1、1Chapter 16Capital Structure Decisions2Topics in ChapternOverview and preview of capital structure effectsnBusiness versus financial risknThe impact of debt on returnsnCapital structure theory,evidence,and implications for managersnExample:Choosing the optimal structure3Basic DefinitionsnV=value of
2、firmnFCF=free cash flownWACC=weighted average cost of capitalnrs and rd are costs of stock and debtnre and wd are percentages of the firm that are financed with stock and debt.4How can capital structure affect value?V=t=1FCFt(1+WACC)tWACC=wd(1-T)rd+wers5A Preview of Capital Structure EffectsnThe imp
3、act of capital structure on value depends upon the effect of debt on:nWACCnFCF(Continued)6The Effect of Additional Debt on WACCnDebtholders have a prior claim on cash flows relative to stockholders.nDebtholders“fixed”claim increases risk of stockholders“residual”claim.nCost of stock,rs,goes up.nFirm
4、s can deduct interest expenses.nReduces the taxes paidnFrees up more cash for payments to investorsnReduces after-tax cost of debt(Continued)7The Effect on WACC(Continued)nDebt increases risk of bankruptcynCauses pre-tax cost of debt,rd,to increasenAdding debt increase percent of firm financed with
5、low-cost debt(wd)and decreases percent financed with high-cost equity(we)nNet effect on WACC=uncertain.(Continued)8The Effect of Additional Debt on FCFnAdditional debt increases the probability of bankruptcy.nDirect costs:Legal fees,“fire”sales,etc.nIndirect costs:Lost customers,reduction in product
6、ivity of managers and line workers,reduction in credit(i.e.,accounts payable)offered by suppliers(Continued)9nImpact of indirect costsnNOPAT goes down due to lost customers and drop in productivitynInvestment in capital goes up due to increase in net operating working capital(accounts payable goes u
7、p as suppliers tighten credit).(Continued)10nAdditional debt can affect the behavior of managers.nReductions in agency costs:debt“pre-commits,”or“bonds,”free cash flow for use in making interest payments.Thus,managers are less likely to waste FCF on perquisites or non-value adding acquisitions.nIncr
8、eases in agency costs:debt can make managers too risk-averse,causing“underinvestment”in risky but positive NPV projects.(Continued)11Asymmetric Information and SignalingnManagers know the firms future prospects better than investors.nManagers would not issue additional equity if they thought the cur
9、rent stock price was less than the true value of the stock(given their inside information).nHence,investors often perceive an additional issuance of stock as a negative signal,and the stock price falls.12Business risk:Uncertainty about future pre-tax operating income(EBIT).ProbabilityEBITE(EBIT)0Low
10、 riskHigh riskNote that business risk focuses on operating income,so it ignores financing effects.13Factors That Influence Business RisknUncertainty about demand(unit sales).nUncertainty about output prices.nUncertainty about input costs.nProduct and other types of liability.nDegree of operating lev
11、erage(DOL).14What is operating leverage,and how does it affect a firms business risk?nOperating leverage is the change in EBIT caused by a change in quantity sold.nThe higher the proportion of fixed costs within a firms overall cost structure,the greater the operating leverage.(More.)15Higher operat
12、ing leverage leads to more business risk:small sales decline causes a larger EBIT decline.(More.)Sales$Rev.TCFQBEEBIT$Rev.TCFQBESales16Operating BreakevennQ is quantity sold,F is fixed cost,V is variable cost,TC is total cost,and P is price per unit.nOperating breakeven=QBEnQBE=F/(P V)nExample:F=$20
13、0,P=$15,and V=$10:nQBE=$200/($15$10)=40.(More.)17ProbabilityEBITLLow operating leverageHigh operating leverageEBITHHigher operating leverage leads to higher expected EBIT and higher risk.18Business Risk versus Financial RisknBusiness risk:nUncertainty in future EBIT.nDepends on business factors such
14、 as competition,operating leverage,etc.nFinancial risk:nAdditional business risk concentrated on common stockholders when financial leverage is used.nDepends on the amount of debt and preferred stock financing.19Consider Two Hypothetical FirmsFirm UFirm LNo debt$10,000 of 12%debt$20,000 in assets$20
