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capital structure

VIEWS: 170 PAGES: 48

									Advanced Project Evaluation


 Global Financial Management




                               1
                         Overview

l   “Capital Structure does not matter!”
     » Modigliani Miller propositions
         – Implications for corporate debt policy
     » Capital structure with taxes and bankruptcy costs
l   Capital structure and required returns
     » The weighted average cost of capital (WACC)
     » Ungearing betas
l   Optimal debt policy




                                                           2
         What is “Capital Structure”?

l   Definition
    The Capital Structure of a firm is the mix of different securities
    issued by the firm to finance its operations.
     » Bonds, Bank loans
     » Equity, Preferences shares
     » Warrants
l   What is the optimal capital structure?
     » Debt/equity mix
     » Maturity structure of debt
     » Option features
     » Currency-mix


                                                                         3
    Capital Structure Does not Matter!
               The Modigliani-Miller Propositions


l   Under the assumption that:
     » There are no taxes.
     » There are no costs of financial distress
     » There are no asymmetries of information
     » The investment and operating policies of the firm are given.
        * the value of a firm is independent of its capital structure
           (MM Proposition I).
l   However,
     » Assumptions are not realistic.
     » Focus on cases where one of the assumptions are violated.



                                                                        4
              Why is This True?
                       An Example



Two ways of buying the same cash flow:

1.   Buy 1% of an unlevered firm
     Outlay:        0.01 VU (Value of unlevered firm)
     Payoff:        0.01 OP (Operating Profit)

Can we replicate this for a levered firm?




                                                        5
Buying a Stake in an Unlevered Firm

YES!
2. Buy 1% of a levered firm:
   Outlay:               0.01 E (Equity of unlevered firm)
                +        0.01 D (Debt of unlevered firm)
                =        0.01 VL (Value of levered firm)
   Payoff:               0.01 I (interest)
                +        0.01 Div (Dividends, OP-I)
                =        0.01 I + 0.01 (OP - I) = 0.01 OP
Conclusion:
  Investors who buy 1% of all liabilities of a levered firm have the
  same payoffs as investors who buy 1% of the shares in an
  unlevered firm. VU = VL
                                                                       6
             Who should Borrow?
                       Firms or Investors?


Assume:
   Private investors can borrow and lend on the same terms as the
   corporation.
Example
1. Buy 1% of the equity of a levered firm:
   Outlay:                         0.01 E = 0.01 (VL - D)
   Payoff:                         0.01 Div = 0.01 (OP - I)
2. Buy 1% of the shares in an unlevered firm and borrow 1% of the
   debt level of the levered firm:
        Outlay                     0.01 VU - 0.01 D
        Payoff                     0.01 OP - 0.01 I
    * If investors can borrow on the same terms, then it does not
       matter who borrows. VU = VL.

                                                                    7
           Perfect Capital Markets:
        Leverage and the Cost of Capital
Firm
Value




   VU                                  VL




                                    DL/EL   8
Why Capital Structure is (Ir)relevant
Investor Preferences:
    Investors are willing to pay a premium for wider choice of
    securities if:
     » they prefer certain types of payoffs; (e. g. highly geared
        securities, securities offering hedges against certain risks)
          – and can’t create the securities themselves (e. g. cannot
            borrow)
          – and no other firm can offer these securities.
Is this realistic?
     » Recall NPV-rule:
          – are you protected from competition/imitation?
          – can your security be replicated? (Cf. options)
          – where could demand come from?

                                                                        9
     Leverage and the Cost of Capital
l   Consider an unlevered firm with earnings before interest and
    taxes of 100 in perpetuity and cost of capital of 10%.
     » Firm value is 1000
     » How is this affected by leverage?
l   Suppose the firm issues debt of 400 with interest of 7%.
     » Then dividends become:
       100-0.07*400=72
     » The value of equity becomes:
       1000-400=600
     » Hence, equity holders return is:
       72/600=12%
l   Hence, the return on the levered firm is unchanged!
       0.6*12%+0.4*7%=10%
l   How does this work generally?                                  10
        Leverage and the Cost of Capital:
                          The General Result

l   Modigliani-Miller Proposition II: In a perfect capital market, the firm’s
    weighted average cost of capital is invariant to its capital structure.
    Hence, r*L = r*U.
l   This implies the following relationship between the firm’s cost of equity
    and its leverage:
                          DL 
                        
    reL  r*L  r*L  rd  L 
                         E 
l   In a perfect capital market, r*L = r*U =reU. This represents a return to
    compensate investors for the inherent business risk of the assets of the
    firm.




