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Chapter 16: Capital Structure Decisions: The Basics

• Overview and preview of capital structure effects • 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?
•∞

•V •= •∑
•t=1

•FCFt
•(1 + WACC)t

•WACC= wd (1-T) rd + wers
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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…) Cal State East Bay 4 .

• Firm’s can deduct interest expenses. goes up. – Debtholders’ “fixed” claim increases risk of stockholders’ “residual” claim.The Effect of Additional Debt on WACC • Debtholders have a prior claim on cash flows relative to stockholders. – Cost of stock. – Reduces the taxes paid – Frees up more cash for payments to investors – Reduces after-tax cost of debt •(Continued…) Cal State East Bay 5 . rs.

to increase • Adding debt increase percent of firm financed with low-cost debt (wd) and decreases percent financed with high-cost equity (we) • Net effect on WACC = uncertain. rd.The Effect on WACC (Continued) • Debt increases risk of bankruptcy – Causes pre-tax cost of debt. •(Continued…) Cal State East Bay 6 .

reduction in productivity of managers and line workers. – Indirect costs: Lost customers.. – Direct costs: Legal fees. etc. accounts payable) offered by suppliers •(Continued…) Cal State East Bay 7 .The Effect of Additional Debt on FCF • Additional debt increases the probability of bankruptcy.e. reduction in credit (i. “fire” sales.

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 down as suppliers tighten credit). •(Continued…) Cal State East Bay 8 .

• Additional debt can affect the behavior of managers.” or “bonds. managers are less likely to waste FCF on perquisites or non-value adding acquisitions. – Reductions in agency costs: debt “pre-commits. Thus. •(Continued…) Cal State East Bay 9 . – Increases in agency costs: debt can make managers too risk-averse.” free cash flow for use in making interest payments. causing “underinvestment” in risky but positive NPV projects.

and the stock price falls.Asymmetric Information and Signaling • Managers know the firm’s future prospects better than investors. investors often perceive an additional issuance of stock as a negative signal. • Managers would not issue additional equity if they thought the current stock price was less than the true value of the stock (given their inside information). Cal State East Bay 10 . • Hence.

so it ignores financing effects.Business risk: Uncertainty about future pre-tax operating income (EBIT). Cal State East Bay 11 . •Probability •Low risk •High risk •0 •E(EBIT) •EBIT Note that business risk focuses on operating income.

Cal State East Bay 12 .Factors That Influence Business Risk • • • • • Uncertainty about demand (unit sales). Uncertainty about input costs. Uncertainty about output prices. Product and other types of liability. Degree of operating leverage (DOL).

and how does it affect a firm’s business risk? • Operating leverage is the change in EBIT caused by a change in quantity sold. •(More. • The higher the proportion of fixed costs within a firm’s overall cost structure..) Cal State East Bay 13 .. the greater the operating leverage.What is operating leverage.

•EBIT •} •TC •F •QBE •F •QBE •Sales •Sales •(More. •$ •Rev.Higher operating leverage leads to more business risk: small sales decline causes a larger EBIT decline..) Cal State East Bay 14 . •$ •TC •Rev..

•Probability •Low operating leverage •High operating leverage •EBITL Cal State East Bay •EBITH 15 .Higher operating leverage leads to higher expected EBIT and higher risk.

– Depends on the amount of debt and preferred stock financing. Cal State East Bay 16 .Business Risk versus Financial Risk • Business risk: – Uncertainty in future EBIT. etc. operating leverage. – Depends on business factors such as competition. • Financial risk: – Additional business risk concentrated on common stockholders when financial leverage is used.

Consider Two Hypothetical Firms Firm U No debt $20.000.000 in assets 40% tax rate $10. They differ only with respect to use of debt.000 of 12% debt $20. and EBIT of $3. Cal State East Bay 17 . business risk.000 equity Firm L $10.000 in assets 40% tax rate $20.000 equity Both firms have same operating leverage.

0% Firm L $3.000 1.000 1 .800 9.200 $1.Impact of Leverage on Returns EBIT Interest EBT Taxes (40%) NI ROE Cal State East Bay Firm U $3.000 0 $3.200 $1.800 720 $1.8% 18 .080 10.

