CAPITAL STRUCTURE POLICY. Principles Applied in This Chapter 15.1 A GLANCE AT CAPITAL STRUCTURE CHOICES IN PRACTICE

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1 CAPITAL STRUCTURE POLICY Chapter 15 Principles Applied in This Chapter Principle 2: There is a Risk-Return Tradeoff Principle 3: Cash Flows Are the Source of Value Principle 5: Investors Respond to Incentives 15.1 A GLANCE AT CAPITAL STRUCTURE CHOICES IN PRACTICE 1

2 Capital Structure Choices in Practice The primary objective of capital structure management is to maximize the total value of the firm's outstanding debt and equity. The resulting financing mix that maximizes this combined value is called the optimal capital structure. Defining a Firm's Capital Structure Capital structure = owner's equity + interest bearing debt Financial structure = Capital structure + noninterest bearing liabilities (such as accounts payable). It is also described using a firm's debt ratio. Defining the Firm's Capital Structure The Debt to Enterprise Value ratio is commonly used to describe a firm's capital structure. 2

3 Defining the Firm's Capital Structure The book value of interest bearing debt includes: Short-term notes payable (e.g., bank loans), Current portion of long-term debt, and Long-term debt. Table 15.1 Financial and Capital Structures for Selected Firms (Year-End 2012) Defining the Firm's Capital Structure Table 15-1 shows that debt ratio is always higher than the debt-to-enterprise value because: Debt ratio is based on book value and book value of equity is always lower than its market value. Debt to value ratio excludes non-interest bearing debt in the numerator resulting in a lower value. 3

4 Defining the Firm's Capital Structure Table 15-1 also reports the Times Interest Earned Ratio, which measures the firm's ability to pay the interest on its debt out of operating earnings. Financial Leverage By borrowing a portion of firm's capital at a fixed rate of interest, firm can leverage the rate of return it earns on its total capital into an even higher rate of return on the firm's equity. For example, if the firm is earning 17% on its investments and paying only 8% on borrowed money, the 9% differential goes to the firm's owners. This is known as favorable financial leverage. If it earns less than 8%, it will be unfavorable financial leverage. How Do Firms Finance Their Assets? Debt-to-Enterprise-Value Ratios for Selected Industries 4

5 A First Look at the Modigliani and Miller Capital Structure Theorem Modigliani-Miller Capital Structure Theorem (M&M) explains what determines capital structure Logic: If Assumptions 1 and 2 hold, then capital structure does not matter (does not affect enterprise value) We know capital structure does matter. Therefore, Assumption 1or 2 (or both) does not hold What was assumed away determine capital structure M&M Capital Structure Theorem M&M showed that, under idealistic conditions, the level of debt in its capital structure does not matter. The theory relies on two basic assumptions: 1. Firm s cash flows are not affected by financing. 2. Financial markets are perfect. M&M Capital Structure Theorem Assumption 2 of perfect market implies that the packaging of cash flows, that is whether they are distributed to investors as dividends or interest payments, is not important. When the two assumptions hold, the value of the firm is not affected by how it is financed. 5

6 Capital Structure, the Cost of Equity, and WACC When there are no taxes, the firm's weighted average cost of capital is also unaffected by its capital structure. Capital Structure, the Cost of Equity, and WACC For simplicity, we are valuing a firm whose cash flows are a level perpetuity. Capital Structure, the Cost of Equity, and WACC Since firm value and firm cash flows are unaffected by the capital structure, the firm's weighted average cost of capital is also unaffected. 6

7 Figure 15.3 Cost of Capital and Capital Structure: M&M Theory Why Capital Structure Matters in Reality? Financial managers care a great deal about how their firms are financed. Indeed, there can be negative consequences for firms that select an inappropriate capital structure, which means that, in reality, at least one of the two M&M assumptions is violated. Violation of Assumption 2 Transaction costs can be important and because of these costs, the rate at which investors can borrow may differ from the rate at which firms can borrow. When this is the case, firm values may depend on how they are financed. 7

8 Violation of Assumption 1 Capital structure affects the total cash flows available 1. Interest is a tax-deductible expense, while dividends are not. Thus, after taxes, firms have more money to distribute to their debt and equity holders if they use debt financing. 2. Debt financing creates a fixed legal obligation. If the firm defaults on its payments, the firm will incur the added cost that the bankruptcy process entails. 3. The threat of bankruptcy can influence the behavior of a firm's executives as well as its employees and customers. Corporate Taxes and Capital Structure Since interest payments are tax deductible (and dividends are not), the after-tax cash flows will be higher if the firm's capital structure includes more debt. Bankruptcy and Financial Distress Costs Even though debt provides valuable tax savings, a firm cannot keep on increasing debt. If the firm's debt obligations (i.e. interest expense) exceed it's ability to generate cash, it will be forced into bankruptcy and incur financial distress costs. 8

