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If so much time is spent on capital structure then there must be some value to it (or managers/investors are irrational)
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).
190
170
150
Value
90
70
50
0%
25%
50% D/E
75%
100%
Benefits of debt
Monitoring function, manages free cash flow problem (Accepting NPV<0 projects), etc.
rD D C PV (TaxShield ) D C rD
190
170
150
Value
130
V(Unlevered) V(Levered)
110
90
70
Financial Distress
As leverage increases, the probability
therefore PV of financial distress increases
VL VU PV (TaxShield ) PV ( FinancialDistressCos t )
190
170
150
130
110
90
70
50 D/E D/E
Indirect Costs
Debt
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
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
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
E D ra rE (1 c )rD V V
D rE ra (1 c )(ra rD ) E
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?
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
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