1. Chapter 15 Capital Structure Decisions: Part I

2. Topics in Chapter • Overview of capital structure effects • Business versus financial risk • The impact of debt on returns • Capital structure theory, evidence, and implications • Choosing the optimal capital structure: An example

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

4. ∞ FCFt ∑ V = (1 + WACC)t t=1 Capital Structure and Firm Value (15-1) WACC= wd (1-T) rd + wcers (15-2)

5. Capital Structure Effects Preview • The impact of capital structure on value depends upon the effect of debt on: • WACC • FCF

6. The Effect of Debt on WACC • Debt increases the cost of equity, rs • Debt holders have a prior claim on cash flows relative to stockholders. • Debtholders’ “fixed” claim increases risk of stockholders’ “residual” claim. • Debt reduces the firm’s taxes • Firm’s can deduct interest expenses. • Frees up more cash for payments to investors • Reduces after-tax cost of debt

7. The Effect of Debt on WACC • Debt increases risk of bankruptcy • Causes pre-tax cost of debt to increase • Adding debt: • Increases percent of firm financed with low-cost debt (wd) • Decreases percent financed with high-cost equity (wce) • Net effect on WACC = uncertain

8. The Effect of Debt on FCF •  debt   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

9. The Effect of Additional Debt • Impact of indirect costs •  Sales &  Productivity • Customers choose other sources • Workers worry about their jobs • NOWC  • Suppliers tighten credit • NOPAT  • FCF 

10. The Effect of Additional Debt on Managerial Behavior • Reduces agency costs: • Debt reduces free cash flow waste • Increases agency costs: • Underinvestment potential

11. Asymmetric Information and Signaling • “Asymmetric Information” = insiders know more than outsiders • Managers know the firm’s future prospects better than investors. Managers would not issue additional equity if they thought the current stock price was less than the true value of the stock = Investors often perceive an additional issuance of stock as a negative signal • Stock price 

12. Business Risk vs. Financial Risk • Business risk: • Uncertainty about future EBIT • Depends on business factors such as competition, operating leverage, etc. • Financial risk: • Additional business risk concentrated on common stockholders when financial leverage is used

13. Probability Low risk High risk 0 E(EBIT) EBIT Note: Business risk focuses on operating income, ignoring financing effects. Business risk: Uncertainty about future pre-tax operating income (EBIT).

14. Factors That Influence Business Risk • Demand variability (uncertainty unit sales) • Sales price variability • Input cost variability • Ability to adjust output prices for changes input costs • Ability to develop new products • Foreign risk exposure • Degree of operating leverage (DOL)

15. Operating Leverage • Operating leverage is the change in EBIT caused by a change in quantity sold. • > Fixed costs  > Operating leverage • The higher the proportion of fixed costs within a firm’s overall cost structure, the greater the operating leverage.

16. Figure 15.1 Illustration of Operating Leverage

17. Higher operating leverage leads to more business risk: small sales decline causes a larger EBIT decline. Rev. Rev. $ $ } TC EBIT TC F F QBE Sales Sales QBE

18. Strasburg Electronics Company

19. Strasburg Expected Sales

20. Strasburg Plan A Figure 15-1 Lower Panel

21. Strasburg Plan B Figure 15-1 Lower Panel

22. Strasburg: Plans A & B Figure 15-1 Upper Panel

23. Operating Breakeven: QBE QBE = F / (P – V) (15-4) • QBE = Operating breakeven quantity • F = Fixed cost • V = Variable cost per unit • P = Price per unit

24. Strasburg Breakeven

25. Strasburg: Plans A & B

26. Higher operating leverage leads to higher expected EBIT and higher risk. Low operating leverage Probability High operating leverage EBITL EBITH

27. Strasburg & Financial Risk • Strasburg going with Plan B • Riskier • Higher expected EBIT and ROIC • Financial risk: • Additional business risk concentrated on common stockholders when financial leverage is used

28. Strasburg - Extended • To date – no debt • Two financing choices: • Remain at 0 debt • Move to $100,000 debt and $100,000 book equity

