Capital Structure

1
Capital Structure

• Merrill Lynch Investment Banking Institute
• July 2008
• Prof. Michael R. Roberts

2
Topic Overview

• How should we think about capital structure?
• A benchmark the MM irrelevance propositions
• When is capital structure relevant?
• Taxes
• Bankruptcy costs
• Agency costs (benefits)
• Asymmetric information

3
The Intuition Behind MM

• Buy a house today for 100,000 and sell one year
  later
• Assume mortgage rate is 10
• E.g., 145,000 (50,000 5,000)/50,000 - 1
  80

(New Price)
(What we owe)
(What we paid)
4
Questions

• Does the value of the house depend on the size of
  the mortgage?
• What does change with the size of the mortgage?

5
Financing InvestmentExample

• All equity firm considers a project (note this
  info.)
• Invest 800 today
• Payoff tomorrow
• 1400 if strong economy w.p. 50
• 900 if weak economy w.p. 50
• Risk-Free Rate (Rf) 5
• Project Risk Premium (Rp-Rf) 10

6
All Equity FinancingExample (Cont.)

• Project NPV Present value of future cash flows
  to project less initial investment
• How much equity can we raise? (Present value of
  future cash flows to equity holders)
• What are returns to shareholders (in both states
  and expectation)?
• What are the entrepreneurs profits?

7
Debt and Equity FinancingExample (Cont.)

• Now suppose borrow 500, in addition to selling
  equity
• Note Project Cash Flows Debt Owed in each
  state ?
• debt is risk-free ? Rd Rf 5
• Payoffs to Debt and Equity
• MM I ? Value of firm is independent of capital
  structure in perfect capital markets ? E 500
• Cash flows of D and E sum to Project cash flows ?
  D and E must sum to value of firm (Law of One
  Price)
• MM I says that V D E, regardless of what D
  and E are!

?
8
Effect of Leverage on Risk and ReturnExample
(Cont.)

• Why isnt the value of equity
• ?
• Levered equity carries a higher risk premium than
  unlevered equity ? rE?15 anymore
• Levered equity higher risk higher return
  (25)
• This is not due to default risk! (Debt is
  risk-free)
• Project risk is the same 15

9
MM I Synopsis

• In a perfect capital market, the total value of
  a firm is equal to the market value of the total
  cash flows generated by its assets and is not
  affected by its choice of capital structure
• Value of Firm (V) Value of Debt (D) Value of
  Equity (E) (No matter what D and E are!)
• Only thing that matters for value (size of the
  pie) is the PV of the cash flowsdoesnt matter
  how you divide them up (slice the pie)

10
The Cost of Capital

• Remember MM I implies
• Vl E D Vu ( Va)
• Return on a portfolio equals weighted average of
  returns to the securities in the portfolio so
• But this implies

11
MM IILeverage, Risk, and the Cost of Capital

• MM Proposition II says
• The cost of capital of levered equity is equal to
  the cost of capital of unlevered equity plus a
  premium that is proportional to the market value
  debt-equity ratio
• With perfect capital markets WACC is constant
  function of leverage because as D/E changes, rE
  changes to compensate
• For really high leverage, rD will change as well
  (rD rA in limit)

12
WACC Leverage in Perfect Capital Markets

• VU1000 rA 15 rD5
• Shape of rE and rD dictated by response of cash
  flows to leverage

13
Leverage and EPS

• Fallacy
• Leverage can increase stock prices via its affect
  on EPS
• Rationale Leverage leads to higher earnings per
  share, which in turn lead to higher stock prices
• Error Ignores the impact of leverage on risk
• Example Levitron Industries (LVI)
• Currently
• All equity with 10mil shares with 7.50/share
• Next year EBIT 10mil
• Considering
• borrowing 15mil _at_ 8 and use proceeds to
  repurchase 2mil shares _at_ 7.50/share
• What are the consequences of this transaction
  assuming perfect capital markets?

14
Implications of Leverage for EPSExample (Cont.)

• Initial EPS
• LVIs earnings (EBIT)
• LVI has no debt ?
• Perfect markets ?
• Initial EPS
• EPS after debt issuance share repurchase
• Creates Annual Interest Payments
• Earnings after interest
• Share Repurchase
• of shares after repurchase
• EPS after debt issue repurchase
• EPS went up!
• Looks good but are shareholders really better off?

