Capital Structure

By :- Dinesh khanna

Advantages of DebtInterest is tax deductible (lowers the

effective cost of debt)Debt-holders are limited to a fixed return

– so stockholders do not have to share profits if the business does exceptionally well

Debt holders do not have voting rights

Disadvantages of DebtHigher debt ratios lead to greater risk and

higher required interest rates (to compensate for the additional risk)

What is the optimal debt-equity ratio?

Need to consider two kinds of risk:◦Business risk◦Financial risk

Business RiskStandard measure is beta (controlling for

financial risk)Factors:

◦Demand variability◦Sales price variability◦ Input cost variability◦Ability to develop new products◦Foreign exchange exposure◦Operating leverage (fixed vs variable costs)

Financial RiskThe additional risk placed on the

common stockholders as a result of the decision to finance with debt

Example of Business RiskSuppose 10 people decide to form a

corporation to manufacture disk drives.If the firm is capitalized only with

common stock – and if each person buys 10% -- each investor shares equally in business risk

Example of Relationship Between Financial and Business RiskIf the same firm is now capitalized with

50% debt and 50% equity – with five people investing in debt and five investing in equity

The 5 who put up the equity will have to bear all the business risk, so the common stock will be twice as risky as it would have been had the firm been all-equity (unlevered).

Business and Financial RiskFinancial leverage concentrates the firm’s

business risk on the shareholders because debt-holders, who receive fixed interest payments, bear none of the business risk

Financial RiskLeverage increases shareholder riskLeverage also increases the return on

equity (to compensate for the higher risk)

Question?Is the increase in expected return due to

financial leverage sufficient to compensate stockholders for the increase in risk?

Modigliani and MillerYESAssuming no taxes, the increase in return

to shock-holders resulting from the use of leverage is exactly offset by the increase in risk – hence no benefit to using financial leverage (and no cost).

Topics To Be CoveredLeverage in a Tax Free EnvironmentHow Leverage Affects ReturnsThe Traditional Position

Capital StructureWhen a firm issues debt and equity

securities it splits cash flows into two streams:◦Safe stream to bondholders◦Risky stream to stockholders

Capital StructureModigliani and Miller (1958) show that

financing decisions don’t matter in perfect capital markets

M&M Proposition 1:◦Firms cannot change the total value of their

securities by splitting cash flows into two different streams

◦Firm value is determined by real assets◦Capital structure is irrelevant

M&M (Debt Policy Doesn’t Matter)

Modigliani & Miller◦When there are no taxes and capital markets

function well, it makes no difference whether the firm borrows or individual shareholders borrow. Therefore, the market value of a company does not depend on its capital structure.

M&M (Debt Policy Doesn’t Matter)AssumptionsBy issuing 1 security rather than 2, company

diminishes investor choice. This does not reduce value if:◦ Investors do not need choice, OR◦ There are sufficient alternative securities

Capital structure does not affect cash flows e.g...◦No taxes◦No bankruptcy costs◦No effect on management incentives

An Example of the Effects of Leverage

D and E are market values of debt and equity of Wapshot Marketing Company. Wapshot has issued 1000 shares and these are currently selling at $50 a share. Wapshot has borrowed $25,000 so Wapshot’s stock is “levered equity”.

E = 1000 x $50 = $50,000D= $25,000V = E + D = $75,000

Effects of LeverageWhat happens if WPS “levers up” again by

borrowing an additional $10,000 and at the same time paying out a special dividend of $10 per share, thereby substituting debt for equity?

This should have no impact on WPS assets or total cash flows:◦ V is unchanged◦ D= $35,000◦ E= $75,000 - $35,000 = $40,000

Stockholders will suffer a $10,000 capital loss which is exactly offset by the $10,000 special dividend.

Effects of LeverageWhat if instead of assuming V is

unchanged we allow V it rise to $80,000 as a result of the change in capital structure?

Then E = $80,000 - $35,000 = $45,000Any increase or decrease in V as a result

of the change in capital structure accrues to the shareholders

Effects of LeverageWhat if the new borrowing increases the

risk of bankruptcy?This would suggest that the risk of the

“old debt” is higher (and the value of the old debt is lower)

If this is the case, then shareholders would gain from the increase in leverage at the expense of the original bondholders.