                                                                                11
  Leverage and the Cost of Capital
                A Graphical Illustration


   Required                                        rLe
   Return



rUe= rU* =rL*
                                                   rLd

                                           DL/EL

                                                         12
        What Determines Risk?
                Market value balance sheet

Assets                               Liabilities
Market value of assets               Debt
                                     Equity
Total value of company               Total value of company
    Market value of assets
=   PV(Cash flow from operations)
=   PV(Cash flows - interest/principal) + PV(interest/principal)
=   Value of equity + value of debt
       The cost of capital does not depend on gearing.
    It depends only on the risk and return of operations.

                                                                   13
    The Weighted Average Cost of Capital
                  WACC
                           l   In a perfect capital market, the
                               firm’s weighted average cost
                               of capital (WACC)is calculated
                               as follows:

                                          EL       DL 
Cost of
                               r*L  reL  L   rd  L 
                                         V        V 
Capital

                           l   However, the WACC does not
                               depend on leverage.
    r* U
                    r*L




                          DL/EL                                   14
         Perfect Capital Markets:
     Leverage and the Cost of Capital
l   In addition to this business risk, there is a leverage effect.
     » The equityholders in the levered firm demand a higher return:
     » compensate them for higher risk of equity in a levered firm.
l   As leverage increases two things happen:
     » the equityholders demand higher returns.
     » we finance more projects by (relatively cheaper) debt.
l   In a perfect capital market, these two effects cancel exactly!




                                                                       15
         Perfect Capital Markets:
     Leverage and the Cost of Capital
l   The CAPM can be used to compute all of these discount rates:
     » Use the equity beta to compute the return on equity:
       E[reL] = rf + beL (E[rm]- rf).
     » Use the debt beta to compute the return on debt:
       E[rd] = rf + bd (E[rm]- rf).
     » Use the asset beta to compute a return commensurate with
       the business risk of the assets:
       E[reU] = rf + beU (E[rm]- rf).
l   Note that the beta of equity in an unlevered firm (beU) is also
    known as the beta of the assets (ba) since the unlevered firm
    has no leverage effect.
l   The only source of risk in the unlevered firm is the inherent
    business risk of the assets themselves.

                                                                      16
              Perfect Capital Markets:
          Leverage and the Cost of Capital
l   The firm’s asset beta is a weighted average of the debt and equity betas:
              DL       EL 
     ba  bd  L   be  L 
           L          L
             V        V 
l   This implies the following relationship between the firm’s equity beta and
    its leverage:

                                DL 
      b e  b a   b a  b d  L 
        L                   L
                               E 




                                                                                 17
      Capital Structure and Returns

Macbeth Spot Removers is 100% equity financed and considers a
debt/equity-swap.
Currently:
        $12m equity
        $2m operating income (perpetuity)
Plan:
        Retire equity worth $6m
        Expected return on debt: 10%
    » What is the required return on equity after the
      recapitalization?
    » What is the debt placed in the recapitalization worth?
    » What is the perpetual stream of dividends and interest?

                                                                18
            MacBeth Spot Removers

l   Issue $6m debt, retire $6m equity
     » Cash flows to firm remain unaffected
l   Uses of funds (in perpetuity):
     » Interest = 0.1*$6m=$600,000
     » Dividends = Operating Income - Interest = $1.4m
     » Return on equity = $1.4m/$6m=23.3%
l   Then cost of capital calculations give us:
     » WACC = 0.5*23.3%+0.5*10%=16.7%
     » Cost of capital=$2m/$12m=16.7%




                                                         19
                  Leverage and Beta

l   Assume a riskfree interest rate of rf = 10.0% and a market risk
    premium of [E(rM)-rf] = 8.0%.
     » Debt beta = 0
     » Asset beta =0.833
l   After the recapitalization we have:
     » Equity beta = 1.667
     » Debt beta = 0
     » Asset beta = 0.5*0+0.5*1.667=0.833
l   How does shareholder wealth changed?




