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Chapter 15

Capital Structure

Decisions

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Capital Structure Decisions


A preview of capital structure issues
Business versus financial risk
The impact of debt on returns
Capital structure theory
Example: Choosing the optimal structure

Setting the capital structure in practice

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Basic Definitions
V = value of firm
FCF = free cash flow
WACC = weighted average cost of
capital
rs and rd are costs of stock and debt
We and wd are percentages of the
firm that are financed with stock and
debt.

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How can capital structure affect value?

t 1

FCFt
t
(1 WACC)

WACC = wd (1-T) rd + we rs
(Continued)

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A Preview of Capital Structure Effects


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

(Continued)

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The Effect of Additional Debt on WACC


Debtholders have a prior claim on
cash flows relative to stockholders.
Debtholders fixed claim increases
risk of stockholders residual claim.
Cost of stock, rs, goes up
(Debt increases the cost of stock).
(Continued)

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The Effect of Additional Debt on WACC


Firms can deduct interest expenses.
Debt reduces the taxes paid
Frees up more cash for payments to

investors
Reduces after-tax cost of debt

(Continued)

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The Effect on WACC (Continued)


Debt increases risk of bankruptcy
Causes pre-tax cost of debt, rd, to increase.

Adding debt increase percent of firm


financed with low-cost debt (wd) and
decreases percent financed with highcost equity (we)
Net effect on WACC = uncertain.
(Continued)

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The Effect of Additional Debt on FCF


Additional debt increases the
probability of bankruptcy.
Direct costs: Legal fees, fire sales, etc.

Indirect costs: Lost customers,


reduction in productivity of managers
and line workers, reduction in credit (i.e.,
accounts payable) offered by suppliers
(Continued)

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Impact of indirect costs


NOPAT goes down due to lost
customers and drop in productivity
Investment in capital goes up due to
increase in net operating working
capital (accounts payable goes up as
suppliers tighten credit).

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Business Risk and Financial Risk


Business risk is the risk a firms common
stockholders would face if the firm had no
debt.
It is the risk inherent in the firms
operations, which arises from uncertainty
about future operating profits and capital
requirements.
It is the uncertainty in projections of future
EBIT, NOPAT, and ROIC.

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Factors That Influence Business Risk

Uncertainty about demand (unit sales).


Uncertainty about output prices.
Uncertainty about input costs.
Product and other types of liability.
Degree of operating leverage (DOL).

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Business Risk and Financial Risk

Financial risk is the additional risk placed


on common stockholders as a result of
the decision to finance with debt.
If a firm debt financial leverage), then the
business risk is concentrated on the
common stockholders.

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Business Risk versus Financial Risk :


A conclusion
Business risk:
Uncertainty in future EBIT , NOPAT, and ROIC.
Depends on business factors such as
competition, operating leverage, etc.

Financial risk:
Additional business risk concentrated on
common stockholders when financial leverage
is used.
Depends on the amount of debt and preferred
stock financing.

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Consider Two Hypothetical Firms


Firm U
No debt
$20,000 in assets
40% tax rate

Firm L
$10,000 of 12% debt
$20,000 in assets
40% tax rate

Both firms have same operating leverage,


business risk, and EBIT of $3,000. They
differ only with respect to use of debt.

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Impact of Leverage on Returns

EBIT
Interest
EBT
Taxes (40%)
NI
ROE

Firm U

Firm L

$3,000
0
$3,000
1 ,200
$1,800

$3,000
1,200
$1,800
720
$1,080

9.0%

10.8%

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Why does leveraging increase return?


More EBIT goes to investors in Firm L.
Total dollars paid to investors:
U: NI = $1,800.
L: NI + Int. = $1,080 + $1,200 = $2,280.
Taxes paid:
U: $1,200; L: $720.
Equity $ proportionally lower than NI.

