The Capital Structure Decision

1
The Capital Structure Decision

• To have debt or not to have debt? That is the
  question!!
• Precise what is the optimal MIX between debt and
  equity?
• Look at some real life examples
• Unfortunately, impossible to pinpoint a precise
  mi()
• Still-there must be som kind of answer

2
1st. Impact of Debt

• Level of debt is a policy decision (within
  limits, not right or wrong but risk and return
  trade-off)
• Debt leverage MAGNIFIER
• This is good and bad!
• Consider an example

3
Firm U Unleveraged
Economy
Bad Avg.
Good
Prob. 0.25 0.50
0.25 EBIT 2,000 3,000
4,000 Intere 0
0 0 EBT 2,000
3,000 4,000 Taxes (40) 800
1,200 1,600 NI
1,200 1,800 2,400
4
Firm L Leveraged
Economy
Bad Avg.
Good
Prob. 0.25 0.50
0.25 EBIT 2,000 3,000
4,000 Interest 1,200 1,200
1,200 EBT 800
1,800 2,800 Taxes (40) 320
720 1,120 NI
480 1,080 1,680 Same as for Firm U.
5
Firm U Bad Avg. Good
BEP 10.0 15.0 20.0 ROI 6.0 9.0 12.0
ROE 6.0 9.0 12.0 TIE
8
8
8
Firm L Bad Avg. Good
BEP 10.0 15.0 20.0 ROI 8.4 11.4
14.4 ROE 4.8 10.8 16.8 TIE 1.7x 2.5x
3.3x ROI (NI Interest)/Total financing.
6
Profitability Measures E(BEP)
15.0 15.0 E(ROI)
9.0 11.4 E(ROE)
9.0 10.8 Risk Measures ?ROE
2.12
4.24 CVROE 0.24
0.39 E(TIE) 2.5x
U L
8
7
Conclusions

• Basic earning power BEP EBIT/Total assets is
  unaffected by financial leverage.
• L has higher expected ROI and ROE because of tax
  savings.
• L has much wider ROE (and EPS) swings because of
  fixed interest charges. Its higher expected
  return is accompanied by higher risk.

(More...)
8

• In a stand-alone risk sense, Firm Ls
  stockholders see much more risk than Firm Us.
• U and L ?ROE(U) 2.12.
• U ?ROE 2.12.
• L ?ROE 4.24.
• Ls financial risk is ?ROE - ?ROE(U) 4.24 -
  2.12 2.12. (Us is zero.)

(More...)
9

• For leverage to be positive (increase expected
  ROE), BEP must be gt kd.
• If kd gt BEP, the cost of leveraging will be
  higher than the inherent profitability of the
  assets, so the use of financial leverage will
  depress net income and ROE.
• In the example, E(BEP) 15 while interest rate
  12, so leveraging works.

10
Impact of Debt

• Note debt leverages ROE
• The return to all investors (stock and debt
  holders) is greater with debt given same EBIT.
  See s
• Why?
• The IRS!-formally Tax shield

11
So, More Debt?

• Trade-off. (as always) Risk vs. Return
• Wheres risk?
• 1st greater volatility. The range of actual ROEs
  is wider than without debt. See probability
  distributions
• Greater Risk(std. Dev. Or CV)
• In fact heres the concept of business risk

12
What is business risk?

• Uncertainty about future operating income (EBIT).
• Note that business risk focuses on operating
  income, so it ignores financing effects.

Probability
Low risk
High risk
EBIT
E(EBIT)
0
13
Factors That Influence Business Risk

• Uncertainty about demand (unit sales).
• Uncertainty about output prices.
• Uncertainty about input costs.
• Product and other types of liability.
• Degree of operating leverage (DOL).

