Capital Structure and Firm Capital Structure and Firm ValueValue

Does Capital Structure affect Does Capital Structure affect value?value?

• Empirical patternsEmpirical patterns– Across IndustriesAcross Industries– Across FirmsAcross Firms– Across YearsAcross Years– Who has lower debt?Who has lower debt?

• High intangible assets/specialized assetsHigh intangible assets/specialized assets• High growth firmsHigh growth firms• High cash flow volatilityHigh cash flow volatility• High information asymmetryHigh information asymmetry• Industry leadersIndustry leaders

• Is capital structure managed?Is capital structure managed?– If so much time is spent on capital structure then If so much time is spent on capital structure then

there must be some value to it (or there must be some value to it (or managers/investors are irrational)managers/investors are irrational)

Debt and Equity Only?Debt and Equity Only?• Typically thought of and measured this Typically thought of and measured this

wayway

• Much more complexMuch more complex– Investment opportunities and strategy (needs)Investment opportunities and strategy (needs)– Financing (sources)Financing (sources)

•Cash balanceCash balance

•Distribution: Dividend and repurchasesDistribution: Dividend and repurchases

•Debt capacityDebt capacity

•Equity capacityEquity capacity

•Existing debt and equityExisting debt and equity

– Other financial policies: Financial Hedging, Other financial policies: Financial Hedging, Cash Flow Volatility, Forms of Compensation Cash Flow Volatility, Forms of Compensation

How does capital structure affect How does capital structure affect value?value?

• To prove this we start in the “perfect world”To prove this we start in the “perfect world”– Based on the work of Miller and ModiglianiBased on the work of Miller and Modigliani– Shows that capital structure is irrelevantShows that capital structure is irrelevant

• Value is derived from market imperfectionsValue is derived from market imperfections

• Example: What if a firm is considering Example: What if a firm is considering issuing debt and retiring equal amounts of issuing debt and retiring equal amounts of equity?equity?

Current Proposed

Assets 8000 8000

Debt 0 4000

Equity 8000 4000

Interest 0.1 0.1

Share Price 20 20

Outstanding Shares 400 200

Current Recession Expected Expansion

Earnings 400 1200 2000

ROA 0.05 0.15 0.25

ROE 0.05 0.15 0.25

EPS 1 3 5

Proposed Recession Expected Expansion

EBI 400 1200 2000

Interest 400 400 400

Earnings 0 800 1600

ROA 0.05 0.15 0.25

ROE 0 0.2 0.4

EPS 0 4 8

Position #1: Buy 100 shares of the levered firm ($20*100=$2,000 Initial Investment)

Recession Expected Expansion

Earnings 0 400 800

Position #2: Buy 200 shares of the unlevered firm and borrow $2000 (($20*200)-$2,000=$2,000 Initial investment).

Recession Expected Expansion

Earnings 200 600 1000

Interest 200 200 200

Net Earnings 0 400 800

Capital Structure is Capital Structure is Irrelevant Irrelevant

• Miller and Modigliani assume perfect Miller and Modigliani assume perfect capital marketscapital markets

• Proposition #1: Proposition #1: The market value of The market value of any firm is independent of its capital any firm is independent of its capital structure.structure.

Firm Value: Perfect Capital Markets

50

70

90

110

130

150

170

190

0% 25% 50% 75% 100%

D/E

Val

ue

V(Unlevered)

Market Imperfections: Market Imperfections: TaxesTaxes

• TaxesTaxes– US Tax Code: Deductibility of interest US Tax Code: Deductibility of interest

leads to lower cost of debt (Rd(1-t))leads to lower cost of debt (Rd(1-t))– Simple specification overvalues benefitSimple specification overvalues benefit

• Ignores personal taxes whichIgnores personal taxes which– Decreases investors debt returnDecreases investors debt return– Increases investors preference for equity Increases investors preference for equity

Capital gains: Defer and rate differenceCapital gains: Defer and rate difference Dividend: Some portion is deductibleDividend: Some portion is deductible

Market Imperfections: Contracting Market Imperfections: Contracting CostsCosts

• In imperfect markets, alternative ways to In imperfect markets, alternative ways to contract optimal behavior are necessarycontract optimal behavior are necessary

• Costs of financial distressCosts of financial distress– Underinvestment (rejecting NPV>0 projects), Underinvestment (rejecting NPV>0 projects),

direct, indirect costs, etc.direct, indirect costs, etc.

• Benefits of debtBenefits of debt– Monitoring function, manages free cash flow Monitoring function, manages free cash flow

problem (Accepting NPV<0 projects), etc.problem (Accepting NPV<0 projects), etc.

