Ch15 Capital Structure Decisions

7/24/2019 Ch15 Capital Structure Decisions

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Chapter 15

Capital Structure Decisions


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Topics in Chapter Overview and preview of capital

structure eects Business versus nancial riskThe impact of det on returns Capital structure theor!" evidence"

and implications for mana#ers $%ample& Choosin# the optimal

structure


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Value = + + +FCF1 FCF2 FCF

(1 + WACC)1 (1 +WACC)

(1 + WACC)2

Free cash fow(FCF)

Market interest rates

Firms !usiness riskMarket risk a"ersion

Firms

#e!t$e%uit&mi'

Cost o #e!t

Cost o e%uit&

Weihte# a"erae

cost o ca*ital(WACC)

et o*eratin*ro,t ater ta'es

-e%uire# in"estmentsin o*eratin ca*ital

.

=

/eterminants o 0ntrinsic Valuehe Ca*ital 3tructure Choice


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Basic Denitions ) * value of rm

+C+ * free cash ,ow

-.CC * wei#hted avera#e cost ofcapital

rsand rd are costs of stock and det

wsand wdare percenta#es of the rm

that are nanced with stock and det/


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0ow can capital structure

aect value

) * 3

t*

1

+C+t

41

-.CC6t

-.CC* wd417T6 rd wsrs


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. 9review of Capital

Structure $ectsThe impact of capital structure on

value depends upon the eect of

det on& -.CC

+C+

(Continued)


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The $ect of .dditional

Det on -.CC Detholders have a prior claim on cash

,ows relative to stockholders/

Detholders; educes after7ta% cost of det

(Continued)


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The $ect on -.CC

4Continued6 Det increases risk of ankruptc!

Causes pre7ta% cost of det" rd" to

increase .ddin# det increase percent of rm

nanced with low7cost det 4wd6 and

decreases percent nanced withhi#h7cost e@uit! 4ws6

Aet eect on -.CC * uncertain/(Continued)


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The $ect of .dditional

Det on +C+ .dditional det increases the

proailit! of ankruptc!/ Direct costs& e#al fees"


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mpact of indirect costs AO9.T #oes down due to lost

customers and drop in productivit! nvestment in capital #oes up due to

increase in net operatin# workin#

capital 4accounts pa!ale #oes downas suppliers ti#hten credit6/

(Continued)


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.dditional det can aect the ehaviorof mana#ers/

>eductions in a#enc! costs& det


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.s!mmetric nformation

and Si#nalin# Gana#ers know the rm;s future

prospects etter than investors/

Gana#ers would not issue additionale@uit! if the! thou#ht the current stockprice was less than the true value of thestock 4#iven their inside information6/

0ence" investors often perceive anadditional issuance of stock as ane#ative si#nal" and the stock price falls/


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Business >isk& Hncertaint!

in $BT" AO9.T" and >OC Hncertaint! aout demand 4unit

sales6/

Hncertaint! aout output prices/

Hncertaint! aout input costs/

9roduct and other t!pes of liailit!/

De#ree of operatin# levera#e4DO6/


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-hat is operatin# levera#e" andhow does it aect a rm;s

usiness risk Operatin# levera#e is the chan#e

in $BT caused ! a chan#e in

@uantit! sold/The hi#her the proportion of %ed

costs relative to variale costs" the

#reater the operatin# levera#e/

(More...)


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0i#her operatin# levera#e leads tomore usiness risk& small sales

decline causes a lar#er $BT decline/

(More...)

Sales

$ Rev.

TC

FQBE

EBIT}$

Rev.

TC

F

QBESales


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Operatin# Breakeven I is @uantit! sold" + is %ed cost" ) is

variale cost" TC is total cost" and 9 is

price per unit/ Operatin# reakeven * IB$ IB$* + J 49 K )6

$%ample& +*L2EE" 9*L15" and )*L1E& IB$* L2EE J 4L15 K L1E6 * (E/

(More...)


