Can your choice of Capital Structure add value to the firm? 1
The firm borrows $4,000 and buys back 200 shares at $20 per share. 2
Notice that the expected return on equity is higher for the leveraged company (both debt and equity), but so is the risk -- notice that the range of return for the all equity company is 5% to 25% while the range for the leveraged company is 0% to 40% -- more variability, more volatility, more risk! 3
decisions will add value to the firm. I ll begin with the quote attributed to Yogi Berra, a noted Manager (not a financial manager) and one-time catcher for the New York Yankees: It is after a ball game and the pizza man is delivering pizza to Yogi. Should I cut it in four slices as usual, Yogi the pizza man asks. No, replies Yogi, Cut it into eight, I m hungry tonight. Can we use this analogy with capital structure? The value of business assets, assuming there is no tax deductibility of interest, is not affected by the capital structure mix of debt and equity. The present value of the cash flows from assets, the value of assets, is equal to the value of securities issued by the business. Changing the mix of securities does not affect the value of the assets. The left-hand side of the balance sheet, assets, determines the size of the pizza; the mix of securities on the right-hand side of the balance sheet determines how the pizza is sliced. The only way to increase the amount of pizza is to increase the value of assets (pizza), not slicing (financing) in a new combination of slices. Good investment decisions are the key to valuation. This theory or idea won Franco Modigliani and Merton Miller (MM) a 4
Nobel Prize. Yogi did not even receive honorable mention. 4
M&M s world was one of no taxes and perfectly efficient capital markets. 5
MM s proposition I (debt irrelevance proposition). Debt policy should not matter to shareholders. It is the assets that count for value. Why should leveraging, or substituting debt for equity in the capital structure, affect the value of assets? Investors do not need businesses to add leverage to their investment portfolio, they can do it themselves. In the example, instead of the firm borrowing, an individual investor can borrow and obtain the same results (in this case borrow $2,000 and buy 100 additional shares). 6
MM s proposition I (debt irrelevance proposition). Debt policy should not matter to shareholders. It is the assets that count for value. Why should leveraging, or substituting debt for equity in the capital structure, affect the value of assets? Investors do not need businesses to add leverage to their investment portfolio, they can do it themselves. In the example, instead of the firm borrowing, an individual investor can borrow and obtain the same results (in this case borrow $2,000 and buy 100 additional shares). 7
Does substituting lower cost debt for higher cost equity lower the cost of capital? Not without a tax advantage for debt (no taxes for M&M). By adding debt to the firm, the shareholders have additional risk. In the event of liquidation, the bondholders would be paid first. To compensate for the addition financial risk, stockholders will demand a higher return, leaving the overall cost of capital unchanged. 8
The WACC or the r assets does not change as debt is added to the capital structure.this concept is MM s proposition II, which states that the expected return on the common stock increases as the debt/equity ratio increases. Why doesn t the WACC change? As more low cost debt is added to the capital structure, the required rate of return on equity increases to offset the advantage of low cost debt. The WACC does not change; the market value of the firm does not change. Debt does not matter in this situation where the deductibility of interest is not a factor. Debt has an explicit cost in the form of an interest rate, and an incidental, implicit cost impact on the required rate of return on equity as debt is added to the capital structure. In the world of MM, any benefits incurred by substituting cheaper debt for more expensive equity are offset by increases in both their costs. Notice that as the cost of debt increases, even the creditors (bondholders) get edgy about sharing the income stream with other bondholders. The default risk increases. The rate of increase in the shareholder s required rate of return begins to slow as bondholders begin to bear a greater share of the risk. The conclusion is the same: the WACC or expected return on assets or the cost of the package of debt and equity (WACC) does not change. Debt does not affect the value of the assets! 9
Reality tells us that financial managers are concerned about finding that right mix of capital structure that produces the lowest or optimal cost of capital. This indicates that there are other factors working beyond MM s assumptions. It is unlikely that capital structure is irrelevant in the real world. In spite of this Modigliani and Miller were pioneers in moving capital structure analysis from an environment in which firms picked their debt ratios based upon their peer group and management preferences to one that recognized trade-offs. They drew attention to the fact that good investment decisions comprise the core of valuation for the firm. There are three claims on the operating income of business: creditors, shareholders, and government. The pizza remains the same size, but there is another slice, the government s. MM would still say that the value of the pizza is not changed by slicing, but anything the firm can do to reduce the size of the government s slice will leave more for the others. The deductibility of interest is a tax shield that diverts government taxes to the shareholders. 10
