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Chapter 16

Chapter 16. Capital Structure. LEARNING OBJECTIVES. 1. Explain why borrowing rates are different based on ability to repay loans. 2. Demonstrate the benefits of borrowing. 3. Calculate the break-even EBIT for different capital structure.

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Chapter 16

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  1. Chapter 16 Capital Structure

  2. LEARNING OBJECTIVES • 1. Explain why borrowing rates are different based on ability to repay loans. • 2. Demonstrate the benefits of borrowing. • 3. Calculate the break-even EBIT for different capital structure. • 4. Explain the appropriate borrowing strategy under the pecking order hypothesis. • 5. Define optimal borrowing in a world of no taxes. • 6. Explain the static theory of capital structure.

  3. Chapter 16: Using other people’s money • Why do we borrow? • Consume today on future income • Households currently have almost $16 trillion in outstanding loans • Does it matter where we get our money? • What makes a good source of funds when we borrow? • Lowest cost for funds • Implicit costs can be very expensive • Is there an optimal borrowing strategy? • Reduce overall costs with a different borrowing pattern

  4. 16.1 Capital Markets • In the corporate world…two major markets for borrowing • From banks and bond markets – Debt Markets • From owners – Equity Markets • Borrowers get different rates from these two markets • Debt market – different yield to maturities on bonds • Debt market – different loan rates from banks • Equity market – different return rates for stocks • Ability to pay back loan impacts the rate • Lenders (and owners) look at the future cash flow

  5. 16.1 Capital Markets • Different Rates for Different Borrowers • Success rate for Angel Investors – impact returns • Example 16.1 in the book Larry and Sherry • Larry is successful on four in ten investments • Sherry is successful on one in ten investments • Required Return on $1,000,000 ($100,000 for each of ten projects) • Larry gets four to payback…each must pay $250,000 so rate is ($250,000 - $100,000) / $100,000 = 150% • Sherry gets only one to payback…it must pay $1,000,000 so rate is ($1,000,000 - $100,000) / $100,000 = 900%

  6. 16.2 Benefits of Borrowing • Who would every pay Sherry 900% on a loan? • You have a project with a 25% chance of making $5,000,000 and a 75% chance of making $0 • No banks or friends will loan you the money • Sherry offers 900% rate for the needed $100,000 investment • Do you take the loan? • Expected Payoff… • 25% x $5,000,000 - $1,000,000 = $250,000 • But…either you make $4,000,000 or you lose $100,000 • Financial Leverage…using other people’s money

  7. 16.2 Benefits of Borrowing • How do we measure financial leverage in a company? • Leverage is the amount of debt borrowed versus the amount of funds from the owners • Highly leveraged firms have high Debt to Equity ratios • Unlevered firms use only equity financing • How do we measure the benefits to a company from debt borrowing? • Earnings Per Share • Does borrowing increase or decrease the owner’s wealth?

  8. 16.2 Benefits of Borrowing • Page 494-497 • Three companies with different Debt / Equity Ratios • Company 1 is unlevered (all equity, 400 shares) • Company 2 is 50 / 50 debt and equity (200 shares) • Company 3 is levered to the max (1 share) • High EBIT -- $2,000 Company 3 structure is best • Low EBIT -- $800 Company 1 structure is best • At $1,000 – All have the same Earnings Per Share • Capital Structure is irrelevant at $1,000

  9. 16.3 Find the Break-Even EBIT • Can only find this in a pair-wise fashion (can only compare two firms at a time) • Set EPS calculation equal under the two structures • Company 1 EPS = EBIT / 400 • Company 2 EPS = (EBIT - $500) / 200 • Company 1 EPS = Company 2 EPS, solve for EBIT • This in a world of no taxes… • Above the Break-Even EBIT more leverage (more debt) is better for the owners.

