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Outline 6: Capital Structure

6.1 Debt and Value in a Tax Free Economy6.2 Capital Structure and Corporate Taxes 6.3 Cost of Financial Distress6.4 Explaining Financial Choices

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Value and Capital Structure

Assets Liabilities and Stockholder’s Equity

Value of cash flows from firm’s real assets and operations

Market value of debt

Market value of equity

Value of Firm Value of Firm

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Average Book Debt RatiosIndustry Debt Ratio

Software and programming 0.07 Semiconductors 0.14 Business services 0.22 Biotech 0.28 Major drugs 0.36 Retail 0.37 Average 0.53 Airlines 0.59 Real estate operations 0.60 Food processing 0.62 Hotels and motels 0.63 Utilities 0.65 Forestry and wood products 0.67

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M&M (Debt Policy Doesn’t Matter)

Modigliani & MillerWhen 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.

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M&M (Debt Policy Doesn’t Matter)

Assumptions

Capital structure does not affect cash flows e.g...No taxesNo bankruptcy costsNo effect on management incentives

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Example - River Cruises - All Equity Financed

17.5%12.5%7.5% shares on Return1.751.25$.75shareper Earnings175,000125,000$75,000Income OperatingBoomExpectedSlump

Economy theof State Outcome

million 1 $Shares of ValueMarket $10shareper Price100,000shares ofNumber

Data

M&M (Debt Policy Doesn’t Matter)

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Example cont.50% debt

25%15%5% shares on Return2.501.50$.50shareper Earnings125,00075,000$25,000earningsEquity 50,00050,000$50,000Interest175,000125,000$75,000Income OperatingBoomExpectedSlump

Economy theof State Outcome

500,000 $debt of ueMarket val500,000 $Shares of ValueMarket

$10shareper Price50,000shares ofNumber

Data

M&M (Debt Policy Doesn’t Matter)

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Example - River Cruises - All Equity Financed- Debt replicated by

investors

25%15%5% investment$10 on Return2.501.50$.50investment on earningsNet 1.001.00$1.0010% @Interest :LESS3.502.50$1.50shares twoon EarningsBoomExpectedSlump

Economy theof State Outcome

M&M (Debt Policy Doesn’t Matter)

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Cost of Capital

)( debtassetsassetsequity rrEDrr

EDEr

EDDrTWACC c equitydebt)1(

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r

DV

rD

rE

Weighted Average Cost of Capital

rA

6- 11Weighted Average Cost of Capitalwithout taxes (M&M view)

Includes Bankruptcy Risk

r

DV

rD

rE

WACC

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r

DV

rD

rE

WACC

Weighted Average Cost of Capital

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Financial Risk - Risk to shareholders resulting from the use of debt.

Financial Leverage - Increase in the variability of shareholder returns that comes from the use of debt.

Interest Tax Shield- Tax savings resulting from deductibility of interest payments.

Cap. Struct. And Corp. Taxes

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Example - You own all the equity of Space Babies Diaper Co.. The company has no debt. The company’s annual EBIT is $1,000. 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?

Cap. Struct. And Corp. Taxes

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All Equity 1/2 Debt

EBIT 1,000

Interest Pmt 0

Pretax Income 1,000

Taxes @ 40% 400

Net Cash Flow $600

All Equity 1/2 Debt

EBIT 1,000 1,000

Interest Pmt 0 100

Pretax Income 1,000 900

Taxes @ 40% 400 360

Net Cash Flow $600 $540

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

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Cap. Struct. and Corp. Taxes

All Equity 1/2 Debt

EBIT 1,000 1,000

Interest Pmt 0 100

Pretax Income 1,000 900

Taxes @ 40% 400 360

Net Cash Flow $600 $540

Total Cash Flow

All Equity = 600

*1/2 Debt = 640*1/2 Debt = 640

(540 + 100)

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?

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Capital Structure

PV of Tax Shield = (assume perpetuity)

D x rD x Tc

rD

= D x Tc

Example:

Tax benefit = 1000 x (.10) x (.40) = $40

PV of 40 perpetuity = 40 / .10 = $400

PV Tax Shield = D x Tc = 1000 x .4 = $400

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Capital StructureFirm Value = Value of All Equity Firm + PV Tax Shield

Example

All Equity Value = 600 / .10 = 6,000

PV Tax Shield = 400

Firm Value with 1/2 Debt = $6,400

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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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Financial Distress

Debt

Mar

ket V

alue

of T

he F

irm

Value ofunlevered

firm

PV of interesttax shields

Costs offinancial distress

Value of levered firm

Optimal amount of debt

Maximum value of firm

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Financial Choices

Trade-off Theory - Theory that capital structure is based on a trade-off between tax savings and distress costs of debt.

Pecking Order Theory - Theory stating that firms prefer to issue debt rather than equity if internal finance is insufficient.