Financial Leverage and Capital Structure Policy

Capital Structure Theories

Modigliani and Miller model

Trade-off theory Agency theory Signaling theory

Capital Structure Effects on Value

The impact of capital structure on value depends upon the effect of debt on:
WACC

Feedback

to FCF

t 1

FCFt t (1 WACC )
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MM entered a theoretical universe where the following conditions existed

No taxes

Capital structure has no impact on operating cash flows

No agency costs No financial distress costs, riskless debt No information asymmetry Perpetual cash flows, no growth Individuals and corporations borrow at the same rate No transactions costs
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MM Proposition 1 with Zero Taxes

The value of a firm is independent of its capital structure. Value depends solely on the level and risk of the firms cash flow VU = value of unlevered firm (no debt) VL = value of levered firm (has debt) and VL = VU = EBIT capitalized at WACC, since with zero growth reinvestment is zero; rsu and rsL are the returns to the stock of an unlevered and levered firm, respectively

EBIT V WACC

EBIT V rsU
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MM Proposition 2 with Zero Taxes

The cost of equity of a levered firm is equal to the cost of equity of an unlevered firm plus a risk premium which depends on the degree of financial leverage. Reductions in capital costs as a result of using more lower cost debt (rd) are exactly offset by increases in the cost of levered equity (rsL) due to added financial risk.

WACC depends on Business Risk

The WACC is equal to the unlevered cost of equity (rsU) over any range of debt levels, where rsU depends on the firms business risk.
Business

risk = Variability in EBIT

Industry cyclicality Fixed costs (operating leverage)

Investors Indifferent

Investors desiring a specific level of leverage can create it by borrowing in their own portfolio MM Conclusion: Capital structure can be viewed as irrelevant under very restrictive assumptions.

Proposition 2 equation for the levered cost of Equity

For a zero-growth company with no taxes, Free Cash Flow to Equity = Net Income = EBIT Interest Expense (1)

rsL

EBIT rd D S EBIT V SD rsU

EBIT rsU ( S D)

From Proposition 1

(2)

rsL

rsU ( S D) rd D S
D S

Substitute (2) into (1)

This is the Proposition 2 equation
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rsL rsU (rsU rd )

MM Proposition 2: No taxes

Cost of Capital (%) rs

rsU

WACC rd Debt/Value Ratio (%)

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MM Proposition 1 with Taxes

The value of an unlevered firm is equal to EBIT (1-T) capitalized at the cost of equity
VU EBIT (1 T ) rsU

The value of a levered firm is equal to the value of an unlevered firm of the same risk class, plus the value of the interest tax savings capitalized at the cost of debt
VL VU rd TD VU TD rd
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MM Proposition 2 with Taxes

The cost of equity of a levered firm is equal to the cost of equity of an unlevered firm plus a risk premium which depends on both the degree of leverage and the corporate tax rate.

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MM Proposition 2 with Taxes

D rsL rsU (rsU rd )(1 T ) SL
Risk premium now includes (1-T)

rsL increases with leverage at a slower rate when corporate taxes are considered. The WACC continues to decline as new debt is added.
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MM Proposition II: With taxes

Cost of Capital (%)

rs

rsU

WACC rd(1 - T) Debt/Value Ratio (%)

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MM relationship between value and debt with taxes

Value of Firm, V (%) VL TD
VU

VU Debt

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Trade-off Theory

MM theory ignores financial distress costs, which increase as more leverage is used: Higher debt costs, including negotiation and monitoring by creditors (MM assume constant cost) Feedback to Free Cash Flow

Rejection of high risk but +NPV investments (underinvestment) Lost customers, suppliers, and employees Loan covenants, which constrain growth Investment in Capital (NOA) increases as lose trade credit Fire sales of assets to raise cash

Contradicts assumption of MM that capital structure doesnt effect operating cash flows
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Trade-off Theory (cont.)

Trade-off theory suggests optimal capital structure is reached at point where marginal distress costs exceed the marginal tax benefit from adding debt in the MM model.
Since these costs are only significant at high levels of debt, WACC could be relatively unaffected for many capital structures

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Trade-off theory suggests these types of firms will use more debt

Strong cash flow Low variability in cash flow Low growth opportunities (predictable funds needs and less risk of jeopardizing growth investments) Large size (safety and lower growth) Marketable collateral (less service or R&D intensive) Product not subject to ongoing maintenance/warranties, observable quality Profitable enough to benefit from tax shelter

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Debt can reduce Equity Agency Costs

Equity agency problem is that managers might:

use corporate funds for non-value maximizing

purposes (perks, acquisitions, value-destroying growth)

or seek low risk due to undiversified interest in firm

Problem is most significant in large firms with diffuse stockholders where management ownership is low
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Debt can reduce Equity Agency Costs (cont.)

The use of financial leverage: Bonds free cash flow for firms generating more cash than required to fund +NPV opportunities, reducing perk consumption and value-destroying growth. Increases free cash flow by forcing efficiencies: failure risk gets managers attention Substitute for other strategies: outside board members, stock ownership, large outside blockholders, takeover threat

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Debt can reduce Equity Agency Costs (cont.)

Debtholders can serve as monitors for diffuse free-riding stockholders However, debt agency costs will increase: negotiation, monitoring, covenants, under-investment

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Signaling Theory

MM assumed that investors and managers have the same information. Where significant information asymmetries exist, stockholders assume: Company issues new stock when it is overvalued Bonds are issued when stock is undervalued Stock issues indicate lower expected FCF, unwilling to commit to increased debt service Leverage-decreasing events signal overvalued stock, and vice versa, supported by empirical data

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Signaling theory results in Pecking Order Hypothesis

Firms will choose the following sequence of funding sources to maintain financial flexibility and avoid negative signals Retained earnings Maintain borrowing Excess cash capacity Debt issuance Stock issuance Evidence: profitable firms use less debt (surprise) because they can build more equity internally. Contradicts Trade-off theory which suggests high debt due to low default risk and need for tax shelters.

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Summing the theories

This leaves us with:
VL = VU + tax benefit financial distress + equity agency debt agency + signaling

Capital structure decision requires judgment!

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Other factors in setting the target capital structure

Effect on sustainable growth: willingness to increase debt allows for higher growth rate now. Debt ratios of other firms in the industry.

Lender and rating agency attitudes (impact on bond ratings).

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