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					Finance                                   School of Management




    Chapter 16: Capital Structure


                        Objective
                  • To understand how to create value through
                              financing decisions
                   • To show how to take account of capital
                            structure in evaluating investment
                                   decisions
                                           1
Finance                                                     School of Management




                  Chapter 16: Contents
         Internal Versus External Financing
         Equity Financing
         Debt Financing
         The Irrelevance of Capital Structure in a Frictionless Environment
         Creating Value through Financing Decisions
         Reducing Costs
         Dealing with Conflicts of Interest
         Creating New Opportunities for Stockholders
         Financing Decisions in Practice
         How to Evaluate Levered Investments



                                                            2
Finance                                            School of Management




      Internal Versus External Financing
     Internal financing arises from the operations of the firm
       – Retained earnings
       – Accrued wages
       – Accounts payable
     External financing occurs whenever the corporation's
      managers raise funds from outside lenders or investors
       – Issuing bonds
      – Issuing stocks



                                                   3
Finance                                                    School of Management




     Internal Versus External Financing
         Internal financing              External financing
          – well established and not       – major expansions
            undertaking any major          – complicated and time
            expansions                       consuming process and the
          – less managerial time and         detailed plans are needed
            effort                         – the discipline of the capital
          – routine and automatic            market
            financing decisions


                             Which one is better?

                                                            4
Finance                                               School of Management




                   Equity Financing
     Equity is a claim to the residual that is left over after all
      debts have been paid
     Three major types of equity claim (Residual Claim)
       – Common stock: class A common stock/ class A common
         stock/restricted stock…
       – Preferred stock
       – Stock options




                                                      5
Finance                                            School of Management




                   Debt Financing
     Corporate debt is a contractual obligation on the part of
      the corporation to make promised future payments in
      return for the resources provided to it
     Debt financing includes:
       – Loans
       – Debt securities: bonds/mortgages
       – Others: accounts payable/leases/pension liability




                                                   6
Finance                                                School of Management




                      Secured Debt
     If the corporation pledges a particular asset as
      security for promise to make a series of payments in
      the future, the debt is called secured debt
      – collateral is the asset pledged as security
      – have the first priority on collateralized assets
      – is similar to a mortgage loan of individual




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Finance                                                School of Management




                   Long-Term Leases
     Leasing a asset is similar to buying the asset and
      financing the purchase with debt secured by the 1eased
      asset
       – The debts of two hypothetical airlines :
           • Airbond Corp. : 30-years secured debt
           • Airlease Corp. : 30-years lease
      – The main difference between the secured bonds and the
          lease is in who bears the risk associated with the residual
          market value
           • Airbond Corp. : itself
           • Airlease Corp. : lessor



                                                        8
Finance                                              School of Management




                Pension Liabilities
     Pension plans are classified into two types:
      – Defined-contribution pension plan
      – Defined-benefit pension plan
          • Funded pension plan (U.S./U.K.): the pension
           liabilities are a form of corporate debt secured by the
           pension assets as collateral (such as stocks, bonds,
           mortgages, etc. )
          • Unfunded pension plan (Germany)



                                                     9
Finance                                              School of Management



     The Irrelevance of Capital Structure
       in A Frictionless Environment
    Modigliani and Miller (M & M, 1958) showed that
            In an economist's idealized world of frictionless
          markets, the total market value of all the securities
          issued by a firm would be governed by the earning
          power and risk of its underlying real assets and would
          be independent of how the mix of securities issued to
          finance it was divided



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Finance                                            School of Management




    M&M’s Frictionless Environment
         No income taxes
         No transactions costs of issuing debt or equity
          securities
         Investors can borrow on the same terms as the firm
         The various stakeholders of the firm are able to
          costlessly resolve any conflicts of interest among
          themselves

     In this frictionless environment, the total market value
     of the firm is independent of its capital structure

                                                   11
Finance                                                        School of Management




              An Illustration: M & M
  Nodett Corp. (All-Equity)               Somedett Corp. (Levered)
    Earnings per year (EBIT) is         EBIT has the same expected value and
     $10 millions                         risk characteristics as Nodett’s
    Pays out all EBIT as dividends      Has issued bonds that have a face
     to holders                           value of $40 million at a interest of 8%
    The market capitalization rate       per year
     is 10% per year                     Interest is $3.2 (0.08* $40 ) million per
    Equity value will be $10             year
     millions/0.1= $100 millions         Somedett’s bonds are default free and
    Its price per share would be         riskless rate of interest is 8% per year
     $100                                The number of shares of its stock is
                                          60% of Nodett’s

                                                                12
Finance                                               School of Management




               An Illustration: M & M
         M & M Capital Structure Irrelevance Proposition
          implies that the market value of Nodett and Somedett
          will be same because they offer exactly the same future
          cash flows
           – Because the interest payments on Somdett’s bonds are
             assumed to be riskless, the bonds will have a market
             value equal to their $40 million face value
           – The market value of Somedett’s equity should be $60
             million ($100 million total firm value- $40 million of
             debt), the price of a share should be $100


