Capital Structure

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The Capital-Structure Capital Structure deals with how the firm pays

for investmentsIt also determines how we slice

the firm’s cash flows Capital Structure is important if how

we slice the cash flows affects the size of the cash flows

Remember: A firm is simply worth the PV of its expected future cash flows to investors

V = D + E

S G

B

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Modigliani-Miller Proposition 1Capital Structure

JUST DOES NOT MATTER

VL = VU

Firm value is not affected by capital structureThis won them a Noble Prize

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MM1: The Simplest of Worlds

Perfect capital markets No taxes or transaction costs

No Bankruptcy Costs Everyone borrows at the same rate Investment decisions are fixed

Operating cash flow is independent of capital structure

MM Intuition Set up

Suppose you have two firms that each make $50/ year

The firms are identical except that one has $50 of debt and the other has no debt

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MM Intuition: Vl < Vu

Consider a 1% investment in EU

Cost = 1% EU = $1.00 Payoff = 1% Profits = $0.50

Now buy 1% of EL & 1% of DL Cost = 1% EL +1%DL=

0.40 + 0.50=$0.90 Payoff Receive 1%*interest=

0.01*10=$0.10 Receive 1%*(Profits-Interest)=

0.01*40=$0.40 Total dollar payoff =

$0.10+$0.40=$0.50

Can Vl < Vu? NO 6

Vu Vl

V $100 $90

E $100 $40

D $0 $50

Int $0 $10

Profit $50 $50

Cost$1 $0.9

Payoff $0.50 $0.5

MM Intuition: Vl > Vu

Consider a1% investment in El Cost = 1% EL = $0.50 Payoff = 1%(Profits –Int)= $0.40

Alt. buy 1% EU, & borrow1% of DL Cost= 1%Vu-1%DL=

$0.90-$0.50=$0.40 Payoff Owe 1%*interest=

0.01*10=$0.10 Receive 1%*Profits=

0.01*50=$0.50 Total dollar payoff =

-$0.10+$0.50=$0.40

Can Vl > Vu? NO 7

Vu Vl

V $90 $100

E $90 $50

D $0 $50

Int $0 $10

Profit $50 $50

Cost$0.4 $0.5

Payoff $0.4 $0.4

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Vl = Vu

If Vl cannot be worth less than Vu

And Vl cannot be worth more than Vu

Vl must be as valuable as Vu

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MM1 and WACC

If you own the entire firm then you are only compensated for the risk of the firm’s assets

Given that the assets do not change as D/V changes the risk of the company will not change

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D/V and Shareholders

While leverage does not affect the risk of the overall firm, it does affect the risk to the shareholders

Leverage increases:

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MM Proposition 2: D/E and re, βe

Increasing leverage increases the financial risk of the equity investment, and equity holders need to be compensated for bearing this risk

D/E relationship with re, βe

ra = D/V * rd + E/V*re

re = ra + D/E * (ra - rd)

a = D /V * d + E/V*e

e = a + D /E * (a - d)

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βe Break-Down

e = a + D /E * (a - d)

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Graph of MM2

As debt increases the cost of equity and debt increases

Why is WACC unchanged?

r

D/E

rWACC

rD

rE

r0

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Corporate Taxes

What does the inclusion of taxes mean for firm value?

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Corporate Taxes & Debt Because interest payments are tax deductible,

they act a shield protecting some of the firm’s cash flows from the government

If less money flows to the government, what will happen to firm value?

Total Cash Flow to Investors

S G S G

B

All-equity firm Levered firm

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Vl with Corporate Taxes

Vl = Vu + PV(Tax Shield)

Vl = Vu + D*Tc

As the tax shield increases company value how should the company be financed?

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Unlevered Firm Value

Consider an un-levered firm, which has an EBIT of $1,500.

The company’s investors require a return on 12%. Taxes are 34%, what is the firm worth?

