Debt Policy and Capital Structure Theories

• Topic is Debt Policy and Theories of Capital Structure

Financial Leverage and Shareholder Value

• Financial Managers aim to find the optimal mix of debt and equity financing to maximize the total value of the firm.
• Levered equity is the ownership interest in a firm with debt in its capital structure.
• Unlevered equity is the equity of a firm with no debt, representing the value of the company's equity as if it were entirely equity-financed.
• Shareholder value is maximized when the financing policy maximizes total value.

Modigliani and Miller Proposition 1

• In a market without taxes and perfect capital markets, a firm's market value is independent of its capital structure.

• The market value depends on the firm's real assets, operations, and growth opportunities rather than the proportion of debt and equity.

• Investment and financing decisions are separate.

• The left-hand side of the balance sheet determines firm value, not the proportions of debt and equity.

• Regardless of the nature of the claims against it, an asset's value is preserved.

• The assumptions are:

  • Issuing one security rather than two diminishes investor choice, which does not reduce value if investors do not need choice, or there are sufficient alternative securities.
  • Capital structure does not affect cash flows.
  • There are also no taxes, bankruptcy costs, or effects on management incentives.

• Example:

  • Firm U: Unlevered, the total equity value EU is equal to the firm value VU (EU = VU).
  • Firm L: Levered, has an equity value EL equal to the firm value less debt (EL = VL - DL).
  • There is no difference in the rate of return for the investor regardless of wheter or not to buy 1% of either Firm.

Modigliani and Miller Proposition 2

• The expected rate of return on a levered firm's common stock increases proportionately with the debt-equity ratio (D/E) expressed in market values.
• The rate of increase is based on the spread between rA, the expected return on a portfolio of all the firm's securities and rD, the expected return on debt.
• In an unlevered firm, equity investors demand rA.
• In a levered firm, they require a premium of (rA - rD)*D/E to compensate for the extra risk.

MM No Tax Result

• A change in capital structure doesn't affect the firm's overall value.

Tax Deductibility of Interest

• Tax deductibility of interest increases the total income that can be paid to bondholders and stockholders.

After-Tax WACC

• WACC = rD ×(1-Tc) × (D/V) + rE × (E/V)
• Tax Adjusted Formula is used.
• The tax benefit from deductible interest expense must be included when calculating the cost of funds.
• Effective cost of debt is reduced by a factor of the marginal tax rate due to this benefit.

Corporate Tax Shield

• PV (tax shield) = (corporate tax rate X interest payment) / (expected return on debt)

MM and Corporate Tax

• Proposition 1 is corrected for taxes.
  • Value of firm = Value of All-Equity Finance + PV(Tax Shield)
  • If debt is fixed AND permanent
  • Value of firm = Value of all Equity finance + T * C * D

Some Tax Shield Caveats

• Debt may not be fixed or perpetual.
• Some firms might face marginal tax rates that are less than 21%.
• No interest is tax shielded unless there are sufficient profits to shield.
• Amount of interest that can be deducted is limited to 30% of EBIT.

Cost of Financial Distress

• Higher debt increases the risk of financial distress and bankruptcy.
• Bankruptcy costs include direct and indirect cost components.
• Financial distress can intensify conflicts between shareholders and debtholders.

Indirect Cost of Financial Distress

• Cautiousness by customers and suppliers about doing business with a potentially failing firm
• Customer concerns about resale value and the availability of service and replacement parts
• Reluctance of suppliers to provide services/parts
• Difficulties in attracting potential employees and retention of current staff
• Reduced appetites for business risks due to high debt/financial risk
• The implication for level of cash flow and cash flow volatility

Agency Cost of Financial Distress

• Circular File Company has $50 1-year of debt.

Risk Shifting First Game

• Suppose that circular has $10 of cash and there is an investment opportunity
  • 10% probability of $120 in returns
  • 90% probability of $0 returns

Refusing to Contribute Equity Capital: The Second Game

• Circular File Company value (assumes safe project with NPV = $5)
• The stockholder loses what the bondholder gains.
• New safe asset is worth $15. The probability of default is less, and the market value of bond increases.
• Equity value goes up by not $15, but by $15 - $8 = $7. The owner puts in $10 of fresh equity capital, but only gains $7 of value.

And Three More Games Briefly

• Cash in and Run
  • "Refusing to contribute equity capital" run in reverse by taking money out.
• Playing for Time
  • Stockholders use delay tactics with creditors such as misreporting, earnings management to hide the true status of financial performance.
• Bait and Switch
  • Start with conservative policy, then later switch and issue a lot more.

Trade-Off Theory

• Trade-Off Theory Theory suggests capital structure is based on tradeoff of:
  • Tax savings.
  • Distress costs of debt.

Value Of Firm

• The Cost of financial distress depend on the probability of distress and the magnitude of costs encountered if distress occurs.
• Value of Firm = Value if all-equity-financed + PV (Tax Shield) -PV (Cost Of Financial Distress)

Pecking Order Theory

• Theory states firms prefer to issue debt over equity if internal finances are insufficient.
• Starts with asymmetric information. Managers know more about their companies' prospects, risks, and values than outsiders.

Implications of The Pecking Order

• Firms prefer internal finances.
• Adapt target dividend payout ratios to investment opportunities while avoiding changes in dividends.
• Internal generated cash flow is sometimes more.
• Dividend policies and investment opportunities.
• If internal finances aren't enough, firms issue the safest security first.
• They first start with debt. If they need more, issue hybrid securities like convertible bonds. Finally, equity is the last resort.

Financial Slack

• Access to cash or debt financing, also having marketable real assets, and ready access to debt to bank financing.
• Ready access requires conservative financing. That way, lenders see the company debt as a safe investment.
• It's most valuable to firms that have positive NPV strategies.
• Free cash flow means that there is a principal agent problem. Debt can discipline managers and improve efficiency.

Capital Structure Decision

• Size: Large firms have higher debt ratios.
• Tangible assets: High ratios of fixed assets to total assets have higher debt ratios.
• Market to book: Firms with higher ratios of market to book value have lower debt ratios.
• Profitability: More profitable firms have lower debt ratios.