                                                                      20
                  The impact of leverage:
           Another Example: East Western Airlines

l   East Western Airlines has 10 million shares out-standing,
     » Share price = $20 and a
     » equity beta = 1.0.
     » Plan issuing $50 million of 10% debt and using the proceeds to pay a
        dividend to shareholders; keep debt constant.
l   What effect will this capital structure change have on
     » the value of the firm
     » the WACC
     » the equity beta
     » the required return on equity
     » the wealth of the firm’s shareholders?
l    Assume a riskfree interest rate of rf = 6.0% and a market risk premium of
    [E(rM)-rf] = 8.0%.
                                                                             21
             East Western Airlines (cont.)
l   Value of the Unlevered Firm:
           VU = 10(20) = 200 million.
l   Cost of Capital for the Unlevered Firm:
            E[reU] = rf + beU (E[rm]- rf).
            E[reU] = 0.06 + 1.0 (0.08) = 0.14.
l   Since the firm is unlevered, the value of equity and cost of equity are the
    same as for the firm as a whole.
l   In perfect capital markets, VL = VU and r*L = r*U.
         VL = VU = $200 million
         r*L = r*U = 14.0%
l   Since the cost of debt is 10.0%, the cost of equity is determined as
    follows:
           reL = reU + [reU -rd ](D/E)
           reL = 0.14 + [0.14 - 0.10 ](50/150) = 0.1533.
                                                                              22
        The impact of leverage - Example
                     (cont.)
l   The equity beta can be determined from the CAPM as follows:
         E[reL] = rf + beL (E[rm]- rf).
         0.1533 = 0.06 + beL (0.08).
         beL = 1.167.
l   The wealth of the firm’s shareholders has not changed.
    Shareholder Wealth = Share Value + Dividend
                           = $150 + $50 = $200 million




                                                                  23
   Corporate Taxes and Leverage
Capital Structure matters if some securities enjoy favourable tax
treatments.
Suppose firm pays out $1 from operating income:
                     $1 EBIT

     Debt                                     Equity

     $1                                       $1(1-TC)

Hence, on debt value D, pay interest rDD and receive tax shield:
rDDT.
What is the tax shield worth?
How does this affect the cost of capital?
                                                                    24
   Valuing the Corporate Tax Shield
Assume capital structure and interest rate are constant. Then:

                      rD DT     r DT            r DT
Value of tax shield =        D           ... D     DT
                      1  rD ( 1  rD )2
                                                  rD

Value of levered company:

        VL = E + D + DT = VU + DT

What is the optimal capital structure now?
What is missing here?
        – Ignores personal taxes
        – Ignores other costs of debt (financial distress)

                                                                 25
              Valuing a Tax Shield
                 Macbeth Spot Removers

Reconsider Macbeth Spot Removers
  Suppose Macbeth pays 10% interest on debt and 34%
  corporation tax on income after interest expenses.
  What is the income statement before/after the recapitalization?
  Capital Structure (Debt)             0                6,000
  EBIT
  Interest
  Pre-tax income
  Tax
  After tax income
  Total income


