Capital structure I

1
Capital structure I

• Lecture 5

• Specifics of different sources of long-term
  financing
• Common stock vs preferred stock vs debt
• The Modigliani and Miller model
• The Miller model

2
The Long-Term Financial Deficit (1999)
3
Capital Structure

• Firms usually spend more than they generate
  internally
• The deficit is financed by new sales of debt
  equity
• Sources of long-term financing
• Internal financing
• Retained earnings
• External financing
• Debt
• Preferred stock
• Common stock

4
Elements of the Capital Structure

• Mix of different classes of capital
• Retained earnings vs debt equity
• Control rights vs cash flow rights
• Maturity refinancing risk vs reinvestment risk
• Agency conflict
• Asymmetric information and signaling
• Important subtopics
• Debt bank credit vs bonds
• Payout policy dividends vs share repurchase
• Costs of new issues

5
Common Stock

• Basic Shareholders Rights (may differ for dual
  classes)
• Control rights
• Residual claim on assets (after paying up
  liabilities)
• Limited liability
• Components of Shareholders Equity
• Common Stock Par Value
• Capital Surplus (directly contributed equity in
  excess of the par value)
• Retained Earnings (accumulated over time)
• Treasury Stock at Cost
• Shares Authorized vs Issued vs Outstanding
• Market vs Book vs Replacement Value
• MV price of the stock times the number of
  shares outstanding
• BV par value capital surplus accumulated
  retained earnings
• RV current cost of replacing the assets of the
  firm
• At the time a firm purchases an asset, MVBVRV

6
The Right to Elect the Directors

• The most important control device
• Directors are elected each year at an annual
  meeting by a vote of the holders of a majority of
  shares who are present and entitled to vote
• Straight voting
• Shareholders have as many votes as shares and
  each position on the board has its own election
• A tendency to freeze out minority shareholders
• Cumulative voting
• Each shareholder may cast shares multiplied by
  directors to be elected these votes can be
  distributed over one or more candidates
• The effect is to permit minority participation
• Proxy voting (giving voting right to someone
  else)
• Proxy fight outsiders try to win enough proxy
  votes to oust the mgt
• Some (e.g. merger) decisions require
  supermajority (e.g. 75)

7
Dividends

• Unless a dividend is declared by the board of
  directors, it is not a liability of the
  corporation
• A corporation cannot default on an undeclared
  dividend
• The payment of dividends by the corporation is
  not a business expense
• Therefore, they are not tax-deductible
• Dividends received by individual shareholders are
  considered ordinary income and are fully taxable
• Intra-corporate dividend exclusion corporations
  are taxed only on the 20 of the received
  dividends

8
Corporate Long-Term Debt

• Bondholders have a contractual claim against the
  corporation, not an ownership interest
• Creditors have no voting power unless the debt is
  not paid,
• when they can legally claim the assets of the
  firm
• The corporations payment of interest on debt is
  considered a cost of doing business..
• and is fully tax-deductible
• Corporations are very adept at creating hybrid
  securities that look like equity but are called
  debt
• Obviously, the distinction is important at tax
  time
• A corporation that succeeds is creating a debt
  security that is really equity obtains the tax
  benefits of debt while eliminating its bankruptcy
  costs

9
The Bond Indenture

• Amount of issue, date of issue, maturity,
  currency, par value
• Coupon payments frequency, floating vs fixed
  rate
• Orderly repayment of debt (to avoid the balloon
  payment)
• Amortization, by regular installments through a
  sinking fund
• With serial bonds
• Option features
• Call provision (possibility to retire the entire
  issue before the maturity)
• Convertibility into stocks
• Security (attachment to the property)
  debenture/note vs bond
• Protective covenants
• Restrictions on further indebtedness, max
  dividends, min working K
• Seniority subordinated debt paid after senior
  debt
• Other determinants of the market price
• Default risk (credit rating), domestic / foreign
  / Eurobond

10
Dual Nature of Preferred Stock

• Preference over common stock in cash rights
• in the payments of dividends
• in the assets in case of bankruptcy
• No voting rights, unless no dividends 6 quarters
  in a row
• Is it really debt in disguise?
• Fixed dividend usually, cumulative (carried
  forward if not paid)
• Stated liquidating value
• Call provision can be converted to common shares
• Corporations get 80 tax exemption on dividends
• But not on debt interest
• Most preferred stock in the U.S. is held by
  corporate investors
• Firms issuing the preferred stock
• Utilities, with low taxable income, avoiding the
  risk of bankruptcy

11
Patterns of Financing

• Firms usually spend more than they generate
  internally
• The deficit is financed by new sales of debt and
  equity
• Internally generated cash flow dominates as a
  source of financing, typically between 70 and 90
• New sales of debt prevail over new equity issues
• Outside the US, firms rely more on external
  equity
• Debt ratios for U.S. non-financial firms have
  been below 50 of total financing

12
Choice of the Capital Structure

• The value of a firm sum of the value of the
  firms debt and the firms equity V B S
• Why should the stockholders care about maximizing
  firm value?

• Since the payoff of the debtholders is fixed
  (in case of no default), changes in capital
  structure benefit the stockholders if and only if
  the value of the firm increases.