?
no interest
?
no taxes
?
10mil / 10mil 1/Share
?
15mil x 8 1.2mil/Year
?
10mil - 1.2mil 8.8mil
?
?
10mil 2mil 8mil
?
8.8mil / 8mil 1.10 1.00
15
Leverage and EPS A Closer LookExample (Cont.)

• MM tells us that there can be no benefit so
  something must give...
• Imagine that EBIT was only 4mil (instead of
  10mil)
• Before debt issuance EPS
• After debt issuance and share repurchase EPS
• So, when earnings are low, leverage amplifies EPS
  fall just as leverage amplifies EPS climb with
  high earnings
• This amplification effect is just increased
  risk of earnings!
• The higher expected EPS is associated with higher
  risk (i.e., MM I still holds)

Risk!
?
4mil / 10mil 0.40/Share
?
?
(4mil 1.2mil) / (10mil 2mil) 0.35/Share
16
Leverage and EPS A Picture

• Average EPS is higher for levered firm
• Risk is higher (steeper line) for levered firm

17
Leverage and Stock PriceExample (Cont.)

• Assume
• LVIs EBIT is constant in the future (10mil)
• All earnings are paid out in dividends
• If we increase EPS, what will happen to the share
  price?
• Unlevered
• Recall Earnings 10mil Shares 10mil ? EPS
  1
• Dividends/Share (DPS)
• Value the company as a perpetuity to get the WACC
• Recall Price/Share 7.50
• Market Cap

1
?
1/rE ? rE 13.33 rA
?
7.50/Shr x 10mil Shr 75mil
?
18
Leverage and Stock Price (Cont.)Example (Cont.)

• Levered
• Recall Issue 15mil debt to repo 15mil of
  equity _at_ 7.50/shr
• ? buyback 15mil/7.50/shr 2mil shr ? 10mil
  2mil 8mil shares remaining after buyback
• MM I ? New Market Cap
• ? New D/E ratio
• MM II New rE
• Earnings Interest
• New EPS
• New Share Price
• Intuition
• EPS is higher but so is risk, so shareholders
  demand higher return rE

75mil - 15mil 60mil
?
?
15/60 1/4
13.33 ¼(13.33 - 8) 14.66
?
?
10mil (15mil x 0.08) 8.8mil
?
8.8mil / 8mil 1.10
1.1 / 14.66 7.50 ( Old Share Price)
?
19
Equity Issuances and
Dilution

• According to CFOs in the US, what is the most
  important consideration when issuing equity
• Dilution!
• Fallacy
• Issuing equity will dilute existing shareholders
  ownership
• Rationale more shares mean the firm must be
  divided among a larger of shares, thereby
  reducing the value of each individual share
• Error Ignores the fact that cash raised by
  issuance increases the firms assets.
• Example Jet Sky Airlines (JSA)
• Currently
• No debt
• 500mil shares trading _at_ 16/shr ? Market cap
  8bil
• Considering
• Expanding operations by buying 1bil new planes
  with new equity _at_ current price 16/share
• What are the implications for the stock price?

?
20
Effect of Equity Issuances on Stock Prices

• The firm issues 62.5mil new shares _at_ 16/share to
  get 1bil
• Firm grows by 1bil, which offsets increase in
  shares
• Any gain or loss from issuance comes from project
  NPV (i.e. what you do with the proceeds)
• Key assumption
• Sell the shares at a fair price!

21
Capital Structure in Perfect Capital
MarketsSumming it Up

• Conservation of Value Principle for Financial
  Markets
• With perfect capital markets, financial
  transactions neither add nor destroy value, but
  instead represent a repackaging of risk (and
  therefore return).
• MM I V E D
• Value of the firm is just the sum of E D,
  regardless of what they are
• MM II rE rA D/E(rA - rD)
• Leverage increases risk of equity (not value
  according to MM I)

22
What are Perfect Capital Markets

• What are the assumptions behind MM? That is,
  when are the MM propositions true?
• no taxes,
• no bankruptcy costs,
• no agency costs/benefits,
• no information asymmetry, and
• no transaction costs
• What the !_at_ ? Whats the point of this?
• If financial policy is to matter, it must be that
  it mitigates (or takes advantage of) one or more
  of these frictions
• Devise financial strategies around minimizing
  (maximizing) the adverse (beneficial) effects of
  these frictions

23
Debt and Taxes

• Corporations pay taxes on their profits after
  interest payments are deducted ? interest expense
  reduces taxes
• Example Safeway, Inc.
• Safeways 2005 net income is lower with leverage
  than without and

24
Debt and Taxes (Cont.)

• equity is lower with leverage than without
• But, Safeway has greater value with leverage!
• Whats going on?
• With leverage, Safeway is worth an additional
  140mil
• This difference is just the value of the interest
  tax shield

25
The Picture with Taxes

• In a perfect capital market, V D E
• Now, the government gets a slice!
• We can minimize that slice by shielding income
  with debt!

