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Financial ManagementFIN 455 - Lecture 13
Capital Structure Decisions Part I
IFM Chapter 15
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Topics Covered
Business versus financial risk
M&M Theory of Capital structure
MM theory
Zero taxes
Corporate taxes
Corporate and personal taxes
Hamadas Equation
Capital Structure and financial distress
Optimal structure
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The key questions of corporate finance
Valuation: How do we distinguish betweengood investment project and bad ones?
Financing: How should we finance theinvestment projects we choose to undertake?
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Financing policy
Real investment policies imply funding needs.
But what is the best source of funds? Internal funds (i.e. cash)?
External
Debt (i.e. borrowing)?
Equity (i.e. issuing stock)?
Moreover, different kinds of Internal funds (e.g. cash reserves, cutting dividends)
Debt (e.g. bonds vs. banks)
Equity (e.g. Venture Capital vs. Initial Public Offering)
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Capital structure
Capital structure represents the mix of claimsagainst the firms assets and free cash flows
Some characteristics of financial claims Payoff structure (e.g. fixed promised payment)
Priority (debt paid before equity)
Maturity
Restrictive covenants
Real investment policies imply funding needs.
Voting rights
Options (convertible securities, call provisions, etc..)
We will focus on leverage (debt vs. equity) and how
it can affect the firm value
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The fundamental questions in
capital structure
Is there an optimal capital structure, i.e.,an optimal mix between debt and equity?
More generally, can you add value on the
RHS of the balance by following a goodfinancial policy, or by changing the mix ofdebt and equity?
Miller and Modigliani said NO under a setof assumptions.
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How can capital structure
affect value?
V =
t=1
FCFt(1 + WACC)t
WACC= wd (1-T) rd + wereThe impact of capital structure on value dependsupon the effect of debt on:
WACCFCF
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Business Risk and Financial Risk
Business risk:
Uncertainty in future EBIT.
Depends on business factors such as competition,operating leverage, etc.
Financial risk:
Additional business risk concentrated on commonstockholders when financial leverage is used.
Depends on the amount of debt and preferredstock financing.
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Capital Structure Theory with Miller
and Modigliani (1958)
Assumptions of the M&M World
1. Investment is given.
2. Perfect Capital Markets
a. No transactions costsb. No taxesc. Info. is costless to obtain, available to all.
3. Equal access
4. Homogeneous expectations
5. Riskless debt
6. Zero growth
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MMs Irrelevance Proposition I
Financing decisions are irrelevant for the value of thefirm
Purely financial transactions do not change the cash
flows. They are zero NPV investments, thus they neither
increase or decrease the value of the firm.
A firm cannot change the total value of its securities just
by splitting its cash flows into different streams.
Firm value is determined by real assets, not by securities it
issues.
Thus, the choice of capital structure is irrelevant as long as
investment is taken as given.
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AN EVERYDAY ANALOGYIt should cost no more to assemble achicken than to buy one whole.
Pie Theory I
VL = VU
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The Law of the Conservation of Value
Proposition I tells us Firm Value is determined on theleft hand side of the balance sheet by real assets-not bythe proportions of debt and equity securities issued bythe firm.
VL = VU
The law also applies to the mixof debt securities issued by the firm.The choice of long-term vs. short-term, secured vs. unsecured, seniorvs. subordinated, convertible vs. nonconvertible debt should have noeffect on firm value.
The law implies that the choice is irrelevant, assumingperfect capital markets and provided that the choicedoes not affect the firms investment, borrowing andoperating policies.
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Under MM I, Borrowing does notaffect Return on Invested Capital
ErDrrEDfirmtheofValueLDA s )(
securitiesallofuemarket val
incomeoperatingexpectedassetsonreturnExpected
Ar
ED
Er
ED
DrWAACr
LDA s
MM showed that, in perfect capital markets, the companys
borrowing decision does not affect either the firms operatingincome or the total market value of its securities. Therefore, itdoes not affect return on invested capital
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How Leverage Affects Equity Return:MMs Proposition II
The cost of equity to a levered firm is equal to cost ofequity of unlevered firm in the same risk class plus arisk premium
rA = rU = rs DUUL rrE
Drrs
M&M II: If the value of the firm remains thesame, why return on equity increases linearly
with leverage (debt-equity ratio) ?
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How changing capital structure
affects betas?
