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					                            Topic 8: Capital Structure and Leverage

This chapter is concerned with topics relating to a company’s capital structure (its chosen mix of
debt and equity financing).

I. Capital Structure: The Basic Idea
Consider this example. Four investors want to start a new company. Each contributes $250,000
so that the firm can purchase $1 million in assets. Initially, they all plan to be owners (common
stockholders), and they agree that the risks of being owners under these circumstances justify an
18% return on equity (ke). So the WACC for a 100% equity capital structure is 1.0 x .18 = 18%.
Note that an investment project should be accepted only if its expected return is at least 18%.

Then one of the four, Ms. A, asks if she can be a lender instead of an owner. She offers to “move
to the front of the line” (giving up her claim on the residual) in return for the promise of a 10%
annual interest rate. (Because the firm’s average income tax rate is 30%, the cost to the firm of
providing this 10% return is only 7%.) Of course, the remaining owners now face higher risks
of not getting paid anything, because Ms. A’s claim is satisfied in full from operating income
before any of the owners get paid anything. So the owners now expect to earn 19% on their
investment. And the WACC for a capital structure of 25% debt, 75% equity is (.25)(.07) +
(.75)(.19) = 16%. By changing its capital structure, the firm has reduced its cost of getting
money and made it profitable to pursue an investment project with a return of, say, 17%.

Then another owner wants to become a lender. But when Mr. B “moves to the front of the line,”
both he and Ms. A face more risk of not being paid in full from the firm’s operating income
(since now half of the firm’s money comes from lenders). So now Ms. A and Mr. B both
demand 12% interest (which after the 30% tax shield costs the firm .7 x .12 = 8.4% to deliver).
Of course, the owners now face higher risks as well, and they now expect to earn 21%. So the
WACC for a capital structure of 50% debt, 50% equity is (.5)(.084) + (.5)(.21) = 14.7%. By
changing its capital structure again, the firm has further reduced its cost of getting money and
made it profitable to pursue an investment project with a return of, say, 15%.

Now Ms. C also wants to become a lender. Of course, if she does, then she and Ms. A and Mr. B
are putting up most of the money and facing most of the risk of loss, while Mr. D (the remaining
owner) gets to make all the firm’s major decisions and keep all the profits. So the lenders want
returns of 22% (which costs the firm .7 x .22 = 15.4% to deliver), and the owner (who has a lot
of upside potential but also a lot of downside risk) expects a return on equity of 30%. So the
WACC for a capital structure of 75% debt, 25% equity is (.75)(.154) + (.25)(.30) = 19.05%.
By changing its capital structure again, the firm has now increased its cost of getting money.

The optimal capital structure for this company (based on the limited list of possibilities
considered) appears to be about 50% debt, 50% equity.

Note that what we want to achieve is to obtain money as cheaply as we can. We already knew
that in a business we want to obtain our production inputs as cheaply as we can (for example,
by procuring labor and materials in the most efficient quantities and combinations) so that more
operating profit will remain after their costs are paid for. Along the same lines of reasoning, we
want to get the money that finances our asset base as cheaply as possible so more economic value
added (EVA) will remain from operating income after financing costs are paid.
Trefzger/FIL 240 & 404                 Topic 8 Outline: Capital Structure                           1
II. Break-Even Analysis
One topic that relates to capital structure is the use of fixed costs in the company’s operations,
which relates to break-even analysis. Consider a small, highly-automated company called
Tableware, Inc. The firm makes two products: drinking glasses and stainless steel flatware.
The monthly fixed cost total is as follows:

                         Rent                          $ 5,500
                         Utilities                       2,000
                         Insurance                         500
                         Mgt. Salaries                   5,000
                                 Fixed Costs           $13,000

The variable costs per unit for the two products are:

                                               Glassware                      Flatware
               Labor                            $10.00                         $ 6.00
               Materials                          8.00                          14.00
               Variable Overhead                  5.00                            4.00
                             Total              $23.00                         $24.00

With sales prices of $25 per set of glassware and $30 per set of flatware, the per-unit contribution
margin for each product is
                                              Glassware                      Flatware
               Sales Price                     $25.00                         $30.00
               - Variable Cost                   23.00                          24.00
               = Contribution Margin            $ 2.00                         $ 6.00

