Capital Structure PDF

Capital Structure Session 15 Capital Structure Choices Capital structure – The collection of securities a firm issues to raise capital from investors. – Mixture of Debt and Equity. – Blend of Debt and Equity is known as Financial Leverage. Capital Structure Choices A firm’s...

Capital Structure Session 15 Capital Structure Choices Capital structure – The collection of securities a firm issues to raise capital from investors. – Mixture of Debt and Equity. – Blend of Debt and Equity is known as Financial Leverage. Capital Structure Choices A firm’s debt-to-value ratio is the fraction of the firm’s total value that corresponds to debt V= D / (E+D) Capital structure choices often vary across industries and within industry as many factors affect the choice.  * *average debt-to-equity ratio Source: https://www.fortuneindia.com/infographics/debt-to-equity-ratio-of-non-financial-corporations-low est-in-6-years/119418 What are the factor that you think affect the choice of CS of companies?. ASAHI INDIA GLASS Capital Structure in Perfect Capital Markets A perfect capital market is a market in which: – Securities are fairly priced – No tax consequences or transactions costs – Investment cash flows are independent of financing choices. Capital Structure in Perfect Capital Markets Application: Financing a coffee shop that costs $24,000 to open – Expected cash flow is $34,500 at the end of one year – Given the risk, coffee shop should earn 15% – What will be value of the coffee shop.  NPV of the project is - $24,000+$34,500/1.15 = $6,000 Equity Financing- Unlevered Financing Assume raising money solely by selling equity in business to your friends and family. Expected Cash flow = 34500 (in one year) PV (Equity cash flow) = 34500/1.15= = 30000 NPV = -24000+ 30000 = 6000 (unlevered equity) Value to owner: 6000 Levered Financing – Debt +Equity Suppose Cash flow are certain up to $ 16000, so we can borrow $15000 at Risk free rate = 5% Debt after 1 year = $15750 How much equity (levered equity) we can raise ?  After the debt is paid Equity holder can expect to receive = $34500-$15750= $18750. So we can raise 18750/1.15= $16304 If this correct, we can raise additional $1304 (15000+16304 = 31304-30000) more in case of leverage.  This indicate that simply financing a project with leverage can make it more valuable. But if this sounds too good to be true, it is. Our analysis assumed that your firm’s equity cost of capital remained unchanged at 15% after adding leverage. But as we will see shortly, that will not be the case—leverage will increase the risk of the firm’s equity and raise its equity cost of capital. Capital Structure in Perfect Capital Markets Modigliani and Miller (MM) with perfect capital markets – In an unlevered firm, cash flows to equity equal the free cash flows from the firm’s assets – In a levered firm, the same cash flows are divided between debt and equity holders – The total to all investors equals the free cash flows generated by the firm’s assets Unlevered Versus Levered Cash Flows with Perfect Capital Markets Capital Structure in Perfect Capital Markets MM Proposition I: – In a perfect capital market, the total value of a firm is equal to the market value of the free cash flows generated by its assets and is NOT affected by its choice of capital structure VL= E + D =VU Returns to Equity in Different Scenarios with and Without Leverage Return of Levered Equity = $18,750/$15,000 - 1 = 25% Unlevered Versus Levered Returns with Perfect Capital Market The Risk and Return of Levered Equity Problem: Suppose you borrow only $6,000 when financing your coffee shop. According to Modigliani and Miller, what should the value of the equity be? What is the expected return? The Risk and Return of Levered Equity Solution: Plan: The value of the firm’s total cash flows does not change: it is still $30,000. Thus, if you borrow $6000, your firm’s equity will be worth $24,000. ‘ To determine its expected return, we will compute the cash flows to equity under the two scenarios ( normal & weak demand). The cash flows to equity are the cash flows of the firm - cash flows to debt (repayment of principal plus interest). The Risk and Return of Levered Equity Execute: The firm will owe debt holders $6,000 × 1.05 = $6,300 in one year Thus, the expected payoff to equity holders is $34,500 – $6,300 = $28,200, for a return of $28,200 - $24,000 = 4200/24000 = 17.5%  The Risk and Return of Levered Equity Evaluate: While the total value of the firm is unchanged, the firm’s equity in this case is more risky than it would be without debt, but less risky than if the firm borrowed $15,000 To illustrate, note that if demand is weak, the equity holders will receive $27,000 – $6,300 = $20,700, for a return of $20,700-$24,000 = -3300/24000= – 13.75% Class Exercise-1 Problem: Suppose you borrow $50,000 when financing a coffee shop which is valued at $75,000. You