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Financial Leverage and Capital Structure Policy
RWJ-Chapter 16
+The Capital-Structure Question and the Pie Theory How should a firm choose its debt-equity ratio?
The value of a firm is defined to be the sum of the value of the firm’s debt and the firm’s equity.
V = D + E
If the goal of the management of the firm is to make the firm as valuable as possible, the firm should pick the debt-equity ratio that makes the pie as big as possible.
Value of the Firm
SE D
In other words, changes in capital structure benefit the stockholders if and only if the value of the firm increases.
+Financial Leverage, EPS, and ROE
Consider an all-equity (unlevered) firm that is considering going into debt. (Maybe some of the original shareholders want to cash out.)
+EPS and ROE Under Current Capital Structure
Recession ExpectedExpansion
EBIT $1,000$2,000$3,000
Interest 0 0 0
Net income $1,000$2,000$3,000
EPS $2.50 $5.00 $7.50
ROA 5% 10% 15%
ROE 5% 10% 15%
Current Shares Outstanding = 400 shares
+EPS and ROE Under Proposed Capital Structure
Recession ExpectedExpansion
EBIT $1,000$2,000$3,000
Interest 640 640 640
Net income $360 $1,360$2,360
EPS $1.50 $5.67 $9.83
ROA 5% 10% 15%
ROE 3% 11% 20%
Proposed Shares Outstanding = 240 shares
+EPS and ROE Under Both Capital Structures
All-EquityRecession Expected Expansion
EBIT $1,000 $2,000 $3,000Interest 0 0 0Net income $1,000 $2,000 $3,000EPS $2.50 $5.00 $7.50ROA 5% 10% 15%ROE 5% 10% 15%Current Shares Outstanding = 400 shares
+Financial Leverage and EPS
(2.00)
0.00
2.00
4.00
6.00
8.00
10.00
12.00
1,000 2,000 3,000
EP
S
Debt
No Debt
Break-even point
EBI in dollars, no taxes
Advantage to debt
Disadvantage to debt EBIT
+Assumptions of the Modigliani-Miller Model
Homogeneous Expectations
Homogeneous Business Risk Classes
Perpetual Cash Flows
Perfect Capital Markets: Perfect competition Firms and investors can borrow/lend at the same rate Equal access to all relevant information (no information
asymmetry) No transaction costs, no bankruptcy costs No taxes
+The MM Propositions I & II (No Taxes) Proposition I
Firm value is not affected by leverage
VL = VU
Proposition II Leverage increases the risk and return to stockholders
rL = rU + (D / E) (rU - rD)
rD is the interest rate (cost of debt)
rL is the return on (levered) equity (cost of equity)
rU is the return on unlevered equity (cost of capital)
D is the value of debt
E is the value of levered equity
+The Cost of Equity, the Cost of Debt, and the Weighted Average Cost of Capital: MM Proposition II with No Corporate Taxes
Debt-to-equity Ratio
Cos
t of
capi
tal:
r (%
)
rU
rD
LDWACC rED
Er
ED
Dr
)( DUUL rrE
Drr
rD
E
D
+MM: An Interpretation
MM results indicate that managers cannot change the value of a firm by repackaging the firm’s securities.
MM argue that the firm’s overall cost of capital cannot be reduced as debt is substituted for equity, even though debt appears to be cheaper than equity.
The reason for this is that as the firm adds more debt, the remaining equity becomes risky. As the risk rises, the cost of equity capital rises as a result.
The increase in the cost of remaining equity capital offsets the higher proportion of the firm financed with low-cost debt. MM proves that the two effects exactly offset each other, so that both the value of the firm and the firm’s overall cost of capital are invariant to leverage.
