Capital Structure Chapter 16 PDF

CAPITAL STRUCTURE: BASIC CONCEPTS – CHAPTER 16  The value of a firm is defined to be the sum of the value of the firm’s debt and the firm’s equity. V=B+S THE CAPITAL- If the goal of the management of the firm S B...

CAPITAL STRUCTURE: BASIC CONCEPTS – CHAPTER 16  The value of a firm is defined to be the sum of the value of the firm’s debt and the firm’s equity. V=B+S THE CAPITAL- If the goal of the management of the firm S B STRUCTURE AND S is to make the firm as valuable as possible B FIRM VALUE then the firm should pick the debt-equity ratio that makes the pie as big as possible. Value of the Firm  There are really two important questions: THE CAPITAL- 1. Why should the stockholders care about maximizing firm value? Perhaps they should be interested in strategies that STRUCTURE maximize shareholder value. QUESTION 2. What is the ratio of debt-to-equity that maximizes the shareholder’s value?  The book demonstrates through an example that shareholders should care about maximizing firm value rather than about maximizing equity MAXIMIZING FIRM value. VALUE VERSUS In general, changes in capital structure benefit (hurt) shareholders if and only if firm value increases (decreases) MAXIMIZING Therefore, managers should choose the capital structure that maximizes STOCKHOLDER firm value. INTERESTS we look at what the “optimal” mix of debt and equity might be to maximize firm value.  FINANCIAL LEVERAGE, EPS, AND ROE Consider an all-equity firm that is considering going into debt. (Maybe some of the original shareholders want to cash out.) Current Proposed Assets $20,000 $20,000 Debt $0 $8,000 Equity $20,000 $12,000 Debt/Equity ratio 0.00 2/3 8% Interest rate n/a 240 Shares outstanding 400 $50 Share price $50 EPS AND ROE - ALL EQUITY FIRM Recession Expected Expansion EBIT $1,000 $2,000 $3,000 Interest 0 0 0 Net income $1,000 $2,000 $3,000 EPS $2.50 $5.00 $7.50 ROA 5% 10% 15% ROE 5% 10% 15% Current Shares Outstanding = 400 shares EPS AND ROE UNDER PROPOSED CAPITAL STRUCTURE Recession Expected Expansion EBIT $1,000 $2,000 $3,000 Interest 640 640 640 Net income $360 $1,360 $2,360 EPS $1.50 $5.67 $9.83 ROA 5% 10% 15% ROE 3.0% 11.3% 19.7% Proposed Shares Outstanding = 240 shares EPS AND ROE UNDER BOTH CAPITAL STRUCTURES All-Equity - Current Shares Outstanding = 400 shares Recession Expected Expansion EBIT $1,000 $2,000 $3,000 Interest 0 0 0 Net income $1,000 $2,000 $3,000 EPS $2.50 $5.00 $7.50 ROA 5% 10% 15% ROE 5% 10% 15% Levered - Proposed Shares Outstanding = 240 shares Recession Expected Expansion EBIT $1,000 $2,000 $3,000 Interest 640 640 640 Net income $360 $1,360 $2,360 EPS $1.50 $5.67 $9.83 ROA 5% 10% 15% ROE 3.0% 11.3% 19.7% FINANCIAL LEVERAGE AND EPS 12.00 EPS 10.00 Debt 8.00 No Debt 6.00 Advantage to Break-even point 4.00 debt 2.00 0.00 1,000 2,000 3,000 (2.00) EBIT, no taxes Disadvantage to debt  Modigliani and Miller LEVERAGE AND When there are no taxes and well functioning capital markets exist, the market value of a company does not depend on its FIRM VALUE capital structure. In other words, managers cannot increase firm value by changing the mix of securities used to finance the company.  