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Capital Structure and Firm Value

• Empirical patterns
– – – –

Does Capital Structure affect value?
Across Industries Across Firms Across Years Who has lower debt? • High intangible assets/specialized assets • High growth firms • High cash flow volatility • High information asymmetry • Industry leaders

• Is capital structure managed?

– If so much time is spent on capital structure then there must be some value to it (or managers/investors are irrational)

Debt and Equity Only?
• Typically thought of and measured this way • Much more complex
Investment opportunities and strategy (needs) Financing (sources) • Cash balance • Distribution: Dividend and repurchases • Debt capacity • Equity capacity • Existing debt and equity – Other financial policies: Financial Hedging, Cash Flow Volatility, Forms of Compensation – –

How does capital structure affect value? • To prove this we start in the “perfect world” – Based on the work of Miller and Modigliani – Shows that capital structure is irrelevant • Value is derived from market imperfections • Example: What if a firm is considering issuing debt and retiring equal amounts of equity? .

1 20 400 Proposed 8000 4000 4000 0.1 20 200 .Current Assets Debt Equity Interest Share Price Outstanding Shares 8000 0 8000 0.

05 1 Recession 400 400 0 0.2 4 Expansion 2000 0.25 5 Expansion 2000 400 1600 0.05 0 0 Expected 1200 0.15 3 Expected 1200 400 800 0.25 0.Current Earnings ROA ROE EPS Proposed EBI Interest Earnings ROA ROE EPS Recession 400 0.4 8 .15 0.15 0.05 0.25 0.

000 Initial Investment) Earnings Recession 0 Expected 400 Expansion 800 Position #2: Buy 200 shares of the unlevered firm and borrow $2000 (($20*200)-$2.000=$2. Recession 200 200 0 Expected 600 200 400 Expansion 1000 200 800 Earnings Interest Net Earnings .000 Initial investment).Position #1: Buy 100 shares of the levered firm ($20*100=$2.

.Capital Structure is Irrelevant • Miller and Modigliani assume perfect capital markets • Proposition #1: The market value of any firm is independent of its capital structure.

Firm Value: Perfect Capital Markets 190 170 150 Value 130 V(Unlevered) 110 90 70 50 0% 25% 50% D/E 75% 100% .

Market Imperfections: Taxes • Taxes – US Tax Code: Deductibility of interest leads to lower cost of debt (Rd(1-t)) – Simple specification overvalues benefit • Ignores personal taxes which – Decreases investors debt return – Increases investors preference for equity  Capital gains: Defer and rate difference  Dividend: Some portion is deductible .

• Contracting costs and taxes are primary motives for static trade off theory debt . alternative ways to contract optimal behavior are necessary • Costs of financial distress Market Imperfections: Contracting Costs – Underinvestment (rejecting NPV>0 projects). direct. etc. indirect costs. manages free cash flow problem (Accepting NPV<0 projects). etc. • Benefits of debt – Monitoring function.• In imperfect markets.

Market Imperfections: Information Costs • With asymmetric information. leverage may reveal something about the existing firm • Market timing: Managers take advantage of superior information • Signaling: Managers use financing to signal future prospects of firms – Issue equity to signal good growth opportunities (preserve financial flexibility) – Issue debt when expected cash flows are strong and stable – Issue equity when it is overvalued – Issue debt when it is undervalued • Motivates Pecking Order Theory .

Can we quantify the value of market imperfections? Debt adds value to the firm due to the interest deductibility (assume taxes only) V + PV (TaxShield ) VL = U Assume the simple case: rD Dτ C PV (TaxShield ) = = Dτ C rD .

Firm Value: Perfect Capital Markets 190 170 150 Value 130 V(Unlevered) V(Levered) 110 90 70 50 0% 25% 50% D/E 75% 100% .

More Complex Tax Shields • Uneven and/or limited time payments – Discount all flows back to time 0 • What r do you use? – Certain the tax shield can be used: rD – Uncertain? Higher r .

the probability therefore PV of financial distress increases VL = VU + PV (TaxShield ) + PV ( FinancialDistressCost ) • • How do we estimate the cost of distress? Probability can be estimated in several ways Logit/Probit regressions – Debt ratings – – Prob(Distress)*Cost of Distress .Financial Distress • As leverage increases.