14
Business vs. Financial Risk

• Even under no debtvariability (EBIT changes and
  so does ROE)
• So a company with great deal of business risk
  would not want a lot of debt because it would
  accentuate that variability even more
• A company with low business risk would be able to
  handle more debt

15
How Much Debt?

• A Risk vs. return, of course
• We said that risk is due to greater volatility in
  returns
• That sounds too fancy. How about some real life
  answers?
• Chain reaction
• Remember Peter Lynch

16
Back to Business Risk

• Recall that business risk is the inherent
  variability of your business.
• As your EBIT fluctuates, so does your ROE and you
  have uncertainty
• How much business risk you have in turn impacts
  how much debt you want to take on

17
Operating Leverage

• def.
• High degree of operating leverage highFC
• Low degree of operating leveragelowFC
• This impacts EBIT and thus ROE

18
What is operating leverage, and how does it
affect a firms business risk?

• Operating leverage is the use of fixed costs
  rather than variable costs.
• The higher the proportion of fixed costs within a
  firms overall cost structure, the greater the
  operating leverage.

(More...)
19
Breakeven Analysis

• 1. If high DOL
• breakeven point will be high (riskier)
• if sales are up bigger profits
• if sales are down bigger losses
• 2. If low DOL
• lower BE point (safer)
• if sales are up lower profits
• if sales are down lower losses

20

• Higher operating leverage leads to more business
  risk, because a small sales decline causes a
  larger profit decline.

(More...)
21
Probability
Low operating leverage
High operating leverage
EBITL
EBITH

• In the typical situation, higher operating
  leverage leads to higher expected EBIT, but also
  increases risk.

22
What is the Optimal Mix?

• Theory on this is based on MM
• 1st to systematically study capital structure
• Very rigid theory (lots of assumptions)
• But nevertheless a neat progression
• 1. Under no Taxes (go ahead and laugh)
• Capital structure is irrelevant
• mix doesnt mattter
• Value of the firm with or without debt is same

23
MM

• 2. What if corporate taxes
• Debt is great! (Tax shield)
• As debt goes up value of the also up
• optimal mix 100 debt!!!
• 3. What if taxes and bankrupcy costs
• more complicated
• trade off benefits of debt vs. cost of debt
• there is an optimal level

24
Trade-off Theory

• MM theory ignores bankruptcy (financial distress)
  costs, which increase as more leverage is used.
• At low leverage levels, tax benefits outweigh
  bankruptcy costs.
• At high levels, bankruptcy costs outweigh tax
  benefits.
• An optimal capital structure exists that balances
  these costs and benefits.

25
Bankrupcy Costs

• Actual costs
• legal expenses
• accounting expenses
• hard to liquidate maybe no liquidity
• Potential costs
• loss of customers/employees/suppliers
• More debt more risk of bankrupcymore costs

26
Notes on Trade-off Model

• Optimal point must exist for every company
• Impossible to precisely determine
• Best we can do is a range
• We will do a hypothetical problem to determine an
  optimal mix

27
Information Asymmetry

• Q Why do some large, well established companies
  have do little debt? A lot less than the
  trade-off model would suggest
• Q2 Research shows that companies prefer to
  finance 1st with RE, next debt and only last with
  new stock. (Pecking order) Why?
• Questions that trade-off model cant answer
• Any ideas?

28
Information Asymmetry to the Rescue

• 1st. There are two assumptions underlying
  information asymmetry
• managers know more than investors
• managers act in the best interest of current
  shareholders
• Having defined that What does info. Asymmetry
  theory state?

29
2 Major Implications

• 1. If the companys prospects are poor (nobody
  knows except insiders) then stock is OVERVAUED
• Finance everything with stock
• a. You can raise more money (lower cost)
• b. Once the stock falls, the losses will be
  shared by old and new stockholders (this favors
  the old shareholders)

30
Ctd.

• 2. If the companys prospects are good (nobody
  knows but insiders) then the stock is UNDERVALUED
• Do not use stock to finance (use debt)
• a. You are not getting enough money for it (cost
  of equity is higher)
• b. When it goes up, it will benefit only old
  shareholders (wont have to share the gains with
  new shareholders)

31
Signaling Theory

• MM assumed that investors and managers have the
  same information.
• But, managers often have better information.
  Thus, they would
• Sell stock if stock is overvalued.
• Sell bonds if stock is undervalued.
• Investors understand this, so view new stock
  sales as a negative signal.
• Implications for managers?