In the real world does capital structure matter? Look at the above example. 11
Cash flow to investors is $6500 in the all-equity case. 12
Case flow to investors (bond holders and stockholders is $7550). Who gets less? The government because of the interest tax shield. 13
How can we calculate the value of the interest tax shield? 14
The interest tax shield is equal to the amount of debt times the tax rate. The value of the leverage firm equals the value of the all-equity firm plus the present value of the interest tax shield. Thus capital structure can add value to the firm. But there is a serious omission in this argument! (see the following page.) 15
What is wrong in this picture? See the next slide for an answer. 16
On the cost of capital side, because of the tax advantage, the cost of capital reclines as you add debt to your capital structure (solid green line), unlike M&M s unchanging WACC (dashed green line). But there is a serious omission in this argument. If the value of the firm rises and the cost of capital drops as we add debt, shouldn t the logically conclusion be to have a capital structure that was all debt? Ah, there s the rub. That argument ignores the fact that as the debt/equity ratio rises, the costs of financial distress (possible bankruptcy) increases. 17
Now our equation is complete. The market value of the firm equals the all-equity value plus the present value of the interest tax shield minus the present value cost of financial distress. The present value of the cost of financial distress depends both on the probability of distress and the magnitude of the costs encountered if distress occurs. Aside: be sure to read about bankruptcy procedures and financial distortions in your text. As a firm gets into financial hot water it loses suppliers, customers and employees. There are no winners in bankruptcy (except the lawyers). 18
The Trade-off Theory says that capital structure matters. At moderate debt levels the probability of financial distress is trivial, and the tax advantages dominate. The added costs of financial distress overtakes the added value of the tax shield at some point and may lower that value of the firm at some high debt/equity ratio. The theoretical optimum capital structure is the debt/equity level in which the PV of the tax shield is just offset by the PV costs of financial distress. This debt/equity level will maximize market value of the business. Notice that this involves a trade-off: between the value of the tax shield and the cost of bankruptcy. 19
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Afterword on the trade-off Theory: Costs of Distress Vary with Type of Asset. Real asset firms tend to lose less value in bankruptcy than firms with significant intangible assets, such as research and development firms who depend upon human capital. If your manufacturing firm is going belly up, the plant and equipment will be around to be liquidated. If a service firm is going belly up, the employees are going to put on their walking shoes and there will be very little to liquidate. Studies have show that sometimes the trade-off theory seems to apply and at other times we see financial sound large companies with little or no debt. It appears they are guided by an alternate theory. (See next page for an explanation of the Pecking Order Theory. 21
Businesses prefer to issue debt rather than external equity if internally generated cash flow is insufficient. Use of internally generated funds does not have the signaling effect, positively or negatively, as external funding does. If external funds must be raised, equity will be used reluctantly, reserved as the residual in the finance pecking order. Pecking order is: 1. Internal Equity (Reinvested funds) 2. Debt 3. External Equity (Stock Issue) Under the pecking order theory there is no target debt/equity ratio because there are two kinds of equity: internally generated earnings retained and external stock sales. Internal equity is the first choice for financing ahead of debt, and finally, external equity funding. (See next page.) 22
Internal funds are the cheapest and have the least oversight. There are no floatation costs involved. Firms that run out of internal funds turn next to the bond market, where costs are less expensive than in the external equity market. External equity is the most expensive, and as we mentioned earlier in the course, an external stock issue signals the market that the stock is overpriced and is usually followed by a correction. Although the approaches are different, both the Trade-off and Pecking Order Theories conclude that capital structure matters and that the choice of capital structure can add value to the firm (unlike what M&M said). 23