Capital Structure FIN 461: Financial Cases

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Capital StructureFIN 461 Financial Cases
Modeling

• George W. Gallinger
• Associate Professor of Finance
• W. P. Carey School of Business
• Arizona State University

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Managements Objective

• Maximize firm's value
• Firm value Market value of debt market value
  of equity
• Firm's investments affect its value
• Accept value enhancing projects.

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Value Eroded Value Created
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Long-Term Value Index
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Valuation of No-Growth Unlevered Firm
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Tax Benefit of Debt Financing
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Valuation of a No-Growth Levered Firm

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Competitive Environments
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PV of Growth Opportunities
Can incorporate growth in the denominator of the
1st term
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Contribution of PVGOs
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Calculating the Cost of Debt
Alternatively, you could use the CAPM to estimate
the cost of debt. The problem is knowing the debt
beta.
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Cost of Preferred Stock
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Cost of Equity Using the Dividend Growth Model
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Cost of Equity Using the SML
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Cost of Equity from a Beta Perspective
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Beta Leverage
Assumes the debt beta is 0.

• In a world with corporate taxes and riskless
  debt, it can be shown that the relationship
  between the beta of the unlevered firm and the
  beta of levered equity is

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Beta Leverage

• If the beta of the debt is non-zero (i.e.,
  risky), then

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Beta Leverage No Corporate Taxes

• In a world without corporate taxes, and with
  riskless corporate debt, it can be shown that the
  relationship between the beta of the unlevered
  firm and the beta of levered equity is

• In a world without corporate taxes, and with
  risky corporate debt, it can be shown that the
  relationship between the beta of the unlevered
  firm and the beta of levered equity is

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Effect of Debt on Cost of Equity
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Cost of Equity
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Calculation of Weights WACC
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Pertinent Info About Ethridge Company
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Firm Value WACC
B
A
C
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Firm Value WACC
A
B
C
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Agency Costs Capital Structure

• A trade-off of debt and equity agency costs
  suggests that some appropriate mix of debt and
  equity financing exists for minimizing total
  agency costs.

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Costs of Financial Distress

• Direct costs of bankruptcy (out-of-pocket cash
  expenses)
• Legal, auditing and administrative costs (include
  court costs)
• Large in absolute amount, but only 1-2 of large
  firm value
• Indirect costs Usually much more important
• Impaired ability to conduct business (e.g., lost
  sales)
• Managerial distraction, loss of best (most
  mobile) personnel
• Financial distress also gives managers adverse
  incentives
• Asset substitution problem Incentive to take
  large risks
• Under-investment problem S/Hs refuse to
  contribute funds
• Trade-off Model of Corporate Capital Structure
• Trade off tax benefits of debt vs costs of
  Financial distress

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Agency Costs Of Outside Debt

• Issuing debt externally helps minimize agency
  costs of equity
• Gives rise to Agency Costs of Outside Debt
• Costs increase with amount of debt issued
• High debt loads give managers, acting for
  shareholders, incentives to play two perverse
  games
• Expropriate bondholder wealth by paying excessive
  dividends
• Bait And Switch Promise to use borrowed money
  for safe investment, then use to buy high/risk,
  high/return asset
• Bondholders understand incentives, protect
  themselves with positive and negative covenants
  in lending contracts
• Positive covenants mandate what borrower must do
• Negative covenants mandate what borrower must not
  do
• Agency costs of debt are burdensome, but so are
  solutions.

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Game 1 The Asset Substitution Problem

• When a firm falls into financial distress,
  management has incentive to substitute assets
• Assume Firm Substitute has debt with a face value
  of 12,000,000 million outstanding, matures 1
  month
• 10,000,000 of cash on hand
• Firm still controls investment policy until
  default actually occurs
• If firm defaults, bondholders take over all
  remaining assets (including cash on hand)
• Substitutes managers offered two projects, both
  requiring 10,000,000 cash investment both
  paying off in 30 days
• Safe promises a certain 10,200,000 payoff (2
  monthly return)
• Lottery offers a 25 chance of 13,000,000
  payoff, and a 75 chance of 7,500,000 expected
  value 8,875,000.

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Game 1 Asset Substitution Problem

• Safe has positive NPV and is preferred by
  bondholders
• But stockholders and managers rationally choose
  Lottery
• If gamble is successful
• Payoff 13,000,000 million
• Pay maturing debt, keep remaining 1,000,000
• If gamble unsuccessful
• Stockholders are no worse off
• Bondholders will take firms remaining assets in
  30 days
• Game is important because shareholders (through
  managers) have incentive to gamble with
  bondholders money
• Would not accept Lottery if all-equity financed
  firm
• Would not accept Lottery if company was a
  partnership
• Limited liability means bondholders have no
  recourse to shareholders.

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Game 2 The Under-Investment Problem

• Shareholders refuse to contribute funds for
  positive NPV projects
• Occurs if shareholders must contribute cash, but
  all projects benefits accrue to bondholders.
• Assume firm has 10,000,000 cash on hand and a
  bond worth 12,000,000 million maturing in 30
  days
• Firm is offered chance to purchase a competitor
  at a discount price of 11,000,000 ? offer open
  only 30 days
• Merger would maximize firm value, and bondholders
  would accept
• Shareholders control firms investment policy
  until default occurs
• Firms managers, acting for the shareholders,
  would reject merger
• Even though value-maximizing, shareholders have
  to contribute additional 1,000,000 cash ? yet
  firm will still default in 30 days
• If firm all-equity financed, shareholders would
  invest additional cash.

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Theoretical Optimal Capital Structure

• Optimal capital structure
• Point where the value of the firm is maximized
• WACC is minimized
• Management trades off benefits realized from the
  interest tax shield against financial distress
  and agency costs.

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Maximize Value of the Firm
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Coverage Ratios
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Median Value by Rating Category
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Industry Debt-to-Asset Ratios
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Market Value Debt Ratios, July 2002
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Financial Relationships

• Earnings before interest and taxes represent the
  operating income (before taxes) generated by the
  firm's assets
• Interest expense is the (accounting) cost of debt
  financing
• If you define ROA as net income/assets, you are
  mixing the earning power of the assets with a
  financing cost.

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Trading on the Equity
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EBIT-Profitability Analysis

• When EBIT is below the level of 80, the firm
  will be more profitable if management finances
  with an all-equity capital structure
• Above the indifference point, a combination of
  debt and equity financing improves
  profitability.

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EBIT Indifference Levels for Different Capital
Structures
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Indifference Levels
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Choice Among Different Capital Structures

• The capital structure choice is to use no debt if
  EBIT is below 90, use 300 of debt and 700 of
  equity financing if EBIT is in the range between
  90 to 104, and use 600 of debt and 400 of
  equity financing if EBIT is above 104.

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Calculating Financial Leverage
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Breakeven Sales Level
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Managing Total Risk
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The End