                                                      13
Finance                                                                  School of Management




                      Arbitrage Arguments
                            When Somedett Sells for $90 per Share
                                         Immediate
                     Position                            Cash Flow in the Future
                                         Cash Flow
          Sell short 1% of the share
          of Nodett stock at $100 $1,000,000                    -1% of EBIT
          per share
          Buy Replicating Portfolio (Synthetic Nodett)
            Buy 1% of the shares of
          Somedett at $90 per share
                                         -$540,000   1% of (EBIT-$3.2 million per year)
            Buy 1% of the bonds of
                                         -$400,000       1% of $3.2 million per year
          Somedett
           Total replicating portfolio   -$940,000              1% of EBIT

          Net Cash Flows                  $60,000                    0



                                                                         14
Finance                                                                         School of Management




                      Arbitrage Arguments
                           When Somedett Sells for $110 per Share
                                             Immediate
                  Position                                     Cash Flow in the Future
                                             Cash Flow
      Sell short 1% of the
      share of Somedett stock      $660,000    -1% of (EBIT-$3.2 million per year)
      at $110 per share
      Buy Replicating Portfolio (Synthetic Somedett)
        Buy 1% of the shares of
      Nodett at $100 per share
                                             -$1,000,000              1% of EBIT

         Borrowing $400,000             in
                                              $400,000             -$32,000 per year
      perpetuity
          Total replicating portfolio        -$600,000     1% of (EBIT-$3.2 million per year)
      Net Cash Flows                          $60,000                      0


                                                                                15
Finance                                                                       School of Management




                         Arbitrage Arguments
            Probability Distribution of EBIT and EPS for Somedett and Nodett
                                        Nodett                           Somedett
          State of the
                                                 EPS                                EPS
          Economy            EBIT                            Net Earnings
                                        (1 million shares)                   (600,000 shares)
          Bad business     $5 million            $5           $1.8 million          $3.00
          Normal business     10                 10                6.8              11.33
          Good business       15                 15               11.8              19.67
          Mean                10                 10                6.8              11.33
          Standard deviation                      4                                  6.81
          Beta                1.0                1.0                                1.67


          Increase of financial leverage will increase both the
          mean EPS and the risk of EPS.

                                                                              16
Finance                                    School of Management




              Implication of M & M
     In     a frictionless environment, M&M
          analysis implies that capital structure
          does not matter and the wealth of
          existing shareholders will not be affected
          by either reducing or increasing the
          firm’s debt ratio


                                           17
Finance                                            School of Management




Creating Value through Financing Decisions

         In the real world there are frictions of many
          sorts, however, management can add value
          through its capital structure decisions
           – reduce its costs or circumvent burdensome
             regulations
           – reduce potentially costly conflicts of interest
             among various stakeholders in the firm
           – provide stakeholders with financial assets


                                                   18
Finance                                                        School of Management




                       Reducing Costs
         Corporate income taxes and subsidies
             CFSomedett = Net Earnings + Interest
                        = .66(EBIT – Interest) + Interest
                        = .66EBIT + .34Interest
                        = CFNodett + .34Interest

    Somdett's market value is maximized by having as much debt as possible


  Market Value of Somdett = Market Value of Nodett + PV of Interest Tax Shield



                                                               19
Finance                                               School of Management




                    Reducing Costs
      As the proportion of debt in a firm's capital structure
       increases, so too does the likelihood that firm might
       default on its debt
      Firms that are in imminent danger of defaulting on
       their debt obligations are said to be in financial distress
      Cost of financial distress
        – the time and effort of the firm’s managers
        – fees paid to lawyers specializing in bankruptcy
          proceedings
        – lost business because of the threat of bankruptcy


                                                      20
Finance                                                  School of Management




          Trade-off Between Taxes and
               Financial Distress
     Stock Price
         or           Effect of the Debt Ratio on Stock Price
     Firm Value

          Maximum                 ●



                    Tax Shields        Financial Distress &
                     Dominate         Bankruptcy Dominate




                     Low     Optimum       High       Debt Ratio
                                                         21
Finance                                                School of Management



        Managers-Shareholders Incentive
          Problems: Free Cash Flow
         When managers have a lot of discretion about how to
          allocate a firm's cash flows, there is a temptation to
          use the cash to invest in projects that
           – do not increase the wealth of shareholders (NPV<0)
           – increase the power, prestige, or perks of the managers
         Debt financing will lessen the conflicts by reducing the
          amount of free cash flow available to managers
          because the payments of interest and principle to
          debtholders are prescheduled

                                                       22
Finance                                        School of Management



          Shareholders-Creditors Incentive
             Problems: Overinvestment
         Because of limited liability of shareholders,
          managers acting in the best interests of
          shareholders have incentive to undertake
          more volatile investments that have the effect
          of increasing the wealth of shareholders at the
          expense of the debtholders



                                               23
Finance                                                    School of Management




     Overinvestment: An Illustration
         Suppose the firm’s current assets are worth $100
          million, and the firm has debt with a face value of
          $ 104 million maturing a year from now. Consider
          the investment alternatives:
          – Investing in riskless T-bills maturing in one year pay an
            interest rate of 4%
          – Investing in a venture that will either be worth $ 200
            million or nothing a year from now (be choosed)
  Moral hazard problem: managers might have an incentive to redeploy
  the firm’s assets in a way that actually reduces the firm’s total value
  in order to increase the equity value.
                                                           24
Finance                                              School of Management