                                                                    26
                Valuing a Tax Shield
                  Macbeth Spot Removers
l   Assume the debt level is constant at $6m. Then the value of the
    levered firm is:
         VL = VU +TD
         VL = $12m +(0.34)($6m) =$14.04m
l   The value of equity changes from $12m for the unlevered firm
    to:
         $14.04m - $6m = $8.04m
    Hence the price drop on the ex dividend day is:
          $12m-$8.04m=$3.96m
    Shareholders receive a special dividend of $6m. Then total
    shareholder value is:
         Share price + dividend = $8.04m + $6m = $14.04m
    which is an increase of $2.04m
         – where do they come from?
                                                                      27
Who Benefits from the Interest Tax Shields?
              East Western Airlines Reconsidered

 l   Reconsider the East Western Airlines case:
      » The firm’s tax rate is 34%.
      » How does this capital structure change affect the value of the firm and
         the wealth of the firm’s shareholders?
 l   Since the debt is perpetual, the value of the firm will increase as follows:
           VL = VU +TD
           VL = 200 +(0.34)(50) = 217 million.
 l   Since the debt is issued at fair market value, the value of equity after the
     capital structure change is:
       Equity Value = $217 - $50 = $167 million.
 l   Since the proceeds from the debt issue are used to pay a dividend to
     shareholders, their wealth increases by $17 million. This is the value of
     the interest tax shields on debt.
     Shareholder Wealth = Share Value + Dividend
                            = $167 + $50 = $217 million                         28
 The Effect of Corporate Taxes and
  Leverage on the Cost of Capital

             l   With corporate taxes, the firm’s
                 weighted average cost of capital
Cost of          is calculated as follows:
Capital
                            EL               DL 
    r *U         r*L  reL  L   rd 1    L 
                           V                V 




                                                r *L


                                                  DL/EL
                                                          29
                  Problems of Debt
                 The costs of financial distress


    A firm which is unable, or expects to be unable, to meet its debt
    obligations is in financial distress; this is costly:
l   Direct costs (legal fees, administrator); usually small (typically
    3% of the market value of the firm)
l   Costs from losses on asset values in a “fire sale”.
l   Losses from business opportunities
      » customers and suppliers.
l   Losses from constraints on conducting business during
    corporate reorganizations.
    Indirect costs can be substantial (20% of the value of the firm).



                                                                         30
    Identify Firms with Value at Risk

l   What are the characteristics of firms with low / high costs of
    financial distress?
      » Growth opportunities
      » Tangible assets
      » Riskiness of cash flows




                                                                     31
             The “Trade-off Theory”

Firm value with leverage is now:
VL = VU + PV(Tax shield) - PV (Costs of financial distress)
Costs of distress
  =     costs of bankruptcy x probability of bankruptcy

l   The probability of bankruptcy increases with the debt ratio,
    hence higher debt ratios imply higher expected costs of financial
    distress.
l   The optimum debt ratio trades off increases in the costs of
    distress against increases in the tax shield:



                                                                        32
             The “Trade-off”
             A Graphical Presentation


Firm Value

                                 PV(Cost of Distress)

             PV(Tax Shield)




                                            Debt Ratio
                 Optimum
                                                         33
                  Problems of Debt
          Limited Liability and Risky Investments

Problem:
   Managers have incentives to take negative NPV projects if
   indebtedness is too high.
Example:
   Firm has following asset values:
                                       Debt Equity
        Prob = 1/5              100    50     50




        Prob = 4/5                25     25     0
Debt has a face value of 50.
What is the investment policy of the firm?
                                                               34
  Investment in a Levered Company
                    Do Managers Gamble?


Then we have the following market value balance sheet:

   Assets                40              Equity            10
                                         Debt              30
The firm has the following investment project:

                Prob = 1/5                40

   - 10

                Prob = 4/5                 0
The NPV of this project is -10*4/5+30/5=-2. Will the firm take it?
                                                                     35
 Value Implications of Risky Projects

Equity holders decide on the basis of the value implications for
shareholders:

                                         Debt     Equity
        Prob = 1/5               130     50       80




        Prob = 4/5                15     15        0




                                                                   36
    Risky Projects: a Conflict of Interest

The market value balance sheet now looks like:
  Assets       38              Equity                       16
                               Debt                         22
l   Hence, taking the negative NPV project has:
     » reduced the value of the firm by 2
     » increased the value of equity by 6
     » reduced the value of debt by 8 (6+2).
l    Risky projects with negative NPV can induce a conflict of
    interest between bondholders and stock-holders.
l    If bondholders foresee this, they will either:
      » impose covenants, or
      » require higher interest; hence, higher cost of capital

                                                                 37
       The Debt-Overhang Problem


Now, consider an alternative project the firm may take:

                         Prob = 1/5              5

        - 10

                         Prob = 4/5              15


The NPV of this project is -10 + 5*1/5 +15*4/5 = +3.

