Lecture: Raising Capital and Capital

Structure I
SHEN Tao （沈涛） Tsinghua University
Capital Structure
 Firm need 50M new funds to undertake its project
 Using equity: 15% required return by investor
 Using debt: 6%
 Debt is better? How does the debt affect NPV of the project
and firm value?
 The relative proportions of debt, equity, and other securities
that a firm has outstanding constitute its capital structure.
Financing a Firm with Equity
 An entrepreneur with the following investment opportunity
 an initial investment of $800 this year
 generate cash flows of either $1400 or $900 next year.
 Uncertainty gives rise to risk. Suppose risk-free interest rate is
5%, and risk premium is 10%.
 NPV=-800+(0.5*1400+0.5*900)/1.15=200
 If financed using equity alone, how much is the firm’s shares?
 Future cash flow: (0.5*1400+0.5*900)
 Discount rate 15%
 Price?
Financing a Firm with Equity
 Raise $1000 by selling the equity in the firm
 paying the investment cost of $800
 Keep $200 as profit
 At year 1
 Good economy return : (1400-1000)/1000=40%
 Bad economy return : (900-1000)/1000=-10%
 Expected return at year 0: (40%-10%)/2=15%
 Equity in a firm with no debt is called unlevered equity
 Equity is worth $1000 at year 0
Financing a Firm with Debt and Equity
 Suppose decides to borrow $500 initially, in addition to
selling equity.
 The project’s cash flow will always be enough to repay the debt.
Thus, the firm can borrow at the risk-free interest rate of 5%
 It will owe the debt holders 500 * 1.05 = $525 in one year
 At year 1
 Good economy equity holder get: $1400 - $525 = $875
 Bad economy: $900 - $525 = $375
 What is equity worth at year 0?
 Equity in a firm that also has debt outstanding is called
levered equity
Modigliani and Miller Theorem
 with perfect capital markets, the total value of a firm should
not depend on its capital structure.
 Perfect capital markets :
 all securities are fairly priced,
 no taxes or transaction costs,
 cash flows of the firm’s projects are not affected by how the
firm finances them, nor do they reveal new information about
them
 the combined values of debt and equity must be $1000.
 the value of the levered equity must be E = $1000 - $500 =
$500
Leverage, Risk and Return
 Good economy equity holder: ($875- $500)/$500 = 75%
 Bad economy: ($375 - $500)/$500 = -25%
 Expected return at year 0: (75%-25%)/2=25%

 Why not 15%?

 leverage increases the risk of the equity of a firm.
 Investors of levered equity require a
higher expected return
to compensate for its increased risk.
Summary
 if the firm is 100% equity financed, the equity holders will
require a 15% expected return.
 If the firm is financed 50% with debt and 50% with equity,
the debt holders will receive a lower return of 5%, while the
levered equity holders will require a higher expected return
of 25%
 debt may be cheaper when considered on its own, it raises
the cost of capital for equity.
 Considering both sources of capital together, the firm’s
average cost of capital with leverage is (5%)/2 + (25%)/2 =
15%
Modigliani and Miller (or MM)
 MM Proposition I: In a perfect capital market, the total value of a firm
is equal to the market value of the total cash flows generated by its assets
and is not affected by its choice of capital structure.
 Application: A Leveraged Recapitalization
 recapitalization : a firm makes a significant change to its capital
structure
 Leveraged Recapitalization: issues a large amount of debt
 Harrison Industries is an all-equity firm operating in a perfect
capital market, with 50 million shares outstanding that are trading
for $4 per share. Harrison plans to increase its leverage by
borrowing $80 million and using the funds to repurchase 20
million of its outstanding shares.
Leveraged Recapitalization
 First, Harrison sells debt to raise $80 million in cash. Second,
Harrison uses the cash to repurchase shares.
 First stage
 Harrison’s liabilities grow by $80 million, equal to the amount of cash
the firm has raised.
 Both assets and liabilities increase by the same amount, the market
value of the equity remains unchanged
 Second Stage
 spends the $80 million to repurchase ($80 million /$4 per share) =
20 million shares
 The firm’s assets decrease by $80 million and its debt remains
unchanged, the market value of the equity must also fall by $80
million
 The share price is unchanged
Leveraged Recapitalization

