Capital structure I

Lecture 5

• Specifics of different sources of long-term financing – Common stock vs preferred stock vs

debt

• The Modigliani and Miller model

• The Miller model

7.2 The Long-Term Financial Deficit (1999)

Sources of Cash Flow (100%)

Internal cash flow (retained earnings plus depreciation)

70%

Long-term debt and

equity 30%

Uses of Cash Flow (100%)

Capital spending

80%

Net working

capital plus other uses

20%

Internal cash flow

External cash flow

Financial deficit

7.3 Capital Structure

• Firms usually spend more than they generate internally– The deficit is financed by new sales of

debt & equity

• Sources of long-term financing:– Internal financing

• Retained earnings

– External financing • Debt• Preferred stock • Common stock

7.4 Elements of the Capital Structure

• Mix of different classes of capital:– Retained earnings vs debt & equity

• Control rights vs cash flow rights• Maturity: refinancing risk vs

reinvestment risk• Agency conflict• Asymmetric information and signaling• Important subtopics:

– Debt: bank credit vs bonds– Payout policy: dividends vs share

repurchase– Costs of new issues

7.5 Common Stock

• Basic Shareholders’ Rights (may differ for dual classes):– Control rights– Residual claim on assets (after paying up liabilities)– Limited liability

• Components of Shareholders’ Equity:– Common Stock Par Value– Capital Surplus (directly contributed equity in excess of the

par value)– Retained Earnings (accumulated over time)– Treasury Stock at Cost

• Shares: Authorized vs Issued vs Outstanding • Market vs Book vs Replacement Value

– MV = price of the stock times the number of shares outstanding

– BV = par value + capital surplus + accumulated retained earnings

– RV = current cost of replacing the assets of the firm– At the time a firm purchases an asset, MV=BV=RV

7.6 The Right to Elect the Directors

• The most important control device – Directors are elected each year at an annual meeting by a vote

of the holders of a majority of shares who are present and entitled to vote

• Straight voting– Shareholders have as many votes as shares and each position on

the board has its own election– A tendency to freeze out minority shareholders

• Cumulative voting– Each shareholder may cast # shares multiplied by # directors to

be elected; these votes can be distributed over one or more candidates

– The effect is to permit minority participation

• Proxy voting (giving voting right to someone else)– Proxy fight: outsiders try to win enough proxy votes to oust the

mgt

• Some (e.g. merger) decisions require supermajority (e.g. 75%)

7.7 Dividends

• Unless a dividend is declared by the board of directors, it is not a liability of the corporation– A corporation cannot default on an undeclared

dividend

• The payment of dividends by the corporation is not a business expense– Therefore, they are not tax-deductible

• Dividends received by individual shareholders are considered ordinary income and are fully taxable– Intra-corporate dividend exclusion: corporations are

taxed only on the 20% of the received dividends

7.8 Corporate Long-Term Debt

• Bondholders have a contractual claim against the corporation, not an ownership interest– Creditors have no voting power unless the debt is

not paid, – when they can legally claim the assets of the firm

• The corporation’s payment of interest on debt is considered a cost of doing business.. – and is fully tax-deductible

• Corporations are very adept at creating hybrid securities that look like equity but are called debt – Obviously, the distinction is important at tax time– A corporation that succeeds is creating a debt

security that is really equity obtains the tax benefits of debt while eliminating its bankruptcy costs

7.9 The Bond Indenture

• Amount of issue, date of issue, maturity, currency, par value

• Coupon payments: frequency, floating vs fixed rate• Orderly repayment of debt (to avoid the balloon

payment):– Amortization, by regular installments through a sinking fund– With serial bonds

• Option features:– Call provision (possibility to retire the entire issue before the

maturity)– Convertibility into stocks

• Security (attachment to the property): debenture/note vs bond

• Protective covenants:– Restrictions on further indebtedness, max dividends, min working

K• Seniority: subordinated debt paid after senior debt• Other determinants of the market price:

