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THE DEBT-EQUITY CHOICE

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THE DEBT-EQUITY CHOICE Powered By Docstoc
					THE DEBT-EQUITY CHOICE
The Effect of Financial Leverage

 How does financial leverage affect the EPS and
  ROE of a firm?
 Leverage amplifies the variation in both EPS and
  ROE
   More debt leads to more interest expense
   If we have a really good year, then we pay fixed
    interest and we have more left over for stockholders
   If we have a really bad year, we still have to pay fixed
    interest and we have less left over for stockholders
Leverage vs. EPS and ROE

 An all-equity firm:
    V = $20 million
    1 million shares outstanding
    Current share price: $20
 Change capital structure:
    Raise $10 million in debt (RD = 7.5%)
    Repurchase 500,000 shares
 New capital structure: 50% debt, 50% equity
 Ignore taxes for simplicity
EPS for the Unlevered Firm

 Unlevered (all equity) capital structure:

              Bad times     Good times   Expected

EBIT           $1,250,000   $2,750,000   $2,000,000

Net income     $1,250,000   $2,750,000   $2,000,000

EPS                 $1.25        $2.75         $2.00

ROE                6.25%        13.75%        10.00%
  EPS for the Levered Firm

New levered capital structure (50% equity, 50% debt):

               Bad times    Good times    Expected

 EBIT          $1,250,000    $2,750,000   $2,000,000

 Interest         750,000      750,000      750,000

 Net income      $500,000    $2,000,000   $1,250,000

 EPS                $1.00         $4.00         $2.5

 ROE                5.00%       20.00%       12.50%
 Comparison
              Unlevered
               Bad times     Expected     Good times

EPS                 $1.25         $2.00         $2.75

ROE                 6.25%       10.00%         13.75%

               Levered with 50% debt
EPS                  $1.00         $2.5         $4.00

ROE                 5.00%        12.50%        20.00%

Leverage magnifies shareholders’ gains and losses
 makes equity riskier  expected return higher!
                                                       6
 $3.0
EPS

 $2.5
                                EPS v.s. EBIT
                                Unlevered Firm - - -
                                Levered Firm ......
 $2.0



 $1.5



 $1.0
        1M   1.5M   2M   2.5M      3M     EBIT
Break-Even EBIT

 Find EBIT where EPS is the same under both the
  current and proposed capital structures
 If expected EBIT > break-even point, then
  leverage is beneficial to stockholders
 If expected EBIT < break-even point, then
  leverage is detrimental to stockholders
 Finding Break-Even EBIT

EPS without Debt  EPS with Debt
        EBIT             EBIT  Interest expense
                
                                                    e
     # of shares # of shares after capital restructur
         EBIT       EBIT  $750,000
                
      1,000,000         500,000
  Solve for EBIT :  $1,500,000

            $1,500,000
      EPS              $1.5
            1,000,000
  Capital Structure

 Managers’ ultimate goal: maximize firm value

 Firm value = PV of cash flows to the firm
 WACC is the appropriate discount rate for the firm’s
  asset

 WACC weights determined by capital structure
 Choose combination of debt and equity that
  maximizes firm value or equivalently,
 choose Debt-Equity mix that minimizes WACC!
 Capital Structure Theory Under Three
 Special Cases

 Modigliani and Miller Theory of Capital Structure
   Proposition I – firm value
   Proposition II – WACC
 Case I – Assumptions
   No corporate taxes
   No bankruptcy costs or agency costs
 Case II – Assumptions
   Corporate taxes, but
   No bankruptcy costs or agency costs
 Case III
   Consider corporate taxes, bankruptcy costs and agency
    costs
Case I: M&M Proposition I (1958)
 In the absence of taxes, the value of the firm is
  independent of its financial leverage
 Capital structure is irrelevant.

  Firm
  Value




                                             D/E
Case I: M&M Proposition II (1958)
 If there are no taxes:
              E      D
   WACC  RA   RE   RD  (1  Tc)
              V      V
 Solve for RE:
                               D
       RE  RA  ( RA  RD ) 
                               E
 The greater the leverage the greater RE becomes
  – but WACC stays the same!
              M&M Proposition II (1958)


                    RE = RA + (RA – RD )  (D/E)
Cost of capital




                                                   WACC = RA
                                                   RD

                                                   D/E
    A World without Taxes

   Widget Manufacturing is currently an all-equity
    financed firm worth $5 million. WM plans to issue
    $2,000,000 in debt and to use proceeds to
    repurchase stock. The cost of debt is 10%. The
    cost of unlevered equity equals 14%. Assume no
    taxes.

a. What is the value of the firm after the repurchase?
b. What is the firm’s cost of capital after repurchase?
c. What is its cost of levered equity?
  A World without Taxes

(a) $5 million – in the absence of taxes (and other
distorting factors) debt has no impact on firm value.