Modigliani and MillerAny combination of securities is as good

as any other.Example:

◦Two Firms with the same operating income who differ only in capital structure

Firm U is unlevered: VU=EU

Firm L is levered: EL= VL-DL

Modigliani and Miller Four Strategies Strategy 1

◦ Buy 1% of Firm U’s Equity Dollar investment = .01VU

Dollar Return= .01 Profits Strategy 2

◦ Buy 1% of Firm L’s Equity and Debt Dollar investment= .01DL + .01EL = .01VL

Dollar Return= From owning .01 DL .01 interest From owning .01 EL .01 (Profits – interest) Total .01 Profits

Both Strategies give the same payoff

Modigliani and MillerStrategy 3

◦ Buy 1% of Firm L’s Equity Dollar investment = .01EL= .01(VL-DL) Dollar Return= .01 (Profits – interest)

Strategy 4◦ Buy 1% of Firm U’s Equity and borrow on your own

account .01DL (home-made leverage) Dollar investment= .01(Vu – DL)

Dollar Return= From borrowing .01DL -.01 interest From owning .01 EU .01 (Profits) Total .01 (Profits – interest)

Both Strategies give the same payoff

Modigliani and MillerIt does not matter what risk preferences

are for investors.Just need that investors have the ability

to borrow and lend for their own account (and at the same rate as firms) so that they can “undo” any changes in firm’s capital structure

M&M Proposition 1: the value of a firm is independent of its capital structure

Leverage and Returns

securities all of uemarket val

income operating expectedr assets on return Expected a

EDA r

ED

Er

ED

Dr

r

DE

rD

rE

M&M Proposition II

rA

Risk free debt Risky debt

M&M Proposition 2Bonds are almost risk-free at low debt levels

◦ rD is independent of leverage◦ rE increases linearly with debt-equity ratios and the

increase in expected return reflects increased riskAs firms borrow more, the risk of default rises

◦ rD starts to increase◦ rE increases more slowly (because the holders of risky

debt bear some of the firm’s business risk)

The Return on EquityThe increase in expected equity return

reflects increased riskThe increase in leverage increases the

amplitude of variation in cash flows available to share-holders (the same change in operating income is now distributed among fewer shares)

We can understand the increase in risk in terms of Betas

Leverage and Returns

EDA B

ED

EB

ED

DB

DAAE BBE

DBB

The Traditional PositionWhat did financial experts think before

M&M?They used the concept of WACC

(weighted average cost of capital)◦WACC is the expected return on the portfolio

of all the company’s securities

WACC

EDA r

V

Er

V

DrWACC

WACC is the traditional view of capital structure, risk and return.

WACC

.10=rD

.20=rE

.15=rA

BEBABD

Risk

Expected Return

Equity

All assets

Debt

WACC

Example - A firm has $2 mil of debt and 100,000 of outstanding shares at $30 each. If they can borrow at 8% and the stockholders require 15% return what is the firm’s WACC?

D = $2 million

E = 100,000 shares X $30 per share = $3 million

V = D + E = 2 + 3 = $5 million

WACCExample - A firm has $2 mil of debt and 100,000 of

outstanding shares at $30 each. If they can borrow at 8% and the stockholders require 15% return what is the firm’s WACC? D = $2 million

E = 100,000 shares X $30 per share = $3 million

V = D + E = 2 + 3 = $5 million

12.2%or 122.

15.5

308.

5

2

ED r

V

Er

V

DWACC

The Traditional PositionThe return on equity (rE) is constantWACC declines with increasing leverage

because rD<rE

Given the two assumptions above, a firm will minimize the cost of capital by issuing almost 100% debt

This can’t be correct!

r

DV

rD

rE

rA =WACC

WACC (if rE does not change with increases in leverage )

An intermediate positionA moderate degree of financial leverage

may increase the return on equity (but less than predicted by M&M proposition 2)

A high degree of financial leverage increases the return on equity (but by more than predicted by M&M proposition 2)

WACC then declines at first, then rises with increasing leverage (U-shape)

