70391 - finance leverage and capital...

70391 - Finance

Leverage and Capital StructureThe structure of a firm’s sources of long-term financing

70391 – Finance – Fall 2016Tepper School of BusinessCarnegie Mellon Universityc©2016 Chris Telmer. Some content from slides by Bryan Routledge. Used with permission.

11.21.2016 12:37

Sources of Financing: “Capital Structure”

How do firms pay for their investments?

:: Equity financing

:: Private firm: founders and others contribute money

:: Publicly-traded firm: shareholders contribute money in theinitial public offering (IPO). Subsequently, more funds can beraised in a seasoned equity offering.

:: Retained earnings: shareholders money gets “plowed back in.”

:: Debt financing

:: Bank loans

:: Corporate bonds

Capital Structure 2

Capital Structure

Cash

AR, Inventory

Property, Plant & Equipment

(PPE)

Long-Term Cash

AP

Long-Term AP

Debt

Equity

=

Capital Structure 3

Capital Structure

Future Free Cash Flow (FCF)

Profitability and Efficiency

Profit margins Operating efficiency Capital (asset) efficiency ROIC

Growth Opportunities New customers New products R&D, innovation

Sustainability Barriers to entry Specialized skills, processes Patent protection Brand loyalty

Capital Structure 3

Capital Structure






Market Interest Rates

Risk

Cost of Capital (%)

Investors required rate-of-return

Intrinsic Value of Operations (Discounted FCF)

Discounted by

Capital Markets Capital Structure (firm’s choice

of debt and equity)

Capital Structure 3

Capital Structure







Efficient Markets Market forces will tend to drive market value toward intrinsic value

Risk

Cost of Capital (%)



Market Value of the Firm

Total Debt

Market Value of Equity

Share Price

Number of Shares

Non-Operating Assets (Cash)

Discounted by


of debt and equity)

Capital Structure 3

Why Debt Matters

Companies often borrow in order to invest. Why is this important?

:: Financial leverage

:: Affects risk/return properties of debt and equity

:: Tax

:: Interest expense is tax deductible; more debt reduces taxes owed.:: So debt generates a tax shield value

:: Financial distress (“bankruptcy”)

:: If firm can’t pay debt obligations creditors have right to seize assets:: Bankruptcy proceedings often costly (e.g., legal fees, firm

productivity)

:: Cost of capital

:: Common valuation technique incorporates value of tax shields viaweight average cost of capital (WACC)

:: Incentives

:: Debt/equity mix can affect agency costs ... firm value:: Big topic in advanced corporate finance classes

Capital Structure 4

Plan

:1: What is leverage? What is levered?

:2: Frictionless environment. Miller-Modigliani Theorem:irrelevance of capital structure

:: Capital structure does not change firm value:: But it does change risk/return of debt/equity

:3: Environment with frictions: capital structure relevance

:: Optimal capital structure results from trade-off between taxbenefits of debt and potential bankruptcy costs

:4: Weighted average cost of capital (WACC)

:: A valuation shortcut that incorporates tax benefits of debt

:5: Valuation of defaultable debt

Capital Structure 5

What is Leverage?

Capital Structure 6

Levered Investment

What is “leverage?”

:: Fixed payments, paid first, lever-up the volatility of what’s left

Spreadsheet exercise

Capital Structure 7

http://bertha.tepper.cmu.edu/telmerc/public_files/financial_leverage.xlsx

Operating Leverage, Financial Leverage

Capital Structure 8

Operating Leverage

The risk in the business cash flows is affected by operatingleverage, but not by financial leverage.

Capital Structure 9

Operating AND Financial Leverage

Enter financial leverage

:: It affects the equity cost of capital (recall above example:leverage increases risk for shareholder)

:: Can also affect the debt cost of capital, if debt is big enoughto make financial distress an important possibility

Capital Structure 10

Effect of Corporate Financial Leverage

:: Recall:I Leverage increases riskI Risk is proportional to betaI So leverage must affect beta ....

:: Recall: “value weighted averages”

I Portfolio returns:rp = γ1r1 +

(1− γ1

)r2

I Portfolio expected returns:µp = γ1µ1 +

(1− γ1

)µ2

I Portfolio betas:βp = γ1β1 +

(1− γ1

)β2


Operating + Financial Leverage

Cash

AR, Inventory


(PPE)

AP

Debt

Equity

=


From Equity Beta to Business Asset BetaWe can estimate βE using stock return data and then solve for the beta that applies to the business assets.

:: If debt is riskless:

βBA = βEE

BA

:: If debt is risky (i.e., default is possible)

βBA = βDD

BA+ βE

E

BA


Warning! “Unlevered Beta”NOT what we have above. What you’ll find on the internet. Related to WACC. Assumes debt and tax shield betas are zero.Discussed further below.

