Do firms care about capital structure

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Do firms care about capital structure?

• Capital Structure is a part of a much larger,
  value creating equation. At Sears, as in most
  companies, creating shareholder value is the main
  governing objective.There is considerable effort
  aimed at achieving the lowest long-term cost of
  capital by managing the capital structure. That
  leads to a discussion in which we determine
  ourtarget capital structure. I can tell you we
  have dug seriously into the capital structure
  question.
• - Alice Peterson, Vice-President and
  Treasurer of Sears (1998)

2
Capital Structure

• Think of the capital structure of the firm as an
  analysis of the right side of the balance sheet
• The balance sheet is based on book value capital
  structure on market
• How does the firm finance its activities? Through
  the use of debt or equity?
• Just as an investor views a rate of return, the
  firm must view its cost of capital. Expectations
  must be in synch. How does this effect the
  capital structure?

3
Uses of the Cost of Capital

• Capital budgeting decisions
• Projects
• Divisions
• Risk /return trade-off
• Valuation of the firm
• Up to now, this has always been a given in our
  problems!

4
How does capital structure affect firm value?

• The value of any company is the sum of the firms
  future operating or free cash flows discounted at
  the firms cost of capital (discount rate).
• Does capital structure impact operating cash
  flow?
• Interest expense is not part of operating cash
  flow
• Dividends or distributions to shareholders are
  not part of operating cash flow
• Operating cash flow is based on investments in
  operations.
• Investment and financing decisions are separate
  corporate decisions, but both impact value.
• Does capital structure impact the firms cost of
  capital?
• The cost of capital is the return investors
  require on their investment in the company.
• Do investors require a greater return from more
  levered companies?

5
Assumptions in a Perfect Market

• The following analysis assumes no market
  imperfections. This means
• No Taxes
• No Default Risk
• No Agency Problems
• Once we understand the perfect market, we will
  relax each of these assumptions and determine how
  things change

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How Does Capital Structure Effect Firm Value in a
World with No Taxes?

• Lets consider to companies, one with leverage
  and one without, and the choices available to the
  potential shareholder
• COMPANY A
• Has no debt
• Has a market value of 8.0M
• Has 400,000 shares of stock outstanding at 20
  share
• COMPANY B
• Is identical to company A, but it has issued
  4.0M in debt to buy back 200,000 shares of stock
  at 20/ share
• Has a market value of 8.0M (4.0M in debt/4.0M
  in equity)
• Now has 200,000 shares outstanding at 20 per
  share
• Which of these companies is more attractive to a
  potential shareholder?

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Potential Results for Companies A B
8
Potential Results for Companies A B
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Does the Shareholder prefer the results of A or B?
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Does the Shareholder prefer the results of A or B?

• The presence of debt effects both the
  Shareholders ROE and EPS
• If the shareholder can duplicate the results for
  both capital structures using an investment
  strategy, then the firm is not creating an
  advantage for the shareholder by changing its
  capital structure.
• Consider the following 2 strategies
• Strategy A
• Expend 2,000 to buy 100 shares of the levered
  firm at 20/Share
• Strategy B
• Expend 2,000 to but 100 shares of the Un-Levered
  firm at 20/share and borrow 2,000 using the
  proceeds to buy another 100 shares

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Results of Homemade Leverage
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How Does Capital Structure Effect Cost of Capital

• The cost of capital is the weighted average of
  the cost of equity and the cost of debt (or any
  other securities).
• where E is the market value of equity, D is the
  market value of debt, and V is total market
  value.
• We sometimes use the book value of debt as a
  proxy for the market value of debt when the
  market value of debt is unknown.

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Capital Structure and Cost of Capital

• So, does capital structure affect value, i.e.
  does it alter a firms weighted average cost of
  capital?
• France Modigliani and Merton Miller won the Nobel
  prize for their answer to this question. They
  have two basic propositions re capital structure
  in a world with no taxes
• 1. The value of the levered firm is the same as
  the value of the un-levered firm. So
• VU VL
• 2. The expected return on equity is positively
  related to leverage, so the return to
  shareholders must increase as leverage, and
  consequently risk, also increase.

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Capital Structure and Cost of Capital

• Keeping Value Constant
• If the cost of equity is greater than the cost of
  debt and you add more debt, shouldnt the
  weighted average cost of capital decrease?
• No, because the cost of equity increases with
  more debt in the capital structure. This is
  because the increased debt also increases the
  risk, and hence the return, to shareholders
• So that the WACC is left unaffected.

15
Measuring Risk

• According to the CAPM, the cost of equity Re
  depends on the firms systematic risk as measured
  by Be. We can measure the effect of debt on both
  Re and Be

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Types of Risk

• If you think of Re as being representative of a
  risk adjusted rate, then there are two elements
  of risk related to Re
• The business risk of the firm's equity which
  comes from the nature of the firm's operating
  activities, Ra
• The financial risk of the firm's equity comes
  from the financial policy or capital structure of
  the firm, (Ra - Rd) (D/E)

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Changing leverage ratios without taxes

• Assume that a firm has a debt to equity ratio of
  .4, an equity beta of 1.1, and a cost of equity
  12.8 and a cost of debt of 10
• If the firm increases repurchases of stock and
  finances the repurchase with debt so its debt to
  equity ratio moves from .4 to .6,
• What is the firms new beta?
• What is the firms new cost of equity?
• What does this mean to the WACC?
• What is the change return required because of the
  firms business risk?
• What is the change return required because of the
  firms financial risk?

