Lecture 7 - Capital Structure
Example continued
Notice how WACC decreases with the increase of debt. Also, notice how the cost of equity (expected return) rises with leverage, but at a lower rate with taxes than without.
What is stated in MM Propositions I and II with taxes?
Interest are tax deductible, and provides the company with value through a tax shield. Since less money is paid out in taxes for the levered firm, managers should select high leverage. Proposition I (with Corporate Taxes) Firm value increases with leverage VL = VU + tc D Proposition II (with Corporate Taxes) Some of the increase in equity risk and return is offset by the interest tax shield.
What is capital structure? How is the market value of a company defined?
- The capital structure is how a firm finances its overall operations and growth by using different sources of funds. It may be financed either by equity (stocks), debt (borrowed money) or a combination of these two. - Market value is the sum of financial claims of a company. It is defined by: V= D + E, where D is the market value of debt and E is the market value of equity.
How do we prove MM Proposition I (With Taxes)?
- To prove this we need to find the Present Value of the Tax Shield: We know that the company needs to pay interest at: Interest = RD * D, where RD is the interest rate and D the amount borrowed. - Now, since interest is tax deductible, we can reduce our taxes by: Tc * RD * D, where Tc is the corporate tax rate. - This is called the tax shield from debt. - For simplification we assume that the cash flows are perpetual and that the cash flow has the same risk as the interest on debt. This provides us with the Present Value of the Tax Shield. - To complete MM I (with taxes) we need to calculate the value of the unlevered firm (no debt). We know that the annual aftertax cash flow of an unlevered firm is its Earnings Before Interest and Taxes (EBIT) subtracted by taxes paid. By assuming that the cash flows continue in perpetuity, and discounting at the cost of equity, we find the value of the unlevered firm. - And Now, we find the value of the levered firm.
What are the Costs of Financial Distress faced by companies on the verge of bankruptcy?
A company in financial distress and on the verge of bankruptcy typically faces: Direct Costs - Legal and administrative costs Indirect Costs - Impaired ability to conduct business (e.g., lost sales, compromised supply chain) Agency Costs - Selfish Strategy 1: Incentive to take large risks - Selfish Strategy 2: Incentive toward underinvestment - Selfish Strategy 3: Milking the property
How do we determine the optimal capital structure? Leverage and returns to shareholders
By plotting Earnings per share (EPS) and Earnings before interests (EBI) in both cases with no leverage and with leverage with a given amount of debt. The optimal capital structure will be found at the break-even point were both lines intersect.
How does Selfish Strategy 2: Underinvestment works?
Consider a government-sponsored project that guarantees $350 in one period. Cost of investment is $300 (the firm only has $200 now), so the stockholders will have to supply an additional $100 to finance the project. Required return is 10%. NPV = 18,18 Should we accept or reject? Normally a yes, but let's see how NPV is for a shareholder before making the decision. In this case, the stockholders have a negative NPV, and therefore decide against the project, despite the positive NPV of the project in general. This results in underinvestment since good projects are rejected.
Example: Company in Distress
During a liquidation, the bondholders have the highest priority while shareholders have a residual claim. Therefore, the bondholders get $200 (partially covering the Long-Term bonds at $300); the shareholders get nothing. If the shareholders realize this before bankruptcy, they may choose a selfish strategy in order to recoup some of their value.
What is financial leverage or gearing?
Financial leverage is the degree to which a company uses fixed-income securities such as debt and preferred equity. The more debt financing a company uses, the higher its financial leverage. A high degree of financial leverage means high interest payments, which negatively affect the company's bottom-line earnings per share.
What is financial risk?
Financial risk is the risk to the stockholders that is caused by an increase in debt and preferred equities in a company's capital structure. As a company increases debt and preferred equities, interest payments increase, reducing EPS. As a result, risk to stockholder return is increased. A company should keep its optimal capital structure in mind when making financing decisions to ensure any increases in debt and preferred equity increase the value of the company.
How does a higher leverage affects the average cost of capital?
Generally a higher debt ratio (higher leverage) reduces the average cost of capital, since the interest on debt is lower than the required return on equity. In addition interest is tax deductible.
What is stated in MM Proposition II (No Taxes)?
Leverage increases the risk and return to stockholders. To prove this, we can use the Weighted Average Cost of Capital, and rearrange it to see how leverage (debt / equity) affects the cost of equity. Notice that we are not accounting for taxes. As we increase leverage (higher debt-to-equity ratio), the cost of equity (Rs) increases. Notice that the weighted average is unaffected by the B/S-ratio.
How does Selfish Strategy 3: Milking the Property works?
