On Capital Structure by azw20493

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									           On Capital Structure




The impact of debt financing on firm and project value
To borrow or not to borrow…?
                    Objective



To analyze the relationship between capital structure
              decision and firm value
                             Outline



•   The effect of financial leverage
•   Measures of financial leverage
•   Capital structure and firm value
•   Empirical evidence on capital structure
The effect of financial leverage




What do borrowing does to firm’s earnings?
Case A: The firm is all equity

The firm has 400,000 shares outstanding, selling at $20/share
Case A: The firm is all equity

The firm has 400,000 shares outstanding, selling at $20/share




                           Recession     Normal         Boom
         EBIT              $500,000    $1,000,000    $1,500,000
Case A: The firm is all equity

The firm has 400,000 shares outstanding, selling at $20/share



                           Recession     Normal         Boom
         EBIT              $500,000    $1,000,000    $1,500,000
        Interest                 0          0             0
Case A: The firm is all equity

The firm has 400,000 shares outstanding, selling at $20/share



                          Recession     Normal         Boom
         EBIT             $500,000     $1,000,000   $1,500,000
        Interest                 0         0             0
      Net Income          $500,000     $1,000,000   $1,500,000
Case A: The firm is all equity

The firm has 400,000 shares outstanding, selling at $20/share



                          Recession      Normal        Boom
         EBIT             $500,000     $1,000,000   $1,500,000
        Interest                 0         0             0
      Net Income          $500,000     $1,000,000   $1,500,000
         ROE                6.25%        12.5%        18.75%
Case A: The firm is all equity

The firm has 400,000 shares outstanding, selling at $20/share



                           Recession     Normal         Boom
         EBIT              $500,000    $1,000,000    $1,500,000
        Interest                 0          0             0
      Net Income           $500,000    $1,000,000    $1,500,000
         ROE                 6.25%        12.5%        18.75%
          EPS                $1.25         $2.5         $3.75
Case B: The firm has $4 million in long-term debt @10%/year and

200,000 shares selling at $20/share.



                     Recession          Normal         Boom
     EBIT             $500,000         $1,000,000   $1,500,000
Case B: The firm has $4 million in long-term debt @10%/year and

200,000 shares selling at $20/share.



                     Recession          Normal         Boom
     EBIT             $500,000         $1,000,000   $1,500,000
   Interest           $400,000         $400,000      $400,000
Case B: The firm has $4 million in long-term debt @10%/year and

200,000 shares selling at $20/share.



                     Recession          Normal         Boom
     EBIT             $500,000         $1,000,000   $1,500,000
   Interest           $400,000         $400,000      $400,000
 Net Income           $100,000         $600,000     $1,100,000
Case B: The firm has $4 million in long-term debt @10%/year and

200,000 shares selling at $20/share.



                     Recession          Normal         Boom
     EBIT             $500,000         $1,000,000   $1,500,000
   Interest           $400,000         $400,000      $400,000
 Net Income           $100,000         $600,000     $1,100,000
     ROE                2.5%              15%          27.5%
Case B: The firm has $4 million in long-term debt @10%/year and

200,000 shares selling at $20/share.



                      Recession         Normal          Boom
     EBIT             $500,000         $1,000,000    $1,500,000
    Interest          $400,000         $400,000       $400,000
 Net Income           $100,000         $600,000      $1,100,000
     ROE                2.5%              15%           27.5%
     EPS                 $0.5              $3            $5.5
                         Discussion

The standard deviation of ROE and EPS has increased when compared
to the no-debt case.




                           Conclusion:

       With more debt, EPS and ROE become more volatile
           Several measures of financial leverage



•   The debt-to-equity ratio
•   The total debt ratio
•   The dynamic degree of financial leverage
•   The static degree of financial leverage
•   Times interest earned

•   The cash coverage ratio
               The debt-to-equity ratio


D/E is the ratio of debt to equity.

In case A, D/E = 0


In case B, D/E =1
                The total debt ratio

Total debt ratio = D/(D+E)

D/(D+E) compares the value of debt to the total firm
value

In case A, D/(D+E) =0


In case B, D/(D+E) = 0.5
       The dynamic degree of financial leverage


(DDFL) measures the elasticity of EPS with respect to EBIT.
DDFL= (%Chg. in EPS)/(%Chg. in EBIT)



Consider the change in EBIT and EPS from the normal state to the
booming state of the economy.
In A, DDFL = 1
In B, DDFL = 1.67.