29. Table 15.1 Strasburg Electronics – Effects of Financial Leverage

30. Strasburg with No Debt Table 15-1 Section I ROE = Net Income/Book Equity Expected ROE = ROE under each demand X Probability

31. Strasburg with 50% Debt Table 15-1 Section II

32. Strasburg w/ Zero Debt Strasburg w/ 50% Debt Higher ROE Higher Risk

33. Leveraging Increases ROE • More EBIT goes to investors: • Total dollars paid to investors: • I: NI = $24,000 • II: NI + Int = $18,000 + $10,000 = $28,000 • Taxes paid: • I: $16,000; II: $12,000 • Equity $ proportionally lower than NI

34. Strasburg’s Financial Risk • In a stand-alone sense, stockholders see much more risk with debt. • I: σROE = 14.8% • II: σROE = 29.6% • Strasburg’s financial risk = σROE - σROIC = 29.6% - 14.8% = 14.8%

35. Capital Structure Theory • Modigliani & Miller theory • Zero taxes (MM 1958) • Corporate taxes (MM 1963) • Corporate and personal taxes (Miller 1977) • Trade-off theory • Signaling theory • Pecking order • Debt financing as a managerial constraint • Windows of opportunity

36. MM Results: Zero Taxes • If two portfolios (firms) produce the same cash flows, then the two portfolios must have the same value. A firm’s value is unaffected by its capital structure

37. MM (1958) Assumptions • No brokerage costs • No taxes • No bankruptcy costs • Investors can borrow and lend at the same rate as corporations • All investors have the same information • EBIT is not affected by the use of debt

38. MM Theory: Zero Taxes

39. MM Results: Zero Taxes • MM prove: • If total CF to investors of Firm U and Firm L are equal, then the total values of Firm U and Firm L must be equal: • VL = VU • Because FCF and values of firms L and U are equal, their WACCs are equal • Therefore, capital structure is irrelevant

40. MM (1963): Corporate Taxes • Relaxed assumption of no corporate taxes • Interest may be deducted, reducing taxes paid by levered firms • More CF goes to investors, less to taxes when leverage is used • Debt “shields” some of the firm’s CF from taxes

41. MM Result: Corporate Taxes • MM show that the value of a levered firm = value of an identical unlevered form + any “side effects.” VL = VU + TD (15-7) • If T=40%, then every dollar of debt adds 40 cents of extra value to firm

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

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

44. Miller (1977): Corporate and Personal Taxes • Personal taxes lessen the advantage of corporate debt: • Corporate taxes favor debt financing • Interest expenses deductible • Personal taxes favor equity financing • No gain is reported until stock is sold • Long-term gains taxed at a lower rate

45. VL = VU + 1− D (15-8) Tc = corporate tax rate. Td = personal tax rate on debt income. Ts = personal tax rate on stock income. (1 - Tc)(1 - Ts) (1 - Td) Miller’s Model with Corporate and Personal Taxes

46. VL = VU + 1− D = VU + (1 - 0.75)D = VU + 0.25D Value rises with debt; each $1 increase in debt raises Levered firm’s value by $0.25. (1 - 0.40)(1 - 0.12) (1 - 0.30) Tc = 40%, Td = 30%, and Ts = 12%

47. Trade-off Theory • MM theory assume no cost to bankruptcy • The probability of bankruptcy increases as more leverage is used • At low leverage, tax benefits outweigh bankruptcy costs. • At high levels, bankruptcy costs outweigh tax benefits. • An optimal capital structure exists (theoretically) that balances costs and benefits.

48. Figure 15.2 Effect of Leverage on Value

49. Signaling Theory • MM assumed that investors and managers have the same information. • Managers often have better information and 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.

50. Pecking Order Theory • Firms use internally generated funds first (1): • No flotation costs • No negative signals • If more funds are needed, firms then issue debt (2) • Lower flotation costs than equity • No negative signals • If more funds are still needed, firms then issue equity (3)