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Levered Firm Value

Consider an levered firm, which has an EBIT of $1,500. The firm owes $1,000 in interest The company’s investors require a return on 12%. Taxes are 34%, what is the firm worth? The cash flow to investors are:

Debt: Equity:

VL =

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Levered Firm Value ALT

Consider an levered firm, with an EBIT of $1,500. The firm owes $1,000 in interest The company’s investors require a return on 12%. Taxes are 34%, what is the firm worth? VL = VU + D*T

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Leverage and Firm Value

V

D/E

VL

VU

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MM 2 With Corporate Taxes

Earlier I showed you how re changes with debt, when we ignore taxesre = ra + D/E * (ra - rd)

What happens if we include corporate taxes?

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The Effect of Financial Leverage on the Cost of Debt and Equity Capital

Debt-to-equityratio (D/E)

Cost of capital: r(%)

rU

rB

Er

WACCr

S/h risk and return increase with leverage

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With only Corporate Taxes

Firm value increases with leverage This suggests that firms should be 100% debt

finance which we don’t see in the real world Why not?

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Bankruptcy Costs

One reason we don’t see firms with 100% debt financing

The possibility that a firm goes bankrupt reduces firm value A firm does not need to declare bankruptcy to

experience bankruptcy costs

VL = VU + PV(tax shield) – PV(distress costs)

Bankruptcy Costs Direct Bankruptcy Costs: Legal and

administrative costs associated with bankruptcy Relatively small

Indirect Costs: Impaired ability to conduct business This is where the Big Costs areLost sales, Higher rates, Warranties loss value

A firm can start to experience these indirect costs when it becomes financially distressed

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What is Financial Distress?

Firm’s operating cash flows, are not sufficient to satisfy current obligations

This can lead to:DefaultFinancial PenaltiesFinancial Restructuring

Bankruptcy

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Stock-Based Insolvency The value of the firm’s assets is less than the value of the

debt.

Assets

Debt

Equity

Solvent firm

Debt

Assets Equity

Insolvent firm

Debt

Note the negative equity

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Cash-Based Insolvency When the firms cash flows are insufficient to cover

contractually required payments.

Firm cash flow

Contractual Obligations

Insolvency

$ Cash flow shortfall

time

Stock v Cash Insolvency

Which is worse Stock or Cash Insolvency?

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What Happens in Financial Distress?

Financial distress does not usually result in the firm’s deathWho hasn’t flow on a bankrupt airline?

However, a firm in financial distress may find it hard to operateHow willing are people to accept warranties?How willing are people to extend credit?

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Agency Costs

In addition to bankruptcy costs, when a firm becomes financially distressed, it creates incentive for the equity holders, who control the firm, to try an take from the debt holdersAsset SubstitutionIncentive to underinvestmentMilk the property

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Asset Substitution

A firm has $6m in assets, and has $10m in debt outstanding → Financial Distress

The firm has a project requiring a $2m investment and pays $7m (PV) with a 10% probability or pays nothing with a 90%

Project NPV? Will the firm take the project?

Potential Payoffs

If forgo the project: FV = $__Debt gets $___, Equity gets $___

Take the project and it turns out bad: FV = $__Debt gets $___, Equity gets $___

Take the project and it turns out good: FV = $_Debt gets $___, Equity gets $___

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Potential Payoffs

If forgo the project: FV = $6Debt gets $6, Equity gets $0

Take the project and it turns out bad: FV = $4Debt gets $4, Equity gets $0

Take the project and it turns out good: FV=$11Debt gets $10, Equity gets $1

Equity holders want to take this projectA chance at something is better than nothing

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Underinvestment

Now instead of taking –NPV projects the firm passes on +NPV projects

The same firm has a project requiring $2m investment and pays $5m (PV) with a 50% probability or pays $1m (PV) with a 50% probability

What is the NPV? -2 + [(0.5*5) + (0.5*1)] = $1

Will the firm take the project? Probably not

Potential Payoffs

If forgo the project: FV = $__Debt gets $__, Equity gets $__

Take the project and it turns out bad: FV = $__Debt gets $__, Equity gets $__

Take the project and it turns out good: FV= $_Debt gets $__, Equity gets $__

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Milk the Property (Cash out)

If the value of the firm is less than the value of the debt holders claims, then the shareholders have an incentive to sell off the assets and issue a cash dividends to themselves.

