Finance Lecture9

MBAM 614 Finance Capital Structure Policy II • MBAM614 Class 9 - 1 Summary of Last Class 1. When calculating WACC and fA , always use target capital structure 2. Can estimate the target capital structure with market value weights 3. Always use the WACC that reflects the systematic risk of the project - use firm’s WACC if risk is similar to overall firm’s risk - use divisional WACC if risk is similar to a division’s risk - use the WACC of a suitable pure play - use subjective assignment to risk classes 4. Flotation costs are project expenses and must be included in project cash flows • MBAM614 Class 9 - 2 1 Summary of Last Class 5. The Optimal Capital Structure is the mixture of debt and equity (D/E) that maximizes the value of the firm. Equivalently, the optimal capital structure minimizes the WACC. 6. Financial leverage amplifies the systematic risk of equity 7. Equity returns have two components: a Business Risk component and a Financial Risk component 8. If taxes and other financial imperfections are ignored, firm value under all capital structures is the same. Capital structure is irrelevant. • MBAM614 Class 9 - 3 Agenda 1. How Tax Affects Capital Structure Policy 2. Bankruptcy Costs 3. Financial Distress Costs 4. Static Theory of Capital Structure 5. Optimal Capital Structure and WACC 6. Observed Capital Structures • MBAM614 Class 9 - 4 2 Proposition I With Taxes In reality, of course, firms pay taxes. Interest expenses are tax deductible leading to a tax savings for the levered firm. The value of these savings is called the Interest Tax Shield Value of the interest tax shield = TC × D Since VU = VL in the absence of taxes and including taxes adds the value of the interest tax shield to VL , VL = VU + TC × D Capital structure can affect firm value • MBAM614 Class 9 - 5 Example: Taxes and Firm Value Fantasy Sports Services Inc., which is currently all equity financed, has annual EBIT of $100,000, a corporate tax rate of 30% and a cost of equity of 12.5%. If FSSI raises $100,000 in debt at 10% interest and uses it to retire shares, what will the value of the interest tax shield be? What happens to the value of their remaining equity? Assume FSSI has capital expenditures equal to depreciation each year and no change in net working capital. VU = EBIT(1- TC)/RU = $100,000(1-0.3)/0.125 = $560,000 Interest Tax Shield = D(TC) = $100,000(0.3) = $30,000 VL = VU + D(TC) = $560,000 + $30,000 = $590,000 = E + D = E + $100,000 E = $490,000 • MBAM614 Class 9 - 6 3 Proposition II With Taxes Restating Proposition II with taxes gives Re = RA + (RA - Rd) × (D/E) × (1 - TC) – cost of equity still increases with leverage but not as fast because of the tax savings which belong to shareholders WACC = (E/V) × Re + (D/V) × Rd × (1 - TC) – cost of debt is further reduced by tax savings WACC decreases as more debt is used. Optimal capital structure is all debt! • MBAM614 Class 9 - 7 Proposition II With Taxes Cost of Capital Where is WACC minimized? Optimal capital structure is all debt RA or RU WACC Rd × (1 - TC) Re = RA + (RA - Rd) × (D/E) × (1 - TC) Leverage, D/E • MBAM614 Class 9 - 8 4 Example: Eastern Radio Eastern Radio currently has no debt and an expected EBIT of $4,000,000 which is not expected to change over time. ER’s tax rate is 40% and it can borrow at 8% regardless of how much debt is used. Any money borrowed will be used to repurchase stock so the assets, and thus the EBIT, of ER will not change. The riskiness of ER’s assets (and its EBIT) is such that shareholders require a return of 12% if no debt is used. What is the value of ER? How does the value change if ER borrows $10,000,000? What will ER’s cost of equity and WACC be after the new loan? (Again, assume depreciation is reinvested and no change in net working capital.) Value of Eastern Radio (no debt): VU = EBIT(1-TC)/RU = ($4,000,000)(1-0.4)/(0.12) = $20,000,000 • MBAM614 Class 9 - 9 Example: Eastern Radio Value of Eastern Radio (with