Homogeneous Expectations Homogeneous Business Risk Classes ASSUMPTIONS OF Perpetual Cash Flows THE MODIGLIANI- Perfect Capital Markets:  Perfect competition MILLER MODEL  Firms and investors can borrow/lend at the same rate  Equal access to all relevant information  No transaction costs  No taxes  Suppose you have $1,500 to invest and can only hold shares of the all-equity firm. HOMEMADE LEVERAGE: Can you reproduce the EPS of the levered firm through borrowing and lending? EXAMPLE Yes! If your personal debt-equity ratio is the same as that of the levered firm.  HOMEMADE LEVERAGE: EXAMPLE You need to borrow 2 ´1,500 = $1,000 3 and invest the borrowed funds (at interest rate of 8%) and your own funds to purchase (1,500 + 1,000)/50 = 50 shares at $50 each. B $1,000 2 Your personal debt-equity ratio is: = = S $1,500 3 HOMEMADE LEVERAGE: AN EXAMPLE Recession Expected Expansion EPS of Unlevered Firm $2.50 $5.00 $7.50 Earnings for 400 shares $1000 $2000 $3000 Less interest on $8000 (8%) $640 $640 $640 Net Profits $360 $1360 $2360 ROE (Net Profits / $12,000) 3.0% 11.3% 19.7% Buying 400 shares of a $50 stock on margin gives the same ROE of the levered firm. B $8000 = =2 3 Our personal debt equity ratio is: S $1,2000  Suppose you have $1,500 to invest and you can only hold shares of the levered firm. HOMEMADE Can you reproduce the EPS of the unlevered firm through (UN)LEVERAGE: borrowing and lending? EXAMPLE Yes! If you invest in debt and equity of the levered firm in such a way that the ratio of firm’s debt to equity in your portfolio is the same as that of the levered firm.  Therefore, the share of your funds that you need to invest in the levered firm’s debt, x, is given by: x 2 HOMEMADE = 1- x 3 (UN)LEVERAGE: Solving for x yields 0.4. EXAMPLE The share of the levered firm’s equity is 0.6.  You will invest 0.4 × 1,500 = $600 in the levered firm’s debt and HOMEMADE 0.6 × $1,500 = $900 in the levered firm’s equity to purchase $900/50 = 18 shares (UN)LEVERAGE: EXAMPLE Your ratio of debt-to-equity holdings in the levered firm is given by: B $600 2 = = S $900 3 HOMEMADE (UN)LEVERAGE: AN EXAMPLE Recession Expected Expansion EPS of Levered Firm $1.50 $5.67 $9.83 Earnings for 240 shares $360 $1360 $2360 Plus interest on $8000 (8%) $640 $640 $640 Net Profits $1000 $2000 $3000 ROE (Net Profits / $12,000) 5% 10% 15% Buying 240 shares of an other-wise identical levered firm along with some of the firm’s debt gets us the ROE of the unlevered firm. This is the fundamental insight of M&M  We can create a levered or unlevered position by adjusting trading in our own account. This homemade leverage suggests that capital structure is irrelevant in determining the value of the firm. MM PROPOSITION I (NO TAXES) Proposition I  Firm value is not affected by leverage VL = VU  The Modigliani-Miller (MM) result hinges on two key assumptions: 1. Taxes are zero 2. Individuals can borrow as cheaply as firms. KEY ASSUMPTIONS If assumption 2 is violated so that individuals can only borrow at a higher rate, one can show that corporations can increase firm value by borrowing. It is difficult to argue that individuals must borrow at higher rates than corporations.  