Capital Structure and Firm Value Does Capital

Capital Structure and Firm Value

Does Capital Structure affect value? • Empirical patterns – – Across Industries Across Firms Across Years Who has lower debt? • High intangible assets/specialized assets • High growth firms • High cash flow volatility • High information asymmetry • Industry leaders • Is capital structure managed? – If so much time is spent on capital structure then there must be some value to it (or managers/investors are irrational)

Debt and Equity Only? • Typically thought of and measured this way • Much more complex – Investment opportunities and strategy (needs) – Financing (sources) • Cash balance • Distribution: Dividend and repurchases • Debt capacity • Equity capacity • Existing debt and equity – Other financial policies: Financial Hedging, Cash Flow Volatility, Forms of Compensation

How does capital structure affect value? • To prove this we start in the “perfect world” – Based on the work of Miller and Modigliani – Shows that capital structure is irrelevant • Value is derived from market imperfections • Example: What if a firm is considering issuing debt and retiring equal amounts of equity?

Assets Debt Equity Interest Share Price Outstanding Shares Current 8000 0. 1 20 400 Proposed 8000 4000 0. 1 20 200

Current Earnings ROA ROE EPS Recession 400 0. 05 1 Expected 1200 0. 15 3 Expansion 2000 0. 25 5 Proposed EBI Interest Earnings ROA ROE EPS Recession 400 0 0. 05 0 0 Expected 1200 400 800 0. 15 0. 2 4 Expansion 2000 400 1600 0. 25 0. 4 8

Position #1: Buy 100 shares of the levered firm ($20*100=$2, 000 Initial Investment) Earnings Recession 0 Expected 400 Expansion 800 Position #2: Buy 200 shares of the unlevered firm and borrow $2000 (($20*200)-$2, 000=$2, 000 Initial investment). Earnings Interest Net Earnings Recession 200 0 Expected 600 200 400 Expansion 1000 200 800

Capital Structure is Irrelevant • Miller and Modigliani assume perfect capital markets • Proposition #1: The market value of any firm is independent of its capital structure.

Firm Value: Perfect Capital Markets 190 170 Value 150 130 V(Unlevered) 110 90 70 50 0% 25% 50% D/E 75% 100%

Market Imperfections: Taxes • Taxes – US Tax Code: Deductibility of interest leads to lower cost of debt (Rd(1 -t)) – Simple specification overvalues benefit • Ignores personal taxes which – Decreases investors debt return – Increases investors preference for equity v Capital gains: Defer and rate difference v Dividend: Some portion is deductible

Market Imperfections: Contracting Costs • In imperfect markets, alternative ways to contract optimal behavior are necessary • Costs of financial distress – Underinvestment (rejecting NPV>0 projects), direct, indirect costs, etc. • Benefits of debt – Monitoring function, manages free cash flow problem (Accepting NPV<0 projects), etc. • Contracting costs and taxes are primary motives for static trade off theory debt

Market Imperfections: Information Costs • With asymmetric information, leverage may reveal • something about the existing firm Market timing: Managers take advantage of superior information – Issue equity when it is overvalued – Issue debt when it is undervalued • Signaling: Managers use financing to signal future prospects of firms – Issue equity to signal good growth opportunities (preserve financial flexibility) – Issue debt when expected cash flows are strong and stable • Motivates Pecking Order Theory

Can we quantify the value of market imperfections? Debt adds value to the firm due to the interest deductibility (assume taxes only) Assume the simple case:

Firm Value: Perfect Capital Markets 190 170 Value 150 130 V(Unlevered) V(Levered) 110 90 70 50 0% 25% 50% D/E 75% 100%

More Complex Tax Shields • Uneven and/or limited time payments – Discount all flows back to time 0 • What r do you use? – Certain the tax shield can be used: r. D – Uncertain? Higher r

Financial Distress • As leverage increases, the probability therefore PV of financial distress increases • How do we estimate the cost of distress? – Prob(Distress)*Cost of Distress • Probability can be estimated in several ways – Logit/Probit regressions – Debt ratings