If we can sell only 2,000 sets of glassware the total variable costs will be 2,000 x $23 = $46,000,
and if we (incorrectly) try to allocate half of the total fixed cost to each product, then we have

                                Sales                            $50,000
                                - Variable Costs                  46,000
                                - Half of Fixed Costs               6,500
                                = Operating Income (Loss)        ($ 2,500)

Glassware seems to be a money-loser; should we discontinue it? If we do, then there will be only
one product – Flatware – to absorb all the fixed costs. If we can sell only 2,000 sets of flatware
per month at $30 each, and if the total variable cost is 2,000 x $24 = $48,000, then we have:

                                Flatware Sales                   $60,000
                                - Variable Costs                  48,000
                                - ALL of Fixed Costs              13,000
                                = Operating Income (Loss)        ($ 1,000)

So is flatware a loser also??? No; we have mistakenly asked each product to bear half of the
fixed costs instead of asking what we should: that each product line simply contribute something
toward meeting fixed costs. Note that if we maintain both product lines, we have:

Trefzger/FIL 240 & 404                  Topic 8 Outline: Capital Structure                           2
                         Total Sales    ($50,000 + $60,000)                       $110,000
                         - Total Variable Costs ($46,000 + $48,000)                 94,000
                         = Total Contribution Margin                              $ 16,000
                         - Fixed Costs                                              13,000
                         = Operating Income                                       $ 3,000

So what’s the point? As long as variable costs are covered and there is at least some positive
contribution to help cover fixed costs, we should not discontinue a product unless that productive
capacity can be redirected to products with higher contribution margins.

In less formal terms, we can say that a product with a positive contribution margin is “pulling
its own weight” and also contributing something to the firm’s greater effort. (Remember that
in Economics class they told you to keep producing as long as the variable costs are covered?)

III. Computing Operating & Financial Break-Even Points (BEPs): Numerical Examples
A firm pays $50,000 for a machine to make products over a 5-year period (and the machine has
a 5-year expected life). This machine has investors’ money tied up in it even if production is
temporarily shut down, so we might think of its loss in value over time as largely a fixed cost.
Fixed costs other than the machine’s declining value (i.e., fixed costs that require cash payments)
are $20,000 per year. The company expects to sell the product for a price of $25 per unit, and
variable costs per unit are $15 (so the contribution margin per unit is p – vc = $25 – $15 = $10).
The weighted average cost of capital for a project of this type is 15%.

The general formula for computing a break-even point is

                                             Year ' s  Fixed  Costs
                                   BEP =                              .
                                            Contributi on  M arg in

We know that the contribution margin is $10 per unit made and sold, but how do we define fixed
costs? A less-inclusive way is to think only about the machine’s purchase price, and to measure
its declining value over time through straight-line depreciation. (We could also use accelerated
depreciation, but that approach would result in a different break-even measure for each year of
the project’s expected life, and we typically like to think of a “break-even” point that would be
the same for each year.) The traditional break-even measure (which is known as the accounting
or operating break-even point) is computed as

                                                     Cost  of  Long  Lived  Equipment 
             Year ' s  Fixed  Operating  Costs                                        
                                                                        n                  ,
                                         Contribution  M arg in

which for this example is

                               $50,000 
                    $20,000           
                                  5  $20,000  $10,000 30,000
   Accounting BEP =                                           = 3,000 units/year.
                         $25  $15           $10           10

Trefzger/FIL 240 & 404                   Topic 8 Outline: Capital Structure                       3
So if the firm can produce and sell 3,000 units, it will raise enough revenue to pay the year’s cash
outlays and an accrual-based measure of the year’s share of the equipment cost, for a $0 EBIT.
But that level of revenue is not enough to cover the additional fixed cost of having obtained the
$50,000 to buy the equipment (there is still a time value loss). In other words, we would not feel
fully compensated if we gave up $50,000 today and then simply got back $10,000 per year for
five years. The amount that we would expect to collect each year for five years, to compensate
for both the $50,000 and the 15% annual cost of having obtained the $50,000 from lenders and
owners, would have to be greater than $10,000, specifically:

                                           PMT x FAC = TOT


                                          1 5
                                        1      
                                          115 
                                               .
                                    PMT            = $50,000
                                             .15
                                                  
                                                  

                         PMT (3.352155) = $50,000             PMT = $14,916.