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Business >isk versus+inancial >isk

Business risk& Hncertaint! in future $BT" AO9.T" and >OC/

Depends on usiness factors such ascompetition" operatin# levera#e" etc/

+inancial risk& .dditional usiness risk concentrated on

common stockholders when nancial levera#eis used/

Depends on the amount of det and preferredstock nancin#/


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Consider Two 0!pothetical+irms dentical $%cept for

Det+irm H +irm

Capital L2E"EEE L2E"EEE

Det LE L1E"EEE 412Mrate6

$@uit! L2E"EEE L1E"EEETa% rate (EM (EM

$BT L'"EEE L'"EEEAO9.T L1"?EE L1"?EE>OC M M


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mpact of evera#e on>eturns

+irm H +irm

$BT L'"EEE L'"EEE

nterest E 1"2EE$BT L'"EEE L1"?EE

Ta%es 4(EM6 1 "2EE :2EA L1"?EE L1"E?E

>OC /EM /EM>O$4AJ$@uit!6

/EM 1E/?M


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-h! does levera#in#increase return

Gore cash #oes to investors of +irm /Total dollars paid to investors&

H& A * L1"?EE/ & A nt * L1"E?E L1"2EE * L2"2?E/

Ta%es paid& H& L1"2EE

& L:2E/ n +irm " fewer dollars are tied up in

e@uit!/


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mpact of evera#e on>eturns if $BT +alls

+irm H +irm

$BT L2"EEE L2"EEE

nterest E 1"2EE

$BT L2"EEE L?EE

Ta%es 4(EM6 ?EE '2EA L1"2EE L(?E

>OC 8/EM 8/EM

>O$ 8/EM (/?M


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Capital Structure Theor!

GG theor! ero ta%es Corporate ta%es Corporate and personal ta%es

Trade7o theor! Si#nalin# theor!

9eckin# order Det nancin# as a mana#erial constraint -indows of opportunit!


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GG Theor!& ero Ta%es

+irm H +irm

$BT L'"EEE L'"EEE

nterest E 1"2EE

A L'"EEE L1"?EE

C+ toshareholder

L'"EEE L1"?EE

C+ todetholder

E L1"2EE

Total C+ L'"EEE L'"EEE


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GG >esults& ero Ta%es

GG assume& 416 no transactions costsP 426 norestrictions or costs to short salesP and 4'6individuals can orrow at the same rate as

corporations/ GG prove that if the total C+ to investors of +irm

H and +irm are e@ual" then aritra#e is possileunless the total values of +irm H and +irm aree@ual&

)* )H/ Because +C+ and values of rms and H are

e@ual" their -.CCs are e@ual/ Therefore" capital structure is irrelevant/


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GG Theor!& CorporateTa%es

Corporate ta% laws allow interest toe deducted" which reduces ta%espaid ! levered rms/

Therefore" more C+ #oes toinvestors and less to ta%es whenlevera#e is used/

n other words" the det


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GG >esult& CorporateTa%es

GG show that the total C+ to +irm ;sinvestors is e@ual to the total C+ to +irm

H;s investor plus an additional amount dueto interest deductiilit!& C+* C+H rdDT/

-hat is value of these cash ,ows )alue of C+H* )H GG show that the value of rdDT * TD Therefore" )* )H TD/

f T*(EM" then ever! dollar of det adds(E cents of e%tra value to rm/


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Value of Firm, V

0 Deb

V!

V"

"#er MM %i& 'ororae aes, &e firm*s valuei#'reases 'o#i#uousl+ as more a# more eb is use.

