Optimal Capital Structure

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Stanley Martin
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1 Capital Structure Optimal Capital Structure What is capital structure? How should a firm choose a debt-toequity ratio? The goal: Which is done by: Which is done by:

2 Financial Leverage Scenario A B C Market Value of Debt $0 $50 $75 Market Value of Equity $100 $50 $25 Market Value of Assets Debt-to-Equity Ratio Number of Shares ($1 each) Financial Leverage Scenario A B C Corporate Borrowing Rate 8% 8% 8% EBIT $20 $20 $20 Interest Expense $0 $4 $6 Taxes (assume 0%) $0 $0 $0 Net Income

3 Financial Leverage Scenario A B C ROA ROE EPS e (assume A = 1) Asset Betas and Equity Betas Asset Equity Equity [(1 - T C ) Debt] Equity Equity Asset Debt 1 - T 1 C Equity

4 Financial Leverage What is financial leverage? What are the effects of financial leverage? What is meant by homemade leverage? The use of to change the overall amount of financial leverage to which an individual is exposed. Homemade Leverage Assume the firm in the previous example has no debt (Scenario A). Also assume you personally prefer to have the leverage in Scenario C. How could you do this on your own?

5 The M&M Propositions Why is Keven obsessed with M&Ms? Franco Modigliani and Merton Miller won Nobel prizes for the following (irrelevance) propositions. Consider a world of no taxes (we will consider the role of taxes later), no bankruptcy costs, and perfect, efficient capital markets. People can borrow and lend at the same rate as the firm.

6 M&M Proposition I (no taxes) Does capital structure matter? In our world of no taxes, bankruptcy costs, and perfect, efficient markets, is an individual firm s capital structure important? M&M Proposition I (no taxes) The value of the firm is the firm s capital structure. V L = V U

7 M&M Proposition II (no taxes) What happens to the risk shareholders face when the firm increases its use of debt? What happens to beta? What happens to the cost of equity? M&M Proposition II (no taxes) The firm s cost of equity capital is a positive linear function of the firm s debt-to-equity ratio. R E R A R R A D D E

8 M&M Proposition II (no taxes) Cost of Capital R E R A WACC R D Debt-to-Equity Ratio An Example (no taxes) Executive Chalk is financed solely by common stock and has outstanding 25 million shares with a market value of $10 per share. It now announces that it intends to issue $160 million of debt and use the proceeds to buy back common stock. The firm s current cost of equity is 10 percent. The cost of debt is 8 percent.

9 An Example (no taxes) -- continued How many shares can the company buy back? What is the market value of the firm after the change in capital structure? What is the firm s new debt-to-equity ratio? After the repurchase, what will be the firm s new cost of equity? New cost of capital?

10 Agree or Disagree? The assumption of no taxes is a fair and realistic assumption. Agree or Disagree Capital Structure: The Sequel

11 Review Financial Leverage: 1. Magnifies the gains and losses to shareholders. 2. Increases the risk ( e ) to shareholders. e = A [1 + (1 - t)(d/e)] Review In our happy financial world world of no taxes, perfect, efficient financial markets, and no costs of financial distress, with homemade leverage

12 M&M Proposition I (no taxes) The value of the firm is the firm s capital structure. M&M Proposition II (no taxes) The firm s cost of equity capital is a positive linear function of the firm s debt-to-equity ratio. R E = R A + (R A R D )(D/E)

13 M&M Proposition II (no taxes) Cost of Capital R E R A WACC R D Debt-to-Equity Ratio But then the IRS said, Let there be taxes. And there were.

14 Features of Debt Two features of debt that we ignored in our perfect financial world in the previous lecture: Back to our previous example Scenario A B C Corporate Borrowing Rate 8% 8% 8% EBIT $20 $20 $20 Interest Expense $0 $4 $6 Taxes (assume 50%) $10 $8 $7 Net Income

15 Back to our previous example Cash Flow to Stockholders Cash Flow to Debtholders Total Cash Flow from Assets Scenario A B C What, then, should happen to firm value? Firm Value with Debt and Taxes

16 M&M Proposition I (with taxes) V L = V U + How do we calculate the value of the firm? V U = [EBIT x (1 t c )] / R A Assume that the cost of equity for the firm in scenario A is 10%. Complete the following balance sheet: Back to our previous example Scenario A B C Market Value of Debt $0 $50 $75 Market Value of Equity Market Value of Assets Debt-to-Equity Ratio ROE (assume $1 per share)

17 M&M Proposition I (with taxes) Value of the Firm (V) V L = V U + (t c x D) T c x D V U V U Debt-to-Equity Ratio M&M Proposition II (with taxes) The firm s cost of equity capital is a positive linear function of the firm s debt-to-equity ratio. R E = R A + (R A R D )(D/E)(1 - t c )

18 M&M Proposition II (with taxes) Assume that the cost of equity for the firm in scenario A is 10%. What is the required rate of return on equity for each scenario? M&M Proposition II (with taxes) What is the WACC in each scenario?

19 M&M Proposition II (with taxes) Cost of Capital R E R A WACC R D Debt-to-Equity Ratio Therefore What is the optimal capital structure? Why don t we see this?

20 Let s take another look Executive Chalk is financed solely by common stock and has outstanding 25 million shares with a market value of $10 per share. It now announces that it intends to issue $160 million of debt and use the proceeds to buy back common stock. The firm s current cost of equity is 10 percent. The cost of debt is 8 percent. The tax rate is 35 percent. Assume a M&M world, where all assumptions hold.

21 Let s take another look What is the market value of the firm after the announcement? How many shares can the company buy back? What is the firm s new debt-to-equity ratio? After the repurchase, what will be the firm s new cost of equity? New cost of capital? Optimal Capital Structure (with taxes and bankruptcy costs) Why do different firms have different capital structures? greater for some firms. greater for some firms.

22 The Costs of Financial Distress Costs Legal expenses Administrative expenses Costs Lost sales Lost time Loss of morale and employees Optimal Capital Structure (with taxes and bankruptcy costs) Trade-Off Theory of Capital Structure: The firm borrow up to the point where the tax benefits from an extra dollar of debt is the cost that comes from the increased probability of financial distress.

23 Optimal Capital Structure (with taxes and bankruptcy costs) Value of the Firm (V) T c x D V L = V U + (t c x D) PV of Financial Distress Costs Actual Value V U V U D * Debt-to-Equity Ratio Suggested Problems Questions: 16-1(a - b), 16-4, 16-5, Problems: 16-9, 16-10, and , 17-6, 17-7, and 17-10

Financial Leverage: the extent to which a company is committed to fixed charges related to interest payments. Measured by:

Wk 11 FINS1613 Notes 13.1 Discuss the effect of Financial Leverage Financial Leverage: the extent to which a company is committed to fixed charges related to interest payments. Measured by: The debt to