Chapter 15
Debt Policy: The Capital
Structure Decision
Chapter 15 Overview
Target and Optimal Capital Structure
„ Risk and Different Types of Financing
„
… Business
… Financial
„
„
Risk
Risk
Determining the Optimal Capital Structure
Capital Structure Theory
Value and Capital Structure
Assets
Value of cash flows from
firm’s real assets and
operations
Value of Firm
Liabilities and Stockholder’s Equity
Market value of debt
Market value of equity
Value of Firm
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Recall, the GE’s WACC from
Chapter 12
„ rdebt(1-T)
„
„
„
„
= 4.7%(1-.35) = 3.1% , requity = 10%
D/V = 33%, E/V = 67%
WACC = 7.7%
Question: Why not use more debt financing
since debt financing is so cheap?
Would GE’s WACC be lower, its stock price
higher if more debt financing were used?
Selected Long-term Debt to Total
Market Value (D/V) Ratios
GM: 95%
„ Boeing: 16%
„ McDonald’s 17%
„ Intel & Microsoft 0.1%
„ Disney 17%
„ Wal-Mart 11%
„ SBC 26%
„
Factors Influencing Capital
Structure Decisions
„
Business Risk
„
The firm’s tax position
… riskiness
of firm’s operations if it used no debt
… higher
effective tax rate makes debt financing
more attractive
Access to capital
„ Types of Assets: Tangible vs. Intangible
„ Managerial Risk Attitudes
„
2
Adding Debt to the Picture:
Financial Risk
The additional risk placed on the firm’s
stockholders through the use of debt.
„ More debt means higher interest expense
which represents a higher hurdle for the
firm’s EBIT to cover.
„ Therefore, the use of debt concentrates
(or multiplies) the firm’s business risk on
its stockholders.
„
Lessons from Business & Financial
Risk discussion:
More business risk discourages the
increased use of debt financing.
„ More debt = more risk, which means
higher interest rates as a company
increases the proportion of debt that it
uses in its capital structure.
„ Also, the increase in the proportion of debt
financing leads to a higher required return
on the company’s stock.
„
Determining the Optimal Capital
Structure
First, all debt, now, no debt. What’s the
deal?
„ Of course, the answer has to be
somewhere in between. But where?
„ Although, the cost of debt and equity will
rise as a firm increases its debt proportion,
the company should choose the capital
mix that maximizes its stock price and
minimizes its WACC.
„
3
Determining Optimal Capital
Structure Example
D/V Rd(1-T) Re
WACC EPS=DPS
0%
4.5% 15.0% 15.0%
$3.00
10%
4.5% 15.0% 14.0%
$3.50
20%
4.8% 15.5% 13.4%
$4.00
30%
5.1% 16.1% 12.8%
$4.50
40%
5.6% 16.8% 12.3%
$4.95
50%
6.2% 17.6% 11.9%
$5.40
60%
7.2% 19.4% 12.1%
$5.65
70%
8.5% 21.5% 12.4%
$5.30
80% 10.0% 24.0% 12.8%
$5.20
W ACC = (D/V)Rd(1-T) + (1-D/V)Re
g = 0, so
Price = DPS/Re
Price
$20.00
$23.33
$25.81
$27.95
$29.46
$30.68
$29.12
$24.65
$21.67
Capital Structure and Cost of Capital
30.0%
25.0%
20.0%
Rd(1-T)
Re
W ACC
15.0%
10.0%
5.0%
0.0%
0%
10% 20% 30% 40% 50% 60% 70% 80%
Debt/Value
Capital Structure and Stock Price
$35.00
$30.00
$25.00
$20.00
$15.00
$10.00
$5.00
$0.00
0%
10%
20%
30% 40% 50%
Debt/Value
60%
70%
80%
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Value and Capital Structure
Assets
Value of cash flows from
firm’s real assets and
operations
Value of Firm
Liabilities and Stockholder’s Equity
Market value of debt
Market value of equity
Value of Firm
Capital Structure Theory
Miller and Modigliani (MM) did significant
research trying to determine the effect of
capital structure on firm value.
„ Both won Nobel Prizes for their work, and
Modigliani was an econ. prof. here at the
U of I during part of their research.
„
MM Capital Structure Theory
(no taxes): Prop’s I & II
„
The first MM study assumed no taxes, no bankruptcy
costs, and other unrealistic assumptions.
„
Capital structure does not affect cash flows e.g...
… No
taxes
bankruptcy costs
effect on management incentives
When there are no taxes and capital markets function
well, it makes no difference whether the firm borrows or
individual shareholders borrow. Therefore, the market
value of a company does not depend on its capital
structure.
