Establishing a Target Capital Structure

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Chapter 14

• Establishing a Target Capital Structure

Shapiro and Balbirer Modern Corporate Finance
A Multidisciplinary Approach to Value
Creation Graphics by Peeradej Supmonchai
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Learning Objectives

• Describe the effects of financial leverage on
  equity risks and return.
• Use EBIT-EPS indifference analysis to evaluate
  financing alternatives.
• Explain why capital structure doesnt matter in a
  world without taxes, transactions costs, or other
  market imperfections.
• Explain the existence of an optimal capital
  structure in terms of the trade-offs between the
  tax advantages of debt and the expected costs of
  financial distress.
• Identify those elements of business risk which
  influence the probability of financial distress.

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Learning Objectives (Cont.)

• Discuss how the possibility of financial distress
  may affect management behavior.
• Explain how agency costs can affect a firms
  financing strategy.
• Explain how leveraged recapitalizations such as
  leveraged buyouts can mitigate the agency costs
  of equity.
• Discuss how financing flexibility and the needs
  for financial reserves can influence the capital
  structure choice.

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Financial Leverage and Financial Risk

• Financial Leverage - The substitution of fixed
  cost financing for common stock.
• Business Risk - The inherent variability of a
  firms operating earnings.
• Financial Risk - The risk shareholders bear for
  the firms use of financial leverage.

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Effects of Financial Leverage on ROE
Where rA return on assets before financing
costs i after-tax cost of debt D amount of
debt in the capital structure E amount of
equity in the capital structure
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Consequences of Leverage - An Example
Hi-Tech Running Shoes needs 5 million in assets
to support sales. Option A Issue 500,000 shares
_at_ 10/share Option B Issue 250,000 shares _at_
10/share 2.5 million in debt _at_
10 Expected EBIT 1,000,000 EBIT (Low
Estimate) 200,000 EBIT (High Estimate)
2,000,000
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Consequences of Leverage - An Example

• Effect of leverage on Hi-Techs Earnings Per
  Share
• States of the World
• Bad Mediocre Normal Good
• No Leverage
• 500,000 shares _at_
• 10/share
• EBIT 200,000 500,000
  1,000,000 2,000,000
• Less Interest_at_ 10 0 0 0 0
• Equity Income 200,000 500,000
  1,000,000 2,000,000
• Less Tax _at_ 50 100,000 250,000
  500,000 1,000,000
• Equity income after tax 100,000 250,000
  500,000 1,000,000
• EPS .20 .50 1.00 2.00
• ROE () 2 5 10 20

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Consequences of Leverage - An Example
Effect of leverage on Hi-Techs Earnings Per
Share States of the World Bad Mediocre
Normal Good 50 percent debt
250,000 shares _at_ 10/share 2.5 million
in debt _at_10 interest EBIT
200,000 500,000 1,000,000 2,000,000 Less
Interest_at_ 10 250,000 250,000
250,000 250,000 Equity Income
(50,000) 250,000 750,000 1,750,000 Less
Tax _at_ 50 (25,000) 125,000
375,000 875,000 Equity income after tax
(25,000) 125,000 375,000
875,000 EPS (.10) .50 1.50
3.50 ROE () -1 5 15 35
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EBIT - EPS Indifference Point
Where EBIT EBIT-EPS indifference
point IA,IB interest expense under plan A
and B PA,PB preferred stock dividends under
plan A and B tc corporate tax
rate NA,NB number of shares outstanding under
plan A and B
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Hi-Techs EBIT - EPS Indifference Point
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Effects of Financial Leverage on Risk and Return

• When ROA exceeds the after-tax interest cost of
  debt, financial leverage increase both EPS and
  ROE.
• Financial leverage increase the variability of
  EPS and ROE.
• Financial leverage increases the expected level
  of EPS and ROE.