Note:
If you consider the change in EBIT and EPS from the booming state
to the normal state of the economy the calculation yields a different
ratio.
        The static degree of financial leverage

SDFL = EBIT/(EBIT - Interest)

In A, SDFL =1 for all three states of the nature.


In B, one has to use expected values
SDFL = 1,000,000/600,000 = 1.67


Attention:
SDFL is not always equal to DDFL. Each ratio captures a different
aspect of the degree of financial leverage
                 Times interest earned



TIE= EBIT/Interest

TIE compares EBIT to the annual interest payment


In B, TIE =2.5
                    The cash coverage ratio


Cash coverage = (EBIT + Depreciation)/Interest

Cash coverage compares EBIT plus depreciation to the annual interest
payment.

In B, cash coverage is no less than 2.5 (we don't know the annual amount of
depreciation)
     Measuring and evaluating leverage:
                A summary


Debt makes cash flows more volatile.

There are several ways to measure leverage.
Each method offers a unique vantage point.
Leverage and optimal capital structure




            The static view

       Miller & Modigliani’s view
     Leverage and optimal capital structure:The static
                          view




There is an optimal capital structure:
That debt-to-equity ratio that maximizes total firm value.
           The two opposite effects of leverage




Risk increase (as discussed above)
Discount rate becomes higher -> Total firm value goes down




Tax savings
Cash flows to stakeholders increase   -> Total firm value goes up
                             Remember:


Assets are financed by shareholders and creditors
The cash flow from assets go back to shareholders and creditors

The present value of cash flows from assets is the total market value of the
firm, V:
PV CF from assets = V

At the same time,
V = market value of equity + market value of debt

Hence,
PV CF from assets = market value of equity + market value of debt
            Tax savings: Exemplification

            Project A: Levered   Project A: Unlevered
EBIT               $100                   $100
Interest            $50                     -
EBT                 $50                   $100
Tax (40%)           $20                    $40
NI                  $30                    $60
             Tax savings: Exemplification

            Project A: Levered   Project A: Unlevered
EBIT               $100                   $100
Interest            $50                     -
EBT                 $50                   $100
Tax (40%)           $20                   $40
NI                  $30                   $60
             Tax savings: Exemplification

            Project A: Levered   Project A: Unlevered
EBIT               $100                   $100
Interest            $50                     -
EBT                 $50                   $100
Tax (40%)           $20                   $40
NI                  $30                   $60
             Tax savings: Exemplification

            Project A: Levered   Project A: Unlevered
EBIT               $100                   $100
Interest            $50                      -
EBT                 $50                   $100
Tax (40%)           $20                     $40
NI                  $30                     $60
             Tax savings: Exemplification

            Project A: Levered   Project A: Unlevered
EBIT               $100                   $100
Interest            $50                      -
EBT                 $50                   $100
Tax (40%)           $20                     $40
NI                  $30                     $60
                 Tax savings: Exemplification

               Project A: Levered   Project A: Unlevered
 EBIT                    $100                $100
 Interest                $50                     -
 EBT                     $50                 $100
 Tax (40%)               $20                    $40
 NI                      $30                    $60


Cash flow from assets:
Levered case = $50 + $30 =$80
Unlevered case = $60
By leveraging the project, we increase its total cash flows
        Optimal capital structure:The static view




A little debt will generates tax savings without adding too much risk



A lot of debt will dramatically increase risk more than offsetting tax
savings
     V   Static view: Leverage and firm value




VU




                                                D/E
     V   Static view: Leverage and firm value




VU




                                                D/E
     V   Static view: Leverage and firm value




VU




                                                D/E
     V   Static view: Leverage and firm value




VU




                                                D/E
     V   Static view: Leverage and firm value




VU




                                                D/E
     V   Static view: Leverage and firm value




VU




                                                D/E
     V   Static view: Leverage and firm value




VU




                                                D/E
     V   Static view: Leverage and firm value




VU




                                                D/E
     V   Static view: Leverage and firm value




VU




                                                D/E
     V   Static view: Leverage and firm value




VU




                                                D/E
                          D/E*
             The static view: A summary



The optimal capital structure is simply a matter of balancing
corporate debt tax shields against the risk of financial distress
(bankruptcy costs)
                 The cost of bankruptcy


