L03 MBA WACC (Alternativo 1)

Copyright K. Cuthbertson and D. Nitzsche 1

Lecture

Capital Structureand the Modigliani-Miller Propositions

11/9/2001


Preliminary definitionsPreliminary definitions

~Capital structure question -what is it?~Capital structure question -what is it?

Capital structure question -the theoriesCapital structure question -the theories

~Traditional view~Traditional view

~Modigliani-Miller MM - propositions I and II (no taxes)~Modigliani-Miller MM - propositions I and II (no taxes)

~Modigliani-Miller MM - propositions I and II (with taxes)~Modigliani-Miller MM - propositions I and II (with taxes)

Modigliani-Miller: More RealismModigliani-Miller: More Realism

~Financial Distress and Bankruptcy~Financial Distress and Bankruptcy

TOPICS COVERED


Investments:Spot and Derivative Markets

K.Cuthbertson and D.Nitzsche

CHAPTER 11:CHAPTER 11:

excludingexcluding

Section 11.4 (Dividend Policy) and Section 11.4 (Dividend Policy) and

AppendicesAppendices

READING


Preliminary Definitions

Capital structure question -what is it?


Manufacturing Sector (UK, E. Midlands, averages 1984-94)Manufacturing Sector (UK, E. Midlands, averages 1984-94)

ChemicalsChemicals 140%140%

MetalsMetals 90% 90%

Mech. Eng.Mech. Eng. 76%76%

ConstructionConstruction 75%75%

Retail DistnRetail Distn 158%158%

Business ServicesBusiness Services 125%125%

Figures are all ‘book value’ Figures are all ‘book value’

Leverage = Total Debt / Net Worth(‘Shareholders Funds’) Leverage = Total Debt / Net Worth(‘Shareholders Funds’)

Leverage varies greatly even within same sectorLeverage varies greatly even within same sector

Manufacturing (Leverage =Debt to Equity Ratio)


LEVERED(GEARED) = financed by debt and equity

DISCOUNT RATE TO USE FOR A LEVERED FIRM

Assume (debt-equity ratios will remain broadly unchanged)

(‘After tax’)Weighted Average Cost of Capital WACC,

WACC = (1-z) RS + z RB (1-t)

z = B / V , (1-z) = S / V ~ ‘weights’ sum to 1.

Preliminary Definitions


Using the WACC as the discount rate

WACC can be used:

I) if the new project gives rise cash flows that have the same degree of business risk as the existing general cash flows of the firm. That is, the project is ‘scale enhancing’

and

ii) if the project does not lead to a (large) change in the firm’s debt ratio.

In fact, the WACC calculation assumes that the amount of debt outstanding is rebalanced every period to maintain a constant ratio B/V ratio for the firm as a whole.


SO, VALUE OF THE FIRM IS: V = Y / WACC

Hold the firm’s cash flows constant (and for ever)

(Also, assume Y is independent of capital structure)

CAPITAL STRUCTURE QUESTION

Can we alter WACC (and hence V) by altering the mix of debt and equity finance ?

Example

.$100 total in debt and equity.

Do we gain by moving from 20% debt/80% equity finance, to 70% debt-30% equity finance ?

- done by issuing more $50 more in bonds and using the proceeds to buy-back $50 of outstanding shares.

Capital Structure Question


Capital Structure: Traditional ViewCapital Structure: Traditional View


As you increase the proportion of ‘cheap’ debt

(and initially the required return on equity remains constant ) then WACC will fall and hence V will rise.

After a certain debt level (e.g. 70%) the equity holders will require a higher return because of increased ‘risk’. This will raise the WACC and V will begin to fall.

Hence: There is a particular level for the debt-equity ratio which will maximise the value of the firm.

Capital Structure: Traditional View

Copyright K. Cuthbertson and D. Nitzsche

Traditional View : Cost of Capital

*

Optimal( B/S)*

Equity, Rs

WACC

Debt Rb

Debt-Equity Ratio (B/S)

Cost of Capital

or V

VALUE OF FIRM


Capital Structure: Capital Structure:

Modigliani-MillerModigliani-Miller

Propositions I and II (No taxes)Propositions I and II (No taxes)


Modigliani-Miller Approach

ASSUMPTIONS IN THE MODIGLIANI-MILLER APPROACH• Borrowing and lending rates equal and the same for companies

and persons.

• No corporate or personal taxes or transactions costs.

• No costs of financial distress or liquidation

• net cash flows Y,are independent of the debt-equity mix.