V
EB
V
DBBB sLDUA
V
EB
V
DBBB sLDUA
DUUsL BBE
DBB DUUsL BB
E
DBB
For a given betaof debt, equitybeta increaseswith leverage.
Market risk of a common stock of a levered firm =
business risk of its operating assets
+ financial risk of its capital structure.
E
DBBB UUsL :freeriskisdebtIf
E
DBBB UUsL :freeriskisdebtIf
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r
D
E
rD
rs
M&M Proposition II
rA
= WACC
Risk free debt Risky debt
WACC remainsconstant as leverageincreases and this isconsistent with M&MI, since the company
cost of capitalshould only dependon the risk of itsassets.
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Proposition I: VL = VU.
Proposition II: rsL = rsU + (rsU - rd)(D/E).
If we assume debt is risk free: rd = rf, Bd = 0
= Risk Free Rate + Business Risk Premium + Financial Risk Premium
Take away from M&M with Zero
Taxes (1958)
E
DRRBRRBrr
FMUFMUFLs )(
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Take away from M&M with Zero
Taxes (contd)
According to MM, borrowing increases expected
returns only because it increases risk.
The increase of risk exactly offsets the increase in
expected returns leaving stockholders no better or
worse off.
The firms overall market value is independent of
capital structure.
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Trip to the Real World.
Industry Debt Ratio* (%)
Electric and Gas 43.2Paper and Plastic 30.4
Food Production 22.9
Retailers 21.7
Equipment 19.1
Chemicals 17.3
Computer Software 3.5
Average over all industries 21.50%
Companies and industries vary in their capital structure
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What is Missing from the Simple
M & M Story?
Taxes:
Corporate taxes
Personal taxes
Costs of Financial distress
No transaction costs for issuing debt or equity
No asymmetric information about the firmsinvestments
Capital structure does not influence managersinvestment decisions
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Capital Structure and Corporate Taxes
Financial policy matters because it affects a
firms tax bill.
Different financial transactions are taxed differently.
For a corporation:
Interest payments are considered a business
expense, and are tax exemptfor the firm.
Dividends and retained earnings are taxed.
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Capital Structure & Corporate Taxes
Corporate tax deductibility of interest increases the totaldistributed income to both bondholders and
shareholders.Income
Statement of
Firm U
Income
Statement of
Firm L
Earnings before interest and taxes $1,000 $1,000
Interest paid to bondholders - 80
Pretax income 1,000 920
Tax at 35% 350 322
Net income to stockholders 650 598
Total income to both bondholders and
stockholders $0+650=$650 $80+598=$678
Interest tax shield (.35 x interest) $0 $28
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Capital Structure & Corporate Taxes-- Example (contd)
Example - You own all the equity of Space Babies Diaper Co. Thecompany has no debt. The companys annual cash flow is $900,000before interest and taxes. The corporate tax rate is 35% You have theoption to exchange 1/2 of your equity position for 5% bonds w ith aface value of $2,000,000. Should you do this and why?
($ 1,000 s ) A ll Equity
EBIT 900
Interest Pmt 0
Pretax Income 900
Taxes @ 35% 315
Net Cash Flow 585
1/2 Debt
900100800280
520
Total Cash Flow
All Equity = 585
*1/2 Debt = 620
(520 + 100)Tax benefit: $620 - $585 = $35
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The PV of tax shield
Example (contd):
Tax benefit = amount of Debt x Interest rate x Tax Rate
= 2,000,000 x (.05) x (.35) = $35,000
PV of $35,000 in perpetuity = 35,000 / .05 = $700,000
PV Tax Shield = $2,000,000 x .35 = $700,000
cD
cD TDR
TRDShieldTaxofPV
c
D
cD TDR
TRDShieldTaxofPV
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M&M I with corporate tax
Value of Leveraged firm = Value of All Equity Firm
+ PV Tax Shield
VL = VU + TD
Example (contd):
All Equity Value = 585 / .05 = 11,700,000
PV Tax Shield = 700,000
Firm Value with 1/2 Debt = $12,400,000
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Value of Firm, V
0Debt
VL
VU
Under MM with corporate taxes, the firms value
increases continuously as more and more debt is used.
TD
MM relationship between firm value anddebt when corporate taxes are considered.
VL = VU + TD
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The Cost of Equity at Different Levels of
Debt: Hamadas Equation
MM theory implies that beta changes with leverage.