26
The WACC with and Without Corporate Taxes
27
Leverage Recapitalization RevisitedExample

• Midco Industries
• Currently
• 20mil shares outstanding _at_ 15/share
• Stable earnings
• 35 tax rate
• Plan
• Borrow 100mil (on permanent basis)
• Use proceeds to repurchase shares
• What happens after the share repurchase?

28
Leverage Recapitalization Revisited Example
(Cont.)

• Before Recap
• VA VU E
• After Recap
• PV(interest tax shield) tCD
• VL VU tCD
• E VL D
• Investors get 100mil from repo and equity is
  worth 235mil ? 35mil gain with leverage

20mil shares x 15/share 300mil
?
0.35(100mil) 35mil
?
300 35 335mil ED
?
335mil - 100mil 235mil
?
29
Leverage Recapitalization Revisited Example
(Cont.)

• Assume Midco repurchases shares _at_ current price
  15/share
• Repurchase 100mil 15/share 6.67mil shares
• After repurchase
• New of shares outstanding
• New share price after repo
• Shareholders that keep their shares gain
• Total gain

20mil 6.67mil 13.33mil
?
235mil/13.33mil 17.625/Shr
?
?
17.625 - 15 2.625/Share
2.625/Share x 13.33mil 35mil PV(Int Tax
Shield)
?
30
Leverage Recapitalization RevisitedA Problem

• Why would anyone tender their shares for 15 if
  they know that after the recap their shares will
  be worth 17.63?
• Alternatively, why dont I buy shares _at_ 15
  before the repo, and then sell after the repo _at_
  17.63 for an arbitrage profit?
• It is precisely this arbitrage activity that will
  drive up the price before the recap!
• The announcement of the recap will drive up the
  stock price to incorporate the PV (interest tax
  shield) ex ante
• So Midcos equity will rise from 300mil to
  335mil before the repo
• Price per share will increase to 335mil / 20mil
  16.75
• Tax shield surplus will be split evenly between
  those who tender their shares and those who keep
  their shares
• Original shareholders capture all of the surplus
  1.75 x 20mil 35mil

31
Financial Distress Costs

• Direct Costs
• Legal fees, court costs, opportunity cost of time
• Indirect Costs
• Stakeholder flight
• Supplier
• Distributer
• Customer
• Employees
• Creditor intervention (covenant violations)
• Asset fire sales
• Shareholders pay for these costs!

32
The Picture with Taxes and Financial Distress
Costs

• Now, there is deadweight loss due to financial
  distress costs
• We can minimize that slice by taking on less debt
  but then governments piece gets bigger ?
  tradeoff

33
Agency Costs

• Agency Costs are costs that arise when there are
  conflicts of interest between the firms
  stakeholders
• Different claimants have different incentives,
  which can lead firms to undertake actions that
  hurt one groups to benefit another
• Overinvestment and Asset Substitution
• Underinvestment and Debt Overhang
• Agency costs are another cost of increasing
  leverage, just like bankruptcy costs

34
Are Agency Costs Important?

• Think about some of the giant collapses of the
  last decade
• Enron
• Worldcom
• Adelphi
• Think about all the mechanisms and institutions
  developed to address incentive conflicts
• What do all debt contracts contain? (Hint It
  begins with a c)
• SEC
• SOX
• Board of Directors
• Think about why you do anythingit must be in
  your interest in one way or another

