Docstoc

Capital Structure_ PowerPoint Show - PowerPoint

Document Sample
Capital Structure_ PowerPoint Show - PowerPoint Powered By Docstoc
					Chapter 15

  Capital Structure Decisions:
              Part I


                                 1
Topics in Chapter
   Overview of capital structure effects
   Business versus financial risk
   The impact of debt on returns
   Capital structure theory, evidence, and
    implications
   Choosing the optimal capital structure:
    An example

                                              2
     Basic Definitions
   V = value of firm
   FCF = free cash flow
   WACC = weighted average cost of capital
   rs and rd = costs of stock and debt
   wce and wd = percentages of the firm that
    are financed with stock and debt

                                                3
  Capital Structure and Firm Value

         ∞        FCFt
 V   =   ∑                    (15-1)


         t=1   (1 + WACC)t

WACC= wd (1-T) rd + wcers     (15-2)




                                       4
Capital Structure Effects
Preview
   The impact of capital structure on
    value depends upon the effect of
    debt on:
     WACC
     FCF




                                         5
The Effect of Debt on WACC
   Debt increases the cost of equity, rs
       Debt holders have a prior claim on cash flows
        relative to stockholders.
       Debtholders’ “fixed” claim increases risk of
        stockholders’ “residual” claim.
   Debt reduces the firm’s taxes
       Firm’s can deduct interest expenses.
       Frees up more cash for payments to investors
       Reduces after-tax cost of debt

                                                        6
The Effect of Debt on WACC
   Debt increases risk of bankruptcy
       Causes pre-tax cost of debt to increase
   Adding debt:
       Increases percent of firm financed with
        low-cost debt (wd)
       Decreases percent financed with high-cost
        equity (wce)
       Net effect on WACC = uncertain
                                                    7
    The Effect of Debt on FCF
    debt   probability of bankruptcy
       Direct costs:
            Legal fees
            “Fire” sales, etc.
       Indirect costs:
            Lost customers
            Reduction in productivity of managers and line
             workers,
            Reduction in credit (i.e., accounts payable)
             offered by suppliers                             8
The Effect of Additional Debt
   Impact of indirect costs
        Sales &  Productivity
            Customers choose other sources
            Workers worry about their jobs
       NOWC 
            Suppliers tighten credit
       NOPAT 
       FCF 

                                              9
    The Effect of Additional Debt
    on Managerial Behavior
   Reduces agency costs:
       Debt reduces free cash flow waste
   Increases agency costs:
       Underinvestment potential




                                            10
    Asymmetric Information
    and Signaling
   “Asymmetric Information” = insiders know
    more than outsiders
        Managers know the firm’s future prospects better
         than investors.
Managers would not issue additional equity if
  they thought the current stock price was less
  than the true value of the stock
= Investors often perceive an additional
  issuance of stock as a negative signal
         Stock price 
                                                            11
Business Risk vs. Financial Risk
   Business risk:
       Uncertainty about future EBIT
       Depends on business factors such as
        competition, operating leverage, etc.
   Financial risk:
       Additional business risk concentrated on
        common stockholders when financial
        leverage is used

                                                   12
 Business risk: Uncertainty about future
 pre-tax operating income (EBIT).

         Probability
                            Low risk


                               High risk


              0   E(EBIT)              EBIT
Note: Business risk focuses on operating
      income, ignoring financing effects.

                                              13
Factors That Influence
Business Risk
1. Demand variability (uncertainty unit sales)
2. Sales price variability
3. Input cost variability
4. Ability to adjust output prices for changes
   input costs
5. Ability to develop new products
6. Foreign risk exposure
7. Degree of operating leverage (DOL)

                                                 14
Operating Leverage
   Operating leverage is the change in
    EBIT caused by a change in quantity
    sold.
   > Fixed costs  > Operating leverage
       The higher the proportion of fixed costs
        within a firm’s overall cost structure, the
        greater the operating leverage.