+The MM Propositions I & II (with Corporate Taxes) Proposition I (with Corporate Taxes)
Firm value increases with leverageVL = VU + TC D
TC D: Present value of tax shield from debt
Proposition II (with Corporate Taxes) Some of the increase in equity risk and return is offset by
interest tax shieldrL = rU + (D/E)×(1-TC)×(rU- rD)
rD is the interest rate (cost of debt)rL is the return on equity (cost of equity)rU is the return on unlevered equity (cost of capital)D is the value of debtE is the value of levered equity
+The Effect of Financial Leverage on the Cost of Debt and Equity Capital with Corporate Taxes
Debt-to-equityratio (D/E)
Cost of capital: r(%)
rU
rD
)()1( DUCUL rrTE
Drr
LCDWACC rED
ETr
ED
Dr
)1(
)( DUUL rrE
Drr
+The Effect of Financial Leverage on the Cost of Debt and Equity Capital with Corporate Taxes
+Total Cash Flow to Investors Under Each Capital Structure with Corp. Taxes
The levered firm pays less in taxes than does the all-equity firm.
Thus, the sum of the debt plus the equity of the levered firm is greater than the equity of the unlevered firm. (V=D+E)
E T E T
D
All-equity firm Levered firm
+Total Cash Flow to Investors Under Each Capital Structure with Corp. Taxes
The sum of the debt plus the equity of the levered firm is greater than the equity of the unlevered firm.
This is how cutting the pie differently can make the pie larger: the government takes a smaller slice of the pie!
E T E T
D
All-equity firm Levered firm
+Why are MM propositions important? MM theory assumes perfect capital markets (no
information asymmetry, no bankruptcy costs, etc.).
We know in the real world capital markets are not perfect.
All scientific theories begin with a set of idealized assumptions from which conclusions can be drawn. When we apply the theory, we should consider the consequences of important deviations.
By indicating the conditions under which capital structure is irrelevant, MM provides us clues about what is required for capital structure to be relevant.
+Prospectus: Bankruptcy Costs
So far, we have seen M&M suggest that financial leverage does not matter, or imply that taxes cause the optimal financial structure to be 100% debt.
In the real world, most executives do not like a capital structure of 100% debt because that is a state known as “bankruptcy”.
Next, we will introduce the notion of a limit on the use of debt: financial distress.
+Bankruptcy
Airlines traditionally rely heavily on debt financing. Unfortunately this practice can have adverse consequences when things do not work out as planned. By 2005, a variety of problems in the airline industry had led to a widespread financial distress, particularly among the “legacy” carriers.
Delta, NWA, United Airlines, and US Airways operated under bankruptcy protection.
In June 2005, European commission approved to restructure Italy’s state-owned Alitalia.
There is limit to the financial leverage a company can undertake and the risk of too much leverage is bankruptcy.
+Bankruptcy Costs
Bankruptcy risk versus bankruptcy cost.
The possibility of bankruptcy has a negative effect on the value of the firm.
However, it is not the risk of bankruptcy itself that lowers value.
Rather it is the costs associated with bankruptcy.
It is the stockholders who bear these costs.
+Description of Bankruptcy Costs
Direct Costs Legal and administrative costs (tend to be a small
percentage of firm value; around 3%). Enron filed for bankruptcy in December 2001. The company
wanted to reorganize but complications arose. Enron filed for 5 reorganization plans. By the end of 2004, lawyers, consultants and accountants had earned nearly $1 billion in fees. Worldcom paid around $600 million in fees.
Indirect Costs – Substantial; 10 to 20% of firm value. Impaired ability to conduct business (e.g., lost sales). Agency Costs – conflicts of interest between stockholders
and bondholders Selfish strategy 1: Incentive to take large risks Selfish strategy 2: Incentive toward underinvestment Selfish Strategy 3: Milking the property
+Balance Sheet for a Company in Distress
The bondholders get $200; the shareholders get nothing.
Assets BV MV Liabilities BV MV
Cash $200 $200 LT bonds $300 $200
Fixed Asset $400 $0 Equity $300 $0
Total $600 $200 Total $600 $200
What happens if the firm is liquidated today?
