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Capital Structures & Limits to the Use of Debt Capital Structure – the proportion of debt and equity financing which a firm chooses to optimize its value -The optimal capital structure is one that minimizes a firm’s cost of capital Risk and Capital Structure -Determining a firm’s financial structure means answering two basic questions: -How should the firm’s total sources of funds be divided among long-term and short-term financing? -What proportion of funds should be financed by debt and what proportion by equity? -Long term sources of a firm’s capital structure include: -Debt -Leases -Preferred stock -Common stock -Internally generated funds The Pie Analogy -Max firm value = max shareholder value -When there is a significant probability of bankruptcy: Max firm value ≠ max shareholder value Risk -Business risk: -Can be measured by standard deviation of EBIT -Created by fixed costs -Financial risk: -Variability of EPS -Probability of bankruptcy -Increases as debt-equity ratio increases -May increase or decrease firm value -Created by debt! Operating and Financial Leverage -Operating leverage – arises from fixed cost associated with production -Financial leverage – arises from the amount of debt in a firm -Degree of Operating Leverage (DOL) – measures impact of change in sales on EBIT -Degree of Financial Leverage (DFL) – measures impact of change in operating income on earnings available to common shareholders DFL = % change in Operating leverage = % change in ROE = Net EPS_ EBIT income____ % change in % change in Book value of equity Financial leverage = % change in EPS = Net EPS/ROE Income________ % change in EBIT Number of shares Ex. A new business Net Income = (EBIT – Interest) x (1 – Tax requires a $100,000 investment. The rate) project can either be entirely equity financed, or ½ of the investment can be funded by a 10 year bank loan at 8%. The corporate tax rate is 43%. EBIT is expected to be $25,000, but it could be as low as $5,000 or as high as $45,000. Calculate ROE for all 6 scenarios. Comment. How Much Debt Should a Firm Have? -Tools to assess optimal debt levels: -Indifference analysis -“In making the capital structure decision, focus first and foremost on taxes, risk and financial slack?” -Debt reduces taxes to be paid, increases risk of bankruptcy and volatility of EPS, disciplines managers, and reduces managerial flexibility Indifferent of EPS – EBIT Analysis -Assess the impact of leverage: -Based on EBIT of firm -Rank desirability of alternative capital structures -Shortcomings: -Ignores market reaction to increased debt levels Leverage -Expected EPS and ROE rise as more debt is added, but also becomes more volatile -At low levels of EBIT, ROE/EPS lower for leveraged firm than all equity firm -At high levels of EBIT, ROE/EPS higher for leveraged firm than all equity firm -EBIT – EPS Analysis -Graphical depiction of the amount of EPS for different levels of EBIT -Allows us to visualize the impact of leverage Ex. Emco, an all equity firm has 250,000 shares outstanding, which currently trade at $14. It wishes to raise $5 million, and it has 2 options available: a. Raise the entire amount by issuing equity that will net the firm $12.50 a share b. Raise the entire amount through an issue of 10% debentures What should the firm do, if its tax rate is 46%? Capital Structure – M&M Approach 1. M&M without tax = MM under perfect market (No tax, no bankruptcy cost) 2. M&M with tax = Have tax, no bankruptcy cost 3. Have tax and bankruptcy cost QUESTIONS: 1. Will capital structure affect firm value?  Yes 2. Will capital structure affect cost of capital?  Yes Perfect Capital Markets Assumptions -Assume firms are financed by long term debt and common stock only -Assume that firm is not expected to grow in the future and all earnings are paid out as cash dividends -Homogeneous business risk class: Business risk is measured by σ EBIT Firms with the same business risk belong to the same class -There are no brokerage costs -Ignore any costs of bankruptcy -All investors borrow and lend at the same riskless rate of interest, r = b f -There are no corporate taxes M&M Propositions I and II in Words -Proposition I: -A firm’s value is determined by the operating side of the company and not how the company is financed -Proposition II: -As a firm becomes more levered, equity holders require a higher rate of return to offset their risk *Even though debt is cheaper than equity, firms cannot reduce their cost of capital by issuing more debt A Discussion -The law of one price and no arbitrage argument implies that the market value of any firm is independent of its capital structure. -We have economic arguments why this must be the case too: -Firm value is determined by the left-hand of the Balance Sheet, the firm's assets, and the EBIT generated by them. -A firm cannot change its market value by splitting its cash flows into different streams: i.e., interest or dividends. -M&M irrelevance argument: In a world with no taxes and no bankruptcy, a firm’s value does not depend on its capital structure. Consumers will not value either firm more. -This leads to some relationships between WACC and the return required by the equity holders and debt holders of a firm. Notation -VU= value of the unlevered firm -VL= value of the levered firm -rb= the cost of debt (the risk free rate) -rs= the return on (levered) equity (cost of equity) -r0= the return on assets or the cost of capital/cost of equity in an all equity firm -B = the value of debt -SL= the value of levered equity Proposition I and II Revisited V = Cash Flow to shareholders and debt VU= EBIT VL= EBIT holders PV tax shieldsc R o rWACC S = EBIT - B Interest = B x r b Interest M&M Proposition II (No V = EBIT (1 – T ) V = (EBIT – B x r ) (1 – T ) + U C L b C Bo B B V L V +uT x c taxes) -In the absence of taxes, any savings from debt financing are offset by a higher return required by common shareholders -The firm’s WACC is not altered by issuing either common stock or debt Ex. National Glass Co. has EBIT of $150 million, outstanding equity with a market value of $800 million and 10% coupon perpetual debt worth $200 million. a. Suppose an MM world existed without taxes. What is the cosst of equity capital? What is the firm’s WACC? b. The firm decides to issue an additional $100 million in debt (at 10%) and repurchase $100 million in common stock. What is the firm’s cost of equity capital? What is the firm’s WACC? Criticisms of M&M -The M&M hypothesis implies that personal and corporate leverage are perfect substitutes. -Brokerage costs impede the arbitrage process. -Many institutional investors are prohibited in 'home-made' leverage, thus impeding the arbitrage process. -M&M assume that all investors can borrow and lend at the same rate. -M&M assume that the cost of debt does not rise as leverage increases. -M&M ignore effect of capital structure on incentives of managers and therefore on cash flows. -M&M ignore corporate and personal taxes. Interest Tax Shield -B= Value of debt -rb= Cost of debt rbx B = interest payments Tc= Corporate tax rate Tcx r b B = Annual tax shield generated by debt -If the tax shields are received in perpetuity, then: Value of the Firm -The value is created by the tax deductibility of debt -This effective subsidy changes the situation from being a zero-sum game between two parties (debt holders and equity holders) to a three party game, where the value created is at the expense of the government M&M Propositions I & II(With Taxes) -Proposition I: -The value of the levered firm is -Proposition II: -The return required by shareholders increases as leverage increases -Since firm value rises with debt, rWACC must fall with debt WACC > UACC L M&M Proposition II with Taxes Ex. Rollins International is an all equity firm that generates EBIT of $3 million per year. The cost of equity capit
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