                                                      15
Figure
15.1
Illustration
of
Operating
Leverage




               16
Higher operating leverage leads to more
business risk: small sales decline causes a
larger EBIT decline.


            Rev.                  Rev.
  $                     $
                   TC                } EBIT
                                          TC

                                           F
                   F

      QBE    Sales                       Sales
                            QBE


                                                 17
Strasburg Electronics Company




                                18
Strasburg Expected Sales




                           19
Strasburg Plan A




Figure 15-1 Lower Panel

                          20
Strasburg Plan B




Figure 15-1 Lower Panel

                          21
Strasburg: Plans A & B




Figure 15-1 Upper Panel

                          22
Operating Breakeven: QBE
        QBE = F / (P – V)      (15-4)

   QBE    = Operating breakeven quantity
   F      = Fixed cost
   V      = Variable cost per unit
   P      = Price per unit

                                            23
Strasburg Breakeven




                      24
Strasburg: Plans A & B




                         25
  Higher operating leverage leads to higher
  expected EBIT and higher risk.


                       Low operating leverage
Probability
                           High operating leverage




               EBITL      EBITH


                                                 26
Strasburg & Financial Risk
   Strasburg going with Plan B
       Riskier
       Higher expected EBIT and ROIC
   Financial risk:
       Additional business risk concentrated on
        common stockholders when financial
        leverage is used


                                                   27
Strasburg - Extended
   To date – no debt
   Two financing choices:
       Remain at 0 debt
       Move to $100,000 debt and $100,000
        book equity




                                             28
Table 15.1
Strasburg
Electronics
– Effects of
Financial
Leverage




               29
  Strasburg with No Debt
                                         Table 15-1 Section I




ROE = Net Income/Book Equity
Expected ROE = ROE under each demand X Probability

                                                                30
Strasburg with 50% Debt

               Table 15-1 Section II




                                       31
Strasburg w/
Zero Debt




Strasburg w/
50% Debt



Higher ROE
Higher Risk
               32
Leveraging Increases ROE
   More EBIT goes to investors:
       Total dollars paid to investors:
            I: NI = $24,000
            II: NI + Int = $18,000 + $10,000 = $28,000
       Taxes paid:
            I: $16,000; II: $12,000
   Equity $ proportionally lower than NI


                                                          33
Strasburg’s Financial Risk
   In a stand-alone sense, stockholders
    see much more risk with debt.
       I: σROE = 14.8%
       II: σROE = 29.6%
   Strasburg’s financial risk = σROE - σROIC
    = 29.6% - 14.8% = 14.8%

                                                34
Capital Structure Theory
   Modigliani & Miller theory
       Zero taxes (MM 1958)
       Corporate taxes (MM 1963)
       Corporate and personal taxes (Miller 1977)
   Trade-off theory
   Signaling theory
   Pecking order
   Debt financing as a managerial constraint
   Windows of opportunity
                                                     35
MM Results: Zero Taxes
   If two portfolios (firms) produce the
    same cash flows, then the two
    portfolios must have the same value.

A firm’s value is unaffected by its
 capital structure


                                            36
 MM (1958) Assumptions
1. No brokerage costs
2. No taxes
3. No bankruptcy costs
4. Investors can borrow and lend at the
   same rate as corporations
5. All investors have the same information
6. EBIT is not affected by the use of debt

                                             37
MM Theory: Zero Taxes
                           Firm U         Firm L
EBIT                      $3,000          $3,000
Interest                        0          1,200
NI                        $3,000          $1,800


CF to shareholder         $3,000          $1,800
CF to debt holder               0         $1,200
Total CF                  $3,000          $3,000
Notice that the total CF are identical.
                                                   38
MM Results: Zero Taxes
   MM prove:
       If total CF to investors of Firm U and Firm L are
        equal, then the total values of Firm U and Firm L
        must be equal:
        VL = VU
   Because FCF and values of firms L and U
    are equal, their WACCs are equal
   Therefore, capital structure is irrelevant