debt) : VL = VU + TC D = $20,000,000 + (0.4)($10,000,000) = $24,000,000 = D + E = $10,000,000 + E so E = $14,000,000 Cost of levered equity: Re = RU + (RU - Rd) × (D/E) × (1 - TC) = 12% + (12% - 8%)($10,000,000/$14,000,000)(0.6) = 13.71% Levered WACC: WACC = (E/V) × Re + (D/V) × Rd × (1 - TC) = ($14MM/$24MM)(13.71%) + ($10MM/$24MM)(8%)(1-0.4) = 10.0% • MBAM614 Class 9 - 10 5 The SML and MM Proposition II With Taxes Proposition II: CAPM: Re = RA + (RA - Rd) × (D/E) × (1 - TC) Re = Rf + βe* [E(RM) - Rf] RA = Rf + βA* [E(RM) - Rf] Assuming Rd = Rf and solving for βe gives βe = βA* [1 + (1 - TC) × (D/E)] Business Risk due to riskiness of firm’s assets • MBAM614 Financial Risk due to use of debt - amplifies systematic risk Class 9 - 11 Bankruptcy Costs When taxes are considered, we found that WACC is minimized by using all debt but, in practice, no firms use all debt. Why not? One limit to the use of debt is Bankruptcy Costs – Direct Bankruptcy Costs are legal and administrative expenses directly associated with bankruptcy – Financial Distress Costs are the direct and indirect costs of avoiding bankruptcy Probability of bankruptcy increases with the use of debt Expected Bankruptcy Costs increase with use of debt • MBAM614 Class 9 - 12 6 Direct Bankruptcy Costs Healthy Firm Financially Distressed Firm Bankruptcy Costs Debt V Equity V=D+E V=D+E Debt = D + Equity V E Bankruptcy costs reduce the value of the firm Bankruptcy costs reduce the value of equity Shareholders limit use of debt to avoid bankruptcy costs • MBAM614 Class 9 - 13 Financial Distress Costs Firm’s assets only have value in liquidation (bankruptcy) if they can be sold. – Potential buyers usually wait to get the “best” price. – People who owe firm money often delay or don’t make payment – If assets (inventory or plant & equipment) are highly specialized, reduces number of buyers and chance of sale. Specialized assets have lower liquidation value. Financial distress often reduces the ability of a firm to conduct business (reducing cash flows and thus value) – Customers are staying away from K-Mart because they are afraid returns and warranties would not be honored. – Suppliers are reluctant to ship product to K-Mart for sale in their stores without advance payment. • MBAM614 Class 9 - 14 7 Agency Costs of Financial Distress Financial distress can lead shareholders to make suboptimal decisions, usually at the expense of bondholders. These are called Agency Costs. – Investing in excessively risky projects. Done with bondholders’ money in the hope of a large payoff. Essentially gambling with bondholders’ money. – Under-investing or not selecting profitable projects Not investing in improvements because such investment will only improve the value of the bondholders’ claim. – Milking the property by paying out the value to shareholders through dividends, perqs, etc. • MBAM614 Class 9 - 15 Example: Excessively Risky Projects Our friends at No Doubt Totally Valueless (NDT) are near bankruptcy but are still considering two mutually exclusive potential investments. The current market value balance sheet and the payoffs on the projects are ($ in millions): Assets Cash Liabilities Debt Equity Value 100 90 10 100 Project 1 Project 2 Cost 100 100 Recession (50%) 90 10 Boom (50%) 120 200 Much higher Risk! Expected value of both projects is $105MM • MBAM614 Class 9 - 16 8 Example: Risky Projects What is the value of the firm under each scenario given investment in one or the other project? Assets Project 1 Liabilities Debt Equity Assets Project 2 Liabilities Debt Equity • MBAM614 Recession 90 90 0 Recession 10 10 0 Share holders WIN! Bondholders LOSE Boom 120 90 30 Boom 200 90 110 E.V. 105 90 15 E.V. 105 50 55 Class 9 - 17 Static Theory of Capital Structure Value of Firm VL* VU Maximum Firm Value VU MM no taxes Called the Static Theory of Optimal Capital Structure • All that changes is leverage, assets are static Optimal Amount of Leverage • MBAM614 PV of Tax Shield