FINS3625

Applied Corporate Finance

Lecture 4 (Chapter 16) Jared Staneld March 21, 2012

Capital Structure Choices

When raising funds from outside investors, a rm must choose what type of security to issue and what capital structure to have.

Capital Structure Choices

Capital structure
The collecMon of securiMes a rm issues to raise capital from investors.

Firms consider whether the securiMes issued:

Will receive a fair price in the market Have tax consequences Entail transacMons costs Change future investment opportuniMes

Capital Structure Choices

A rms debt-to-value raMo is the fracMon of the rms total value that corresponds to debt D / (E+D)

Figure 16.1 Debt-to-Value RaMo [D/(E + D)] for Select Industries

Figure 16.2 Capital Structures of Amazon.com and Barnes & Noble

Measuring the Eects of Leverage on a Business

FOXTEL, a cable company and purveyor of hilariously over-sized remotes, is deciding whether it wants to increase the leverage of its business by compleMng a leveraged recapitalizaMon

Measuring the Eects of Leverage on a Business

Leveraged RecapitalizaMon: a change in capital structure or ownership composiMon involving substanMal debt nancing Examples:
Issuing debt and using the proceeds to nance a large project or acquisiMon Issuing debt and using the proceeds to pay a dividend to equity holders Issuing debt and using the proceeds to repurchase shares

Well get to why a rm would want to do this later

Measuring Eects of Leverage

Key RaMos by RaMng and Industry

Earnings SensiMvity

Can they do it? Why would they want to do it?

16.2 Capital Structure in Perfect Capital Markets

A perfect capital market is a market in which:
SecuriMes are fairly priced No tax consequences or transacMons costs Investment cash ows are independent of nancing choices

Leverage will increase the risk of the rms equity and raise its equity cost of capital

16.2 Capital Structure in Perfect Capital Markets

Modigliani and Miller (MM) with perfect capital markets
In an unlevered rm, cash ows to equity equal the free cash ows from the rms assets. In a levered rm, the same cash ows are divided between debt and equity holders. The total to all investors equals the free cash ows generated by the rms assets.

Figure 16.3 Unlevered Versus Levered Cash Flows with Perfect Capital Markets

16.2 Capital Structure in Perfect Capital Markets

MM ProposiMon I:
In a perfect capital market, the total value of a rm is equal to the market value of the free cash ows generated by its assets and is not aected by its choice of capital structure.

VL= E + D =VU (Eq. 16.1)

Table 16.1 Returns to Equity in Dierent Scenarios with and Without Leverage

Figure 16.4 Unlevered Versus Levered Returns with Perfect Capital Market

16.2 Capital Structure in Perfect Capital Markets

Homemade leverage
Investors use leverage in their own porkolios to adjust rms leverage A perfect subsMtute for rm leverage in perfect capital markets.

16.2 Capital Structure in Perfect Capital Markets

Leverage and the Cost of Capital
Weighted average cost of capital (pretax)

D E rU = rD + rE D+E D+E

(Eq. 16.2)

16.2 Capital Structure in Perfect Capital Markets

MM ProposiMon II: The cost of capital of levered equity:
The Cost of Levered Equity

D rE = rU + (rU rD ) E

(Eq. 16.3)

Cost of levered equity equals the cost of unlevered equity plus a premium proporMonal to the debt-equity raMo.

Figure 16.5 WACC and Leverage with Perfect Capital Markets

CompuMng the Equity Cost of Capital in an MM World

Gemng ready for the release of Hunger Games, you decide to start a gin shop called Hunger Gins. You will carry an assortment of movie-related items such as bows and arrows, futurisMc beard kits, and absolutely zero copies of the Japanese lm Barle Royale

CompuMng the Equity Cost of Capital in an MM World

Your rm has a market value of $75,000. Suppose you borrowed $50,000 when nancing Hunger Gins, your unlevered cost of equity was 12% and your cost of debt was 3%. According to MM ProposiMon II, what will your rms equity cost of capital be?

$50,000 rE = 12% + (12% 4%) = 28% $25,000

The equity cost of capital should be the expected return of the equity holders given the capital structure (with MM assumpMons).

Relaxing the MM AssumpMons

This helps us understand why rms choose their capital structures the way they do Market imperfecMons can create a role for the capital structure.
Corporate taxes:
CorporaMons can deduct interest expenses. Reduces taxes paid
Increases amount available to pay investors. Increases value of the corporaMon.

