Corporate Claims EC Borja Larrain

Transcription

1 Corporate Claims EC 1745 Borja Larrain

2 Today: 1. Cash-flow rights and control rights. 2. Measuring leverage. 3. Leverage irrelevance of Modigliani and Miller. 4. WACC in an M&M world. 5. Perspective on M&M Readings: Chapters 15 and 16 Welch Assignment 6 due next Monday 11/24

3 In this class: What makes debt different from equity? Do corporations around the world issue similar types of securities? Is the ownership structure of typical U.S. firms the standard around the world? What is leverage? Why can leverage be irrelevant for the value of a corporation? What is the WACC of a corporation? Does the WACC vary with leverage?

4 1 Cash-flow rights and control rights The financial instruments issued by a firm assign two basic rights: Cash flow rights: how much and in what order claimholders get paid. Control rights: who takes decisions with respect to the use of the assets of the company and under what circumstances. Doing these two things at the same time sounds very complicated, but in practice it is done in almost all firms with a mixture of debt and equity. Debt: Cash-flow rights: debt gets paid first. Debt is the "senior" claim.

5 Control rights: most of the time debtholders have little influence over how a firm is managed ("armslength" financing). But debtholders can force bankruptcy and gain more control over the assets of the firm (Also, covenants). The Japanese or German model is very different from the Anglo-Saxon model in the sense that banks have big direct/indirect stakes in companies. Role of conglomerates (Keiretsus is Japan, Chaebols in Korea). Tax status: interest is "good" for the firm. Interest expense is considered a cost of production and it reduces the tax base of the corporation. Trading/Liquidity: often OTC (over-the-counter). Common equity: Cash-flow rights: equity gets paid after debt. "Junior" claim. Equity gets all the upside.

6 Control rights: shareholders vote. Shareholders are the "owners". Usually 1-share/1-vote in Anglo-Saxon markets, by law or regulation of the exchange. In other markets it is often the case that there are several "classes" of shares for the same company, with different cash flow and control rights. Most of the time there are two classes of shares and one of them carries most of the control rights (dual class shares). What is the value of control? Dispersed ownership vs. concentrated ownership and pyramids outside the U.S. Tax status: dividends are "bad" for the firm, they are an expensive way of paying to investors. Trading/Liquidity: often well-traded. Thetypicalstockinanemergingmarketistradedinonly 50% of the potential trading days, so not very liquid. Although liquidity has increased a lot in the last 5-10 years.

7 Sometimes it is useful to see these securities in payoff diagrams: payoff as a function of the value of the total value of the firm Payoff to debt is flat after its face value has been covered. Equity gets the upside. It looks like a call option. Convertible bond: a combination of debt and equity. E.g.: a bond with face value of $100 and convertible to 25% of the value of the firm if the investor wants to. Many things are left outside payoff diagrams: control rights and the timing of the cash flows (which, remember, for finance is crucial!) Other securities: Preferred stock:

8 Now rare in public companies. Cash-flow right: somewhere between debt and equity. Control right: not in general. Tax status: with better treatment of dividends for ordinary shares preferred equity is becoming less important. Stock options: granted to CEOs and employees. A call option allows you the CEO to buy shares of the company at a predetermined price, therefore it is more valuable when the price has increased. It is supposed to provide incentives to work hard. In the balance sheet, most assets of the firm ("capital" in the language of economics) have a counterpart in terms of financial claims. But a firm is not only capital. Workers also have "cash-flow" rights (wages) and "control" rights (e.g., strikes). For our analysis we ll ignore these non-financial claims.