15、,000 in assets40%tax rate40%tax rate Both firms have same operating leverage,business risk,and EBIT of$3,000.They differ only with respect to use of debt.20Impact of Leverage on ReturnsFirm UFirm LEBIT$3,000$3,000Interest 0 1,200EBT$3,000$1,800Taxes(40%)1,200720NI$1,800$1,080ROE9.0%10.8%21Why does l
16、everaging increase return?nMore EBIT goes to investors in Firm L.nTotal dollars paid to investors:nU:NI=$1,800.nL:NI+Int=$1,080+$1,200=$2,280.nTaxes paid:nU:$1,200;L:$720.nEquity$proportionally lower than NI.22ContinuednNow consider the fact that EBIT is not known with certainty.What is the impact o
17、f uncertainty on stockholder profitability and risk for Firm U and Firm L?23Firm U:UnleveragedEconomyBadAvg.GoodProb.0.250.500.25EBIT$2,000$3,000$4,000Interest 0 0 0EBT$2,000$3,000$4,000Taxes(40%)800 1,200 1,600NI$1,200$1,800$2,40024Firm L:LeveragedEconomyBadAvg.GoodProb.*0.250.500.25EBIT$2,000$3,00
18、0$4,000Interest 1,200 1,200 1,200EBT$800$1,800$2,800Taxes(40%)320 720 1,120NI$480$1,080$1,680*same as for Firm U25Firm UBadAvg.GoodBEP10.0%15.0%20.0%ROIC6.0%9.0%12.0%ROE6.0%9.0%12.0%TIEn.a.n.a.n.a.Firm LBad Avg.GoodBEP10.0%15.0%20.0%ROIC6.0%9.0%12.0$ROE4.8%10.8%16.8%TIE1.7x2.5x3.3x26Profitability Me
19、asures:ULE(BEP)15.0%15.0%E(ROIC)9.0%9.0%E(ROE)9.0%10.8%Risk Measures:ROIC2.12%2.12%ROE2.12%4.24%27ConclusionsnBasic earning power(EBIT/TA)and ROIC(NOPAT/Capital=EBIT(1-T)/TA)are unaffected by financial leverage.nL has higher expected ROE:tax savings and smaller equity base.nL has much wider ROE swin
20、gs because of fixed interest charges.Higher expected return is accompanied by higher risk.(More.)28nIn a stand-alone risk sense,Firm Ls stockholders see much more risk than Firm Us.nU and L:ROIC=2.12%.nU:ROE=2.12%.nL:ROE=4.24%.nLs financial risk is ROE-ROIC=4.24%-2.12%=2.12%.(Us is zero.)(More.)29nF
21、or leverage to be positive(increase expected ROE),BEP must be rd.nIf rd BEP,the cost of leveraging will be higher than the inherent profitability of the assets,so the use of financial leverage will depress net income and ROE.nIn the example,E(BEP)=15%while interest rate=12%,so leveraging“works.”30Ca
22、pital Structure TheorynMM theorynZero taxesnCorporate taxesnCorporate and personal taxesnTrade-off theorynSignaling theorynPecking ordernDebt financing as a managerial constraintnWindows of opportunity31MM Theory:Zero TaxesnMM prove,under a very restrictive set of assumptions,that a firms value is u
23、naffected by its financing mix:n VL=VU.nTherefore,capital structure is irrelevant.nAny increase in ROE resulting from financial leverage is exactly offset by the increase in risk(i.e.,rs),so WACC is constant.32MM Theory:Corporate TaxesnCorporate tax laws favor debt financing over equity financing.nW
24、ith corporate taxes,the benefits of financial leverage exceed the risks:More EBIT goes to investors and less to taxes when leverage is used.nMM show that:VL=VU+TD.nIf T=40%,then every dollar of debt adds 40 cents of extra value to firm.33Value of Firm,V0DebtVLVUUnder MM with corporate taxes,the firm
25、s value increases continuously as more and more debt is used.TDMM relationship between value and debt when corporate taxes are considered.34Cost of Capital(%)020406080100Debt/Value Ratio(%)rsWACCrd(1-T)MM relationship between capital costs and leverage when corporate taxes are considered.35Millers T
26、heory:Corporate and Personal TaxesnPersonal taxes lessen the advantage of corporate debt:nCorporate taxes favor debt financing since corporations can deduct interest expenses.nPersonal taxes favor equity financing,since no gain is reported until stock is sold,and long-term gains are taxed at a lower
27、 rate.36VL=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)Millers Model with Corporate and Personal Taxes37 VL=VU+1-D=VU+(1-0.75)D=VU+0.25D.Value rises with debt;each$1 increase in debt raises Ls value by$0.25.(1-0.40)(1-0.12)(
28、1-0.30)Tc=40%,Td=30%,and Ts=12%.38Conclusions with Personal TaxesnUse of debt financing remains advantageous,but benefits are less than under only corporate taxes.nFirms should still use 100%debt.nNote:However,Miller argued that in equilibrium,the tax rates of marginal investors would adjust until t