Firm Value: with Taxes and Fiancial Distress 190 170 150 130 V(Unlevered) V(Levered) V(Distress) 110 90 70 50 D/E D/E .

accounting and other professional fees – Re-organization losses – Estimated btw 4-10% of firm value (t-3) – – – – Reputation costs Market share Operating losses Estimated as 7.• Direct Costs Financial Distress: Bankruptcy Costs – Legal.8% of firm value (t-2) • Indirect Costs .

Financial Distress: Agency Costs • Risk shifting and asset substitution – Shareholders invest in high risk projects and shift risk to the debt holders – Shareholders issue more debt. diminishing old debt holders protection • Underinvestment • Expropriating funds • Difficult to estimate .

decreasing managerial discretion •Bankruptcy as a strategic move??? .Other Advantages of Debt •Agency cost of Equity (motive) – Shirking is less likely when issuing debt – Perquisites are less likely with debt – Over-investment is less likely with debt •Agency cost of Free Cash Flow (opportunity) – Retained earnings versus dividends? – Growth and investment opportunities •Debt serves as a monitoring device.

Formal Models of Capital Structure Pecking Order • Pecking Order – Firms prefer to raise capital •Internally generated funds •Debt •Equity – Implies capital structure is derived from •Financing needs and capital availability •Dynamic rather than static •Asymmetric information and signaling • Static Trade Off .

Static trade-off theory of debt Firm Value Maximum Firm Value Actual Firm Value Debt Optimal amount of Debt .

lower debt . stable profit firms will have more debt Higher the costs of distress lower debt Lower taxes. lower debt Less (more) favorable tax treatment of debt (equity).Implications of Static Trade Off rather than dynamic • Static • Taxes and Contracting Cost drive value • Readjustment may be sticky – Optimal trade off between cost of issuances and benefit of capital structure • Insights – – – – Large.

Evidence: Taxes • This method usually overestimates the tax consequence – Magnitude of leverage differences across countries and tax regimes is not that big – Equity taxes (personal taxes) are overestimated (Miller) • Timing of capital gains • Higher effective marginal tax rate. higher the leverage (Graham. 2001) .

lower (higher) the leverage – Higher growth opportunities would prefer • Shorter maturity debt (or call provisions) • Less restrictive covenants • More convertibility provisions • More concentrated investors (private) – Consistent with market timing (SEO’s lead to -3% return) – Inconsistent with signaling and pecking order • Information costs • Taxes: Higher effective marginal tax rate.Evidence • Contracting Costs: Consistent evidence – Higher (lower) the growth opportunities. higher (lower) the potential underinvestment problem. higher the leverage .

.MM: Proposition II • How does leverage affect rE • Start with the WACC E D ra = rE + rD V V • Solve for rE D rE = ra + (ra − rD ) E • The rate of return on the equity of a firm increases in proportion to the debt to equity ratio (D/E). debt to equity ratio (D/E).

MM: Proposition II (with taxes) E D ra = rE + (1 − τ c )rD V V D rE = ra + (1 − τ c )(ra − rD ) E .

The unlevered cost of equity is 18%. has no debt and is expected to generate $4 million in EBIT in perpetuity.The firm is considering a restructuring. All after-tax earnings are paid as dividends. • What is the current value of Blue? • What will the new value be after the restructuring? • What will the new required return on equity be? • What if we use the new WACC? . Tc=30%. with a perpetual fixed $10 million in floating rate debt at an expected interest rate of 8%.• Blue Inc.

• The ability to quickly change the level and type of financing What About Financial Flexibility? • Value increasing if – Growth opportunities exist – Company is willing to exercise and extinguish future flexibility – New investments are unpredictable and large – Precautionary debt ratings cushion is valuable • Value destroying if the opposite is true .

How do we value financial flexibility? .

What do we do? • Choosing a target capital structure – Minimize taxes and contracting costs (while paying attention to information costs) – Target ratio should reflect the company’s • Expected investment requirements • Level and stability of cash flows • Tax status • Expected cost of financial distress • Value of financial flexibility • Dynamic management – Financing is typically a lumpy process – Find optimal point where cost of adjusting capital structure is equal to cost of deviating from target .