Capital Structure. Capital Structure. Konan Chan. Corporate Finance, Leverage effect Capital structure stories. Capital structure patterns

Size: px

Start display at page:

Download "Capital Structure. Capital Structure. Konan Chan. Corporate Finance, Leverage effect Capital structure stories. Capital structure patterns"

Osborn Arnold
5 years ago
Views:

1 Capital Structure, 2018 Konan Chan Capital Structure Leverage effect Capital structure stories MM theory Trade-off theory Free cash flow theory Pecking order theory Market timing Capital structure patterns Konan Chan 2 1

2 Capital Structure and the Pie The value of a firm is defined to be the sum of the value of the firm s debt and the firm s equity. V = D + E E D If the goal of the firm s management is to make the firm as valuable as possible, then the firm should pick the debt-equity ratio that makes the pie as big as possible. Value of the Firm Konan Chan 3 Leverage Effect Example Konan Chan 4 2

Example Konan Chan 5 Leverage Effect When increase financial leverage by more debt Let s ignore tax here for simplicity In good year, we have more left-over after paying interests; in bad year, we

3 Example Konan Chan 5 Leverage Effect When increase financial leverage by more debt Let s ignore tax here for simplicity In good year, we have more left-over after paying interests; in bad year, we have less left-over ROE changes from 6%-20% to 2%-30% range EPS changes from $.6-$2 to $.2-$3 range The variability in both ROE and EPS increases when financial leverage is increased Konan Chan 6 3

4 EPS and EBIT Konan Chan 7 Capital Structure Theory Modigliani & Miller Propositions No tax (MM,1958) With corporate tax (MM, 1963) Trade-off theory Free cash flow theory (Jensen, 1986) Pecking order theory (Myers and Majluf, 1984) Market timing (Baker and Wurgler, 2002) Konan Chan 8 4

5 Homemade Leverage Assume a world no tax, transaction costs, and other costs Individuals can borrow (lend) at the same interest rate as a firm can do If an agent prefers a firm with leverage, but all firms are unlevered; (s)he can borrow at the personal level to create homemade leverage for firms If an agent prefers a firm without leverage, but all firms have leverage; (s)he can un-do the corporate leverage by lending Konan Chan 9 MM Propositions (no tax) MM proposition I Capital structure does affect not firm value or WACC WACC keeps the same for any debt ratio MM proposition II Given proposition I, WACC keeps the same WACC = R D (D/V) + R E (E/V) = R A = R U where V=D+E R E = R U + (D/E)(R U - R D ) the expected return on equity increases with the debt-equity ratio Konan Chan 10 5

6 MM Proposition II (No Taxes) Cost of capital: R (%) R U RD R D Debt-to-equity Ratio Konan Chan 11 Business and Financial Risk R E = R U + (D/E)(R U - R D ) R U is the cost of the firm s business risk, i.e., the risk of the firm s assets (R U R D )(D/E) is the cost of the firm s financial risk, i.e., the additional return required by stockholders to compensate for the risk of leverage Konan Chan 12 6

7 Example: MM w/o Tax Suppose required return on assets = 16%, cost of debt = 10%, debt/assets = 45% What is the cost of equity? R E = 16% + (16% - 10%)(.45/.55) = 20.91% Suppose the cost of equity is 25%, what is the debtto-equity ratio? What is equity/assets? 25% = 16% + (16% - 10%)(D/E) D/E = (25% - 16%) / (16% - 10%) = 1.5 E/V = 1 / 2.5 = 40% Konan Chan 13 Tax Shield Compare unlevered (U) with levered firm (L: 4 million debt, R D = 10% ) (EBIT - R D D)(1-T C ) EBIT(1-T C ) + T C R D D The difference between 790,000 and 650,000 is 140,000 (T C R D D = 0.35 * 0.1 * 4,000,000) T C R D D: tax shield from debt - the advantage of using debt (disadvantage of equity financing) Konan Chan 14 7

Cash Flows with or without Leverage Konan Chan 15 MM Theory with Taxes If tax shield is perpetual, PV of tax shield = D * R D * T C / R D = T C * D Value of levered firm (V L ) = unlevered firm value