9 2 Measuring leverage The purpose is to measure the extent to which owners (shareholders) are using somebody else s capital to run the firm. High leverage means that the equity share is small. Remember the simple version of a balance sheet: Assets Short term assets: Cash Inventories Accounts receivable Long term assets: PP&E Intangible assets Liabilities + Equity Short term debt: Short term bank debt Commercial paper Accounts payable Long term debt Shareholders equity: Equity raised Retained earnings

10 Short-term debt or current liabilities: includes claims by what we normally call "investors (e.g., banks), but also claims by suppliers (accounts payable), employees (compensation and benefits), etc. Long-term debt: different types of bonds and notes, of different maturities (longer than 3 years usually), currencies, etc. Other liabilities: "catch-all line" where many accounting tricks are buried. Usually long maturity claims by non-investors: government (taxes, environmental accruals), employees (pensions), and others. Financial Debt (FD) is often defined as long-term debt plus debt in current liabilities (exclude accounts payable and similar lines). Equity: book value or market value? Book value if the historical cost, better to use market value.

11 Debt is almost always measured with book values. Adjustmentsaretoohardandmostofthetimedo not affect the conclusions. One possible measure of leverage is FD/(FD+equity). FD/Equity: same as above, but not between 0 and 1. Also, Total Liabilities/Assets: broader than the previous definition. Similarly, Total Liabilities/Equity. Avoid FD/Assets: the converse is not really equity/assets, since it includes a lot of non-financial liabilities. For capital budgeting and the WACC (later in this class) use FD/(FD+equity).

12 Sometimes people use leverage as a measure of the vulnerability of the firm or as a measure of the chance of financial distress. This definition can misrepresent this vulnerability. The interest coverage ratio is a measure of "vulnerability". But remember that cash flows and earnings change easily fromoneyeartoanother.

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14 3 Leverage irrelevance of Modigliani and Miller With so many securities that a firm can issue: does it make a difference how the firm structures the RHS of the balance sheet? Does the composition of financing add value to the project? Modigliani and Miller (M&M) answered this question in 1958 with a strong NO! Both won a Nobel Prize in economics afterwards, so they were not stupid. However, in practice there is the intuition that some capital structures are better than others. For example, a highly levered firm can run into problems too often although its projects are good in a long-run sense.

15 So, are Modigliani and Miller stupid? Both won a Nobel Prize in economics, so we should better check that our "intuition" makes sense. The leverage irrelevance theorem of M&M is better understood as a way of illustrating when and why the capital structure of the firm affects value. M&M show that in a frictionless model the capital structure of the firm is irrelevant for value. So, look for distortions in markets if the capital structure is to have an effect. M&M do not teach us that there are no frictions in real markets. Intuition for M&M: pizza story (If you are really hungry you cut it into more slices?!)

16 More formally: if the operating revenue of the firm is the same under different capital structures, then capital structure is irrelevant for the firm s value. 3.1 Assumptions of the M&M Irrelevance Theorem Perfect capital markets, i.e., No transaction costs. No taxes. No differences of opinion. No big players (buyers/sellers). Perfect capital markets imply that the firm is following its optimal investment plan. Remember, there

17 are no differences of opinion, no liquidity problems, etc. (in short, no limits to arbitrage). So, if you see a firm with a sub-optimal investment level it is costless to take it over and move to the optimal investment plan. Every firm follows the NPV rule without any deviations. The Irrelevance Theorem of M&M states that, in a perfect capital market, capital structure should not matter. In words, if a firm has assets for $100, it will not affect its value if it takes more or less debt. Why? Assume, towards a contradiction, that the optimal capital structure of the firm is 25% debt and 75% equity. In other words, the firm is worth more than $100 with this capital structure, and less everywhere else. Since it s costless to move there, the firm would do it instantly: repurchase all existing securities and issue 25% debt and 75% equity. Since this is costless: should it really add value?

18 3.2 Proof of M&M I: "home-made" leverage Assume there are two firms, A and B, and each one produces the same cash flows F. Firm A is 100% equity: V A = S A Firm B has debt for D: V B = D + S B Interest rate on debt is r D. For simplicity, assume that there is no risk of default, i.e., F >(1 + r D )D in any state of nature. This is not absolutely necessary, we could do everything substituting r D for the expected return on debt as we saw early in this course. The key thing is that there are not costs of default, not that the probability of default is zero. More on this later in the course.