(b) WACC = RE = 14%
  To verify: WACC = 16.67%  3/5 + 10%  2/5 = 14%
    The firm’s cost of capital has not changed!

(c) V = $5M, D = $2M => D/E = 2/3
    R E  R A  (R A - R D )  (D/E)
         14%  (14% - 10%)  (2/3)  16.67%

With debt, the equity is riskierrequired return increases
Case II: Proposition I with Taxes (1963)

 Tax shield is generated by interest payments
 PV of interest tax shields:
                 RD  D  TC
                              D  TC
                     RD
 The Value of levered firms (VL) is equal to the value of
  unlevered firms (VU) plus the PV of the interest tax shield.
                      VL  VU  D  TC
            Value of equity = VL – Value of debt

 Implication: Debt financing is advantageous if we ignore
  bankruptcy costs and agency costs.
M&M Proposition I (1963)

Value of Levered Firm =
      Value of Unlevered Firm + PV of Interest Tax Shields


                          VL=VU+D  TC
   Firm Value




                                  DTC

                                             VU
                                  VU

                                         D
Case II: Proposition II with Taxes
 The levered cost of equity is
                                           D
            R EL    R EU  (R EU  R D )   (1  TC )
                                           E
            REL : levered cost of equity
            REU : unlevered cost of equity capital
M&M Proposition II (1963)

                       REL
Cost of capital




                       REU

                       WACC
                       RD  (1 – TC)


                        D/E
    A World with Taxes

   An all-equity financed firm has after-tax cash perpetual
    flows of $300,000 and the cost of (unlevered) equity is
    15%. The firm could borrow $1,000,000 at 8% to
    repurchase part of its equity. Tax rate is 40%. Assume
    that the agency and bankruptcy costs of debt are zero.

a. What is the value of the all-equity firm?
b. What would be the value of the firm if it decided to go
   ahead and borrow $1,000,000?
c. Calculate the WACC for the levered firm.
  A World with Taxes

(a) The value is the PV of future after-tax cash flows:
    VU = $0.3M/0.15 = $2M


(b) VL = VU + DTC = $2M + $1M  0.4 = $2.4 M

(c) E = VL – D = $2.4M – $1M = $1.4M
                   D
   R EL  R EU      (R EU  R D )  (1  TC )
                   E
  REL=15% + (15% – 8%)(1 – 0.4)1/1.4=18%
  WACC=18%1.4/2.4+8%(1– 0.4) 1/2.4= 12.5% < 15%
    Case III: Capital Structure with FC and AC


    The tradeoff between the benefits and costs of
     using debt leads to a basic capital structure
     theory.

      Benefits: tax shield on interest

      Costs: Interest payments
              Financial distress costs (FC)
              Agency costs (AC)

                                                      23
 Cost of Leverage: Financial Distress

 Debt increases the probability of default and
  bankruptcy!
 Direct costs
   Legal and administrative costs (lawyers)
   Example: http://query.nytimes.com/gst/fullpage.html?res=940DE1D81530F93BA35754C0A96E948260
 Indirect costs
   Losses due to “fire sale” liquidations
   Business opportunities lost due to financial distress
        Customers lose faith
        Suppliers may deny credit
        Employees may flee


                                                                                            24
Cost of Leverage: Agency Costs

 Debt changes managers’ incentives
 May lead to changes in investment policies
   Asset substitution: Firm may invest in negative
    NPV “gambles” when it is in financial distress
   Under-investment: Forego positive NPV
    projects when close to bankruptcy
   Milking the property




                                                 25
Balance Sheet for a Company in Distress

  Assets          BV  MV        Liabilities     BV  MV
  Cash          $200 $200       LT bonds      $300 $200
  Fixed Asset   $400   $0       Equity        $300 $0
  Total         $600 $200       Total         $600 $200

  What happens if the firm is liquidated today?

  The bondholders get $200; the shareholders get
  nothing.
  Agency Cost: Asset Substitution
 The Gamble               Probability          Payoff
 Win Big                  10%                  $1,000
 Lose Big                 90%                  $0

 Cost of investment is $200 (all the firm’s cash)
 Required return is 50%

 Expected CF from the Gamble = $1000 × 0.10 + $0 = $100

      NPV = -$200 + $100/1.1 = -$133
Agency Cost: Asset Substitution

 Expected CF from the Gamble
    To Bondholders = $300 × 0.10 + $0 = $30
    To Stockholders = ($1000 - $300) × 0.10 + $0 = $70