Its minimum point is the point of “optimal capital structure”.

r

DE

rD

rE

WACC

WACC (intermediate view)

The intermediate positionInvestors don’t notice risk of “moderate”

borrowingThey wake up with debt is “excessive”The problem with this view is that it confuses

default risk with financial risk.◦ Default risk may not be serious for moderate

amounts of leverage◦ Financial risk (in terms of increased volatility of return

and higher beta) will increase with leverage even with no risk of default

Modigliani and Miller Revisited M&M proposition 1: A firm’s total value is

independent of its capital structure Assumptions needed for Prop 1 to hold:

1. Capital markets are perfect and complete2. Before-tax operating profits are not affected by

capital structure3. Corporate and personal taxes are not affected by

capital structure4. The firm’s choice of capital structure does not

convey important information to the market

Modigliani and Miller RevisitedM&M Proposition 2: The return on equity

will rise as the debt-equity ratio rises in order to compensate equity holders for the additional (financial) risk.

Note: Proposition 2 does not rely on default risk – rE rises because of the rise in financial risk

r

DE

rD

rE

WACC

WACC (M&M view)

Financial Risk - Risk to shareholders resulting from the use of debt.

Financial Leverage - Increase in the variability of shareholder returns that comes from the use of debt.

Interest Tax Shield- Tax savings resulting from deductibility of interest payments.

Capital Structure and Corporate Taxes

Example - You own all the equity in a company. The company has no debt. The company’s annual cash flow is $1,000, before interest and taxes. The corporate tax rate is 40%. You have the option to exchange 1/2 of your equity position for 10% bonds with a face value of $1,000.

Should you do this and why?

Capital Structure and Corporate Taxes

All Equity 1/2 Debt

EBIT 1,000 1,000

Interest Pmt 0 100

Pretax Income1,000 900

Taxes @ 40% 400 360

Net Cash Flow$600 $540

Capital Structure and Corporate Taxes

Total Cash Flow

All Equity = 600

*1/2 Debt = 640

(540 + 100)

Capital StructurePV of Tax Shield = (assume perpetuity)

D x rD x Tc

rD

= D x Tc

Example:

Tax benefit = 1000 x (.10) x (.40) = $40

PV of 40 perpetuity = 40 / .10 = $400

PV Tax Shield = D x Tc = 1000 x .4 = $400

Capital StructureFirm Value = Value of All Equity Firm + PV Tax Shield

Example

All Equity Value = 600 / .10 = 6,000

PV Tax Shield = 400

Firm Value with 1/2 Debt = $6,400

Capital Structure and Financial Distress

Costs of Financial Distress - Costs arising from bankruptcy or distorted business decisions before bankruptcy.

Market Value = Value if all Equity Financed

+ PV Tax Shield - PV Costs of Financial

Distress

Weighted Average Cost of Capitalwithout taxes (traditional view)

r

DE

rD

rE

Includes Bankruptcy Risk

WACC

Financial Distress

Debt/Total Assets

Mar

ket V

alue

of

The

Fir

m

Value ofunlevered

firm

PV of interesttax shields

Costs offinancial distress

Value of levered firm

Optimal amount of debt

Maximum value of firm

M&M with taxes and bankruptcyWACC now is more hump-shaped (similar

to the traditional view – though for different reasons).

The minimum WACC occurs where the stock price is maximized.

Thus, the same capital structure that maximizes stock price also minimizes the WACC

Financial Choices

Trade-off Theory - Theory that capital structure is based on a trade-off between tax savings and distress costs of debt.

Pecking Order Theory - Theory stating that firms prefer to issue debt rather than equity if internal finance is insufficient.

Pecking Order Theory The announcement of a stock issue drives down the stock price

because investors believe managers are more likely to issue when shares are overpriced.

Therefore firms prefer internal finance since funds can be raised without sending adverse signals.

If external finance is required, firms issue debt first and equity as a last resort.

The most profitable firms borrow less not because they have lower target debt ratios but because they don't need external finance.

Pecking Order Theory

Some Implications:Internal equity may be better than

external equity.Financial slack is valuable.If external capital is required, debt is

better. (There is less room for difference in opinions about what debt is worth).