19 If I buy the shares of company B I receive dividends of F (1 + r D )D. If I buy the shares of company A, taking a debt of D myself, I receive a flow of F (1 + r D )D. Therefore, since flows are the same under the two strategies, the value of these two strategies has to be the same S B = S A D V B = V A See the assumptions working: same interest rate for the firm and individual investors, short-selling is implicitly allowed, etc. What happens if there are frictions in the market? This logic does not work. Again, M&M teaches us that in a frictionless market the capital structure is irrelevant, not that there are no frictions to start with.

20 4 WACC in an M&M world In an M&M world, the value of the firm is: V = E( F ) 1+E(r a ) Where E(r a ) is the expected return on the assets or projects of the firm (e.g., the CAPM rate of return) WACC stands for Weighted Average Cost of Capital: WACC = w d E(r d )+(1 w d )E(r s ) Where w d istheweightofdebtinthecapitalstructure, i.e., leverage, and E(r i ) is the expected return on a security such as debt or equity. Does the WACC depend on leverage? It does not, according to M&M.

21 In a frictionless market, the average expected return on the securities issued by the firm has to be equal totheexpectedreturnontheprojectsownedbythe firm: WACC = E(r a ). If WACC 6= E(r a ) there is an arbitrage opportunity. It s like a portfolio with an expected return different from the average expected return of what is inside the portfolio. Remember that arbitrage is costless in an M&M world! This is just a way of restating the first irrelevance theorem in terms of rates of return. Why does the WACC stay constant? Magic? No, leverage and expected returns are moving in a way that their changes perfectly cancel out each other.

22 If the expected return on debt does not change with leverage (assume that there is no risk of default so E(r d )=r F ), then the expected return on equity is: E(r s )=E(r a )+ w d 1 w d [E(r a ) r F ] As leverage increases, the expected return on equity increases, but in such a way that the WACC stays constant. See graphs for the cases of risk-free debt and risky debt. Example: A one-period firm with E(r a ) = 10%. Cash flows are $50 with 50% probability and $150 with 50% probability. Its debt promises to pay $75 and has expected return of 7%. What is the price of equity, and its expected return? Compare this with a firm with 100% equity.

23 Graphing all Rates 30 Expected Rate of Return, in % Normally Distributed Payoffs Risk Free Rate = 5.55% Bond, Promised Rate of Return Stock E(R) Bond E(R) WACC = Firm E(R) = 10% Debt Ratio, in %

24 Only Equity Levered Equity State Equity Debt Equity High cash flow $150 $75 $75 Low cash flow $50 $50 $0 E(cash flow) $100 $62.5 $37.5 E(r) 10% 7%? P $90.9 $58.4? w d 0%? From M&M we know that the value of equity in the second case has to be =32.5. This implies that the expected return on equity is 37.5/32.5-1=15.4% Leverage, w d, is 58.4/90.9=64% in this case. The WACC of the levered firm is: WACC = 64% 7% + (1 64%) 15.4% WACC = 10% WACC = E(r a )

25 Homework: What if debt promises $80 and has an expected return of 7.2%? Note that by E(r a ) we refer to the expected return on the real assets, e.g., the machines and projects of the firm. In the M&M world the "firm" is simply the sum of real assets. A "firm" will be different from the sum of real assets when financing starts to matter (next few classes). Does it all fit together: the NPV, CAPM, WACC? Yes, it does. Usually the CAPM is used to compute expected returns on debt and equity and with those 2 inputs plus leverage you can compute the WACC. Then the WACC is used as the denominator in the NPV formula. Careful: this last step makes sense if the project under study is similar to the average project that the company already has.

26 5 Perspective on M&M M&M not only applies to capital structure, but to any re-packaging of securities that does not change the underlying cash flows. Capital structure will have value consequences when it affects the investment policy of the firm, i.e., the cash flowsorthesizeofthepizza. M&M is just a benchmark. It clarifies confusions with respect to why capital structure should matter (you ll find plenty of it in the real world, even if people have received an MBA from HBS or Chicago!).