                       Agency Costs
         Agency costs is the costs induced by the potential
          conflicts of interest among various stakeholders in
          the firm
         As the increase of the amount of the debt, the
          agency costs induced by the conflicts of interest
           – between managers and shareholders will decrease
           – between shareholders and creditors will increase
         There should have a optimal level of debt in the
          firm’s capital structure


                                                     25
Finance                                      School of Management



          Creating New Opportunities for
                   Stakeholders
     By altering the claims it issues to stakeholders,
      the firm can create value without any change in
      the size or composition of its operating assets
       – Pension Promises as a form of corporate
         financing




                                             26
Finance                                           School of Management




     Financing Decisions in Practice
         Financing decisions always involve trade-offs
          that depend on the specific circumstances of
          the firm
          – Debt with Warrants: Orr Oil Company
          – Leasing Arrangement: Gormeh Foods, Inc.
          – Factoring Receivables: Bombay Textile Company
          – Loans from “Family”: Holey’s Burger Queen
          – Common Stock: Lee Productions



                                                  27
Finance                                               School of Management




  Evaluation of Levered Investments
         In chapter 6, we studied that a firm should accept any
          project that has a positive net present value (NPV)
         Alternative methods to take into account a company’s
          capital structure in evaluating investment projects
          – Adjusted present value (APV)
          – Flows to equity (FTE)
          – Weighted average cost of capital (WACC)




                                                      28
Finance                                                           School of Management




                    An Illustration: GCC
         Current capitalization of Gcc is
          $1 billion
                                                  Unlevered Expected Cash Flow
         New investment requires an
                                                = (1-0.3) × ($20 million - $5 million)
          initial outlay of $100 billion, and
                                                = 0.7 × $15 million
          annual maintenance expense is
                                                = $10.5 million
          $5 million (lasts indefinitely)
         The increased revenues are $20
                                                  NPV without Leverage
          million per year
                                                = PV of Revenues-Initial Outlays
         The Gcc debt is riskless with an      = $10.5 million/0.1 -$100 million
          interest rate of 8% per year          = $5 million
         Tax rate is 30%
         The required rate of return on
          unlevered investments is 10% per
          year
                                                                  29
Finance                                                    School of Management




  The Adjusted Present Value (APV)
          APV= Unlevered PV + PV of Incremental Tax Shield
             = Unlevered PV + Tax Rate*Amount of New Debt

  The amount of new debt (perpetual) created by taking the project
    is 20% of the increase in the market value of the firm, or
    0.2*APV of the project
          APV= Unlevered PV + PV of Incremental Tax Shield
                = $105 million + 0.06×APV
                = $105 million / 0.94= $111.7 million
         ANPV= Unlevered NPV + PV of Incremental Tax Shield
                = $5.0 million + $6.70 million= $11.7 million

                                                           30
Finance                                                        School of Management




           The Flows to Equity (FTE)
     The    cost of equity capital, ke
                             ke  k  (1  t )( k  r )d
        where
                k = the cost of capital with no leverage
                t = the tax rate
                r = the rate of interest on the debt (default free)
                d = market debt-to-equity ratio
       Increase in the present value of equity
          E=Increase in incremental cash flow to shareholders/ke



                                                                31
Finance                                                                      School of Management




            The Flows to Equity (FTE)
   Since GCC maintain a fixed debt-to-equity ratio
                                     d = 0.20 / 0.80=0.25
     we have
                  ke  0.10  (1  0.30 )  (0.10  0.08 )  0.25  0.1035
   The expected incremental after-tax cash now to GCC's shareholders

          CFS = Unlevered Expected Cash F1ow-After-tax Interest Expense
              = $105 million -(1-t)×r×Debt
              = $105 million - 0.70×0.08×Debt
              = $105 million - 0.056×Debt



                                                                             32
Finance                                                    School of Management




          The Flows to Equity (FTE)
   The Present value of equity outstanding is
                        E = CFS/ke
                           = $101.45 million-0.5411×Debt
                           = $101.45 million-0.5411×0.25×E
                           = $101.45 million-0.1353×E
                           = $101.45 milion/1.1353
                           = $89.36 million
   The NPV to the shareholders from undertaking the project is the
    present value of equity outstanding-the amount of new equity to be
    issued to finance the project ($100 million -0.25×$89.36 million) is
                $89.36 million- $77.66 million =$11.70 million


                                                            33
Finance                                                      School of Management




 The Weighted Average Cost of Capital
   The weighted average cost of capital, WACC, is
                                  1                d
                    WACC  k e        (1  t ) r
                                1 d              1 d
                            0.1035  0.80  0.7  0.08  0.20
                            0.094
     The NPV of the project is computed as the expected unlevered after-
      tax annual cash flow discounted at the WACC less the initial outlay
          NPV = Unlevered Expected Cash Flow/WACC- Investment Cost
             = $10.5 million/0.094- $100 million
             = $11.7 million


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