32
SIGNALING

• Because this concept of information asymmetry is
  well known, how a company raises becomes a
  signal!
• Issue stock bad news (overvalued)
• Issue debt good news (undervalued)
• Warning this applies more to large, well
  established cos with access to all capital mkts

33

• New companies
• fast growth will require that co. uses all
  possible capital including equity
• or a small new company may not have easy access
  to bond market so it can only raise money trhough
  equity
• Here the signals are probably not relevant

34

• New companies
• fast growth will require that co. uses all
  possible capital including equity
• or a small new company may not have easy access
  to bond market so it can only raise money trhough
  equity
• Here the signals are probably not relevant

35
Info. Asym. Conclusion

• Q1 Why some cos have less optimal debt?
• A They keep a reserve borrowing capacity So if
  they need more , they can issue debt and not
  have to send a (-) signal by issuing stock
• Q2 Why is there a pecking order?
• A Issuing stock is a bad signal that should be
  done as a last resort

36
Closing Comments

• There is an optimal capital structure (maximizes
  value of the firm)
• Quantifying it accurately is impossible
• Still great accuracy may not be necessary
• That is, you can be relatively far away from your
  theoretical optimal and the impact on firm value
  is minor

37
Closing Comments Still

• The truth is that the effect of capital structure
  decisions is small compared to the effect of
  operating decisions
• Operating decisions find new markets, produce
  more efficiently, increase sales, lower costs
• These are the primary determinants of your
  success, not capital structure

38
Closing Comments (endless)

• You can have lousy financial arrangements but
  good sales and youll survive and even prosper
• Even the best financial plans cant overcome
  operating deficiencies

39
Perpetual Cash Flow Example
Expected EBIT 500,000 will remain constant
over time. Firm pays out all earnings as
dividends (zero growth). Currently is all-equity
financed. 100,000 shares outstanding. P0 20 T
40.
40
Component Cost Estimates
Amount Borrowed (000) kd ks 0
- 15.0 250 10.0 15.5
500 11.0 16.5 750 13.0 18.0
1,000 16.0 20.0
If company recapitalizes, debt would be issued to
repurchase stock.
41

• The MM and Miller models cannot be applied here
  because several assumptions are violated.
• kd is not a constant.
• Bankruptcy and agency costs exist.
• Theory provides some valuable insights, but
  because of invalid assumptions, direct real-world
  application is questionable.

42
Sequence of Events in a Recapitalization

• Firm announces the recapitalization.
• Investors reassess their views and estimate a new
  equity value.
• New debt is issued and proceeds are used to
  repurchase stock at the new equilibrium
  price.

(More...)
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(No Transcript)
44
D 250, kd 10, ks 15.5. S1

1,839. V1 S1 D1 1,839 250
2,089. P1 20.89.
(EBIT - kdD)(1 - T) ks
500 - 0.1(250)(0.6) 0.155
2,089 100
45
Shares 250 repurchased
20.89 Shares remaining Check on
stock price P1
20.89. Other debt levels treated similarly.
11.97. n1 100 - 11.97
88.03.
S1 n1
1,839 88.03
46
What is the firms optimal amountof debt?

• Debt kd ks P
• 250 10 15.5 20.89
• 500 11 16.5 21.18
• 750 13 18.0 20.92
• 500,000 of debt produces the highest stock price
  and thus is the best of the debt levels
  considered.

47
Calculate EPS at debt of 0, 250K, 500K, and
750K, assuming that the firm begins at zero debt
and recap-italizes to each level in a single step.
Net income NI EBIT - kd D(1 - T). EPS
NI/n. 0 300 100.00 3.00 250 285
88.03 3.24 500 267 76.39 3.50 750 242
64.15 3.77
D NI n EPS
48

• EPS continues to increase beyond the 500,000
  optimal debt level.
• Does this mean that the optimal debt level is
  750,000, or even higher?

49
Find the WACC at each debt level.
D S V kd ks WACC
0 2,000 2,000 -- 15.0 15.0 250
1,839 2,089 10 15.5 14.4 500 1,618
2,118 11.0 16.5 14.2 750 1,342
2,092 13.0 18.0 14.3
e.g. D 250WACC (250/2,089)(10)(0.6)
(1,839/2,089)(15.5) 14.4.
50

• The WACC is minimized at D 500,000, the same
  debt level that maximizes stock price.
• Since the value of a firm is the present value of
  future operating income, the lowest discount rate
  (WACC) leads to the highest value.