Cash

AR, Inventory


(PPE)

AP

Debt

Equity

=

PV(tax benefits)

V = Vu + τD = D + E

=⇒ βuVu

V+ βtax

τD

V=

D

VβD +

E

VβE

=⇒ βu =E

V − τDβE =

1

1 + (1− τ)D/EβE


Example: AEO


Example: GPS


Industry DataNote: second column is net debt: Dnet = D − cash. So EV = BA = Dnet + E , and βBA = βE E/EV = βE (1 − Dnet/EV ), so

you can compute the 4th column given the 2nd and 1st . Source: COMPUSTAT averages, 1980-2012, via Bryan Routledge.


Summary: Operating + Financial Leverage


Summary: Operating + Financial Leverage







Efficient Markets Market forces will tend to drive market value toward intrinsic value

Risk

Cost of Capital (%)



Market Value of the Firm

Total Debt

Market Value of Equity

Share Price

Number of Shares

Non-Operating Assets (Cash)

Discounted by


of debt and equity)


The Irrelevance of Capital Structure(The Miller-Modigliani Theorems)


Capital Structure

:: Corporation Finance

:: Capital Budgeting

:: Decisions about the operations of the company

:: Use financial markets to select projects

:: Capital Structure

:: How should a project be funded?

:: How should the cash flows be allocated?


Capital Structure Decisions - Modern FinanceFranco Modigliani and Merton Miller, “The Cost of Capital, Corporation Finance and the Theory of Investment,” AmericanEconomic Review, 48, June 1958, 261-297


Debt Policy: No Frictions (no tax)

:: Two companies (A and B) have identical assets. Eachcompany produces cash flows (earnings or EBIT) equivalentto one ounce of gold for ONE year.

A: Debt = $0

B: Debt = $950 principal + $50 interest = $1000

:: Tax Rate is zero (τ = 0)


MM: Frictionless, Certainty


MM: Frictionless, Uncertainty


Effect of Capital Structure: No Frictions

:: In frictionless capital markets capital structure does notchange the value of the firm

:: Dividing up the cash-flow differently can’t change itsmagnitude nor its present value

:: Capital structure does affect the value of the components(equity, debt)

:: And the risk of the components


Effect of Capital Structure: No Frictions

No effect of firm value, big effect on risk and return

Cash + BA = V = Debt + EquityCash

VE (r$) +

BA

VE(rBA

)= E (rV ) =

D

VE (rD) +

E

VE (rE )

E (rE ) = E (rV ) +D

E

(E (rV )− E (rD)

)


Easy to see with Beta

βV =D

VβD +

E

VβE


Levered Project

Spreadsheet exercise


http://bertha.tepper.cmu.edu/telmerc/public_files/corporate_financial_leverage.xlsx

Summary: Frictionless Case

Corporate financial leverage ...

:: Does not change firm value

:: Does change the distribution of risk and expected returnbetween debt and equity holders

:: Does not make the firm riskier

:: Does make the equity riskier

:: Can make the debt risky (or riskier)


Capital Structure and Taxes(The present value of “tax shields”)


Debt Policy – In Practice

:: In practice companies spend a lot of effort choosing anoptimal capital structure

:: Capital structure changes do affect value


Debt Policy – In Practice[John R. Graham, Campbell R. Harvey, The theory and practice of corporate finance: evidence from the field, Journal of FinancialEconomics, Volume 60, Issues 2-3, May 2001, Pages 187-243 http://bit.ly/21Dj7K]


Debt Policy - Frictions (taxes!)

:: Two companies (A and B) have identical assets (hold capitalbudgeting decision fixed.) Each company produces cash flows(EBIT) equivalent to one ounce of gold per year (inperpetuity).

A: has debt of zero (100% equity financing)

B: as perpetual debt of D with an interest rate of r%

:: Tax rate is not zero (τ = 35%)


Perpetual Debt: Fact or Fiction?Source: U.K. to Repay First World War Bonds, Wall Street Journal, October 31, 2014. The bond is perpetual. The U.K.

government makes interest payments, but doesn’t have to pay the principal. But they were exercising some sort of prepaymentoption and paying the debt off since, in October 2014, interest rates were low relative to the rates on the bonds (exactlyanalogous to a homeowner pre-paying their mortgage when rates fall). Note for history buffs ... these bonds include debt incurredduring the Crimean War and the collapse of the South Sea Company! The latter got bundled in, along with a bunch of WWIdebt, during a 1927 “restructuring.”


http://www.wsj.com/articles/u-k-to-repay-first-world-war-bonds-1414745764

More Recent ExampleSource: Financial Times, LEX Column, April 1, 2016


MM: Taxes


Debt policy - Taxes and “Tax Shields”

V = VU + Value of Interest Deductibility

V ≈ VU + τ D

V = Value of the debt and equity (“the firm”)

VU = Value of the firm if it had no leverage

τ = Marginal tax rate

D = Amount of debt

Note: value of “interest deductibility” often called value of “taxshields.”


