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Capital Structure and Firm Value

Does Capital Structure affect value?


Empirical patterns
Across Industries Across Firms Across Years Who has lower debt? High intangible assets/specialized assets High growth firms High cash flow volatility High information asymmetry Industry leaders

Is capital structure managed?

If so much time is spent on capital structure then there must be some value to it (or managers/investors are irrational)

Debt and Equity Only?


Typically thought of and measured this way Much more complex
Investment opportunities and strategy (needs) Financing (sources) Cash balance Distribution: Dividend and repurchases Debt capacity Equity capacity Existing debt and equity Other financial policies: Financial Hedging, Cash Flow Volatility, Forms of Compensation

How does capital structure affect value?


To prove this we start in the perfect world
Based on the work of Miller and Modigliani Shows that capital structure is irrelevant

Value is derived from market imperfections

Example: What if a firm is considering

issuing debt and retiring equal amounts of equity?

Assets Debt Equity Interest Share Price Outstanding Shares

Current 8000 0 8000 0.1 20 400

Proposed 8000 4000 4000 0.1 20 200

Current Earnings ROA ROE EPS

Recession 400 0.05 0.05 1

Expected 1200 0.15 0.15 3

Expansion 2000 0.25 0.25 5

Proposed EBI Interest Earnings ROA ROE EPS

Recession 400 400 0 0.05 0 0

Expected 1200 400 800 0.15 0.2 4

Expansion 2000 400 1600 0.25 0.4 8

Position #1: Buy 100 shares of the levered firm ($20*100=$2,000 Initial Investment)

Earnings

Recession 0

Expected 400

Expansion 800

Position #2: Buy 200 shares of the unlevered firm and borrow $2000 (($20*200)-$2,000=$2,000 Initial investment).

Earnings Interest Net Earnings

Recession 200 200 0

Expected 600 200 400

Expansion 1000 200 800

Capital Structure is Irrelevant


Miller and Modigliani assume perfect
capital markets

Proposition #1: The market value of any

firm is independent of its capital structure.

Firm Value: Perfect Capital Markets

190

170

150

Value

130 V(Unlevered) 110

90

70

50

0%

25%

50% D/E

75%

100%

Market Imperfections: Taxes


Taxes
US Tax Code: Deductibility of interest leads to lower cost of debt (Rd(1-t)) Simple specification overvalues benefit Ignores personal taxes which
Decreases investors debt return Increases investors preference for equity Capital gains: Defer and rate difference Dividend: Some portion is deductible

Market Imperfections: Contracting Costs

In imperfect markets, alternative ways to


contract optimal behavior are necessary Costs of financial distress
Underinvestment (rejecting NPV>0 projects), direct, indirect costs, etc.

Benefits of debt
Monitoring function, manages free cash flow problem (Accepting NPV<0 projects), etc.

Contracting costs and taxes are primary


motives for static trade off theory debt

Market Imperfections: Information Costs


With asymmetric information, leverage may reveal
something about the existing firm Market timing: Managers take advantage of superior information
Issue equity when it is overvalued Issue debt when it is undervalued

Signaling: Managers use financing to signal future


prospects of firms
Issue equity to signal good growth opportunities (preserve financial flexibility) Issue debt when expected cash flows are strong and stable

Motivates Pecking Order Theory

Can we quantify the value of market imperfections?


Debt adds value to the firm due to the interest deductibility (assume taxes only) VL VU PV (TaxShield )
Assume the simple case:

rD D C PV (TaxShield ) D C rD

Firm Value: Perfect Capital Markets

190

170

150

Value

130

V(Unlevered) V(Levered)

110

90

70

50 0% 25% 50% D/E 75% 100%

More Complex Tax Shields


Uneven and/or limited time payments
Discount all flows back to time 0

What r do you use?


Certain the tax shield can be used: rD Uncertain? Higher r

Financial Distress
As leverage increases, the probability
therefore PV of financial distress increases

VL VU PV (TaxShield ) PV ( FinancialDistressCos t )

How do we estimate the cost of distress?