And thus our more inclusive measure of fixed costs provides the numerator for the financial
break-even point (which provides a $0 EVA), computed as

                                                     Cost  of  Long  Lived  Equipment 
                                                     n  Year  PV  of  Annuity  Factor 
             Year ' s  Fixed  Operating  Costs                                         
                                                                                            ,
                                         Contribution  M arg in

which for this example is

                              $50,000 
                   $20,000           
                              3.352155 $20,000  $14,916 34,916
   Financial BEP =                                              = 3,492 units/year.
                         $25  $15             $10           10

So what is the connection with capital structure? We’re getting there. Consider another
production process the firm might employ, in which it buys a more expensive machine (again, we
think of its loss in value over time as a fixed cost) that is more efficient and thus allows variable
costs per unit to fall (perhaps less hand-finish work is needed, less raw material is wasted). Let’s
say the firm pays $80,000 for this machine, fixed costs other than the machine’s declining value
remain at $20,000 per year, and the WACC is still 15%. The product will still sell for $25 per
unit, but variable cost per unit drops to $14 (so the contribution margin per unit rises to $11).
The accounting or operating break-even point (with $16,000 in annual straight-line depreciation
over five years as our measured loss in value) is a higher

                            $80,000 
                 $20,000           
                               5  $20,000  $16,000 36,000
Accounting BEP =                                           = 3,273 units/year.
                      $25  $14           $11           11

Trefzger/FIL 240 & 404                    Topic 8 Outline: Capital Structure                        4
The amount we would expect to collect each year to compensate for both the $80,000 and the
15% cost of having obtained the $80,000, would have to be greater than $16,000, specifically:

                                         1 5
                                       1      
                                         115 
                                              .
                                   PMT            = $80,000
                                            .15
                                                 
                                                 

                         PMT (3.352155) = $80,000           PMT = $23,866.

Thus, the financial break-even point is an even higher

                              $80,000 
                   $20,000           
                              3.352155 $20,000  $23,866 43,866
   Financial BEP =                                              = 3,988 units/year.
                         $25  $14             $11           11

This example illustrates the frequently-encountered case in which the incurring of higher fixed
costs leads to a higher break-even point. That sounds bad. But the tradeoff is a lower variable
cost per unit and thus a higher contribution margin per unit. So a company that is confident in
its ability to meet a sufficiently high sales level might redesign its operation to have greater fixed
cost and a higher BEP, but with the benefit of a higher contribution margin (here, once the higher
BEP is met, each additional unit sold contributes $11 in profit rather than $10).

But the key is not simply hitting a higher BEP; consider the accounting BEP above. The process
with the $80,000 machine contributes $11 to profit for each unit sold beyond the 3,273 unit BEP,
but at that sales level the process with the $50,000 machine would already be 273 units past its
3,000 unit BEP, and thus would be contributing 273 x $10 = $2,730 to profit. To determine the
sales level that would make the switch to the plan with higher fixed costs worthwhile, we solve
for quantity Q in an equation that sets total revenue minus total costs equal for both cases:

                               p•Q – FC1 – vc1•Q = p•Q – FC2 – vc2•Q ,

(FC1 is total annual fixed costs under initial plan, FC2 is expected total annual fixed cost under
new plan, vc1 is variable cost/unit under initial plan, vc2 is expected variable cost/unit under new
plan, and p is expected selling price/unit, which we treat as the same in this type of analysis no
matter how many units are sold, even though basic economics tells us that to sell more units we
would likely have to cut the per-unit price, unless the market were perfectly competitive). This
equation simplifies to
                                                                  FC 2  FC1
                        Q (vc1 – vc2) = FC2 – FC1  Q                        ,
                                                                   vc1  vc 2

which for the situation described above results in

                               $36,000  $30,000 $6,000
                          Q                           = 6,000 units.
                                   $15  $14       $1

Trefzger/FIL 240 & 404                  Topic 8 Outline: Capital Structure                           5
Under the more capital-intensive process, each unit sold beyond 3,273 contributes $25 – $14 =
$11 (not just $25 – $15 = $10) to operating income. But for sales up to 6,000 units the less
capital-intensive arrangement would be better, and at 6,000 units sold the operating income is the
same under either plan:
                        ($25 x 6,000 units) – $30,000 – ($15 x 6,000 units)
                           = $150,000 – $30,000 – $90,000 = $30,000.