Summary

:: Having debt creates value

:: Reduces your tax bill

:: So “PV the FCF” understates a levered firm’s value.

:: NOPAT is “too low” since it ignores interest expense

:: What to do? Either

:1: Adjust the cash flows (“Adjusted Present Value” (APV))

:2: Adjust the discount rate (“Weighted Average Cost of Capital”(WACC))


Application: Levered Re-Cap


A Levered Re-Cap – Using MM and Tax Shields

Company X currently has $910 million debt (market value). Thereare 100 million shares outstanding at $81.90 each (market value).The CFO wants to issue $2,000 million in new debt and issue adividend with the proceeds. The tax rate is 30%.


Levered Re-Cap


Levered Re-Cap – Yeah ... Buts. . .

:: Why bother paying a dividend? Just hold on to the cash!

:: But equity is more risky for shareholders!

:: Increased interest expense is a bad thing: earnings will belower


Finance-1 in the News


Weighted Average Cost of Capital(The WACC)


Debt policy - Taxes, “Tax Shields” and the WACCBare bones: more coming in further finance classes

WACC: Weighted Average Cost of Capital

:: NOPAT (part of FCF) ignores interest expense

:: So expected taxes in FCF is too large

:: As a fix, the WACC lowers the discount rate to offset


WACC

WACC ≡ rf (1− τ)D

V+ re

E

V

:: rf = debt cost of capital (assumed riskless)

:: re = equity cost of capital (expected return)

:: τ = (marginal) corporate tax rate

:: rf (1− τ) = after tax cost of debt

:: V = D + E


Modigliani-Miller WACC FormulaRelating the definition of the WACC to the cost-of-capital for the (unlevered) business assets, r .

Simplest set of assumptions: (i) c = constant, perpetual stream ofafter tax expected FCF, unlevered firm (ii) D= principal onperpetual risk-free debt (iii) riskless interest rate = rf , (iv)opportunity cost of capital = r .

Tax shields:

Net Income =(EBIT − rf D

)(1− τ

)= EBIT

(1− τ

)− rf D︸︷︷︸

Net Income, No Deduction

+ rf τ D︸︷︷︸Tax Shield

Present value, perpetual stream of tax shields:

PV (Tax Shields) =rf τ D

rf

= τ D


Modigliani-Miller WACC Formula

Firm Value = Value(Unlevered Firm) + Value(Tax Shields)

Firm Value:

V =c

r+ τ D

Define L = D/V :

V =c

r+ τ L V

=c

r

( 1

1− τL

)=

c

r(1− τ DV )

Weighted-Average Cost of Capital:

WACC = r(1− τ D

V)




Firm Value:

V =c

r+ τ D

Define L = D/V :

V =c

r+ τ L V

=c

r

( 1

1− τL

)

=c

r(1− τ DV )


WACC = r(1− τ D

V)




Firm Value:

V =c

r+ τ D

Define L = D/V :

V =c

r+ τ L V

=c

r

( 1

1− τL

)=

c

r(1− τ DV )


WACC = r(1− τ D

V)


What the Hell is This Thing?

V =∞∑

t=1

E (FCFt)

(1 + r)t+∞∑

t=1

E (tst)

(1 + rts)t

=∞∑

t=1

E (FCFt)

(1 + rWACC )t


What the Hell is This Thing?

V =∞∑

t=1

E (FCFt)

(1 + r)t+∞∑

t=1

E (tst)

(1 + rts)t=∞∑

t=1

E (FCFt)

(1 + rWACC )t


Unlevered Beta ReduxAssume that the debt beta and the tax-shield beta are zero.


Using It


Bankruptcy and Tradeoff Theory(When debt becomes risky .... optimal capital structure)


A Levered Re-Cap – OK then. . .

:: Why stop at $2,000 million in debt?


Bankruptcy

Important to distinguish between:

:: Bankruptcy

:: Liquidity (can’t pay rD)

:: Insolvency (D > PV (FCF ))

:: A division of the cash flows

:: Business failure (FCF < 0)


Bankruptcy

Bankruptcy is typically not the main problem

Bankruptcy is a division of the cash flows


Bankruptcy Costs

Nevertheless .... dividing-up results in “deadweight costs.”