        Will equity holders take this project?

                                                          38
                Value Implications
                    The overborrowing-trap



                                      Debt    Equity
       Prob = 1/5              95     50      45




       Prob = 4/5              30     30       0


The value of equity has now been reduced to 45*1/5=9.




                                                        39
  The Conflict of Interest - Reversed

The market value balance sheet becomes:

        Assets 43               Equity                   9
                                Debt                    34
Hence, taking this project:
   » increases the value of the firm by 3
   » reduces the value of equity by 1
   » increases the value of debt by 4 (1+3)
Equity-holders would loose; project cannot be financed through
equity (or junior debt). Positive NPV is lost. Only solution:
    » lower gearing
    » renegotiate debt

                                                                 40
    Factors that Influence Debt
         Policy in Practice
l   Tax Position of the Corporation
l   Costs of Bankruptcy and Financial Distress
l   Variability of the Firm’s Earnings and Cash Flows
l   Asset Type: Tangible vs. Intangible Assets
l   Investment (or Growth) Opportunities
l   The Need for Financial and Operating Flexibility
l   Informational Asymmetries




                                                        41
                Accounting for Leverage
                 in Capital Budgeting
l   Each investment project has its own cost of capital that depends upon
    the risk of the investment.
     » NPV must be computed using a discount rate appropriate for the
        project, not the firm.
l   The risk of the investment project depends upon its unlevered (asset)
    beta.
l   The unlevered cost of capital can be estimated using the CAPM.
l   The project’s leverage ratio should depend upon its own debt capacity,
    not on the particular source of funds used to finance the project.




                                                                             42
                Accounting for Leverage
                 in Capital Budgeting
l   How do we find this?
     » Step 1: Compute the beta of the assets by unlevering another firm’s
       equity beta.
     » Step 2: Use the CAPM to determine a required return to compensate
       investors for bearing this inherent business risk.
     » Step 3: Use this required return to find the NPV.




                                                                         43
               Capital Budgeting Example
l   Your firm is currently in the computer software business, but is considering
    investing in the development of a new airline. Information on your firm and
    the airline industry are given below:


                                            Your          Airline
                                            Firm         Industry
         Equity Beta                        1.20           1.95
         Debt-Equity Ratio                     0            67%
         Ave. Cost of Debt                      -           10%


                                                                              44
               Capital Budgeting Example
l   Your airline project is expected to cost $20 million per year for the next 5
    years and is expected to generate after-tax cash flows of $10 million per
    year indefinitely thereafter.
l   Because of your firm’s current debt position, you will finance the airline
    project with 50% debt, even though this is less than standard for airline
    projects.
l   The corporate tax rate is 34%, the riskfree interest rate is 9%, and the
    market risk premium is 8%.




                                                                                   45
             Capital Budgeting Example
l   Step 1: Unlever Equity Beta for Airlines

                       E  b
       b a  b Equity              D
                      V      Debt  
                                    V

l   The debt beta, bD comes from the CAPM:
      rd  0.10  0.09  b d 0.08
       b d  0.125

      b a  1.95 * 0.6  0.125 * 0.4  1.22




                                               46
                Capital Budgeting Example
l   Step 2: Calculate the Unlevered Cost of Capital

     r*U  0.09  1.220.08  0.1876
l   Step 3: Calculate the NPV of the Project
                          5
                   $10            $20
    NPV                              37.61million
          t 6 (11738) t t 1 (11738) t
                 .              .




                                                          47
                         Summary

l   Capital structure is irrelevant
     » unless there are market imperfections to exploit
l   Leverage changes the required rates of return on debt and
    equity,
     » but not the required rate of return on a company
     » unless taxes are important
l   Take into account costs of debt
     » costs of financial distress
     » costs from overborrowing problem
     » induce managers to gamble



                                                                48

								
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