Firm Value: with Taxes and Fiancial Distress 190 170 150 130 V(Unlevered) V(Levered) V(Distress) 110 90 70 50 D/E

Financial Distress: Bankruptcy Costs • Direct Costs – Legal, accounting and other professional fees – Re-organization losses – Estimated btw 4 -10% of firm value (t-3) • Indirect Costs – Reputation costs – Market share – Operating losses – Estimated as 7. 8% of firm value (t-2)

Financial Distress: Agency Costs • Risk shifting and asset substitution – Shareholders invest in high risk projects and shift risk to the debt holders – Shareholders issue more debt, diminishing old debt holders protection • Underinvestment • Expropriating funds • Difficult to estimate

Other Advantages of Debt • Agency cost of Equity (motive) – Shirking is less likely when issuing debt – Perquisites are less likely with debt – Over-investment is less likely with debt • Agency cost of Free Cash Flow (opportunity) – Retained earnings versus dividends? – Growth and investment opportunities • Debt serves as a monitoring device, decreasing managerial discretion • Bankruptcy as a strategic move? ? ?

Formal Models of Capital Structure • Pecking Order – Firms prefer to raise capital • Internally generated funds • Debt • Equity – Implies capital structure is derived from • Financing needs and capital availability • Dynamic rather than static • Asymmetric information and signaling • Static Trade Off

Static trade-off theory of debt Firm Value Maximum Firm Value Actual Firm Value Debt Optimal amount of Debt

Implications of Static Trade Off • Static rather than dynamic • Taxes and Contracting Cost drive value • Readjustment may be sticky – Optimal trade off between cost of issuances and benefit of capital structure • Insights – – Large, stable profit firms will have more debt Higher the costs of distress lower debt Lower taxes, lower debt Less (more) favorable tax treatment of debt (equity), lower debt

Evidence: Taxes • This method usually overestimates the tax consequence – Magnitude of leverage differences across countries and tax regimes is not that big – Equity taxes (personal taxes) are overestimated (Miller) • Timing of capital gains • Higher effective marginal tax rate, higher the leverage (Graham, 2001)

Evidence • Contracting Costs: Consistent evidence – Higher (lower) the growth opportunities, higher (lower) the potential underinvestment problem, lower (higher) the leverage – Higher growth opportunities would prefer • Shorter maturity debt (or call provisions) • Less restrictive covenants • More convertibility provisions • More concentrated investors (private) • Information costs – Consistent with market timing (SEO’s lead to -3% return) – Inconsistent with signaling and pecking order • Taxes: Higher effective marginal tax rate, higher the leverage

MM: Proposition II • How does leverage affect r. E • Start with the WACC • Solve for r. E • The rate of return on the equity of a firm increases in proportion to the debt to equity ratio (D/E).

MM: Proposition II (with taxes)

• Blue Inc. has no debt and is expected to generate $4 million in EBIT in perpetuity. Tc=30%. All after-tax earnings are paid as dividends. The firm is considering a restructuring, with a perpetual fixed $10 million in floating rate debt at an expected interest rate of 8%. The unlevered cost of equity is 18%. • What is the current value of Blue? • What will the new value be after the restructuring? • What will the new required return on equity be? • What if we use the new WACC?

What About Financial Flexibility? • The ability to quickly change the level and type of financing • Value increasing if – Growth opportunities exist – Company is willing to exercise and extinguish future flexibility – New investments are unpredictable and large – Precautionary debt ratings cushion is valuable • Value destroying if the opposite is true

How do we value financial flexibility?

What do we do? • Choosing a target capital structure – Minimize taxes and contracting costs (while paying attention to information costs) – Target ratio should reflect the company’s • Expected investment requirements • Level and stability of cash flows • Tax status • Expected cost of financial distress • Value of financial flexibility • Dynamic management – Financing is typically a lumpy process – Find optimal point where cost of adjusting capital structure is equal to cost of deviating from target