Prob(Distress)*Cost of Distress

Probability can be estimated in several ways


Logit/Probit regressions Debt ratings

Firm Value: with Taxes and Fiancial Distress

190

170

150

130

V(Unlevered) V(Levered) V(Distress)

110

90

70

50 D/E D/E

Financial Distress: Bankruptcy Costs Direct Costs


Legal, accounting and other professional fees Re-organization losses Estimated btw 4-10% of firm value (t-3)
Reputation costs Market share Operating losses Estimated as 7.8% of firm value (t-2)

Indirect Costs

Financial Distress: Agency Costs


Risk shifting and asset substitution
Shareholders invest in high risk projects and shift risk to the debt holders Shareholders issue more debt, diminishing old debt holders protection

Underinvestment Expropriating funds Difficult to estimate

Other Advantages of Debt


Agency cost of Equity (motive)
Shirking is less likely when issuing debt Perquisites are less likely with debt Over-investment is less likely with debt

Agency cost of Free Cash Flow (opportunity)


Retained earnings versus dividends? Growth and investment opportunities

Debt serves as a monitoring device,


decreasing managerial discretion Bankruptcy as a strategic move???

Formal Models of Capital Structure


Pecking Order
Firms prefer to raise capital Internally generated funds Debt Equity Implies capital structure is derived from Financing needs and capital availability Dynamic rather than static Asymmetric information and signaling Static Trade Off

Static trade-off theory of debt


Firm Value

Maximum Firm Value Actual Firm Value

Debt

Optimal amount of Debt

Implications of Static Trade Off


Static rather than dynamic Taxes and Contracting Cost drive value Readjustment may be sticky
Optimal trade off between cost of issuances and benefit of capital structure

Insights
Large, stable profit firms will have more debt Higher the costs of distress lower debt Lower taxes, lower debt Less (more) favorable tax treatment of debt (equity), lower debt

Evidence: Taxes
This method usually overestimates the tax
consequence
Magnitude of leverage differences across countries and tax regimes is not that big Equity taxes (personal taxes) are overestimated (Miller) Timing of capital gains

Higher effective marginal tax rate, higher


the leverage (Graham, 2001)

Evidence
Contracting Costs: Consistent evidence
Higher (lower) the growth opportunities, higher (lower) the potential underinvestment problem, lower (higher) the leverage Higher growth opportunities would prefer Shorter maturity debt (or call provisions) Less restrictive covenants More convertibility provisions More concentrated investors (private) Consistent with market timing (SEOs lead to -3% return) Inconsistent with signaling and pecking order

Information costs

Taxes: Higher effective marginal tax rate, higher


the leverage

MM: Proposition II
How does leverage affect rE Start with the WACC E Solve for rE

D ra rE rD V V

D rE ra (ra rD ) E

The rate of return on the equity of a firm increases


in proportion to the debt to equity ratio (D/E).

MM: Proposition II (with taxes)

E D ra rE (1 c )rD V V
D rE ra (1 c )(ra rD ) E

Blue Inc. has no debt and is expected to generate $4

million in EBIT in perpetuity. Tc=30%. All after-tax earnings are paid as dividends.The firm is considering a restructuring, with a perpetual fixed $10 million in floating rate debt at an expected interest rate of 8%. The unlevered cost of equity is 18%.

What is the current value of Blue? What will the new value be after the restructuring? What will the new required return on equity be? What if we use the new WACC?

What About Financial Flexibility?


The ability to quickly change the level and
type of financing

Value increasing if
Growth opportunities exist Company is willing to exercise and extinguish future flexibility New investments are unpredictable and large Precautionary debt ratings cushion is valuable

Value destroying if the opposite is true

How do we value financial flexibility?

What do we do?
Choosing a target capital structure
Minimize taxes and contracting costs (while paying attention to information costs) Target ratio should reflect the companys Expected investment requirements Level and stability of cash flows Tax status Expected cost of financial distress Value of financial flexibility

Dynamic management
Financing is typically a lumpy process Find optimal point where cost of adjusting capital structure is equal to cost of deviating from target