 PV of Bonds Without the Gamble = $200
 PV of Stocks Without the Gamble = $0

 PV of Bonds With the Gamble = $30 / 1.5 = $20
 PV of Stocks With the Gamble = $70 / 1.5 = $47
Agency Cost: Underinvestment

 Consider a government-sponsored project that guarantees
  $350 in one period
 Cost of investment is $300 (the firm only has $200 now)
  so the stockholders will have to supply an additional $100
  to finance the project
 Required return is 10%

                 $350
    NPV  $300        $18.18
                  1.10

    • Should we accept the project?
Agency Cost: Underinvestment (Continued)

 Expected CF from the government sponsored project:
    To Bondholder = $300
    To Stockholder = ($350 - $300) = $50

 PV of Bonds Without the Project = $200

 PV of Stocks Without the Project = $0

 PV of Bonds With the Project = $300 / 1.1 = $272.73

 PV of Stocks With the project = $50 / 1.1 - $100 = -$54.55
Agency Cost: Milking the Property

 Liquidating dividends
   Suppose our firm paid out a $200 dividend to
    the shareholders. This leaves the firm
    insolvent, with nothing for the bondholders,
    but plenty for the former shareholders.
   Such tactics often violate bond indentures.
 Increase perquisites to shareholders
  and/or management
Optimal Capital Structure (w/ FC, AC)

   The use of debt initially causes the firm’s WACC to
    decline. (Reason: RD <RE since debt has seniority over
    equity and RD is tax-deductible.)

   As debt increases, RD and RE both increase due to
    higher risk associated with financial distress and
    agency costs. At some point, WACC will increase.

   The mix of debt and equity financing at the point
    where the WACC is minimized and firm value is
    maximized is called the optimal capital structure.



                                                             32
Case III: Firm Value

               Bankruptcy costs

Agency costs


        VL VU  DTC  A( D)  BC ( D)


Tax shield



                                          33
           Cost of Capital and Leverage

                                       REL
Cost of capital




                                      REU
                                      WACC (w/ BC and AC)

                                      WACC (M&M II & Taxes)
                                       RD  (1 – TC)

                   Optimal Leverage   D/E ratio
                                                        34
   Firm Value and Debt


             PV of Agency and
             Bankruptcy Costs     VL= VU+D  TC
Firm Value




                                  VL= VU+D  TC
                                   – BC(D) – A(D)
                                  VU



                        Optimal   D
                        Debt
                                                  35
Optimal Capital Structure

 Optimal debt level will:
   Increase with expected cash flows
   Decrease with past profitability (pecking order:
    profitable firm does not need to issue debt)
   Decrease with risk of cash flows
   Decrease with level of R&D spending




                                                  36
The Real World: Debt Policy

 Most CFOs do not seem to care about:
   Bankruptcy costs
   Comparable firms
 Most important factors that determine
  CFOs capital structure decisions:
   Funding needs
   Financial flexibility and risk
   Cost of financing



                                          37
Survey evidence on whether firms have optimal or target debt-equity ratios. The
survey is based on the responses of 392 CFOs. Source: Graham and Harvey
Journal of Financial Economics 60 (2001) 187-243
             Debt Policy Factors
                  Financial flexibility

                         Credit rating

    Earnings and cash flow volatility

          Insufficient internal funds

               Level of interest rates

                 Interest tax savings

        Transactions costs and fees

Equity undervaluation/overvaluation

         Comparable firm debt levels

          Bankruptcy/distress costs

          Customer/supplier comfort


                                      0%         10%         20%         30%         40%          50%           60%
                                           Percent of CFO's identifying factor as important or very important

       Survey evidence on some of the factors that affect the decision to issue debt. The survey is based on the
       responses of 392 CFOs. Source: Graham and Harvey Journal of Financial Economics 60 (2001) 187-243
The Real World: Equity Issuance

 Capital structure is more often changed by
  changes in the total market value of equity
  rather than the amount of debt
 Firms issue stock when
   Share price overvalued
   Reached “debt capacity”
 Firms repurchase stock
   Share price undervalued
   Avoid dilution due to stock option compensation
              Common Stock Factors

                        Earnings per share dilution

Magnitude of equity undervaluation/overvaluation

If recent stock price increase, selling price "high"

Providing shares to employee bonus/option plans

              Maintaining target debt/equity ratio

         Diluting holdings of certain shareholders

         Stock is our "least risky" source of funds

   Sufficiecny of recent profits to fund activities

  Similar amount of equity as same-industry firms

    Favorable investor impression vs. issuing debt

                                                   0%    10%       20%      30%       40%      50%       60%       70%
                                                        Percent of CFO's identifying factor as important or very
                                                                               important
        Survey evidence on some of the factors that affect the decision to issue common stock. The survey
        is based on the responses of 392 CFOs.

				
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