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The Trade-off Between


Profitability And Risk
If a company decides to use debt, it
will be faced with a trade-off between
the following:
Debt can be issued to increase
expected EPS, but then the firms
shareholders will have to take
more risk.

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The Trade-off Between


Profitability And Risk
Stay all-equity financed, but then the
firm shareholders will end up with
lower expected EPS
To find out what to do, we need to
determine how debt financing affects
the firms value, not just EPS
The pizza theory of capital structure
provides the answer.

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Capital Structure
Theory

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Capital Structure Theory


MM theory
Zero taxes
Corporate taxes
Corporate and personal taxes

Trade-off theory
Signaling theory

Pecking order theory

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Who are Modigliani and Miller (MM)?


They published theoretical papers
that changed the way people thought
about financial leverage.
They won Nobel prizes in economics
because of their work.
MMs papers were published in 1958
and 1963. Miller had a separate
paper in 1977. The papers differed in
their assumptions about taxes.

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What assumptions underlie the MM


and Miller models?

Firms can be grouped into


homogeneous classes based on
business risk.
Investors have identical
expectations about firms future
earnings.
There are no transactions costs.
(More...)

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All debt is riskless, and both


individuals and corporations can
borrow unlimited amounts of money
at the risk-free rate.
All cash flows are perpetuities. This
implies perpetual debt is issued,
firms have zero growth, and
expected EBIT is constant over time.
(More...)

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MMs first paper (1958) assumed


zero taxes. Later papers added
taxes.
No agency or financial distress
costs.
These assumptions were necessary
for MM to prove their propositions
on the basis of investor arbitrage.

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MM Theory: Zero Taxes


MM prove, under a very restrictive set of
assumptions, that a firms value is
unaffected by its financing mix:
VL = VU.

Therefore, capital structure is irrelevant.


Any increase in ROE resulting from financial
leverage is exactly offset by the increase in
risk (i.e., rs), so WACC is constant.

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MM Theory: Corporate Taxes


Corporate tax laws favor debt financing
over equity financing.
With corporate taxes, the benefits of
financial leverage exceed the risks: More
EBIT goes to investors and less to taxes
when leverage is used.
MM show that: VL = VU + TD.
If T=40%, then every dollar of debt adds 40
cents of extra value to firm.

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MM relationship between value and debt


when corporate taxes are considered.
Value of Firm, V
VL
TD
VU
Debt
0
Under MM with corporate taxes, the firms value
increases continuously as more and more debt is used.

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MM relationship between capital costs


and leverage when corporate taxes are
considered.
Cost of
Capital (%)

rs

20

40

60

80

WACC
rd(1 - T)
Debt/Value
100
Ratio (%)

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Millers Theory: Corporate and


Personal Taxes

Personal taxes lessen the advantage


of corporate debt:
Corporate taxes favor debt financing
since corporations can deduct interest
expenses.
Personal taxes favor equity financing,
since no gain is reported until stock is
sold, and long-term gains are taxed at a
lower rate.

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Millers Model with Corporate and


Personal Taxes

(1 - Tc)(1 - Ts)
VL = VU + 1 (1 - Td)

]D.

Tc = corporate tax rate.


Td = personal tax rate on debt income.
Ts = personal tax rate on stock income.

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Tc = 40%, Td = 30%, and Ts = 12%.

(1 - 0.40)(1 - 0.12)
VL = VU + 1 D
(1 - 0.30)
= VU + (1 - 0.75)D
= VU + 0.25D.

Value rises with debt; each $1 increase in


debt raises Ls value by $0.25.

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Conclusions with Personal Taxes

Use of debt financing remains


advantageous, but benefits are less
than under only corporate taxes.
Firms should still use 100% debt.
Note: However, Miller argued that in
equilibrium, the tax rates of marginal
investors would adjust until there
was no advantage to debt.

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Trade-off Theory
MM theory ignores bankruptcy (financial
distress) costs, which increase as more
leverage is used.
At low leverage levels, tax benefits
outweigh bankruptcy costs.
At high levels, bankruptcy costs outweigh
tax benefits.
An optimal capital structure exists that
balances these costs and benefits.