on Debt MM with taxes VL = VU + TC × D Financial Distress Costs Actual Firm Value D*/E* Leverage, D/E Class 9 - 18 9 Optimal Capital Structure According to the Static Theory of Capital Structure: – gain from tax shield on debt is offset by financial distress costs – there is a capital structure, D*/E*, where the additional gain from leverage just balances the additional loss from financial distress costs This is the Optimal Capital Structure As use of debt increases: – the cost of equity, Re , increases – possibility of financial distress and bankruptcy increases Cost of Debt, Rd , will ultimately increase (more risk) • MBAM614 Class 9 - 19 Optimal Capital Structure and WACC Cost of Capital Minimum Cost of Capital Re WACC* RU WACC Rd × (1-TC ) Optimal Amount of Leverage • MBAM614 D*/E* Leverage, D/E Class 9 - 20 10 Determinants of Capital Structure Theory does not identify D*/E* for us but does identify key determinants: – Tax Savings due to Debt Tax Shield the higher the tax rate, the more important debt is – Financial Distress Costs the lower the cost and risk (likelihood) of financial distress, the more likely is borrowing – variability in EBIT reduces borrowing (high risk) – easily transferable assets increases borrowing (low distress costs) – specialized assets reduces borrowing (high distress costs) • MBAM614 Class 9 - 21 Observed D/E Ratios Industry Auto Acc. and parts Food stores Agricultural implements Cement Communications Fish products Construction Pharmaceuticals Ratio 3.048 1.828 2.739 0.814 0.635 4.053 3.005 0.686 High portion of fixed assets and many potential buyers - low distress costs Stable industry, constant demand, stable EBIT - low risk Volatile industry with high variance in EBIT - high risk Heavy investment in R&D which is difficult to transfer - high distress costs • MBAM614 Class 9 - 22 11 Practical Debt Policy and Market Signals Restrictive Covenants Risk Premium Availability of Funds Bond Ratings Share Price Dynamics A goal of the Financial Strategy is to ENSURE access to funding in the future • MBAM614 Class 9 - 23 Key Points 1. In a world with taxes and other market imperfections, changing the capital structure of a firm does affect firm value 2. Bankruptcy costs and market imperfections give rise to an optimal capital structure where firm value is maximized and WACC is minimized. this structure is almost certainly not all debt. 3. Corporate tax rates, business risk, and nature of assets all play a role in determining the optimal capital structure • MBAM614 Class 9 - 24 12 MBAM 614 Finance Dividend Policy • MBAM614 Class 9 - 25 Agenda 1. 2. 3. 4. 5. 6. Dividends Dividend Policy Irrelevance Dividend Policy and the Real World Establishing a Dividend Policy Share Repurchases Stock Dividends and Splits • MBAM614 Class 9 - 26 13 How Firms Use Cash Flow = + Total Cash Flow Internal Cash Flow New Financing New investments Existing Total operations Cash Debt Flow interest Payments to Shareholders Cash Dividends & Stock Repurchases • MBAM614 Class 9 - 27 Dividends A disbursement to the current shareholders of a firm is called a Dividend Unlike interest on debt, firms do not have to pay dividends - they are not an obligation of the firm Once Declared by the Board of Directors, dividends become an obligation or debt of the firm Dividends come in many flavors: – Regular Cash – Extra or Special – Liquidating Paid in the usual course of business May or may not be repeated One-time dividend that won’t be repeated • MBAM614 Class 9 - 28 14 Dividend Payment Chronology two Thu Mar 11 Wed business Mar 17 days Fri Mar 19 Mon Apr 5 Declaration Date Ex-Dividend Date Record Date Payment Date Declaration Date - date the Board resolves to pay a dividend Ex-Dividend Date - people who buy the stock on or after this date will not get the dividend (the stock trades “ex-dividend”) Record Date - date the firm prepares a list of shareholders to receive the dividend from their “records” – Ex-Dividend date