                         ($25 x 6,000 units) – $36,000 – ($14 x 6,000 units)
                            = $150,000 – $36,000 – $84,000 = $30,000.

And then for each unit made and sold beyond 6,000 the higher fixed cost plan would contribute
an extra $11 to operating income, while the lower fixed cost plan would contribute only an extra
$10. For example, at 6,200 cases sold the respective operating income levels would be

                         ($25 x 6,200 units) – $30,000 – ($15 x 6,200 units)
                            = $155,000 – $30,000 – $93,000 = $32,000.

                         ($25 x 6,200 units) – $36,000 – ($14 x 6,200 units)
                            = $155,000 – $36,000 – $86,800 = $32,200;

for output levels beyond the 6,000 annual unit indifference point, the arrangement with the higher
fixed cost/higher BEP provides a higher accounting-based operating income.


IV. Operating, Financial, and Total Leverage
But it still seems unclear how the break-even idea relates to capital structure, right? Consider
that a company with a higher break-even point is said to have higher operating leverage.
Leverage, in the most general sense, is the use of methods that involve fixed costs for the purpose
of magnifying financial returns. Activities involving fixed costs might be chosen instead of
activities involving variable costs, at least to some degree, both in a firm’s production processes
(as shown above) and in its financing plan.

Imagine a company with fixed cost = $30,000 , selling price per unit = $15, and variable cost per
unit = $12 (so contribution margin per unit = $3). At 20,000 units of output, the degree of
operating leverage (DOL) is computed as

                  Q( p  vc)     Q( p  vc)        20,000($15  $12)       $60,000
      DOL =                                                                     =2.
               Q( p  vc)  FC    EBIT        20,000($15  $12)  $30,000 $30,000

The degree of operating leverage is 2; therefore, a 1% change in sales results in a 2% change in
EBIT, or operating income. (You will not have to compute DOLs, but should be able to interpret
what a DOL of 2 or 2.6 or 1.4 would mean.) How does a 1% change in sales lead to a 2% change
in EBIT? Consider this example, in which sales in units grow from 20,000 to 20,200, or by 1%:

        Sales (20,000 x $15)           $300,000                  (20,200 x $15)   $303,000
        - VC (20,000 x $12)             240,000                  (20,200 x $12)    242,400
        - FC                             30,000                                     30,000
        = EBIT                         $ 30,000                                   $ 30,600
Trefzger/FIL 240 & 404                  Topic 8 Outline: Capital Structure                         6
[Sales go up from $300,000 to $303,000, or by 1% – but EBIT rises from $30,000 to $30,600,
or by 2%.] And a 10% increase in sales (from 20,000 to 22,000 units) leads to a 20% increase in
EBIT:
        Sales (20,000 x $15)        $300,000              (22,000 x $15) $330,000
        - VC (20,000 x $12)          240,000              (22,000 x $12)      264,000
        - FC                          30,000                                   30,000
        = EBIT                      $ 30,000                                $ 36,000

[Sales go up from $300,000 to $330,000, or by 10% – but EBIT rises from $30,000 to $36,000,
or by 20%.] But leverage is said to be a “two-edged sword;” note that a 10% decrease in sales
(from 20,000 to 18,000 units) leads to a 20% decrease in EBIT:

        Sales (20,000 x $15)          $300,000                  (18,000 x $15)         $270,000
        - VC (20,000 x $12)            240,000                  (18,000 x $12)          216,000
        - FC                            30,000                                           30,000
        = EBIT                        $ 30,000                                         $ 24,000

[Sales drop from $300,000 to $270,000, or by 10% – but EBIT declines from $30,000 to
$24,000, or by 20%.] It should be clear that operating leverage relates to incurring fixed
costs in the process of producing goods or services. If all production costs were variable and
proportional, DOL would simply be 1; a 1% change in sales would lead to a 1% change in EBIT.

Now consider financial leverage, incurring fixed cost in financing the business. We treat debt
financing (borrowed money) as having a fixed cost, in that a lender typically receives a financial
return that is a fixed percentage of the amount of money lent (whereas the returns to equity
investors are variable, changing with the company’s financial performance). [We usually think
of EBIT as being unaffected by the use of debt financing, though extreme amounts of borrowing
could disrupt relationships with customers and suppliers, who might fear the firm is at risk of
going bankrupt, and thus could affect EBIT, as suppliers charge higher prices or service fees.]