The WACC remains constant for a given firm and unaffected by leverage. B S WACC = rB + rS B+S B+S IMPLICATION OF Returning to our example, rB = 0.08 PROPOSITION I Cost of equity (ROE) in normal scenario: Expected earnings after interest 2,000 = = 0.1  Unlevered firm: Equity 20,000 Expected earnings after interest 1,360  Levered firm: = = 0.113 Equity 12,000 IMPLICATION OF PROPOSITION I Unlevered firm, WACCU 𝑈 0 20,000 𝑊𝐴𝐶𝐶 = × 0.08 + ×.1 = 10% 20,000 20,000 Levered firm, WACCL 8,000 12,000 𝑊𝐴𝐶𝐶 𝐿 = × 0.08 + ×.113 = 10% 20,000 20,000  Proposition II – Leverage increases the risk and return to stockholders: MM PROPOSITION II rs = r0 + (B / SL) (r0 - rB) (NO TAXES) rB is the interest rate (cost of debt) rs is the return on (levered) equity (cost of equity) r0 is the return on unlevered equity (cost of capital) B is the value of debt SL is the value of levered equity  Proposition II rs = r0 + (B / S) (r0 - rB) MM PROPOSITION II (NO TAXES) Required ROE is a linear function of the firm’s debt-to- equity ratio. Leverage increases the risk and return to shareholders.  MM PROPOSITION II WITH NO CORPORATE TAXES B Cost of capital: r (%) rS = r0 +  (r0 − rB ) SL B S r0 rW ACC =  rB +  rS B+S B+S rB rB B Debt-to-equity Ratio S  As a firm adds debt, the remaining equity becomes riskier, resulting in a higher cost of equity. MM INTERPRETATION The increase in the cost of remaining equity exactly offsets the higher proportion of the firm financed with low-cost debt. – NO TAXES As a result, overall cost of capital does not change as leverage changes, and neither does firm value.  Do real-world managers follow MM by treating capital structure decisions with indifference?  Virtually all companies in certain industries, such as banking, MM IN PRACTICE choose high debt-equity ratios.  Companies in other industries, such as pharmaceuticals, choose low debt-equity rations.  Almost any industry has a debt-equity ratio to which companies in that industry adhere.  Proposition I (with Corporate Taxes) Firm value increases with leverage: VL = VU + TC rB B Proposition II (with Corporate Taxes) TAXES: THE MM Some of the increase in equity risk and return is offset by interest tax shield PROPOSITIONS I & II (WITH TAXES) rS = r0 + (B/S)×(1-TC)×(r0 - rB) rB is the interest rate (cost of debt) rS is the return on equity (cost of equity) r0 is the return on unlevered equity (cost of capital) B is the value of debt S is the value of levered equity THE EFFECT OF FINANCIAL LEVERAGE ON THE COST OF DEBT AND EQUITY CAPITAL WITH CORPORATE TAXES B rS = r0 +  (r0 − rB ) SL B rS = r0 +  (1 − TC )  (r0 − rB ) SL Cost of capital: r (%) r0 B SL rW ACC =  rB  (1 − TC ) +  rS B+SL B + SL rB Debt-to-equity ratio (B/S) TOTAL CASH FLOW TO INVESTORS UNDER EACH CAPITAL STRUCTURE WITH CORPORATE TAXES All-Equity Recession Expected Expansion EBIT $1,000 $2,000 $3,000 Interest 0 0 0 EBT $1,000 $2,000 $3,000 Taxes (Tc = 35% $350 $700 $1,050 Total Cash Flow to S/H $650 $1,300 $1,950 Levered Recession Expected Expansion EBIT $1,000 $2,000 $3,000 Interest ($8000 @ 8% ) 640 640 640 EBT $360 $1,360 $2,360 Taxes (Tc = 35%) $126 $476 $826 Total Cash Flow $234+640 $468+$640 $1,534+$640 (to both S/H & B/H): $874 $1,524 $2,174 EBIT(1-Tc)+TCrBB $650+$224 $1,300+$224 $1,950+$224 $874 $1,524 $2,174  The levered firm pays less in taxes than does the all-equity firm. All-equity firm Levered firm TOTAL CASH FLOW G TO INVESTORS G UNDER EACH S S B CAPITAL Thus, the sum of the debt plus the equity of the levered firm is greater than the equity of the unlevered firm.  The sum of the debt plus the equity of the levered firm is greater than the equity of the unlevered firm. TOTAL CASH FLOW All-equity firm Levered firm TO INVESTORS UNDER EACH G G CAPITAL STRUCTURE S S WITH CORPORATE B TAXES This is how cutting the pie differently can make the pie larger: the government takes a smaller slice of the pie!