Capital Structure

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Capital Structure
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Capital Structure

• Firm must decide how to raise long term funds
• Capital structure decision
• The capital structure decision is one of the most
  important strategic decisions faced by a firm
• Can have large affect on the overall value of the
  firm
• Direct impact on health of the firm and viability

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Capital Structure

• Many aspects to the decision
• How much debt and how much equity?
• Equity preferred stock or common stock?
• Maturity of debt long term versus short term?
• Structure of debt bank debt vs. bonds, secured
  vs. debentures, use of convertible bonds, et
  cetera
• What currency should debt be denominated in?
• If capital structure is to be changed, how to
  accomplish it?
• Other aspects

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• Here, we will concentrate on the most basic
  question
• Debt versus equity how much of each?
• How much should the firm borrow?
• Is there an optimal capital structure?
• Assumption The goal of the financial manager is
  to maximize the value of the firm.
• Makes capital structure decision in order to help
  accomplish this.

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WACC vs. Firm Value

• Maximizing the value of the firm is equivalent to
  minimizing the firms cost of capital.
• Capital structure affects WACC, and therefore
  firm value
• Example
• Firm generates free cash flow of FCFF each year
• Assume it goes on forever and, for simplicity,
  assume it does not grow.
• The market value of the firm (market value of
  debt plus market value of equity) is the present
  value of all future cashflows
• In this simple case, this is a perpetuity

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WACC vs. Firm Value

• Market value of the firm V
• If WACC decreases, firm value increases (and vice
  versa)
• Therefore, choose capital structure to obtain
  minimum cost of capital
• This makes the firm worth the maximum possible
  amount.

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• Point of Todays Discussion
• Is there an optimal amount of debt (optimal
  capital structure)?
• What factors affect/determine the optimal amount?
• These questions first looked at formally by
• Modigliani and Miller
• a.k.a.
• M M

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M M

• Before M M (1958), there were no formal methods
  for evaluating capital structure
• Many researchers and firms searched for how to
  determine the best structure
• M M did a formal, mathematical evaluation of
  capital structure
• Their model was based on some simplifying
  assumptions
• The two most important assumptions
• No Taxes
• No Costs of Bankruptcy
• Under these assumptionsCapital Structure is
  irrelevant.

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M M

• M M said a firms choice of capital structure
  did not matter?
• WHY?
• Consider WACC
• Debt is normally cheaper than equity
• If a firm borrows more, it puts more weight on a
  cheaper source of financing
• BUTthe firm becomes riskier
• Therefore investor's required return on equity
  increases
• The cost of equity to the firm goes up

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M M
This weight goes up, decreasing WACC
This cost increases, increasing WACC

• M M showed that under their assumptions, the
  two effects exactly offset.
• WACC does not change if the capital structure
  changes.

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M M

• Another way to think of it
• A firm cannot increase its value by its choice of
  financing, it is only the investments it makes
  that matter
• Can think of the value of the firm as a pie
• Part is equity
• Part is debt
• You cannot change the overall size of the pie by
  slicing it differently

debt
debt
equity
equity
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M M

• Conclusions based on assumptions which are
  clearly unrealistic
• Why important?
• If there are no taxes, no bankruptcy then capital
  structure does not matter
• Thus, factors that are important in determining
  capital structure in the real world must be taxes
  and bankruptcy
• M M then extended their model to include effect
  of corporate taxes
• important factorinterest payments on debt are
  tax deductible
• This gives debt an advantage over equity, and the
  capital structure the firm chooses does matter

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MM with Corporate Taxes

• Considering taxes, there is a benefit to using
  more debt
• This comes because of the valuable tax deduction
  generated
• Example
• Firm considers two ways to finance itself
• 100 equity
• Borrow some, and use some equity (amount borrowed
  D)
• In either case, the firms underlying business is
  the same
• EBIT is the same in either case
• Assume (for simplicity) no depreciation, no new
  investments, and no growth in cashflow in the
  future

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MM with Corporate Taxes

• If firm is unlevered
• Cashflow FCFF EBIT(1-T)
• Value of the unlevered firm VU
• Where rEU cost of equity of unlevered firm
• WACC of unlevered firm

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MM with Corporate Taxes

• If firm is levered
• FCFF (EBIT rDD)(1-T) rDD
• Where rD is cost of debt.
• Calculate present value of this to find market
  value of levered firm.

