Leverage and Capital Structure The structure of a firm s sources of long-term financing

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70391 - Finance Leverage and Capital Structure The structure of a firm s sources of long-term financing 70391 Finance Fall 2016 Tepper School

1 Finance Leverage and Capital Structure The structure of a firm s sources of long-term financing Finance Fall 2016 Tepper School of Business Carnegie Mellon University c 2016 Chris Telmer. Some content from slides by Bryan Routledge. Used with permission :37

2 Sources of Financing: Capital Structure How do firms pay for their investments? :: Equity financing :: Private firm: founders and others contribute money :: Publicly-traded firm: shareholders contribute money in the initial public offering (IPO). Subsequently, more funds can be raised in a seasoned equity offering. :: Retained earnings: shareholders money gets plowed back in. :: Debt financing :: Bank loans :: Corporate bonds Capital Structure 2

3 Capital Structure Cash AR, Inventory Property, Plant & Equipment (PPE) Long-Term Cash = AP Long-Term AP Debt Equity Capital Structure 3

Capital Structure Future Free Cash Flow (FCF) Profitability and Efficiency Profit margins Operating efficiency Capital (asset) efficiency ROIC Growth

4 Capital Structure Future Free Cash Flow (FCF) Profitability and Efficiency Profit margins Operating efficiency Capital (asset) efficiency ROIC Growth Opportunities New customers New products R&D, innovation Sustainability Barriers to entry Specialized skills, processes Patent protection Brand loyalty Capital Structure 3

5 Capital Structure Intrinsic Value of Operations (Discounted FCF) Discounted by Cost of Capital (%) Investors required rate-of-return Future Free Cash Flow (FCF) Profitability and Efficiency Profit margins Operating efficiency Capital (asset) efficiency ROIC Growth Opportunities New customers New products R&D, innovation Sustainability Barriers to entry Specialized skills, processes Patent protection Brand loyalty Market Interest Rates Risk Capital Markets Capital Structure (firm s choice of debt and equity) Capital Structure 3

6 Capital Structure Total Debt Share Price Number of Shares Market Value of Equity Market Value of the Firm Intrinsic Value of Operations (Discounted FCF) Non-Operating Assets (Cash) Efficient Markets Market forces will tend to drive market value toward intrinsic value Discounted by Cost of Capital (%) Investors required rate-of-return Future Free Cash Flow (FCF) Profitability and Efficiency Profit margins Operating efficiency Capital (asset) efficiency ROIC Growth Opportunities New customers New products R&D, innovation Sustainability Barriers to entry Specialized skills, processes Patent protection Brand loyalty Market Interest Rates Risk Capital Markets Capital Structure (firm s choice of debt and equity) Capital Structure 3

7 Why Debt Matters Companies often borrow in order to invest. Why is this important? :: Financial leverage :: Affects risk/return properties of debt and equity :: Tax :: Interest expense is tax deductible; more debt reduces taxes owed. :: So debt generates a tax shield value :: Financial distress ( bankruptcy ) :: If firm can t pay debt obligations creditors have right to seize assets :: Bankruptcy proceedings often costly (e.g., legal fees, firm productivity) :: Cost of capital :: Common valuation technique incorporates value of tax shields via weight average cost of capital (WACC) :: Incentives :: Debt/equity mix can affect agency costs... firm value :: Big topic in advanced corporate finance classes Capital Structure 4

8 Plan :1: What is leverage? What is levered? :2: Frictionless environment. Miller-Modigliani Theorem: irrelevance of capital structure :: Capital structure does not change firm value :: But it does change risk/return of debt/equity :3: Environment with frictions: capital structure relevance :: Optimal capital structure results from trade-off between tax benefits of debt and potential bankruptcy costs :4: Weighted average cost of capital (WACC) :: A valuation shortcut that incorporates tax benefits of debt :5: Valuation of defaultable debt Capital Structure 5

9 What is Leverage? Capital Structure 6

10 Levered Investment What is leverage? :: Fixed payments, paid first, lever-up the volatility of what s left Spreadsheet exercise Capital Structure 7

11 Operating Leverage, Financial Leverage Capital Structure 8

12 Operating Leverage The risk in the business cash flows is affected by operating leverage, but not by financial leverage. Capital Structure 9

13 Operating AND Financial Leverage Enter financial leverage :: It affects the equity cost of capital (recall above example: leverage increases risk for shareholder) :: Can also affect the debt cost of capital, if debt is big enough to make financial distress an important possibility Capital Structure 10

