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Capital Structure

Capital Structure. What finance functions add the most to firm value?. Corporate Financing. We have been focusing on investment decision What should the firm buy? Now we are turning to the financing decision How does the firm pay for it?. How do Firms Pay for Stuff.

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Capital Structure

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  1. Capital Structure

  2. What finance functions add the most to firm value?

  3. Corporate Financing • We have been focusing on investment decision • What should the firm buy? • Now we are turning to the financing decision • How does the firm pay for it?

  4. How do Firms Pay for Stuff • Companies prefer to use the cash they generate • This account for about 70-90% of all purchases • If cash is insufficient they sell securities

  5. Capital-Structure • Addresses: What securities should the firm sell • This determines how the firm’s cash flows are divide • Capital Structure becomes important if the division affects the size of the cash flows • Remember: A firm is simply worth the PV of its expected future cash flows to investors S B

  6. The Value of E and D • E: The PV of cash flows to equity holders • If a company pays $1.5 mil. in dividends each year (re=8%) E = • D: The PV of the cash flows to debt holders • If a company pays $0.75 mil. in interest each year (rd=4%) D = • V =

  7. The Value of E and D • E: The PV of cash flows to equity holders • If a company pays $1.5 mil. in dividends each year (re=8%) E = 1.5 / 0.08 = $18.75mil • D: The PV of the cash flows to debt holders • If a company pays $0.75 mil. in interest each year (rd=4%) D = 0.75/0.04= $18.75mil • V = 18.75 + 18.75 = $37.5 mil

  8. Cap Structure and Value While capital structure appears to influence firm value in the real world to understand how/why we need to start with a situation where it doesn’t

  9. Modigliani-Miller Proposition 1 Capital Structure DOES NOT MATTER VL = VU

  10. MM1: The Simplest of Worlds • Perfect capital markets • Notaxes or transaction costs • No Bankruptcy Costs • Everyone borrows at the same rate • Investment decisions are fixed • Operating cash flow is independent of capital structure

  11. MM Investment Intuition Set up Suppose you have two firms that each make $50/ year The firms are identical except that one has $50 of debt and the other has no debt

  12. MM Intuition • Suppose Vl < Vu • Consider a 1% investment in EU • Cost = 1% EU = • Payoff = 1% Earnings = • Now buy 1% of EL & 1% of DL • Cost = 1% EL +1%DL= Payoff • Receive 1%*Interest= Receive 1%*(Earnings -Int)= • Total dollar payoff = • Can Vl < Vu?

  13. MM Intuition • Suppose Vl < Vu • Consider a 1% investment in EU • Cost = 1% EU = $1.00 • Payoff = 1% Earnings = • Now buy 1% of EL & 1% of DL • Cost = 1% EL +1%DL= Payoff • Receive 1%*Interest= Receive 1%*(Earnings -Int)= • Total dollar payoff = • Can Vl < Vu?

  14. MM Intuition • Suppose Vl < Vu • Consider a 1% investment in EU • Cost = 1% EU = $1.00 • Payoff = 1% Earnings = $0.50 • Now buy 1% of EL & 1% of DL • Cost = 1% EL +1%DL= Payoff • Receive 1%*Interest= Receive 1%*(Earnings -Int)= • Total dollar payoff = • Can Vl < Vu?

  15. MM Intuition • Suppose Vl < Vu • Consider a 1% investment in EU • Cost = 1% EU = $1.00 • Payoff = 1% Earnings = $0.50 • Now buy 1% of EL & 1% of DL • Cost = 1% EL +1%DL= 0.40 + 0.50=$0.90 • Payoff • Receive 1%*Interest= 0.01*10=$0.10 • Receive 1%*(Earnings-Int)= 0.01*40=$0.40 • Total dollar payoff = $0.10+$0.40=$0.50 • Can Vl < Vu?