If annual EBIT is $30,000 and annual interest expense is $10,000, then the degree of financial
leverage (DFL) is
                         EBIT             $30,000         $30,000
                                                                  = 1.5 .
                       EBIT  Int $30,000  $10,000 $20,000

DFL is 1.5; therefore, a 1% change in EBIT results in a 1.5% change in net income. How does a
1% change in EBIT lead to 1.5% change in net income? Consider this example:

                EBIT                  $ 30,000                              $ 30,300
                - Interest              10,000                                10,000
                = EBT                 $ 20,000                              $ 20,300
                - 40% Tax                8,000                                 8,120
                = Net Income          $ 12,000                              $ 12,180

[EBIT goes up from $30,000 to $30,300, or by 1% – but net income goes up from $12,000 to
$12,180, or by 1.5%.] Note that a 10% change in EBIT leads to a 15% change in net income:


Trefzger/FIL 240 & 404                 Topic 8 Outline: Capital Structure                            7
                EBIT                   $ 30,000                              $ 33,000
                - Interest               10,000                                10,000
                = EBT                  $ 20,000                              $ 23,000
                - 40% Tax                 8,000                                 9,200
                = Net Income           $ 12,000                              $ 13,800

[EBIT goes up from $30,000 to $33,000, or by 10% – but net income goes up from $12,000 to
$13,800, or by 15%.] Note that a 10% decrease in EBIT leads to a 15% decrease in net income:

                EBIT                   $ 30,000                              $ 27,000
                - Interest               10,000                                10,000
                = EBT                  $ 20,000                              $ 17,000
                - 40% Tax                 8,000                                 6,800
                = Net Income           $ 12,000                              $ 10,200

[EBIT drops from $30,000 to $27,000, or by 10% – but net income declines from $12,000 to
$10,200, or by 15%.] As with operating leverage, the DFL would be 1 if there were no debt
financing. After all, if there were no debt to pay interest on, then any improvement in operating
performance would simply be passed directly to the “bottom line” as net income for the owners.

Finally, consider total (sometimes called combined) leverage: the combined impact of operating
and financial leverage. The degree of total leverage measures the impact on net income when
there is a change in sales. We compute degree of total leverage (DTL) as DOL x DFL. So from
the above examples, if DOL = 2 and DFL = 1.5, then DTL = 2 x 1.5 = 3. The interpretation is
that a 1% change in sales is expected to bring about a 3% change in net income. If sales increase
by 1%, net income should rise by 3% (if the underlying relationships remain constant). But if
sales fall by 10%, then net income can be expected to fall by 30%!

It is for the latter reason – that a small change in sales can lead to a large change (for better or
worse) in net income – that we say leverage is a “two-edged sword.” Of course, if all costs
were variable (and proportional), then a 1% (or any other percentage) change in sales would
be accompanied by a 1% (or other stated percentage) change in net income. It is the existence
of fixed costs – costs that do not rise when output is higher and that do not fall when output
is reduced – that gives rise to the magnifying effect we call “leverage.”

This combined effect of operating and financial leverage shows how fixed costs and break-even
points relate to capital structure. If a company’s operations are characterized by high fixed costs
(typically because of the type technology used), then it might not want to have high fixed costs
(a high proportion of debt financing) on the financing side, or else a small percentage decline in
sales would cause a huge percentage decline in net income. In theory (and sometimes, but not
always, borne out in practice), a firm burdened with higher operating leverage would choose to
have less financial leverage (i.e., would choose a capital structure with a lower proportion of debt
financing than would firms with less operating leverage).

The idea of operating, financial, and total leverage can also be used as a quick financial
forecasting tool. For example, let’s say that the past year’s sales totaled $1 million and net
income was $75,000. If DTL is 3, and if you expect sales to increase by 10% (to $1.1 million),
then net income should be predicted to increase by 30%, to 1.3 x $75,000 = $97,500.
Trefzger/FIL 240 & 404                  Topic 8 Outline: Capital Structure                             8
V. EBIT/EPS Analysis
Another way to address whether debt financing benefits a company is EBIT/EPS analysis.
Financial leverage has a beneficial (detrimental) impact on owners’ financial returns if the
interest rate paid to the lenders is less (greater) than the rate of return earned on the assets paid
for with the borrowed money. That rate of return can be measured either as return on invested
capital (ROIC), which we compare to the after-tax percentage interest cost; or more typically
as the basic earning power ratio, which we compare to the quoted interest rate (i.e., without
adjustment for the income tax savings on borrowing). We compute basic earning power as

                                                            EBIT
                               Basic Earning Power =                    .
                                                         Total  Assets

It follows that a company should be neutral about borrowing if basic earning power equals the
quoted interest rate; if the purchased assets produce exactly enough in returns to pay for the
borrowed money, the return to the owners is the same regardless of whether the company pays
for the assets entirely with owners’ (equity) money or almost entirely with borrowed money.

