repurchase shares, then total dollars used equals

nPrior is number of shares before repurchase, nPost is number after. Total shares remaining:

(DNew DOld) = ($53.19 - $0) = $53.19.

nPost = nPrior (DNew DOld)/P nPost = 10 ($53.19/$26.60) nPost = 8 million.

(Ignore rounding differences; see Ch15 Mini Case.xls for actual calculations).

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Anatomy of a Recap: After Rupurchase

Before Debt Vop + ST Inv. VTotal Debt S $250 0 $250 0 $250

After Debt, Before Rep.

$265.96 53.19 $319.15 53.19 $265.96

After Rep. $265.96 0 $265.96 53.19 $212.77

n
P Total shareholder

10
$25.00

10
$26.60

8
$26.60

wealth: S + Cash

$250

$265.96

$265.9662

Key Points

ST investments fall because they are used to repurchase stock. Stock price is unchanged. Value of equity falls from $265.96 to $212.77 because firm no longer owns the ST investments. Wealth of shareholders remains at $265.96 because shareholders now directly own the funds that were held by firm in ST investments.
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Intrinsic Stock Price Maximized at Optimal Capital Structure

wd
rd ws b rs WACC Vop D S n P

0%
0.0% 100% 1.000 12.00% 12.00% $250.00 $0.00 $250.00 10 $25.00

20%
8.0% 80% 1.150 12.90% 11.28% $53.19 $212.77 8 $26.60

30%
8.5% 70% 1.257 13.54% 11.01% $81.74 $190.74 7 $27.25

40%
10.0% 60% 1.400 14.40% 11.04% $271.74 $108.70 $163.04 6 $27.17

50%
12.0% 50% 1.600 15.60% 11.40% $263.16 $131.58 $131.58 5 $26.32
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$265.96 $272.48

Shortcuts

The corporate valuation approach will always give the correct answer, but there are some shortcuts for finding S, P, and n. Shortcuts on next slides.

65

Calculating S, the Value of Equity after the Recap

S = (1 wd) Vop At wd = 20%: S = (1 0.20) $265.96 S = $212.77.

(Ignore rounding differences; see Ch15 Mini Case.xls for actual calculations).

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Number of Shares after a Repurchase, nPost

At wd = 20%: nPost = nPrior(VopNewDNew)/(VopNewDOld) nPost = 10($265.96 $53.19)/($265.96 $0) nPost = 8

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Calculating PPost, the Stock Price after a Recap

At wd = 20%: PPost = (VopNewDOld)/nPrior nPost = ($265.96 $0)/10 nPost = $26.60

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Optimal Capital Structure

wd = 30% gives:

Highest corporate value Lowest WACC Highest stock price per share

But wd = 40% is close. Optimal range is pretty flat.

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