Chapter 15. Chapter 15 Overview

Transcription

1 Chapter 15 Debt Policy: The Capital Structure Decision Chapter 15 Overview Target and Optimal Capital Structure Risk and Different Types of Financing Business Risk Financial Risk Determining the Optimal Capital Structure Capital Structure Theory 1 Recall, the P&G WACC example from Chapter 12 s Lectures r debt (1-T) = 5%(1-.35) = 3.25%, r pref = 7.9%, r equity = 9% D/V = 9%, P/V = 1%, E/V = 90% WACC = 8.5% Question: Why not use more debt financing since debt financing is so cheap? Would P&G s WACC be lower, its stock price higher if more debt financing were used?

2 Target and/or Optimal Capital Structure Target is the mix of types of financing with which the company plans to raise capital. This target mix should be the company s optimal capital structure that maximizes the company s stock price. Optimal Cap. Structure should balance risk and return to maximize stock price Factors Influencing Capital Structure Decisions Business Risk riskiness of firm s operations if it used no debt The firm s tax position higher effective tax rate makes debt financing more attractive Access to capital Types of Assets: Tangible vs. Intangible Managerial Risk Attitudes 2 Business Risk The uncertainty involved with projections of future returns on assets (ROA) Factors affecting business risk: Unit sales and sales price variability Input price variability Stickiness of output (sales) price given input price changes The extent of fixed costs: operating leverage

3 Adding Debt to the Picture: Financial Risk The additional risk placed on the firm s stockholders through the use of debt. More debt means higher interest expense which represents a higher hurdle for the firm s EBIT to cover. Therefore, the use of debt concentrates the firm s business risk on its stockholders. Lessons from Business & Financial Risk discussion: More business risk discourages the increased use of debt financing. More debt = more risk, which means higher interest rates as a company increases the proportion of debt that it uses in its capital structure. Also, the increase in the proportion of debt financing leads to a higher required return on the company s stock. 3 Determining the Optimal Capital Structure First, all debt, now, no debt. What s the deal? Of course, the answer has to be somewhere in between. But where? Although, the cost of debt and equity will rise as a firm increases its debt proportion, the company should choose the capital mix that maximizes its stock price and minimize its WACC.

4 Determining the Optimal Capital Structure (continued) Translation: As an all-equity firm adds debt to its capital structure, it should find they can increase their use of debt and lower their WACC & increase their stock price. But the firm will eventually reach a point where the increased use of debt will start raising their WACC and decreasing their stock price because of the increasing risk. Average Book Debt Ratios Industry Debt Ratio Software and programming 0.07 Semiconductors 0.14 Business services 0.22 Biotech 0.28 Major drugs 0.36 Retail 0.37 Average 0.53 Airlines 0.59 Real estate operations 0.60 Food processing 0.62 Hotels and motels 0.63 Utilities 0.65 Forestry and wood products Capital Structure Theory Miller and Modigliani (MM) did significant research trying to determine the effect of capital structure on firm value. Both have won Nobel Prizes for their work, and Modigliani was an econ. prof. here at the U of I during part of their reasearch.

5 MM Capital Structure Theory (no taxes): Prop s I & II The first MM study assumed no taxes, no bankruptcy costs, and other unrealistic assumptions. Capital structure does not affect cash flows e.g... No taxes No bankruptcy costs No effect on management incentives When there are no taxes and capital markets function well, it makes no difference whether the firm borrows or individual shareholders borrow. Therefore, the market value of a company does not depend on its capital structure. First MM study result: capital structure doesn t matter, it has no effect on firm value or WACC. See following graph. Weighted Average Cost of Capital r r E 5 r D r A D V MM Capital Structure Theory & Taxes A follow-up MM study incorporated the effect of taxes. Result: More debt is best, because the interest deduction generates extra value. (Tax shield = debt x r x T) Value of levered firm = value of all-equity firm + present value of tax shield PV of tax shield = D x r D x T c = D x T c r D Value of firm = value of all-equity firm + T c D

6 MM Tax Effect of Financial Leverage on Firm Value Value Added by Debt Tax Shelter Benefits Value of All-Equity Firm Value of Levered Firm Capital Structure Theory in Reality MM ignored the costs of bankruptcy and the threat of bankruptcy in their 2nd analysis = costs of financial distress Reality is: there is a trade-off between the benefits of debt financing against higher interest rates and the increased risk of bankruptcy. 6 Financial Distress Costs of Financial Distress - Costs arising from bankruptcy or distorted business decisions before bankruptcy. Market Value = Value if all Equity Financed + PV Tax Shield - PV Costs of Financial Distress

7 Market Value of The Firm Financial Distress Maximum value of firm Value of unlevered firm PV of interest tax shields Costs of financial distress Value of levered firm Debt Optimal amount of debt Financial Choices Trade-off Theory - Theory that capital structure is based on a trade-off between tax savings and distress costs of debt. Pecking Order Theory - Theory stating that firms prefer to issue debt rather than equity if internal finance is insufficient. Financial Slack Theory that firms want to maintain ready access to cash &/or financial markets to ensure investment in new profitable projects. 7 Pecking Order and Signaling Theory Asymmetric Information - managers have different and better information about the firm s prospects than do investors. The way management decides to raise capital sends a signal about the firm s future prospects. New Debt issue = good signal, attractive investment opportunities for the firm, don t want to dilute these good returns by sharing them with more stockholders Bad future prospects including possible losses can be signaled by issuing more new stock to spread the future pain.