9 The Tradeoff Theory and the Optimal Capital Structure Thus two factors can have material impact on the role of capital structure in determining firm value and firms must tradeoff the pluses and minuses of both these factors: Interest expense is tax deductible. Debt makes it more likely that firms will experience financial distress costs. Figure 15.5 The Cost of Capital and the Tradeoff Theory Capital Structure Decisions and Agency Costs Debt financing can help reduce agency costs. For example, debt financing by creating fixed dollar obligations will reduce the firm's discretionary control over cash and thus reduce wasteful spending. 9

10 Making Financing Choices When Managers are Better Informed than Shareholders When firms issue new shares, it is perceived that the firm's stock is overpriced and accordingly share price generally falls. This provides an added incentive for firms to prefer debt. Making Financing Choices When Managers are Better Informed than Shareholders Stewart Myers suggested that because of the information issues that arise when firms issue equity, firms tend to adhere to the following pecking order when they raise capital: Internal sources of financing Marketable securities Debt Hybrid securities Equity Managerial Implications 1. Higher levels of debt can benefit the firm due to tax savings and potential to reduce agency costs. 2. Higher levels of debt increase the probability of financial distress costs and offset tax and agency cost benefits of debt. 10

11 Figure 15.6 Capital Structure and Firm Value with Taxes, Agency Costs, and Financial Distress Costs Why Do Capital Structures Differ Across Industries? Firms in some industries (such as utilities) tend to generate relatively more taxable income and can benefit more from tax savings on debt. Financial distress can be fatal for some companies (like computer and software firms like Apple) as consumers will be very reluctant to buy the product if there is a possibility of bankruptcy. Thus such firms will tend to have lower levels of debt. Benchmarking the Firm's Capital Structure By benchmarking a firm's capital structure, we compare the firm's current and proposed capital structures to firms that are in similar lines of business and consequently subject to the same types of risks. Table 15.3 provides a simple template for benchmarking. 11

12 Table 15.3 Worksheet for Benchmarking a Capital Structure Decision CHECKPOINT 15.1: CHECK YOURSELF Benchmarking a Financing Decision The Problem Under the debt financing alternative, what will Sister Sarah's financial ratios look like in just two years after the firm has repaid $4 million of the loan (assuming nothing else changes)? 12

13 Step 1: Picture the Problem The pro-forma balance sheet after $4 million in longterm debt has been paid off will change and is given on the next slide. Step 1: Picture the Problem Balance Sheet Before After $4 million paid off Accounts Payable $4,500,000 $4,500,000 Short-term Debt $3,200,000 $3,200,000 Total Current $7,700,000 $7,700,000 Liabilities Long-term Debt $12,800,000 $8,800,000 Total Liabilities $20,500,000 $16,500,000 Common Equity $19,300,000 $19,300,000 Total Liabilities and Equity $39,800,000 $35,800,000 Step 1: Picture the Problem Income Statement Pro formas Adjusted for New Financing 2010 Equity Debt Revenues $50,000,000 $60,000,000 $60,000,000 Cost of Goods Sold (25,000,000) (30,000,000) (30,000,000) Gross Profit $25,000,000 $30,000,000 $30,000,000 Operating Expenses (10,000,000) (12,000,000) (12,000,000) Depreciation Expenses (2,000,000) (3,000,000) (3,000,000) EBIT $13,000,000 $15,000,000 $15,000,000 Interest Expense (480,000) (480,000) (960,000) Earnings before Taxes $12,520,000 $14,520,000 $14,040,000 Taxes (3,756,000) (4,356,000) (4,212,000) Net Income $8,764,000 $10,164,000 $9,828,000 Earnings per Share $1.461 $1.603 $1.638 Return on Equity 45.4% 34.7% 50.9% Sinking Fund Payment 1,200,000 1,200,000 2,400,000 13

14 Step 1: Picture the Problem The total interest expense on the income statement will reduce as $4 million of debt has been paid off. The interest expense will reduce by $ (=$4,000,000.08) New interest expense = $1,280,000 $320,000 = $960,000 Step 2: Decide on a Solution Strategy Table 15.3 can be used to solve the four key financial leverage ratios. Step 3: Solve Given: 2010 Equity Financing Debt Financing Borrowing Rate 8.0% 8.0% 8.0% Shares of Common Stock 6,000,000 6,342,309 6,000,000 Tax Rate 30.0% 30.0% 30.0% Revenues $50,000,000 $60,000,000 $60,000,000 Cost of Goods Sold/Sales 50.0% 50.0% 50.0% Operating Expenses/Sales 20.0% 20.0% 20.0% Depreciation Expense $2,000,000 $3,000,000 $3,000,000 New Borrowing $10,000,000 New Equity $10,000,000 Price Earnings Ratio Sinking Fund as % of Debt 20% 20% 20% Cost of Capital Equipment 10,000, ,000, Depreciable Life