The overall cost of bankruptcy is also called the cost of financial
distress:

direct (legal and administrative expenses)

indirect (opportunity costs caused by the increasing difficulties of
running a business on the brink of bankruptcy)
   The theory of optimal capital structure (Merton
           Miller and Franco Modigliani)



This theory is known as the irrelevance theory because
M&M argue that capital structure doesn’t really matter
                        M&M 1958


I. The overall market value of the firm and the WACC
are completely independent of firm's capital structure.

II. The cost of equity is a linear function of firm's
leverage
                    Proposition I
                      (assume perpetual CF)




Proof:
VL = (CF to s/h + CF to b/h)/(wacc)
VL = [(EBIT - rD) +rD]/(wacc) = VU
                           Proposition I
                              Alternative proof

Assume two firms:
L is levered VL = SL + D
U is unlevered VU = SU

                               portfolio A         portfolio B
                                                  buy aSU = a VU
    invest today           buy aSL = a(VL - D)
                                                    borrow aD
 receive the payoff           a(EBIT - rD)         a(EBIT - rD)
                           Proposition I
                               Alternative proof

Assume two firms:
L is levered VL = SL + D
U is unlevered VU = SU

                               portfolio A          portfolio B
                                                   buy aSU = a VU
    invest today           buy aSL = a(VL - D)
                                                     borrow aD
 receive the payoff           a(EBIT - rD)          a(EBIT - rD)
                           Proposition I
                              Alternative proof

Assume two firms:
L is levered VL = SL + D
U is unlevered VU = SU

                               portfolio A         portfolio B
                                                  buy aSU = a VU
    invest today           buy aSL = a(VL - D)
                                                    borrow aD
 receive the payoff           a(EBIT - rD)         a(EBIT - rD)
                           Proposition I
                              Alternative proof

Assume two firms:
L is levered VL = SL + D
U is unlevered VU = SU

                               portfolio A         portfolio B
                                                  buy aSU = a VU
    invest today           buy aSL = a(VL - D)
                                                    borrow aD
 receive the payoff           a(EBIT - rD)         a(EBIT - rD)
                           Proposition I
                              Alternative proof

Assume two firms:
L is levered VL = SL + D
U is unlevered VU = SU

                               portfolio A         portfolio B
                                                  buy aSU = a VU
    invest today           buy aSL = a(VL - D)
                                                    borrow aD
 receive the payoff           a(EBIT - rD)         a(EBIT - rD)


   Since the payoffs are equal:

   a(VL - D) = aVU - aD
   VL = VU.
                           Proposition II

II. The cost of equity is a linear function of firm's leverage, that is a
function of its debt/equity ratio

ke = wacc + (wacc - r)(D/E)


beta equity = business risk + financial risk
beta equity = beta assets + (D/E) beta assets
                      M&M 1963


I. The overall market value of the firm is an
   increasing function of leverage

II. The cost of equity is a function of capital
  structure and corporate taxes.
            M&M 1963: Proposition I



VL= [PVCF to s/h + PVCF to b/h] = EBIT(1-T)/ke + rTD/r


VL = VU + tax shield
                     M&M 1963: Proposition I
                               Alternative proof

Assume two firms:
L is levered VL = SL + D
U is unlevered VU = SU

                               portfolio A            portfolio B
  invest today             buy aSL = a(VL - D)     buy aSU = a VU
                                                   borrow (1-T)aD
receive the payoff          a(1-T)(EBIT - rD)      a(1-T)(EBIT - rD)
                     M&M 1963: Proposition I
                                Alternative proof

Assume two firms:
L is levered VL = SL + D
U is unlevered VU = SU

                               portfolio A             portfolio B
  invest today             buy aSL = a(VL - D)      buy aSU = a VU
                                                    borrow (1-T)aD
receive the payoff          a(1-T)(EBIT - rD)       a(1-T)(EBIT - rD)
                     M&M 1963: Proposition I
                                Alternative proof

Assume two firms:
L is levered VL = SL + D
U is unlevered VU = SU

                               portfolio A             portfolio B
  invest today             buy aSL = a(VL - D)      buy aSU = a VU
                                                    borrow (1-T)aD
receive the payoff          a(1-T)(EBIT - rD)       a(1-T)(EBIT - rD)
                     M&M 1963: Proposition I
                                Alternative proof