16.3 Debt and Taxes

Interest Tax Shield
The gain to investors from the tax deducMbility of interest payments
Interest Tax Shield = Corporate Tax Rate Interest Payments

CompuMng the Interest Tax Shield

Hunger Gins pro-forma income statement is below. Given its marginal corporate tax rate of 39%, what is the expected amount of the interest tax shield for Hunger Gins in years 2012 through 2015?
Hunger'Gifts'Income'Statement'($'million) Total&sales Cost&of&sales Selling,&general,&and&administrative&expense Depreciation Operating'income Other&income EBIT Interest&expense Income'before'tax Taxes&(39%) Net'Income 2012 $&&&&&&&& 1,058 $&&&&&&&&&& (670) $&&&&&&&&&& (207) $&&&&&&&&&&&& (64) $&&&&&&&&&&& 117 $&&&&&&&&&&&&&&& 2 $&&&&&&&&&&& 119 $&&&&&&&&&&&& (27) $&&&&&&&&&&&&& 92 $&&&&&&&&&&&& (36) $&&&&&&&&&&&&& 56 2013 $&&&&&&&&& 960 $&&&&&&&& (572) $&&&&&&&& (187) $&&&&&&&&&& (65) $&&&&&&&&& 136 $&&&&&&&&&&&&& 7 $&&&&&&&&& 143 $&&&&&&&&&& (29) $&&&&&&&&& 114 $&&&&&&&&&& (44) $&&&&&&&&&&& 70 2014 $&&&&&&&& 1,036 $&&&&&&&&&& (621) $&&&&&&&&&& (195) $&&&&&&&&&&&& (65) $&&&&&&&&&&& 155 $&&&&&&&&&&&&&&& 1 $&&&&&&&&&&& 156 $&&&&&&&&&&&& (32) $&&&&&&&&&&& 124 $&&&&&&&&&&&& (48) $&&&&&&&&&&&&& 76 2015 $&&&&&&&& 1,117 $&&&&&&&&&& (634) $&&&&&&&&&& (193) $&&&&&&&&&&&& (59) $&&&&&&&&&&& 231 $&&&&&&&&&&&&&&& 9 $&&&&&&&&&&& 240 $&&&&&&&&&&&& (35) $&&&&&&&&&&& 205 $&&&&&&&&&&&& (80) $&&&&&&&&&&& 125

CompuMng the Interest Tax Shield

Plan:
From Eq. 16.4, the interest tax shield is the tax rate of 39% mulMplied by the interest payments in each year.

CompuMng the Interest Tax Shield

Execute:

($million) Interest'expense Interest'tax'shield'(39%''interest'expense)

2012 $''''''''''''' 27 $'''''''''' 10.5

2013 $''''''''''' 29 $''''''''' 11.3

2014 $''''''''''''' 32 $'''''''''' 12.5

2015 $''''''''''''' 35 $'''''''''' 13.7

CompuMng the Interest Tax Shield

Evaluate:
By using debt, Hunger Gins is able to reduce its taxable income and therefore decreased its total tax payments by $48.0 million over the four- year period. Thus the total amount of cash ows available to all investors (debtholders and equity holders) is $48.0 million higher over the four-year period.

16.3 Debt and Taxes

When a rm uses debt, the interest tax shield provides a corporate tax benet each year. To determine the benet, compute the present value of the stream of future interest tax shields.

! Cash Flows to Investors$ ! Cash Flows to Investors$ # & = # without Leverage & + (Interest Tax Shield) " with Leverage % " %

Figure 16.6 The Cash Flows of the Unlevered and Levered Firm

16.3 Debt and Taxes

By increasing the cash ows paid to debt holders through interest payments, a rm reduces the amount paid in taxes. The increase in total cash ows paid to investors is the interest tax shield.

16.3 Debt and Taxes

Value of the Interest Tax Shield
Cash ows of the levered rm are equal to the sum of the cash ows from the unlevered rm plus the interest tax shield. By the ValuaMon Principle the same must be true for the present values of these cash ows.

16.3 Debt and Taxes

Value of the Interest Tax Shield
MM ProposiMon I with taxes: The total value of the levered rm exceeds the value of the rm without leverage due to the present value of the tax savings from debt: VL = VU + PV(Interest Tax Shield) (Eq. 16.5)

16.3 Debt and Taxes

Interest Tax Shield with Permanent Debt
The level of future interest payments varies due to:
changes in the amount of debt outstanding, changes in the interest rate on that debt, changes in the rms marginal tax rate, and the risk that the rm may default and fail to make an interest payment.