  16. MM Intuition • Suppose Vl < Vu • Consider a 1% investment in EU • Cost = 1% EU = $1.00 • Payoff = 1% Earnings = $0.50 • Now buy 1% of EL & 1% of DL • Cost = 1% EL +1%DL= 0.40 + 0.50=$0.90 • Payoff • Receive 1%*Interest= 0.01*10=$0.10 • Receive 1%*(Earnings -Int)= 0.01*40=$0.40 • Total dollar payoff = $0.10+$0.40=$0.50 • Can Vl < Vu?

  17. If Vl < Vu then • An investor can purchase a claim in the levered firm with the same payoff as a claim in the un-levered firm, for a lower price! • This situation is impossible in a well functioning capital market (arbitrage) • Investors will buy Vl and sell it for Vu until Vl = Vu

  18. MM Intuition the Other Way • Suppose Vl > Vu • Consider a1% investment in El • Cost = 1% EL = • Payoff = 1%(Earnings –Int)= • Alt. buy 1% EU, & borrow1% of DL • Cost= 1%Vu-1%DL= Payoff • Owe 1%*Interest= • Receive 1%* Earnings = • Total dollar payoff =

  19. MM Intuition the Other Way • Suppose Vl > Vu • Consider a1% investment in El • Cost = 1% EL = $0.50 • Payoff = 1%(Earnings –Int)= • Alt. buy 1% EU, & borrow1% of DL • Cost= 1%Vu-1%DL= Payoff • Owe 1%*Interest= • Receive 1%* Earnings = • Total dollar payoff =

  20. MM Intuition the Other Way • Suppose Vl > Vu • Consider a1% investment in El • Cost = 1% EL = $0.50 • Payoff = 1%(Earnings –Int)= $0.40 • Alt. buy 1% EU, & borrow1% of DL • Cost= 1%Vu-1%DL= Payoff • Owe 1%*Interest= • Receive 1%* Earnings = • Total dollar payoff =

  21. MM Intuition the Other Way • Suppose Vl > Vu • Consider a1% investment in El • Cost = 1% EL = $0.50 • Payoff = 1%(Earnings –Int)= $0.40 • Alt. buy 1% EU, & borrow1% of DL • Cost= 1%Vu-1%DL= $0.90-$0.50=$0.40 • Payoff • Owe 1%*Interest= 0.01*10=$0.10 • Receive 1%* Earnings = 0.01*50=$0.50 • Total dollar payoff = -$0.10+$0.50=$0.40

  22. MM Intuition the Other Way • Suppose Vl > Vu • Consider a1% investment in El • Cost = 1% EL = $0.50 • Payoff = 1%(Earnings –Int)= $0.40 • Alt. buy 1% EU, & borrow1% of DL • Cost= 1%Vu-1%DL= $0.90-$0.50=$0.40 • Payoff • Owe 1%*Interest= 0.01*10=$0.10 • Receive 1%* Earnings = 0.01*50=$0.50 • Total dollar payoff = -$0.10+$0.50=$0.40

  23. If Vl > Vu then • In perfect capital markets the inequality cannot hold. Since both strategies have the same payoff, they should cost the same.

  24. On balance • The intuition shows how we can take positions in the levered and un-levered company that generate the same payoff, but which only costs the same if the two firms have the same firm value • The law of one price states that investments with the same payoffs need to cost the same, therefore the two firms must be equally valuable • Arbitrage

  25. MM 1 Cash Flow Proof • Two firms • Earn $1,000 • Unlevered • re = 10% • Levered • re = 15% • rd = 5% • D= 5,000

  26. MM 1 Cash Flow Proof • Two firms • Earn $1,000 • Unlevered • re = 10% • Levered • re = 15% • rd = 5% • D= 5,000

  27. MM 1 Cash Flow Proof • Two firms • Earn $1,000 • Unlevered • re = 10% • Levered • re = 15% • rd = 5% • D= 5,000

  28. MM 1 Cash Flow Proof • Two firms • Earn $1,000 • Unlevered • re = 10% • Levered • re = 15% • rd = 5% • D= 5,000

  29. MM 1 Cash Flow Proof • Two firms • Earn $1,000 • Unlevered • re = 10% • Levered • re = 15% • rd = 5% • D= 5,000

  30. MM 1 Cash Flow Proof • Two firms • Earn $1,000 • Unlevered • re = 10% • Levered • re = 15% • rd = 5% • D= 5,000

  31. V D/V Main result in this “perfect world” The value of the firm is independent of its capital structure

  32. Investors and Capital Structure • While leverage does not affect the risk of the overall firm, it does affect investors’ risks • Leverage increases: Financial/Default Risk

