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Capital Structure: Debt Versus Equity
Capital Structure: Debt Versus Equity
Advantages of Debt
Interest is tax deductible (lowers the effective cost of debt) Debt-holders are limited to a fixed return so stockholders do not have to share profits if the business does exceptionally well Debt holders do not have voting rights
Disadvantages of Debt
Higher debt ratios lead to greater risk and higher required interest rates (to compensate for the additional risk)
Business Risk
Standard measure is beta (controlling for financial risk) Factors:
Demand variability Sales price variability Input cost variability Ability to develop new products Foreign exchange exposure Operating leverage (fixed vs variable costs)
Financial Risk
The additional risk placed on the common stockholders as a result of the decision to finance with debt
Financial Risk
Leverage increases shareholder risk Leverage also increases the return on equity (to compensate for the higher risk)
Question?
Is the increase in expected return due to financial leverage sufficient to compensate stockholders for the increase in risk?
Topics To Be Covered
Leverage in a Tax Free Environment How Leverage Affects Returns The Traditional Position
Capital Structure
When a firm issues debt and equity securities it splits cash flows into two streams:
Safe stream to bondholders Risky stream to stockholders
Capital Structure
Modigliani and Miller (1958) show that financing decisions dont matter in perfect capital markets M&M Proposition 1:
Firms cannot change the total value of their securities by splitting cash flows into two different streams Firm value is determined by real assets Capital structure is irrelevant
Assumptions
By issuing 1 security rather than 2, company diminishes investor choice. This does not reduce value if: Investors do not need choice, OR There are sufficient alternative securities Capital structure does not affect cash flows e.g... No taxes No bankruptcy costs No effect on management incentives
Effects of Leverage
What happens if WPS levers up again by borrowing an additional $10,000 and at the same time paying out a special dividend of $10 per share, thereby substituting debt for equity? This should have no impact on WPS assets or total cash flows:
V is unchanged D= $35,000 E= $75,000 - $35,000 = $40,000
Stockholders will suffer a $10,000 capital loss which is exactly offset by the $10,000 special dividend.
Effects of Leverage
What if instead of assuming V is unchanged we allow V it rise to $80,000 as a result of the change in capital structure? Then E = $80,000 - $35,000 = $45,000 Any increase or decrease in V as a result of the change in capital structure accrues to the shareholders
Effects of Leverage
What if the new borrowing increases the risk of bankruptcy? This would suggest that the risk of the old debt is higher (and the value of the old debt is lower) If this is the case, then shareholders would gain from the increase in leverage at the expense of the original bondholders.
Strategy 2
Buy 1% of Firm Ls Equity and Debt
Dollar investment= Dollar Return= From owning .01 DL From owning .01 EL Total .01DL + .01EL = .01VL .01 interest .01 (Profits interest) .01 Profits
Strategy 4
Buy 1% of Firm Us Equity and borrow on your own account .01DL (home-made leverage)
Dollar investment= Dollar Return= From borrowing .01DL From owning .01 EU Total .01(Vu DL) -.01 interest .01 (Profits) .01 (Profits interest)
D E rA = rD + rE D+E D+E
M&M Proposition II
rE rA
rD
Risk free debt Risky debt
D E
M&M Proposition 2
Bonds are almost risk-free at low debt levels
rD is independent of leverage rE increases linearly with debt-equity ratios and the increase in expected return reflects increased risk
D BE = BA + ( BA BD ) E
WACC
WACC is the traditional view of capital structure, risk and return.
D E WACC = rA = rD + rE V V
WACC
Expected Return .20=rE .15=rA .10=rD
Debt All assets Equity
BD
BA
BE
Risk
WACC
Example - A firm has $2 mil of debt and 100,000 of outstanding shares at $30 each. If they can borrow at 8% and the stockholders require 15% return what is the firms WACC?
D = $2 million E = 100,000 shares X $30 per share = $3 million V = D + E = 2 + 3 = $5 million
WACC
Example - A firm has $2 mil of debt and 100,000 of outstanding shares at $30 each. If they can borrow at 8% and the stockholders require 15% return what is the firms WACC? D = $2 million
E = 100,000 shares X $30 per share = $3 million V = D + E = 2 + 3 = $5 million
An intermediate position
A moderate degree of financial leverage may increase the return on equity (but less than predicted by M&M proposition 2) A high degree of financial leverage increases the return on equity (but by more than predicted by M&M proposition 2) WACC then declines at first, then rises with increasing leverage (U-shape) Its minimum point is the point of optimal capital structure.
rD
D E
rD
D E
Capital Structure
PV of Tax Shield =
(assume perpetuity)
D x rD x Tc rD
= D x Tc
Example: Tax benefit = 1000 x (.10) x (.40) = $40 PV of 40 perpetuity = 40 / .10 = $400
Capital Structure
Firm Value = Value of All Equity Firm + PV Tax Shield Example All Equity Value = 600 / .10 = 6,000 PV Tax Shield = 400
rE
WACC
rD
D E
Financial Distress
Maximum value of firm
Debt/Total Assets
Financial Choices
Trade-off Theory - Theory that capital structure is based on a trade-off between tax savings and distress costs of debt. Pecking Order Theory - Theory stating that firms prefer to issue debt rather than equity if internal finance is insufficient.