Capital Structure and Firm Value Does Capital Structure affect value?



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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?
  • Current
  • Proposed
  • Assets
  • 8000
  • 8000
  • Debt
  • 0
  • 4000
  • Equity
  • 8000
  • 4000
  • Interest
  • 0.1
  • 0.1
  • Share Price
  • 20
  • 20
  • Outstanding Shares
  • 400
  • 200
  • Current
  • Recession
  • Expected
  • Expansion
  • Earnings
  • 400
  • 1200
  • 2000
  • ROA
  • 0.05
  • 0.15
  • 0.25
  • ROE
  • 0.05
  • 0.15
  • 0.25
  • EPS
  • 1
  • 3
  • 5
  • Proposed
  • Recession
  • Expected
  • Expansion
  • EBI
  • 400
  • 1200
  • 2000
  • Interest
  • 400
  • 400
  • 400
  • Earnings
  • 0
  • 800
  • 1600
  • ROA
  • 0.05
  • 0.15
  • 0.25
  • ROE
  • 0
  • 0.2
  • 0.4
  • EPS
  • 0
  • 4
  • 8
  • Position #1: Buy 100 shares of the levered firm
  • ($20*100=$2,000 Initial Investment)
  • Recession
  • Expected
  • Expansion
  • Earnings
  • 0
  • 400
  • 800
  • Position #2: Buy 200 shares of the unlevered firm and borrow
  • $2000 (($20*200)-$2,000=$2,000 Initial investment).
  • Recession
  • Expected
  • Expansion
  • Earnings
  • 200
  • 600
  • 1000
  • Interest
  • 200
  • 200
  • 200
  • Net Earnings
  • 0
  • 400
  • 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
  • 50
  • 70
  • 90
  • 110
  • 130
  • 150
  • 170
  • 190
  • 0%
  • 25%
  • 50%
  • 75%
  • 100%
  • D/E
  • Value
  • V(Unlevered)

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
          • Capital gains: Defer and rate difference
          • 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
  • 50
  • 70
  • 90
  • 110
  • 130
  • 150
  • 170
  • 190
  • 0%
  • 25%
  • 50%
  • 75%
  • 100%
  • D/E
  • Value
  • V(Unlevered)
  • V(Levered)

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: rD
    • Uncertain? Higher r

Financial Distress

  • As leverage increases, the probability therefore PV of financial distress increases
  • How do we estimate the cost of distress?
  • Probability can be estimated in several ways
    • Logit/Probit regressions
    • Debt ratings
  • Firm Value: with Taxes and Fiancial Distress
  • 50
  • 70
  • 90
  • 110
  • 130
  • 150
  • 170
  • 190
  • D/E
  • D/E
  • V(Unlevered)
  • V(Levered)
  • V(Distress)

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)
  • 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
  • Maximum
  • Firm Value
  • Firm Value
  • Debt
  • Optimal amount of Debt
  • Actual Firm Value

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 rE
  • Start with the WACC
  • Solve for rE
  • 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%.

  • 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

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