Debt Policy & Theories of Capital Structure

Debt Policy and Theories of Capital Structure

• This topic covers debt policy and theories of capital structure.

Learning Objectives

• Understand the relationship between total market value of firms and shareholder value.
• Modigliani and Miller's Proposition 1 states that capital structure is irrelevant for value.
• Understand MM's Proposition II.
• Learn about the interest tax shield and the use of debt.
• Understand the cost of financial distress.
• Understand the trade-off theory of capital structure.
• Learn about the pecking order of financing choice.
• Understand the bright and dark side of financial slack.

Financial Leverage and Shareholder Value

• Financial managers aim to find the optimal combination of debt and equity financing to maximize the firm's total value.
• Levered equity is the ownership interest in a firm that has debt in its capital structure.
• Unlevered equity is the equity of a firm with no debt, representing equity value as if financed entirely by equity without financial leverage.
• Any value increase/decrease from changing capital structure accrues to stockholders, assuming the market value of old debt remains constant and new debt holders demand a fair rate of return.
• The financing policy that maximizes total firm value also maximizes shareholder value.

Modigliani and Miller Proposition 1

• In perfect capital markets (no taxes, well-functioning markets), the firm's borrowing decision is irrelevant; the market value of a company is independent of its capital structure.
• A company's market value is determined by its real assets, operations, and growth opportunities, not by the mix of debt and equity.
• Investment and financing decisions are separate.
• Firm value is based on real assets on the left-hand side of the balance sheet, not the debt and equity proportions used to buy the assets.
• The value of an asset remains constant, regardless of the nature of claims against it.

Assumptions of Modigliani and Miller Proposition 1

• Issuing just one security instead of two does diminish investor choice, BUT, this doesn’t reduce value if:
  • Investors don't need choice
  • Or there are sufficient alternative securities
• Capital structure does not affect cash flows.
  • There are no taxes.
  • There are no bankruptcy costs.
  • There is no effect on management incentives.

Modigliani and Miller Proposition 1: Example

• Consider two firms generating the same operating profits but with different capital structures.
• Firm U is unlevered, its equity value (EU) equals the total firm value (VU): EU = VU.
• Firm L is levered; its equity value is the firm value less the debt value: EL = VL - DL.
• Buying 1% of Firm U means an investment of 0.01 VU entitling you to 1% of the operating profits.
• Buying 1% of Firm L involves buying 1% of its equity and 1% of its debt.
• Under M&M Proposition 1, there is no difference in return for the investor between the two strategies.
• Two strategies give the same return. This means VU=VL if the market is well-functioning.

Macbeth Spot Removers: Current Position of the Firm

• Current position: 1,000 shares outstanding.
• Current position: Price per share is $10.
• Current position: Market value of shares is $10,000.
• Earnings Per Share (EPS) varies with operating income, with the return on shares being 15% at $1,500 income.

Macbeth Spot Removers: Equity: Debt = 50:50

• Issue $5,000 in debt at 10% interest to repurchase 500 shares in the firm.
• Return on shares is 20% with debt at an operating income of $1500 compared to 15% without debt.

Macbeth's Leverage

• An investor putting up $10 of their own money and borrowing a further $10 to invest total in two unlevered Macbeth shares gets the same set of payoffs as simply buying one share in a levered company.

M&M No Tax: Result

• A change in capital structure has no impact on the overall firm value.

Macbeth's EPS

• Shows relationship between Earnings per share (EPS), operating income with equal proportions debt and equity with Macbeth's EPS all equity.

Leverage and Expected Returns: MM's Proposition 2

• Leverage increases the expected stream of earnings per share but not the share price.
• The change in the expected earnings stream is exactly offset by a change in the rate at which the earnings are discounted.

MM's Proposition 2

• The expected rate of return on levered firm common stock increases proportionally to the debt-equity ratio (D/E), expressed in market values.
• The rate of increase depends on the spread between rA (return on portfolio of all firm's securities) and rD (return on debt).
• Without leverage, equity investors demand return rA; with leverage, they demand a premium of (rA - rD)*D/E to compensate for the extra risk.

How Changing Capital Structure Affects Beta

• Stockholders and debtholders share the firm's cash flows and risk. Financial leverage does not affect the risk or the expected return on the firm's assets. Financial leverage affects how the riskiness of cash flows is distributed between stockholders and debtholders.

Tax Deductibility of Interest

• Interest tax deductibility increases the total income that can be paid out and bondholders and stockholders.