:: Direct costs

:: Legal fees:: Opportunity cost of management time

:: Indirect Costs

:: Lost business:: Production inefficiencies:: Employees quitting:: Inefficient liquidation (“firesale”)

Deadweight bankruptcy costs are costs that a non-levered firmwould not face if in the same business situation


How Big?

:: Bankruptcy Cost

= Value of assets before bankruptcy (but including anyeconomic distress) minus value after bankruptcy resolved


Bankruptcy Costs - LBOs/MBOs of the 1980s[Gregor Andrade and Steven N. Kaplan, How Costly is Financial (Not Economic) Distress? Evidence from HighlyLeveragedTransactions that Became Distressed, Journal of Finance, 53: 5 (October 1998)]


Bankruptcy and Tax Shields – The Tradeoff

:: Cash flows (EBIT) equivalent to one ounce of gold nextyear

:: Debt of D with an interest rate of y% (owe (1 + y)D atyear-end)

:: Tax Rate is τ = 35%

:: “Bankruptcy costs” are $b (e.g., legal fees)

:: Choose D


Trade-Off Theory of Capital Structure

VL = VU

+Value of tax savings of interest

−Value of bankruptcy costs


Defaultable Debt(“Junk Bonds”)


They Might Not Pay!Price=$100, par=$100, coup=0.15, prob(up)=0.9,recovery=$70. Returns = 15%, -30%, E(r) = 10.5%.

What do bondholders get if “default” occurs? What is their:

:: Promised return? (i.e., maximum return)

:: Realized return?

:: Expected return?


Exercise

Same as above, but the bond does not “sell at par:”

:: Price =$95

I Answer: realized returns are 0.2105263 and −0.2631579 and expected return is0.1631579


Debt Policy and Bankruptcy – Pricing Corporate Debt[Source: FINRA http://cxa.gtm.idmanagedsolutions.com/finra/bondcenter/tracemarketaggregatestats.aspx ]

:: Corporate bond yields are not “expected rates of return” theyare “maximum rates of return”



:: Corporate bond yields are not “expected rates of return” theyare “maximum rates of return”

:: Example: X Co. issues a one-year bond that will sell

at par ($100). The coupon rate (paid once at the end

of the year) is c. If the the company goes bankrupt

(20% chance), the bondholder will get $90 per bond.

The beta on this bond is 0. The riskless rate is 2%

and that the equity risk premium (E [rm − rf ]) on the

market is 6%.

:: Expected return = 2%

:: Promised (maximum) return = c%

:: Exercise: What is c?


Answer

Price =0.2× 90 + 0.8× 100× (1 + c)

1 + Expected Return

=0.2× 90 + 0.8× 100× (1 + c)

1 + rf + β(E (rm)− rf )

=0.2× 90 + 0.8× 100× (1 + c)

1 + rf + 0× 0.06

Solve for c :

c = 0.05

Point:

0.05 > 0.02


Exercise

:: Suppose that the beta on the bond is 0.3. What is theanswer?

I Answer: c = 7.25%. Comes from changing the discount rate from the risk-freerate to: rf + β(Erm − rf ) = .02 + .3× 0.06 = 0.038.


Finance-1 in the NewsSource: Hunt for yield risks inflating EM bond bubble, Financial Time, September 7, 2016


http://bertha.tepper.cmu.edu/telmerc/public_files/FTHuntForYieldRisk.pdf

Or TRY

“Hunt for The Hunt for Yield Ends in Argentina WSJ” see graphics(this one’s probably better)


Summary


Conclusion: Capital Structure

:: Debt policy (“leverage”) changes allocation of risk

:: This is super important to know

:: Note: shareholders can choose portfolios accordingly

:: Debt policy (“leverage”) changes value (wealth) because of(only because of) “frictions”

:: Taxes

:: Bankruptcy costs

:: [and others]


Summary: Capital Structure Module

:: What is leverage? What is the capital structure decision?

:: Modigliani-Miller: no ”frictions”

:: Leverage is irrelevant for firm value

:: Leverage affects risk/return properties of equity/debt:: Equity beta, asset beta

:: Frictions:

:: Tax: debt ”shield” adds value

:: WACC: discount rate that incorporates tax shield

:: Bankruptcy costs:: Levered Re-Cap

:: Pricing defaultable debt

:: Optimal capital structure: trades-off tax benefits of debt against costs ofbankruptcy.

::Capital Structure 76

EXTRA TIME? Debt Policy - Other Factors

:: Personal Taxes

:: Management Incentives

:: Conflicts of interest (agency)

:: Strategic (business strategy)

:: Others

:: More generally: capital structure is more than just “debtratio”


70391 - finance leverage and capital...

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