15 Step 3: Solve (cont.) Ratio with Ratios after 2- Ratio Current Debt Financing years with $4 million debt paid off Debt Ratio 51.5% 46.09% ($7.7m + $8.8m)/$35.8m ($3.2m+$8.8m)/$35.8m Interest Bearing Debt Ratio Times Interest Earned Ratio % 33.52% $15m/$0.96m $15m+$.96m $.96m+$2.4m/.7 EBITDA Coverage Ratio Step 4: Analyze All ratios drop and become stronger. Comparing it to the benchmark ratios, the debt alternative is still more aggressive compared to industry norms. The firm's management will have to determine whether the firm can support a higher than average leverage based on future earnings prospects. Financial Leverage and the Level of EPS Firms that use more debt financing will experience greater swings in their earnings per share in response to changes in firm revenues and operating earnings. This is referred to as the financial leverage effect. 15

16 Table 15.4 Alternative Financial Structures Being Considered by the House of Toast, Inc. Table 15.5 Structure and the Level of EPS for the House of Toast, Inc. Financial Leverage and the Volatility of EPS The table below also illustrates the impact of financial leverage on the volatility of earnings per share. Capital Structure Worst case EBIT =$10,000 Best Case EBIT = $40,000 $ Change in EPS % Change in EPS Plan A % Plan B % Plan C % 16

17 Financial Leverage and the Volatility of EPS We observe that when EBIT is high, a more levered firm will realize higher EPS. However, if EBIT falls, a firm that uses more financial leverage will suffer a large drop in earnings per share (EPS) than a firm that relies less on financial leverage. Using the EBIT-EPS Chart to Analyze the Effect of Capital Structure on EPS The EBIT-EPS chart analyzes: Whether the debt plan produces a higher level of EPS for the most likely range of EBIT values. Possible swings in EPS that might occur under the capital structure alternatives. CHECKPOINT 15.2: EVALUATING THE EFFECT OF FINANCING DECISIONS ON EPS 17

18 Checkpoint 15.2: Check Yourself House of Toast likes the new investment very much. However, in the weeks since the project was first analyzed, the firm has learned that credit tightening in the financial markets has caused the cost of debt financing for the debt financing plan to increase to 10%. What level of EBIT produces zero EPS for the new borrowing rate? Step 1: Picture the Problem The current and prospective capital structure alternatives can be described using pro forma balance sheets as given in the next slide. Step 1: Picture the Problem (cont.) Current Capital Structure With New Debt Financing Long-term debt at 8% $50,000 $50,000 Long-term debt at 10% $50,000 Common Stock $150,000 $150,000 Total Liabilities and Equity $200,000 $250,000 Common Shares Outstanding 1,500 1,500 18

19 Step 2: Decide on a Solution Strategy A firm's capital structure will affect both the EPS for a given level of operating earnings (EBIT) and the volatility of changes in EPS corresponding to changes in EBIT. We can use pro forma income statements for a range of levels of EBIT that the firm believes is relevant to its future performance. Step 3: Solve We calculate the EPS over a range of EBITs. 50,000* ,000*.10 Tax rate =50% EBIT/EPS Analysis EBIT $5,000 $9,000 $20,000 $25,000 $30,000 $35,000 Less: Interest Expense $9,000 $9,000 $9,000 $9,000 $9,000 $9,000 EBT $(4,000) $ $11,000 $16,000 $21,000 $26,000 Less: Taxes $(2,000) $ $5,500 $8,000 $10,500 $13,000 Net Income $(2,000) $ $5,500 $8,000 $10,500 $13,000 EPS $(1.33) $ $3.67 $5.33 $7.00 $8.67 EPS = Net income/1500 Step 3: Solve (cont.) 10 EBIT-EPS Chart for House of Toasts, Inc EPS ($) $9, EBIT($, thousands) 19

20 Step 4: Analyze We examine the EPS within the EBIT range of $5,000 to $35,000. The EPS ranges from a low of -$1.33 to a high of $8.67. At EBIT of $9,000, the EPS is equal to zero. Computing EPS Indifference Points for Capital Structure Alternatives The point of intersection of the two capital structure lines found in Figure 15-7 is called the EBIT-EPS indifference point. The point identifies the level at which EPS will be the same regardless of the financing plan chosen by the firm. Figure 15.7 EBIT-EPS Chart for the House of Toast, Inc.: Under New Financing 20

21 Computing EPS Indifference Points for Capital Structure Alternatives (cont.) At EBIT amounts in excess of the EBIT indifference level, the financing plan with more leverage will generate a higher EPS. At EBIT amounts below the EBIT indifference level, the financing plan involving less leverage will generate a higher EPS. Survey Evidence: Factors That Influence CFO Debt Policy Figure 15.8 reports the survey results of 392 CFOs who were asked about the potential determinants of capital structure choices on a scale of 0 to 4 (0 = not important, 4 = very important). Figure 15.8 CFO Opinions Regarding Factors That Influence Corporate Debt Use 21