                                                            39
    MM (1963): Corporate Taxes
   Relaxed assumption of no corporate
       taxes
   Interest may be deducted, reducing taxes
       paid by levered firms
   More CF goes to investors, less to taxes
       when leverage is used
   Debt “shields” some of the firm’s CF from
       taxes

                                                40
    MM Result: Corporate Taxes
   MM show that the value of a levered firm
    = value of an identical unlevered form +
    any “side effects.”
            VL = VU + TD            (15-7)

   If T=40%, then every dollar of debt adds
    40 cents of extra value to firm


                                               41
    MM relationship between value and debt
    when corporate taxes are considered.
  Value of Firm, V

                                      VL
                                 TD
                                      VU

                                           Debt
    0

Under MM with corporate taxes, the firm’s value
increases continuously as more and more debt is used.
                                                        42
   MM relationship between capital costs and
   leverage when corporate taxes are considered


 Cost of
Capital (%)
                                    rs




                                    WACC
                                    rd(1 - T)
                                        Debt/Value
    0         20   40   60   80   100    Ratio (%)
                                                     43
        Miller (1977): Corporate and
        Personal Taxes
   Personal taxes lessen the advantage of
    corporate debt:
      Corporate taxes favor debt financing

           Interest expenses deductible
       Personal taxes favor equity financing
         No gain is reported until stock is sold
         Long-term gains taxed at a lower rate




                                                    44
Miller’s Model with Corporate
and Personal Taxes

             (1 - Tc)(1 - Ts)
VL = VU + 1−                    D   (15-8)
                  (1 - Td)
Tc = corporate tax rate.
Td = personal tax rate on debt income.
Ts = personal tax rate on stock income.


                                             45
 Tc = 40%, Td = 30%,
 and Ts = 12%

               (1 - 0.40)(1 - 0.12)
VL = VU + 1−                          D
                     (1 - 0.30)
   = VU + (1 - 0.75)D
   = VU + 0.25D

Value rises with debt; each $1 increase in
debt raises Levered firm’s value by $0.25.
                                             46
Trade-off Theory
   MM theory assume no cost to bankruptcy
   The probability of bankruptcy increases as
    more leverage is used
       At low leverage, tax benefits outweigh
        bankruptcy costs.
       At high levels, bankruptcy costs outweigh tax
        benefits.
   An optimal capital structure exists
    (theoretically) that balances costs and
    benefits.
                                                        47
Figure 15.2
Effect of Leverage on Value




                              48
Signaling Theory
   MM assumed that investors and
    managers have the same information.
   Managers often have better information
    and would:
       Sell stock if stock is overvalued
       Sell bonds if stock is undervalued
   Investors understand this, so view new
    stock sales as a negative signal.
                                             49
    Pecking Order Theory
   Firms use internally generated funds first (1):
        No flotation costs
        No negative signals
   If more funds are needed, firms then issue
    debt (2)
        Lower flotation costs than equity
        No negative signals
   If more funds are still needed, firms then
    issue equity (3)

                                                      50
Pecking Order Theory

          INTERNAL EXTERNAL
 DEBT                 2
 EQUITY      1        3




                              51
Debt Financing & Agency Costs
   Agency problem #1: Managers use
       corporate funds for non-value
       maximizing purposes
   Financial leverage:
       Bonds commit “free cash flow”
       Forces discipline on managers to avoid
         perks and non-value adding acquisitions.
       LBO = ultimate use of debt controlling
         management actions
                                                    52
    Debt Financing & Agency Costs
   Agency problem #2: “Underinvestment”
     Debt increases risk of financial

      distress
     Managers may avoid risky projects

      even if they have positive NPVs




                                           53
Investment Opportunity Set and
Reserve Borrowing Capacity
   Firms should normally use more
    equity, less debt than optimal
      “Reserve borrowing power”

      Especially important if:

       Many investment opportunities
       Asymmetric information issues cause

        equity issues to be costly

                                              54
  Windows of Opportunity
  Managers try to “time the market” when
             issuing securities.
Issue      When              And
Equity     Market is “high” Stocks have “run up”
Debt       Market is “low”   Interest rates low
S/T Debt      Term structure is upward sloping
L/T Debt            Term structure is flat
                                                   55
Empirical Evidence
   Tax benefits are important
       $1 debt adds  $0.10 to value
       Supports Miller model with personal taxes
   Bankruptcies are costly
       Costs can =10% to 20% of firm value
   Firms don’t make quick corrections
    when Δstock price  Δdebt ratios
       Doesn’t support trade-off model
                                                    56
Empirical Evidence
   After stock price , debt ratio , but firms
    tend to issue equity not debt
       Inconsistent with trade-off model
       Inconsistent with pecking order
       Consistent with windows of opportunity
   Firms tend to maintain excess borrowing
    capacity
       Firms with growth options
       Firms with asymmetric information problems

                                                     57
Implications for Managers
   Take advantage of tax benefits by
    issuing debt, especially if the firm
    has:
     High tax rate
     Stable sales

     Less operating leverage




                                           58
Implications for Managers
   Avoid financial distress costs by
    maintaining excess borrowing capacity,
    especially if the firm has:
       Volatile sales
       High operating leverage
       Many potential investment opportunities
       Special purpose assets (instead of general
        purpose assets that make good collateral)

                                                     59
Implications for Managers
   If manager has asymmetric information
    regarding firm’s future prospects, then:
       Avoid issuing equity if actual prospects are
        better than the market perceives
   Consider impact of capital structure
    choices on lenders’ and rating agencies’
    attitudes

                                                       60
The Optimal Capital Structure
   Maximizes shareholder wealth
   Maximizes firm value
   Maximizes stock price
   Minimizes WACC
   Does NOT maximize EPS



                                   61
Estimating the Optimal Capital
Structure: 5 Steps
1. Estimate the interest rate the firm will
     pay (cost of debt)
2.   Estimate the cost of equity
3.   Estimate the WACC
4.   Estimate the free cash flows and their
     present value (value of the firm)
5.   Deduct the value of debt to find
     Shareholder Wealth  Maximize
                                          62
Choosing the Optimal Capital
Structure: Strasburg Example
   Currently all-equity financed
   Expected EBIT = $40,000
   10,000 shares outstanding
       rs    = 12%     P0   = $25
       T     = 40%     b    = 1.0
       rRF   = 6%      RPM = 6%

                                    63
      Step 1:
      Estimates of Cost of Debt




TABLE 15.2



                                  64
The Cost of Equity at Different Levels
of Debt: Hamada’s Equation

   MM theory  beta changes with
    leverage
   bU = the beta of a firm with NO debt
       Unlevered beta
   b = bU [1 + (1 - T)(D/S)]
       D = Market value of firm’s debt
       S = Market value of firm’s equity
       T = Firm’s corporate tax rate
                                           65
    Step 2:
    The Cost of Equity for wd = 50%
   Use Hamada’s equation to find beta:
     b = bU [1 + (1 - T)(D/S)]
        = 1.0 [1 + (1-0.4) (50% / 50%) ]
        = 1.60
   Use CAPM to find the cost of equity:
      rs= rRF + bL (RPM)
       = 6% + 1.60 (6%) = 15.6%
                                           66
TABLE 15.3
Strasburg’s optimal Capital Structure




                                        67
   Step 3: Strasburg’s WACC &
   Optimal Capital Structure




Note: The Capital Structure that MAXIMIZES firm value is
      the one that MINIMIZES WACC
                                                           68
Notes to Table 15-3