Liquidating dividends Suppose our firm paid out a $200 dividend to the shareholders. This leaves the firm insolvent, with nothing for the bondholders, but plenty for the former shareholders. Such tactics often violate bond indentures or protective covenants: E.g. limit dividend payout, limit sale of assets, minimum working capital requirement, limit on further borrowing, etc.
Does leverage (more debt) increase firm value?
Since a higher leverage increases the expected EPS, does it mean that the company value also increases in value? What if we account for risk? No. According to Modigliani and Miller's proposition I (MM I), the market value of any firm is independent of its capital structure. In other words: Financial managers (i.e. stockholders) should not worry about the financial leverage of the firm. Ex in the pic: The investor receives the same payoff whether she Buys shares in the levered company, or Buys shares in an unlevered company and borrows on personal account. In both cases her initial investment is the same (= $2,000). Therefore, MM I concludes that the value of the levered firm is the same as the value of the unlevered firm.
How does Selfish Strategy 1: Take Risks works?
Since the shareholders with the current Market Value gets nothing, the shareholders don't have anything to lose by betting the last $200 in cash. And, the riskier the project, the higher the possible payoff, resulting in a very high risk appetite for the shareholder. While bondholders lose a lot from this gamble, the PV of shareholders increases from $0 to $47. Therefore, the shareholders will take the project, despite the negative NPV.
How do we calculate MM Proposition II (With Taxes)?
The derivation is the same as for MM II without taxes. Start with the Weighted Average Cost of Capital (WACC), but this time include taxes.
How can debt be used as a signal?
The firm's capital structure is optimized where the marginal subsidy to debt equals the marginal cost. Since there is a tax shield for debt, investors view debt as a signal of firm value. • Firms with low anticipated profits will take on a low level of debt (smaller tax shield). • Firms with high anticipated profits will take on a high level of debt (higher tax shield). A manager that takes on more debt than is optimal in order to fool investors will pay the cost in the long run.
What does The Pecking-Order Theory states?
Theory stating that firms prefer to issue debt rather than equity if internal financing is insufficient. ◦ Rule 1 - Use internal financing first. ◦ Rule 2 - Issue debt next, new equity last. The pecking-order theory is at odds with the tradeoff theory: ◦ There is no target D/E ratio (compared to MM with taxes and financial distress). ◦ Profitable firms use less debt since they generate internal financing (compared to MM where the tax shield implies a high leverage for profitable firms) ◦ Companies like financial slack (opposite of theory of agency costs of equity).
How does stockholder's interest relates with the value of the firm?
There are two important questions: 1.Why should the stockholders care about maximizing firm value? Perhaps they should be interested in strategies that maximize shareholder value. 2.What is the ratio of debt-to-equity that maximizes the shareholder's value? As it turns out, changes in capital structure benefit the stockholders if and only if the value of the firm increases. The capital structure producing the highest firm value is the one that maximizes shareholders wealthy.
What is the starting point of The Pecking-Order Theory?
Uses the theory of signaling and asymmetric information: 1. The manager of a firm will consider these strategies: A. Issue stocks when stocks are overvalued. B. Issue bonds when stocks are undervalued. 2. However, the investor knows this, and will not purchase stocks in a company that has recently issued stocks, since it is probably overvalued. 3. Consequently, issuing stocks leads to a decrease in stock value, and current shareholders lose value. 4. Therefore, the manager/CEO concludes that it is safest to issue debt, since in theory debt will not give a negative signal for the stocks.
What is stated in MM Proposition I (No Taxes)?
We can create a levered or unlevered position by adjusting the trading in our own account. This homemade leverage suggests that capital structure is irrelevant in determining the value of the firm.
Tax effects and financial distress
We know that due to taxes, debt increases the value of the company (MM I and II). On the other hand, we know that the probability of financial distress (direct/indirect bankruptcy costs and agency costs) increases with debt. As a result there is a trade-off between the tax advantage of debt and the costs of financial distress. It is difficult to express this with a precise and rigorous formula.
Why don't companies use 100% debt?
While in theory (MM with taxes) a company should finance itself by debt, we also know that as we increase leverage the probability of going bankrupt increases. This is a direct consequence of the legal right a bondholder has to interest on debt, compared to residual claim a stockholder has on company cash flows. If the company can't pay interest, it will go bankrupt. In an ideal world a bankrupt company is handed over to the bondholders when the company value equals the bond value (and equity value = 0). However, due to imperfections (bankruptcy cost) the bondholders will not receive their total claim.
Does MM supports high leverage?
Yes! According to MM a company should increase their leverage, since the tax shield will increase the firm value. Why don't companies use 100% debt? The next chapter explains how there are several reasons why companies are not all-debt financed.