case4
Maria Castro 
3-CapitalStructure.pptx1
Capital Structure
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Capital Structure Basics
What is capital structure?
The firm’s mixture of debt and equity
How do firms raise funds?
Internally (Profits)
Externally (Debt and Equity Sources)
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Sources of Funds, Non-Financial U.S. Corporations
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How do we define debt?
Debt / Total Assets
(1,579 + 2,725) / 7,856 = 0.55
LT Liabilities / (LT Liabilities + Equity)
2,725 / (2,725 + 3,552) = 0.43
Is this too much?
Too little? Just right?
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Basic Definitions
V = value of firm
FCF = free cash flow
WACC = weighted average cost of capital
rs and rd are costs of stock and debt
ws and wd are percentages of the firm that are financed with stock and debt
Also account for preferred stock (ps)
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Estimating WACC
Stock price is $50
3 million shares of stock
$25 million of preferred stock
$75 million of debt
Cost of debt is 10%
Cost of preferred stock is 9%
Cost of common stock is 12.8%
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Estimating Weights (Continued)
Vs = $50(3 million) = $150 million
Vps = $25 million
Vd = $75 million
V = Total value = ?
$150 + $25 + $75 = $250 million
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Estimating Weights (Continued)
ws = $150/$250 = 0.6
wps = $25/$250 = 0.1
wd = $75/$250 = 0.3
These are market value weights
Target weights usually close (here the same)
But, often market weights temporarily deviate from targets due to changes in stock prices
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What’s the WACC using the target weights?
WACC = wdrd(1 – T)
+ wpsrps
+ wsrs
WACC = 0.3(10%)(1 − 0.4)
+ 0.1(9%)
+ 0.6(12.8%)
WACC = 10.38% ≈ 10.4%
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Why (1-T) for rd?
Interest expense is tax deductible
Interest Expense = $1,200 = Total Debt * rd
Tax Savings for Firm L = Interest Expense * Tax Rate = $1,200 * 0.40 = $480
| Firm U | Firm L | |
| EBIT | $3,000 | $3,000 |
| Interest | 0 | 1,200 |
| EBT | $3,000 | $1,800 |
| Taxes (40%) | 1 ,200 | 720 |
| NI | $1,800 | $1,080 |
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Why (1-T) for rd?
Levered firm saves $480 in taxes, so total cost of debt is $1,200 - $480 = $720
In general, firm’s actual cost of debt:
(Total Debt * rd) – [(Total Debt * rd) * T]
= Total Debt * [rd – (rd * T)]
= Total Debt * [rd * (1 – T)]
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What factors influence a company’s WACC?
Uncontrollable factors:
Market conditions, especially interest rates
The market risk premium
Tax rates
Controllable factors:
Capital structure policy
Dividend policy
Investment policy (firms with riskier projects generally have a higher cost of equity)
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How can capital structure affect value?
V
=
∑
∞
t=1
FCFt
(1 + WACC)t
The impact of capital structure on value depends upon the effect of debt on:
WACC and FCF
Sound familiar?
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The Effect of Additional Debt on WACC
Debtholders have a prior claim on cash flows relative to stockholders
Debtholders’ “fixed” claim increases risk of stockholders’ “residual” claim
Cost of stock, rs, goes up
Firms can deduct interest expenses
Reduces the taxes paid
Frees up more cash for payments to investors
Reduces after-tax cost of debt
(Continued…)
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The Effect on WACC (Continued)
Debt increases risk of bankruptcy
Causes pre-tax cost of debt, rd, to increase
Adding debt increases percent of firm financed with low-cost debt (wd) and decreases percent financed with high-cost equity (ws)
Net effect on WACC = uncertain
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The Effect of Additional Debt on FCF
Additional debt increases the probability and costs of bankruptcy
Bankruptcy costs:
Direct: Legal fees, “fire” sales, etc.
Indirect: Lost customers, reduction in productivity, reduction in credit (i.e., accounts payable)
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The Effect of Additional Debt on Managerial Behavior
Reductions in agency costs
Debt “pre-commits” (or “bonds”) free cash flow for use in making interest payments
Managers less likely to waste FCF on perquisites or non-value adding acquisitions
Increases in agency costs
Debt can make managers too risk-averse, causing “underinvestment” in risky but positive NPV projects
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Business Risk vs Financial Risk
Business risk:
Uncertainty in future EBIT, NOPAT, and ROIC
Depends on business factors such as competition, operating leverage, etc.
