CHAPTER 16-7 Capital Structure Decisions: The Basics (Short version)

1. CHAPTER 16-7Capital Structure Decisions: The Basics (Short version) • Business vs. financial risk • Capital structure theory • Setting the optimal capital structure

3. Capital Structure Decisions: Extensions • MM models • Miller model • Financial distress and agency costs • Tradeoff models

4. HOW DO YOU MEASURE THE VALUE OF THE FIRM? • From the perspective of capital structure theory, the answer is: • V = S(market value of equity--common and preferred) + D (market value of debt. • Key question: Does the ratio of Debt to equity (D/S) affect the value of the firm?

6. ISOLATION OF FINANCING DECISION • When discussing optimal capital structure, to isolate this decision, we insist that any issuance of debt must be accompanied by a repurchase of stock; and any issuance of stock must be accompanied by a retirement of debt. • Hence, only debt-equity ratio changes; no increase or decrease in “size” of the firm.

7. Isolation of financing decision (continued) • By this isolation, the financing decision is isolated from decisions relating to asset management or investment decisions of the firm

8. Data of industrial debt equity ratiosInsert graphs • Do these represent “optimal” capital structure, or • Do they simply represent stupidity on the part of financial managers?

11. DIGRESSION: TAX SHIELD • Advantage of debt in a world of corporate taxes is that interest payments are a tax-deductible expense to the debt-issuing firm; however dividends are not tax-deductible. • Hence, total amount of funds available to pay both debtholders and shareholders is greater if debt is employed. gman208n\txshld.xls

14. EV(tax shield benefits): • Tax savings are not usually certain, as implied above, because: • if taxable income is low or negative, tax benefits are reduced, or even eliminated • if firm should go bankrupt and liquidate, future tax benefits stop. • uncertainty that Congress may change the tax rate.

15. Business Risk vs. Financial risk

16. Business Risk versus Financial Risk • Business risk: • Uncertainty in 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. • Depends on the amount of debt and preferred stock financing. • Concentrates business risk on stockholders.

17. We will skip operating leverage to save some time.

18. Financial Leverage

19. Business Risk vs. Financial Risk • Firm’s total risk (to its stockholders) is the sum of its business and financial risk: • Total risk = Business risk + financial risk

20. Total (stand alone) risk vs. market risk • Risk may be measured in either a total (stand alone) risk or a market risk framework. This is similar to the discussion of total vs. market risk in portfolio theory.

21. How are financial and business risk measured in a stand-alone (or total) risk framework, i.e., the stock is not held in a portfolio? Stand-alone Business Financial risk risk risk = + . Stand-alone risk = sROE. Business risk = sROE(U). Financial risk = sROE - sROE(U).

22. 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? • Suppose, the unleveraged firm issues $10K of debt and buys back $10K of equity.

23. Economy Bad Avg. Good Prob. 0.25 0.50 0.25 EBIT $2,000 $3,000 $4,000 Interest 0 0 0 EBT $2,000 $3,000 $4,000 Taxes (40%) 800 1,200 1,600 NI $1,200 $1,800 $2,400 Firm U: Unleveraged A=20K, D=0,E=20K

24. Economy Bad Avg. Good Prob.* 0.25 0.50 0.25 EBIT* $2,000 $3,000 $4,000 Interest 1,200 1,200 1,200 EBT $ 800 $1,800 $2,800 Taxes (40%) 320 720 1,120 NI $ 480 $1,080 $1,680 Firm L: Leveraged *Same as for Firm U. A=20K, D=10K, E=10K, int=.12

25. Firm U Bad Avg. Good BEP 10.0% 15.0% 20.0% ROI* 6.0% 9.0% 12.0% ROE 6.0% 9.0% 12.0% TIE Firm L Bad Avg. Good BEP 10.0% 15.0% 20.0% ROI* 8.4% 11.4% 14.4% ROE 4.8% 10.8% 16.8% TIE 1.7x 2.5x 3.3x 8 8 8 *ROI = (NI + Interest)/Total financing.

26. Profitability Measures: U L E(BEP) 15.0% 15.0% E(ROI) 9.0% 11.4% E(ROE) 9.0% 10.8% Risk Measures: ROE 2.12% 4.24% CVROE 0.24 0.39 E(TIE) 2.5x 8

27. Conclusions • Basic earning power = BEP = EBIT/Total assets is unaffected by financial leverage. • L has higher expected ROI and ROE because of tax savings. • L has much wider ROE (and EPS) swings because of fixed interest charges. Its higher expected return is accompanied by higher risk. (More...)

28. In a stand-alone risk sense, Firm L’s stockholders see much more risk than Firm U’s. • U and L: ROE(U) = 2.12%. • U: ROE = 2.12%. • L: ROE = 4.24%. • L’s financial risk is ROE - ROE(U) = 4.24% - 2.12% = 2.12%. (U’s is zero.) (More...)