TD

GG relationship etween value anddet when corporate ta%es are

considered/


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Giller;s Theor!& Corporateand 9ersonal Ta%es

9ersonal ta%es lessen the advanta#eof corporate det& Corporate ta%es favor det nancin#

since corporations can deduct intereste%penses/

9ersonal ta%es favor e@uit! nancin#"since no #ain is reported until stock issold" and lon#7term #ains are ta%ed ata lower rate/


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Giller;s Godel withCorporate and 9ersonal

Ta%es

)* )H 1Q D

Tc* corporate ta% rate/

Td* personal ta% rate on detincome/

Ts* personal ta% rate on stock

income/

(1 - Tc)(1 - Ts)

(1 - Td)


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Tc* (EM" Td* 'EM"

and Ts* 12M/

)

* )H

1Q D

* )H 41 7 E/:56D

* )H

E/25D/

)alue rises with detP each L1 increasein det raises ;s value ! LE/25/

(1 - 0.40)(1 - 0.12)

(1 - 0.30)


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Conclusions with 9ersonalTa%es

Hse of det nancin# remainsadvanta#eous" ut enets are less

than under onl! corporate ta%es/ +irms should still use 1EEM det/ Aote& 0owever" Giller ar#ued that in

e@uilirium" the ta% rates ofmar#inal investors would adFust untilthere was no advanta#e to det/


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Trade7o Theor!

GG theor! i#nores ankruptc! 4nancialdistress6 costs" which increase as morelevera#e is used/

.t low levera#e levels" ta% enetsoutwei#h ankruptc! costs/

.t hi#h levels" ankruptc! costs

outwei#h ta% enets/ .n optimal capital structure e%ists that

alances these costs and enets/


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Ta% Shield vs/ Cost of +inancialDistress

Value of Firm, V

0 Deb

V!

V"

Ta S&iel

Disress Coss


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Si#nalin# Theor!

GG assumed that investors andmana#ers have the same information/

But" mana#ers often have etterinformation/ Thus" the! would& Sell stock if stock is overvalued/ Sell onds if stock is undervalued/

nvestors understand this" so view newstock sales as a ne#ative si#nal/

mplications for mana#ers


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9eckin# Order Theor!

+irms use internall! #enerated fundsrst" ecause there are no ,otation

costs or ne#ative si#nals/ f more funds are needed" rms then

issue det ecause it has lower ,otationcosts than e@uit! and not ne#ative

si#nals/ f more funds are needed" rms then

issue e@uit!/


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Det +inancin# and.#enc! Costs

One a#enc! prolem is thatmana#ers can use corporate funds

for non7value ma%imiRin# purposes/The use of nancial levera#e&

Bonds


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. second a#enc! prolem is thepotential for


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nvestment Opportunit! Setand >eserve Borrowin#

Capacit! +irms with man! investment

opportunities should maintain

reserve orrowin# capacit!"especiall! if the! have prolemswith as!mmetric information

4which would cause e@uit! issuesto e costl!6/


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-indows of Opportunit!

Gana#ers tr! to


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$mpirical $vidence

Ta% enets are importantK L1 detadds aout LE/1E to value/

Bankruptcies are costl!K costs cane up to 1EM to 2EM of rm value/

+irms don;t make @uick corrections

when stock price chan#es causetheir det ratios to chan#eK doesn;tsupport trade7o model/


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$mpirical $vidence4Continued6

.fter i# stock price run ups" det ratiofalls" ut rms tend to issue e@uit!instead of det/ nconsistent with trade7o model/ nconsistent with peckin# order/ Consistent with windows of opportunit!/

Gan! rms" especiall! those with #rowthoptions and as!mmetric informationprolems" tend to maintain e%cessorrowin# capacit!/


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mplications for Gana#ers

Take advanta#e of ta% enets !issuin# det" especiall! if the rm

has& 0i#h ta% rate

Stale sales

ow operatin# levera#e


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mplications for Gana#ers4Continued6

.void nancial distress costs !maintainin# e%cess orrowin#

capacit!" especiall! if the rm has& )olatile sales 0i#h operatin# levera#e Gan! potential investment opportunities

Special purpose assets 4instead of #eneralpurpose assets that make #ood collateral6


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mplications for Gana#ers4Continued6

f mana#er has as!mmetricinformation re#ardin# rm;s future

prospects" then avoid issuin# e@uit!if actual prospects are etter thanthe market perceives/

.lwa!s consider the impact ofcapital structure choices on lenders;and ratin# a#encies; attitudes