  33. MM Proposition 2: D/E and re,βe • As leverage increases so does financial risk • D/E relation with re,βe • ra = D/V * rd + E/V*re • re = ra + D/E * (ra- rd) • a = D/V * d + E/V*e • e= a + D/E * (a - d)

  34. βe Break-Down e= a + D/E * (a - d) • a: Captures the Business Risk of the firm • D/E * (a - d): Captures the Financial Risk of the firm

  35. Re Ra Rd MM 2: Graph • Look familiar?

  36. Question 1 • Shareholders demand a higher rate of return than bondholders. As debt is cheaper, we should increase the D/V ratio as it reduces ra. True or False? • False. As D/E increases, re & rd also increase (financial risk) → So ra will not change

  37. Question 2 • As the firm borrows more and debt becomes riskier, both shareholders and bondholders demand a higher rate of return. Thus by reducing the debt-equity ratio, we can reduce the cost of debt and the cost of equity. This makes everybody better off. True or False? • False. rd & re will fall, but a larger proportion of the firm is financed by relatively expensive equity. So the overall effect is to leave ra unchanged.

  38. Cash flows and Firm Value 1 A firm is only worth the PV of it’s cash flows to investors • Consider an un-levered firm, which has an EBIT of $1,500. • The company’s investors require a return on 12%. • Assume no taxes, what is the firm worth? • Vu = E • Vu = 1,500 / 0.12 = $12,500

  39. Cash flows and Firm Value 2 • Consider a levered firm, which has an EBIT of $1,500. • The firm owes $1,000 in interest payments/year • The company’s investors (equity and debt) require a return on 12%. • Assume no taxes, what is the firm worth? • VL = D + E • D= 1,000/0.12 = $8,333.33 • E= 500/0.12 = $4,166.67 • VL =$12,500

  40. Lets get Real • MM showed us that in the theoretical world capital structure does not matter • But by relaxing the MM assumptions and allowing for a more realistic world, we can see how capital structure affects firm value

  41. Corporate Taxes • When we include taxes will the firm be more or less valuable than in a world without taxes? • LESS Valuable • As some of the money generated by the company is now needed to pay taxes less flows to the investor, reducing firm value

  42. Who gets paid first? • Debt • Interest payments reduce our taxable income → reducing our taxes • Less money to Uncle Sam mean more for investors • Firm value will increase as debt increases

  43. Example • We have two identical firms • EBIT $1,000 • L: debt of $5,000 @ 6%

  44. Example • We have two identical firms • EBIT $1,000 • L: debt of $5,000 @ 6%

  45. Example • We have two identical firms • EBIT $1,000 • L: debt of $5,000 @ 6%

  46. Example • We have two identical firms • EBIT $1,000 • L: debt of $5,000 @ 6%

  47. Example • We have two identical firms • EBIT $1,000 • L: debt of $5,000 @ 6%

  48. Example • We have two identical firms • EBIT $1,000 • L: debt of $5,000 @ 6%

  49. Example • We have two identical firms • EBIT $1,000 • L: debt of $5,000 @ 6% • The tax shield increases the cash available for investors

  50. Tax Shield’s Effect on Firm Value • The tax shield increases firm value by the present value of the tax reduction • Tax Shield = Tax Rate * Dollar Interest • PV (T.S.) = Tax Rate * Dollar Interest / rd = Tax Rate * (Debt * rd) / rd = Tax Rate * Debt = 0.4 * 5,000 = $2,000

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