                      69
Figure 15.3
Strasburg’s Required Rate of Return on Equity




                                          70
Figure 15-4: Effects of Capital
Structure on Cost of Capital




                                  71
Step 4:
Corporate Value for wd = 0%
   Vop = FCF(1+g) / (WACC-g)
   g=0, so investment in capital is zero
       FCF = NOPAT = EBIT (1-T)
   NOPAT = ($40,000)(1-0.40) = $24,000
   Vop = $24,000 / 0.12 = $200,000



                                            72
    Step 4: Strasburg’s Firm Value




Note: The Capital Structure that MAXIMIZES firm value is
      the one that MINIMIZES WACC
                                                           73
Implications for Strasburg
   Firm should recapitalize (“recap”)
   Issue debt
   Use funds to repurchase equity
   Optimal debt = 40%
       WACC = 10.80%
       Maximizes Firm Value


                                         74
Anatomy of Strasburg’s Recap:
Before Issuing Debt




                                75
Issue Debt (wd = 40%), But
Before Repurchase
   WACC decreases to 10.80%
   Vop increases to $222,222
   Short-term funds = $88,889
       Temporary until it uses these funds to
        repurchase stock
   Debt is now $88,889


                                                 76
Anatomy of a Recap: After
Debt, but Before Repurchase


                   Vop  $222,222

                   Debt      = $88,889
                   S/T funds = $88,889

                   Stock Price  $22.22




                    Shareholder wealth 
                         $222.222
                                          77
    The Repurchase:
    No Effect on Stock Price
   Announcement of intended repurchase might
    send a signal that affects stock price
   The repurchase itself has no impact on stock
    price.
      If investors think the repurchase would:

           stock price, they would purchase stock the
           day before, which would drive up its price.
           stock price, they would all sell short the stock
           the day before, which would drive down the
           stock price.
                                                                78
Remaining Number of Shares
After Repurchase
   D0 = original amount of debt
   D = amount after issuing new debt
   If all new debt is used to repurchase shares,
    then total dollars used equals:
       (D – D0) = ($88,889 - $0) = $88,889
   n0 = number of shares before repurchase,
   n = number after repurchase.
       n = n0 – (D – D0)/P = 10,000 - $88,889/$22.22
       n = 10,000 – 4,000 = 6,000
                                                        79
Anatomy of Strasburg’s Recap:
After Repurchase




                                80
Strasburg after Recapitalization
Key Points
   Short Term investments used to
    repurchase stock
   Stock price is unchanged
   Value of stock falls to $133,333
       Firm no longer owns the short-term
        investments
   Wealth of shareholders remains at
    $222,222
                                             81
Shortcuts
   The corporate valuation approach will
    always give the correct answer
   There are some shortcuts for finding
    S, P, and n
   Shortcuts on next slides



                                            82
Calculating S, the Value of
Equity after the Recap
   S = (1 – wd) Vop                 (15-13)

   At wd = 40%:
       SPrior = S + (D – D0)        (15-14)

       S = (1 – 0.40) $222,222
       S = $133,333
       SPrior = $133,333 + (88,889 – 0)
       SPrior = $222,222

                                               83
Calculating P, the Stock Price
after the Recap

P = [S + (D – D0)]/n0      (15-15)

P = $133,333 + ($88,889 – 0)
         10,000
P = $22.22 per share


                                     84
Number of Shares after a
Repurchase, n
   # Repurchased = (D - D0) / P
   n = n0 - (D - D0) / P
   # Rep. = ($88,889 – 0) / $22.22
   # Rep. = 4,000
   n = 10,000 – 4,000
   n = 6,000


                                      85
TABLE 15.5
Strasburg’s Stock Price & EPS




                                86
     Analyzing the Recap




Table 15-5




                           87
FIGURE 15.5   Effects of Capital Structure on Firm Value, Price and EPS




                                                                          88
Effects of Capital Structure on
Price and EPS




                                  89
Optimal Capital Structure
   wd = 40% gives:
     Highest corporate value
     Lowest WACC

     Highest stock price per share

     Does NOT maximize EPS




                                      90

				
DOCUMENT INFO