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Choosin# the OptimalCapital Structure& $%ample

* 1/EP r>+* 8MP >9G* 8M/

Cost of e@uit! usin# C.9G& rs* r>+ 4>9G6* 8M 148M6 * 12M

Currentl! has no det& wd* EM/ -.CC * rs* 12M/

Ta% rate is T * (EM/


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Current )alue ofOperations

$%pected +C+ * L'E million/

+irm e%pects Rero #rowth& # * E/

)op* +C+41#6J4-.CC #6

)op* L'E41E6J4E/12 0)

)op* L25E million/


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Other Data for )aluation.nal!sis

Compan! has no ST investments/

Compan! has no preferred stock/

1EE"EEE shares outstandin#


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Current )aluation .nal!sis

)op L25E

ST nv/ E

)Total L25E

Q Det E

S L25E

Un 1E

9 L25/EE

t t k id d


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nvestment ankers providedestimates of rdfor dierent capital

structures/w# 45 245 645 745 845

r# E/EM ?/EM ?/5M 1E/EM 12/EM

f compan! recapitaliRes" it will use proceedsfrom det issuance to repurchase stock/

Th C t f $ it t Di t


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The Cost of $@uit! at Dierentevels of Det& 0amada;s

+ormula GG theor! implies that eta

chan#es with levera#e/

His the eta of a rm when it hasno det 4the unlevered eta6

* H1 41 7 T64wdJws6

Th C f $ i f


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The Cost of $@uit! for wd*

2EM

Hse 0amada;s e@uation to nd eta&

* H1 41 7 T64wdJws6 * 1/E 1 417E/(6 42EM J ?EM6

* 1/15

Hse C.9G to nd the cost of e@uit!&

rs* r>+ C 4>9G6

* 8M 1/15 48M6 * 12/M


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The -.CC for wd* 2EM

-.CC * wd417T6 rd wcers -.CC * E/2 41 K E/(6 4?M6 E/?

412/M6 -.CC * 11/2?M

>epeat this for all capitalstructures under consideration/


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Beta" rs" and -.CC

w# 45 245 645 745 845


ws 1EEM ?EM :EM 8EM 5EM

! 1/EEE 1/15E 1/25: 1/(EE 1/8EE

rs 12/EEM 12/EM 1'/5(M 1(/(EM 15/8EM

WACC 12/EEM 11/2?M 119415 11/E(M 11/(EM

he WACC is minimi:e# or w#= 6459 his is the

o*timal ca*ital structure9

C t ) l f


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Corporate )alue for wd*

2EM

)op* +C+41#6J4-.CC #6

)op* L'E41E6J4E/112? 0)

)op* L285/8 million/ Det * DAew* wd)op

Det * E/2E4285/86 * L5'/1 million/

$@uit! * S * ws)op

$@uit!* E/?E4285/86 * L212/:: million/

) l f O i D


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)alue of Operations" Det"and $@uit!

w# 45 245 645 745 845



! 1/EEE 1/15E 1/25: 1/(EE 1/8EE

rs 12/EEM 12/EM 1'/5(M 1(/(EM 15/8EM

WACC 12/EEM 11/2?M 11/E1M 11/E(M 11/(EM

Vo* L25E/EE L285/8 ;2


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.natom! of a >ecap&Before ssuin# Det

Before Det

)op L25E

ST nv/ E

)Total L25E

Q Det E

S L25E

Un 1E9 L25/EE

Totalshareholder

wealth& S

D t 4 2EM6


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ssue Det 4wd* 2EM6"

But Before >epurchase

-.CC decreases to 11/2?M/

)opincreases to L285/5:(/

+irm temporaril! has short7terminvestments of L5'/115 4until ituses these funds to repurchase

stock6/ Det is now L5'/115/

. t f > .ft


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.natom! of a >ecap& .fterDet" ut Before>epurchase

Before Det.fter Det"