U is the beta of a firm when it has no debt (theunlevered beta)
sL = U [1 + (1 - T)(D/E)]
= Risk Free Rate + Business Risk Premium + Financial Risk
Premium
E
DTRRBRRBrr
FMUFMUFLs )1()(
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Notes About the New Propositions
When corporate taxes are added,
VL VU. VL increases as debt is added to thecapital structure, and the greater the debt
usage, the higher the value of the firm.
rsL increases with leverage at a slower rate
when corporate taxes are considered.
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Personal Taxes
Investors return from debt and equity aretaxed differently
Classical Tax Systems
Interest and dividends are taxed as ordinaryincome.
Capital gains are taxed at a lower rate.
Capital gains can be deferred (contrary todividends and interest)
Corporations have a 70% dividend exclusion
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Capital structure and personal &
corp. taxes -- Example
Interest Equity Income
Income before tax $1 $1
Less corporate tax at Tc =.35 0 0.35Income after corporate tax 1 0.65
Personal tax at TpB = .35 and Tpe = .105 0.35 0.068
Income after all taxes $0.675 $0.582
Advant age to deb t= $ .083
Capital structure determines whether operatingincome is paid out as interest or equity income.
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Corporate and Personal TaxesMillers Model
TC = corporate tax rate.
TPB = personal tax rate on debt income.
TPE = personal tax rate on stock income.
D
TTTVV
PB
PECUL ]
1)1)(1(1[
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Millers Model with Corporate
and Personal Taxes Example
DV
DV
DVV
U
U
UL
25.0
)75.01(
]30.01
)12.01)(40.01(1[
Tc = 40%, TPB = 30%, and TPE = 12%.
Value rises with debt; each $1 increase in debt raisesLs value by $0.25.
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Tax shield of debt matters,
potentially quite a bit
Pie theory gets you to ask the right question: How does afinancing choice affect the IRS bite of the corporate pie?
Pie Theory II
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Is debt policy still irrelevant withCorporate and Personal Taxes?
Two special cases:
ifTPB = TPE, then the relative advantagedepends only on the corporate tax rate.
If(1-TpB) = (1-TpE)(1-Tc) then debt policy isirrelevant.
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Conclusions with Personal Taxes
Use of debt financing remainsadvantageous, but benefits are less thanunder only corporate taxes.
Implications: Is leverage good? Since taxes favor debt for most firms, should all
firms be 100% debt financed?
Note: However, Miller argued that in equilibrium,the tax rates of marginal investors would adjustuntil there was no advantage to debt.
What is missing?
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Cost of Financial Distress
Costs arising from bankruptcy or distorted businessdecisions before bankruptcy.
Financial distress without bankruptcy: Financial distressoccurs when promises to creditors are broken or
honored with difficulty. Financial distress includesfailure to pay interest or principal or both. Financialdistress can sometimes lead to bankruptcy.
Evidence of bankruptcy costs: Eastern Airlines: $114 millions in professional fees Enron: $306 millions in consultants fees
The mere threat of bankruptcy can be very costly Loss of suppliers Loss of valuable employees and inability to attract new
employees
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Debt policy matters if debt is risky and
may cause Financial Distress
Pie Theory III
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Capital structure and costly
financial distress
Market Value = Value if all Equity Financed
+ PV Tax Shield
- PV Costs of Financial Distress
VL = VU + TD PV (Cost of Financial Distress)
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Tradeoff between the tax benefits and the costs of distress
determines an optimal capital structure
Debt
MarketValueofTheFirm
Value ofunlevered
firm
PV of interesttax shields
Costs offinancial distress
Value of levered firm
Optimal amountof debt
Maximum value of firm
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Static-tradeoff Theory of Capital
Structure
There is a tradeoff between the tax benefits and the
costs of financial distress. This tradeoff determines the optimal capital structure.
At moderate debt levels, the increase in risk issmall, so tax advantages dominate.
At some point, the probability of financial distressincreases rapidly with additional borrowing.
Also, if the firm cant be sure of utilizing the taxshield further, the tax advantage disappears.
This is known as the static-tradeoff theory of capitalstructure.
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Beyond M&M,
Theories of Capital Structure
The static-tradeoff theory:
taxes, costs of distress
Pecking order approach.
Asymmetric information: convey private information,
reduce adverse selection costs.
Agency Costs:
conflicts of interest between stakeholders.
Corporate control contests:
leverage influences the ability of firms to avoid hostile
takeovers.