– Default risk (credit rating), domestic / foreign / Eurobond

7.10 Dual Nature of Preferred Stock

• Preference over common stock in cash rights:– in the payments of dividends – in the assets in case of bankruptcy

• No voting rights, unless no dividends 6 quarters in a row

• Is it really debt in disguise?– Fixed dividend: usually, cumulative (carried forward if not

paid) – Stated liquidating value

• Call provision: can be converted to common shares• Corporations get 80% tax exemption on dividends

– But not on debt interest – Most preferred stock in the U.S. is held by corporate investors

• Firms issuing the preferred stock: – Utilities, with low taxable income, avoiding the risk of

bankruptcy

7.11 Patterns of Financing

• Firms usually spend more than they generate internally– The deficit is financed by new sales of debt and

equity

• Internally generated cash flow dominates as a source of financing, typically between 70 and 90%

• New sales of debt prevail over new equity issues

• Outside the US, firms rely more on external equity

• Debt ratios for U.S. non-financial firms have been below 50% of total financing

7.12 Choice of the Capital Structure

• The value of a firm: sum of the value of the firm’s debt and the firm’s equity: V = B + S

• Why should the stockholders care about maximizing firm value?

Value of the Firm

S B

• Since the payoff of the debtholders is fixed (in case of no default), changes in capital structure benefit the stockholders if and only if the value of the firm increases.

7.13 Modigliani-Miller Model: Assumptions

• Perfect capital markets:– Perfect competition– Firms & investors can borrow/lend at the same rate– No frictions (transaction costs / taxes / bankruptcy

costs)– Informational efficiency

• No need for signaling

– Managers are perfectly aligned with shareholders• No agency costs

• Firms can be classified to homogeneous risk classes– No CAPM at that time

• Perpetual cash flows, no growth• The firm can issue risk-free debt

7.14 Homemade Leverage: An Example

RecessionExpectedExpansionEPS of Unlevered Firm $2.50 $5.00 $7.50

Earnings for 40 shares $100 $200 $300Less interest on $800 (8%)$64 $64 $64Net Profits $36 $136 $236ROE (Net Profits / $1,200)3% 11% 20%

We are buying 40 shares of a $50 stock and borrow $800. We get the same ROE as in the levered firm. Our personal debt equity ratio: 3

2200,1$

800$

S

B

7.15 Homemade (Un)Leverage: An Example

RecessionExpectedExpansionEPS of Levered Firm $1.50 $5.67 $9.83

Earnings for 24 shares $36 $136 $236Plus interest on $800 (8%)$64 $64 $64Net Profits $100 $200 $300ROE (Net Profits / $2,000)5% 10% 15%

Buying 24 shares of an otherwise identical levered firm along with some of the firm’s debt gives us ROE of the unlevered firm.This is the fundamental insight of MM

7.16 The MM Propositions (No Taxes), 1958

• Prop. I: firm's value is not affected by leverage

VL = VU

• Prop. II: leverage increases the risk and return to stockholders

rs = r0 + (B/S) (r0 - rB)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 debtS is the value of levered equity

7.17

Debt-to-equity Ratio

Cos

t of

capi

tal:

r (%

)

r0

rB

SBWACC rSB

Sr

SB

Br

)( 00 BL

S rrS

Brr

rB

S

B

MM II: Cost of Equity and WACC

7.18 The MM Propositions (with Corporate Taxes), 1963

• Prop. I: firm's value increases with leverage

VL = VU + TC B• Prop. II: the increase in equity risk and

return is partly offset by the tax shield of debt

rS = r0 + (B/S)×(1-TC)×(r0 - rB) 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 debtS is the value of levered equityTC is the corporate tax rate

7.19 Derivation of MM (with Corporate Taxes)

• Each period, shareholders and bondholders receive

(EBIT - RBB)(1 - TC) + RBB = EBIT(1 - TC) + TCRBB• PV of this stream of CFs discounted at r0 and rB is

S + B ≡ VL = VU + TC B• Thus, VU = S + B(1-TC). Both sides yield equal CFs:

r0VU = rSS+rBB(1-TC) or r0(S+B(1-TC)) =rSS+rBB(1-TC) • The cost of equity: rs = r0 + (B/S) (1-TC) (r0 - rB)• WACC: rS S/(S+B) + (1 - TC) rB B/(S+B) = r0 [1 - TC B/(S+B)]

7.20 MM II: Cost of Equity and WACC

Debt-to-equityratio (B/S)

Cost of capital: r(%)

r0

rB

)()1( 00 BCL

S rrTS

Brr

SL

LCB

LWACC r

SB

STr

SB

Br

)1(

7.21 Summary: MM Model

Does it matter how to cut the pizza into pieces?