expect to generate a cash flow of $75,000 at the end of the year if demand is weak, $84,000 if demand is as expected and $93,000 if demand is strong. Each scenario is equally likely. The current risk-free interest rate is 4%, and there’s an 8% risk premium for the risk of the assets. According to Modigliani and Miller, what should the value of the equity be? What is the expected return? Solution Plan: The value of the firm’s total cash flows does not change: it is still $75,000 (expected cash flow of $84,000 discounted at 12%). Thus, if you borrow $50,000, your firm’s equity will be worth $25,000. To determine its expected return, we will compute the cash flows to equity under the two scenarios. The cash flows to equity are the cash flows of the firm net of the cash flows to debt (repayment of principal plus interest). Execute: The firm will owe debt holders $50,000 × 1.04 = $52,000 in one year. Thus, the expected payoff to equity holders is $84,000 – $52,000 = $32,000, for a return of $32,000 / $25,000 – 1 = 28%. Evaluate: While the total value of the firm is unchanged, the firm’s equity in this case is more risky than it would be without debt. To illustrate, if demand is weak, the equity holders will receive $75,000 – $52,000 = $23,000, for a return of $23,000-$25,000 =-2000/25000= – 8%. If demand is strong, the equity holders will receive $93,000 – $52,000 = $41,000, for a return of $41,000-$25,000 = 16000/25000 = 64%. Without debt (Unlevered), equity holders expect to receive $84,000-75,000 = 9000/75000 = 12%. Capital Structure in Perfect Capital Markets Leverage and the Cost of Capital – Weighted average cost of capital (pretax)  Capital Structure in Perfect Capital Markets MM Proposition II: The cost of capital of levered equity: – The Cost of Levered Equity – Cost of levered equity equals the cost of unlevered equity plus a premium proportional to the debt-equity ratio WACC and Leverage with Perfect Capital Markets WACC and Leverage with Perfect Capital Markets (cont’d) Computing the Equity Cost of Capital Problem: Suppose you borrow only $6,000 when financing your coffee shop. According to MM Proposition II, what will your firm’s equity cost of capital be? Computing the Equity Cost of Capital Solution: Plan: Because your firm’s assets have a market value of $30,000, by MM Proposition I, the equity will have a market value of $24,000 = $30,000 – $6,000. We know the unlevered cost of equity is ru = 15%. We also know that rD is 5%. Computing the Equity Cost of Capital Execute: Debt and Taxes Market imperfections can create a role for the capital structure – Corporate taxes: Corporations can deduct interest expenses Reduces taxes paid – Increases amount available to pay investors – Increases value of the corporation Debt and Taxes Consider the impact of interest expenses on taxes paid by Safeway, Inc. – In 2012, Safeway had earnings before interest and taxes of $1.13 billion – Interest expenses of $300 million – Corporate tax rate is 35% – Compare Safeway’s actual net income with what it would have been without debt Safeway’s Income with and without Leverage, 2012 ($ millions) Total amount available to all investors is: Debt and Taxes Interest Tax Shield – The gain to investors from the tax deductibility of interest payments Interest Tax Shield = Corporate Tax Rate × Interest Payments Computing the Interest Tax Shield Problem: Shown on the next slide is the income statement for E.C. Builders (ECB). Given its marginal corporate tax rate of 35%, what is the amount of the interest tax shield for ECB in years 2010 through 2013? Example 16.3 Computing the Interest Tax Shield Problem (cont’d): Computing the Interest Tax Shield Execute: ($ million) 2010 2011 2012 2013 Interest expense 50 80 100 100 Interest tax shield (35% X interest expense) 17.5 28 35 35 The Cash Flows of the Unlevered and Levered Firm Debt and Taxes Value of the Interest Tax Shield – MM Proposition I with taxes: The total value of the levered firm exceeds the value of the firm without leverage due to the present value of the tax savings from debt: VL = VU + PV(Interest Tax Shield) Debt and Taxes Interest Tax Shield with Permanent Debt – As we know that, the market value of debt must equal the present value of its future interest payments: Market value of Debt = D = PV(Future Interest Payments) Debt and Taxes Interest Tax Shield with Permanent Debt – If the firm’s marginal tax rate (TC) is constant, we have the following general formula: Value of the Interest Tax Shield of Permanent Debt PV(Interest Tax Shield)=PV(TC X Future Interest Payments) =TC X PV(Future Interest Payments) =TC X D Debt and Taxes Weighted Average Cost of Capital with Taxes – Another way to incorporate the benefit of the firm’s future interest tax shield – Weighted Average Cost of Capital with Taxes Debt and Taxes The reduction in the WACC increases with the amount of debt financing The higher the firm’s