Cal State East Bay 19 .800. – Total dollars paid to investors: • U: NI = $1. • L: NI + Int = $1.080 + $1.200 = $2. L: $720.280.Why does leveraging increase return? • More of the EBIT goes to investors in Firm L.200. – Taxes paid: • U: $1.

Uncertainty • Now consider the fact that EBIT is not known with certainty. What is the impact of uncertainty on stockholder profitability and risk for Firm U and Firm L? Cal State East Bay •Continue d… 20 .

EBIT Interest EBT Taxes(40%) NI Cal State East Bay .50 $3.800 Good 0.200 $1.000 800 $1.000 1.000 0 $2. 0.600 $2.25 $4.400 21 Prob.000 0 $4.000 1.25 $2.000 0 $3.Firm U: Unleveraged Bad 0.200 Economy Avg.

Firm L: Leveraged Bad 0.120 $1.000 1.200 $ 800 320 $ 480 Economy Avg.50 $3. 0.* EBIT Interest EBT Taxes(40%) NI Cal State East Bay .200 $2.000 1.800 1.080 Good 0.25 $2.200 $1.800 720 $1.000 1.25 $4.680 22 Prob.

Levered Firm U BEP ROIC ROE Bad 10.0% 16. 15.0% 9.Unlevered vs.0% 6.0% Firm L BEP ROIC ROE Cal State East Bay Bad 10.0% 12.0% 12.0% 9.0% 12.0% 10. 15.0% 4.8% Avg.8% Good 20.0% 6.0% 6.0% 9.8% 23 .0% Avg.0% Good 20.

Profitabilty Ratios • BEP (Basic earning power)=EBIT / Total assets • ROIC (Return on invested capital) = NOPAT / Total Assets = EBIT (1-T) / Total assets • ROE (Return on equity) = Net income / Equity Cal State East Bay 24 .

Conclusions • Basic profitability ratios. •(More. • L has much wider ROE swings because of fixed interest charges.) Cal State East Bay 25 . earning power and ROIC are unaffected by financial leverage.. Higher expected return is accompanied by higher risk..

12% 2.0% L 15.12% 2.24% 26 .0% 9.12% 4.Risk and return Profitability Measures: E(BEP) E(ROIC) E(ROE) Risk Measures: σROIC σROE Cal State East Bay U 15.0% 9.0% 10.0% 9.8% 2.

24% 2.12%. • L’s financial risk is σROE .) 27 Cal State East Bay . – L: σROE = 4. – U: σROE = 2.12% = 2.12%.12%. – U and L: σROIC = 2. Firm L’s stockholders see much more risk than Firm U’s.• In a stand-alone risk sense.24%...) •(More. (U’s is zero.σROIC = 4.

Capital Structure Theory • MM theory – Zero taxes – Corporate taxes – Corporate and personal taxes • Trade-off theory • Signaling theory • Debt financing as a managerial constraint Cal State East Bay 28 .

Net effect on WACC is zero. Cal State East Bay 29 . under a very restrictive set of assumptions. that a firm’s value is unaffected by its financing mix: – VL = VU. capital structure is irrelevant. – WACC=ws*rs + wd*rd – As wd increases. • Therefore. ws decreases and rs increases.MM Theory: Zero Taxes • MM prove.

• Therefore. ws decreases and rs increases.MM Theory: Zero Taxes • MM prove. Net effect on WACC is zero. – WACC=ws*rs + wd*rd – As wd increases. under a very restrictive set of assumptions. Cal State East Bay 30 . capital structure is irrelevant. that a firm’s value is unaffected by its financing mix: – VL = VU.

MM Theory: Zero Taxes Cal State East Bay 31 .

the benefits of financial leverage exceed the risks: More EBIT goes to investors and less to taxes when leverage is used. then every dollar of debt adds 40 cents of extra value to firm. – WACC=ws*rs + wd*rd*(1-T) • With corporate taxes.MM Theory: Corporate Taxes • Corporate tax laws favor debt financing over equity financing. • If T=40%. Cal State East Bay 32 . • MM show that: VL = VU + TD.