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• If firm is levered (continued)
• FCFF (EBIT rDD)(1-T) rDD
• EBIT(1-T) rDD rDDT rDD
• EBIT(1-T) rDDT
• Take present value of each piece separately at
  appropriate discount rates to get value of
  levered firm (VL)

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MM with Corporate Taxes

• The value of the firm increases with the use of
  debt
• TD the present value of the interest tax shield
• Implication the more debt the firm uses, the
  more valuable it is
• A little more realistic than original MM model
• Implies that optimal capital structure is 100
  debt for all firms
• Obviously, that is not what happens in the real
  world.
• There must be other factors at work that offset,
  to a certain extent, the tax benefits if debt

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Factors Affecting Capital Structure

• A number of factors affect what the optimal
  capital structure is for a firm
• These are things that should be considered in
  making the capital structure decision
• Some factors are more important for certain types
  of firms and less important for others
• Unfortunately, not all the factors are
  quantifiable

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Factors Affecting Choice of Capital Structure

• Taxes
• Bankruptcy Costs
• Industry Averages
• Control of Firm
• Risk Structure of Firm
• Signaling
• Need for Financial Slack
• Agency Problems
• Between shareholders and bondholders
• Between shareholders and management

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Factors Affecting Choice of Capital Structure

• Given that the factors listed are taken into
  consideration, is there an optimal capital
  structure? A structure that is best for the firm?
• YES
• (Probably, the optimal is a range, rather than a
  single point.)
• Can we calculate what the optimal capital
  structure is?
• NO

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Factors Affecting Choice of Capital Structure

• The tax effect of debt is quantifiable
• Unfortunately, many of the other factors are not
• In some cases there are quantitative methods to
  help analyze the situation, but no methods to
  calculate the exact affect of the factors on the
  optimal capital structure
• The capital structure decision is one that must
  be made qualitatively in the end (again, there
  are quantitative methods that can help)
• The list of factors is a list of things which
  should be considered by the manager and taken
  into account
• Lets look at each factor in turn

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Taxes

• Effect as previously discussed
• More debt means more interest tax shield higher
  firm value
• Other considerations
• Firms tax rate
• The higher the tax rate, the more valuable the
  interest tax shield
• Is the firm profitable? Does it have loss
  carry-forwards?
• Does the firm have lots of non-debt tax shields?
• Example Capital Cost Allowance
• The firm may not need the interest tax deduction

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Bankruptcy Costs

• Increased debt means a higher probability of
  going bankrupt
• Even if the firm does not go bankrupt, having a
  high probability of doing so can affect business
• There are some very important costs to being
  financially distressed
• The costs of financial distress mitigate the tax
  benefits of debt
• Two types of costs of financial distress
• Direct Costs of Bankruptcy
• Indirect Costs

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Bankruptcy Costs

• Direct Costs of Bankruptcy
• Actually going bankrupt can be costly
• Legal fees, administrative fees, cost of
  liquidating assets etc.
• Direct costs of bankruptcy estimated around 5 of
  value of assets for a sample of US railroads
  (Warner (1977))
• Capital structure decision based on expected
  bankruptcy costs
• (probability of bankruptcy) (cost of bankruptcy)
• This increases as more is borrowed, offsets tax
  benefits of debt

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Bankruptcy Costs

• Direct Costs of Bankruptcy (continued)
• Firms with lower expected direct costs of
  bankruptcy should carry a higher debt load
• Firms with mostly tangible assets should carry
  more debt than firms with mostly intangible
  assets
• Tangible assets better as collateral and easier
  for creditors to sell to recoup money
• Therefore creditors will lend at better rates

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Bankruptcy Costs

• Direct Costs of Bankruptcy (continued)
• Firms with asset which have many uses (high
  fungibility or high plasticity) should carry more
  debt
• Highly specialized assets are hard to finance
  with debt
• In bankruptcy, they are hard to sell so creditors
  will charge higher rates
• Firms with specialized assets will generally
  carry less debt

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Bankruptcy Costs

• Indirect Costs of Financial Distress
• Indirect costs are costs borne by firm because of
  the possibility of bankruptcy
• Essentially, if people believe that a firm may go
  bankrupt both customers and suppliers may stop
  doing business with that firm
• Financial distress results in loss of business
• If a firm has high indirect costs of financial
  distress, it should use less debt.

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Bankruptcy Costs

• Indirect Costs of Financial Distress (continued)
• Firms will tend to have higher indirect costs of
  financial distress if
• They sell a durable good that requires future
  servicing, parts, or for which a warranty is
  important
• They take payment in advance for services
  rendered in the future.
• They finance a lot of day to day operations with
  trade credit
• They sell a good/service for which quality is
  important , but the quality is difficult for
  customer to gauge.
• The product produced depends on complementary
  products produced by other suppliers.
• A firm in any of these situations should
  generally use less debt.

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Industry Averages

• Many firms will look at what other firms in the
  industry are doing with capital structure in
  order to gauge what they should do
• This is a risk averse strategy.
• Do what everyone else is doing.
• If you a wrong you do not look too bad because
  everyone else is wrong too
• But, will never get an advantage over
  competition.
• If you assume that other firms, on average, use
  an optimal capital structure, this approach may
  be the best.
• If you deviate a lot from what others are doing,
  may have to consider what rating agencies,
  analysts and banks will say

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Control of Firm

• The more important control of firm is to the
  current owners, the less likely they are to issue
  new equity (i.e will tend to use more debt).
• Aside The earliest instance when entrepreneurs
  face the prospect of giving up some control of
  the firm is usually when they go looking for
  venture capital. What form do venture capital
  investments usually take?