Before >ep/

)op L25E L285/8

ST nv/ E 5'/1

)Total L25E L'1/15

Q Det E 5'/1

S L25E L285/8

Un 1E 1E

9 L25/EE L28/8E

Total

shareholder

.ft i D t B f


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.fter ssuin# Det" Before>epurchasin# Stock

Stock price increases from L25/EEto L28/8E/

-ealth of shareholders 4due toownership of e@uit!6 increasesfrom L25E million to L285/8

million/

Th > h A $ t


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The >epurchase& Ao $ecton Stock 9rice

The announcement of an intended repurchasemi#ht send a si#nal that aects stock price"and the previous chan#e in capital structure

aects stock price" ut the repurchase itselfhas no impact on stock price/ f investors thou#ht that the repurchase would

increase the stock price" the! would all purchasestock the da! efore" which would drive up its price/

f investors thou#ht that the repurchase woulddecrease the stock price" the! would all sell short thestock the da! efore" which would drive down thestock price/

> i i A f


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>emainin# Aumer ofShares .fter >epurchase

DOldis amount of det the rm initiall! has"DAewis amount after issuin# new det/

f all new det is used to repurchase

shares" then total dollars used e@uals 4DAewK DOld6 * 4L5'/1 7 LE6 * L5'/1/

n9rioris numer of shares eforerepurchase" n9ostis numer after/ Total

shares remainin#& n9ost* n9riorK 4DAewK DOld6J9n9ost* 1E K 4L5'/1JL28/8E6

n9ost* ? million/

4#nore roundin# dierencesP see Ch15 Mini Case.xlsfor actual calculations6/

. t f > .ft


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.natom! of a >ecap& .fter>upurchase

Before Det.fter Det"

Before >ep/ .fter >ep/

)op L25E L285/8 L285/8

ST nv/ E 5'/1 E

)Total L25E L'1/15 L285/8

Q Det E 5'/1 5'/1

S L25E L285/8 L212/::

Un 1E 1E ?

9 L25/EE L28/8E L28/8E

Total

shareholder


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We! 9oints

ST investments fall ecause the! areused to repurchase stock/

Stock price is unchan#ed/ )alue of e@uit! falls from L285/8 to

L212/:: ecause rm no lon#er ownsthe ST investments/

-ealth of shareholders remains at

L285/8 ecause shareholders nowdirectl! own the funds that were held !rm in ST investments/

ntrinsic Stock 9rice


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ntrinsic Stock 9riceGa%imiRed at OptimalCapital Structurew# 45 245 645 745 845



! 1/EEE 1/15E 1/25: 1/(EE 1/8EE

rs 12/EEM 12/EM 1'/5(M 1(/(EM 15/8EM

WACC 12/EEM 11/2?M 119415 11/E(M 11/(EM

Vo* L25E/EE L285/8 ;2


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Shortcuts

The corporate valuation approachwill alwa!s #ive the correct

answer" ut there are someshortcuts for ndin# S" 9" and n/

Shortcuts on ne%t slides/

Calculatin# S the )alue of


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Calculatin# S" the )alue of$@uit! after the >ecap

S * 41 K wd6 )op .t wd* 2EM&

S * 41 K E/2E6 L285/8

S * L212/::/

4#nore roundin# dierencesP see Ch15 Mini Case.xlsfor actual calculations6/

Aumer of Shares after a


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Aumer of Shares after a>epurchase" n9ost

.t wd* 2EM&

n9ost* n9rior4)opAewDAew6J4)opAewDOld6

n9ost* 1E4L285/8 L5'/16J4L285/8 LE6

n9ost* ?

Calculatin# 99ost the


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Calculatin# 99ost" theStock 9rice after a >ecap

.t wd* 2EM&

99ost* 4)opAewDOld6Jn9rior

n9ost* 4L285/8 LE6J1E

n9ost* L28/8E


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Optimal Capital Structure

wd* 'EM #ives&

0i#hest corporate value owest -.CC

0i#hest stock price per share

But wd* (EM is close/ Optimal ran#eis prett! ,at/

Documents

Ch15 Capital Structure Decisions