• In a world of no taxes:– The firm’s value is fully determined by

investments• Shareholders can achieve any pattern of payouts

they desire with homemade leverage

• In a world of taxes, but no bankruptcy costs:– The firm’s value increases with leverage

• If you count the government as the stakeholder, value of the firm stays the same!

– WACC differs from r0

• Both models give unrealistic predictions

7.22 The Miller Model: Impact of Personal TaxesMiller (1977) shows that the value of a levered firm

can be expressed in terms of an unlevered firm as:

BT

TTVV

B

SCUL

1

)1()1(1

where

TS = personal tax rate on equity income

TB = personal tax rate on bond income

TC = corporate tax rate

7.23 Derivation of the Miller Model

)1()1()(

receive firm levered a in rsShareholde

SCB TTFrEBIT

)1(

receive sBondholder

BB TFr

)1()1()1()(

is rsstakeholde all flow to cash total theThus,

BBSCB TFrTTFrEBIT

B

SCBBSC T

TTTFrTTEBIT

1)1()1(

1)1()1()1(

as rewritten be can This

Assume that each year the firm earns EBIT and pays interest on debt with face value F:

7.24 Derivation of the Miller Model

B

SCBBSC T

TTTFrTTEBIT

1)1()1(

1)1()1()1(

The first term is the cash flow of an unlevered firm after all taxes.

Its value = VU

The bond promises to pay rBF×(1-TB) after taxes and is worth B=F(1-TB). Thus, the value of the second term is:

B

SC

T

TTB

1

)1()1(1

The total CF to all stakeholders in the levered firm is:

The value of the sum of these two terms must be VL

BT

TTVV

B

SCUL

1

)1()1(1

7.25

Debt (B)

Val

ue

of f

irm

(V

)

VU

VL = VU+TCB when TS =TB

VL < VU + TCBwhen TS < TB but (1-TB) > (1-TC)×(1-TS)

VL =VU when (1-TB) = (1-TC)×(1-TS)

VL < VU when (1-TB) < (1-TC)×(1-TS)

BT

TTVV

B

SCUL

1

)1()1(1

Firm Value with Corporate & Personal Taxes

7.26 Interpretation of the Miller Model

• Personal tax rates differ: TS < TB

– Effective tax rate on capital gains is lower (can be deferred)

– 80% of dividends received by corporations are tax-exempt

– Many types of investment funds pay no taxes

• Bond market equilibrium (assuming TS = 0):

– The supply of funds is fixed at rS = r0/(1-TC)

– The demand rises from r0 sufficient for tax-exempt investors to r0/(1-TB,i) for investors in i's tax bracket

– In equilibrium, no tax advantage for leverage

• An equilibrium amount of corporate debt is determined by relative corporate & personal tax rates

7.27 DeAngelo-Masulis Model, 1980

• The tax shield may be underutilized: – Effects of tax shield substitutes (depreciation

and investment tax credit)– Higher debt increases probability of negative

earnings and bankruptcy

• Modified bond market equilibrium:– The supply of funds depends on the

corporation-specific tax rate: rS = r0/(1-TC,i)

• The higher the level of tax shield substitutes and the cost of bankruptcy, the lower the leverage

7.28

Value of the Firm(MM-Proposition I with Taxes and Bankruptcy)

Debt-Equity Ratio (B/S)

MM-no taxes

MM-with corporate taxes only

MM-with corporate taxes and bankruptcy costs

Optimal debt-equity ratio

Value of the Firm