16.3 Debt and Taxes

Weighted Average Cost of Capital with Taxes
Another way to incorporate the benet of the rms future interest tax shield Weighted Average Cost of Capital with Taxes

16.3 Debt and Taxes

The reducMon in the WACC increases with the amount of debt nancing. The higher the rms leverage, the more the rm exploits the tax advantage of debt, and the lower its WACC.

Figure 16.7 The WACC with and without Corporate Taxes

Relaxing More AssumpMons: Costs of Financial Distress

If increasing debt increases the value of the rm, why not shin to 100% debt? With more debt, there is a greater chance that the rm will default on its debt obligaMons. A rm that has trouble meeMng its debt obligaMons is in nancial distress.

Relaxing More AssumpMons: Costs of Financial Distress

Direct Costs of Bankruptcy
Each country has a bankruptcy code designed to provide an orderly process for serling a rms debts.
However, the process is sMll complex, Mme-consuming, and costly. Outside professionals are generally hired. The creditors may also incur costs during the process. They onen wait several years to receive payment.

Relaxing More AssumpMons: Costs of Financial Distress

Direct Costs of Bankruptcy
Average direct costs are 3% to 4% of the pre- bankruptcy market value of total assets.
Likely to be higher for rms with more complicated business operaMons and for rms with larger numbers of creditors.

Relaxing More AssumpMons: Costs of Financial Distress

Indirect Costs of Financial Distress
Dicult to measure accurately, and onen much larger than the direct costs of bankruptcy.
Onen occur because the rm may renege on both implicit and explicit commitments and contracts.

EsMmated potenMal loss of 10% to 20% of value Many indirect costs may be incurred even if the rm is not yet in nancial distress, but simply faces a signicant possibility that it may occur in the future.

Relaxing More AssumpMons: Costs of Financial Distress

Examples:
Loss of customers:
Customers may be unwilling to purchase products whose value depends on future support or service from the rm.

Loss of suppliers:
Suppliers may be unwilling to provide a rm with inventory if they fear they will not be paid

Relaxing More AssumpMons: Costs of Financial Distress

Examples:
Cost to employees:
Most rms oer their employees explicit long- term employment contracts. During bankruptcy these contracts and commitments are onen ignored and employees can be laid o

Fire Sales of Assets:

Companies in distress may be forced to sell assets quickly.

OpMmal Capital Structure: The Tradeo Theory

Tradeo Theory:
Total value of a levered rm equals the value of the rm without leverage plus the present value of the tax savings from debt, less the present value of nancial distress costs:
V L = VU + PV (Interest Tax Shield) PV (Financial Distress Costs)

(Eq. 16.10)

16.5 OpMmal Capital Structure: The Tradeo Theory

Key qualitaMve factors determine the present value of nancial distress costs:
The probability of nancial distress
Depends on the likelihood that a rm will default. Increases with the amount of a rms liabiliMes (relaMve to its assets). It increases with the volaMlity of a rms cash ows and asset values.

16.5 OpMmal Capital Structure: The Tradeo Theory

Key qualitaMve factors determine the present value of nancial distress costs:
The magnitude of the direct and indirect costs related to nancial distress that the rm will incur.
Depend on the relaMve importance of the sources of these costs and likely to vary by industry.

16.5 OpMmal Capital Structure: The Tradeo Theory

As debt increases, tax benets of debt increase unMl interest expense exceeds EBIT. Probability of default, and hence present value of nancial distress costs, also increases. The opMmal level of debt, D*, occurs when these the value of the levered rm is maximized. D* will be lower for rms with higher costs of nancial distress.

Figure 16.8 OpMmal Leverage with Taxes and Financial Distress Costs

16.5 OpMmal Capital Structure: The Tradeo Theory

Costs of nancial distress reduce the value of the levered rm.
Amount of the reducMon increases with probability of default, which increases with debt level.

16.5 OpMmal Capital Structure: The Tradeo Theory

Tradeo Theory:
rms should increase their leverage unMl it reaches the maximizing level. The tax savings that result from increasing leverage are just oset by the increased probability of incurring the costs of nancial distress. With higher costs of nancial distress, it is opMmal for the rm to choose lower leverage.

16.5 OpMmal Capital Structure: The Tradeo Theory

The Tradeo Theory helps to resolve two important facts about leverage:
The presence of nancial distress costs can explain why rms choose debt levels that are too low to fully exploit the interest tax shield. Dierences in the magnitude of nancial distress costs and the volaMlity of cash ows can explain the dierences in the use of leverage across industries.

Relaxing More AssumpMons: Agency Issues and InformaMon Costs

Agency costs:
costs that arise when there are conicts of interest between stakeholders.