51
How would higher or lower business risk
affect the optimal capital structure?

• At any debt level, the firms probability of
  financial distress would be higher. Both kd and
  ks would rise faster than before. The end result
  would be an optimal capital structure with less
  debt.
• Lower business risk would have the opposite
  effect.

52
This is an Alternative Presentation
53
Capital Structure

• Debt is a Magnifier
• Example 2 types of financing-1 is zero debt the
  other is 50 debt ratio
• Assume we need 175,000 financing. If we borrow
  half-87,500, the interest rate is 10
• Consider two cases an expected situation and a
  bad situation

54
Example

• I. Expected case No debt 50
• EBIT 35,000 35,000
• -Int 0 8,750
• EBT 35,000 26,250
• -taxes 14,000 10,500
• Net Income 21,000 15,750 ROE 12 18

55
Example

• I. Bad News case No debt 50
• EBIT 5,000 5,000
• -Int 0 8,750
• EBT 5,000 3,750
• -taxes 2,000 1,500
• Net Income 3,000 2,250 ROE 1.7 -2.6

56
Why the difference?

• Cash Flow to Investors No debt 50
• Shareholders 21,000 15,750
• Bondholders 0 8,750 Total 21,000 24,500
• Difference is 3,500 difference in taxes!

57
LeverageVolatility

• This means that a company with uncertain earnings
  would make itself that much more risky by
  financing with debt.
• The formal concept is called business risk and
  financial risk
• Lets look at them

58
What is business risk?

• Uncertainty about future operating income (EBIT).
• Note that business risk focuses on operating
  income, so it ignores financing effects.

Probability
Low risk
High risk
EBIT
E(EBIT)
0
59
Business Risk and Financial Risk

• If the Standard deviation of the ROE with zero
  debt is 2.14
• And if the standard deviation of the ROE with 50
  debt is 4.5
• Follows that the business risk is 2.14
  (variability without leverage) and the financial
  risk is 4.5-2.14 2.36

60
Factors That Influence Business Risk

• Uncertainty about demand (unit sales).
• Uncertainty about output prices
• Uncertainty about input costs.
• Product and other types of liability.
• Degree of operating leverage (DOL).

61
Operating Leverage

• Lets look at this factor in more detail
• It is the extent to which the your costs are
  fixed vs. variable
• High degree of operating leverage highFC
• Low degree of operating leveragelowFC
• This impacts business risk as it impacts EBIT and
  thus ROE

62
Operating Leverage

• Operating leverage is the use of fixed costs
  rather than variable costs.
• The higher the proportion of fixed costs within a
  firms overall cost structure, the greater the
  operating leverage.
• You can see this through breakeven analysis

(More...)
63
Breakeven Analysis

• 1. If high DOL
• breakeven point will be high (riskier)
• if sales are up bigger profits
• but if sales are down bigger losses
• 2. If low DOL
• lower BE point (safer)
• if sales are up lower profits
• but if sales are down lower losses

64

• Higher operating leverage leads to more business
  risk, because a small sales decline causes a
  larger profit decline.

(More...)
65
What is the optimal level of debt?

• Theory on this is based on Miller Modigliani
  (MM-Nobel Prize)
• They were the 1st to systematically study capital
  structure
• Their main results are two without taxes and
  with taxes

66
MM

• 1. Under no Taxes
• Capital structure is irrelevant
• mix doesnt mattter
• Value of the firm with or without debt is same
• It is easy to criticize this result as being
  unrealistic-irrelevant/yet it provides clues as
  to what is relevant

67
MM

• 2. What if corporate taxes
• Debt is great! (Tax shield)
• As debt goes up value of the also up
• optimal mix 100 debt!!!
• Now, we see no companies at 100 leverage. So
  what is next?

68
Trade-off Theory

• MM theory ignores bankruptcy (financial distress)
  costs, which increase as more leverage is used.
• At low leverage levels, tax benefits outweigh
  bankruptcy costs.
• At high levels, bankruptcy costs outweigh tax
  benefits.
• An optimal capital structure exists that balances
  these costs and benefits.