Consider a case in which XCorp is trying to identify its optimal capital structure. It expects to
earn a $26,750 annual operating income, or EBIT, on $250,000 in total assets (operating income
should not be affected much by the way assets are paid for). The common stock’s market value
is $40 per share, the quoted (pre-tax) interest rate on borrowed money would be 10%, and there
are no income taxes. A simple “EBIT/EPS” analysis for three representative debt ratios shows:

Debt Ratio                             10%                      50%                    90%
Amount of Debt                      $ 25,000                  $125,000               $225,000
Amount of Equity                    $225,000                  $125,000               $ 25,000
Shares of $40 Common Stock           5,625                      3,125                   625

Operating Income (EBIT)             $ 26,750                  $ 26,750               $ 26,750
Minus 10% Interest                  $ 2,500                   $ 12,500               $ 22,500
Net Income (ignoring tax)           $ 24,250                  $ 14,250               $ 4,250

Net Income/Equity = ROE              10.78%                      11.4%                  17%
Net Income/Shares = EPS               $4.31                      $4.56                 $6.80

In this situation, the 10.7% basic earning power (EBIT/Total Assets = $26,750/$250,000) is
greater than the 10% pre-tax interest cost, so the returns to the owners are magnified as XCorp
borrows progressively more of the money to pay for its $250,000 in assets, and thus more
borrowing appears to be good. (We can view ROE and EPS as proxies for maximizing owners’
wealth, if we can assume that these values indicate trends over the longer term). If the interest
rate exceeded basic earning power, ROE and EPS would become smaller at higher debt ratios.
EBIT/EPS analysis is a convenient means of thinking about how additional borrowing benefits a
firm’s owners if the interest rate is “low.”

There are problems with the assumptions in this type of analysis, however. For example, here
we treat the interest rate as being the same if XCorp pays for anywhere from 10% to 90% of its
assets with debt financing. In fact, a practical problem in analyzing capital structure is that as the
debt ratio rises and lenders face more risk, they are likely to charge a higher interest rate, thereby
Trefzger/FIL 240 & 404                  Topic 8 Outline: Capital Structure                              9
reducing the chance that basic earning power could exceed the interest rate. Other assumptions
that might be inconsistent with reality are that income tax would play no role, and perhaps that
the value/share of common stock would be the same no matter how many shares were created.


VI. Capital Structure: The Issues

A. Does Capital Structure Matter?
Compelling theoretical arguments have been made on both sides of this issue: both that a firm’s
value can be enhanced by its choice of debt vs. equity financing; and the opposite, which is that
capital structure might conceivably make no difference.

   Modigliani and Miller (M&M) Arguments: Capital Structure Does Not Matter

Financial theorists Franco Modigliani and Merton Miller won the Nobel Prize in Economics
for their groundbreaking work in corporate financial theory, including their ideas on capital
structure irrelevance. Miller once offered a simple explanation of the complex underlying ideas:
think of a company as being like a pizza, in that the value is unaffected by the way the pie is
sliced. (This argument holds that a company – the substantive value of which depends on the
type and risk of its assets, and its ability to use those assets in producing and distributing goods
and services – is not worth more or less simply because the equity claim is larger and the debt
claim is smaller – or vice versa – any more than a pizza is worth more if it is cut into six pieces
rather than eight).

As supporting evidence, M&M said: assume that capital structure does matter, and that a firm’s
managers have chosen a non-optimal debt/equity mix. If such an outcome occurred, then each
individual investor could simply borrow money and buy more of the firm’s stock (or sell some
stock and lend out the money received, since lending undoes the effects of borrowing), to create
a debt/equity mix for her own investment in the firm that provides the desired risk/return profile
and financial returns. Since investors can make use of this “homemade leverage,” M&M argue,
company managers should not waste time and resources trying to find a “right” capital structure.