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Market Imperfections

• So, in a perfect world, capital structure
  influences the firms financial risk and, thus,
  the cost of equity but not the firms cost of
  capital (WACC).
• But what if the world is not perfect.
• Taxes
• Interest on debt is tax deductible for
  Corporations.
• Shareholders and Bondholders have different tax
  rates.
• Default Risk
• Debt increases the probability of Bankruptcy.
• Agency Problems
• Debt may alter shareholder incentives.
• Debt may alter managers incentives.

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Corporate Taxes

• Assume I am holding 10 for you. If I put 5 in
  my left pocket and 5 in my right, do you care?
  No, (unless I have a hole in my pocket!).
• Lets pretend now that my right pocket is a magic
  pocket and will turn 1 dollar into 1 dollar and
  25 cents.
• Now, if I am holding your 10. Do you care if I
  hold it in my right or left pocket?
• Debt is like the right pocket and the magic
  taxes.
• Interest is tax deductible. Dividends are not.
  So, a firm can keep money from the government by
  having more debt rather than equity.
• So, debt accomplishes 2 things
• It provides an Interest deduction which reduces
  taxes
• It creates the potential for bankruptcy

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Corporate Taxes

• MM recognize the impact of corporate taxes and
  show that
• where R(U) is the cost of capital for the
  un-levered firm, which is equivalent to the cost
  of equity for the un-levered firm since it has no
  debt.
• This implies that firms should have 100 debt to
  maximize the value of the tax shield. However,
  other costs and benefits of debt must be
  considered.

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Corporate Taxes

• The WACC equation with corporate taxes only
  accounts for one benefit and none of the costs of
  debt. We often use this equation in our
  analysis.
• It is important to recognize that there are other
  costs and benefits to debt and a firm will
  obviously not have 100 debt.

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Corporate Taxes

• Corporate Taxes reduce the financial risk of the
  firm.
• We can also restate the relationship between beta
  and leverage incorporating debt.

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Changing the Capital Structure

• Using the WACC incorporating taxes to value the
  firm requires that the firm does not change its
  leverage ratio. If the firms leverage changes,
  then the WACC will change.
• You must UNLEVER and RELEVER

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Changing leverage ratios with taxes

• Assume in a world with no taxes, that a firm has
  a debt to equity ratio of .5, an equity beta of
  1.4, and a cost of equity 15.2 and a cost of
  debt of 10.
• If the firm increases repurchases stock and
  finances the repurchase with debt and its debt to
  equity ratio from .5 to .7,
• What is the equity of the firms new beta?
• What is the firms new cost of equity?
• What is the change return required because of the
  firms business risk?
• What is the change return required because of the
  firms financial risk?

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Changing leverage ratios with taxes

• Now, in addition, assume that a firm has a
  corporate tax rate of 30
• What happens to the firms WACC?
• What happens to the firms cost of equity?
• What happens to the beta of that equity?
• What happens to the cash flows, and hence the
  valuation of the levered firm?
• Assume EBIT 1,000
• Levered firm has 1,000 in debt at an 8 interest
  rate in perpetuity
• Levered firm has a tax rate of 30

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Accounting for Leverage in Valuation

• To examine the costs and other benefits of debt
  and how they influence value, we must break up
  the value of the firm into the value of the firm
  if it had no debt and the value due to debt.
• Note this is NOT the value of debt but the value
  due to having debt.

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Accounting for Leverage in Valuation

• Value of the levered firm
• Value of the un-levered firm Value of Debt
• You can either
• Value the levered firm at the WACC, or
• Value the firm as if it is un-levered at the
  un-levered cost of capital and add any benefits
  or subtract any costs of having debt.

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Cost of Capital for the Levered Firm

• To value the firm as a whole (AB)
• As in the cases of Smuckers and Barnes Noble,
  you would discount the FCF and terminal value at
  the firms weighted average cost of capital
  (WACC).
• WACC is the Cost of Capital for the levered firm
  (AB)
• Emarket value of equity
• DMarket value of debt
• VED

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• But, to Value the firm in parts (Value of A
  Value of B)
• Value of the un-levered firm
• FCF and Terminal Value discounted at the COC
• for the un-levered firm r(U).
• Value added by debt ? (this is not the same as
  the value of debt)
• Must consider all of the costs and benefits of
  debt to derive the firms Optimal Capital
  Structure.
• Corporate Taxes
• Bankruptcy Costs
• Agency Problems

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Corporate Taxes

• What is the value of debt considering only the
  impact of corporate taxes?
• Present Value of the Interest Tax Shield
• Tax Shield Interest Paid corporate tax rate
• (Debt rD) tc
• PV(Tax Shield) (Debt rD) tc
• rD
• The Tax Shield is a perpetuity just like the
  firms cash flows are a perpetuity. (Going
  Concern Assumption of Accounting)
• Value added by Debt PV(Tax Shield) Debt tc
• If Debt1,000 and the tax rate is 30, the value
  added by debt is 300.