Financial risk:
Additional business risk concentrated on common stockholders when financial leverage is used
Depends on the amount of debt and preferred stock financing
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Consider Two Hypothetical Firms Identical Except for Debt
| Firm U | Firm L | |
| Capital | $20,000 | $20,000 |
| Debt | $0 | $10,000 (12% rate) |
| Equity | $20,000 | $10,000 |
| Tax rate | 40% | 40% |
| EBIT | $3,000 | $3,000 |
| NOPAT | $1,800 | $1,800 |
| ROIC | 9% | 9% |
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Impact of Leverage on Returns
| Firm U | Firm L | |
| EBIT | $3,000 | $3,000 |
| Interest | 0 | 1,200 |
| EBT | $3,000 | $1,800 |
| Taxes (40%) | 1,200 | 720 |
| NI | $1,800 | $1,080 |
| ROIC | 9.0% | 9.0% |
| ROE (NI/Equity) | 9.0% | 10.8% |
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Why does leveraging increase return?
More cash goes to investors of Firm L
Total dollars paid to investors:
U: NI = $1,800
L: NI + Int = $1,080 + $1,200 = $2,280
Taxes paid:
U: $1,200
L: $720
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Impact of Leverage on Returns if EBIT Falls
| Firm U | Firm L | |
| EBIT | $2,000 | $2,000 |
| Interest | 0 | 1,200 |
| EBT | $2,000 | $800 |
| Taxes (40%) | 800 | 320 |
| NI | $1,200 | $480 |
| ROIC | 6.0% | 6.0% |
| ROE | 6.0% | 4.8% |
| Leverage magnifies risk and return! |
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Capital Structure Theory
Modigliani and Miller (MM) theory
Zero taxes
Corporate taxes
Corporate and personal taxes
Trade-off theory
Signaling theory
Pecking order
Debt financing as a managerial constraint
Windows of opportunity
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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 debtholder | 0 | $1,200 |
| Total CF | $3,000 | $3,000 |
| Notice that the total CF are identical for both firms. |
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MM Results: Zero Taxes
MM assume:
(1) no transactions costs (e.g. taxes, bankruptcy, brokerage)
(2) no restrictions or costs to short sales
(3) individuals can borrow at the same rate as corporations
Firm U:
No taxes or debt, so 100% of EBIT to stockholders
Firm L:
Debtholders receive rd*D
Stockholders receive EBIT – (rd*D)
Together: rd*D + EBIT – (rd*D) = EBIT
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MM Results: Zero Taxes
MM prove that if the total CF to investors of Firm U and Firm L are equal, then the total values of Firm U and Firm L are equal:
VL = VU
Because FCF and values of firms L and U are equal, their WACCs are equal
Therefore, capital structure is irrelevant
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MM Theory: Corporate Taxes
Corporate tax laws allow interest to be deducted, which reduces taxes paid by levered firms
Therefore, more CF goes to investors and less to taxes when leverage is used
In other words, the debt “shields” some of the firm’s CF from taxes
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MM Result: Corporate Taxes
MM show that the total CF to Firm L’s investors is equal to the total CF to Firm U’s investor plus an additional amount due to interest deductibility:
CFL = CFU + rdDT
What is the value of these cash flows?
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MM Result: Corporate Taxes
CFL = CFU + rdDT
1) Value of CFU = VU
2) Value of rdDT = PV (Tax Shield)
PV (Tax Shield) = Tax Shield / rd
Tax Shield = Int Payment * Corp Tax Rate
Int Payment = Debt * rd
Then, PV (Tax Shield) = (Debt*rd*Tax Rate) / rd
Therefore, VL = VU + (Debt * Tax Rate)
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MM Result: Corporate Taxes
If T=40%, then every dollar of debt adds 40 cents of extra value to firm
What is optimal capital structure?
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Value of Firm, V
0
Debt
VL
VU
Under MM with corporate taxes, the firm’s value increases continuously as more and more debt is used
TD
MM relationship between value and debt when corporate taxes are considered
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Miller’s Theory: Corporate and Personal Taxes
Personal taxes lessen the advantage of corporate debt:
Corporate taxes favor debt financing since corporations can deduct interest expenses
Personal taxes favor equity financing, since no gain is reported until stock is sold, and long-term gains are taxed at a lower rate
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Miller’s Model with Corporate and Personal Taxes
VL = VU + 1− D
Tc = corporate tax rate
Td = personal tax rate on debt income
Ts = personal tax rate on stock income
(1 - Tc)(1 - Ts)
(1 - Td)
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Tc = 40%, Td = 30%, and Ts = 12%
VL = VU + 1− D
= VU + (1 - 0.75)D
= VU + 0.25D
Value rises with debt; each $1 increase in debt raises L’s value by $0.25
(1 - 0.40)(1 - 0.12)
(1 - 0.30)
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Trade-off Theory
MM theory ignores bankruptcy (financial distress) costs, which increase as more leverage is used
At low leverage levels, tax benefits outweigh bankruptcy costs
At high levels, bankruptcy costs outweigh tax benefits
An optimal capital structure exists that balances these costs and benefits
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Tax Shield vs. Cost of Financial Distress
Value of Firm, V
0
Debt
VL
VU
Tax Shield
Distress Costs
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Signaling Theory
MM assumed that investors and managers have the same information
But, managers often have better information:
If stock is overvalued?