29、here was no advantage to debt.39Trade-off TheorynMM theory ignores bankruptcy(financial distress)costs,which increase as more leverage is used.nAt low leverage levels,tax benefits outweigh bankruptcy costs.nAt high levels,bankruptcy costs outweigh tax benefits.nAn optimal capital structure exists th
30、at balances these costs and benefits.40Signaling TheorynMM assumed that investors and managers have the same information.nBut,managers often have better information.Thus,they would:nSell stock if stock is overvalued.nSell bonds if stock is undervalued.nInvestors understand this,so view new stock sal
31、es as a negative signal.nImplications for managers?41Pecking Order TheorynFirms use internally generated funds first,because there are no flotation costs or negative signals.nIf more funds are needed,firms then issue debt because it has lower flotation costs than equity and not negative signals.nIf
32、more funds are needed,firms then issue equity.42Debt Financing and Agency CostsnOne agency problem is that managers can use corporate funds for non-value maximizing purposes.nThe use of financial leverage:nBonds“free cash flow.”nForces discipline on managers to avoid perks and non-value adding acqui
33、sitions.(More.)43nA second agency problem is the potential for“underinvestment”.nDebt increases risk of financial distress.nTherefore,managers may avoid risky projects even if they have positive NPVs.44Investment Opportunity Set and Reserve Borrowing CapacitynFirms with many investment opportunities
34、 should maintain reserve borrowing capacity,especially if they have problems with asymmetric information(which would cause equity issues to be costly).45Windows of OpportunitynManagers try to“time the market”when issuing securities.nThey issue equity when the market is“high”and after big stock price
35、 run ups.nThey issue debt when the stock market is“low”and when interest rates are“low.”nThe issue short-term debt when the term structure is upward sloping and long-term debt when it is relatively flat.46Empirical EvidencenTax benefits are important$1 debt adds about$0.10 to value.nSupports Miller
36、model with personal taxes.nBankruptcies are costly costs can be up to 10%to 20%of firm value.nFirms dont make quick corrections when stock price changes cause their debt ratios to change doesnt support trade-off model.47Empirical Evidence(Continued)nAfter big stock price run ups,debt ratio falls,but
37、 firms tend to issue equity instead of debt.nInconsistent with trade-off model.nInconsistent with pecking order.nConsistent with windows of opportunity.nMany firms,especially those with growth options and asymmetric information problems,tend to maintain excess borrowing capacity.48Implications for M
38、anagersnTake advantage of tax benefits by issuing debt,especially if the firm has:nHigh tax ratenStable salesnLess operating leverage49Implications for Managers(Continued)nAvoid financial distress costs by maintaining excess borrowing capacity,especially if the firm has:nVolatile salesnHigh operatin
39、g leveragenMany potential investment opportunitiesnSpecial purpose assets(instead of general purpose assets that make good collateral)50Implications for Managers(Continued)nIf manager has asymmetric information regarding firms future prospects,then avoid issuing equity if actual prospects are better
40、 than the market perceives.nAlways consider the impact of capital structure choices on lenders and rating agencies attitudes51Choosing the Optimal Capital Structure:ExamplenCurrently is all-equity financed.nExpected EBIT=$500,000.nFirm expects zero growth.n100,000 shares outstanding;rs=12%;P0=$25;T=
41、40%;b=1.0;rRF=6%;nRPM=6%.52Estimates of Cost of Debt%financed with debt,wdrd0%-20%8.0%30%8.5%40%10.0%50%12.0%If company recapitalizes,debt would be issued to repurchase stock.53The Cost of Equity at Different Levels of Debt:Hamadas Equation nMM theory implies that beta changes with leverage.nbU is t
42、he beta of a firm when it has no debt(the unlevered beta)nbL=bU 1+(1-T)(D/S)54The Cost of Equity for wd=20%nUse Hamadas equation to find beta:bL=bU 1+(1-T)(D/S)=1.0 1+(1-0.4)(20%/80%)=1.15nUse CAPM to find the cost of equity:rs=rRF+bL(RPM)=6%+1.15(6%)=12.9%55Cost of Equity vs.Leveragewd D/SbL rs0%0.