• Investors can arbitrage between the shares of companies (with the same business risk) where one is all-equity financed and the other is a levered firm.


Under certain restrictive assumptions MM show

that the fall in WACC as you increase the proportion of debt finance is exactly offset by the rise in the required return on equity, RS

- so the overall WACC remains constant.

In this MM world there is therefore no optimal debt-equity ratio.

So, MM argue that you can finance a project with NPV>0, with any arbitrary mix of debt and equity, without affecting the overall value of the firm.

MM PROPOSITION I (NO TAXES)


The Value of the Firm: MM Proposition-I (no taxes)

Value of firm, V


V

V is independent of B/S


Why do shareholders demand a higher return on equity Rs as we increase proportion of debt relative to equity finance ?

Rs increases because these returns are more uncertain (i.e. have a higher standard deviation) the larger is the proportion of debt finance.

Why Does Rs Increase With Leverage ?


Earnings Y can be either £0.5m , £2m or £4m (with equal probability). This is ‘business risk’.

What is the range of outcomes for shareholder’s returns Rs in

a) the all (100%) equity financed firm

b) the levered firm with 50% debt and 50% equity

The range is much greater in (b) since the interest income on the debt is paid first.

Why Does Rs Increase With Leverage ?


Leverage and Equity Returns

Earnings Yi

Equ

ity

Ret

urn,

RS

70%

40%

30%

20%

10%

Yi changes from 1m to 4m, RS for the all equity firm moves from 10% to 40% (A to B)But for the 50% levered firm the equity return changes much more, from 10% to 70% (A’ to C). Hence ‘debt finance’ introduces additional ‘leverage risk’.

10.5 4

100% Equity (0% Debt)

50% Equity (50% Debt)C

B

A A’

2


Capital raised=$10m =S + B = shares + debt (bonds)

Cost of Debt =10%

1. Poor 2. Average 3. Good

Earnings before interest Y1 = $0.5 Y2 = $2 Y3 = $4.0

(equal probability=1/3)

Note (below):

Expected return is calculated ER = 1/3 R1 + 1/3 R2 +1/3 R3

Standard Deviation is:

‘Sum from k=1 to 3 of [ 1/3( Rk - ER)2 ]




Earnings before interest, Yi Y1 = $0.5 Y2 = $2 Y3 = $4.0

.100% Equity (0% Leverage) ( S = $10m equity)Debt interest rB 0 0 0Earnings/Dividends $0.5 $2 $4Return on shares,

Ri = Div/ S 0.5/10 = 5% 2/10 = 20% 4/10 = 40%

Expected Return (standard deviation) = 21.7% (14.3)

Note (not crucial here!):

R = Total Earnings / Total value shares = Div / S

= Earnings per share / Share price = EPS / PS

where PS = S / N




Earnings before interest Y1 = $0.5 Y2 = $2 Y3 = $4.0

..20% Levered (z = B/V = 2/10)(B= $2m debt, S= $8m equity)

Debt interest rB $0.2 $0.2 $0.2Earnings $0.3 $1.8 $3.8

Ri = Div/ S 0.3/8 = 3.75% 1.8/8 = 22.5% 3.8/8 = 47.5%

Expected Return (standard deviation) = 24.6 (17.9)



TRADITIONAL VIEW

There is a debt-equity mix which minimises the WACC and hence maximises the firm’s market value.

MM : ‘PROPOSITION I ’: NO TAXES

The WACC and the value of the firm V are both independent of the debt-equity mix (used in financing the firm’s activities)

SUMMARY SO FAR !


MM ‘PROPOSITION II: NO TAXES

Since the WACC (Rw) is independent of debt-equity ratio,

this implies

cost of equity capital Rs rises with the debt-equity ratio B/S

Note: Re-arrange WACC formula, it can be shown that:

RS = Rw + [Rw-Rb] B/S

Rw is constant (MM-1) and Rw - Rb >0

then Rs will rise as B/S increases.

The intuition for this was given above as the ‘increase in leverage risk’


CONSEQUENCES OF MM(2)

Rs (or Rw or Rb)


Rb

Rw

RS = Cost of equity

Rs = Rw + [Rw-Rb] B/S

Cost of equity rises with rising Debt-Equity Ratio


MM I AND II

WITH

CORPORATE TAXES

( ‘MM-I goes crazy’ )


MM I AND II ‘WITH TAXES’

MM PROPOSITION I (With Corporate Taxes):

For two firms with the same business risk, then the optimal debt ratio that maximises the value of the firm involves 100% leverage (i.e. all debt financed) !