14 Effect of Corporate Financial Leverage :: Recall: Leverage increases risk Risk is proportional to beta So leverage must affect beta... Capital Structure 11

15 Portfolio returns: r p = γ 1 r 1 + ( 1 γ 1 ) r2 Portfolio betas: β p = γ 1 β 1 + ( 1 γ 1 ) β2 Effect of Corporate Financial Leverage :: Recall: Leverage increases risk Risk is proportional to beta So leverage must affect beta... :: Recall: value weighted averages Portfolio expected returns: µ p = γ 1 µ 1 + ( 1 γ 1 ) µ2 Capital Structure 11

16 Operating + Financial Leverage Cash AR, Inventory Property, Plant & Equipment (PPE) = AP Debt Equity Capital Structure 12

17 From Equity Beta to Business Asset Beta We can estimate β E using stock return data and then solve for the beta that applies to the business assets. :: If debt is riskless: β BA = β E E BA :: If debt is risky (i.e., default is possible) β BA = β D D BA + β E E BA Capital Structure 13

18 Warning! Unlevered Beta NOT what we have above. What you ll find on the internet. Related to WACC. Assumes debt and tax shield betas are zero. Discussed further below. Cash AR, Inventory Property, Plant & Equipment (PPE) PV(tax benefits) = AP Debt Equity V = V u + τd = D + E τd V = β u V u V + β tax = β u = = D V β D + E V β E E V τd β E = (1 τ)d/e β E Capital Structure 14

19 Example: AEO Capital Structure 15

20 Example: GPS Capital Structure 16

21 Industry Data Note: second column is net debt: D net = D cash. So EV = BA = D net + E, and β BA = β E E/EV = β E (1 D net /EV ), so you can compute the 4 th column given the 2 nd and 1 st. Source: COMPUSTAT averages, , via Bryan Routledge. Capital Structure 17

22 Summary: Operating + Financial Leverage Capital Structure 18

23 Summary: Operating + Financial Leverage Total Debt Share Price Number of Shares Market Value of Equity Market Value of the Firm Intrinsic Value of Operations (Discounted FCF) Non-Operating Assets (Cash) Efficient Markets Market forces will tend to drive market value toward intrinsic value Discounted by Cost of Capital (%) Investors required rate-of-return Future Free Cash Flow (FCF) Profitability and Efficiency Profit margins Operating efficiency Capital (asset) efficiency ROIC Growth Opportunities New customers New products R&D, innovation Sustainability Barriers to entry Specialized skills, processes Patent protection Brand loyalty Market Interest Rates Risk Capital Markets Capital Structure (firm s choice of debt and equity) Capital Structure 19

24 The Irrelevance of Capital Structure (The Miller-Modigliani Theorems) Capital Structure 20

25 Capital Structure :: Corporation Finance :: Capital Budgeting :: Decisions about the operations of the company :: Use financial markets to select projects :: Capital Structure :: How should a project be funded? :: How should the cash flows be allocated? Capital Structure 21

Corporation Finance and the Theory of Investment,

26 Capital Structure Decisions - Modern Finance Franco Modigliani and Merton Miller, The Cost of Capital, Corporation Finance and the Theory of Investment, American Economic Review, 48, June 1958, Capital Structure 22

27 Debt Policy: No Frictions (no tax) :: Two companies (A and B) have identical assets. Each company produces cash flows (earnings or EBIT) equivalent to one ounce of gold for ONE year. A: Debt = $0 B: Debt = $950 principal + $50 interest = $1000 :: Tax Rate is zero (τ = 0) Capital Structure 23

28 MM: Frictionless, Certainty Capital Structure 24

29 MM: Frictionless, Uncertainty Capital Structure 25

30 Effect of Capital Structure: No Frictions :: In frictionless capital markets capital structure does not change the value of the firm :: Dividing up the cash-flow differently can t change its magnitude nor its present value :: Capital structure does affect the value of the components (equity, debt) :: And the risk of the components Capital Structure 26

31 Effect of Capital Structure: No Frictions No effect of firm value, big effect on risk and return Cash + BA = V = Debt + Equity Cash V E(r $) + BA V E( ) r BA = E(rV ) = D V E(r D) + E V E(r E ) E(r E ) = E(r V ) + D E ( ) E(r V ) E(r D ) Capital Structure 27

32 Easy to see with Beta β V = D V β D + E V β E Capital Structure 28

33 Levered Project Spreadsheet exercise Capital Structure 29

34 Summary: Frictionless Case Corporate financial leverage... :: Does not change firm value :: Does change the distribution of risk and expected return between debt and equity holders :: Does not make the firm riskier :: Does make the equity riskier :: Can make the debt risky (or riskier) Capital Structure 30