Issue Stocks (SEOs)
If stock undervalued?
Sell bonds
Investors understand this, so view new stock sales as a negative signal
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Pecking Order Theory
1) Use internally generated funds (no flotation costs or negative signals)
2) Issue debt (lower flotation costs than equity and not negative signal)
3) Issue equity (high flotation costs and negative signal)
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Debt Financing and Agency Costs
One agency problem is that managers can use corporate funds for non-value maximizing purposes (i.e. perks and empire-building)
The use of financial leverage:
Bonds “free cash flow”
Forces discipline on managers to avoid perks and non-value adding acquisitions
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Debt Financing and Agency Costs (continued)
A second agency problem is the potential for “underinvestment”
The use of financial leverage:
Increases risk and costs of financial distress
Therefore, managers may avoid risky projects even if they have positive NPVs
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Windows of Opportunity: Market Timing
Managers try to “time the market” when issuing securities
They issue equity when the market is “high” and after big stock price run ups
They issue debt when the stock market is “low” and when interest rates are “low”
They issue short-term debt when the term structure is upward sloping and long-term debt when it is relatively flat
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Implications for Managers
Take advantage of tax benefits by issuing debt, especially if the firm has:
High tax rate
Stable sales
Low operating leverage
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Implications for Managers (Continued)
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)
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Implications for Managers (Continued)
Avoid issuing equity if actual prospects are better than the market perceives (in this case, firm is undervalued)
Always consider the impact of capital structure choices on lenders’ and rating agencies’ attitudes
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Choosing the Optimal Capital Structure: Example
β = 1.0; rf = 6%; RPM = 6%
Cost of equity using CAPM:
rs = rRF +b (RPM)= 6% + 1(6%) = 12%
Currently has no debt: wd = 0%
WACC = rs = 12%
Tax rate is T = 40%
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Current Value of Operations
Expected FCF = $30 million
Firm expects zero growth: g = 0
Vop = [FCF(1+g)]/(WACC − g)
Vop = [$30(1+0)]/(0.12 − 0)
Vop = $250 million
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Other Data for Valuation Analysis
Company has no ST investments
Company has no preferred stock
10,000,000 shares outstanding
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Current Valuation Analysis
| Vop | $250 |
| + ST Inv. | 0 |
| VTotal | $250 |
| − Debt | 0 |
| S | $250 |
| ÷ n | 10 |
| P | $25.00 |
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Investment bankers provided estimates of rd for different capital structures
| wd | 0% | 20% | 30% | 40% | 50% |
| rd | 0.0% | 8.0% | 8.5% | 10.0% | 12.0% |
| If company recapitalizes, it will use proceeds from debt issuance to repurchase stock. | |||||
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The Cost of Equity at Different Levels of Debt: Hamada’s Formula
Theory implies that beta changes with leverage (leverage magnifies risk)
βU is the beta of a firm when it has no debt (the unlevered beta)
β = βU [1 + (1 - T)(wd/ws)]
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The Cost of Equity for wd = 20%
Use Hamada’s equation to find beta:
β = βU [1 + (1 - T)(wd/ws)]
= 1.0 [1 + (1-0.4) (20% / 80%) ]
= 1.15
Use CAPM to find the cost of equity:
rs= rRF + βL (RPM)
= 6% + 1.15 (6%) = 12.9%
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The WACC for wd = 20%
WACC = wd (1-T) rd + ws rs
WACC = 0.2 (1 – 0.4) (8%) + 0.8 (12.9%)
WACC = 11.28%
Repeat this for all capital structures under consideration
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Beta, rs, and WACC
| wd | 0% | 20% | 30% | 40% | 50% |
| rd | 0.0% | 8.0% | 8.5% | 10.0% | 12.0% |