MM relationship between value and debt when corporate taxes are considered. the firm’s value increases continuously as more and more debt is used. Cal State East Bay 33 . V •V L •TD •V U •Debt •0 •Under MM with corporate taxes. •Value of Firm.

MM relationship between capital costs and leverage when corporate taxes are considered. •Cost of Capital (%) •rs •0 Cal State East Bay 20 40 60 80 •WACC •rd(1 .T) •Debt/Value 100 Ratio (%) 34 .

– Personal taxes favor equity financing. since no gain is reported until stock is sold. Cal State East Bay 35 . and long-term gains are taxed at a lower rate.Miller’s Theory: Corporate and Personal Taxes • Personal taxes lessen the advantage of corporate debt: – Corporate taxes favor debt financing since corporations can deduct interest expenses.

•Td = personal tax rate on debt income.Tc)(1 . s Cal State East Bay .Ts) •VL = VU + 1 (1 .Td) [ ]D.Miller’s Model with Corporate and Personal Taxes (1 . 36 •Tc = corporate tax rate. • T = personal tax rate on stock income.

12) (1 .25.75)D = VU + 0.0. • (1 . each $1 increase in debt raises L’s value by $0.0. Td = 30%.Tc = 40%.25D •Value rises with debt.30) •VL= VU + 1 - [ ]D • • = VU + (1 .40)(1 -. Cal State East Bay 37 . and Ts = 12%.0.

but benefits are less than under only corporate taxes.Conclusions with Personal Taxes • Use of debt financing remains advantageous. Cal State East Bay 38 . • Firms should still use 100% debt.

• At low leverage levels. tax benefits outweigh bankruptcy costs. • At high levels. Cal State East Bay 39 . bankruptcy costs outweigh tax benefits. which increase as more leverage is used. • An optimal capital structure exists that balances these costs and benefits.Trade-off Theory • MM theory ignores bankruptcy (financial distress) costs.

so view new stock sales as a negative signal. • But. they would: – Sell stock if stock is overvalued. • Implications for managers? Cal State East Bay 40 .Signaling Theory • MM assumed that investors and managers have the same information. – Sell bonds if stock is undervalued. • Investors understand this. Thus. managers often have better information.

• The use of financial leverage: – Bonds “free cash flow.) Cal State East Bay 41 .” – Forces discipline on managers to avoid perks and non-value adding acquisitions.Debt Financing and Agency Costs • One agency problem is that managers can use corporate funds for non-value maximizing purposes.. •(More..

– Debt increases risk of financial distress.Agency costs • A second agency problem is the potential for “underinvestment”. managers may avoid risky projects even if they have positive NPVs. Cal State East Bay 42 . – Therefore.

000. 100. rs = 12%. Expected EBIT = $500. Cal State East Bay 43 .Choosing the Optimal Capital Structure: Example • • • • Currently is all-equity financed. b = 1.000 shares outstanding. T = 40%. Firm expects zero growth.0. rRF = 6%. P0 = $25. • RPM = 6%.

Estimates of Cost of Debt % financed with debt.5% 10. debt would be issued to repurchase stock. Cal State East Bay 44 .0% If company recapitalizes.0% 30% 40% 8. wd rd 0% 20% 8.0% 50% 12.

• bU is the beta of a firm when it has no debt (the unlevered beta) • bL = bU [1 + (1 .T)(D/S)] Cal State East Bay 45 .The Cost of Equity at Different Levels of Debt: Hamada’s Equation • MM theory implies that beta changes with leverage.

The Cost of Equity for wd = 20% • Use Hamada’s equation to find beta: bL= bU [1 + (1 .T)(D/S)] = 1.15 • Use CAPM to find the cost of equity: rs= rRF + bL (RPM) = 6% + 1.9% Cal State East Bay 46 .15 (6%) = 12.4) (20% / 80%) ] = 1.0 [1 + (1-0.

000 1.00 0.90% 13.60% 47 .00% 12.400 1.25 0.40% 15. Leverage wd 0% 20% 30% D/S 0.600 14.257 rs 12.67 1.00 1.43 bL 1.150 1.Cost of Equity vs.54% 40% 50% Cal State East Bay 0.