43、001.00012.00%20%0.251.15012.90%30%0.431.25713.54%40%0.671.40014.40%50%1.001.60015.60%56The WACC for wd=20%nWACC=wd(1-T)rd +we rsnWACC=0.2(1 0.4)(8%)+0.8(12.9%)nWACC=11.28%nRepeat this for all capital structures under consideration.57WACC vs.LeveragewdrdrsWACC0%0.0%12.00%12.00%20%8.0%12.90%11.28%30%8
44、.5%13.54%11.01%40%10.0%14.40%11.04%50%12.0%15.60%11.40%58Corporate Value for wd=20%nV=FCF/(WACC-g)ng=0,so investment in capital is zero;so FCF=NOPAT=EBIT(1-T).nNOPAT=($500,000)(1-0.40)=$300,000.nV=$300,000/0.1128=$2,659,574.59Corporate Value vs.LeveragewdWACCCorp.Value0%12.00%$2,500,00020%11.28%$2,6
45、59,57430%11.01%$2,724,79640%11.04%$2,717,39150%11.40%$2,631,57960Debt and Equity for wd=20%The dollar value of debt is:D=wd V=0.2($2,659,574)=$531,915.S=V D S=$2,659,574-$531,915=$2,127,659.61Debt and Stock Value vs.LeveragewdDebt,DStock Value,S0%$0$2,500,00020%$531,915$2,127,66030%$817,439$1,907,35
46、740%$1,086,957$1,630,43550%$1,315,789$1,315,789Note:these are rounded;see Ch 16 Mini Case.xls for full calculations.62Wealth of ShareholdersnValue of the equity declines as more debt is issued,because debt is used to repurchase stock.nBut total wealth of shareholders is value of stock after the reca
47、p plus the cash received in repurchase,and this total goes up(It is equal to Corporate Value on earlier slide).63Stock Price for wd=20%nThe firm issues debt,which changes its WACC,which changes value.nThe firm then uses debt proceeds to repurchase stock.nStock price changes after debt is issued,but
48、does not change during actual repurchase(or arbitrage is possible).(More)64Stock Price for wd=20%(Continued)nThe stock price after debt is issued but before stock is repurchased reflects shareholder wealth:n S,value of stocknCash paid in repurchase.(More)65Stock Price for wd=20%(Continued)nD0 and n0
49、 are debt and outstanding shares before recap.nD-D0 is equal to cash that will be used to repurchase stock.nS+(D-D0)is wealth of shareholders after the debt is issued but immediately before the repurchase.(More)66Stock Price for wd=20%(Continued)P=S+(D D0)n0P=$2,127,660+($531,915 0)100,000P=$26.596
50、per share.67Number of Shares Repurchased#Repurchased=(D-D0)/P#Rep.=($531,915 0)/$26.596=20,000.#Remaining=n=S/P n=$2,127,660/$26.596=80,000.68Price per Share vs.Leverage#shares#shareswd PRepurch.Remaining0%$25.000100,00020%$26.6020,00080,00030%$27.2530,00070,00040%$27.1740,00060,00050%$26.3250,00050