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Traditional Approach to Capital Structure
According to the traditional approach to capital
structure, the prudent use of debt can lower the
firms overall cost of capital and thereby
increase its market value.
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Traditional Approach to Capital Structure - A
Graphical View
ke Cost of equity capital
k0 Weighted Average Cost of Capital
Required return
kd Cost of debt capital
L
Debt/Total Equity
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Modigliani and Millers Proposition I
In the absence of taxes, transaction costs and
other market imperfections, the value of firm is
independent of its capital structure.
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Modigliani and Millers Proposition I - An Example
Suppose two firms are identical in all respects
except for capital structure. Firm U is
unlevered, and Firm L has 1 million in 10
percent debt. Both firms have an expected EBIT of
500,000.
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Modigliani and Millers Proposition I - An Example
Suppose the two firms have the following
valuations Firm U Firm
L EBIT 500,000 500,000 Interest
0 100,000 Dividends 500,000 4
00,000 Cost of Equity 0.15
0.16 Market Value of Equity 3,333,333
2,500,000 Market Value of Debt
0 1,000,000 Market Value of
Firm 3,333,333 3,500,000
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Modigliani and Millers Proposition I - An Example
Suppose you owned 10 percent of Ls stock with a
market value of 250,000. According to MM, you
should 1. Sell off your shares in L for
250,000 2. Borrow an amount equal to 10 percent
of Ls debt (100,000) at an interest rate
of 10 percent 3. Buy 10 percent of the shares of
U for 333,333 With these transactions you would
receive 350,000 in cash for the sale of your
stock in L, plus your borrowing, whereas you
would be spending only 333,000 to buy Us stock.
You would earn 16,667 from this transaction in
uncommitted funds.
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Modigliani and Millers Proposition I - An Example
The effects of these financial transactions on
your income will be Old income From New
Income From Investment in L Investment in
U 10 Firms Equity Income 500,000
500,000 Interest Expense on Borrowing
0 100,000 Net Income 500,000 400,000 I
nvestment income from the common stock is the
same in both cases, but now you have 16,668 to
spend as you please.
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Modigliani and Millers Proposition II
The cost of equity capital for a levered firm
equals the overall cost of capital plus a risk
premium that equals the spread between the
overall cost of capital and the cost of debt.
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The MMs Proposition II - A Graphical
Representation
(ke )
Required return
(k0 )
(kd )
Debt / Equity
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MM with Corporate Taxes
Consider two firms are identical in all respects
except for capital structure. Firm U is
unlevered, and Firm L has 1 million in 10
percent debt. Both firms have an expected EBIT of
500,000 and marginal tax rates of 40 percent.
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MM with Corporate Taxes
Income Statement Firm U Firm
L Earning Before Interest and Taxes 500,000
500,000 Interest Paid to Bondholders
0 100,000 Pre-tax Profits 500,000
400,000 Taxes _at_ 40 200,000
160,000 Income to Stockholders
300,000 240,000 Income
to Stockholders and Bondholders 300,000
340,000 Interest Tax Shield (Interestx0.40)
0 40,000 Present
Value of Tax Shield 0 400,000
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MM with Corporate Taxes
In a world where the only market imperfection is
corporate taxes, the value of a levered firm (VL)
equal the value of an unlevered firm (VU) plus
the present value of the debt tax shields
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Financial Leverage and Financial Distress

• Financial Distress - A situation where a firm has
  difficulty meeting its contractual obligations.
• Bankruptcy - An extreme form of financial
  distress where a firm defaults on its obligations
  and is placed under the protection of the court
  until a place is devised to pay creditors.

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Financial Leverage and Financial Distress - A
Graphical View
PV costs of financial distress
PV of interest tax shield
Value of firm with debt financing
Market value of the firm
Value of firm if all-equity financed
L optimal debt ratio
Debt Ratio
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Probability of Financial Distress

• For any given level of debt, the higher the
  business risk, the greater will be the likelihood
  of financial distress. Determinants of business
  risk are
• The Firms Cost Structure
• Demand Stability
• Competition
• Price Fluctuations
• Firm Size and Diversification
• Stage in the Industry Life Cycle

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Costs of Financial Distress - Adverse Selection

• Selection of High-Risk Projects
• Foregoing Low-Risk Positive NPV Projects
• Myopic Decision Making

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Cost of Financial Distress - Industry
Characteristics

• Industry-specific characteristics that argue for
  low debt ratios include the following
• Products that require repairs
• Good/Services where quality is an important
  attribute, but where it is difficult to access in
  advance
• Products for which there are switching costs
• Products whose value to the customer depends on
  services and/or complementary products supplied
  by other firms

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Cost of Financial Distress - Industry
Characteristics

• Firm-specific characteristics that argue for low
  debt ratios include the following
• High growth opportunities
• Substantial Organizational assets
• Large excess tax deductions

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Agency Costs and Capital Structure

• Stockholder-Manager Conflicts
• Excessive Perk Consumption
• Shrinking Responsibility
• Stockholder-Bondholder Conflicts
• Shareholder incentive to take on high-risk
  projects
• Shareholder incentive to pass up certain positive
  NPV projects

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Agency Cost of Debt

• Costs of monitoring to insure that they are not
  exploited by shareholders.
• Control costs in the form of restrictive
  covenants.

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Agency Costs of Equity

• Managements interest in the firm decreases as
  outside equity increases.
• Incentives to expand the size of the firm
• Reduce dividend payments
• Invest in substandard projects

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Reducing Agency Costs of Equity - Expanding
Leverage

• One answer to the agency costs of equity is
  through a leveraged recapitalization that
  restricts managements discretion over free cash
  flows by boosting debt and shrinking equity. Two
  ways of doing this are
• Leveraged Cash-Out
• Leveraged Buyout

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Strategic Factors Influencing Capital Structure

• Financial Flexibility and Corporate Strategy
• Value of Financial Reserves
• Less valuable for well-established, publicly
  traded firms
• Most valuable for privately held firms, small
  companies, or firms that the market has
  difficulty in valuing