69
Bankrupcy Costs

• 1. Actual costs (Direct costs)
• legal expenses
• accounting expenses
• hard to liquidate maybe no liquidity
• 2. Potential costs (Indirect Costs)
• loss of customers/employees/suppliers
• Both are hard to measure-nevertheless studies
  shown them to be 8-10 of value

70
Notes on Trade-off Model

• Optimal point must exist for every company
• Impossible to precisely determine
• Best we can do is a range
• We will do a hypothetical problem to determine an
  optimal mix

71
Another Theory

• Trade-off model is well accepted (although cant
  quantify it).
• Yet, there is another theory that is popular in
  explaining cap. Structure
• Called Information Asymmetry and it is based on
  the idea that managers know more than investors

72
Information Asymmetry

• 1st. There are two assumptions underlying
  information asymmetry
• managers know more than investors
• managers act in the best interest of current
  shareholders
• Having defined that What does info. Asymmetry
  theory state?

73
Information Asymmetry

• Q Why do some large, well established companies
  have do little debt? A lot less than the
  trade-off model would suggest
• Q2 Research shows that companies prefer to
  finance 1st with RE, next debt and only last with
  new stock. (Pecking order) Why?
• Questions that trade-off model cant answer
• Any ideas?

74
2 Major Implications

• 1. If the companys prospects are poor (nobody
  knows except insiders) then stock is OVERVAUED
• Finance everything with stock
• a. You can raise more money (lower cost)
• b. Once the stock falls, the losses will be
  shared by old and new stockholders (this favors
  the old shareholders)

75
Ctd.

• 2. If the companys prospects are good (nobody
  knows but insiders) then the stock is UNDERVALUED
• Do not use stock to finance (use debt)
• a. You are not getting enough money for it (cost
  of equity is higher)
• b. When it goes up, it will benefit only old
  shareholders (wont have to share the gains with
  new shareholders)

76
Signaling Theory

• MM assumed that investors and managers have the
  same information.
• But, managers often have better information.
  Thus, they would
• Sell stock if stock is overvalued.
• Sell bonds if stock is undervalued.
• Investors understand this, so view new stock
  sales as a negative signal.
• Implications for managers?

77
SIGNALING

• Because this concept of information asymmetry is
  well known, how a company raises becomes a
  signal!
• Issue stock bad news (overvalued)
• Issue debt good news (undervalued)
• Warning this applies more to large, well
  established cos with access to all capital mkts

78
Pecking Order of Financing

• Research shows that companies prefer to finance
  1st with RE, next debt and only last with new
  stock. (Pecking order) Why?
• Information asymmetry would help explain this.
  Stock sends bad signals-last resort
• Information asymmetry may also explain why
  companies like financial slack (or reserve
  borrowing capacity)

79
Financial Slack/Reserve Borrowing Capacity

• It is easier to have cash ahead of your needs.
  That way you do not have to worry about the
  signaling problems of issuing securities
• It is easier to have less debt than optimal, that
  way you can always borrow when the opportunity
  comes
• Theres a dark side to financial slack though

80
Factors that favor Debt

• 1. Taxes!
• 2. Reduce Agency costs-debt imposes discipline
  and focus on your managers
• 3. Control- debt allows you to finance without
  losing control
• 4. Information asymmetry- issuing debt send
  better signals than issuing equity

81
Factors that Discourage Borrowing

• 1. Financial Distress-cost increases as you take
  on more debt
• 2. High business risk-if you are volatile to
  begin with, debt only increases this
• 3. Agency costs-more debt comes with strings
  attached-this restricts your flexibility
• 4. Dividend policy-too much debt can hurt your
  ability to have stable dividends

82
Closing Comments

• There is an optimal capital structure (maximizes
  value of the firm)
• Quantifying it accurately is impossible
• Still great accuracy may not be necessary
• That is, you can be relatively far away from your
  theoretical optimal and the impact on firm value
  is minor

83
Closing Comments Still

• The truth is that the effect of capital structure
  decisions is small compared to the effect of
  operating decisions
• Operating decisions find new markets, produce
  more efficiently, increase sales, lower costs
• These are the primary determinants of your
  success, not capital structure

84
Closing Comments (endless)

• You can have lousy financial arrangements but
  good sales and youll survive and even prosper
• Even the best financial plans cant overcome
  operating deficiencies