 Expected EPS?
 Compare EPS and P/E across firms
 Banks valuation
Leverage, Risk, and Cost of Capital
 MM Proposition I: financing choice does not affect value.
 Why cost of capital differs for different securities?
 D: market value of debt
 E: market value of equity if levered
 U: market value of equity if unlevered
 A: the market value of the firm’s assets.
 MM Proposition I: E + D = U = A
Leverage, Risk, and Cost of Capital
 The return of a portfolio is equal to the weighted average of the returns of the
securities in it:
E D
RU = R + R
E+D E E+D D
RE: returns of levered equity
RD: returns of debt
RU: returns of unlevered equity
 MM Proposition II: The cost of capital of levered equity increases with
the firm’s market value debt-equity ratio
Leverage, Risk, and Cost of Capital
 Capital Budgeting
 rWACC= rU= rA
 Is debt always better?
Taxes
 In a perfect capital market, a firm’s choice of capital
structure is unimportant.
 If capital structure does matter, then it must stem from a
market imperfection
 focus on one such imperfection, taxes
Interest Tax Deduction

 the total amount available to all investors was higher with

leverage
 leverage allows the firm to pay out more in total
 raise more total capital initially
 Additional $150M comes from tax savings 35% * $430M
 interest tax shield
The Interest Tax Shield and Firm Value

 the same must be true for the present values of these cash
flows.
 VL: firm value with leverage;
 VU: firm value without leverage
 VL=VU+PV(interest tax shield)
The Interest Tax Shield and Firm Value
 How large is this tax benefit?
 forecast future interest payments, determine the interest tax
shield, compute its present value by an appropriate rate.
 Variation: the amount of debt, interest rate, default , tax rate
 special case: permanent debt.
 A perpetual bond, making only interest payments but never
repaying the principal.
 Or issues a five-year coupon bond. When the principal is due,
simply refinances it. The debt is effectively permanent.
 maintains a fixed dollar amount of debt, rather than a fixed
leverage
The Interest Tax Shield and Firm Value
 Special case:
PV(interest tax shield)=(𝜏 ×rf×D)/rf=𝜏 ×D
=PV(𝜏 × Future Interest Payments)=𝜏 × PV(Future Interest Payments)=
tax rate ×D
𝐸 𝐷
 After tax WACC: 𝑟𝑊𝐴𝐶𝐶 = 𝑟 + 𝑟 (1 − 𝜏)
𝐸+𝐷 𝐸 𝐸+𝐷 𝐷
 the effective cost of capital to the firm
 pretax WACC, the average return paid to the firm’s investors
 More realistic, many firms target a specific debt-equity ratio instead
 PV(interest tax shield)=VL-VU
 VL : cash flows discount by WACC
 VU: cash flows discount by pretax WACC
WACC
Leveraged Recap with Taxes
 Midco Industries has 20 million shares outstanding with a
market price of $15 per share and no debt. Midco has had
consistently stable earnings, and pays a 35% tax rate.
Management plans to borrow $100 million on a permanent
basis through a leveraged recap in which they would use the
borrowed funds to repurchase outstanding shares.
 VU=(20 million shares) * ($15/share) = $300 million
 PV(Interest Tax Shield) =𝜏D= 35% * $100 million = $35
million
 VL= VU+ PV(Interest Tax Shield) =$335 million
Leveraged Recap with Taxes
 E=VL-D=$235 million
 The Share Repurchase
 repurchases its shares at their current price of $15 per share,
$100 million / $15 per share = 6.667 million shares
 20 - 6.667 = 13.333 million shares outstanding
 the total value of equity is $235 or $17.625 per share
 capital gain of $17.625 - $15 = $2.625
 $2.625/share * 13.333 million shares = $35 million
Leveraged Recap with Taxes
 Investors could buy shares for $15 immediately before the
repurchase, and they could sell these shares immediately afterward
at a higher price.
 this activity would raise the share price above $15 even before the
repurchase
 $335 million /20 million shares = $16.75 per share
 With a repurchase price of $16.75, the shareholders who
tender their shares and the shareholders who hold their
shares both gain $16.75 - $15 = $1.75 per share
 the original shareholders of a firm capture the full benefit of
the interest tax shield from an increase in leverage
Leveraged Recap with Taxes

 Expected EPS?