week 8

Slide 1

Introduction

Welcome to Financial Management. In this lesson we will discuss capital structure decisions.

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Slide 2

Topics

The following topics will be covered in this lesson:

A preview of capital structure issues;

Business risk and financial risk;

Capital structure theory;

Capital structure evidence and implications;

Estimating the optimal capital structure; and

Anatomy of recapitalization.

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Slide 3

A preview of capital structure issues

Managers should make capital structure decisions to maximize the intrinsic value of the firm. The firm’s capital structure is its mixture of debt and equity. While the actual levels of debt and equity may vary over time, most firms try to maintain a financing mix that is close to its target capital structure. Recall, the value of the firm’s operations is the present value of its expected future cash flows, FCF, discounted at the firm’s weighted average cost of capital, WACC. Mathematically, the value of the firm’s operations is given by the following equation:

V sub OP equals summation T equals one through infinity FCF sub T divided by the quantity one plus WACC raised to the tth power;

Where WACC equals w sub D times the quantity one minus T times R sub D plus W sub S times R sub S; and

WACC depends on the percentages of debt and common equity, W sub D and W sub S, the cost of debt, R sub D, the cost of equity, R sub S, and the corporate tax rate T. The only way any decision can change the firm’s value is by changing either FCF or its cost of capital. Debtholders’ claim on the firm’s cash flows rank ahead of the stockholders’ claim because they have a residual claim on the cash flows after debtholders’ are paid.

The fixed claim of debtholders increases the cost of equity, R sub S, because their residual claim becomes riskier. Interest expense is tax deductible which reduces the firm’s taxable income and therefore its tax bill. The tax reduction reduces the after-tax cost of debt which results in more income available to debtholders and other investors.

When the firm increases its debt level the probability of financial distress or bankruptcy increases. This results in an increased pretax cost of debt, R sub D, because debt-holders will require a higher interest rate. The net impact on the WACC is indeterminate because both R sub D and R sub S change because it is a weighted average of relatively low-cost debt and relatively high-cost equity. The risk of bankruptcy can reduce FCF and the value of the firm. When the risk of bankruptcy increases, customers may make purchases from another firm and hence sales decline which reduces net operating profit as well as FCF. Additionally any type of financial distress negatively impacts the productivity of managers and employees and reduces net operating profit after taxes, NOPAT, and FCF. Moreover the firm experiences a reduction in accounts payable and results in an increase in net working capital which reduces FCF. Higher debt levels may impact managers’ behavior in two opposing ways.

First, in good times, managers may waste cash flow on unnecessary expenditures. When faced with an increased threat of bankruptcy, unnecessary expenditures are reduced and FCF increases.

Second, managers may reject positive but risky net present value, or NPV, projects which may negatively impact stockholders.

Therefore, high debt levels can result in managers forgoing positive NPV projects unless they’re very safe. This is referred to as the underinvestment problem.

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Slide 4

Business risk and financial risk

Business risk and financial risk jointly determine the total risk of the firm’s future return on equity. Business risk is the uncertainty inherent in the firm’s future operating earnings before interest and taxes. Business risk depends upon a number of factors:

First variability and product demand;

Second, variability in sales prices and input costs;

Third, business risk is higher in firms that are slow to bring new products to the market;

Fourth, the risk of currency fluctuations and political risk that arise from international operations;

Last if the firm has a high percentage of fixed costs that do not decrease when demand falls the firm has a high degree of operating leverage and hence increased business risk.

Operating leverage is the extent to which fixed costs are part of the firm’s operations. If the firm has a high degree of operating leverage a relatively small change in sales results in a relatively large change in earnings before interest and taxes, EBIT, net operating profit after taxes, NOPAT, and the return on invested capital, ROIC. The higher the firm’s fixed costs the higher the firm’s operating leverage. Generally, higher fixed costs are associated with capital intensive firms, firms that employ highly skilled workers, and firms with high product development costs. The firm’s breakeven point is given by the following:

EBIT equals P times Q minus V times Q minus F equals zero;

Where EBIT is interest before interest and taxes, P times Q is sales revenue, V times Q equals variable costs, and F equals fixed costs. Solving for breakeven quantity yields the following:

Q sub BE equals F divide by the quantity P minus V.