29. For leverage to be positive (increase expected ROE), BEP must be > rd. • If rd > BEP, the cost of leveraging will be higher than the inherent profitability of the assets, so the use of financial leverage will depress net income and ROE. • In the example, E(BEP) = 15% while interest rate = 12%, so leveraging “works.”

30. In Fact: • ROE = BEP + (BEP - rd)(1-T) * (D/E)

31. Market risk framework Market Risk Framework • Hamada’s equation provides the relationship between business risk and financial risk: • rsL= rrf + (rm - rrf)bu + (rm - rrf) bu(1-T)(D/S) • = Time value premium business risk premium + financial risk premium + But also, rsL= rrf + (rm - rrf) bL

32. Market risk framework (continued) • Therefore, • rrf + (rm - rrf) bu + (rm - rrf) bu(1-T)(D/S) = rrf + (rm - rrf) bL or bL = bu + bu(1-T)(D/S) business risk Total risk = financial risk +

33. Hamada equation for beta: bL = + = + = + . bU Unlevered beta, which reflects the riskiness of the firm’s assets Business risk bU(1 - T)(D/S) Increased volatility of the returnsto equitydue to the use of debt Financialrisk

34. Consider financial risk term: bu(1-T)(D/S) The higher the D/S, the higher the financial risk The higher the T, the lower the financial risk. Why?

35. Market risk framework (continued) • or , another way to write total risk bL = bu [1 + (1-T)(D/S)] or bu = bL / [1 + (1-T)(D/S)]

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

37. Here’s a valuation model which includes financial distress and agency costs. • [X] represents either Tc in the MM model or the more complex Miller term. • Conclusion: Optimal leverage involves a tradeoff between the tax benefits of debt financing and the costs associated with financial distress and agency. PV of agency costs PV of expected financial distress VL = VU + [X]D - -

38. VL = VU + [X]D - PV(fin.dist.costs) - PV(agency costs) Tax effect alone Value of Firm ($) Net Tax effect alone 4 3 2 1 Financial distress and agency costs W/ taxes and bankruptcy and agency costs Debt ($) Opt. Capital structure

39. Relationship between value and leverage. Value of Firm ($) 4 3 2 1 Debt ($) Another view

40. Relationships between capital costs and leverage considering financial distress and agency costs. Cost of Capital (%) ks 14 4 WACC kd Debt ($)

41. Define financial distress andagency costs. Financial distress: As firms use more and more debt financing, they face a higher probability of future financial distress, which brings with it lower sales, EBIT, and bankruptcy costs. Lowers value of stock and bonds. Agency costs: The costs of monitoring managers’ actions. Increases with leverage. More on agency and bankruptcy costs

42. Bankruptcy Costs • In a bankruptcy, bondholders are likely to hire lawyers to negotiate or sue the company. Similarly, the firm is likely to hire lawyers to protect itself. Costs are also incurred in a bankruptcy. These fees are all paid before the bondholder gets paid. • Further, costs of purchasing inputs by a risky (subject to bankruptcy) firm increase.

43. BANKRUPTCY COSTS (cont’d) • The possibility of bankruptcy has a negative effect on the value of the firm. • It is not the RISK of bankruptcy, but rather it is the COSTS associated with bankruptcy that lower value. • Bankruptcy eats up part of the “pie” leaving less for stockholders and bondholders.

44. AGENCY COSTS • Definition: A contract under which one or more people (principals) hire another person (agent) to perform some service and then delegates decision making authority to that agent.

45. Types of Agency Cost relationships • Stockholders vs. management • Stockholders vs. bondholders: Recall Marriott example. Assets 200 Debt 100 Assets 100 Debt 100 Eq. 100 Assets 100 Equity 100

46. Event Risk • The risk that some deliberate action or event will convert a high-grade bond into a junk bond overnight and thus lead to a sharp decline in it value. E.g. Marriott or RJR. Effect of adding more and more debt: From the stockholder’s point of view: Heads I win {risks pay off}; Tails you (the bondholder) lose.{risks don’t pay off}

47. AGENCY COSTS • If a company were to sell only a small amount of debt, the debt would have: • low risk • a high bond rating • a low interest rate • However, if, after it sold the low risk debt, it issued more debt, secured by the same assets…

48. This would: • Raise risk faced by all bondholders • Cause rd to rise • Cause original bondholders to suffer capital losses

49. Similarly, suppose that after issuing the new debt, the firm decides to restructure its assets: • Selling of low risk assets, and • Acquiring riskier assets, which have a higher expected rates of return

50. If things work out, stockholders benefit; • If things don’t work out, most of the loss falls on the leveraged bondholders: • Stockholders are playing the game “Heads I win, tails you lose” with the bondholders.