MM Proposition II (with corporate taxes)

There is (still) a positive relationship between the required return on equity in a levered firm and the debt-equity ratio BL /SL.


MM Proposition I (with corporate taxes)

Taxes are paid after deduction of (debt) interest payments.

As you increase the proportion of ‘cheap’ debt finance:

Rs increases (because of increased ‘risk’)but this does not completely offset the lower after tax cost

of the debt finance (1-t) Rb .

Hence:WACC falls continuously and value of a firm (with taxableprofits) reaches a maximum value, at 100% debt finance.


Modigliani-Miller: More RealismModigliani-Miller: More Realism

Financial Distress and BankruptcyFinancial Distress and Bankruptcy


MM (with taxes) + Costs Of Financial Distress

Costs of distress

- ‘legal fees’ and the loss in a ‘fire sale’

- difficult relationship with customers and suppliers

- most efficient workers leave - Football teams, Polly Peck, Rover, M&S, Media and internet co.


As the B/S increases then probability of ‘distress’ will

increase

then Rb and Rs will increase as will WACC, so V falls.

Then there is a ‘theoretical’ optimal debt-equity ratio in

this ‘new’ MM world

- but it requires measuring some very intangible costs !

MM (with taxes) + Costs Of Financial Distress


Figure 11.5 : Value of the Firm(MM-Proposition I with Taxes and Bankruptcy)

.


MM-no taxes

MM-with corporate taxes only

MM-with corporate taxes and bankruptcy costs

Optimal debt-equity ratio

Value of the Firm


More Realism ?: Definitions

Agency costscosts of ensuring that managers (the agents) act in the

best interests of the shareholders (i.e. the owners or principals).

Debt agreements (e.g. for bonds, bank loans) usually contain restrictive covenants(e.g. preclude the managers from investing in high risk ventures)

Bondholders suffer from information asymmetry.


More Realism ?: Issues Ignored In MM Model

COSTLY MONITORING implies debt-holders may require higher Rb as leverage increases.

This increases the WACC and lowers V.


Issues Ignored in MM Model

Perceived probability and costs of distress depends on;

the greater the variability in earnings, the higher the risk of liquidation or ‘distress’

costs of distress will be lower the greater the liquidity and marketability of the firm’s assets

the probability and costs of distress are lower, the higher the proportion of variable to fixed costs (e.g. can you quickly reduce staffing costs)


Shareholders may persuade managers of ‘near bankrupt’ firm to undertake highly risky projects. - ‘go-for-broke’ strategy - this worries bondholders

advertising firm (with few tangible assets as security)

versus leisure firm(with hotels to sell off, to repay bondholders).

The latter has a higher ‘debt capacity’ than the former.

Managers keep debt levels low to get the benefit of an ‘option to expand’ into profitable projects.



Debt levels might influence future cash flows is if they affect managerial incentives. Firms with high leverage, have to meet high interest payments every year.

This may provide incentives for managers to increase productivity, cut costs and concentrate on their ‘core competencies’.

Also, highly leveraged firms may not be able to ‘empire build’ since there are little or no ‘free cashflows’.

Hence, high leverage might increase profits by discouraging ‘empire building’.



‘External’ Factors Influence Debt Levels

The pecking order ‘model’ assumes managers

I) use internal funds (retained profits) first, then

ii) debt (loan and bond) markets and finally

ii) equity markets.

High growth firms invest more than retained earnings and will therefore take up debt and then equity.

Slow growing firms with ‘normal’ profits will not have any debt since there will be enough internal funds for all desirable projects


‘External’ Factors Influence Debt Levels

FI and venture capitalists

might ‘force’ a particular (non-optimal) capital structure on firms. (i.e. correspondent banking relationships and venture capitalists on the board - with their preferred debt-equity mix)

When in financial distress, ‘restructuring is often decided by a diverse group of creditors (usually a consortium of banks ) - e.g. Eurotunnel in 1990s and British Telecom in 2000


No easy practical solutions to the capital structure question once we take into account the complexities of the real world.

Many influences on the perceived optimal debt-equity mix

-the cost of financial distress/monitoring

-agency and incentive problems

- MBO’s and LBO’s (an unsatisfied ‘clientele’ for this type of debt)

- debt restructuring ( forced on companies by creditors)

Debt Levels In Practice: Nothing Fits Well !


END OF SLIDES

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Documents

L03 MBA WACC (Alternativo 1)