But M&M’s ideas are based on some simplifying assumptions that do not reflect the “real
world:” absence of income tax differentials between debt and equity; “perfect capital markets”
with interest rates the same for lenders and borrowers, large and small; no transaction costs (e.g.,
for borrowing money and buying more stock); and ready availability of all relevant information
(including the idea that lenders know everything the firm’s owners and managers are doing). So
are M&M’s ideas wrong? Certainly not!! First, by seeing that capital structure would not matter
if these assumptions held true, we can infer that if capital structure does matter the reason(s)
must relate to the subjects of these assumptions. Second, note that the real world might come
to look increasingly like the M&M world; consider how much lower some transaction costs have
become in the electronic age.

   Real World Observations: Capital Structure Does Matter

As noted, the M&M theories are based on some restrictive assumptions that do not reflect current
“real world” observations. Another financial theorist, Stewart Myers, has offered a simple
explanation of complex ideas with an alternative food example: chicken. When a grocery store

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sells chicken, it usually charges a higher price for the cut-up pieces than it charges for a whole
chicken. Why? Packaging costs, including risks the store bears in breaking things apart into the
pieces the store thinks people want to buy. The store creates economic value if it finds the right
mix of pieces to package together such that shoppers will pay the highest total price for the
amount of chicken the store has in inventory. And a company creates economic value (increases
the value of the firm, meaning the value of the common stock) if it breaks the claims on assets
into the appropriate pieces (debt of various types, preferred stock in some cases, common stock).


B. The Role of Debt
If capital structure does matter, should a company make greater use or less use of debt?

   Point of View 1: Relatively more debt is better
Firms can benefit by borrowing money. In the US the federal government absorbs part of the
financing cost by allowing a firm that borrows to deduct its interest cost from income before
computing the income tax; and as long as a firm does not borrow too much, the interest rate it
pays should be lower than the basic earning power it earns on assets. And by raising needed
money through borrowing, the firm also prevents the “dilution” of each current owner’s share of
voting and profits.

Another financial theorist, Michael Jensen, has even suggested that debt financing helps to
motivate a firm’s managers to work hard and make good decisions. The idea is that principal
and interest owed to lenders must, by law, be paid in full and on specified dates, whereas money
available to compensate owners might be viewed by the firm’s managers as “free cash flow” that
they might misspend (e.g., overcompensating themselves). Along similar lines is the information
asymmetry idea: issuing new common stock means that managers are not optimistic about the
company’s future (if they are willing to share the residual with new investors, they must not think
the residual will be all that substantial).

    Point of View 2: Relatively less debt is better
If a firm’s relative amount of borrowing gets too high, there is a high risk of bankruptcy: a small
downturn in sales revenue could leave the firm with too little operating income (money left
after having paid workers, material suppliers, etc.) to pay all the interest and principal owed to
lenders. High debt, relative to equity, also creates agency problems, in that the firm’s owners/
managers might conduct the business operations in a risky way.

Why? Big risks provide big payoffs to the owners (who get to keep all the profits) if the situation
turns out well, but they impose unacceptable burdens on the lenders, who have downside risk
(they lose their investment if the situation turns out poorly) but no upside potential – they get
nothing extra, in the typical case, even if the risks lead to big payoffs. We would expect lenders
to react to these agency problems by charging higher interest rates as the proportion of debt
financing rises, and these progressively higher rates would eventually cause the cost of capital
to be quite high (thus the value of the firm to be quite low).

There are other arguments for keeping the level of debt relatively low. The comparative tax
benefit of debt is sometimes overstated; firms with loss carry-forwards or other tax shields may
get no additional tax benefit from borrowing, while, at the same time, equity investors are not
taxed on capital gains (based on retained earnings) until they sell their stock. Also, as seen
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earlier, using more debt financing (“financial leverage”) can create high overall risk if the firm
also has a high degree of fixed cost (“operating leverage”) in its production processes; high
overall fixed costs could place the firm in jeopardy if sales revenues and operating income
dropped even slightly. Finally, a firm might want to hold back on borrowing in good times
to maintain flexibility, keeping its ability to borrow intact for a possible future emergency.