Managerial Entrenchment:
managers onen own shares of the rm, but usually own only a very small fracMon of the outstanding shares. Shareholders have the power to re managers.
In pracMce, they rarely do so.

Relaxing More AssumpMons: Agency Issues and InformaMon Costs

SeparaMon of ownership and control creates the possibility of management entrenchment

Managers may make decisions that:
Benet themselves at investors expense, Reduce their eort, Spend excessively on perks Engage in empire building.

Relaxing More AssumpMons: Agency Issues and InformaMon Costs

If these decisions have negaMve NPV for the rm, they are a form of agency cost.
Debt provides incenMves for managers to run the rm eciently:
Ownership may remain more concentrated, improving monitoring of management. Since interest and principle payments are required, debt reduces the funds available at managements discreMon to use wastefully.

Relaxing More AssumpMons: Agency Issues and InformaMon Costs

Equity-Debt Holder Conicts

A conict of interest exists if investment decisions have dierent consequences for the value of equity and the value of debt.
most likely to occur when the risk of nancial distress is high. managers may take acMons that benet shareholders but harm creditors and lower the total value of the rm.

Relaxing More AssumpMons: Agency Issues and InformaMon Costs

Agency costs for a company in distress that will likely default:

Excessive risk-taking
A risky project could save the rm even if the expected outcome is so poor that it would normally be rejected.

Under-investment problem
Shareholders could decline new projects. Management could distribute as much as possible to the shareholders before the bondholders take over.

Relaxing More AssumpMons: Agency Issues and InformaMon Costs

As debt increases, rm value increases

Interest tax shield (TCD) Improvements in managerial incenMves.

If leverage is too high, rm value is reduced by

present value of nancial distress costs agency costs

The opMmal level of debt, D*, balances these benets and costs of leverage.

Relaxing More AssumpMons: Agency Issues and InformaMon Costs

Asymmetric informaMon
Managers informaMon about the rm and its future cash ows is likely to be superior to that of outside investors. This may moMvate managers to alter a rms capital structure.

Relaxing More AssumpMons: Agency Issues and InformaMon Costs

Leverage as a Credible Signal

Managers use leverage to convince investors that the rm will grow, even if they cannot provide veriable details. The use of leverage as a way to signal good informaMon is known as the signaling theory of debt.

Relaxing More AssumpMons: Agency Issues and InformaMon Costs

Market Timing
Managers sell new shares when they believe the stock is overvalued, and rely on debt and retained earnings if they believe the stock is undervalued.

Relaxing More AssumpMons: Agency Issues and InformaMon Costs

Adverse SelecMon and the Pecking Order Hypothesis

Suppose managers issue equity when it is overpriced. Knowing this, investors will discount the price they are willing to pay for the stock. Managers do not want to sell equity at a discount so they may seek other forms of nancing.

Relaxing More AssumpMons: Agency Issues and InformaMon Costs

The pecking order hypothesis states:

Managers have a preference to fund investment using retained earnings, followed by debt, and will only choose to issue equity as a last resort.

Relaxing More AssumpMons: Financial Flexibility

So far these decisions have been largely from the perspecMve that nancing decisions are one-Mme events
A broader perspecMve views these individual events within the context of a longer-run nancing strategy If a rm will always be able to raise debt and equity capital on acceptable terms, this is a non- issue

Relaxing More AssumpMons: Financial Flexibility

More realisMc is a rm has to worry about how nancing decisions today will aect future access to capital markets
Say the Hunger Games is a big hit and becomes a huge franchise (a la Star Wars or Lord of the Rings). Hunger Gins becomes a rapidly growing business in conMnuing need of nancing. Even if an immediate debt issue appears arracMve, extensive reliance on debt nancing will close o the top
Unable to get more debt without addiMonal equity

Relaxing More AssumpMons: Financial Flexibility

Whats the problem with that?

Think about the market-Mming story we talked about earlier

Equity can be a ckle source of nancing

Depending on market condiMons and previous performance, equity may not be available at a reasonable price (or any price)

16.7 Capital Structure: Pumng It All Together

Use the interest tax shield if your rm has consistent taxable income Balance tax benets of debt against costs of nancial distress Consider short-term debt for external nancing when agency costs are signicant. Increase leverage to signal condence in the rms ability to meet its debt obligaMons.

16.7 Capital Structure: Pumng It All Together

Be mindful that investors are aware that you have an incenMve to issue securiMes that you know are overpriced Rely rst on retained earnings, then debt, and nally equity Do not change the rms capital structure unless it departs signicantly from the opMmal level.