First MM study result: capital structure doesn’t matter, it
has no effect on firm value or WACC.
… No
… No
„
„
5
ofno
Capital
M&M No taxCost
world:
change in cash
flow, just different split between
investors.
requity = rassets +
D
(rassets − rdebt )
E
⎛ D ⎞
⎛ E ⎞
WACC = (1 − Tc )rdebt ⎜
⎟ + requity ⎜
⎟
⎝D+E⎠
⎝D+E⎠
Weighted Average Cost of Capital
r
rE
6
rD
rA
D
V
Weighted Average Cost of Capital
without taxes (M&M view)
r
rE
WACC
rD
Includes Bankruptcy Risk
D
V
MM Capital Structure Theory &
Taxes
„
„
„
„
A follow-up MM study incorporated the effect of
taxes. Result: More debt is best, because the
interest deduction generates extra value. (Tax
shield = debt x r x T)
Value of levered firm = value of all-equity firm +
present value of tax shield
PV of tax shield = D x rD x Tc = D x Tc
rD
Value of firm = value of all-equity firm + TcD
C.S. & Corporate Taxes
Example - You own all the equity of Space
Babies Diaper Co.. The company has no debt.
The company’s annual cash flow is $1,000,
before interest and taxes. The corporate tax
rate is 40%. You have the option to exchange
1/2 of your equity position for 10% bonds with a
face value of $1,000.
Should you do this and why?
C.S. & Corporate Taxes
Example - You own all the equity of Space Babies Diaper Co. with a
required return of 10%. The company has no debt. The company’s
annual cash flow is $1,000, before interest and taxes. The
corporate tax rate is 40%. You have the option to exchange 1/2 of
your equity position for 10% bonds with a face value of $1,000.
Should you do this and why?
EBIT
Interest Pmt
Pretax Income
All Equity
1/2 Debt
1,000
1,000
0
100
1,000
900
Taxes @ 40%
400
360
Net Cash Flow
$600
$540
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C.S. & Corporate Taxes
Example - You own all the equity of Space Babies Diaper Co. with a
required return of 10%. The company has no debt. The company’s
annual cash flow is $1,000, before interest and taxes. The
corporate tax rate is 40%. You have the option to exchange 1/2 of
your equity position for 10% bonds with a face value of $1,000.
Should you do this and why?
All Equity
1/2 Debt
1,000
1,000
0
100
Pretax Income
1,000
900
Taxes @ 40%
400
360
Net Cash Flow
$600
$540
EBIT
Interest Pmt
Total Cash Flow
All Equity = 600
*1/2 Debt = 640
(540 + 100)
Capital Structure
PV of Tax Shield =
(assume perpetuity)
D x rD x Tc
= D x Tc
rD
Example:
Capital Structure
Firm Value =
Value of All Equity Firm + PV Tax Shield
Example
8
MM Tax Effect of Financial
Leverage on Firm Value
Value Added by Debt
Tax Shelter Benefits
Value of All-Equity
Firm
Value of Levered
Firm
Capital Structure Theory in
Reality
MM ignored the costs of bankruptcy and
the threat of bankruptcy in their 2nd
analysis = costs of financial distress
„ Reality is: there is a trade-off between the
benefits of debt financing against higher
interest rates and the increased risk of
bankruptcy.
„
Financial Distress
Costs of Financial Distress - Costs arising from
bankruptcy or distorted business decisions
before bankruptcy.
Market Value =
Value if all Equity Financed
+ PV Tax Shield
- PV Costs of Financial Distress
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Market Value of The Firm
Financial Maximum
Distress
value of firm
Costs of
financial distress
PV of interest
tax shields
Value of levered firm
Value of
unlevered
firm
Optimal amount
of debt
Debt
Financial Choices
Trade-off Theory - Theory that capital structure is
based on a trade-off between tax savings and
distress costs of debt.
Financial Slack – Theory that firms want to
maintain ready access to cash &/or financial
markets to ensure investment in new profitable
projects.
Pecking Order Theory - Theory stating that firms
prefer to issue debt rather than equity if internal
finance is insufficient.
Pecking Order and Signaling
Theory
„
„
„
„
Asymmetric Information - managers have
different and better information about the firm’s
prospects than do investors.
The way management decides to raise capital
sends a signal about the firm’s future prospects.
New Debt issue = good signal, attractive
investment opportunities for the firm, don’t want
to dilute these good returns by sharing them with
more stockholders
Bad future prospects including possible losses
can be signaled by issuing more new stock to
spread the future pain.
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