5. Capital Structure

CapitalStructureandFirmValueDoesCapitalStructureaffectvalue?•Empiricalpatterns–AcrossIndustries–AcrossFirms–AcrossYears–Whohaslowerdebt?•Highintangibleassets/specializedassets•Highgrowthfirms•Highcashflowvolatility•Highinformationasymmetry•Industryleaders•Iscapitalstructuremanaged?–Ifsomuchtimeisspentoncapitalstructurethentheremustbesomevaluetoit(ormanagers/investorsareirrational)DebtandEquityOnly?•Typicallythoughtofandmeasuredthisway•Muchmorecomplex–Investmentopportunitiesandstrategy(needs)–Financing(sources)•Cashbalance•Distribution:Dividendandrepurchases•Debtcapacity•Equitycapacity•Existingdebtandequity–Otherfinancialpolicies:FinancialHedging,CashFlowVolatility,FormsofCompensationHowdoescapitalstructureaffectvalue?•Toprovethiswestartinthe“perfectworld”–BasedontheworkofMillerandModigliani–Showsthatcapitalstructureisirrelevant•Valueisderivedfrommarketimperfections•Example:Whatifafirmisconsideringissuingdebtandretiringequalamountsofequity?CurrentProposedAssets80008000Debt04000Equity80004000Interest0.10.1SharePrice2020OutstandingShares400200CurrentRecessionExpectedExpansionEarnings40012002000ROA0.050.150.25ROE0.050.150.25EPS135ProposedRecessionExpectedExpansionEBI40012002000Interest400400400Earnings08001600ROA0.050.150.25ROE00.20.4EPS048Position#1:Buy100sharesoftheleveredfirm($20*100=$2,000InitialInvestment)RecessionExpectedExpansionEarnings0400800Position#2:Buy200sharesoftheunleveredfirmandborrow$2000(($20*200)-$2,000=$2,000Initialinvestment).RecessionExpectedExpansionEarnings2006001000Interest200200200NetEarnings0400800CapitalStructureisIrrelevant•MillerandModiglianiassumeperfectcapitalmarkets•Proposition#1:Themarketvalueofanyfirmisindependentofitscapitalstructure.FirmValue:PerfectCapitalMarkets5070901101301501701900%25%50%75%100%D/EValueV(Unlevered)MarketImperfections:Taxes•Taxes–USTaxCode:Deductibilityofinterestleadstolowercostofdebt(Rd(1-t))–Simplespecificationovervaluesbenefit•Ignorespersonaltaxeswhich–Decreasesinvestorsdebtreturn–IncreasesinvestorspreferenceforequityCapitalgains:DeferandratedifferenceDividend:SomeportionisdeductibleMarketImperfections:ContractingCosts•Inimperfectmarkets,alternativewaystocontractoptimalbehaviorarenecessary•Costsoffinancialdistress–Underinvestment(rejectingNPV0projects),direct,indirectcosts,etc.•Benefitsofdebt–Monitoringfunction,managesfreecashflowproblem(AcceptingNPV0projects),etc.•ContractingcostsandtaxesareprimarymotivesforstatictradeofftheorydebtMarketImperfections:InformationCosts•Withasymmetricinformation,leveragemayrevealsomethingabouttheexistingfirm•Markettiming:Managerstakeadvantageofsuperiorinformation–Issueequitywhenitisovervalued–Issuedebtwhenitisundervalued•Signaling:Managersusefinancingtosignalfutureprospectsoffirms–Issueequitytosignalgoodgrowthopportunities(preservefinancialflexibility)–Issuedebtwhenexpectedcashflowsarestrongandstable•MotivatesPeckingOrderTheoryCanwequantifythevalueofmarketimperfections?Debtaddsvaluetothefirmduetotheinterestdeductibility(assumetaxesonly)Assumethesimplecase:)(TaxShieldPVVVULCDCDDrDrTaxShieldPV)(FirmValue:PerfectCapitalMarkets5070901101301501701900%25%50%75%100%D/EValueV(Unlevered)V(Levered)MoreComplexTaxShields•Unevenand/orlimitedtimepayments–Discountallflowsbacktotime0•Whatrdoyouuse?–Certainthetaxshieldcanbeused:rD–Uncertain?HigherrFinancialDistress•Asleverageincreases,theprobabilitythereforePVoffinancialdistressincreases)()(tistressCosFinancialDPVTaxShieldPVVVUL•Howdoweestimatethecostofdistress?–Prob(Distress)*CostofDistress•Probabilitycanbeestimatedinseveralways–Logit/Probitregressions–DebtratingsFirmValue:withTaxesandFiancialDistress507090110130150170190D/ED/EV(Unlevered)V(Levered)V(Distress)FinancialDistress:BankruptcyCosts•DirectCosts–Legal,accountingandotherprofessionalfees–Re-organizationlosses–Estimatedbtw4-10%offirmvalue(t-3)•IndirectCosts–Reputationcosts–Marketshare–Operatinglosses–Estimatedas7.8%offirmvalue(t-2)FinancialDistress:AgencyCosts•Riskshiftingandassetsubstitution–Shareholdersinvestinhighriskprojectsandshiftrisktothedebtholders–Shareholdersissuemoredebt,diminishingolddebtholdersprotection•Underinvestment•Expropriatingfunds•DifficulttoestimateOtherAdvantagesofDebt•AgencycostofEquity(motive)–Shirkingislesslikelywhenissuingdebt–Perquisitesarelesslikelywithdebt–Over-investmentislesslikelywithdebt•AgencycostofFreeCashFlow(opportunity)–Retainedearningsversusdividends?–Growthandinvestmentopportunities•Debtservesasamonitoringdevice,decreasingmanagerialdiscretion•Bankruptcyasastrategicmove???FormalModelsofCapitalStructure•PeckingOrder–Firmsprefertoraisecapital•Internallygeneratedfunds•Debt•Equity–Impliescapitalstructureisderivedfrom•Financingneedsandcapitalavailability•Dynamicratherthanstatic•Asymmetricinformationandsignaling•StaticTradeOffStatictrade-offtheoryofdebtMaximumFirmValueFirmValueDebtOptimalamountofDebtActualFirmValueImplicationsofStaticTradeOff•Staticratherthandynamic•TaxesandContractingCostdrivevalue•Readjustmentmaybesticky–Optimaltradeoffbetweencostofissuancesandbenefitofcapitalstruct