Capital Structure

7-2

1. Explain why borrowing rates are different based on ability to repay loans.

2. Demonstrate the benefits of borrowing.

3. Calculate the break-even EBIT for different capital structure.

4. Explain the appropriate borrowing strategy under the pecking order hypothesis.

5. Define optimal borrowing in a world of no taxes.

6. Explain the static theory of capital structure.

LEARNING OBJECTIVES

Chapter 16: Using other people’s moneyWhy do we borrow?

Consume today on future incomeHouseholds currently have almost $16 trillion in

outstanding loansDoes it matter where we get our money?

What makes a good source of funds when we borrow? Lowest cost for funds Implicit costs can be very expensive

Is there an optimal borrowing strategy?Reduce overall costs with a different borrowing

pattern3

16.1 Capital Markets

• In the corporate world…two major markets for borrowing• From banks and bond markets – Debt Markets• From owners – Equity Markets

• Borrowers get different rates from these two markets• Debt market – different yield to maturities on bonds• Debt market – different loan rates from banks• Equity market – different return rates for stocks• Ability to pay back loan impacts the rate• Lenders (and owners) look at the future cash flow

7-3

16.1 Capital Markets• Different Rates for Different Borrowers

Success rate for Angel Investors – impact returnsExample 16.1 in the book Larry and Sherry

Larry is successful on four in ten investments Sherry is successful on one in ten investments

Required Return on $1,000,000 ($100,000 for each of ten projects) Larry gets four to payback…each must pay $250,000

so rate is ($250,000 - $100,000) / $100,000 = 150% Sherry gets only one to payback…it must pay

$1,000,000 so rate is ($1,000,000 - $100,000) / $100,000 = 900%

7-4

16.2 Benefits of BorrowingWho would every pay Sherry 900% on a loan?

You have a project with a 25% chance of making $5,000,000 and a 75% chance of making $0

No banks or friends will loan you the moneySherry offers 900% rate for the needed $100,000

investmentDo you take the loan?

Expected Payoff…25% x $5,000,000 - $1,000,000 = $250,000 But…either you make $4,000,000 or you lose

$100,000Financial Leverage…using other people’s money

7-5

16.2 Benefits of Borrowing• How do we measure financial leverage in a

company?• Leverage is the amount of debt borrowed versus the

amount of funds from the owners• Highly leveraged firms have high Debt to Equity

ratios• Unlevered firms use only equity financing

• How do we measure the benefits to a company from debt borrowing?– Earnings Per Share– Does borrowing increase or decrease the owner’s

wealth?

7-6

16.2 Benefits of BorrowingPage 494-497

Three companies with different Debt / Equity RatiosCompany 1 is unlevered (all equity, 400 shares)Company 2 is 50 / 50 debt and equity (200 shares)Company 3 is levered to the max (1 share)

High EBIT -- $2,000 Company 3 structure is bestLow EBIT -- $800 Company 1 structure is bestAt $1,000 – All have the same Earnings Per Share

Capital Structure is irrelevant at $1,000

7-8

16.3 Find the Break-Even EBITCan only find this in a pair-wise fashion

(can only compare two firms at a time)Set EPS calculation equal under the two

structuresCompany 1 EPS = EBIT / 400Company 2 EPS = (EBIT - $500) / 200Company 1 EPS = Company 2 EPS, solve for EBIT

This in a world of no taxes…Above the Break-Even EBIT more leverage

(more debt) is better for the owners. 