35 Capital Structure and Taxes (The present value of tax shields ) Capital Structure 31

37 Debt Policy In Practice :: In practice companies spend a lot of effort choosing an optimal capital structure :: Capital structure changes do affect value Capital Structure 32

38 Debt Policy In Practice [John R. Graham, Campbell R. Harvey, The theory and practice of corporate finance: evidence from the field, Journal of Financial Economics, Volume 60, Issues 2-3, May 2001, Pages Capital Structure 33

39 Debt Policy - Frictions (taxes!) :: Two companies (A and B) have identical assets (hold capital budgeting decision fixed.) Each company produces cash flows (EBIT) equivalent to one ounce of gold per year (in perpetuity). A: has debt of zero (100% equity financing) B: as perpetual debt of D with an interest rate of r% :: Tax rate is not zero (τ = 35%) Capital Structure 34

Perpetual Debt: Fact or Fiction? Source: U.K. to Repay First World War Bonds, Wall Street Journal, October 31, 2014. The bond is perpetual. The U.K. government makes interest payments, but doesn t have to pay the principal.

40 Perpetual Debt: Fact or Fiction? Source: U.K. to Repay First World War Bonds, Wall Street Journal, October 31, The bond is perpetual. The U.K. government makes interest payments, but doesn t have to pay the principal. But they were exercising some sort of prepayment option and paying the debt off since, in October 2014, interest rates were low relative to the rates on the bonds (exactly analogous to a homeowner pre-paying their mortgage when rates fall). Note for history buffs... these bonds include debt incurred during the Crimean War and the collapse of the South Sea Company! The latter got bundled in, along with a bunch of WWI debt, during a 1927 restructuring. Capital Structure 35

41 More Recent Example Source: Financial Times, LEX Column, April 1, 2016 Capital Structure 36

42 MM: Taxes Capital Structure 37

43 MM: Taxes Capital Structure 38

44 MM: Taxes Capital Structure 39

45 Debt policy - Taxes and Tax Shields V = V U + Value of Interest Deductibility V V U + τ D V = Value of the debt and equity ( the firm ) V U = Value of the firm if it had no leverage τ = Marginal tax rate D = Amount of debt Note: value of interest deductibility often called value of tax shields. Capital Structure 40

46 Summary :: Having debt creates value :: Reduces your tax bill :: So PV the FCF understates a levered firm s value. :: NOPAT is too low since it ignores interest expense :: What to do? Either :1: Adjust the cash flows ( Adjusted Present Value (APV)) :2: Adjust the discount rate ( Weighted Average Cost of Capital (WACC)) Capital Structure 41

47 Application: Levered Re-Cap Capital Structure 42

48 A Levered Re-Cap Using MM and Tax Shields Company X currently has $910 million debt (market value). There are 100 million shares outstanding at $81.90 each (market value). The CFO wants to issue $2,000 million in new debt and issue a dividend with the proceeds. The tax rate is 30%. Capital Structure 43

49 Levered Re-Cap Capital Structure 44

50 Levered Re-Cap Yeah... Buts... :: Why bother paying a dividend? Just hold on to the cash! :: But equity is more risky for shareholders! :: Increased interest expense is a bad thing: earnings will be lower Capital Structure 45

51 Finance-1 in the News Capital Structure 46

52 Weighted Average Cost of Capital (The WACC) Capital Structure 47

53 Debt policy - Taxes, Tax Shields and the WACC Bare bones: more coming in further finance classes WACC: Weighted Average Cost of Capital :: NOPAT (part of FCF) ignores interest expense :: So expected taxes in FCF is too large :: As a fix, the WACC lowers the discount rate to offset Capital Structure 48

54 WACC WACC r f (1 τ) D V + r e E V :: r f = debt cost of capital (assumed riskless) :: r e = equity cost of capital (expected return) :: τ = (marginal) corporate tax rate :: r f (1 τ) = after tax cost of debt :: V = D + E Capital Structure 49

55 Modigliani-Miller WACC Formula Relating the definition of the WACC to the cost-of-capital for the (unlevered) business assets, r. Simplest set of assumptions: (i) c = constant, perpetual stream of after tax expected FCF, unlevered firm (ii) D= principal on perpetual risk-free debt (iii) riskless interest rate = r f, (iv) opportunity cost of capital = r. Capital Structure 50