+Selfish Strategy 1: Take Large Risks
The Gamble Probability Payoff
Win Big 10% $1,000
Lose Big 90% $0
Cost of investment is $200 (all the firm’s cash)
Required return is 50%
Expected CF from the Gamble = $1000 × 0.10 + $0 = $100
NPV = –$200 + $100
(1.50)
NPV = –$133
+Selfish Stockholders Accept Negative NPV Project with Large Risks Expected CF from the Gamble
To Bondholders = $300 × 0.10 + $0 = $30 To Stockholders = ($1000 – $300) × 0.10 + $0 = $70
PV of Bonds Without the Gamble = $200
PV of Stocks Without the Gamble = $0
PV of Bonds With the Gamble: $20=$30/(1.50)
PV of Stocks With the Gamble: $47=$70/(1.50).
+Selfish Strategy 2: Underinvestment Consider a government-sponsored project that
guarantees $350 in one period
Cost of investment is $300 (the firm only has $200 now) so the stockholders will have to supply an additional $100 to finance the project
Required return is 10%
NPV = –$300 + $350
(1.10)
NPV = $18.18
Should we accept or reject?
+Selfish Stockholders Forego Positive NPV ProjectExpected CF from the government sponsored project:
To Bondholder = $300
To Stockholder = ($350 – $300) = $50
PV of Bonds Without the Project = $200
PV of Stocks Without the Project = $0
PV of Bond With the Project: $272.73=$300/(1.10)
PV of Stocks With the Project: -$54.55=$50/(1.10)-$100
+Selfish Strategy 3: Milking the PropertyLiquidating dividends
Suppose our firm paid out a $200 dividend to the shareholders. This leaves the firm insolvent, with nothing for the bondholders, but plenty for the former shareholders.
Such tactics often violate bond indentures.
Increase perquisites to shareholders
and/or management
+Who Pays for the Cost of Selfish Investment Strategies?
Shareholders ultimately pay for these costs.
Rational bondholders know that when financial distress is imminent stockholders are likely to choose investment strategies that reduce the value of the bonds.
Bondholders protect themselves accordingly by raising the interest rate they require on bonds. Because the stockholders must pay these high rates, they ultimately bear the costs of selfish strategies.
+Optimal Capital Structure
There is a trade-off between the tax advantage of debt and the costs of financial distress.
Trade-off theory implies that there is an optimum amount of debt for any individual firm. This amount of debt becomes the firm’s target level.
It is difficult to express this with a precise and rigorous formula.
+Integration of Tax Effects and Financial Distress Costs
Debt (D)
Value of firm (V)
0
Present value of taxshield on debt
Present value offinancial distress costs
Value of firm underMM with corporatetaxes and debt
VL = VU + TCD
V = Actual value of firm
VU = Value of firm with no debt
D*
Maximumfirm value
Optimal amount of debt
+Signaling
The firm’s capital structure is optimized where the marginal subsidy to debt equals the marginal cost.
Investors view debt as a signal of firm value. Firms with low anticipated profits will take on a low level of
debt. Firms with high anticipated profits will take on high levels of
debt.
A manager that takes on more debt than is optimal in order to fool investors will pay the cost in the long run.
+Signaling-Example
Firm P (positive prospects) has just discovered an unpatentable cure for common cold. They want to keep the new product a secret as long as possible. New plants must be built, capital must be raised. How should they raise capital?
If they issue stock now, when the product is revealed the stock price is going to soar. But is it in the best interest of the company and the managers to issue stock?
Firm N (negative prospects) has information that new orders are off sharply because of competition. Firm N must upgrade its facilities just to maintain its sales. How should Firm N raise capital? Can Firm N mimic Firm P’s behavior?
+Issuing Undervalued Equity
Issuing undervalued equity is costly for original shareholders. Dilution will occur in this case.
Let’s say Firm P is currently traded at $10 a share and has 20 million shares outstanding ($200 million value). The managers believe the true value of the firm is $300 million ($15 a share).
P needs to raise $60 million. If Firm P issues equity today before the news is released, it has to issue 6 million shares.
After the good news is released the value of the firm will be: $300 million + 60 million = 360 million. 26 million shares outstanding, value per share is $13.85.