8 Cash Flows with or without Leverage Konan Chan 15 MM Theory with Taxes If tax shield is perpetual, PV of tax shield = D * R D * T C / R D = T C * D Value of levered firm (V L ) = unlevered firm value (V U ) + PV of tax shield = EBIT(1- T C ) / R U + T C * D More debt is better, because the interest deduction generates extra value (save tax) R WACC = (E/V)R E + (D/V)(R D )(1-T C ) R E = R U + (R U R D )(D/E)(1-T C ) Konan Chan 16 8

9 MM Propositions (with corp. tax) MM proposition I (with tax) Capital structure does matter MM proposition II The cost of equity is positively related to leverage Konan Chan 17 Cost of capital: R (%) The Effect of Financial Leverage R U R D Debt-to-equity ratio (D/E) Konan Chan 18 9

10 Example - MM with Tax Suppose EBIT is 25 million, tax rate 35%, debt $75 million, cost of debt 9%, unlevered cost of capital 12% V U = 25(1-.35) /.12 = $ million V L = (.35) = $ million E = = $86.67 million R E = 12% + (12%-9%)(75/86.67)(1-.35) = 13.69% R WACC = (86.67/161.67)(13.69%) + (75/161.67)(9%)(1-.35) = 10.05% Konan Chan 19 Example - MM with Tax Suppose that the firm changes its capital structure so that the debt-to-equity ratio becomes 1. What will happen to the cost of equity under the new capital structure? R E = 12% + (12% - 9%)(1)(1-.35) = 13.95% What will happen to the weighted average cost of capital? R WACC =.5(13.95%) +.5(9%)(1-.35) = 9.9% Konan Chan 20 10

11 MM in Reality and Trade-off In reality, no firm takes the extreme step of using 100% debt financing as implied by MM with tax MM ignored the costs of bankruptcy in their analysis of MM with taxes By including the cost of bankruptcy, there is a tradeoff between the benefits of debt financing (tax shields) against costs of debt financing (increased risk of bankruptcy) Firm value = unlevered firm value + PV tax shield - PV of financial distress costs Konan Chan 21 Costs of Financial Distress Direct costs Legal and administrative costs (lawyers, accountants, professional witness, etc.) About 3% of total market value, at most 10% Indirect costs Impaired ability to conduct business (lost sales) Agency costs of debt (over-investment (Jensen and Meckling, 1976), under-investment (Myers and Majluf, 1984)) Costly managerial efforts Employee s unwillingness to work (wage reduction, search new jobs) Konan Chan 22 11

12 Trade-off Theory Trade-off between the benefits (tax shields) and costs (financial distress) of using debt There exists an optimal level of debt which maximizes the firm value Konan Chan 23 Konan Chan 24 12

13 Konan Chan 25 Trade-off Theory Konan Chan 26 13

14 Factors Affect Trade-off Growth high growth firms should use less debt because their growth potential will be easily destroyed by financial distress Types of assets firms with more intangible assets should have less debt (high-tech. vs. airlines) because firms with tangible assets can sell assets to recover from financial distress Uncertainty of operating income firms with more uncertain operating income should have less debt (software vs. utilities) because these firms have a high probability of experiencing financial distress Konan Chan 27 Agency Costs What is the agency relationship? The relationship between the principal and agent The agent is hired by the principal to act on behalf of the principal Examples: stockholders and the manager, investors and fund manager, landlord and tenant Is there any problem? Will the agent always act in the interests of the principal? Why? Conflict of interests agency costs Konan Chan 28 14

15 Ways to Reduce Agency Costs: Align interests of the manager and stockholders The threat of firing (Hostile) Takeover Managerial compensation Leveraged buyouts (LBOs): pro and con Align interests of the stockholders and bondholders Protective covenants Consolidation of debt Strip financing Konan Chan 29 RJR Nabisco LBOs: Stock price Bond value Oct. 27, 1988 (before ann.) $56 $5.0 billion Oct. 28, 1988 (after ann.) $75 $4.4 billion Nov. 30, 1988 (final bid) $109 KKR won the bid (25 billion in total), even though the management bid $3 more Konan Chan 30 15

16 Free Cash Flow Theory Managers have incentives to not distribute free cash flows and cause their firms to grow beyond the optimal size The use of debt and corporate market control (takeovers, LBOs) can help to reduce the agency costs of free cash flows benefits of using debt ways to reduce the agency cost of equity Example: Oil industry in 80 s Konan Chan 31 Free Cash Flow Hypothesis Theory An individual will work harder for a firm if he is one of the owners than if he is one of the hired help. While managers may have motive to partake in perquisites, they also need opportunity. Free cash flow provides this opportunity. Suggestion An increase in dividends should benefit the stockholders by reducing the ability of managers to pursue wasteful activities. An increase in debt will reduce the ability of managers to pursue wasteful activities more effectively than dividend increases. Konan Chan 32 16