C. The Optimal Capital Structure
A firm’s optimal capital structure is the one that correctly balances the decrease in stock price
that accompanies higher risk with the increase in stock price that accompanies higher expected
return. A more direct way to state it is that the optimal capital structure minimizes the firm’s
weighted average cost of capital. In trying to find its optimal capital structure a company
considers several factors. One is business risk, or uncertainty regarding future ROE. Business
risk relates to the basic nature and stability of the company’s business and its asset holdings (food
producers tend to have less business risk than luxury goods producers), and to its DOL. Business
risk thus ties the DOL/DFL/DTL idea to capital structure. More business risk (related to
operating leverage) may prompt the firm to use less debt financing (less financial leverage).

Other factors are the firm’s tax position (more need to shelter taxes  more debt financing is
better); its financial flexibility (more likelihood of needing to obtain money later on short notice
 less debt financing is better, to preserve the ability to borrow later); and management’s
aggressiveness (more aggressive philosophy  more debt financing is better, to magnify return
on equity and earnings per share for the company’s owners).

Some Points to Note:
 We can not find the “optimal” capital structure with precision; we might feel that a particular
   firm could benefit from replacing some debt with equity (or vice versa), but there is no way
   to state that a given firm should be financed with precisely 47.19% debt and 52.81% equity.
 Firms often work within a range of the “optimal” breakdown, financing with debt when
   interest rates are low and with equity when stock prices are high (though those situations
   often coincide), as long as they do not stray too far from what is believed to be optimal.
 Managers may stick with their own preferences or company traditions (e.g., some firms have
   operated for many years with no long-term debt) rather than seeking the theoretical optimum.
 Finding the optimal capital structure allows a company to minimize its weighted average cost
   of capital, thereby making more investment projects profitable and maximizing the value of
   the common stockholders’ investment.
 Different capital structure measures emerge depending on whether we use the book value
   (original purchase price of the common stuck, plus actual retained earnings totals) or market
   value (the total price that all of the common stock could be sold for in today’s market) of the
   stockholders’ equity position.
 The Modigliani and Miller arguments are typically presented in the form of two
   “propositions:”

M&M Proposition 1: Capital structure is irrelevant, so the value of an “unlevered” firm (one with
no debt financing) is equal to the value of the same firm if some financial leverage (some debt
financing) were employed. Symbolically, VL = VU.



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M&M Proposition 1 adjusted for the income tax sheltering benefits of debt financing: The
greater the use of debt financing, the greater the shielding of income from taxes. So more debt
financing is always better, and the value of the levered firm is equal to the value of the same firm
if unlevered, plus the value of the tax shield (the amount of debt financing times the company’s
average income tax rate). Symbolically, VL = VU + tD.

M&M Proposition 2: The common stockholders’ expected return on their equity investment is
the weighted average cost of capital, plus the debt/equity ratio times the difference between the
WACC and the expected cost of debt financing. Why? Recall that we can compute a simple
weighted average cost of capital WACC (or kA) as

                                      kA = wdkd (1 – t) + weke

If there were no income tax benefits for debt financing, then we would compute WACC or kA as

                                         kA = wdkd + weke

And if we represented the weights wd and we instead as D/V and E/V, we would compute

                                     kA = D/V (kd) + E/V (ke)

Rearranging terms, we would find         E/V (ke) = kA – D/V (kd).

Since we can remove the E/V from the left side by multiplying each side by V/E, we have

                                     ke = V/E (kA) – D/V (V/E) (kd).

And since D/V times V/E equals D/E, we have

                                         ke = V/E (kA) – D/E (kd).

And because value = equity + debt (V = E + D), we can restate the relationship as

                                   ke = E/E (kA) + D/E (kA) – D/E (kd)
                                         ke = kA + D/E (kA – kd)

Thus return on equity ke is shown, under this analysis, to be determined by the required return
on all invested money (the assets), which reflects business risk, and by the proportion of debt
financing in the capital structure and the interest rate paid on debt, which reflect financial risk.
But while this idea (that the return expected by the company’s owners depends on the company’s
business activity and its reliance on borrowed money) is useful for shaping our understanding of
capital structure, using it to compute a specific ke becomes problematic because M&M treat the
interest rate on debt in this analysis as being constant: the same whether the firm pays for 10%
or 90% of its assets with borrowed money (just as is done in standard EBIT/EPS analysis). As
noted earlier, in a real world setting, the average interest rate on debt would likely be higher if
lenders collectively provided more of the money with which the company paid for its assets.



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