is, at most, two business days earlier Payment Date - date the dividend checks are mailed to shareholders of record • MBAM614 Class 9 - 29 Ex-Dividend Share Prices What happens to the value of a share when it goes exdividend? Stock price, P0, is just the PV of E(dividends) t=0 D0 1 D1 2 D2 3 D3 Cum-Dividend: Ex-Dividend: P0 = D0 + PV(D1) + PV(D2) + … P0 = PV(D1) + PV(D2) + … Class 9 - 30 Stock price changes by the amount of the dividend, D0 • MBAM614 15 Dividend Policy Clearly, dividends are valuable and shareholders will demand them Dividend Policy refers to the timing of dividend payout The Dividend Policy Question is not about whether to pay dividends at all but rather, whether to use current cash flow to pay them now or re-invest current cash flow to pay bigger dividends later Should the firm pay a large portion of earnings now or a small (possibly zero) portion now? • MBAM614 Class 9 - 31 Dividend Policy Irrelevance As long as a firm’s investments (assets) remain fixed, its cash flows from operations will remain the same All else equal, and in particular, if the capital structure doesn’t change, increasing earlier dividends can only be done if later dividends are reduced Alternatively, reducing early dividends will increase later dividends Once time-value of money is accounted for, any change in dividends is exactly offset by an opposite change at some other time • MBAM614 Class 9 - 32 16 Example: Dividend Policy Irrelevance Criesler Corp., an all equity financed firm, has projected cash flows of $100,000,000 per year for the next two years which they are planning to pay out, in full, to the holders of their 1,000,000 shares ($100/share/year). After two years, Criesler will wind up operations. Russ Parrot, a particularly vocal (and large) shareholder, wants more dividends now and demands that Criesler increase next year’s dividend to $120 per share. When Lou Iacoacoa (Criesler’s CEO) asked Parrot how they could afford to pay a higher dividend than total cash flow, Parrot muttered something about “Let them sell equity” and then flew off to rescue some hostages in the Middle East. If Criesler’s cost of equity is 20%, what will the share price be under both dividend policies? • MBAM614 Class 9 - 33 Example: Dividend Policy Irrelevance Current Policy P0 = PV(D1) + PV(D2) = $100/1.2 + $100/1.22 = $152.78 Parrot’s Policy - need an additional $20,000,000 to pay the $120,000,000 next year - raised by selling new equity next year however, new equity holders will require a 20% ROE or $24,000,000 in year 2 - thus, only $76,000,000 of CF left for current shareholders’ dividends in year 2. D2 = $76 not $100 P0 = PV(D1) + PV(D2) = $120/1.2 + $76/1.22 = $152.78 • MBAM614 Class 9 - 34 17 Example: Homemade Dividends You own 950 shares of Criesler. Perhaps people prefer Parrot’s proposed payment plan. Do you? If you don’t, you can simply re-invest your additional dividends in Criesler next year. Re-invest difference = $114,000 - $95,000 = $19,000 Present Plan, 950 × $100/share Same as under original plan Class 9 - 35 Proposed Dividend, 950 × $120/share Price in one year: Shares purchased: Total year 2 dividend: P1 = PV1 (D2) = $76/1.2 = $63.33 $19,000/$63.33 = 300 $76 × (950 + 300) = $95,000 • MBAM614 Example: Homemade Dividends Alternatively, if the proposed plan is not adopted, you can duplicate it by selling shares in one year. Under the current plan: Price in one year: Shares sold: Total year 2 dividend: P1 = PV1 (D2) = $100/1.2 = $83.33 $19,000/$83.33 = 228 $100 × (950 - 228) = $72,200 Additional cash req’d in year 1 Same as (950 × $76) under proposed plan By buying and selling stock, investors can create any pattern of payments the company can so Dividend Policy should not affect share value. Dividend Policy is irrelevant. • MBAM614 Class 9 - 36 18 Key Points 1. Dividend Policy should be irrelevant since investors can create whatever payment pattern they like by buying and selling stock. • MBAM614 Class 9 - 37 19