leverage, the more the firm exploits the tax advantage of debt, and the lower its WACC The WACC with and without Corporate Taxes QUESTION? If increasing debt increases the value of the firm, why not shift to 100% debt? The Costs of Bankruptcy and Financial Distress With more debt, there is a greater chance that the firm will default on its debt obligations A firm that has trouble meeting its debt obligations is in financial distress Direct and Indirect Cost of Bankruptcy Outside professionals , accounting experts, consultants, auctioneers and other with experience of selling distressed assets. Creditors may incur cost during bankruptcy cost Loss of customers Loss of suppliers Cost to employees Fire Sale of assets Optimal Capital Structure: The Tradeoff Theory Tradeoff Theory: – Total value of a levered firm equals the value of the firm without leverage plus the present value of the tax savings from debt, less the present value of financial distress costs: Optimal Capital Structure: The Tradeoff Theory Key qualitative factors determine the present value of financial distress costs: – The probability of financial distress Depends on the likelihood that a firm will default Increases with the amount of a firm’s liabilities (relative to its assets) It increases with the volatility of a firm’s cash flows and asset values Optimal Capital Structure: The Tradeoff Theory As debt increases, tax benefits of debt increase until interest expense exceeds EBIT Probability of default, and hence present value of financial distress costs, also increases The optimal level of debt, D*, occurs when these the value of the levered firm is maximized D* will be lower for firms with higher costs of financial distress Optimal Leverage with Taxes and Financial Distress Costs  Optimal Capital Structure: The Tradeoff Theory The Tradeoff Theory helps to resolve two important facts about leverage: – The presence of financial distress costs can explain why firms choose debt levels that are too low to fully exploit the interest tax shield – Differences in the magnitude of financial distress costs and the volatility of cash flows can explain the differences in the use of leverage across industries Additional Consequences of Leverage: Agency Costs and Information Agency costs: – costs that arise when there are conflicts of interest between stakeholders Separation of ownership and control: – Managers may make decisions that: Benefit themselves at investors’ expense Reduce their effort Spend excessively on perks Engage in “empire building” – focusing on expansion rather than more NPV creating projects  Additional Consequences of Leverage: Agency Costs and Information If these decisions have negative NPV for the firm, they are a form of agency cost – Debt provides incentives for managers to run the firm efficiently: Ownership may remain more concentrated, improving monitoring of management Since interest and principle payments are required, debt reduces the funds available at management’s discretion to use wastefully. Additional Consequences of Leverage: Agency Costs and Information Equity-Debt Holder Conflicts – A conflict of interest exists if investment decisions have different consequences for the value of equity and the value of debt most likely to occur when the risk of financial distress is high managers may take actions that benefit shareholders but harm creditors and lower the total value of the firm Optimal Leverage with Taxes, Financial Distress, and Agency Costs Pecking Order Theory The pecking order hypothesis states: – Managers have a preference to fund investment using retained earnings, followed by debt, and will only choose to issue equity as a last resort. Retained Earning/ Internal Funding/Private Debt Private Debt Public Debt Equity  The pecking order theory states that companies prioritize their sources of financing (from internal financing to equity) and consider equity financing as a last resort. Internal funds are used first, and when they are depleted, debt is issued. When it is not prudent to issue more debt, equity is issued Capital Structure: Putting It All Together Use the interest tax shield if firm has consistent taxable income Balance tax benefits of debt against costs of financial distress Consider short-term debt for external financing when agency costs are significant. Increase leverage to signal confidence in the firm’s ability to meet its debt obligations Capital Structure: Putting It All Together Rely first on retained earnings, then debt, and finally equity Do not change the firm’s capital structure unless it departs significantly from the optimal level. Determinants of CS - Factors Profitability growth, cash flow, Size of firm, industry characteristics Interests rate Tax structure Assets tangibility- lower financing cost Rising burden of Debt in Indian Cos. Does Size Matters? Industry wise trend last two years Profitability Data of Sample Companies