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Signaling Theory
MM assumed that investors and
managers have the same information.
But, managers often have better
information. Thus, they would:
Sell stock if stock is overvalued.
Sell bonds if stock is undervalued.

Investors understand this, so view


new stock sales as a negative signal.

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Pecking Order Theory


Firms use internally generated funds
first, because there are no flotation
costs or negative signals.
If more funds are needed, firms then
issue debt because it has lower
flotation costs than equity and not
negative signals.
If more funds are needed, firms then
issue equity.

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Choosing the Optimal


Capital Structure:
Example

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Choosing the Optimal Capital Structure:


Example
Currently is all-equity financed.
Expected EBIT = $500,000.
Firm expects zero growth.
100,000 shares outstanding; rs = 12%;
P0 = $25; T = 40%; b = 1.0; rRF = 6%;
RPM = 6%.

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Estimates of Cost of Debt


Percent financed
with debt, wd
rd
0%
20%
8.0%
30%
8.5%
40%
10.0%
50%
12.0%
If company recapitalizes, debt would be
issued to repurchase stock.

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The Cost of Equity at Different Levels


of Debt: Hamadas Equation

MM theory implies that beta changes


with leverage.
bU is the beta of a firm when it has no
debt (the unlevered beta)
bL = bU [1 + (1 - T)(D/S)]

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The Cost of Equity for wd = 20%


Use Hamadas equation to find beta:
bL = bU [1 + (1 - T)(D/S)]
= 1.0 [1 + (1-0.4) (20% / 80%) ]
= 1.15
Use CAPM to find the cost of equity:
rs = rRF + bL (RPM)
= 6% + 1.15 (6%) = 12.9%

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Cost of Equity vs. Leverage


wd

D/S

bL

rs

0%

0.00

1.000

12.00%

20%

0.25

1.150

12.90%

30%

0.43

1.257

13.54%

40%

0.67

1.400

14.40%

50%

1.00

1.600

15.60%

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The WACC for wd = 20%


WACC = wd (1-T) rd + we rs
WACC = 0.2 (1 0.4) (8%) + 0.8 (12.9%)
WACC = 11.28%
Repeat this for all capital structures
under consideration.

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WACC vs. Leverage


wd

rd

rs

WACC

0%

0.0%

12.00%

12.00%

20%

8.0%

12.90%

11.28%

30%

8.5%

13.54%

11.01%

40%

10.0%

14.40%

11.04%

50%

12.0%

15.60%

11.40%

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Corporate Value for wd = 20%

V = FCF / (WACC-g)
g=0, so investment in capital is zero;
so FCF = NOPAT = EBIT (1-T).
NOPAT = ($500,000)(1-0.40) = $300,000.
V = $300,000 / 0.1128 = $2,659,574.

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Corporate Value vs. Leverage


wd

WACC

Corp. Value

0%

12.00%

$2,500,000

20%

11.28%

$2,659,574

30%

11.01%

$2,724,796

40%

11.04%

$2,717,391

50%

11.40%

$2,631,579

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Debt and Equity for wd = 20%


The dollar value of debt is:
D = wd V = 0.2 ($2,659,574) = $531,915.
S = V D
S = $2,659,574 - $531,915 = $2,127,659.

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Optimal Capital Structure

wd = 30% gives:
Highest corporate value
Lowest WACC

But wd = 40% is close. Optimal


range is pretty flat.

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What other factors would managers


consider when setting the target
capital structure?
Debt ratios of other firms in the
industry.

Pro forma coverage ratios at


different capital structures under
different economic scenarios.
Lender and rating agency attitudes
(impact on bond ratings).

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Reserve borrowing capacity.


Effects on control.
Type of assets: Are they tangible,
and hence suitable as collateral?
Tax rates.