• Contracting costs and taxes are primary Contracting costs and taxes are primary motives for static trade off theory debtmotives for static trade off theory debt

Market Imperfections: Information Market Imperfections: Information CostsCosts

• With asymmetric information, leverage may With asymmetric information, leverage may reveal something about the existing firm reveal something about the existing firm

• Market timing: Managers take advantage of Market timing: Managers take advantage of superior informationsuperior information– Issue equity when it is overvaluedIssue equity when it is overvalued– Issue debt when it is undervaluedIssue debt when it is undervalued

• Signaling: Managers use financing to signal Signaling: Managers use financing to signal future prospects of firmsfuture prospects of firms– Issue equity to signal good growth opportunities Issue equity to signal good growth opportunities

(preserve financial flexibility)(preserve financial flexibility)– Issue debt when expected cash flows are strong Issue debt when expected cash flows are strong

and stable and stable • Motivates Pecking Order TheoryMotivates Pecking Order Theory

Can we quantify the value of Can we quantify the value of market imperfections?market imperfections?

Debt adds value to the firm due to the Debt adds value to the firm due to the interest deductibility (assume taxes interest deductibility (assume taxes only)only)

Assume the simple case:Assume the simple case:

)(TaxShieldPVVV UL

CD

CD Dr

DrTaxShieldPV

)(

Firm Value: Perfect Capital Markets

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70

90

110

130

150

170

190

0% 25% 50% 75% 100%

D/E

Va

lue

V(Unlevered)

V(Levered)

More Complex Tax ShieldsMore Complex Tax Shields

• Uneven and/or limited time Uneven and/or limited time paymentspayments– Discount all flows back to time 0Discount all flows back to time 0

• What What rr do you use? do you use?– Certain the tax shield can be used: rCertain the tax shield can be used: rDD

– Uncertain? Higher Uncertain? Higher rr

Financial DistressFinancial Distress

• As leverage increases, the probability As leverage increases, the probability therefore PV of financial distress increasestherefore PV of financial distress increases

)()( tistressCosFinancialDPVTaxShieldPVVV UL • How do we estimate the cost of distress?How do we estimate the cost of distress?

– Prob(Distress)*Cost of DistressProb(Distress)*Cost of Distress

• Probability can be estimated in several waysProbability can be estimated in several ways– Logit/Probit regressionsLogit/Probit regressions– Debt ratingsDebt ratings

Firm Value: with Taxes and Fiancial Distress

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70

90

110

130

150

170

190

D/E

D/E

V(Unlevered)

V(Levered)

V(Distress)

Financial Distress: Bankruptcy Financial Distress: Bankruptcy CostsCosts

• Direct CostsDirect Costs– Legal, accounting and other professional Legal, accounting and other professional

feesfees– Re-organization lossesRe-organization losses– Estimated btw 4-10% of firm value (t-3) Estimated btw 4-10% of firm value (t-3)

• Indirect CostsIndirect Costs– Reputation costsReputation costs– Market shareMarket share– Operating lossesOperating losses– Estimated as 7.8% of firm value (t-2)Estimated as 7.8% of firm value (t-2)

Financial Distress: Agency Financial Distress: Agency CostsCosts

• Risk shifting and asset substitutionRisk shifting and asset substitution– Shareholders invest in high risk projects Shareholders invest in high risk projects

and shift risk to the debt holdersand shift risk to the debt holders– Shareholders issue more debt, Shareholders issue more debt,

diminishing old debt holders protectiondiminishing old debt holders protection

• UnderinvestmentUnderinvestment

• Expropriating fundsExpropriating funds

• Difficult to estimateDifficult to estimate

Other Advantages of DebtOther Advantages of Debt

•Agency cost of Equity (motive)Agency cost of Equity (motive)– Shirking is less likely when issuing debtShirking is less likely when issuing debt– Perquisites are less likely with debtPerquisites are less likely with debt– Over-investment is less likely with debtOver-investment is less likely with debt

•Agency cost of Free Cash Flow (opportunity)Agency cost of Free Cash Flow (opportunity)– Retained earnings versus dividends?Retained earnings versus dividends?– Growth and investment opportunitiesGrowth and investment opportunities

•Debt serves as a monitoring device, Debt serves as a monitoring device, decreasing managerial discretiondecreasing managerial discretion

•Bankruptcy as a strategic move???Bankruptcy as a strategic move???

Formal Models of Capital Formal Models of Capital StructureStructure• Pecking OrderPecking Order

– Firms prefer to raise capitalFirms prefer to raise capital•Internally generated fundsInternally generated funds•DebtDebt•EquityEquity

– Implies capital structure is derived Implies capital structure is derived fromfrom•Financing needs and capital availabilityFinancing needs and capital availability•Dynamic rather than staticDynamic rather than static•Asymmetric information and signalingAsymmetric information and signaling

• Static Trade OffStatic Trade Off

Static trade-off theory of Static trade-off theory of debtdebt

Maximum Firm Value

Firm Value

Debt

Optimal amount of Debt

Actual Firm Value

Implications of Static Trade Implications of Static Trade OffOff• Static rather than dynamicStatic rather than dynamic