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Risk Structure of Firm

• Firms with very volatile or very cyclical
  earnings (or revenues) should use less debt.
• If earnings are volatile, the probability of
  bankruptcy is greater (increases expected
  bankruptcy costs).
• Could measure this with asset (unlevered) beta
• Example Utilities tend to have stable revenues.
  Utilities typically use high levels of debt

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Risk Structure of Firm

• The cost structure of the firm can also affect
  its level of risk.
• In particular, firms with high operating leverage
  will tend to have more volatile earnings
• High operating leverage occurs when fixed are
  high relative to variable costs
• Example two firms (A and B) in same business.
  Volatility in their revenues is the same. Each
  uses different production technology.
• Firm A fixed costs 500, variable costs 50
  of revenue
• Firm B fixed costs 300, variable costs 70
  of revenue
• A has greater operating leverage.

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Firm A
Recession Average Expansion
Revenues 500 1000 1500
Fixed Costs 500 500 500
Var. Costs 250 500 750
EBIT -250 0 250

Firm B
Recession Average Expansion
Revenues 500 1000 1500
Fixed Costs 300 300 300
Var. Costs 350 700 1050
EBIT -150 0 150
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Risk Structure of Firm

• Firm with higher operating (Firm A) leverage has
  more variability in EBIT
• Firms with higher operating leverage should use
  less debt.
• Note there may be strategic trade-off between
  production technology chosen and financing
  chosen.
• If utilize high fixed costs use less debt
• If decide to use more variable costs can use
  more debt.

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Signaling

• A firms choice of financing can send a signal to
  the financial markets.
• Empirically when firms issue equity, share
  price drops (on average)
• Market sees firm selling stock
• Market believes that managers of firm have inside
  knowledge
• If managers are selling shares, it must be
  because the share price is too high.

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Signaling

• Empirically when firms increase debt, share
  price increases (on average)
• Market sees firm increasing debt
• Market believes that managers of firm have inside
  knowledge
• Managers would only increase debt if they knew
  the firm could handle the increased interest
  payments therefore the future must be good for
  the firm.

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Need for Financial Slack

• Asymmetric Information managers may know more
  about the true value of the firm than
  shareholders do
• Underinvestment With asymmetric information,
  managers may pass up NPV gt 0 projects if they
  cannot be financed with internal funds. (covered
  previously in course)
• If stock (perhaps temporarily) undervalued, firm
  may decide not to issue new shares to finance a
  NPVgt0 project
• The fact that managers may pass up some good
  projects depresses current share price.

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Need for Financial Slack

• Financial slack internal funds (or unused debt
  capacity) which the firm can use to invest in
  good projects when they come along.
• Having financial slack is valuable
• The greater the potential for NPV gt 0 projects
  coming along, the more important is financial
  slack
• E.g. more important in rapidly expanding
  industries than in mature industries

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Need for Financial Slack

• If the firm has financial slack, then the firm
  does not have to pass up good investments
• Market knows that a firm with slack will take all
  good projects, and therefore the share price is
  higher.
• Underinvestment can occur when firm has to issue
  new equity, but a similar story holds for issuing
  new debt too (firm may pay higher interest rate
  than the manager knows they really deserve to)
• However, much lesser effect than for issuing new
  equity
• Debt has less asymmetric information than equity
• Leads to pecking order of financing choices for
  firms
• Firms use internal funds to finance projects
  first (or pre-arranged debt, such as line of
  credit).
• If no internal funds, then they use new debt.
• If cannot get debt, use equity.

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Agency Problems

• Agency problem an agent is supposed to act on
  behalf of someone else. If the agent shirks their
  responsibilities, there is an agency problem.
• Essentially, there are certain conflicts in a
  firm between different parties. One party may not
  act in the best interests of the other party.
• Two types of conflicts in particular
• Conflicts between shareholders and lenders.
• Conflicts between shareholders and managers.

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Agency Problems

• Conflicts between shareholders and lenders
• Underinvestment
• Default Option
• Covered previously in course
• Because of these possibilities, lenders will
  charge higher rates
• Limits the amount of debt a firm will take on

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Agency Problems

• Conflict between shareholders and managers
• Separation of ownership and control in a
  corporation
• If managers have corporate cash at their
  disposal, they may use it for their own benefit
  rather than for the benefit of the shareholders
  as they are supposed to do.
• That is, they may just waste money if they have
  too much around.
• Debt in the capital structure forces managers to
  pay out excess cash.

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Agency Problems

• Managers must be more careful in running company
  well, because of the discipline imposed by debt.
• If they do not run firm well, bankruptcy is
  possible
• In terms of motivating managers
• Debt is a sword, equity a pillow

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• Note
• Too much cash on hand managers may waste it.
• Not enough cash on hand no financial slack
• There is a balancing act and the correct amount
  of cash to have on hand depends on the
  characteristics of the firm and the industry.

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Conclusion

• Many factors to consider in determining optimal
  capital structure
• Tax effect is quantifiable, many others are not.
• Firm must weigh different factors against each
  other and attempt to come to a (hopefully)
  optimal decision.