Chapter 15. Chapter 15 Overview. Value and Capital Structure. Debt Policy: The Capital Structure Decision

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1 Chapter 15 Debt Policy: The Capital Structure Decision Chapter 15 Overview Target and Optimal Capital Structure Risk and Different Types of Financing Business Risk Financial Risk Determining the Optimal Capital Structure Capital Structure Theory 1 Value and Capital Structure Assets Value of cash flows from firm s real assets and operations Liabilities and Stockholder s Equity Market value of debt Market value of equity Value of Firm Value of Firm

2 Recall, the GE s WACC from Chapter 12 r debt (1-T) = 4.7%(1-.35) = 3.1%, r equity = 10% D/V = 33%, E/V = 67% WACC = 7.7% Question: Why not use more debt financing since debt financing is so cheap? Would GE s WACC be lower, its stock price higher if more debt financing were used? Selected Long-term Debt to Total Market Value (D/V) Ratios GM: 95% Boeing: 16% McDonald s 17% Intel & Microsoft 0.1% Disney 17% Wal-Mart 11% SBC 26% 2 Factors Influencing Capital Structure Decisions Business Risk riskiness of firm s operations if it used no debt The firm s tax position higher effective tax rate makes debt financing more attractive Access to capital Types of Assets: Tangible vs. Intangible Managerial Risk Attitudes

3 Adding Debt to the Picture: Financial Risk The additional risk placed on the firm s stockholders through the use of debt. More debt means higher interest expense which represents a higher hurdle for the firm s EBIT to cover. Therefore, the use of debt concentrates (or multiplies) the firm s business risk on its stockholders. Lessons from Business & Financial Risk discussion: More business risk discourages the increased use of debt financing. More debt = more risk, which means higher interest rates as a company increases the proportion of debt that it uses in its capital structure. Also, the increase in the proportion of debt financing leads to a higher required return on the company s stock. 3 Determining the Optimal Capital Structure First, all debt, now, no debt. What s the deal? Of course, the answer has to be somewhere in between. But where? Although, the cost of debt and equity will rise as a firm increases its debt proportion, the company should choose the capital mix that maximizes its stock price and minimizes its WACC.

4 Determining Optimal Capital Structure Example D/V Rd(1-T) Re WACC EPS=DPS Price 0% 4.5% 15.0% 15.0% $3.00 $ % 4.5% 15.0% 14.0% $3.50 $ % 4.8% 15.5% 13.4% $4.00 $ % 5.1% 16.1% 12.8% $4.50 $ % 5.6% 16.8% 12.3% $4.95 $ % 6.2% 17.6% 11.9% $5.40 $ % 7.2% 19.4% 12.1% $5.65 $ % 8.5% 21.5% 12.4% $5.30 $ % 10.0% 24.0% 12.8% $5.20 $21.67 WACC = (D/V)Rd(1-T) + (1-D/V)Re g = 0, so Price = DPS/Re 30.0% 25.0% Capital Structure and Cost of Capital 20.0% 15.0% 10.0% 5.0% 0.0% 0% 10% 20% 30% 40% 50% 60% 70% 80% Debt/Value Rd(1-T) Re WACC 4 Capital Structure and Stock Price $35.00 $30.00 $25.00 $20.00 $15.00 $10.00 $5.00 $0.00 0% 10% 20% 30% 40% 50% 60% 70% 80% Debt/Value

5 Value and Capital Structure Assets Value of cash flows from firm s real assets and operations Liabilities and Stockholder s Equity Market value of debt Market value of equity Value of Firm Value of Firm Capital Structure Theory Miller and Modigliani (MM) did significant research trying to determine the effect of capital structure on firm value. Both won Nobel Prizes for their work, and Modigliani was an econ. prof. here at the U of I during part of their research. 5 MM Capital Structure Theory (no taxes): Prop s I & II The first MM study assumed no taxes, no bankruptcy costs, and other unrealistic assumptions. Capital structure does not affect cash flows e.g... No taxes No bankruptcy costs No effect on management incentives 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. First MM study result: capital structure doesn t matter, it has no effect on firm value or WACC.

6 M&M No tax Cost world: of no Capital change in cash flow, just different split between investors. r equity = r assets D + E ( rassets rdebt ) D E WACC = (1 Tc ) rdebt + requity D + E D + E Weighted Average Cost of Capital r r E 6 r D r A D V Weighted Average Cost of Capital without taxes (M&M view) r r E WACC r D Includes Bankruptcy Risk D V

7 MM Capital Structure Theory & Taxes A follow-up MM study incorporated the effect of taxes. Result: More debt is best, because the interest deduction generates extra value. (Tax shield = debt x r x T) Value of levered firm = value of all-equity firm + present value of tax shield PV of tax shield = D x rd x Tc = D x Tc rd Value of firm = value of all-equity firm + TcD C.S. & Corporate Taxes Example - You own all the equity of Space Babies Diaper Co.. 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, Should you do this and why? C.S. & Corporate Taxes Example - You own all the equity of Space Babies Diaper Co. with a required return of 10%. 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? All Equity 1/2 Debt EBIT 1,000 1,000 Interest Pmt Pretax Income 1, % Net Cash Flow $600 $540

8 C.S. & Corporate Taxes Example - You own all the equity of Space Babies Diaper Co. with a required return of 10%. 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? All Equity 1/2 Debt EBIT 1,000 1,000 Interest Pmt Pretax Income 1, % Net Cash Flow $600 $540 Total Cash Flow All Equity = 600 *1/2 Debt = 640 ( ) Capital Structure PV of Tax Shield = (assume perpetuity) D x r D x Tc r D = D x Tc Example: 8 Capital Structure Firm Value = Value of All Equity Firm + PV Tax Shield Example

9 MM Tax Effect of Financial Leverage on Firm Value Value Added by Debt Tax Shelter Benefits Value of All-Equity Firm Value of Levered Firm Capital Structure Theory in Reality MM ignored the costs of bankruptcy and the threat of bankruptcy in their 2nd analysis = costs of financial distress Reality is: there is a trade-off between the benefits of debt financing against higher interest rates and the increased risk of bankruptcy. 9 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

10 Financial Distress Market Value of The Firm Maximum value of firm Value of unlevered firm PV of interest tax shields Costs of financial distress Value of levered firm Debt Optimal amount of debt Financial Choices Trade-off Theory - Theory that capital structure is based on a trade-off between tax savings and distress costs of debt. Financial Slack Theory that firms want to maintain ready access to cash &/or financial markets to ensure investment in new profitable projects. Pecking Order Theory - Theory stating that firms prefer to issue debt rather than equity if internal finance is insufficient. 10 Pecking Order and Signaling Theory Asymmetric Information - managers have different and better information about the firm s prospects than do investors. The way management decides to raise capital sends a signal about the firm s future prospects. New Debt issue = good signal, attractive investment opportunities for the firm, don t want to dilute these good returns by sharing them with more stockholders Bad future prospects including possible losses can be signaled by issuing more new stock to spread the future pain.