Example, names changed to protect the guilty

Marriot IncOwes $1 billion and has $500 million in assets

Management creates a new firm Marriot CoEvery Inc shareholder receives shares in Co

The same shareholders own both firms

Inc sells its $500m in assets to Co for $1.00 Co has $499,999,999 in assets and no debt Inc has $1 in assets and $1b in debt

How happy are debt holders?39

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Intelligent Bondholders

Bondholders know about these agency problems and act accordinglyRequiring: Higher rd, covenants

Limit possible div payments, Restrict debt issuances or sales of assets

All of this requires costly monitoring of the firmThis is another costs borne by equity holders

Trade-Off

The firm trades off the benefits and costs associated with debt to maximize firm value

If we put everything we talked about together we get:

Vl = Vu + PV (Tax shields) – PV (Bankruptcy costs) – PV (Agency costs)

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Trade-off Implications

Firms have an optimal level of debtThe amount will depend on the industry and firm

Safe, highly profitable firms with lots of tangible assets should have lots of debtUS studies finds that profitable firms have little

debt Risky, marginally profitable firms with lots of

intangible assets should have little debt

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Tax Effects, Financial Distress and Agency costs

D/E

Value of firm (V)

0

Present value of taxshield on debt

Present value ofdistress & agency costs

Vu simple world

VL = Taxes, Distress and Agency Cost

VU = With Taxes

B*Optimal amount of debt

VL = With Taxes

-Vu NoTax-Vu Tax-Vl Tax-Vl Bank-Tax Shield-Bank Cost

Agency Costs Part Deux

Because managers run the firm, but don’t own the firm they can potentially run the firm for their personal benefit instead of shareholdersThis reduces firm value

But in order for management to act badly, they need both:

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Motive and Opportunity Motives

Who doesn’t want their own jet, little empire, more money, better car

Recent research finds that when a firm goes private it reduces its fleet of corporate jets by 40%

OpportunityFree cash flow: Money that is not needed to

cover the firms current operations

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Free Cash Flow Hypothesis If shareholders limit the amount of free cash they

reduce the amount of money that managers can wasteThis lowers the agency costs

This is accomplished with either increased dividends or increased debt

Which is a more efficient? Why?

TTU: Jonathan “Jody” Nelson

TTU accounting grad who became CFO at Patterson-UTI Energy

Embezzled over $77 mill between 1998-2005Basically wrote checks to himself

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Real World Facts Capital structures differ across industries. In general US firms appear to be underleveraged Changes leverage does affect firm value

Stock price increases with increases in leverage and vice-versa;

consistent with M&M with taxes.

Another interpretation is that firms signal good news when they lever up.

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Factors in D/E Ratio Taxes

If corporate tax rates tax shield is more valuable Types of Assets

Tangible assets are easier to sell and make better collateral, reducing the cost of debt

Uncertainty of Operating IncomeThe more uncertain a firm’s cash flows are the

more likely it will enter financial distress

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Summary and Conclusions In a perfect world

Capital structure does not affect firm value In a world with taxes

Tax shields enhance value But there’s a limit

Bankruptcy costs

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Summary and Conclusion

On the one handDebt may constrain managers and reduce

agency costs On the other

Adds additional agency costsShareholders vs bondholders?Managers vs bondholders?

Quick Quiz

How does financial leverage affect firm value without taxes? With taxes?

What is homemade leverage? What are the direct and indirect costs of

bankruptcy? Define 3 agency conflicts in financially

distressed firms?

Why do we care?

This is big real world financeThis is where people make real money

It is encompasses most of the finance that we have done so farIf you get this then you have a pretty good

understand of finance

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