• Taxes and Contracting Cost drive valueTaxes and Contracting Cost drive value

• Readjustment may be stickyReadjustment may be sticky– Optimal trade off between cost of issuances Optimal trade off between cost of issuances

and benefit of capital structureand benefit of capital structure

• InsightsInsights– Large, stable profit firms will have more debtLarge, stable profit firms will have more debt– Higher the costs of distress lower debtHigher the costs of distress lower debt– Lower taxes, lower debtLower taxes, lower debt– Less (more) favorable tax treatment of debt Less (more) favorable tax treatment of debt

(equity), lower debt(equity), lower debt

Evidence: TaxesEvidence: Taxes• This method usually overestimates This method usually overestimates

the tax consequencethe tax consequence– Magnitude of leverage differences Magnitude of leverage differences

across countries and tax regimes is not across countries and tax regimes is not that bigthat big

– Equity taxes (personal taxes) are Equity taxes (personal taxes) are overestimated (Miller)overestimated (Miller)•Timing of capital gainsTiming of capital gains

• Higher effective marginal tax rate, Higher effective marginal tax rate, higher the leverage (Graham, 2001)higher the leverage (Graham, 2001)

EvidenceEvidence• Contracting Costs: Consistent evidenceContracting Costs: Consistent evidence

– Higher (lower) the growth opportunities, higher Higher (lower) the growth opportunities, higher (lower) the potential underinvestment problem, (lower) the potential underinvestment problem, lower (higher) the leveragelower (higher) the leverage

– Higher growth opportunities would preferHigher growth opportunities would prefer• Shorter maturity debt (or call provisions)Shorter maturity debt (or call provisions)• Less restrictive covenantsLess restrictive covenants• More convertibility provisionsMore convertibility provisions• More concentrated investors (private)More concentrated investors (private)

• Information costsInformation costs– Consistent with market timing (SEO’s lead to -3% Consistent with market timing (SEO’s lead to -3%

return)return)– Inconsistent with signaling and pecking orderInconsistent with signaling and pecking order

• Taxes: Higher effective marginal tax rate, Taxes: Higher effective marginal tax rate, higher the leverage higher the leverage

MM: Proposition IIMM: Proposition II• How does leverage affect rHow does leverage affect rEE

• Start with the WACCStart with the WACC

• Solve for rSolve for rEE

• The rate of return on the equity of a firm increases in The rate of return on the equity of a firm increases in proportion to the debt to equity ratio (D/E).proportion to the debt to equity ratio (D/E).

DEa rV

Dr

V

Er

)( DaaE rrE

Drr

MM: Proposition II (with MM: Proposition II (with taxes)taxes)

DcEa rV

Dr

V

Er )1(

))(1( DacaE rrE

Drr

•Blue Inc. has no debt and is expected to generate Blue Inc. has no debt and is expected to generate $4 million in EBIT in perpetuity. Tc=30%. All after-$4 million in EBIT in perpetuity. Tc=30%. All after-tax earnings are paid as dividends.The firm is tax earnings are paid as dividends.The firm is considering a restructuring, with a perpetual fixed considering a restructuring, with a perpetual fixed $10 million in floating rate debt at an expected $10 million in floating rate debt at an expected interest rate of 8%. The unlevered cost of equity is interest rate of 8%. The unlevered cost of equity is 18%.18%.

•What is the current value of Blue?What is the current value of Blue?

•What will the new value be after the restructuring?What will the new value be after the restructuring?

•What will the new required return on equity be?What will the new required return on equity be?

•What if we use the new WACC?What if we use the new WACC?

What About Financial What About Financial Flexibility?Flexibility?

• The ability to quickly change the level The ability to quickly change the level and type of financingand type of financing

• Value increasing ifValue increasing if– Growth opportunities existGrowth opportunities exist– Company is willing to exercise and Company is willing to exercise and

extinguish future flexibilityextinguish future flexibility– New investments are unpredictable and New investments are unpredictable and

largelarge– Precautionary debt ratings cushion is Precautionary debt ratings cushion is

valuablevaluable

• Value destroying if the opposite is trueValue destroying if the opposite is true

How do we value financial flexibility?How do we value financial flexibility?

What do we do?What do we do?• Choosing a target capital structureChoosing a target capital structure

– Minimize taxes and contracting costs (while Minimize taxes and contracting costs (while paying attention to information costs)paying attention to information costs)

– Target ratio should reflect the company’sTarget ratio should reflect the company’s• Expected investment requirementsExpected investment requirements

• Level and stability of cash flowsLevel and stability of cash flows

• Tax statusTax status

• Expected cost of financial distressExpected cost of financial distress

• Value of financial flexibilityValue of financial flexibility

• Dynamic managementDynamic management– Financing is typically a lumpy processFinancing is typically a lumpy process– Find optimal point where cost of adjusting capital Find optimal point where cost of adjusting capital

structure is equal to cost of deviating from targetstructure is equal to cost of deviating from target