35
Asymmetric InformationStock Returns Around
Equity Issuances
36
Capital Structure and Asymmetric Information

• Asymmetric information refers to a situation
  where parties have different information
• E.g., Managers often have better information
  relative to investors regarding their firm
• Adverse selection refers to the idea that with
  asymmetric information, the average quality of
  assets in the market will differ from the average
  overall quality
• Investors know managers are selling overvalued
  equity
• Lemons principle when seller has private
  information about the value of a good, buyers
  will discount the price they will pay because of
  adverse selection
• Investors discount the price they will pay for
  the equity
• Alternative Use debt as a signal to investors
• Issuing debt suggests that the firm really will
  grow since Ive pre-committed to pay back the debt

37
Summary

• If you want to add value to a firm with financial
  policy or strategy, then you have to be able to
  point to at least one of the following channels
• Reducing taxes
• Reducing bankruptcy costs
• Mitigating incentive conflicts
• Getting managers to behave
• Mitigating adverse selection costs
• Credibly conveying to the market that you are a
  good firm
• Much of financial innovation revolves around
  addressing these issues to create value for
  firms/investors
• MIPS
• Junk Debt
• CDOs
• Syndicated Loans

38
Asset Substitution or OverinvestmentBaxter Inc.

• Owes 1mil due at end of year
• Without a change in strategy, assets will be
  worth only 0.9mil ? Baxter will default if they
  take no action
• Baxters considering a new strategy
• No upfront investment
• Success will increase firms assets to 1.3mil
  w.p. 50
• Failure will decrease firms assets to 0.3mil
  w.p. 50
• This is a negative NPV project since expected
  value of firms assets decline from 900mil to
  800mil
• But, does this mean Baxter wont undertake the
  investment?

39
Asset Substitution or OverinvestmentBaxter Inc.
(Cont.)

• Note
• Equityholders gain 150mil from investment (0 to
  150mil)
• Debtholders lose 250mil from investment (900mil
  to 650mil)
• Net gain (loss) in firm value of -100mil NPV
  of strategy
• 0.5(1300-900) 0.5(300-900) -100mi
• Equity holders have incentive to gamble with
  debt holders money but debt holders will
  anticipate this and pay less ex ante

40
Debt Overhang and UnderinvestmentBaxter Inc.

• Owes 1mil at end of year but without a change in
  strategy, assets will be worth only 0.9mil ?
  default
• Considering alternative strategy
• Requires initial investment of 0.1mil
• Generates risk-free return of 50
• Clearly a positive NPV investment
• Problem (?) Baxter doesnt have the cash on hand
• Can they raise the money in the equity market?

41
Debt Overhang and UnderinvestmentBaxter Inc.
(Cont.)

• If equity holders contribute 0.1mil, they only
  get back 0.05mil
• 0.1mil goes to debt holders, whose payoff goes
  from 0.9mil to 1mil
• Even though project is positive NPV, equity
  holders wont undertake it because most of the
  benefit goes to debt holders
• Underinvestment or Debt Overhang

42
Agency Costs and the Value of Leverage

• Leverage can encourage managers and shareholders
  to act in ways that reduce firm value.
• It appears that equity holders benefit at expense
  of debt holders.
• But, ultimately the shareholders bear these
  agency costs.
• When a firm adds leverage to its capital
  structure, the decision has two effects on the
  share price.
• The share price benefits from equity holders
  ability to exploit debt holders in times of
  distress.
• But, debt holders recognize this possibility and
  pay less for the debt when its issued ? reduces
  amount firm can distribute to shareholders.
• Debt holders lose more than shareholders gain
  from these activities and the net effect is a
  reduction in the initial share price of the firm.

43
Agency Costs and the Amount of LeverageExample

• Scenario 1 Do nothing
• Firm will be worth 0.9mil ? E 0.5mil D
  0.4mil
• Scenario 2 Risky strategy
• Equity worth only 0.45mil under risky strategy,
  0.5mil under existing so shareholders will
  reject it

44
Agency Costs and the Amount of Leverage Example
(Cont.)

• Scenario 3 Conservative strategy
• Shareholders value increase by 0.15mil for a
  0.1mil investment so theyre willing to invest
  in the project

45
Mitigating Agency Costs

• Shorter maturity debt can offset agency costs by
  limiting scope of expropriation
• Covenants can mitigate agency costs by forcing
  managers to commit not to expropriate debtholders