Assume two firms:
L is levered VL = SL + D
U is unlevered VU = SU

                               portfolio A             portfolio B
  invest today             buy aSL = a(VL - D)      buy aSU = a VU
                                                    borrow (1-T)aD
receive the payoff          a(1-T)(EBIT - rD)       a(1-T)(EBIT - rD)
                        M&M 1963: Proposition I
                                 Alternative proof

Assume two firms:
L is levered VL = SL + D
U is unlevered VU = SU

                                portfolio A             portfolio B
  invest today             buy aSL = a(VL - D)       buy aSU = a VU
                                                     borrow (1-T)aD
receive the payoff           a(1-T)(EBIT - rD)       a(1-T)(EBIT - rD)

  Since the payoffs are equal,
  a(VL - D) = aVU - a(1-T)D
  That is VL = VU + (D)(T)
  (D)(T) = tax shield
  Exemplification: NoDebt Inc. and MoreDebt S.A. have identical EBIT of $69,230.77 in perpetuity.
  NoDebt has 15,000 shares outstanding selling at $30 each and no debt. MoreDebt has 20,000 shares
  outstanding and $200,000 in perpetual debt. The corporate tax rate is 35%, and the interest on debt is 5%.


Mr. R buys 800 shares in MoreDebt SA, while Mr. P borrows $5,200 (at 5%) and uses his own savings to buy 600
shares in NoDebt. Who will have a higher cash flow at the end of the year?

CF (Mr. R) = (0.04)[$69,230.77 – (0.05)(200,000)](0.65) = $1,540
CF (Mr. P) = (0.04)($69,230.77)(0.65) – (0.05)(5,200) = $1,540

What is the price per share for More Debt Inc.?

Since the payoff for the two portfolios is equal, 600 shares in NoDebt should have the same market value as 800 shares in
MoreDebt and a 5,200 loan.
$18,000 = (X)800 + 5,200; x = $16/share
Total MV (NoDebt) = (30)(15,000) = $450,000
Total MV (MoreDebt) = (16)(20,000) + 200,000 = $520,000
Notice that $520,000 = $450,000 + (0.35)(200,000)

What is the cost of equity and the WACC for each of the two firms?

WACC(NoDebt) = Ke(NoDebt) = (69,230.77)(0.65)/450,000 = 0.1
Ke(More Debt) = (69,230.77- 10,000)(0.65)/320,000 = 0.1203

Notice that 0.1203 = 0.1 + (0.1 – 0.05)(0.65)(0.625)

WACC(MoreDebt) = (0.1203)(0.6154) + (0.05)(0.65)(0.3846) = 8.65%
            M&M 1963: Proposition II



II. The cost of equity is a function of capital
structure and corporate taxes.


ke = wacc + (wacc - r)(1-T)(D/E)
             Capital structure with corporate and
                 personal taxes (Miller 1976)


Stockholders receive: (EBIT- rD)(1-Tc)(1-Ts)
Tc = corporate tax

Ts = personal tax on equity income




Bondholders receive: rD(1-Td)
Td = personal tax on ordinary income
Capital structure with corporate and
    personal taxes (Miller 1976)


VL = PV of (EBIT- rD)(1-Tc)(1-Ts) + rD(1-Td)

    VL = VU + [1 - (1-Tc)(1-Ts)/(1-Td)]D


            VL = VU + tax shield
   Capital structure with corporate and personal taxes
                       (Miller 1976)



The tax shield can be negative, positive or zero, depending on
  the differences between personal and corporate tax rates.
                      Summary




VL = VU + Debt tax shield - Cost of bankruptcy - Agency costs
                            Discussion

Debt clearly makes residual cash flow more volatile.

Debt generates tax shields.

The net effect is unclear

Since wacc is calculated as an average of a relatively high cost
of equity and relatively low cost of debt, it is not clear what
happens to the overall market value of the firm.
                    Discussion (con’t)

In an ideal world, capital structure should have no impact on
total firm value (M&M 1958)


In the real world, however, capital structure appears to have
some influence on total market value.
          Discussion (con’t)




           The real question:
   How much impact has debt financing?

If impact is small, then we’re back to M&M
                     Discussion (con’t)



Choosing the right investment projects is the main determinant of
                            firm value

      Financing the projects is only a matter of fine tuning
                    Conclusion



The range of optimal capital structure is a matter of
                 managerial opinion
                   NPV implications



Even though the impact of debt financing might be small, one
         has to account for it when calculating NPV

								
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