S
B
Value of the Firm
13
Modigliani-Miller Model Assumptions

• Perfect capital markets
• Perfect competition
• Firms investors can borrow/lend at the same
  rate
• No frictions (transaction costs / taxes /
  bankruptcy costs)
• Informational efficiency
• No need for signaling
• Managers are perfectly aligned with shareholders
• No agency costs
• Firms can be classified to homogeneous risk
  classes
• No CAPM at that time
• Perpetual cash flows, no growth
• The firm can issue risk-free debt

14
Homemade Leverage An Example
Recession Expected Expansion EPS of Unlevered
Firm 2.50 5.00 7.50 Earnings for 40
shares 100 200 300 Less interest on 800
(8) 64 64 64 Net Profits 36 136 236 ROE
(Net Profits / 1,200) 3 11 20 We are buying
40 shares of a 50 stock and borrow 800. We get
the same ROE as in the levered firm. Our personal
debt equity ratio
15
Homemade (Un)Leverage An Example

• Recession Expected Expansion
• EPS of Levered Firm 1.50 5.67 9.83
• Earnings for 24 shares 36 136 236
• Plus interest on 800 (8) 64 64 64
• Net Profits 100 200 300
• ROE (Net Profits / 2,000) 5 10 15
• Buying 24 shares of an otherwise identical
  levered firm along with some of the firms debt
  gives us ROE of the unlevered firm.
• This is the fundamental insight of MM

16
The MM Propositions (No Taxes), 1958

• Prop. I firm's value is not affected by leverage
• VL VU
• Prop. II leverage increases the risk and return
  to stockholders
• rs r0 (B/S) (r0 - rB)
• rB is the interest rate (cost of debt)
• rs is the return on (levered) equity (cost of
  equity)
• r0 is the return on unlevered equity (cost of
  capital)
• B is the value of debt
• S is the value of levered equity

17
MM II Cost of Equity and WACC
Cost of capital r ()
r0
rB
rB
Debt-to-equity Ratio
18
The MM Propositions (with Corporate Taxes), 1963

• Prop. I firm's value increases with leverage
• VL VU TC B
• Prop. II the increase in equity risk and return
  is partly offset by the tax shield of debt
• rS r0 (B/S)(1-TC)(r0 - rB)
• rB is the interest rate (cost of debt)
• rs is the return on (levered) equity (cost of
  equity)
• r0 is the return on unlevered equity (cost of
  capital)
• B is the value of debt
• S is the value of levered equity
• TC is the corporate tax rate

19
Derivation of MM (with Corporate Taxes)

• Each period, shareholders and bondholders receive
  
• (EBIT - RBB)(1 - TC) RBB EBIT(1 - TC) TCRBB
• PV of this stream of CFs discounted at r0 and rB
  is
• S B VL VU TC B
• Thus, VU S B(1-TC). Both sides yield equal
  CFs
• r0VU rSSrBB(1-TC) or r0(SB(1-TC))
  rSSrBB(1-TC)
• The cost of equity
• rs r0 (B/S) (1-TC) (r0 - rB)
• WACC
• rS S/(SB) (1 - TC) rB B/(SB) r0 1 - TC
  B/(SB)

20
MM II Cost of Equity and WACC
Cost of capital r()
r0
rB
Debt-to-equityratio (B/S)
21
Summary MM Model

• Does it matter how to cut the pizza into pieces?
• In a world of no taxes
• The firms value is fully determined by
  investments
• Shareholders can achieve any pattern of payouts
  they desire with homemade leverage
• In a world of taxes, but no bankruptcy costs
• The firms value increases with leverage
• If you count the government as the stakeholder,
  value of the firm stays the same!
• WACC differs from r0
• Both models give unrealistic predictions

22
The Miller Model Impact of Personal Taxes

• Miller (1977) shows that the value of a levered
  firm can be expressed in terms of an unlevered
  firm as

where TS personal tax rate on equity income TB
personal tax rate on bond income TC corporate
tax rate
23
Derivation of the Miller Model

Assume that each year the firm earns EBIT and
pays interest on debt with face value F
24
Derivation of the Miller Model

• The total CF to all stakeholders in the levered
  firm is

The first term is the cash flow of an unlevered
firm after all taxes. Its value VU
The bond promises to pay rBF(1-TB) after taxes
and is worth BF(1-TB). Thus, the value of the
second term is
The value of the sum of these two terms must be VL
25
Firm Value with Corporate Personal Taxes
VL VUTCB when TS TB
Value of firm (V)
VL lt VU TCBwhen TS lt TB but (1-TB) gt
(1-TC)(1-TS)
VU
VL VU when (1-TB) (1-TC)(1-TS)
VL lt VU when (1-TB) lt (1-TC)(1-TS)
Debt (B)
26
Interpretation of the Miller Model

• Personal tax rates differ TS lt TB
• Effective tax rate on capital gains is lower (can
  be deferred)
• 80 of dividends received by corporations are
  tax-exempt
• Many types of investment funds pay no taxes
• Bond market equilibrium (assuming TS 0)
• The supply of funds is fixed at rS r0/(1-TC)
• The demand rises from r0 sufficient for
  tax-exempt investors to r0/(1-TB,i) for investors
  in i's tax bracket
• In equilibrium, no tax advantage for leverage
• An equilibrium amount of corporate debt is
  determined by relative corporate personal tax
  rates

27
DeAngelo-Masulis Model, 1980

• The tax shield may be underutilized
• Effects of tax shield substitutes (depreciation
  and investment tax credit)
• Higher debt increases probability of negative
  earnings and bankruptcy
• Modified bond market equilibrium
• The supply of funds depends on the
  corporation-specific tax rate rS r0/(1-TC,i)
• The higher the level of tax shield substitutes
  and the cost of bankruptcy, the lower the leverage

28
Value of the Firm(MM-Proposition I with Taxes
and Bankruptcy)
MM-with corporate taxes only
Value of the Firm
MM-with corporate taxes and bankruptcy costs
MM-no taxes
Optimal debt-equity ratio
Debt-Equity Ratio (B/S)