Financial risk is the additional business risk stockholders assume because the firm decides to finance with debt. Stockholders assume a certain amount of business risk which results from uncertainty in EBIT, NOPAT, and ROIC. The use of debt, or financial leverage, shifts business risk to the common stockholders because debtholders are paid before stockholders.

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Slide 5

Capital structure theory

Capital structures differ across industries and within industries. To explain these differences several theories have been developed. In 1958, Franco Modigliani and Merton Miller, known as MM, develop the first model to explain the firm’s capital structure. Based on some very restrictive assumptions, MM proposed two hypothetical portfolios. One portfolio consists of all the equity of the unlevered firm where the firm’s value is denoted as V sub U or simply the value of the unlevered firm. Under MM assumptions, the firm has no growth and pays no taxes so it can pay out all of its EBIT in the form of dividends. Hence the portfolios cash flow equals EBIT. The second firm is the same as the first but it is partially financed with debt. The second portfolio includes the entire levered firm’s stock, S sub L and debt, D, so the total value of the portfolio is denoted V sub L or simply the total value of the levered firm.

Assuming the interest on debt is R sub D, the firm pays R sub D times D amount in interest. Assuming no growth and no taxes, the firm pays out EBIT minus R sub D times D in dividends. The cash flow of each portfolio is EBIT. Using this information MM concluded that since both portfolios have the same cash flow they must have the same value.

Therefore, V sub L equals V sub U equals S sub L plus D. Given their assumptions, MM concluded that the value of the firm is independent of the firm’s capital structure. In 1963MM modified their original model to include corporate taxation. Since interest on debt is tax deductible but dividends paid to stockholders are not, the differential tax treatment favors the use of debt in the firm’s capital structure. The interest paid on debt reduces the firm’s tax liability to the government and is referred to as a tax shield. In this case MM concluded that the value of the levered firm equals at the value of the unlevered firm plus the present value of the tax shield.

Under their assumptions MM showed that the present value of the tax shield equals the corporate tax rate, T, times the amount of debt, D.

In1977, Merton Miller included personal taxes in the modified model he developed with Modigliani where they included corporate taxes. Miller argued that investors will accept a relatively lower before-tax returns on stock relative to the before tax return on bonds. Miller concluded that one, since interest on debt is tax deductible debt financing is favored but two, the more favorable tax treatment of the income from stock decreases the required rate of return on stock and therefore equity financing is favored. According to Miller the net impact of corporate and personal taxes is given by the formula:

V sub L equals V sub U plus the quantity one minus the quantity one minus T sub C times the quantity one minus T sub S divided by the quantity one minus T sub D the entire quantity multiplied by D, where T sub C is in corporate tax rate;

T sub S is the personal tax rate on income from stocks, and T sub D is the tax rate on income from debt. Miller concluded that in the presence of personal and corporate taxes parcel taxes reduce but do not completely eliminate the advantage from debt financing.

Another assumption made by MM is that there are no bankruptcy costs. Realistically, firms in bankruptcy have high legal and accounting costs and have difficulty retaining customers, suppliers, and employees. Costs related to bankruptcy have two components, first the probability of financial distress and second, the costs that would be incurred if financial distress occurs. The tradeoff theory says that the value of the unlevered firm equals the value of the unlevered firm plus the value of the tax shield and the expected costs related to financial distress and any other side effects.

MM assumed that investors and managers have the same information about the firm’s prospects. This is referred to as symmetrical information. Usually managers have better information than the investors and this is referred to as asymmetrical information which impacts the firm’s optimal capital structure. In good times firm should use more equity and less debt than suggested by the trade-off theory so they can maintain a reserve borrowing capacity. That way when a good investment opportunity is presented, the firm can finance it with debt. When the firm is faced with flotation costs asymmetric information may cause the firm to raise capital according to a pecking order. Specifically, the firm will first finance with retained earnings and selling short term marketable securities, then debt, and then preferred stock. The firm should issue common stock only as a last resort.