After-Tax WACC

• Tax-adjusted WACC formula: WACC = rD*(1-Tc)(D/V) + rE(E/V)
• The tax benefit from interest expense deductibility reduces the cost of funds.
• This tax benefit reduces the effective cost of debt by a factor of the marginal tax rate.

Corporate Tax Shield

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

Market Value Balance Sheets

• Normal Balance Sheet (Market Values): Assets are valued at present value of after-tax cash flows, split between Debt and Equity to give the Total value.
• Expanded Balance Sheet (Market Values): Assets valued at present value of pre-tax cash flows, split between Debt, Government's claim (present value of future taxes), and Equity to give Total pre-tax value.

Simplified Balance Sheets

• Johnson & Johnson Balance Sheet December 2020 (figures in millions).
  • Book Values and Market Values

MM and Corporate Tax

• MM's Proposition 1 Corrected for Taxes: ValueFirm = ValueAll-Equity-Financed + PV(Tax Shield)
• If debt is fixed, permanent: ValueFirm = ValueAll-Equity-Financed + TCD

MM and Corporate Tax Caveats

• Debt may not be fixed and perpetual.
• Some firms face marginal tax rates less than 21%.
• No interest tax shields unless sufficient profits to shield.
• The amount of interest that can be deducted is limited to 30% of EBIT.

The value of Tax Shield and Unlimited Debt?

• A fuller examination of the U.S. system of corporate and personal taxation may uncover a tax disadvantage of corporate borrowing, offsetting the present value of the interest tax shield.
• Firms that borrow may incur other costs e.g,. bankruptcy costs.

Corporate and Personal Taxes

• Relative tax advantage of debt = (1 - Tp) / ((1 - TPE) * (1 - Tc))
• Advantage to debt = $0.057.

Cost of Financial Distress

• High debt increases the risk of financial distress and bankruptcy.
• Bankruptcy has direct and indirect costs.
• Financial distress can intensify agency problems between shareholders and debtholders.

Ace Limited

• Total payoff to Ace Limited security holders.
• There is a $200 bankruptcy cost in the event of default (shaded area).

Indirect Cost of Financial Distress

• Customers and suppliers are extra cautious about doing business with a firm that may not be around for long.
• Customers worry about resale value and the availability of service and replacement parts.
• Suppliers are disinclined to put effort into servicing the distressed firm's account and may demand cash made immediately and in full at the time of the transaction for their products.
• Potential employees are unwilling to sign on and existing staff keep slipping away from their desks for job interviews.
• High debt, and thus high financial risk, also appears to reduce firms' appetites for business risk.
• The implication for the level of cash flow and the volatility of cash flow.

Agency Costs of Financial Distress

• Circular File Company has $50 of 1-year debt.
• Circular File Company (Book Values) and (Market Values)

Risk Shifting: The First Game

• Suppose that Circular has $10 cash. The following investment opportunity comes up:

Refusing to Contribute Equity Capital: The Second Game

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

Games played during financial distress

• 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.

Ms. Ketchup Faces Credit Rationing

• Henrietta Ketchup has two possible investment projects.

The Trade-Off Theory of Capital Structure

• The Trade-Off Theory is a theory that capital structure is based on a trade-off between tax savings and distress costs of debt.
• The costs 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 destress)

Pecking Order Theory

• 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 finance.
• Adapt target dividend payout ratios to investment opportunities while avoiding changes in dividends.
• Internally generated cash flow is sometimes more than capital expenditures, other times not.
  • Due to dividend policies plus fluctuations in profitability and investment opportunities.
  • If more, firm pays off debt or invests in marketable securities.
  • If less, firm first draws down cash balance or sells holdings of marketable securities.
• If external finance is required, firms issue the safest security first.
  • they start with debt, then possibly hybrid securities, such as convertible bonds, then equity as a last resort.

Financial Slack

• Defined as: read access to cash or debt financing
  • Having cash, marketable securities,readily saleable real assets, and ready access to debt markets or to bank financing.
• Ready access basically requires conservative financing so that potential lenders see the company's debt as a safe investment.
• In the long run, a company's value rests more on its capital investment and operating decisions than on financing.
• Financial slack is most valuable to firms with plenty of positive-NPV growth opportunities.
• Free-cash-flow problem: the principal-agent problem between shareholders and management; Debt can discipline managers and provide the pressure to force improvements in operating efficiency.

The Capital Structure Decision: the Evidence

• Size. Larger firms often have higher debt ratios.
• Tangible Assets. Firms with 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