7-9

16.4 Pecking Order Hypothesis• Borrow from the cheapest source first

• Once the source is “exhausted” move to the second cheapest source

• Continue to additional sources as needed for funding once each level is “exhausted”

• This borrowing hypothesis is based on asymmetric information• One set of agents (company managers and owners)

know more about the future cash flow prospects of the company than the lending agents

• Firms Prefer Internal Financing First• Firms Choose to Issue the cheapest security first• Firms Use Equity as a Last Resort

7-10

Example 16.3 Rogen vs. Rudd CorporationsFacts: Outsiders think that the stock could go as

high as $50 or as low as $35 but it now is fairly valued at $42

Rogen CEO knows the company has a major break-through and stock will climb to $50However the information is proprietary

Rudd CEO knows they have a new product too but, will not cause a rise in stock pricesCompetitors will be able to quickly imitate new

product

7-10

16.4 Pecking Order Hypothesis

16.4 Pecking Order HypothesisHow do you finance the needed $50 million?

Rogen CEO cannot tell public about product and will not sell equity below the new $50 value once the product is released (transfer of wealth from original owners to new owners) as the new owners will only pay $42 a share without the inside information

Rogen CEO thus chooses to use debt to avoid wealth transfer

Rudd CEO knows stock is worth $42 but if he chooses to sell equity the market will pay only $35. New owners believe that Rudd would only sell equity if it is overpriced, thus the $35 is the correct price

Rudd CEO thus chooses to use debt to avoid wealth transfer

7-11

16.4 Pecking Order HypothesisConclusion

Profitable companies will borrow less and signal more debt capacity

Less profitable companies need more outside funding and will first seek debt (avoiding wealth transfer)

As a last resort, companies will sell equityWhile this Hypothesis has some support, we see

many companies use debt when they have internal funding…

13

16.5 Modigliani and Miller on Optimal Capital StructureStart with the simplest world…no taxes and no

bankruptcy (firms never default)M&M Proposition 1 – Capital Structure is irrelevant

Value of an all equity firm (VE) is equal to the value of a leveraged firm (VL)

Think of two pies of equal size, the value (volume) of the pie does not change when we cut it into smaller pieces

M&M Proposition 2 – A firm’s value is based on The required rate of return The cost of Debt The firm’s debt-to-equity ratio

7-14

16.5 Modigliani and Miller on Optimal Capital Structure

7-15

The math…•WACC = (E/V) x Re + (D/V) x Rd x (1 - Tc ) •The required return on the assets, Ra, is equal to WACC•Ra = (E/V) x Re + (D/V) x Rd

•In a world of no taxes, the required return on assets is the weighted average of equity and debt• Re = Ra + (Ra –Rd) x (D/E)

•The visual…page 504 Figure 16.3

16.5 Modigliani and Miller on Optimal Capital Structure

7-16

• But the world has taxes…so what happens when we add taxes

• M&M Proposition 1 – with taxes• All debt financing is preferred• Adding debt reduces the government’s

claim to the pie• M&M Proposition 2 – with taxes

• As the firm adds debt the WACC falls• There is a tax shield with debt • The bigger the debt the greater the

tax shield

• Visual is Pie Charts on page 505

16.5 Modigliani and Miller on Optimal Capital Structure What is the tax shield?

The government allows the deduction of interest expense from taxable income (pays part of the interest for the company)

The owners of the company claim this tax shield VL = VE + (D x TC)

Thus the owner’s value increases as a company adds more debt financing

See Figure 16.5 on page 507Optimal Capital Structure is now all debt

7-17

16.5 The Static Theory of Capital Structure

• We now relax the last parameter…bankruptcy– When a firm borrows “too much” and cash flow

is insufficient to cover interest payments– The company goes into bankruptcy– Technically the debt holders get the company

– Bankruptcy costs– Direct costs are relatively small– Indirect costs can be large…takes the managers away

from the required tasks and puts the company in financial distress

– The greater the debt, the greater the chance of financial distress

7-16

16.5 The Static Theory of Capital Structure

7-17

As a firm starts to add debt…the tax shield provides wealth to the owners of the company (again cutting into the government’s share) and the WACC is falling across this range

At some point the costs of financial distress begin to enter as more debt is added

Eventually the additional $1 benefit of the tax shield is exactly offset by the additional cost of financial distress

At that point WACC is lowest and we have the optimal debt/equity ratio for the firm.

See Figure 16.6 on page 510