If managers have too much of cash available to them it may create an agency problem in that they may spend funds in a wasteful manner. One way the firm can control this problem is to increase the debt level. In doing this the firm can bond that the cash flow. An example of bonding the cash flow is a leveraged buyout in which the firm uses a high level of debt and a small amount of cash to finance the purchase of the firm’s shares and takes the firm private. Although bankruptcy and financial distress are costly, if the firm has few profitable investment opportunities a high debt level may increase the value of the firm. If we assume that markets are efficient security prices include all available information because shares are fairly priced. The windows of opportunity theory says that managers don’t believe this and instead believe that stock prices and interest rates are either too high or too low when compared to their fundamental values. This theory says that managers try to time the market and issue equity when they think the stock market is too high and debt when they think interest rates are too low.

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Slide 6

Capital structure evidence and implications

Firms try to focus on the tax benefit of issuing debt while avoiding the costs associated with financial distress and sometimes allow debt ratios to deviate from the optimal target ratios. While there is a great deal of evidence to support the windows of opportunity theory, there is little evidence to support a pecking order and the use of issuing securities as a signal. Finally, firms with numerous growth opportunities or problems with informational asymmetry usually maintain reserve a reserve capacity.

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Slide 7

Estimating the optimal capital structure

When determining its optimal capital structure the firm follows a set procedure.

First, estimate the interest rate it will pay.

Second, estimate the cost of equity.

Third, estimate the WACC.

Finally, estimate the value of the firm’s operations.

Its objective is to determine the level of debt financing that maximizes the value of the firm’s operations. To estimate the cost of debt investment bankers first analyze industry conditions and prospects.

Next, they appraise the firm’s business risk based on historic financial statements, current technology, and customer base. The investment bankers also forecast financial statements using different capital structures and analyze key ratios.

Finally, they incorporate current conditions in financial markets. To estimate the cost of equity the firm must first estimate the value of the unlevered beta, B sub U because the stock’s beta is the measure of risk for well-diversified investors. Moreover, beta increases with financial leverage because an increase in the debt ratio is the risk assumed by the stockholders.

Mathematically the impact of financial average on beta is given by B equals B sub U times the quantity one plus the quantity one minus T times the quantity W sub D divided by W sub S;

Where W sub D and W sub S are the percentages of debt and equity. This format can be arranged to solve for B sub U and the capital asset pricing model can be used to estimate R sub S for various capital structures. Then, the firm’s WACC and the value of the firm are determined and the capital structure that maximizes the value of the firms selected.

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Slide 8

Anatomy of Recapitalization

When a firm recapitalizes it issues enough additional debt to optimize its capital structure and uses the proceeds to repurchase its stock. Before the firm issues additional debt it analyzes the impact of the additional debt on the wealth of the stockholders. If the firm practices value based management sometimes small improvements in operations resulted in large increases in value. However, very often it is difficult to improve operations especially when the firm is in a competitive industry and is well managed. While it’s easy for the firm to change its capital structure doing this will add only a small amount of value. A firm should deleverage if its debt level is more than optimal. With the debt level decreased the firm issues new shares of stock and uses the proceeds to pay off the debt.

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Slide 9

Check Your Understanding

Slide 10

Summary

We have now reached the end of this lesson. Let’s review what we’ve covered.

First, we looked at a number of issues that impact the capital structure decision by the firm. Factors like the risk of bankruptcy risk, business risk, and financial risk affect the firm’s WACC which affects the capital structure.

Next, we learned business risk and financial risk jointly determine the total risk of the firm’s future return on equity. Business risk is the uncertainty inherent in the firm’s future operating earnings before interest and taxes.

Then, we studied MM’s theory that is based on some very restrictive assumptions, but relaxed the assumption of no corporate taxes. Miller extended the model to include personal taxes and concluded that they do not completely eliminate the advantage of debt financing.

Then, we looked at several other theories and how they impact the firm’s capital structure. Empirically we found that there is a great deal of evidence to support the windows of opportunity theory, but little evidence to support a pecking order and the use of issuing securities as a signal.

Next, we looked at the procedure the firm uses to determine its optimal capital structure. When determining its optimal capital structure the firm follows a set procedure.

First, estimate the interest rate it will pay.

Second, estimate the cost of equity.

Third, estimate the WACC.

And fourth, estimate the value of the firm’s operations.

Finally, we looked at what happens when the firm recapitalizes. It issues enough additional debt to optimize its capital structure and uses the proceeds to repurchase its stock.

This concludes this lesson.