56 Modigliani-Miller WACC Formula Relating the definition of the WACC to the cost-of-capital for the (unlevered) business assets, r. Simplest set of assumptions: (i) c = constant, perpetual stream of after tax expected FCF, unlevered firm (ii) D= principal on perpetual risk-free debt (iii) riskless interest rate = r f, (iv) opportunity cost of capital = r. Tax shields: Net Income = ( EBIT r f D )( 1 τ ) = EBIT ( 1 τ ) r f D + r f τ D }{{}}{{} Net Income, No Deduction Tax Shield Capital Structure 50

57 Modigliani-Miller WACC Formula Relating the definition of the WACC to the cost-of-capital for the (unlevered) business assets, r. Simplest set of assumptions: (i) c = constant, perpetual stream of after tax expected FCF, unlevered firm (ii) D= principal on perpetual risk-free debt (iii) riskless interest rate = r f, (iv) opportunity cost of capital = r. Tax shields: Net Income = ( EBIT r f D )( 1 τ ) = EBIT ( 1 τ ) r f D + r f τ D }{{}}{{} Net Income, No Deduction Tax Shield Present value, perpetual stream of tax shields: PV (Tax Shields) = r f τ D r f = τ D Capital Structure 50

58 Modigliani-Miller WACC Formula Firm Value = Value(Unlevered Firm) + Value(Tax Shields) Firm Value: V = c r + τ D Capital Structure 51

59 Modigliani-Miller WACC Formula Firm Value = Value(Unlevered Firm) + Value(Tax Shields) Firm Value: V = c r + τ D Define L = D/V : V = c r + τ L V Capital Structure 51

60 Modigliani-Miller WACC Formula Firm Value = Value(Unlevered Firm) + Value(Tax Shields) Firm Value: Define L = D/V : V = c r + τ D V = c r + τ L V = c ( 1 ) r 1 τl Capital Structure 51

61 Modigliani-Miller WACC Formula Firm Value = Value(Unlevered Firm) + Value(Tax Shields) Firm Value: V = c r + τ D Define L = D/V : V = c r + τ L V = c ( 1 ) r 1 τl c = r(1 τ D V ) Capital Structure 51

62 Modigliani-Miller WACC Formula Firm Value = Value(Unlevered Firm) + Value(Tax Shields) Firm Value: V = c r + τ D Define L = D/V : V = c r + τ L V = c ( 1 ) r 1 τl c = r(1 τ D V ) Weighted-Average Cost of Capital: WACC = r(1 τ D V ) Capital Structure 51

63 What the Hell is This Thing? V = t=1 E(FCF t ) (1 + r) t + t=1 E(ts t ) (1 + r ts ) t Capital Structure 52

64 What the Hell is This Thing? V = t=1 E(FCF t ) (1 + r) t + t=1 E(ts t ) (1 + r ts ) t = E(FCF t ) (1 + r WACC ) t t=1 Capital Structure 52

65 Unlevered Beta Redux Assume that the debt beta and the tax-shield beta are zero. Capital Structure 53

66 Using It Capital Structure 54

67 Bankruptcy and Tradeoff Theory (When debt becomes risky... optimal capital structure) Capital Structure 55

68 A Levered Re-Cap OK then... :: Why stop at $2,000 million in debt? Capital Structure 56

69 Bankruptcy Important to distinguish between: :: Bankruptcy :: Liquidity (can t pay rd) :: Insolvency (D > PV (FCF )) :: A division of the cash flows :: Business failure (FCF < 0) Capital Structure 57

70 Bankruptcy Bankruptcy is typically not the main problem Capital Structure 58

71 Bankruptcy Bankruptcy is typically not the main problem Bankruptcy is a division of the cash flows Capital Structure 58

72 Bankruptcy Costs Nevertheless... dividing-up results in deadweight costs. :: Direct costs :: Legal fees :: Opportunity cost of management time :: Indirect Costs :: Lost business :: Production inefficiencies :: Employees quitting :: Inefficient liquidation ( firesale ) Capital Structure 59

73 Bankruptcy Costs Nevertheless... dividing-up results in deadweight costs. :: Direct costs :: Legal fees :: Opportunity cost of management time :: Indirect Costs :: Lost business :: Production inefficiencies :: Employees quitting :: Inefficient liquidation ( firesale ) Deadweight bankruptcy costs are costs that a non-levered firm would not face if in the same business situation Capital Structure 59

74 How Big? :: Bankruptcy Cost = Value of assets before bankruptcy (but including any economic distress) minus value after bankruptcy resolved Capital Structure 60