If the company waits for the good news to come out and issue equity: Issue 4 million shares @15 a share. Value per share (300 million + 60 million)/24 million = $15
+Signaling – Empirical Evidence
Exchange offers: Stockholders exchange some of their stock for debt, thereby increasing
leverage. Bondholders exchange some of their debt for stock, decreasing
leverage.
Stock prices rise substantially on the date when an exchange offer increasing leverage is announced.
Stock prices fall substantially when an offer decreasing leverage is announced.
The market infers from an increase in debt that the firm is better off, leading to stock price rise.
The market infers the reverse from a decrease in debt, implying a stock price fall.
+The Pecking-Order Theory
Information asymmetry and timing of the issues “I want to issue stock in one situation only- when it is
overvalued. If the stock of the firm is selling at $50 a share, but I think it is actually worth $60, I will not issue stock. My current shareholders will be upset since the firm will get $50 in cash for the stock that is worth $60. In such a case, I will issue bonds. But if the stock is overvalued, I would issue stock.”
“Even all the time I put into studying stocks, I cannot possibly know what the managers know. So, I watch what the managers do. If a firm issues stock, the firm was likely to be overvalued before hand.”
+The Pecking-Order Theory
When we look at both issuers and investors, we see a kind of poker game. There are two prescriptions to the issuer in this poker game: Issue debt instead of equity when the stock is undervalued. Issue debt when the firm is overvalued. If the firm issues
equity, investors will infer that the stock is overvalued. They will not buy it until the stock has fallen enough to eliminate any advantage from equity issuance.
But in the presence of financial distress costs, firms may issue debt up to a point. If financial distress becomes a real possibility beyond a point, the firm may issue equity instead.
+The Pecking-Order Theory
Theory stating that firms prefer to issue debt rather than equity if internal finance is insufficient. Rule 1
Use internal financing first. Rule 2
Issue debt next, equity last.
The pecking-order theory is at odds with the trade-off theory: There is no target D/E ratio. Profitable firms use less debt. Companies like financial slack: They accumulate cash today
to finance future projects.
+Observed Capital Structures
There is no exact formula for evaluating the optimal debt-equity ratio. Prescriptions for capital structure under the trade-off model or the pecking-order theory are quiet vague. So, we turn to the evidence from the real world.
Most corporations have low debt-asset ratios.
A number of firms use no debt: Agrawal and Nagarajan (1990) found that 100 firms in NYSE do not have any long-term debt. These firms have high cash levels; managers have high equity ownership.
There are differences in capital structure across industries.
There is evidence that firms behave as if they had a target Debt to Equity ratio.
+Total Debt as a Percentage of the Market Value of Equity: U.S. Nonfinancial firms
Market Debt Ratio
0%
10%
20%
30%
40%
50%
60%
70%
1995 1996 1997 1998 1999 2000 2001 2002 2003 2004
Year
Mar
ket D
ebt R
atio
(%
)
Most corporations have low debt ratios
+Ratios of Debt to Total Value (Book value)
Debt/Total Value (%)
48
72
4945
58 59
01020304050607080
USJa
pan
Germ
any
Canada
Franc
eIta
ly
Country
Per
cen
t
+High Leverage vs. Low Leverage Industries
Debt/MV of equity+debt
52.8 5647.7
42.251.9
0102030405060
Debt/MV of equity+debt
4.7
9.8
4
8.2
5.3
02468
1012
+Survey Results on the Use of Target Debt-Equity Ratios (Graham and Harvey, 2001)
Flexible Target37%
No Target Ratio/Range
19%
Very Strict Target10%
Somew hat Tight
Target/Range34%
+Factors in Target D/E Ratio
Taxes Interest is a tax deductible expense, and deductions are
most valuable for firms with high tax rates.
Types of Assets Firms whose assets are more suitable as security for loans
tend to use debt more heavily. Thus real estate companies are usually highly leveraged, whereas companies involved in technological research are not.