| ws | 100% | 80% | 70% | 60% | 50% |
| b | 1.000 | 1.150 | 1.257 | 1.400 | 1.600 |
| rs | 12.00% | 12.90% | 13.54% | 14.40% | 15.60% |
| WACC | 12.00% | 11.28% | 11.01% | 11.04% | 11.40% |
| The WACC is minimized for wd = 30%. This is the optimal capital structure. Remember: PV increases as discount rate decreases! | |||||
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Corporate Value for wd = 30%
Vop = [FCF(1+g)]/(WACC − g)
Vop = [$30(1+0)]/(0.1101 − 0)
Vop = $272.48 million
Debt = DNew = wd Vop
Debt = 0.30(272.48) = $81.74 million
Equity = S = ws Vop
Equity = 0.70(272.48) = $190.74 million
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Value of Operations, Debt, and Equity
| wd | 0% | 20% | 30% | 40% | 50% |
| rd | 0.0% | 8.0% | 8.5% | 10.0% | 12.0% |
| ws | 100% | 80% | 70% | 60% | 50% |
| b | 1.000 | 1.150 | 1.257 | 1.400 | 1.600 |
| rs | 12.00% | 12.90% | 13.54% | 14.40% | 15.60% |
| WACC | 12.00% | 11.28% | 11.01% | 11.04% | 11.40% |
| Vop | $250.00 | $265.96 | $272.48 | $271.74 | $263.16 |
| D | $0.00 | $53.19 | $81.74 | $108.70 | $131.58 |
| S | $250.00 | $212.77 | $190.74 | $163.04 | $131.58 |
| Value of operations is maximized at wd = 30%. |
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Anatomy of a Recapitalization: Before Issuing Debt
| Before Debt | |
| Vop | $250 |
| + ST Inv. | 0 |
| VTotal | $250 |
| − Debt | 0 |
| S | $250 |
| ÷ n | 10 |
| P | $25.00 |
| Total stockholder | |
| wealth: S + Cash Used to Repur. | $250 |
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Issue Debt (wd = 30%), But Before Repurchase
WACC decreases to 11.01%
Vop increases to $272.48
Firm temporarily has short-term investments of $81.74 (until it uses these funds to repurchase stock)
Debt is now $81.74
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Anatomy of a Recap: After Debt, but Before Repurchase
| Before Debt | After Debt, Before Rep. | |
| Vop | $250 | $272.48 |
| + ST Inv. | 0 | 81.74 |
| VTotal | $250 | $354.22 |
| − Debt | 0 | 81.74 |
| S | $250 | $272.48 |
| ÷ n | 10 | 10 |
| P | $25.00 | $27.25 |
| Total stockholder | ||
| wealth: S + Cash Used to Repur. | $250 | $272.48 |
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Remaining Number of Shares After Repurchase
DOld is amount of debt the firm initially has, DNew is amount after issuing new debt
If all new debt is used to repurchase shares, then total dollars used equals
(DNew – DOld) = ($81.74 - $0) = $81.74
nPrior is number of shares before repurchase, nPost is number after. Total shares remaining:
nPost = nPrior – (DNew – DOld)/P
nPost = 10 mil – ($81.74 mil/$27.25)
nPost = 7 million
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Anatomy of a Recap: After Rupurchase
| Before Debt | After Debt, Before Rep. | After Rep. | |
| Vop | $250 | $272.48 | $272.48 |
| + ST Inv. | 0 | 81.74 | 0 |
| VTotal | $250 | $354.22 | $272.48 |
| − Debt | 0 | 81.74 | 81.74 |
| S | $250 | $272.48 | $190.74 |
| ÷ n | 10 | 10 | 7 |
| P | $25.00 | $27.25 | $27.25 |
| Total stockholder | |||
| wealth: S + Cash Used to Repur. | $250 | $272.48 | $272.48 |
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Key Points
ST investments fall because they are used to repurchase stock
Stock price is unchanged
Value of equity falls from $272.48 to $190.74 because firm no longer owns the ST investments
Wealth of shareholders remains at $272.48 because shareholders now directly own the funds that were held by firm in ST investments
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Intrinsic Stock Price Maximized at Optimal Capital Structure
| wd | 0% | 20% | 30% | 40% | 50% |
| rd | 0.0% | 8.0% | 8.5% | 10.0% | 12.0% |
| ws | 100% | 80% | 70% | 60% | 50% |
| b | 1.000 | 1.150 | 1.257 | 1.400 | 1.600 |
| rs | 12.00% | 12.90% | 13.54% | 14.40% | 15.60% |
| WACC | 12.00% | 11.28% | 11.01% | 11.04% | 11.40% |
| Vop | $250.00 | $265.96 | $272.48 | $271.74 | $263.16 |
| D | $0.00 | $53.19 | $81.74 | $108.70 | $131.58 |
| S | $250.00 | $212.77 | $190.74 | $163.04 | $131.58 |
| n | 10 | 8 | 7 | 6 | 5 |
| P | $25.00 | $26.60 | $27.25 | $27.17 | $26.32 |
63
Optimal Capital Structure
wd = 30% gives:
Highest corporate value
Lowest WACC
Highest stock price per share
But wd = 40% is close (optimal range is fairly flat)