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Default Risk

• Lets think back to the money in my right and
  left pocket.
• Assume that there is a hole in the top of my
  right pocket.
• If you put a little money in it no problem
• If you put too much money in the right pocket,
  then some will get lost
• Debt is like the right pocket and the potential
  for bankruptcy is the hole in the pocket.
• Too much debt and you will lose some of your
  money.

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Default Risk

• Debt increases the probability of Financial
  Distress, or Bankruptcy.
• Financial distress short of bankruptcy has costs
• Management time in dealing with debtholders
• Time spent managing working capital
• Bankruptcy has costs.
• Direct Costs Legal and Administrative
• Only 1 of market value 7 years prior Warner
  (1977).
• Indirect Bankruptcy Costs due to disruption of
  normal activities (ex. Business lost due to
  pending bankruptcy).
• Approximately 12 of market value 3 years prior
  Altman (1984).

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Default Risk

• Bankruptcy impacts value by the present value of
  the expected bankruptcy costs (estimated costs
  probability of bankruptcy).
• Value added by Debt Debt tc PV(EBankruptcy
  Costs)
• If PV(bankruptcy cost) are 500 and the
  probability of bankruptcy is 5, then the value
  added 350 - (.05 500)325

34
Agency Problems between Shareholders and
Debtholders

• Shareholders incentives
• Shareholders of a levered firm may take on more
  risk because they have less to lose.
• By doing this, they increase the value of the
  equity and reduce the value of debt.
• Assume a firm has two choices of equal
  probability cashflow and the firm will distribute
  all cashflow (so expected CF Value).

35
Agency Problems between Shareholders and Managers

• Managers may waste excess cash flow (i.e. free
  cash flow after dividend and debt payments).
• The more you have the more you spend.
• Managers may invest in NPV projects (pet
  projects) or consume perquisites.
• Debt acts as a monitor. The more debt the less
  excess cash to waste.
• Make use of protective covenants to protect the
  debtholder
• Value added by Debt Debt tc PV(Bankruptcy
  Costs) Value loss due to excess risk taking
  improved monitoring due to debt
• It is more difficult to calculate these costs.

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Why do debt ratios differ?

• Corporate Tax shield
• Same for all firms with effective tax rate
• Differ if more non-debt tax shields
• Bankruptcy Costs
• Increase with probability of bankuptcy (risk and
  volatility)
• Increase with cost of bankruptcy (intangibles)
• Agency Problems between debtholders and
  shareholders
• Increase with growth opportunities
• Agency Problems between managers and shareholders
• Increase with excess cash flow

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Understanding Firms Debt Ratios

• Why doesnt Microsoft have any debt?
• Benefit of tax shield out weighed by costs of
  debt
• High growth / intangibles so greater agency
  problems between debtholders and equityholders.
• Higher bankruptcy costs?
• Probability low but cost may be high if firm is
  unique
• Agency problems between shareholders and
  managers may not be an issue because of high
  insider ownership.
• Other firms with higher than average debt to
  assets ratios (1997)
• Benefit of tax shield costs of debt
• Dole Foods 0.31
• General Motors 0.41
• Sears 0.54

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Review

• To value the unlevered firm by discounting FCF
  and terminal value at unlevered firms cost of
  capital plus the value added by debt we need 3
  things
• We know how to value debt.
• We know how to calculate FCF and terminal value
• How do you calculate the unlevered cost of
  capital?

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Cost of Capital for the Unlevered Firm

• If there is a tax advantage to debt, you must
  unlever the firms cost of equity.
• If you consider personal taxes, you multiply the
  unlevered COC by (1- te). However, you must also
  do the same for the cash flow you are
  discounting, so they cancel each other out.
• Without taxes, WACC R(U), the return on the
  unlevered firm.

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Valuing the levered firm

• Two ways to value the levered firm.
• Value unlevered firm by discounting FCF and
  terminal value at unlevered firms cost of
  capital plus the value added by debt (considering
  all costs and benefits).
• Value whole firm by discounting FCF and terminal
  value at the levered firms cost of capital.
• Need the levered firms weighted average cost of
  capital.
• How do you incorporate other costs and benefits
  of debt into WACC?
• Bankruptcy costs and the agency cost of debt will
  influence the firms cost of debt.
• The monitoring benefit of debt will influence the
  cost of equity.

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Optimal Capital Structure

• A firm wants to choose a capital structure that
  maximizes firm value or minimizes the cost of
  capital.
• This targeted debt/equity mix will be
• Greater due to corporate taxes
• Affected by personal taxes (possible lower)
• Lower due to bankruptcy costs.
• Lower due to the risk shifting that occurs due to
  the agency problems between shareholders and
  debtholders
• Greater due to debt monitoring, reduction in
  agency problems between managers and
  shareholders.

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