Uncertainty of Operating Income Even without debt, firms with uncertain operating income
have high probability of experiencing financial distress. Thus these firms must finance with equity (e.g. Drug companies)
+Determinants of Capital Structure According to Financial Managers According to a survey (Pinegar and Wilbricht) financial
managers consider the following factors in making capital structure decisions (In order of importance) Maintaining financial flexibility Ensuring long-term survivability Maintaining a predictable source of funds Maximizing security prices Maintaining financial independence Maintaining a high debt rating Maintaining comparability with other firms in the industry Minimizing the probability of being acquired
+Bankruptcy:What Happens to the Company? Chapter 11: Gives a chance to the company to
reorganize the business and to try to become profitable again. Management continues to run the day-to-day operations but all significant business decisions must be approved by a bankruptcy court.
Chapter 7: The company stops all operations and goes completely out of business. A trustee is appointed to liquidate the company’s assets and the money is used to pay off the debt.
+How are Assets Divided in Bankruptcy?
The distribution of the proceeds of the liquidation occurs according to the following priority list:
1. Administrative expense related to the bankruptcy2. Wages, salaries, and commissions3. Contributions to employee benefit plans4. Consumer claims5. Government tax claims6. Payment to unsecured creditors7. Payment to preferred stockholders8. Payment to common stockholders
Secured creditors are entitled to the proceeds from the sale of security and are outside this ordering.
In reality what happens and who gets what in the event of bankruptcy are subject to much negotiation; as a result the priority list might not be followed.
+What Happens to Stocks and Bonds of the Company? (1)
A company’s securities may continue to trade even after the company has filed for bankruptcy under Chapter 11.
In most cases, these companies are unable to meet the listing standards of NYSE or Nasdaq.
If the company’s shares are delisted, the shares can continue to trade over the counter.
It is extremely risky to buy common stocks of a company operating under Chapter 11. Although the company may emerge from bankruptcy, the creditors become the new owners of shares. In most cases, the company’s plan of reorganization will cancel the existing equity shares.
+What Happens to Stocks and Bonds of the Company? (2)
During bankruptcy, bondholders will stop receiving interest and principal payments, and stockholders will stop receiving dividends.
If you are a bondholder, you may receive new stock in exchange of your bonds, new bonds, or a combination of stock and bonds.
If you are a stockholder, you might be asked to send back your old stock in exchange for new shares. The new shares may be fewer in number and may be worth less than your old shares.
For more information:
http://sec.gov/investor/pubs/bankrupt.htm
http://www.uscourts.gov/bankruptcycourts/bankruptcybasics/chapter7.html
+What is Strategic Bankruptcy?
Some bankruptcy filings are actually strategic actions intended to improve a firm’s competitive position.
Firms file for bankruptcy even though they are not insolvent at the time.
Continental Airlines filed for bankruptcy in 1983 following deregulation of airline industry. It filed for Chapter 11 although it was not insolvent at the time.
The firm argued that, based on pro forma data, it would become insolvent in the future.
By filing for bankruptcy it was able to terminate labor agreements, layoff workers, and reduce wages.
Texaco filed for bankruptcy after Pennzoil litigation. Later settled the case for $3.5 billion and emerged from bankruptcy.
+Summary and Conclusion
Costs of financial distress cause firms to restrain their issuance of debt. Direct costs
Lawyers’ and accountants’ fees Indirect Costs
Impaired ability to conduct business Incentives to take on risky projects Incentives to underinvest Incentive to milk the property
+Summary and Conclusion
Because costs of financial distress can be reduced but not eliminated, firms will not finance entirely with debt.
Debt (B)
Value of firm (V)
0
Present value of taxshield on debt
Present value offinancial distress costs
Value of firm underMM with corporatetaxes and debt
VL = VU + TCB
V = Actual value of firm
VU = Value of firm with no debt
B*
Maximumfirm value
Optimal amount of debt
+Summary and Conclusions
Debt-to-equity ratios vary across industries.
Factors in Target D/E Ratio Taxes Types of Assets Uncertainty of Operating Income