17 US Financing Pattern Konan Chan 33 Pecking Order Theory Theory: Firms heavily rely on internally generated funds When needs external financing is necessary, debt is the primary way to get financing Equity is the last resort to finance projects Konan Chan 34 17

18 Pecking Order Theory Rationale: Information asymmetry causes difficulty in pricing equity Firm will issue over-valued shares only and thus investors discount shares Firms prefer to use internally generated funds Bonds are safer than equity because valuation of bonds is less affected by information asymmetry Konan Chan 35 Implications from Pecking Order Theory No defined target (optimal) capital structure Most profitable firms generally borrow less is not because they have low target debt ratios but because they don t need outside money Less profitable firms issue debt because debt financing is first on the pecking order of external financing Firms will avoid external financing, if with enough internal funds Konan Chan 36 18

19 Implications from Pecking Order Financial slack Cash buildup, low debt level, and ready access to debt financing Financial slack is valuable because it avoids the costs of financial distress and external financing during bad times It s more valuable if firms with more positive NPV projects Explains why growth firms have low debt ratios Time the issues in good times to reserve financial slack Konan Chan 37 Market Timing Theory Managers time the market and issue equity when the market price is high Loughran and Ritter (1995) find issuers underperform after equity issuance The market timing has long and persistent effect on capital structure Capital structure is the outcome of managers past attempt to issue equity opportunistically Konan Chan 38 19

20 Testing Market Timing (M/B) efwa is the weighted average of historical market-to-book ratios, giving more weight when firms issue more equity Konan Chan 39 Konan Chan 40 20

21 Market Value Debt Ratios, 2002 Company Debt/Assets LT debt/capital M/B Microsoft Intel ExxonMobil Merck Procter & Gamble Boeing Walt Disney American Electric Power Delta Air Lines General Motors Konan Chan 41 Leverage Ratios Konan Chan 42 21

22 Negative news for Equity offerings Security type Two-day announcementperiod abnormal return Common stock -3.14% Preferred stock -0.19% Convertible preferred stock -1.44% Straight bonds -0.26% Convertible bonds -2.07% Konan Chan 43 Positive news for leverage-increasing Konan Chan 44 22

23 Rajan and Zingales (1995) Konan Chan 45 Capital Structure Patterns Worldwide Capital structures have strong industry patterns High: utilities, transport, and capital-intensive manufacture Low: service, mining, most rapidly growing or high-tech The industry's asset mix and variability affect capital structure Capital structures vary across countries US, UK, Canadian firms have lower book debt ratios than firms in Japan, France, and Italy US & German firms have lower market value debt ratios Leverage in developing countries is less than developed ones Historical, institutional, & cultural factors may play a part Konan Chan 46 23

24 Capital Structure Patterns Worldwide Leverage ratios are inversely related to the perceived costs of financial distress. Both across industries & across countries, the more costly is financial distress, the less debt will be used. Companies rich in collateralizeable assets have higher leverage than firms rich in growth options. Within industries, leverage is inversely related to profitability In all industries, the most profitable firms typically borrow the least Taxes influence capital structures, but they cannot explain the differences in leverage across industries and countries Increased corporate tax rates yield increased debt usage It s not clear firms in US use more debt now Konan Chan 47 Capital Structure Patterns Worldwide Existing shareholders consider leverage-increasing events "good news" and leverage-decreasing events "bad news" Stock prices rise when leverage-increasing events announced, but fall for leverage-decreasing events. Corporations that are forced away from a preferred capital structure tend to return to that structure over time Has occurred frequently, particularly for US firms that have taken on large amounts of new debt to finance takeovers. More generally, corporations like to operate within target leverage zones, and will issue new equity when debt ratios get too high and will issue debt if they fall too low. Konan Chan 48 24

Chapter 16 Debt Policy

Chapter 16 Debt Policy Konan Chan Financial Management, Fall 2018 Topic Covered Capital structure decision Leverage effect Capital structure theory MM (no taxes) MM (with taxes) Trade-off Pecking order