46
Agency Benefits of Leverage

• Managerial Entrenchment occurs from the
  separation of ownership and control in which
  managers make decisions to benefit themselves at
  the expense of investors
• Leverage can preserve ownership concentration and
  mitigate agency costs
• Issuing debt can maintain the original
  shareholders stake, while issuing equity can
  dilute original shareholders incentives because
  any agency costs are shared with others
• Leverage can mitigate empire building tendencies
  arising from incentives to run large firms (e.g.,
  salary structure, perquisites)
• Leverage imposes discipline by pre-committing the
  cash flows and by creditor monitoring

47
Agency Costs and the Tradeoff Theory

• The value of the levered firm can now be shown to
  be

48
Aggregate Sources of Funding for Capital
Expenditures, U.S. Corporations
49
Leverage and the Equity Cost of CapitalExample

• Levered equity has a return sensitivity that is
  125 that of unlevered equity ? risk premium is
  125 that of unlevered equity

50
Effect of Leverage on Risk and Return Example
(Cont.)

• The returns to equity holders are very different
  with and without leverage.
• Unlevered equity has a return of either 40 or
  10, for an expected return of 15.
• Levered equity has higher risk, with a return of
  either 75 or 25, for an higher expected return
  of 25.
• Levered equity has twice the systematic risk of
  unlevered equity ? has twice the risk premium

51
Homemade Leverage and ArbitrageExample

• Same assets ? same value ? unlevered firm is
  undervalued (or levered firms is overvalued)
• Buy low and sell high!
• Buy the equity of the unlevered firm on margin to
  replicate the levered equity cash flows
• Short sell the equity of the levered firm

• What is impact of arbitrage activity on security
  prices?

52
Leveraged Recapitalization

• A leveraged recapitalization is when a firm
  borrows money to pay a (large) special dividend
  or repurchase (a lot of) shares
• Example Harrison Industries
• All equity firm 50mil shares _at_ 4/share ? Market
  Cap 200mil
• Plan Borrow 80mil to repurchase _at_ 4/shr,
  80mil/4 20mil shares
• What are the implications of the planned recap?

53
Leveraged Recapitalization Example (Cont.)

• Note
• Share price doesnt change since its a 0-NPV
  transaction 80mil in debt for 80mil in equity

54
Multiple Securities

• When firms have multiple securities, the WACC is
  computed by a weighted average cost of capital of
  all the securities
• Example Consider entrepreneurs firm at outset
  but
• Capital structure is
• Risk-free debt 500 _at_ 5
• Equity 440 _at_ rE
• Warrants 60 pay 210 in strong economy and 0 in
  weak
• The WACC is

55
Multiple SecuritiesExample (Cont.)

• Compute return on Warrants, rW
• Compute return on equity, rE
• Compute WACC

56
Net Debt

• We can view cash as negative debt
• Its risk-free and reduces risk, the opposite of
  debt
• 1 of cash in the firm will earn the risk-free
  rate
• 1 of debt in the firm will pay the risk-free
  rate
• Net Debt Debt Cash (and Risk-Free Securities)

57
Cash and Beta Example

• Ciscos net debt 0 - 16bil -16bil
• Implies total value E D 110bil (-16bil)
  94bil
• Whats going on?
• Equity has capitalized 94bil in assets and
  16bil in cash
• Business assets are risky (ßA 2.57), cash is
  not (ßC 0)
• So, equity is less risky than firms business
  assets because of the cash

58
Interest Tax Shields withTarget Debt-Equity
Ratios

• When a firm adjusts its leverage to maintain a
  target debt-equity ratio, we can compute its
  value with leverage, VL, by discounting its free
  cash flow using the weighted average cost of
  capital.
• The value of the interest tax shield can be found
  by comparing the value of the levered firm, VL,
  to the unlevered value, VU, of the free cash flow
  discounted at the firms unlevered cost of
  capital, the pretax WACC.

59
Valuing the Interest Tax Shield with a Target
Debt-Equity Ratio Example

• Compute unlevered value
• Step 1 Compute pre-tax WACC
• Step 2 Compute firm value as growing perpetuity

60
Valuing the Interest Tax Shield with a Target
Debt-Equity Ratio Example (Cont.)

• Compute levered value
• Step 1 Compute post-tax WACC
• Step 2 Compute firm value as growing perpetuity
• Compute value of interest tax shield

61
Interest Tax Shield with Personal TaxesExample

• In 2005 t15
• VU300mil
• VL VU tD 300 0.15(100) 315mil
• With 20mil original shares outstanding, stock
  price would increase by 15mil / 20mil
  0.75/share