75 Bankruptcy Costs - LBOs/MBOs of the 1980s [Gregor Andrade and Steven N. Kaplan, How Costly is Financial (Not Economic) Distress? Evidence from Highly LeveragedTransactions that Became Distressed, Journal of Finance, 53: 5 (October 1998)] Capital Structure 61

76 Bankruptcy and Tax Shields The Tradeoff :: Cash flows (EBIT) equivalent to one ounce of gold next year :: Debt of D with an interest rate of y% (owe (1 + y)d at year-end) :: Tax Rate is τ = 35% :: Bankruptcy costs are $b (e.g., legal fees) :: Choose D Capital Structure 62

77 Trade-Off Theory of Capital Structure V L = V U +Value of tax savings of interest Value of bankruptcy costs Capital Structure 63

78 Defaultable Debt ( Junk Bonds ) Capital Structure 64

79 They Might Not Pay! Price=$100, par=$100, coup=0.15, prob(up)=0.9,recovery=$70. Returns = 15%, -30%, E(r) = 10.5%. What do bondholders get if default occurs? What is their: :: Promised return? (i.e., maximum return) :: Realized return? :: Expected return? Capital Structure 65

80 Exercise Same as above, but the bond does not sell at par: :: Price =$95 Capital Structure 66

81 Exercise Same as above, but the bond does not sell at par: :: Price =$95 Answer: realized returns are and and expected return is Capital Structure 66

Debt Policy and Bankruptcy Pricing Corporate Debt [Source: FINRA http://cxa.gtm.idmanagedsolutions.

82 Debt Policy and Bankruptcy Pricing Corporate Debt [Source: FINRA ] :: Corporate bond yields are not expected rates of return they are maximum rates of return Capital Structure 67

Debt Policy and Bankruptcy Pricing Corporate Debt [Source: FINRA http://cxa.gtm.

83 Debt Policy and Bankruptcy Pricing Corporate Debt [Source: FINRA ] Capital Structure 68

84 Debt Policy and Bankruptcy Pricing Corporate Debt [Source: FINRA ] :: Corporate bond yields are not expected rates of return they are maximum rates of return :: Example: X Co. issues a one-year bond that will sell at par ($100). The coupon rate (paid once at the end of the year) is c. If the the company goes bankrupt (20% chance), the bondholder will get $90 per bond. The beta on this bond is 0. The riskless rate is 2% and that the equity risk premium (E[r m r f ]) on the market is 6%. :: Expected return = 2% :: Promised (maximum) return = c% :: Exercise: What is c? Capital Structure 69

85 Answer Solve for c: Point: Price = = = (1 + c) 1 + Expected Return (1 + c) 1 + r f + β(e(r m ) r f ) (1 + c) 1 + r f c = > 0.02 Capital Structure 70

86 Exercise :: Suppose that the beta on the bond is 0.3. What is the answer? Answer: c = 7.25%. Comes from changing the discount rate from the risk-free rate to: r f + β(er m r f ) = = Capital Structure 71

87 Finance-1 in the News Source: Hunt for yield risks inflating EM bond bubble, Financial Time, September 7, 2016 Capital Structure 72

88 Or TRY Hunt for The Hunt for Yield Ends in Argentina WSJ see graphics (this one s probably better) Capital Structure 73

89 Summary Capital Structure 74

90 Conclusion: Capital Structure :: Debt policy ( leverage ) changes allocation of risk :: This is super important to know :: Note: shareholders can choose portfolios accordingly :: Debt policy ( leverage ) changes value (wealth) because of (only because of) frictions :: Taxes :: Bankruptcy costs :: [and others] Capital Structure 75

91 Summary: Capital Structure Module :: What is leverage? What is the capital structure decision? :: Modigliani-Miller: no frictions :: Leverage is irrelevant for firm value :: Leverage affects risk/return properties of equity/debt :: Equity beta, asset beta :: Frictions: :: Tax: debt shield adds value :: WACC: discount rate that incorporates tax shield :: Bankruptcy costs :: Levered Re-Cap :: Pricing defaultable debt :: Optimal capital structure: trades-off tax benefits of debt against costs of bankruptcy. :: Capital Structure 76

92 EXTRA TIME? Debt Policy - Other Factors :: Personal Taxes :: Management Incentives :: Conflicts of interest (agency) :: Strategic (business strategy) :: Others :: More generally: capital structure is more than just debt ratio Capital Structure 77

Module 4: Free Cash Flow (FCF) Which cash flows do we discount?

70391 - Finance Module 4: Free Cash Flow (FCF) Which cash flows do we discount? 70391 Finance Fall 2016 Tepper School of Business Carnegie Mellon University c 2016 Chris Telmer. Some content from slides