9%) • WACC = 11. Cal State East Bay 48 .2 (1 – 0.28% • Repeat this for all capital structures under consideration.The WACC for wd = 20% • WACC = wd (1-T) rd + we rs • WACC = 0.8 (12.4) (8%) + 0.

0% 12.00% 11. Leverage wd 0% 20% 30% 40% 50% Cal State East Bay rd 0.40% 49 .5% 10.WACC vs.90% 13.00% 12.54% 14.40% 15.01% 11.60% WACC 12.0% 8.04% 11.0% 8.28% 11.0% rs 12.

Corporate Value for wd = 20%
• V = FCF(1+g) / (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 0% 20% 30% 40% WACC 12.00% 11.28% 11.01% 11.04% Corp. Value $2,500,000 $2,659,574 $2,724,796 $2,717,391

50%
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$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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439 $1.000 $2. D Stock Value.435 $1.127.957 $1.630.907.357 $1.789 Cal State East Bay 53 .315. S 0% 20% 30% 40% 50% $0 $531.500.915 $817.Debt and Stock Value vs.660 $1.789 $2. Leverage wd Debt.315.086.

and this total goes up (It is equal to Corporate Value on earlier slide).Wealth of Shareholders • Value of the equity declines as more debt is issued. because debt is used to repurchase stock. Cal State East Bay 54 . • But total wealth of shareholders is value of stock after the recap plus the cash received in repurchase.

• Stock price changes after debt is issued.Stock Price for wd = 20% • The firm issues debt. but does not change during actual repurchase (or arbitrage is possible). which changes its WACC. •(More…) Cal State East Bay 55 . • The firm then uses debt proceeds to repurchase stock. which changes value.

•(More…) Cal State East Bay 56 .Stock Price for wd = 20% (Continued) • The stock price after debt is issued but before stock is repurchased reflects shareholder wealth: – S. value of stock – Cash paid in repurchase.

915 – 0) 100.660 + ($531.000 P = $26.127.Stock Price for wd = 20% (Continued) P = S + (D – D0) n0 P = $2. Cal State East Bay 57 .596 per share.

# Remaining = n = S / P n = $2.000.915 – 0) / $26.596 = 80.000. = ($531.D0) / P # Rep.596 = 20.127. Cal State East Bay 58 .660 / $26.Number of Shares Repurchased # Repurchased = (D .

60 0 20.000 40.32 30.000 50.25 $27.000 100.000 70.000 30% 40% 50% Cal State East Bay $27. Leverage # shares wd P Repurch.Price per Share vs.000 59 .000 50.17 $26.000 80.000 60.00 $26. # shares Remaining 0% 20% $25.

Optimal Capital Structure • wd = 30% gives: – Highest corporate value – Lowest WACC – Highest stock price per share Cal State East Bay 60 .

Empirical Evidence • Tax benefits are important– $1 debt adds about $0.10 to value. • Firms don’t make quick corrections when stock price changes cause their debt ratios to change– doesn’t support trade-off model. – Supports Miller model with personal taxes. • Bankruptcies are costly– costs can be up to 10% to 20% of firm value. Cal State East Bay 61 .

debt ratio falls. – Inconsistent with pecking order. – Inconsistent with trade-off model. but firms tend to issue equity instead of debt. • Many firms. tend to maintain excess borrowing capacity. – Consistent with windows of opportunity.Empirical Evidence (Continued) • After big stock price run ups. especially those with growth options and asymmetric information problems. Cal State East Bay 62 .

Implications for Managers • Take advantage of tax benefits by issuing debt. especially if the firm has: – High tax rate – Stable sales – Less operating leverage Cal State East Bay 63 .

especially if the firm has: – Volatile sales – High operating leverage – Many potential investment opportunities – Special purpose assets (instead of general purpose assets that make good collateral) Cal State East Bay 64 .Implications for Managers (Continued) • Avoid financial distress costs by maintaining excess borrowing capacity.

• Always consider the impact of capital structure choices on lenders’ and rating agencies’ attitudes Cal State East Bay 65 . then avoid issuing equity if actual prospects are better than the market perceives.Implications for Managers (Continued) • If manager has asymmetric information regarding firm’s future prospects.