  10. 16.4 Pecking Order Hypothesis • Borrow from the cheapest source first • Once the source is “exhausted” move to the second cheapest source • Continue to additional sources as needed for funding once each level is “exhausted” • This borrowing hypothesis is based on asymmetric information • One set of agents (company managers and owners) know more about the future cash flow prospects of the company than the lending agents • Firms Prefer Internal Financing First • Firms Choose to Issue the cheapest security first • Firms Use Equity as a Last Resort

  11. 16.4 Pecking Order Hypothesis • Example 16.3 Rogen vs. Rudd Corporations • Facts: Outsiders think that the stock could go as high as $50 or as low as $35 but it now is fairly valued at $42 • Rogen CEO knows the company has a major break-through and stock will climb to $50 • However the information is proprietary • Rudd CEO knows they have a new product too but, will not cause a rise in stock prices • Competitors will be able to quickly imitate new product

  12. 16.4 Pecking Order Hypothesis • How do you finance the needed $50 million? • Rogen CEO cannot tell public about product and will not sell equity below the new $50 value once the product is released (transfer of wealth from original owners to new owners) as the new owners will only pay $42 a share without the inside information • Rogen CEO thus chooses to use debt to avoid wealth transfer • Rudd CEO knows stock is worth $42 but if he chooses to sell equity the market will pay only $35. New owners believe that Rudd would only sell equity if it is overpriced, thus the $35 is the correct price • Rudd CEO thus chooses to use debt to avoid wealth transfer

  13. 16.4 Pecking Order Hypothesis • Conclusion • Profitable companies will borrow less and signal more debt capacity • Less profitable companies need more outside funding and will first seek debt (avoiding wealth transfer) • As a last resort, companies will sell equity • While this Hypothesis has some support, we see many companies use debt when they have internal funding…

  14. 16.5 Modigliani and Miller on Optimal Capital Structure • Start with the simplest world…no taxes and no bankruptcy (firms never default) • M&M Proposition 1 – Capital Structure is irrelevant • Value of an all equity firm (VE) is equal to the value of a leveraged firm (VL) • Think of two pies of equal size, the value (volume) of the pie does not change when we cut it into smaller pieces • M&M Proposition 2 – A firm’s value is based on • The required rate of return • The cost of Debt • The firm’s debt-to-equity ratio

  15. 16.5 Modigliani and Miller on Optimal Capital Structure • The math… • WACC = (E/V) x Re + (D/V) x Rd x (1 - Tc ) • The required return on the assets, Ra, is equal to WACC • Ra =(E/V) x Re+ (D/V) x Rd • In a world of no taxes, the required return on assets is the weighted average of equity and debt • Re =Ra + (Ra –Rd) x (D/E) • The visual…page 504 Figure 16.3

  16. 16.5 Modigliani and Miller on Optimal Capital Structure • But the world has taxes…so what happens when we add taxes • M&M Proposition 1 – with taxes • All debt financing is preferred • Adding debt reduces the government’s claim to the pie • M&M Proposition 2 – with taxes • As the firm adds debt the WACC falls • There is a tax shield with debt • The bigger the debt the greater the tax shield • Visual is Pie Charts on page 505

  17. 16.5 Modigliani and Miller on Optimal Capital Structure • What is the tax shield? • The government allows the deduction of interest expense from taxable income (pays part of the interest for the company) • The owners of the company claim this tax shield • VL = VE + (D x TC) • Thus the owner’s value increases as a company adds more debt financing • See Figure 16.5 on page 507 • Optimal Capital Structure is now all debt

  18. 16.5 The Static Theory of Capital Structure • We now relax the last parameter…bankruptcy • When a firm borrows “too much” and cash flow is insufficient to cover interest payments • The company goes into bankruptcy • Technically the debt holders get the company • Bankruptcy costs • Direct costs are relatively small • Indirect costs can be large…takes the managers away from the required tasks and puts the company in financial distress • The greater the debt, the greater the chance of financial distress

  19. 16.5 The Static Theory of Capital Structure • As a firm starts to add debt…the tax shield provides wealth to the owners of the company (again cutting into the government’s share) and the WACC is falling across this range • At some point the costs of financial distress begin to enter as more debt is added • Eventually the additional $1 benefit of the tax shield is exactly offset by the additional cost of financial distress • At that point WACC is lowest and we have the optimal debt/equity ratio for the firm. • See Figure 16.6 on page 510

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